The flavour of the season, the buzzword of the month and the topic of discussion with many in and out of equity markets is the pledging of shares. Something that was routine to the point of being banal is now being seen as the big bogey.

It is not surprising to overhear, people whispering in scary tones, the fact that promoters of the Tata Group had to pledge shares to raise funds.

?If the Tata group needs to do this, then what must be the state of other Indian corporates,? said one executive to another with the right erudite air.

But then, this fear-provoking view is not without reason. Promoters of Satyam Computers had pledged shares with financial institutions for loans. And when the share prices started tumbling after the failed bid to acquire another group company Maytas, the institutions started selling these shares. And then, the scam unfolded and the share prices dived further.

?This entire episode has created a negative mindset against the action of share pledging done by promoters,? says a relationships manager with a global wealth management firm.

?I have been speaking with a lot of clients who have been pressing to sell shares of pristine and valuable companies, just because their promoters have pledged shares. There is no logic to this harsh action but simple emotion. I have a tough time convincing them,? he sites his plight.

Now that the Securities and Exchange Board of India, the capital markets regulator, made it mandatory for companies to disclose the amount of shares pledged by the promoters on an ongoing basis, several companies have come out and disclosed these numbers. According to estimates, more than 310 companies have now disclosed these numbers and the amount of shares pledged at the moment is around Rs 35,000 crore (roughly $7 billion).

A Morgan Stanley report calculates that the amount raised through pledged shares is about 1.1% of the current market capitalisation of the country. ?Assuming 50% margin, the bank credit to these promoters at $3.4 billion is 0.6% of outstanding bank credit,? the report adds. And, the count increases by the day.

Undoubtedly, such a huge funds raised through share pledging comes as a surprise for a few. For others, it is routine. ?Raising funds by pledging shares with financial institutions is not a new thing in India or overseas. Disclosing these transactions is definitely new, so there is bound to be anxiety,? says a senior partner with a major accounting firm.

The reasoning

This anxiety too is not without reason. Seeing the market boom since 2003, several promoters sought the route to pledge shares and raise funds. Some of them played the markets and some used these funds to feed their ambitions through acquisitions. The fact that many companies played the markets can be seen from the fact that the component of other income, which comprises of earnings from non-core activities like share trading and profit from sale of assets, was around 30% of the profit before tax. Now that the markets have tanked and many asset classes corrected, pledging shares to play the markets can be extremely risky. Also repaying of loans for acquisitions can cause pain as the share price of the pledged companies have also come down.

Typically, promoters would pledge their shares with financial institutions for meeting short-term funding requirements. The reasoning was simple. The shares held by promoters would be lying idle with them. By pledging these shares, promoters could raise monies at lower rates. Banks typically would hold a margin and then lend money at easy rates. After all, these companies are listed entities and therefore have to carry out the required due diligence set out by the exchanges and the regulatory authorities. Thus, for a Rs 100 share, the bank would keep a margin or around 20% to 50%, depending on the reputation of the company and loan the remaining.

The banks would then keep tracking the price and in case the shares dipped below the margin set by the bank, the promoters would have to make good the difference. A Balasubramaniam, chief investment officer at Birla Sun Life Asset Management, reckons, ?Pledging of shares by a promoter is not a crime, especially if the funds used are for building the business further. Pledging is mostly practiced for getting a loan for growth of the company, making it difficult to judge if the impact will be good or bad.?

But then, there are several promoters who have taken wild bets during the boom phase and are now finding it difficult to carry these plans out. And, like Ramalinga Raju said, ?I was sitting on a tiger and did not know when to get down. If I got down, the tiger would eat me up.? Similarly, several promoters are stuck with their plans and can neither give the projects up nor continue with them as lending norms have become stricter and financing a big problem.

Sifting through the chaff

For investors, however, the thing to remember is that there are no common rules to judge a company whose promoters have pledged shares. However, there are several questions that the investors should be aware off.

One of them is clearly knowing the extent of shares pledged by the promoters. Here, one could look at the pledge as a percentage of the share capital or even as a percentage of the promoters holding.

Kenneth Andrade, vice-president, equity, IDFC Asset Management, feels ?Share pledging has different implications in the case of different companies. It could be a cause of concern for investors if a large stakeholder who has pledged shares is running the risk of insolvency. However, if the shares pledged are not significantly large and if the company is doing well, then investors need not worry. For companies that are financially healthy, anywhere between 5-8% of the total promoter holdings could be pledged without it raising any alarms.

The risks involved with pledging too depends entirely on a company?s financial standing, and as long as a company has not gone overboard, that risk is manageable.?

Finer points

In several cases, as mentioned in the tables, several promoters have actually gone overboard. As of February 12, as many as 47 promoters have pledged shares that are around 30% or more of the total paid-up capital of the company. These are cases where investors have to be extremely careful.

?In cases where promoters have pledged more than 50% of the paid-up capital, investors should be extremely cautious. This is a clear sign that there is something amiss,? says another fund manager.

However, sometimes this could be a blessing as well as the promoters could be forced to sell off to better managements. But then, this is utopian thought, reckons the fund manager.

Such companies often end up being distressed as the promoters have surely used their resources to create alternative projects that have not fructified. This can be one strong interpretation.

This gets the second important factor for judging pledging of shares ? knowing the end-use of funds. ?If promoters manage their personal finance properly, then there should be little to worry about. Sometimes, promoters borrow money for the business by pledging their own shares. They may also pledge their shares in order to increase holdings in their own companies if the opportunity arises and hence it may not be a bad move at all,? reckons Balasubramaniam.

As far as the risks companies run, if the shares pledged by promoters cannot be repaid, Balasubramaniam feels, ?Not being able to repay the loan against pledged shares will affect the value and share price of the firm, which from an investors? perspective are the most critical.?

At the moment, Sebi does not make it mandatory for companies and promoters to mention the end-use of funds. However, there are several companies that have voluntarily disclosed the end-use, and this should be seen as a positive factor for the companies, reckon analysts. However, the regulator is working on making this step mandatory as well and when it happens, investors would get to see things more clearly.

The source

The next important thing for investors to look at is the amount of money raised and the institution with whom the shares have been pledged. Here, investors could only arrive at smart guessestimates. Many companies, not all though, have been disclosing the date at which the shares were pledged and this can allow the investor to calculate the amount raised.

By multiplying the share price on the specified day with the number of shares pledged and then removing off a margin of around 30%, a fair estimate of the amount raised can be ascertained.

Now, the pertinent thing to look at is will the promoter be able to pay up this amount or will the pledgee have to sell shares in the open market. The promoters? background in such matters often is a strong guideline that the investor can look at.

In conjunction, investors can also look at the institution with whom the shares have been pledged. This critical factor again is not a mandatory condition placed by Sebi. However, many companies have taken the initiative to disclose this information as well. This data is important because it indicates the need by promoters to raise funds as well as the risk level for the promoters holdings.

Analysts suggest that scheduled commercial banks are extremely stringent in making such loans and tend to carry out proper due diligence. Funds sourced from non-banking financial institutions are typically more costly and these are the firms that could tend to relax their lending norms a bit. However, such firms are also extremely quick to sell shares when prices turn unfavorable.

Tracking

Overall, the fact that investors would have to carry out such diligence and then take a risk puts the entire share pledging actions in negative light.

Analysts rather save their time in researching sound companies instead of investigating details of share pledging at the moment, hence share prices tend to tumble. But for good companies, these shares prices have recovered as fast as they have fallen. However, a simple logic to support investors tracking companies whose promoters have pledged shares is by looking at the fall in share price. A 25% plus dip in the share of a company whose promoters have pledged shares is an early warning signal to start getting cautious, say expert.

This is because the margins that bankers and institutions take range from 20% to 50% of the share value and a 25% dip would certainly set off a selling trigger for many.

But if the reputation of the company and its promoters is well established and the percentage of shares pledged by the promoters is not significant, then investors can well put these things aside and not lose their sleep. Not all share pledging should cause a panic.