What is Pledging of Shares?

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In layman’s terms, pledging of shares is nothing but taking a loan against existing shares that an investor is holding. As shares are considered as assets, this allows the promoters of a company to use their shares as collateral to complete their financial obligations. During pledging of shares, the borrower shall continue to have ownership of the shares and also continue to earn dividends on the same. Shares can be pledged for any purpose including requirement of working capital, new ventures, to trade in the equity market, futures and options, or even personal financial requirements.

As the value of the shares keep changing due to market fluctuations, as does the value of the pledged shares. The promoters have to maintain the value of the collateral as agreed in the contract. If the value of the pledged shares decreases and falls below the amount agreed upon, the borrower will have to increase his collateral either by bringing in more cash, or adding more shares to the already pledged ones. The lenders also have the option to sell off the pledged shares in an event where the borrower fails to pay the collateral value, or make up for a difference in the value.

Pledging is generally considered as a last resort taken by promoters in order to raise funds. A few safer bets available to promoters are through equity funding, or other loans. When promoters turn to pledging their shares, it means that they cannot raise funds by other means.

The Risk behind Pledging of Shares

When promoters pledge their shares as collateral in order to take loans, it might not cause too many problems in a positively trending market, or a bull market, as the market is moving upward, and the investor sentiment is positive. The risk arises when the market starts to fall, that is in the bear market. As the market value of the shares keeps changing on account of market fluctuations, the value of the collateral will also fluctuate as the shares fluctuate. Most contracts will require the borrowers to maintain the amount of collateral. In the case that there is a drop in the value of the shares, the borrower will be required, as agreed in the terms of the contract, to maintain the amount of collateral by pledging more shares, or by bringing in more money. If the borrower is not able to make up for the difference in the collateral amount, the pledged shares will be sold in the open market in order to recover the money.

When pledged shares are sold in the open market, there can be a chance of a great fall in the value of the share. This panic selling by other shareholders will further cause a shortfall in the collateral amount of the borrower. This can be even more disastrous to the borrower, because as the price falls, the borrower will have to pledge more and more shares, or bring in more and more capital to make up for the shortfall in the collateral amount.  Additionally a selloff of pledged shares can lead to a change in the shareholder pattern of the company. This can affect their voting powers in the company, and they may not be able to make critical decisions on behalf of the company.

 Advantages of Pledging Shares

• Lower Interest Rates: When a borrower pledges his shares as collateral, he is granted a secured loan. Secured loans are preferred to unsecured loans as the lender can easily recover the amount borrowed, in an event where the borrower defaults, by liquidating the collateral. It is easier to avail a secured loan, and the interest charged on secured loans is much less than that charged on unsecured loans. Additionally if the borrower has a poor credit history, pledging shares as collateral could be the only way to obtain a loan.
• Easy Access to Cash: Liquidity is the ability to easily convert an asset to cash form. A shareholder who requires cash can obtain liquidity using shares in two different ways. Firstly by selling the shares, however this could result in the shareholder having a tax liability if there is a profit. Additionally the shareholder would lose out on dividend income in case the shares are sold. The second option will be for the shareholder to pledge the shares as collateral, and take a secured loan. The shares aren’t sold, so there is no resulting tax liability, and the borrower will continue to receive dividends from the shares.

 Disadvantages of Pledging Shares

• Shareholder Risk: The main disadvantage of pledging shares is the risk it poses to shareholders. In case a borrower who has pledged shares as collateral defaults on the loan, the lender has the option to sell the shares. If the amount of shares pledged is large, the market value of the share can take a massive fall, and will cause losses for shareholders. If the borrower who has defaulted is a promoter of the company whose shares he had pledged, then the default would take on the appearance of stock sale by an insider, this could show the company in a negative light. This could also cause a fall in the market value of the share.

The final verdict

Pledging of shares generally occurs in companies where the shareholding of the promoters is high. Normally pledging of shares above 50% is considered risky for the promoters.

It is advisable for retail investors to avoid companies who have a high pledging percentage, so as to avoid unnecessary trouble. As pledging of shares shows that the company has a low cash flow, low credibility, high debt, and that they are unable to meet their short term requirements.

Pledging of shares is not always a negative point for a company. A lot of companies are able to recover the pledged amount from their borrowers, and sometimes the amount borrowed is used to better the company itself, including new products, services and even new projects. These can oftentimes create a huge boost for companies.  If companies have a good and increasing operating cash flow, and good future prospects, then it is not a big concern if their shares are pledged. In these cases pledging of shares helps in expanding the growth and revenue of the company. It is not a big problem if the companies whose shares are pledged are a fundamentally sound company.  Shares pledged in small quantities are easy to manage, but the problem arises when there are too many shares pledged.