Explanation of Pledging of shares
The concept of pledging of shares by promoters is not new to India but it caught the attention of investors only after the Satyam debacle and also due to companies going bankrupt.

Promoters, in order to raise funds for either personal or company needs, pledge their holding shares to any financial institution. Non-banking financial institutions are more active than banks in providing such loans.
There can be several reasons. It can be for either personal needs or business expansion.

Sometimes, promoters collateralize their shares for converting warrants into shares.

For instance, KS Oil borrowed Rs 50 crore to raise money required for conversion of warrants into shares. Also, they might find share prices in the secondary market quite lucrative for fresh purchase and adopt this route for garnering funds for the consideration to be paid for open market purchase.
What are the disclosure norms?
In developed countries like the US, not just promoters but directors too are required to disclose their pledged shares. In the UK this is covered under insider trading regulation.

But in India, until recently when Securities and Exchange Board of India made it compulsory for promoters to disclose their pledged shares, there were no disclosure norms.

However, post Satyam debacle, Sebi has made it mandatory for promoters and promoter groups to disclose the details of pledging of shares of their listed entities. Under this guideline, apart from disclosing whenever shares are pledged, promoters are also supposed to disclose it periodically.

Respective stock exchanges are to be informed about the details of share pledging.
What is the risk to promoters?
Bankers or financiers give loan taking the shares as collateral. Hence, whenever the prices of shares come down to a certain level in the secondary market, the promoter is required to either make some payment or pledge more shares. If the promoter cannot do either, the lender keeps the right to sell pledged shares in the market. Apart from this, promoters always have the risk of a hostile takeover.

What cues does it send to investors?
If promoters raise the money for the betterment of the business, investors should take it positively but if the money is raised for any personal needs, it imparts negative signal. Even if the funds are raised for improving the business it indicates a liquidity problem.

What is the difference between pledging of shares by general shareholders and promoters?
Banks and financial institutions give loan against shares. To avail such loans any shareholder can pledge shares to the lender. But unlike promoters, small shareholders are not required to disclose. For taking a loan against shares, the investors have to collateralize the physical shares to the bank.
As on 31 March, 2015, there were 25 companies in which the entire promoter holding (100 per cent) was under pledge, 77 companies with more than 90 per cent promoter pledge and around 200 companies with more than 50 per cent promoter pledge.

High promoter pledge can play havoc in a counter if the price continues to fall and we have seen instances like that in the past.

If the promoter obliges, the pledging as a percentage of promoter holding will go up and this may negatively affect the sentiments further.

If the promoters can't give more margins, the institutions may sell the stocks in the market to recover their money and this will result in sudden fall in price. A forced sell may result in change in management also.

There are some large-cap companies (with a market cap of Rs.5,000 crore or more) in the list. For example, Suzlon Energy is among the top 10 companies with maximum pledges. It has 98.56 per cent of its promoters' holding under pledge (see table). There are also nine large-cap companies where the promoter pledges are more than 50 per cent of their holdings.
One of the way is to stay away from such stocks. There are so many other good stocks in the market. It is better for retail investors to stay away from these stocks, especially where the promoter pledge is more than 50 per cent,

There are technical factors also working against these counters. The promoter pledging will only make the counter more volatile. "Even when the fundamental is good, the corrections in these counters, whenever it happens, will be more. Investors need to be extra careful when the promoter pledging is high.

Risk takers, however, can still invest in them provided they do proper research. Our advice to those investors is to study following factors before buying such stocks:-
1) Check the reasons behind the share pledging
It is fine if the pledging has been done in the interest of the company. Sometimes, banks ask promoters to pledge their holding in the company to get project or working capital funding for the company. This only shows the commitment by the promoters to the company. And since it is treated only as additional collaterals, there is very little chance of banks selling these shares if the share price comes down in the open market.

2) However, investors should avoid the company if the pledge is for the promoter's personal use, for example to invest in other businesses. Investors also need to take a closer look to find out who is pledging the shares-core promoters or someone in the distant family, who is also clubbed as promoters due to regulatory reasons. If it is not the core promoter, there won't be any strategic incentive to retain the holdings and if the price continues to fall, the same share may come to the market for sale.
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