Pledging shares

Promoters intending to use their holdings as collateral should offer ordinary shareholders the right of first refusal

By Mohan Sule

A market reeling under negative news is ready to believe the worst of companies whose promoters have used their stake to raise funds. The issue of pledged shares had flared up first during the downturn following the global economic meltdown of 2008-09, when promoter Ramalinga Raju was found to have borrowed against his holdings in Satyam Computer Services. One company even changed hands on the failure of the promoter, who had used his entire stake in the company as collateral, to buy back the shares. Pledging shares against loans is not the exclusive practice of promoters. Even small investors use their portfolio to meet emergency needs or as a leverage to make further investments. The problem starts when the market begins its slide, depreciating the value of the pledged shares. Earlier, small investors had no way of knowing about these off-market deals till Sebi late January 2009 ordered disclosure from companies whose promoters had pledged more than 25,000 shares or 1% of the company’s equity, whichever is less, in a quarter. Instead of calming the market, the move towards transparency has made matters worse. There is stampede to liquidate stocks whose promoters have pledged shares. So promoters face a dilemma. If they pledge shares to meet working capital requirement, a common reason, the revelation defies the purpose as the value of the collateral undergoes a rapid slide, thereby making the task difficult. Promoters who want to pledge their holdings to raise funds for consolidation of their ownership or acquisitions may find the tables turned: from being hunters they become preys. The lender may sell the shares even to competitors to get a good price though their market price may have eroded substantially post disclosure.

The irony is that most promoters pledge their shares during a bull run rather than a bearish phase. Getting a good price is part of the reason. This is the time when they need funds to undertake expansion or diversify. Going through organised channels is time consuming, requiring subjecting their companies to due diligence. Or the institution may have exhausted the sector quota. Besides, too much loan skews the debt-equity ratio and makes the company vulnerable to swings in interest rates, going forward. Issuing fresh equity leads to dilution of earning, especially for long gestation projects, as well as controlling stake. Instead, pledging of shares can be quick. For the lender the upside is that instead of holding stocks that may turn dud when the bull bubble is pricked, he can make a neat profit from the pledged shares by selling them to rivals. This is what happened in the case of Great Offshore. But this is a lose-lose situation for the retail investors. First, the news itself creates panic in the belief that the promoter is in trouble. Not all promoters pledge their shares for official reasons. They may need funds in their personal capacity. Many small investors take exposure to a company because of the comfortable promoter holding. According to market wisdom, higher the promoter holding, greater is his commitment to the company. The prospect of the promoter losing his grip, therefore, is worrisome for these investors. Reduction in their equity can also curb promoters’ decision- making and execution prowess.

In view of the unease of ordinary investors, promoters of late are opting for private placement, thereby setting a benchmark price for the stock. This route also bolsters investor confidence in the company. Those investors worrying about earning dilution get an opportunity to exit at a premium. A follow-on offer or a rights issue allows investors to take fresh exposure, invariably at a discount. The lower price also acts as a floor for those who want to quit. Though a burden, debt is seen necessary for capital-intensive companies to grow business. At least there would be some long-term gain, goes the logic. Pledging of shares signifies loss of confidence by institutional investors and lenders in the promoter or in the reasons for mopping the resources. The market views it as an act of selfishness of the promoter, who wants to maintain his holding and, at the same time, raise money. It also means existing shareholders have to gear for a free fall in the stock’s price soon after the disclosure. Only a hostile takeover can reverse the course. Making promoters to go public of their pledged holdings is a welcome but just the first step in protecting ordinary shareholders’ interest. Sebi must now make it mandatory for promoters to give ordinary shareholders the right of first refusal. The offer, at about prevalent market price, should come with a call option. Failure to redeem could give strategic investors or competitors an opportunity to bid for the shares. This would ensure a safety net as well as boost valuations in the long run. Not only promoters, even ordinary shareholders would be in a win-win situation.

Mohan Sule