Promoter pledging - a boon or a bane? - Views on News from Equitymaster

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Promoter pledging - a boon or a bane?

Jul 4, 2013

When you go to a bank to avail a loan, you have an option to take a loan against shares. The banks offer loans up to a certain percentage of the value of shares held in your demat account. In essence this is exactly what promoter pledging is all about. Only in this case it is the promoter of the company using his shares in the company as collateral to take a loan. The loan could be for the promoter's personal needs. Or could be funds redeployed by the promoter into the business.

What is the risk for an investor?

As such this is not a bad thing. After all the promoter needs funds and is using his shareholding in the company to do so. If these funds are redeployed into the main business then it should bode well for the company. For it provides another source of funding. Though the question does remain why were other sources of funding not availed by the company? On the other hand, if the loans are being taken for the promoter's personal needs then it should be treated as a warning signal.

But in either case, promoter pledging is something we have time and again highlighted as an investment risk for a stock. In our opinion, pledging of the company's shares by the promoters increases the risk for the stock. We believe that high promoter pledging can lead to high volatility in the stock price.

Why? Let us try and explain the problem related to promoter pledging through an example. Let us assume that the promoter of a hypothetical company A decides to pledge 10% of his shares. Let us also assume that when this happens, the price of A's stock is Rs 100 per share. The bank may set a level to which if the price falls, then the promoter would need to repay the loan or pledge more shares. In our example let us assume that price is 20% lower. In a few months time, the price of A dips to Rs 80. At this point in time, the bank could ask the promoter to repay some loan or pledge more shares to make up for the loss in collateral value. If the promoter chooses not to repay or is unable to do so then he would be compelled to increase the pledging to 20% of his total shares. The process could go on till the pledging reaches 100% or the promoter decides to repay the loan.

This is where the catch lies. If the promoter is unable to pay the loan or pledge any more shares then the bank has the right to sell the shares in the open market to recover the loan. A bulk sale of this sort could send prices crashing. Think of how that would affect the shareholdings of the investors. Such an event reflects poorly on the promoter as well as on the company because it questions their ability to repay their loans. As a result, the prices may not bounce back any time soon.

What next?

The above example makes it clear that promoter pledging can turn out to be a major investment risk. Therefore investors would do well to check the level of promoter holding that a company has. SEBI (Securities and Exchange Board of India) has made it mandatory for companies to disclose the information on their promoter pledged shares. This information is available with the stock exchange and can be accessed from the exchange website.

We at Equitymaster have developed a screener for investors to see companies which have high level of promoter pledging. Following are the top 10 companies with very high level of promoter pledging.

Name of the stock Pledged Promoter Holdings (%)
Eastern Silk Industries 100.0
Paramount Communications Ltd 100.0
Subex Ltd 100.0
Asian Hoteld (North) 99.6
Samtel Color Ltd 99.2
Amar Remedies 99.0
ICSA India 98.7
United Spirits Ltd 97.9
Plethico Pharma 97.8
Suzlon Energy 97.7
Data Source: Equitymaster database
Though promoter pledging is a big risk, but like every other screener one needs to remember that the purpose of these screeners is to present the universe of stocks that pass or fail on a particular criteria. Companies without any promoter pledging record cannot be deemed to be good. One still needs to analyse the performance record, management credibility and future prospects before making the final buying or selling decision.

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