This article was first published in the The Prime Directory 2023, Prime Database Group, September 2023. Co-aurthors: with Ray, Sougata & Ramachandran, Kavil; https://www.primedatabase.com/article/2023/Article-Nupur_Pavan_Bang.pdf
Introduction
The
practice of pledging of shares has existed in the Indian financial system for a
long time. However, it gained significant disrepute during the Satyam Corporate
Governance scandal in 2009. Since then, the Securities and Exchange Board of
India (SEBI) mandated the promoter shareholders of firms to declare their
pledging activities to the stock exchanges within seven days.
Regulatory
bodies such as SEBI and RBI have continually highlighted their concerns around
pledging. As pledging-induced corporate governance scandals have seen stock
prices plummet, investors too have called for pledging to be curtailed via the
introduction of stringent regulations. Academics and corporate governance
experts have associated share pledging with several detrimental firm-level
outcomes. Some of these concerns are highlighted below.
Concerns
Health
of the financial system: In India, financial institutions have seen a
considerable rise in their exposure to debt backed by pledged shares in the
past decade. Often, the asset cover set by lending institutions may be too
small to cover the price risk associated with shares as collateral. Where
pledging loans are non-recourse (i.e., the borrower is not personally liable
for the loan apart from the provision of collateral), there is a possibility of
the lender not recovering the principal amount in the event of a sudden
downturn in the stock price and loan default.
Loss
of control of the firm for controlling shareholders: In the hunt for wealth diversification and legacy building, controlling
shareholders may be tempted to over-pledge their shares with a lack of provisions
to repay the loan or answer margin calls. There have been numerous instances
where margin calls have led to controlling shareholders losing control of the
firm. These disruptions result in a significant loss in market capitalization
of the firm and raise considerable doubt over its future.
Underinvestment in innovation and risk-aversion: While innovation is a strategic driver of
long-term growth and firm value, investment in innovation is much riskier than
the firm’s business-as-usual activities. Post pledging, there may be a
strong incentive for the promoters to underinvest in R&D activities to
reduce the possibility of future margin calls.
Impact on accounting practices: To reduce the risk of a decline in the firm’s
share price and subsequent margin calls, promoters may attempt to falsely
present a positive picture of the firm. Consequently, firms where controlling
shareholders pledge shares have a higher propensity to indulge in inferior
accounting practices such as earnings management and choose lower-quality
auditors to continue earnings management and navigate through the regulatory
requirement of a financial audit.
Decline
in Firm Value: Following a share pledge by a controlling
shareholder, increased risk-aversion and a rise in the firm’s equity risk is
likely to contribute to a decline in firm value in the longer term. Thus, while
insiders pledging shares receive benefits in the form of a loan, outsiders must
face a decline in firm value with no associated upsides, if the loan amount is
not used for the same firm and with a judicious strategic plan.
Theoretically,
there is a divergence in risks and rewards of the promoters who pledge their
shares and other shareholders of a firm. This may act as an incentive for the
promoters to pledge their shares despite all the concerns mentioned above. In
the next section, the authors enumerate a few recommendations for the
regulators that should help minimize the negative impact of pledging, while
retaining the tool to access funds when in need.
Recommendations
Awareness and information dissemination: Despite concerns from
all quarters over the negative implications of pledging, SEBI has indicated
that it does not intend to prohibit the pledging of shares. SEBI believes that
it should be the right of the owner of equity to decide the best possible way
of utilizing it. Hence, given its positioning as a relatively accessible form
of financing for shareholders, pledging of shares is expected to remain in the
financial markets as a popular form of raising capital. Moving forward, it is
critical for the regulators to create awareness and disseminate information
about pledging of shares to all key stakeholders (including minority
shareholders and financial institutions).
Integration and standardization: As of now, the
disclosures on pledging by promoters to SEBI and the information available to
RBI regarding the lending by financial institutions are not integrated. Both
the regulators should jointly seek information from the promoters and
disseminate the information in a consolidated manner to the investors. In
addition, rules surrounding adequate cover for share pledges (and provision of
the maintenance margin) must be standardized and ensured that they are
implemented across all financial institutions uniformly.
End-use of pledging capital: SEBI has been
considerably proactive in monitoring the pledging of shares and introducing
stricter regulations around the same. We feel that these are steps in the
correct direction. However, disclosure of the reasons for pledging must be
mandated against all share pledges irrespective of the size of the pledge to
further protect the interest of the minority shareholders. SEBI must actively
mandate the precise destination of the funds obtained through pledging, as
several promoters provide vague reasons for pledging in the disclosure
reports.
Control and cash flows: In an ideal scenario,
the associated risks, returns and control should be homogenous across the
firm’s shareholders. That is, the promotors, institutional investors and the
retail investors should receive returns (in the form of capital gains and
dividends), face risks and exercise control in accordance with the size of
their shareholding in the firm. However, pledging may alter this homogeneity
associated with stock ownership. While the shares are used as a collateral to
raise funds, the promoters continue to enjoy all cash flows associated with
those shares as well as their control and voting rights. In a way, this
incentivizes the promoter to pledge their shares since there is no immediate negative
consequence of doing so.
While, in a situation where the
firm is close to default or needs immediate cash, the promoters might have no
choice but to use pledging as a tool to access immediate capital, the promoters
should have a plan to pay back the loan to the financial institution. Checks
and balances are required to ensure that due to asymmetry of information, the
promoters do not “cash out” of firms in distress leaving the financial
institutions (lenders) and other shareholders to take the fall. A negative
spiral in the stock price will most significantly impact the minority
shareholders and leave the lenders with a collateral that may not cover the
value of the loan extended. Such divergence can be checked by the SEBI by
bringing in clauses such as deferred dividend payments until the shares are
pledged or suspending the voting rights in proportion to the extent of shares
pledged.
Guidance to the board: The role of the board
of directors is critical in the event the promoters pledge their shares due to
its far-reaching implications. The Ministry of Corporate Affairs may stress of
the benefits of an empowered board of directors. It may also lay out the
responsibilities of the board if a promoter wants to pledge its shares. The
directors must caution the promoters from over pledging and should shield the
firm from the promoters if they try to manage the margin calls by taking hasty
or short-term view decisions in the firm. In addition, the board of directors
should also evaluate if pledging is indeed the best option for the firm.
Independent directors to be more vigilant and check that decision making at
firm level is not impacted. In addition, they should be made more accountable
for lack of carrying out their fiduciary duties.
Guidance to promoters: The Companies Act
should also detail the expectations from the promoters when deciding to raise
capital via pledging, viz. the promoters should be cognizant of the risks that
this form of financing carries, the promoters should be reasonably confident of
the cash-flow generation abilities of the investments made by them in the
future. Overtly wishful and hopeful thinking by promoters without due diligence
has indeed impacted many business barons in making over-optimistic bets. Also,
the impact of variations in stock price of the firm observed in the short-term
on the pledging contract should be manageable. The promoter should also have a
contingency plan to answer margin calls made to the firm and they should
disclose it to SEBI.
Compliance: Disclosure by the
promoters and the companies should be monitored stringently with strict action
for delays and non-compliance. For a better governed and efficient running of
the market, there must not be any slip between the cup and the lip.
Conclusion
When
we study individual cases of pledging of shares, we find that in conjunction
with bad business decisions, pledging has had dire consequences for the
promoters and other stakeholders. Such companies are many. They include Satyam,
Future Group, and Zee Entertainment. However, there are also companies that
have created long-term wealth for all shareholders by using pledging as a
strategic tool to raise funds for expansion and growth. Examples include Apollo
Hospitals and Granules Pharmaceuticals.
Therefore,
all cases of pledging of shares should not be painted with the same stroke of
negative. Rather, responsible pledging should be promoted, with appropriate
checks and balances, transparent motivations to pledge, and a plan to revoke
the pledge.
