Shares Pledging: Meaning, Advantages, and Stock Margin Effects?
In the stock market, shares pledging can be a regular practice. A company’s shares may be pledged as collateral security to banks and other financial institutions in order to secure loans. For investors and promoters looking to raise money without giving up any equity in the company, it can be a good option.
We will talk about the process of share pledging in this blog. Moreover, things to think about prior to shares pledging in a publicly traded company.
Share Pledge: What Is It?
Pledge shares refers to the process of obtaining a loan by putting shares up as collateral. A shareholder, or the pledgor, gives their shares to a lender, or the pledgee, in this procedure as security for a loan or credit. Due to their continued ownership of the shares, the pledgor is still able to vote and receive dividends. In the event that the pledgee is unable to collect the outstanding amount from the pledgor, the pledgee may be entitled to sell the shares that were pledged. In order to obtain capital while keeping ownership of their shares, promoters, and investors may pledge their shares as collateral security.
What Is the Process for Pledge of Shares?
When stocks are pledged as collateral for a loan, ownership of the shares is transferred from the shareholder to the lender. Until the loan is entirely repaid, the shares are held by the bank or other financial organization. It continues to reap the rewards of ownership during this time, including dividends and the ability to vote. But in the event that the borrower defaults on the loan, the lender is entitled to recoup the outstanding balance by selling the shares on the open market.
Here is an example to show how a share pledge operates:
Assuming a 60% ownership stake, the promoters of XYZ Ltd. Promoters would own 60 lakh shares if there were 1 crore outstanding shares, or a 60% stake. Each share costs ₹500 on the market. By multiplying 60,000 by 500, the value of the promoters’ stake is ₹300 crore.
Imagine that the promoters are looking to the bank for a loan in order to raise Rs. 100 crore to increase the company’s manufacturing capacity.
When making a loan based on a shares pledge, the RBI mandates that a loan-to-value (LTV) ratio of 50% be maintained at all times. The promoters must pledge a minimum of ₹200 crore worth of shares with the bank, or 40 lakh shares, in order to qualify for the proposed ₹100 crore loan amount. Keep in mind that any LTV shortfall resulting from share price fluctuations must be fixed within 7 working days.
A poor financial performance causes XYZ Ltd.’s share price to drop to ₹450, lowering the collateral value to ₹180 crores and increasing the loan-to-value ratio to approximately 55%. An LTV of 50% requires the promoters to pledge 4.44 lakh shares. It would require 17.14 lakh more shares if the price dropped to ₹350. Offers 60 lakh shares at ₹333, representing the full promoter stake.
The financial institution will sell the shares in the market, realize the proceeds, and reduce the loan liability if the promoters are unable to increase the collateral at any point by pledging additional shares or by making cash payments to lower the loan liability.
The share price of XYZ Ltd. fell from ₹500 to ₹250 in a matter of days due to extraordinary circumstances. A 66.67% LTV (100 / 150) is obtained even if the promoters pledge their 60 lakh shares because the collateral is still worth ₹150 crores. Selling 20 lakh shares and raising ₹50 crores is required to reduce LTV to 50%. This leaves ₹50 crores (100 – 50) in debt and ₹100 crores (150 – 50) in pledged value. 20% of all shares being dumped could put more pressure on the share price.
Why Do Promoters Pledge Shares?
Pledges of shares can have a number of advantages, such as the following:
- Raising Funds: Offering shares as collateral is a simple and rapid approach to obtain funds without reducing ownership. Shareholders may pledge their shares in order to get a loan for personal, working capital, or business expansion.
- No Need to Sell Shares: If you need to raise money, you might consider using shares pledged as a substitute for selling shares. A shareholder can retain their shares and take part in the company’s expansion by pledging them.
- Low Interest Rates: Since the lender has security in the form of shares, share pledging may offer a lower interest rate than unsecured loans. This kind of funding access may be more affordable.
- Improved Loan Terms: Investors and promoters may be able to get better loan terms, such as longer repayment terms and reduced interest rates, by pledging shares.
- Benefits for Taxes: Interest paid on loans obtained using pledged shares is deductible from taxes, which may lower the borrower’s taxable income.
Effect of Shares Pledging on Valuation
The following are some possible effects of share pledging on stock valuation:
- Market Perception: A high percentage of pledged shares may be interpreted by analysts and investors as a sign of financial strain or a lack of faith in the company. Stock prices may drop as a result of this belief.
- Liquidity Issues: A stock’s liquidity may be reduced by pledging shares. Shares that are pledged in large quantities could make it difficult to sell them on the open market, which would reduce the stock’s overall liquidity.
- Volatility: The price volatility of stocks with a high number of pledged shares may be higher. Any unfavorable news or changes in the market may have a more noticeable effect on the stock’s value.
- Possibility of Forced Selling: Should the lender choose to liquidate the pledged stocks due to the pledgor’s failure to fulfill financial obligations, this could result in an abrupt rise in the number of shares available on the market, which would lower the price of the stock.
- Risk Assessment: When evaluating the total risk attached to a stock, investors may take the number of pledged shares into account. Greater pledging may be viewed as a risk factor that reduces the stock’s appeal.
How can I find out if shares of the company are pledged?
A company’s financial statements reveal this information for each promoter who pledges shares. A company’s quarterly financial reports, which reveal the percentage of promoter holding and the proportion of pledged shares, can be used to determine whether or not the company has pledged shares.
How Can I Pledge Shares?
A shareholder must take the following actions in order to pledge shares of a listed company:
- Open a Demat Account: In order for shares to be pledged, they must be held in dematerialized form. The shareholder needs to open a depository participant (DP) demat account.
- Sign a Pledge Agreement: The lender will require the shareholder to sign a pledge agreement outlining the terms and conditions of the loan, such as the interest rate, the repayment schedule, and the quantity of shares that must be pledged.
- Share Transfer: The shareholder must move the shares to the demat account of the lender. This can be accomplished through an on-market transaction or an off-market transfer.
- Lien on Shares: Upon transfer of the shares, the lender places a lien on them, entitling it to sell the shares in the event that the borrower defaults on the loan.
What Does “Haircut” Mean in a Share Pledge?
The haircut is the percentage that is deducted from the market value of the pledged shares. Lenders use it as a risk management strategy to shield themselves from a decline in the share price. For example, the effective value of the shares will be Rs. 80,000 if the market value of the pledged shares is Rs. 1,00,000 and the haircut is 20%. In light of the pledged shares, the lender will provide a loan of Rs. 80,000.
What Does Share Unpledging Mean?
Unpledging of shares is the process by which a lender releases shares that have been pledged once the borrower has fully repaid the loan. The system returns the shares to the shareholder’s demat account after the shareholder repays the loan.
Benefits of Share Pledges
There are a few benefits to pledging shares, including:
- Access to Capital: By using their current stock holdings as collateral for loans, shareholders who pledge their shares can obtain additional capital for a variety of uses.
- Retained Ownership: The pledged shares remain the property of the shareholders, who will also continue to get dividend payments, voting privileges, and the possibility of capital gains.
- Flexible Use of Funds: The money raised through share pledges can be put toward a variety of goals, including personal expenses, working capital needs, and business expansion.
- Cost-Effective Financing: Since pledging shares uses your current assets as collateral, it might be a more affordable financing option than other borrowing options.
- No Dilution of Control: Pledges of shares do not reduce the ownership or control of current shareholders, including company promoters, in contrast to the issuance of new shares.
Although these benefits may sound good, it’s important for shareholders to carefully weigh the risks involved and the terms of the pledging arrangement before moving forward because things like share price fluctuations or loan default can become problems.
Risks Associated With Shares Pledging
Shareholders should be aware of the following risks when pledging shares as collateral security, even though there are many advantages to be gained:
- Share Value: The value of the collateral declines if the share price drops. The lender might request more collateral in such a case. In order to keep the necessary collateral value, the shareholder might also need to contribute more money.
- Ownership Loss: Upon pledging shares, the shareholder gives the lender ownership of the shares until the loan is repaid. Loss of control over the shares, including dividends and voting rights, may follow from this.
- Margin Calls: Lenders may require borrowers to maintain a certain level of collateral value in order to secure the loan. The lender may issue a margin call if the value of the pledged shares drops below the predetermined margin. This implies that either the borrower must offer more collateral or make the entire loan repayment. The borrower may not have the funds to cover the margin call, which presents a serious risk.
- Forcible Sale: The lender is entitled to sell the pledged shares in order to recoup the outstanding balance in the event of a default. This may result in forced sales in the market, which might send the share price plummeting and cost the borrower a lot of money.
- Negative Perception: The pledge of shares may be interpreted negatively by shareholders and investors as a sign of financial difficulties or a lack of faith on the borrower’s future prospects for the company.
To Conclude
For shareholders who need money quickly, pledging shares can be a good option. Without having to sell shares, it provides easy access to money. It does, however, come with risks, including the potential for forced share sales and ownership loss. It is imperative that shareholders thoroughly weigh the advantages and disadvantages prior to making a share pledge in the stock market and that they comprehend the terms and conditions of the pledge agreement.
Finally, it should be noted that share pledging is a typical financial strategy in the stock market. Analyze the benefits and drawbacks thoroughly and, if necessary, consult an expert before making any financial decisions. Smallcase is another option for professionally assembled pre-made portfolios.
FAQs About Share Pledging:
What is Share Pledging in the Stock Market?
In the stock market, a share pledging refers to using shares as security for loans. As a result, businesses and individuals can raise money without having to sell their stock.
Can I sell the shares I pledged?
It is possible to sell pledged shares. However, depending on the rules set forth by your broker, you might have to unpledge the shares first.
How many distinct holdings can I pledge in total?
Depending on your broker, there may be a maximum limit to the variety of holdings you can pledge. Nonetheless, the majority of brokers permit you to pledge a maximum of 100 distinct holdings.
When will I receive the margin after pledging my shares?
For stocks pledged before 5 pm on T+1 day, the margin becomes available.
Is Shares Pledging good?
A useful strategy for raising money without reducing equity is to pledge shares. In the event that the share price drops, it’s crucial to control the risk that the lender will sell some of the shares.
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