Don't sell off in a hurry, find out why the promoter has pledged shares

While pledging is usually a sign of financial distress, sometimes the promoter may be raising capital he can deploy for attractive returns

When the news of a company's promoter pledging his shares for the first time — or of him raising the level of pledged shares even higher — hits the market, investors usually perceive the news negatively. Experts suggest that they should investigate the reasons behind pledging before they react.

A recent report by Kotak Institutional Securities says the percentage of pledged promoter holding (as a percentage of total promoter shares) fell to 7.8 per cent in December from 8.3 per cent in September 2017 for BSE 500 stocks. Such reduction in pledged shareholding is positive news, as it signals improvement in promoters’ financial health. But what happens when the reverse happens and the promoter pledges more of his shares, as was the case with many stocks in the BSE 500 in the December quarter (see table)? How should investors react then?

When a promoter pledges a large percentage of his shares, it makes the stock riskier. Suppose that the market tanks due to extraneous reasons, driving the share price down. The lender will demand more shares or cash as collateral. If the promoter is unable to meet the demand, the lender takes possession of the pledged shares. If he sells them to recover his loan, the higher supply of stocks amid weak market conditions could trigger a further fall. "The risk-reward ratio is highly skewed against the investor in a stock where the level of pledging by the promoter is high," says Shailendra Kumar, chief investment officer, Narnolia Securities. Investors need to be cautious about any stock where the level of pledging is above 25 per cent, he says.

Sometimes, a high level of pledging can be an indicator of mala fide intentions. "The promoter may know that he is in a debt trap from which he can't escape, or he may not be interested in the business. In such cases, he may pledge shares as a means to pull money out of it," says Nalini Jindal, chief investment advisor, Intellistocks. The promoter may be aware that his company is not in good health or that he has cooked the books. He knows that the current stock price does not reflect its true state, and hence wants to benefit from it at the earliest. If he sells the shares, prices could drop dramatically and he may have to meet insider-trading norms.

How then does he convert the shares to cash without moving prices, before the rest of the market learns the bad news? One option is to pledge shares. Once information about the company’s poor financial health comes out, the share price will drop and the lender will ask the promoter for more collateral. But the promoter may have no intention of doing so. Then it becomes the lender’s responsibility to recover the money. "This is outright fraud and could be a reason why prices drop when share pledges by promoters are announced. In the aftermath of Satyam, the market largely assumed that this was the case," says Ramabhadran Thirumalai, clinical assistant professor of finance at Indian School of Business.

But sometimes promoters pledge shares to raise capital for increasing their stake in the company. In high-growth sectors, they do so to raise money for expansion, or to fund a project from which they expect attractive returns. Such cases indicate the promoter's faith in the company's long-term prospects.

Investors should react positively in such circumstances.

Whenever lenders invoke the pledged shares (sell them to recover money) or when pledging rises beyond 50-60 per cent of the promoter's holdings, investors should exit the stock.