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Rule #29: Avoid companies where promoters pledged their shares
Companies need money for several reasons.
For example, they need money for conducting day to day business activities. This type of money called Working capital.
In some cases, they need money to fund a project, such as building a factory or a facility.
Sometimes, when interest rates are low, they would money to repay and close a higher interest loan taken earlier.
When companies need money, they reach out to finance companies or banks for the funding.
Loans are given to the company when some assets (such as land or factory) is pledged or given as collateral for the loan.
When companies need money beyond this level, the promoters of the companies would give their shares as the pledge.
The intention is that if the company fails to repay the loan, the finance company can sell the company shares in the market.
When a pledge is put on the shares, the shares will be marked as a lien which means that they cannot be transferred without a removing the lien mark.
Even the promotes will not have control on the pledged shares. And this leads to some less security in the minds of share holders.
Invocation of pledge
When a pledge is invoked, it means that the lender transfers the shares to itself when the borrower fails to pay back the loan.
Invoking means that the lender has exercised his right on security and the shares have been actually transferred from the demat a/c of borrowers to the demat account of lenders.
To that extent the promoters holding has reduced and lender has the liberty to sell the shares at any time and sue the borrower for balance amount.
If the loan is not repaid, the pledgee, after giving notice to the pledgor as per the terms of the agreement, may instruct its DP to invoke the pledge by submitting the "Pledge Form" with a tick on "Invoke Pledge".
On execution of this instruction, the securities are transferred into the pledgee's account. This does not require any confirmation from the pledgor.
As per regulation no. 31 of SEBI (Substantial Acquisition of Shares & Takeovers) Regulations, 2011:-
31(1) The promoter of every target company shall disclose details of shares in such target company encumbered by him or by persons acting in concert with him in such form as may be specified.
(2) The promoter of every target company shall disclose details of any invocation of such encumbrance or release of such encumbrance of shares in such form as may be specified.
(3) The disclosures required under sub-regulation (1) and sub-regulation (2) shall be made within seven working days from the creation or invocation or release of encumbrance, as the case may be to,—
(a) every stock exchange where the shares of the target company are listed; and
(b) the target company at its registered office.
The news of invocation of pledge often leads to panic selling by investors.
Adding fuel to fire, the lender will too will sell the shares he received.
This is because he is at liberty to sell the shares in the open market to safeguard his investment.
So there is a possibility of stock price coming down.
Added to this, the promoter holding in the company too comes down.
All these are not that good for a company and raises the questions on the part of management.
Time Lag for disclosure
When the promoters pledge shares, the information is almost immediately disclosed to the stock exchanges.
However, when the promoter depledges the shares, there is a bit of time lag.
Here is why..
When the promoter repays the money to the NBFC, the NBFC takes some time to get the shares transferred back to the demat account of the promoter. There is no standard time frame specified for this.
A company secretary usually can inform the exchanges about the depledge only after the shares come to the demat account of the promoter.
Hence, though the news of the promoter depledging shares comes out to the public early, the official disclosure often takes more time.
Pledging of shares over leverages the company.
Share pledging is the second level of collaterals given as security for the loan (the first being pledge of fixed assets of the company, such as lands, factories etc)
When promoter shares are pledged, the company is taking loans way beyond the normal course.
Hence, there should a strong reason for utilizing such loan money.
Pledged shares put time-chasing pressure on the company to repay the principal and interest in a timely manner.
Inability to repay will put a bad remark in the minds of investors.
Further, there is a risk that the finance company can sell the shares in the open market and that a competitor would buy them from the open market and then make a hostile take over.
Generally institutional investors will not show interest in investing in companies that are stretched this much.
Question on bank taking pledge
Question: If a company pledges part of its shares, and the market is expecting correction, the bank (or the concerned) loses the money they lend to the company? At the end of the day, the bank would be able to recover only partially. How the bank treats this scenario?
Yes. Pledging is a risky way of taking loan. In general, banks will not sell the holding in open market even though they can do it as long as the promoter repays the loan and interest. However, when the share price of the company falls, the banks will pressure the promoter for additional pleding. Banks usually do not sell the collateral holding unless the promoter is branded as a defaulter. There is a legal process involved and banks generally do not go that extent as a routine thing. But recent experience from Kingfisher is forcing Government to change the defaulter tag norms.
Open your Demat statement.
For each of the companies that you are invested in, find out how much holding is in the hands of promoters. And how much of promoter holding is pledged.
Make some conclusions about it in regard to your portfolio.