What is Pledging of Shares? Why it is Dangerous for Investors?

By Trader Pit

July 9, 2021


Pledging is similar to the conventional process of placing an order at a stock exchange, then buying or selling stocks at a later date. Pledging allows investors to buy or sell stocks at a later date, and only pay a portion of the cost at that time. This technique is used by investors to avoid the fluctuations in the stock market by receiving a more stable rate of return. However, there are many risks involved, such as:

What is Pledging of Shares? Why it is Dangerous for Investors? Pledging or pledging shares is a method of raising capital that was legalized in the U.S. more than a decade ago. Since then, it has spread globally and is useful for certain types of businesses. Pledging shares is complicated, technical, and difficult to understand for the typical investor. It involves sophisticated financial arrangements and sophisticated legal jargon. That said, pledging of shares is not illegal.

Understand what a pledge of shares is or a pledge of shares : When looking for stocks to invest in, stock safety is one of the many important factors to consider and is often overlooked by many investors. A large number of pledged shares may raise concerns among shareholders. In this article, we’ll look at what exactly a stock pledge entails and why highly pledged stocks can be unpleasant for investors.

This will be an interesting article and I am sure you will learn a lot about pledging shares. So make sure you read this article all the way through. So, without wasting time, let’s get started.

1. What is a pledge on shares?

Simply put, pledging shares is obtaining a loan secured by the shares a person owns.

Shares are considered as assets. Pledging shares is a way for company founders to get loans to meet their business or personal needs by lending their shares as collateral to lenders. The equity guarantee can be used to meet various needs, such as B. for working capital, financing of other businesses, new acquisitions, personal obligations, etc.

2. Why do property developers pledge their shares?

As described above, founders pledge their shares to meet various business or personal needs.

Pledging shares is usually the last option for promoters to raise funds. For founders, it is relatively safer to raise funds through equity or debt financing. However, if promoters want to pledge their shares, this means that all other fundraising options are closed.

These situations occur in times of economic downturn. Since the shares are assets of the founders, they can be used as collateral to obtain loans from banks.

Also read :

3. Why is pledging shares risky for shareholders?

When shares are pledged, promoters use their shares as collateral to obtain secured loans. During a bull market, it may not be a big deal to get out of stocks because the market is rising and investors are optimistic. However, it becomes problematic in a declining market or when economic growth slows.

Since the price of shares fluctuates constantly, the value of the collateral (for the secured loan) also changes with the changes in the price of shares. In most cases, however, the founders are required to maintain the value of this security.

If the share price falls, the value of the guarantee also falls. To cover the difference in the value of the loan, the promoters have to cover the shortfall by providing additional money or by pledging additional shares to the lender.

 

  Value of mortgage (on receipt of loan) Value of mortgage after 30% fall in share price Value of mortgage after a 50% fall in share price
Real-time costs 100 kr. 70 million. 50 Kr.
Comment No output Additional partial obligation to cover the difference of the remaining 30 crowns Allocation of higher shares to cover the remaining difference of Rs. 50 million.

In the worst case, if the promoters fail to make up the difference, the lender can sell the pledged shares in the open market to get his money back. This minimum value of the loan is laid down in the agreement between the creditors and the founders. It therefore gives the lender the right to sell the pledged shares if their value falls below the minimum.

4. What is the risk to retail investors of pledged shares?

Overall, the share price could fall sharply on news that the lenders are selling the shares pledged by the company’s sponsors on the open market. This could lead to a further decline in the value of collateral due to panic sales by the public.

Moreover, the sale of shares pledged by creditors may lead to a change in the company’s ownership structure. This may affect the voting rights of promoters, as they now own fewer shares, and their ability to make important decisions.

Moreover, the bailout could have disastrous consequences if stock prices continue to fall. This is because the promoters have to keep pledging shares to cover the difference in value of the loan.

5. How do I find information on equity deposits of Indian companies?

You can find information about depositing shares of any listed Indian company using any of the following two methods.

METHOD 1:

You can find the pledged share as a percentage of total pledged shares on the website of BSE or NSE. Listed companies must provide quarterly information on their shareholder structure to the stock exchanges. For example, the BSE/NSE website provides up-to-date information on their ownership structure.

Here are the exact steps to find shares for Indian public companies.

  1. Visit the BSE India website.
  2. Search for the company name in the top search bar.
  3. Click the Shareholder Structure tab on the left sidebar of the Company Page.
  4. Open the latest quarterly report on shareholder structure.
  5. You can find a summary statement of ownership of specific titles.

For example, you can see here the holding pattern for Suzlon Energy shares for the March 2021 quarter. Note the current pledge of the share (88.54%) by the promoters.

METHOD 2:

This portal provides latest information on shareholding structure and pledged shares of all public companies in India. This is a relatively easier and faster way to find committed shares.

Here are the steps to follow to locate a stock pledge through the portal:

  1. Access to the portal
  2. Search for the company name in the top search bar and open the company page.
  3. Go to Share Ownership Structure and search for pledged shares.

Here, for example, is the shareholder structure of Suzlon Energy on the portal. Here we can observe that pledged shares for promoters were 88.54% for the quarter of 21. March.

Also read : How do I find a complete list of stocks listed on the Indian Stock Exchange?

6. Baseline

Equity pledges typically occur in companies with high promoter ratios. In general, pledging shares of more than 50% can be risky for sponsors.

Always ignore companies that promise lots of action to avoid unnecessary problems. Indeed, pledging shares is a sign of poor cash flow, a low credit rating of a highly indebted company and an inability to meet short-term needs. (If sponsors have committed a high percentage of shares, it is always useful to know why).

 

Short note
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In any case, a decline in the number of shares pledged over time is a good sign for investors. On the other hand, a growing equity deposit can be dangerous for promoters and shareholders. Even quality companies can be victimized if the share guarantee does not diminish over time.

However, pledging shares is not always bad for companies. In many cases, companies are able to develop new products, services, etc., which allows them to make a turnaround with a loan against the pledged shares. If the company has a growing operational cash flow and good future prospects, pledging shares is not a major problem for the company. In this case, the pledging of shares enables the company to expand or to carry out new projects, which leads to higher revenues in the future. Furthermore, the pledging of 5-10% of shares in fundamentally sound companies should not be considered a problem. Smaller pledged shares can be managed efficiently. However, the problem arises when the guarantees increase too much.

In any case, the point is to avoid investing in companies with high (or increasing) equity.

So much for this post. I hope this was helpful. Have fun investing!

Hello, my name is Kritesh (Tweet me here), I am a certified fundamental equity analyst with NSE and an electrical engineer (NIT Warangal) by profession. I am passionate about stocks and have spent the last four years researching, investing and teaching people how to invest in the stock market. That’s why I like to share my knowledge with you. #HappyInvesting

Frequently Asked Questions

What is pledging of share?

Pledging of share is the act of selling or transferring ownership of a share in a company to another person or entity.

What happens if I don’t pledge my shares?

If you don’t pledge your shares, you will not be able to vote for the next board of directors. If you don’t vote, you will not be able to receive any dividends until the next election. What happens if I pledge shares to a new company, but then decide to sell those shares? If you pledge shares to a new company, but then decide to sell those shares, you will be able to vote for the next board of directors if you donate the shares back to the company. If you sell your shares, you will not be able to vote for the next board of directors.

How does a share pledge work?

A share pledge is a legal contract between a company and its shareholders that obligates the company to issue shares to the shareholders. Share pledges are typically used when a company is going public and needs to raise money.

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About the author

Trader Pit

A yogi who like Finance and Technology. I have been in Indian Stock market for over 12 years now as financial analyst, portfolio manager, trader. Now, I focus on Yoga, Financial Education & Long term investing. 

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