What is Pledging of Shares: Meaning & Impact on Stock Valuation
Pledging of shares in the stock market can be a common practice. Pledging is where company shares are pledged as collateral security for obtaining loans from banks and financial institutions. It is common for individuals and companies to raise capital to meet their capital requirements, pay their existing debt, etc.
In this blog, we will discuss how pledging of shares works. Additionally, things to consider before pledging shares of a listed company.
What is Pledging of Shares?
Pledged shares meaning is the practice of using any shares as collateral to secure a loan. In this process, a shareholder or the pledged holdings (the pledgor) provides their shares to a lender (the pledgee) as security for a loan or credit, also called collateral margin. The ownership of the shares remains with the pledgor, allowing them to continue receiving dividends and exercising voting rights. However, if the pledgor fails to meet the loan obligations, the pledgee may have the right to sell the pledged shares to recover the outstanding amount. The pledge of shares as collateral security or margin against shares is used by investors and promoters to access capital while retaining ownership of their shares.
How Does Pledging of Shares Work?
Pledging stocks involves the transfer of ownership of shares from the shareholder to the lender, as collateral security for a loan. The bank or financial institution holds the shares until you fully repay the loan. During this period, it works continues to enjoy the benefits of ownership, such as dividends and voting rights. However, if the borrower defaults on the loan, the lender has the right to sell the shares in the open market to recover the outstanding amount.
Here’s an example to demonstrate how pledging of shares works:
Let’s assume that the promoters of XYZ Ltd hold a 60% stake in the company. Suppose Rs.1 Crore shares are outstanding. Here, a 60% stake means promoters hold 60 lakh shares. So if the market price of each share is Rs. 500, then the promoter’s shareholding worth is Rs.300 crore (60,00,000 * 500). Now let’s also assume that the promoters want to raise Rs. 100 crore to expand the company’s manufacturing capacity and are seeking a loan from the bank.
As per RBI regulations, a loan-to-value (LTV) ratio of 50% is always maintained when lending based on the stock pledge. Since the proposed loan amount is Rs.100 crore, the promoters will have to pledge stocks of at least Rs.200 crore worth of shares with the bank; this translates to 40 lakh shares. One must rectify any LTV shortfall due to share price changes within seven working days.
Why Do Promoters Pledge Shares?
The practice of pledging shares can offer several benefits, including the following:
- Raising Capital: Pledging of shares is a quick and easy way to raise capital without diluting equity. Shareholders can share a pledge to obtain a loan for business expansion, working capital, or personal needs.
- No Need to Sell Shares: Shares pledging can be a good alternative to selling shares to meet financial obligations. By pledging shares, the shareholder can continue holding and participating in the company’s growth.
- Low-Interest Rates: Share pledging can provide a lower interest rate than unsecured loans as the lender has security in the form of shares. Thus, this arrangement can be a cost-effective way to access funds.
- Better Loan Terms: Pledging of shares can help investors and promoters obtain better loan terms, such as lower interest rates and more extended repayment periods.
- Tax Benefits: Interest paid on loans taken against pledged shares is tax-deductible, which can help reduce the borrower’s tax liability.
Impact of Pledging Shares on Stock Valuation
The pledging of shares can have several impacts on stock valuation:
- Market Perception: Investors and analysts may view a high level of pledged shares as a signal of financial stress or lack of confidence in the company. This perception can lead to a decline in stock prices.
- Liquidity Concerns: Pledging shares can restrict a stock’s liquidity. When a substantial portion of shares is pledged, it may pose difficulties in selling those shares on the open market, which can affect the stock’s overall liquidity.
- Volatility: Stocks with a high level of pledged shares may experience increased price volatility. Any adverse news or market fluctuations can trigger a more pronounced impact on the stock’s value.
- Potential for Forced Selling: If the pledgor fails to meet financial obligations and the lender decides to liquidate the pledged stocks, it can lead to a sudden increase in the supply of shares in the market, putting downward pressure on the stock price.
- Risk Assessment: Investors may factor in the level of pledged shares when assessing the overall risk associated with a stock. Higher pledging can be considered a risk factor, impacting the stock’s attractiveness.
How to Pledge Shares?
To pledge shares of a listed company, the shareholder needs to follow these steps:
- Open a Demat Account: The shares must be held in dematerialised form, so the shareholder must open a demat account with a depository participant (DP) to pledge them.
- Sign a Pledge Agreement: The shareholder needs to sign a pledge agreement with the lender, which states the terms and conditions of the loan, including the interest rate, repayment schedule, and the number of shares to be pledged.
- Transfer Shares to the Lender: The shareholder needs to transfer the shares to the lender’s demat account. This can be done either through an off-market transfer or an on-market transaction.
- Create a Lien on Shares: Once the shares are transferred, the lender creates a lien on them, which means the lender has the right to sell them if the borrower defaults.
How Do Non-Promoters Pledge Shares?
Non-promoter pledge involves individuals or entities outside a company’s promoter group using their shares as collateral for securing loans or financing. The Non-promoters may pledge shares to raise funds, fund other investments, or address personal financial obligations. However, it comes with risks, including the impact of stock price fluctuations on pledged shares, potential loss of voting rights, and the possibility of margin calls. Non-promoter pledges can affect a company’s ownership structure and financial stability, underscoring the importance of careful monitoring and management of such arrangements.
Is Pledging of Shares Good or Bad?
Stock pledging provides benefits as well as drawbacks. On the upside, it grants access to capital for different purposes, helping manage liquidity without needing to sell assets and enabling strategic investments. Some promoters utilise the company’s shares to finance other ventures while also benefiting from the dividends provided by the company.
However, some potential risks are higher risk of margin calls, negative market sentiment causing stock price fluctuations, and the chance of losing company control if repayment becomes difficult.
Whether share pledging is good or bad depends on its purpose, management’s ability to manage it effectively, and its consistency with long-term financial objectives.
How to Find Out if the Company has Pledged Shares?
Each promoter pledging shares of a company discloses this in their financial statements. Determining if a pledge of shares of listed company involves examining its quarterly financial reports, which provide information on the percentage of promoter holding and the proportion of pledged shares.
What is Haircut in Pledging of Shares?
The percentage discount applied to the market value of the pledged shares is known as the haircut. The haircut percentage is a risk management measure that lenders use to protect themselves from a fall in the value of the shares. For example, if the market value of the pledged shares is Rs.1,00,000 and the haircut is 20%, the effective value of the shares will be Rs.80,000. This means the lender will give a loan of Rs. 80,000 against the pledged shares.
What is the Unpledging of Shares?
Unpledged shares, meaning the release of pledged shares by the lender after the borrower repays the loan in full. Once the shareholder repays the loan, the system transfers the shares back to their demat account.
Advantages of Pledging Shares
Pledging shares can offer certain advantages, including:
- Access to Capital: Pledging shares allows shareholders to leverage their existing stock holdings to secure loans, providing a source of additional capital for various purposes.
- Retained Ownership: Shareholders retain ownership of the pledged shares, continuing to benefit from dividends, voting rights, and potential capital appreciation.
- Flexible Use of Funds: The capital raised through pledging shares can be used for diverse purposes, such as business expansion, working capital, or personal financial requirements.
- Cost-Efficient Financing: Pledging shares may offer a cost-effective financing option compared to other forms of borrowing, as it utilises existing assets as collateral.
- No Dilution of Control: Unlike issuing new shares, pledging shares does not dilute the ownership or control of existing shareholders, including company promoters.
While these advantages can be appealing, it’s crucial for shareholders to carefully consider the associated risks and terms of the pledging arrangement before proceeding, as fluctuations in share prices or failure to meet loan obligations can pose challenges.
Risks Associated With the Pledging of Shares
While pledging shares as collateral security can offer several benefits, it also involves certain risks that shareholders should be aware of:
- Value of Shares: If the share price falls, the value of the collateral decreases. In such a scenario, the lender may demand additional collateral. The shareholder may also provide additional funds to maintain the required collateral value.
- Loss of Ownership: When pledging shares, the shareholder transfers ownership to the lender until repaying the loan. This can result in losing control over the shares, including voting rights and dividends.
- Margin Calls: Lenders often require borrowers to maintain a certain level of collateral to secure a loan. If the value of the pledged shares drops below the agreed-upon margin, the lender might initiate a margin call. This obligates the borrower to provide more collateral or repay the loan in full. This scenario can pose a serious risk to the borrower, who may lack the necessary resources to fulfil the margin call.
- Forced Selling: In the event of a default, the lender has the right to sell the pledged shares to recover their outstanding amount. This can lead to forced selling in the market, which can cause a sharp decline in the share price and result in significant losses for the borrower.
- Negative Perception: Investors and shareholders may perceive the pledging of shares negatively, as it could indicate financial difficulties or a lack of confidence in the company’s future prospects by the borrower.
To Wrap It Up
To conclude, shareholders seeking short-term funding may find pledging shares a viable solution, providing easy access to funds without selling the shares outright. Nonetheless, this option carries risks, including potential loss of ownership and the possibility of forced sale. Therefore, it’s essential for shareholders to thoroughly assess the advantages and risks of pledging shares in the stock market and fully understand the terms and conditions of the pledge agreement.
As with any financial decision, weigh the pros and cons carefully and consult your financial advisor before investing.
FAQs
Pledge meaning in share market, is the use shares as collateral to obtain loans. It allows individuals and companies to raise capital without selling their shares.
Yes, you can sell pledged shares. However, depending on your broker’s policies, you may need to unpledge the shares first.
The maximum number of holdings you can pledge varies depending on your broker. However, most brokers will allow you to pledge up to 100 holdings.
The margin becomes available on T+1 day for the pledged stocks before 5 pm.
Pledging shares can be a good way to raise capital without diluting equity. However, it is important to manage the risk of the lender selling shares if the share price falls.
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