Share Pledging 101

A recent news article stated that the value of shares pledged by promoters in the BSE 500 companies during the June 2020 quarter declined to 1.95%, from 2.34% in the previous quarter. According to the article, at the end of the June quarter, pledging of shares worth ₹ 1.3 trillion by the promoters took place — less than 1% of India’s total market cap.

Through this post let’s attempt to understand what pledging of shares is and how it affects investors in the company?

What is pledging?

Pledging refers to delivering an asset as security for the payment of a debt – the asset will be subject to forfeiture on failure to pay or fulfil the promise. For instance, in the case of a housing loan, a person can borrow money from a bank / financial institution to buy an apartment or build a house. The collateral, in this case, is the apartment/house itself. The bank / financial institution usually provides a loan of up to 90% of the value of the apartment/house. So if the cost of the house is ₹25 lakhs, usually up to ₹22.5 lakh (25 * 90%) is available as a loan. In case the homeowner fails to repay the loan on time, the lender has a legal right to acquire the property, sell the same and realise the proceeds.

Pledging of shares by promoters

Pledging of shares works in a similar manner, however, instead of a house, shares of a listed company are pledged. Anybody who owns shares of a public company can pledge the same and obtain a loan. However, investors need to take notice of the same when promoters of the company are pledging their holdings.

Investors can look up details of pledged shares on both BSE and NSE website. The data is available under the shareholding pattern heading for each company and will be published once every quarter.

Below is the shareholding pattern for Adani Transmission Limited (ISIN: INE931S01010) for June 2020 quarter.

In the first row, it can be seen that promoters hold 82.39 crore shares in the company and have pledged 29.48 crores of those shares. This is 35.78% of all the shares held by the promoter and 26.81% of all the shares outstanding of the company.

Why do promoters pledge shares?

• Promoters might pledge shares to raise money for personal expenses or to float new businesses not related to the existing ones. 
• Suppose the promoter feels that the share price of the company is undervalued and is confident about the prospects of the company, he might decide to buy more shares from the secondary market. The promoter might then decide to raise necessary funds by pledging his holdings. 
• Promoters might also need to raise funds to exercise warrants. A stock warrant, issued directly by the company, grants the holder the right to purchase a company’s shares at a specific price and a specific date. A promoter interested in buying the shares by exercising warrants might decide to pledge the existing shares to raise funds.
• When a company needs to raise additional funds the promoters might pledge their existing shares as collateral.

How does promoter pledging work?

Let’s assume that the promoters of XYZ Ltd hold a 60% stake in the company. Suppose 1 crore shares are outstanding, a 60% stake means promoters hold 60 lakh shares. The market price of each share is ₹500. So the promoters shareholding is worth ₹300 crore (60,00,000 * 500).

Now suppose the promoters want to raise Rs.100 crore for expanding the manufacturing capacity of the company and are seeking a loan from the bank.

As per RBI regulations, a loan to value (LTV) ratio of 50% is to be maintained at all times when lending based on the stock pledge. Since the proposed loan amount is ₹100 crore, the promoters will have to pledge at least ₹200 crores worth of shares with the bank, this translates to 40 lakh shares. It is also important to note that any shortfall in the maintenance of the 50% LTV occurring on account of the movement in the share prices should be made good within 7 working days.

Now suppose the share price of XYZ Ltd. falls to ₹450 due to poor financial performance. The collateral is now worth only (40 * 450) ₹180 crores and as a consequence, the LTV has increased to ~55% (100/180). The promoters will now be called upon to pledge more shares so that adequate LTV of 50% is maintained. By pledging an additional 4.44 lakh shares, the value of the collateral can be brought upto ₹200 crore. Suppose the price further drops to ₹350, the promoters will have to pledge an additional 17.14 lakh shares. Once the price drops to ₹333, 60 lakh shares will have to be pledged to ensure that the value of the collateral is approximately ₹200 crore, this is the entire stake of the promoter entity.

If at any point the promoters are not able to increase the collateral either by pledging additional shares or by paying cash to reduce the loan liability, the financial institution will sell the shares in the market, realise the proceeds and reduce the loan liability.

Let’s suppose due to extraordinary circumstances the share price of XYZ Ltd drops from ₹500 to ₹250 within a matter of a few days. Even if the promoters pledge their entire stake of 60 lakh shares the collateral will only amount to ₹150 crores and the LTV, in this case, is 66.67% (100 / 150). LTV can be brought down to 50% only by selling the shares, realising the proceeds and using it to reduce the loan amount. If 20 lakh shares are sold, ₹50 crore can be raised. Then the loan outstanding is ₹50 crore (100 – 50) and the pledged value will drop down to ₹100 crore (150 – 50), leading to an LTV of 50% (50/100). However, dumping 20% of the entire shares outstanding of the company into the market will create pressure on share price and it will drop further.

Implications of share pledge on stock price

• As long as the share price of the company is increasing, a high promoter pledge does not pose any risk to the investor. However in a falling market, if the lender resorts to selling the shares, the excess supply will further push down the stock price, exacerbating the investor’s loss. 
• Funds raised by share pledging usually tend to carry higher interest rates and indicates the promoter’s inability to raise funds at cheaper rates. Servicing the interest will eat into the margins of the company and might affect future financial performance.
• Research indicates that companies whose promoters have pledged for the first time tend to manipulate earnings upward, at least during the first year of the pledge. 
• In extreme situations, promoters might also lose control of their company when pledged shares are sold in the open market.

Hence investors have to keep an eye out on the percentage of pledged shares and preferably invest only in companies with low or modest share pledge percentage.

The screener on Tickertape provides a feature that allows sorting companies on the basis of promoter pledge percentage.

The Yes Bank saga and extracting the economic value of the shares

Yes Bank Ltd’s case can be explored to understand how promoters extract all the value of the shares they hold, by pledging the shares, before abandoning or selling their stake in the company.

Yes Bank Ltd was a new age bank and obtained its banking licence from the RBI in 2004. Unlike other banking businesses which had a heavy retail focus, the management of Yes Bank was keen on growing rapidly by tapping the wholesale banking business.

After Rana Kapoor took over the management in 2011 the pace of business expansion quickened. The loan book of the bank grew from ₹34,636.6 crore in 2011 to ₹2,41,286.5 crore in 2019. In fact the loan book almost doubled from ₹1,32,048.7 crore in 2017 to ₹2,41,286.5 crore in 2019. During this period, the bank reported that the non-performing loan amount as a percentage of loan book inched up only to 3.27% from 1.53%. 

Subsequently, RBI audited the books of the bank and identified a large divergence in the non-performing asset (NPA) reported by the bank and the actual number. In Sept 2018, RBI cut short Rana Kapoor’s term at the helm of Yes Bank and asked the bank to draw up a succession plan. In response, the share price of the bank tanked by ~30% in a day.

In the same month, Rana Kapoor had promised that he would never sell shares of the bank.

Following RBI’s adverse observations, in Oct 2018 Yes Bank Ltd’s board recommended that bonuses paid to Rana Kapoor for prior 2 years be clawed back. It also did not propose any new bonus payment and recommended that the salary hike be frozen until the end of 2019.

On March 1st 2019 Ravneet Gill was appointed as the new CEO, replacing Rana Kapoor. 

During this entire time Rana Kapoor, in his personal capacity, had borrowed money from mutual funds and NBFCs by pledging the shares of Yes Bank. However, the transaction was executed in such a manner that Kapoor did not have to disclose the pledging to stock exchanges. According to publicly available sources, between June 2018 – June 2019,  the pledged shareholding as % of total shares held by promoters in Yes Bank was around a minuscule 3.6%. As news of the borrowing started getting out, the bank announced that as of Sept 2019, pledged shareholding as % of total shares held by promoters had reached 35.1%. Between 1st June 2019 and 30th Sept 2019 the stock had lost ~72% of its value.

On 1st Oct 2019, the stock further fell 22.7% due to “forced sale” of 10 crore equity shares, which amounted to 3.92% stake in the bank, by lenders invoking shares pledged with it. By the end of Dec 2019, the promoter stake in the company had fallen to 8.3% from 13.1%, the previous quarter. By the end of March 2020, the stake dropped down to 1.4% and subsequently to 0% in June 2020.

Through various routes, the promoter entity took loans on the basis of the market value of their holding in the bank. In order to ensure that there would be no adverse reaction from shareholders to news of pledging, the fact was hidden and Rana Kapoor publicly announced that he would never sell the shares. When the promoter entity failed to make timely repayment, the lenders sold the shares recovering at least part of the due amount. What the promoters of Yes Bank did was to extract the economic value of the shares without actually selling the shares. It was only the public shareholders who paid a very high price. Between Sept 2018 and June 2020 the stock lost ~93% of its value.

Similar value destruction was witnessed in the case of shares of  Zee Entertainment Enterprise and Granules India. While in the former case, shares were pledged by promoters to fund other businesses, in the latter case shares were pledged to fund business expansion. Hence regardless of the underlying reasons for share pledge, the best strategy one can adopt is to avoid investing in companies with a heavy pledge ratio.

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