Understanding the pledged share fiasco in India

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If you are a reader of business news one term you must have heard a lot recently is pledged shares. The term has gained infamy over the last few months with even good firms with high proportion of shares pledged seeing significant downward movements. In today's post we understand what pledged shares are, why they are used, and their implication on firms and stock price.

Let us start by understanding what pledged shares are. Promoters often need loans often for themselves for personal purposes or for the firm for various liquidity needs. A recent RBI report pointed out that an overwhelming amount of these were for personal use of the promoter. When the promoter decides to get these loans keeping shares that they have as collateral, these shares are said to be pledged. This would in a way make the loan more secure for the person who is lending, enabling lower rates as well as extension of credit in cases where it otherwise wouldn't have been possible. In a country where promoters continue to retain mid to high double digit shares in the company well after listing, this proves to be a good source of funding. The credit squeeze in India made unsecured lending tougher and costlier, leading to a further rise in pledging shares for loans.

So where does the issue arise. Well, shares are volatile and every time the share price goes down the value of the collateral put up in the form of shares goes down as well. If the value goes below a certain level, the promoter has to make up for the difference with an additional infusion of shares. If they are unable to do so, the lender reserves the right to sell the shares in open market. Every one of these steps has negative share price implications. The looming threat of the lender selling shares in the open market creates a downward pressure on the stocks. As promoter pledges away more and more of their shares (this needs to be disclosed quarterly), investors also begin to worry about loss of control for the promoter. The downward moving prices increase the quantum of shares that require to be pledged thereby entering a vicious cycle.

So where do we stand now. The loans against pledged share stands at around 2.25tn INR, a significantly high amount but off its historic highs of around 3tn INR. Firms that have seen an increase in pledged share percentage have seen a massive amount of shareholder value destruction, and promoters of some of India's largest companies have in many cases been reduced to small positions, in many cases losing control of their companies. It is important for all parties involved to take a step back and analyze this better. Investors need to monitor it to understand the implications on the short term due to short term selling, as well as long term due to change in control. Lenders who in this case are largely NBFCs and Mutual funds need to do a better assessment of the amount of margin of safety (lenders have already begun increasing cover: i.e. The amount of collateral they need to give out a certain amount of loan) they would need as well as potential risk mitigation tools that can be used on such loans given the high volatility and price crashes some of these shares have seen. And promoters need to be careful in the extent to which they tap into pledged shares as a source of funding. And if players do not move towards moderation by themselves, and it is increasingly looking like they won't, there is always room for the regulator to come in and tighten things up a bit.

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