In simple terms, pledging of shares is defined as taking a loan from the bank by giving the shares as collateral. When the promoters of the company require money for running daily business operations or for personal reasons, then they pledge the shares to the bank for arranging funds. It is one of the sources of borrowing money to meet the various capital requirements of the business such as launching a new product, funding other ventures, for the expansion purpose and more.
Why there is a need to pledge shares?
As discussed above, the pledging of shares is carried out by the promoters to either run the business operations or for the personal reasons. It is to be noted that the pledging of shares decision is undertaken by the promoters when there are no avenues or options left to arrange the funds. This type of situation generally crops up when the during the time when there is a slowdown in an economy. Many people may not know that the shares are considered to be the assets and they can be offered as collateral to the banks for availing loans.
Risks associated with the pledging of shares
There is no doubt at all that the pledging of shares is one of the sources to secure desired funds from the bank, but there are also some risks associated with it that must not be overlooked.
In the bull market, when the share prices are increasing, then there are no issues as the investors are really optimistic. However, the main problem occurs during the bear market. In this type of market, the share prices do not remain stable and keep on fluctuating. The main challenge here for the investors here is that they have to maintain the total value of the collateral.
If the share prices are falling continuously, then it is quite obvious that the total value of the collateral will also decrease. To maintain the difference in the value, the promoters may have to arrange additional cash or pledge more shares. Let us understand this with an example:
The total value of the collateral while taking the loan against the shares was Rs 100 crores. However, there was a steep decline of 20% in the share price. The fall in the shares has led to the decrease in the total value of the collateral by 80 crores. In order to maintain the difference of 20 crores, either more cash or pledging of shares is required.
Do banks have the right to sell the pledged shares?
Yes, absolutely, if the promoters fail to arrange extra cash or shares to maintain the difference, then the banks have the right to sell the shares. If the promoters are able to provide extra cash or pledging of shares is revoked, then it goes on to create a positive sentiment among the investors regarding the company.
How pledging of shares is a disadvantage for the retail investors?
The retail investors are of a greater risk if the share prices do not become stable and continue to fall. The problem may even worsen if the lenders sell the shares that have been pledged as this may lead to a considerable fall in the share prices and create a panic among the investors. Moreover, the voting power of the promoters also gets affected if the shares are sold because they now hold few shares.
In general, the pledging of shares is not considered as a good sign for the business. If the shares have been pledged by the promoters, then it creates a negative sentiment about the company. It means that the company is under debt, which in turn impacts the credibility. If a company is engaged in the continuous pledging of shares, then it is considered to be highly risky both for the promoters and shareholders. Anyways, the bottom line here is that you must maintain a safe distance from the companies with the higher pledging of shares.
Note: All information & data provided in this article is for the educational purpose as well as to give general information on the finance & economy, not to provide any professional advice or service. Views & opinions are not biased against the company and do not affect any official policy or any other agency, an organization within the content.