Pledging of Shares

Shareholders often pledge their shares as collateral to secure loans. This practice, known as the pledging of shares, has become popular recently as companies seek to raise funds for expansion and other activities.

Pledging of shares of a listed company can also have significant risks for both the company and the shareholders involved. This blog explores the pledging of shares meaning, its advantages and disadvantages, and what companies and shareholders should consider before entering into such agreements.

What is Pledging of Shares?

What is Pledging of Shares?

Let’s discuss what is a pledge in the share market.

Pledging of shares is a financial arrangement in which the promoters of a company pledge their shares as collateral to secure a loan or meet their financial requirements. Pledge in the stock market means taking a loan against its securities. 

This arrangement is typical for companies where investors hold many shares. The borrower retains ownership of these stocks and receives dividends, interests, and capital gains on those shares. 

Fluctuations in the market value of pledged shares change the value of the collateral. Promoters must maintain the minimum collateral value agreed upon in the contract. If the value of the shares falls below the agreed amount, the borrower must provide additional shares or pay cash to make up for the shortfall. 

Banks or lenders may sell these shares in the open market if the borrower cannot do so. The shares are lost if sold, reducing the promoters’ shareholding and value of the stock. 
 

How Does the Pledging of Shares Work?

Investors commonly use pledging shares to meet their financial needs by providing them as collateral. This practice is prevalent among investors who own high-value shares. Since the market is constantly changing, the collateral value and share value fluctuate. Pledging shares help investors avoid missing out on trading opportunities due to a lack of available cash. 

Why Promoters Pledge Shares?

Promoters typically pledge their shares as a last resort to meet various financial needs. This method of raising funds is considered safer than borrowing. If promoters pledge their shares, they have exhausted all other fundraising options. Economic slowdowns can often lead to such situations.

Banks offer loans with shares held as collateral because they are assets of the promoter borrowing the loan.
 

What is a Haircut?

A haircut margin protects the lender's interests when pledging shares. The difference between the actual and collateral value of the shares is known as the haircut margin. 

For instance, if an investor pledges shares worth Rs. 10 lakhs based on current stock prices, the collateral value may be less than Rs. 10 lakhs. The lender may offer a collateral value of Rs. 8 lakhs, resulting in a 20% haircut percentage.

The lender utilises the haircut margin as a precautionary measure against the fluctuating nature of the stock market. If the value of the shares decreases abruptly, the lender may experience significant losses if they do not maintain the haircut percentage.
 

Advantages of Pledging Shares

Here are the advantages of pledging shares.

1.    Pledging shares enables an investor to obtain a secure loan from the lender against its shares which typically attract low-interest rates compared to unsecured loans.
2.    One of the primary benefits of using shares as collateral is the ability to access extra funds for various financial purposes, such as margin for trading or meeting other requirements.
3.    Pledging shares does not attract any tax liability.
4.    Borrowers do not have to sell their shares, which means that if the markets rise, the investment value also increases. At the same time, borrowers can avail of additional cash without selling their shares.
5.    Borrowers can also benefit from additional advantages, such as dividend income, which remain unaffected and are passed on to them.
 

Disadvantages of Pledging Shares

Below are the disadvantages of pledging shares.

1.    One disadvantage of pledging shares is the risk associated with it. If a borrower fails to repay a loan that was secured using shares as collateral, the lender can sell the shares in the market to recover the amount owed.
2.    The selling of shares by the lender, especially for high net-worth investors, may lead to a further collapse in the prices of these shares, affecting other shareholders.
3.    Suppose the promoter of a company defaults on loans with the pledged shares as collateral. In that case, this can leave a negative impression on the company and impact share prices negatively for extended periods.
4.    Pledging shares also reduces an investor's ability to sell those shares in the market or take advantage of any price appreciation.
 

Is Pledging of Shares Risky for Investors?

Let’s find out the answer to “Is pledging shares good or bad for investors”.

Company promoters use their stocks or shares as security to obtain loans according to their needs, called a share pledge. In a bullish market, pledging shares does not create any issues as the market moves positively, giving investors a sense of ease.

However, during a bear market, i.e., when the market is moving downwards, investors tend to panic. This causes a problem as the value of the collateral fluctuates along with the stock prices. If the stock prices continue to fall, the value of the collateral decreases. In such cases, promoters can pay in cash or pledge more shares to their lender to maintain the value.

If the promoter cannot cover the shortfall, the lender can sell the pledged shares as collateral to retrieve their funds. As a result, promoters lose their stock.
 

Is Pledging of Shares Risky for Investors?

It's important to understand that market news heavily influences stock prices. Lenders publicly selling pledged shares can cause a significant decline in stock prices. This can lead to a decrease in the value of the collateral as panicked individuals begin selling their shares. 

Additionally, when lenders sell these shares, it can alter the organisation's shareholding pattern, directly affecting the voting rights of candidates who may be left with only a few shares. This can diminish their authoritative power.

If share prices continue to plummet, it can create a continuous cycle of chaos. Promoters may be required to pledge more shares to maintain the value of the collateral.
 

Conclusion

Pledging shares refers to using your shares as collateral to obtain loans. Promoters often use it to raise funds for their organisation or as a strategy to invest in the market without sacrificing profits.

Pledging shares can help investors trade in high volumes, as it allows for higher margins. With careful planning and strategising, investors and promoters can reap the benefits of pledging shares.