Pledging shares is a concept that might sound complicated, but it’s actually a straightforward way for individuals and companies to raise money by using their stocks as collateral for loans. In this guide, we’ll explain pledging in simple terms, so you can understand how it works, its advantages, and the risks involved.
What is Pledging Shares?
Pledging shares means offering your stocks as security for a loan. When someone pledges their shares, they still own them and can continue to receive dividends and voting rights (in most cases). However, they cannot sell the shares until the loan is paid back. Essentially, they’re borrowing money, using their shares as collateral.
How Does Pledging Work?
- Loan Against Shares: When shares are pledged, the lender (often a bank or financial institution) offers a loan, but typically for less than the current market value of the shares. This is because the stock market can be unpredictable, so the lender wants to protect themselves from the risk of the share value dropping.
- Impact of Market Fluctuations: If the value of the pledged shares falls, the person who took the loan may need to pledge more shares or deposit additional money to maintain the loan’s required value. If they can’t meet this demand, the lender has the right to sell the pledged shares to recover the loan amount.
- Consequences of Defaulting: If the borrower cannot repay the loan, and the value of the shares has dropped significantly, the lender may sell the pledged shares. This could cause a drop in stock prices, leading to panic in the market. This is why pledging shares can sometimes create instability, especially if a large number of shares are involved.
Why Do Promoters Pledge Shares?
Promoters, or the major shareholders of a company, often pledge their shares to secure loans. They typically pledge a portion of their shares to raise funds without selling them outright. This can help company promoters keep control of the company while still accessing necessary capital.
However, when too many shares are pledged, it can raise concerns among investors, causing stock prices to fall. In India, the Reserve Bank of India (RBI) has highlighted the risks of pledging shares, especially in companies with significant promoter pledges.
Understanding Haircuts in Pledging
A haircut in pledging refers to the difference between the market value of the shares and the loan amount the lender is willing to provide. For example, if shares are worth ₹10 lakh, but the lender offers only ₹8 lakh, the haircut is 20%. This margin acts as a buffer to protect the lender if the stock’s value drops.
Advantages of Pledging Shares
There are several benefits to pledging shares:
- Access to Cash: Pledging shares allows investors to get a loan quickly without needing to sell their shares. It’s a fast way to access funds, which can be used for various purposes.
- Retain Ownership: Even though you pledge your shares, you still retain ownership. This means you can continue to earn dividends and benefit from potential price increases in the future.
- Lower Interest Rates: Since the loan is secured by your shares, you might get lower interest rates compared to unsecured loans. Lenders are more willing to offer better terms when there’s security involved.
- No Immediate Tax Implications: Pledging shares does not trigger immediate tax liabilities, which can be an advantage for investors who want to avoid selling their shares and facing capital gains tax.
Disadvantages of Pledging Shares
While pledging shares has its benefits, there are some risks to consider:
- Risk of Default: If the borrower defaults on the loan, the lender can sell the pledged shares. This might cause a decline in stock prices, which can negatively impact the market sentiment and other shareholders.
- Negative Market Perception: If the company’s promoter defaults on a loan, it can damage the company’s reputation. This can lead to a drop in stock prices and create uncertainty among investors.
The Pledging Process for Investors
Here’s how the process works if you want to pledge your shares:
- Request Submission: The investor or promoter initiates the pledging process by submitting a request through a trading terminal.
- Verification: The request is sent to a depository like the National Securities Depository Limited (NSDL) or Central Depository Services Limited (CDSL) for verification.
- Approval: Once the request is verified, the depository notifies the investor via email or SMS, and the pledged shares can be used as collateral for the loan.
What Are Pledged Shares?
When a company’s leaders, like the CEO or promoters, pledge their shares, they offer a portion of their holdings as collateral to secure a loan. For example, if a CEO of a tech company wants to raise funds for expansion, they might pledge 10% of their shares to a lender. The lender then holds those shares as security until the loan is paid back.
Why Do Companies Pledge Shares?
Promoters often pledge their shares to:
- Raise funds for business expansion or operations
- Keep ownership without selling their shares
- Get better loan terms, such as lower interest rates and longer repayment periods
How Do Non-Promoters Pledge Shares?
Non-promoters (regular shareholders) can also pledge their shares to get loans. However, this comes with additional risks, such as:
- The potential loss of voting rights on the pledged shares
- A margin call (request for more money or collateral) if the share price falls
- The risk of the lender selling their shares if the loan isn’t repaid
Steps to Pledge Shares
If you’re interested in pledging your shares, follow these simple steps:
- Check Eligibility: Not all shares can be pledged. Contact your broker to find out which shares you can use.
- Initiate the Pledge: Start the process through your broker. You can usually do this online or by phone.
- Choose Shares and Amount: Decide how many shares you want to pledge and how much loan you need.
- Review the Agreement: Carefully read the terms and conditions of the pledge before proceeding.
- Authorize the Pledge: Confirm the pledge through your depository, which may require a one-time password for security.
How to Find Out if a Company Has Pledged Shares
Companies are required to disclose pledged shares to regulatory bodies like the National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE). You can check their public filings to see if any shares have been pledged.
Conclusion: Should You Pledge Your Shares?
Pledging shares can be a good way to access funds without selling your shares. It allows you to keep your stake in the company while securing a loan. However, there are risks, such as the potential for margin calls and the impact of market fluctuations. If you decide to pledge your shares, it’s important to carefully consider the loan terms and the risks involved to make an informed decision that aligns with your long-term goals.
