What is Pledging of Sharing? How Does It Work? (2024)

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Pledging of shares in the stock market can be a common practice. Pledging is where shares of a company are pledged as collateral security for obtaining loans from banks and financial institutions. It can be a good option for promoters pledging and investors to raise capital without diluting their equity stake in the company.

In this blog, we will discuss how pledging of shares works. Additionally, things to consider before pledging shares of a listed company.

What is Pledging of Shares?

Pledge shares meaning is to the practice of using shares as collateral to secure a loan. In this process, a shareholder or the pledged holdings (the pledgor) provides their shares to a lender (the pledgee) as security for a loan or credit. The ownership of the shares remains with the pledgor, allowing them to continue receiving dividends and exercising voting rights. However, if the pledgor fails to meet the loan obligations, the pledgee may have the right to sell the pledged shares to recover the outstanding amount. Pledge of shares as collateral security is used by investors and promoters to access capital while retaining ownership of their shares.

How Does Pledging of Shares Work?

Pledging stocks involves the transfer of ownership of shares from the shareholder to the lender, as collateral security for a loan. The bank or financial institution holds the shares until you fully repay the loan. During this period, it works continues to enjoy the benefits of ownership, such as dividends and voting rights. However, if the borrower defaults on the loan, the lender has the right to sell the shares in the open market to recover the outstanding amount.

Here’s an example to demonstrate how pledging of shares works:

Let’s assume that the promoters of XYZ Ltd hold a 60% stake in the company. Suppose 1 crore shares are outstanding, a 60% stake means promoters hold 60 lakh shares. The market price of each share is ₹500. So the promoters shareholding is worth ₹300 crore (60,00,000 * 500).

Now suppose the promoters want to raise Rs.100 crore for expanding the manufacturing capacity of the company and are seeking a loan from the bank.

As per RBI regulations, a loan-to-value (LTV) ratio of 50% is to be maintained at all times when lending based on the stock pledge. Since the proposed loan amount is ₹100 crore, the promoters will have to pledge stocks at least ₹200 crore worth of shares with the bank, this translates to 40 lakh shares. Note that one must rectify any LTV shortfall due to share price changes within 7 working days.

The share price of XYZ Ltd. drops to ₹450 due to poor financial performance, reducing collateral value to ₹180 crores, raising LTV to ~55%. Promoters must pledge 4.44 lakh shares to maintain a 50% LTV. If the price falls to ₹350, there would be a need of an additional 17.14 lakh shares. Pledges the entire promoter stake of 60 lakh shares at ₹333.

If at any point the promoters are not able to increase the collateral either by pledging additional shares or by paying cash to reduce the loan liability, the financial institution will sell the shares in the market, realise the proceeds and reduce the loan liability.

Extraordinary circ*mstances caused XYZ Ltd’s share price to plummet from ₹500 to ₹250 in just days. Even if the promoters pledge their 60 lakh shares, collateral remains at ₹150 crores, resulting in a 66.67% LTV (100 / 150). Reducing LTV to 50% requires selling 20 lakh shares, raising ₹50 crores, leaving a loan of ₹50 crores (100 – 50) and a pledged value of ₹100 crores (150 – 50). Dumping 20% of total shares may further pressure the share price.

Why Do Promoters Pledge Shares?

The practice of pledging shares can offer several benefits, including the following:

• Raising Capital: Pledging of shares is a quick and easy way to raise capital without diluting equity. Shareholders can share pledge to obtain a loan for business expansion, working capital, or personal needs.
• No Need to Sell Shares: Shares pledging can be a good alternative to selling shares to meet financial obligations. By pledging shares, the shareholder can continue to hold the shares and participate in the company’s growth.
• Low-Interest Rates: Share Pledging can provide a lower interest rate than unsecured loans as the lender has security in the form of shares. This can be a cost-effective way to access funds.
• Better Loan Terms: Pledging of shares can help investors and promoters obtain better loan terms such as lower interest rates and longer repayment periods.
• Tax Benefits: Interest paid on loans taken against pledged shares is tax-deductible, which can help reduce the borrower’s tax liability.

Impact of Pledging Shares on Stock Valuation

The pledging of shares can have several impacts on stock valuation:

• Market Perception: Investors and analysts may view a high level of pledged shares as a signal of financial stress or lack of confidence in the company. This perception can lead to a decline in stock prices.

• Liquidity Concerns: Pledging shares can limit the liquidity of a stock. If a significant portion of shares is pledged, it might create challenges for selling these shares in the open market, impacting the overall liquidity of the stock.

• Volatility: Stocks with a high level of pledged shares may experience increased price volatility. Any adverse news or market fluctuations can trigger a more pronounced impact on the stock’s value.

• Potential for Forced Selling: If the pledgor fails to meet financial obligations and the lender decides to liquidate the pledged stocks, it can lead to a sudden increase in the supply of shares in the market, putting downward pressure on the stock price.

• Risk Assessment: Investors may factor in the level of pledged shares when assessing the overall risk associated with a stock. Higher pledging can be considered a risk factor, impacting the stock’s attractiveness.

How to Find Out if the Company has Pledged Shares?

Each promoter pledging shares of a company discloses this in their financial statements. Determining if a company has pledged shares involves examining its quarterly financial reports, which provide information on the percentage of promoter holding and the proportion of pledged shares.

How to Pledge Shares?

To pledge shares of a listed company, the shareholder needs to follow these steps:

• Open a Demat Account: The shares must be held in dematerialized form to be pledged. The shareholder must open a demat account with a depository participant (DP).
• Sign a Pledge Agreement: The shareholder needs to sign a pledge agreement with the lender, which states the terms and conditions of the loan, including the interest rate, repayment schedule, and the number of shares to be pledged.
• Transfer Shares to the Lender: The shareholder needs to transfer the shares to the lender’s demat account. This can be done either through off-market transfer or through an on-market transaction.
• Create a Lien on Shares: Once the shares are transferred, the lender creates a lien on the shares, which means that the lender has the right to sell the shares if the borrower defaults on the loan.

What is Haircut in Pledging of Shares?

The percentage discount applied to the market value of the pledged shares is known as the haircut. It is a risk management measure that lenders use to protect themselves from a fall in the value of the shares. For example, if the market value of the pledged shares is Rs. 1,00,000 and the haircut is 20%, the effective value of the shares will be Rs. 80,000. This means that the lender will give a loan of Rs. 80,000 against the pledged shares.

What is the Unpledging of Shares?

Unpledging of shares refers to the release of pledged shares by the lender after the borrower repays the loan in full. Once the shareholder repays the loan, the system transfers the shares back to their demat account.

Advantages of Pledging Shares

Pledging shares can offer certain advantages, including:

• Access to Capital: Pledging shares allows shareholders to leverage their existing stock holdings to secure loans, providing a source of additional capital for various purposes.
• Retained Ownership: Shareholders retain ownership of the pledged shares, continuing to benefit from dividends, voting rights, and potential capital appreciation.

• Flexible Use of Funds: The capital raised through pledging shares can be used for diverse purposes, such as business expansion, working capital, or personal financial requirements.

• Cost-Efficient Financing: Pledging shares may offer a cost-effective financing option compared to other forms of borrowing, as it utilizes existing assets as collateral.

• No Dilution of Control: Unlike issuing new shares, pledging shares does not dilute the ownership or control of existing shareholders, including company promoters.

While these advantages can be appealing, it’s crucial for shareholders to carefully consider the associated risks and terms of the pledging arrangement before proceeding, as fluctuations in share prices or failure to meet loan obligations can pose challenges.

Risks Associated With the Pledging of Shares

While pledging shares as collateral security can offer several benefits, it also involves certain risks that shareholders should be aware of:

• Value of Shares: If the share price falls, the value of the collateral decreases. In such a scenario, the lender may demand additional collateral. The shareholder may, also, have to provide additional funds to maintain the required collateral value.
• Loss of Ownership: When pledging shares, the shareholder transfers ownership to the lender until repaying the loan. This can result in a loss of control over the shares, including voting rights and dividends.
• Margin Calls: To secure the loan, lenders may demand that borrowers maintain a specific collateral value. If the value of the pledged shares falls below the agreed margin, the lender may issue a margin call. This means that the borrower needs to provide additional collateral or repay the loan in full. This can be a significant risk for the borrower as they may not have the resources to meet the margin call.
• Forced Selling: In the event of a default, the lender has the right to sell the pledged shares to recover their outstanding amount. This can lead to forced selling in the market, which can cause a sharp decline in the share price, and result in significant losses for the borrower.
• Negative Perception: Investors and shareholders may perceive the pledging of shares negatively, as it could indicate financial difficulties or a lack of confidence in the company’s future prospects by the borrower.

To Wrap It Up

Pledging of shares can be a useful option for shareholders who require funds in a short period. It offers quick access to funds without the need to sell shares. However, it also involves risks, such as a loss of ownership and the possibility of forced sale of shares. It is essential for shareholders to carefully evaluate the benefits and risks before pledging shares in the stock market and to have a clear understanding of the terms and conditions of the pledge agreement.

In conclusion, pledging of shares is a common financial practice in the stock market. As with any financial decision, it is crucial to weigh the pros and cons carefully and seek expert advice if needed. And for expert-curated readymade portfolios, there’s smallcase!

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