Explained: How sensitive is the issue of pledge of shares by promoters?

How sensitive is the issue of pledge of shares by promoters? The Reserve Bank of India (RBI) has found it important enough to highlight the issue in three Financial Stability Reports (FSRs) over the past decade — in its December 2013, December 2014 and June 2019 editions. Now that the banking regulator and the Securities and Exchange Board of India (Sebi) are seized of this fund-raise route in the aftermath of the turbulence in the financial markets after Hindenburg’s report on the Adani group, just what were the concerns raised in the FSRs?

The FSR June 2019 noted that a high level of pledging by promoters is “a warning signal, indicating the company’s poor health and probably a situation where the company is unable to access funding through other options”. While not being explicit, it was hinting that governance may be a casualty in firms with a high level of such pledging and, by extension, may come to trouble RBI regulated entities. Pledging is risky for any company as debt repayment will leave no room for a company’s growth. As a general trend, promoters pledge shares when managing existing debt becomes tough for them that eventually leads them to an increased debt trap, and which is detrimental for investor interests. But it was the FSR December 2014, which called attention to its peculiarities in our context.

A majority of Indian companies are family-owned/controlled, as substantial levels of promoter shareholding are concentrated within the family. The promoters’ shares can be significant collateral for a typical company if it wants to expand leverage. Pledging of shares is practised in other advanced economies, too, but it has taken a significantly different form in India — promoters pledge shares not for funding “outside” business ventures, but for the company itself. By pledging shares, the promoters have no personal liability other than to the extent of their pledged shares. In some instances, shares pledged by unscrupulous promoters could go down in value and the promoters may not mind losing control of the company as there is a possibility of diversion of funds before the share prices collapse.

While a lender has the option of selling the shares when prices fall and hit a point that can be called a default event, this can still have an impact on minority shareholders through market impact costs, as with the invoking of the pledge, the pledged shares will have to be sold immediately. A high level of pledged shares unwittingly converts a lending entity into a private equity firm. The FSR December 2014 referred to the fact that company executives in the US do pledge shares to collateralise loans to fund “outside” businesses and prior purchase of shares of the company — although many large companies prohibit their executives or directors from such practices. (In the US, “promoter” is largely unknown, and therefore, the reference to company executives). The Institutional Shareholder Services Inc — one of the world’s leading corporate governance solution providers — has in its policy stated that “pledging of company stock in any amount as collateral for a loan is not a responsible use of equity”.

It would also be mistaken to assume that because promoters’ shares are pledged, they may behave better for fear of losing control of the company. This is simplistic and has not worked in the past. Take the RBI’s Strategic Debt Restructuring (SDR) scheme of June 2015. On paper, if push came to shove, lenders could band together, convert a funny firm’s loans to equity, and kick the promoter out. But the proposition can work only when there was a genuine interest from both the borrower and lender to regularise cash flows from the underlying asset. In most cases, it only meant many lenders got a vuvuzela — because the promoter anyway had parachuted out of the company. Now, this has to read along with the poor realisation under the Insolvency and Bankruptcy Code as well.

A related aspect is that of leverage itself. Take holding companies (Holdcos) that start acting as operating companies (Opcos). The FSR December 2019 refers to “double leveraging”, especially in the infrastructure space when companies undertake large projects and need not have to raise a lot of resources while satisfying their equity contributions. In a typical double leveraging, the Holdco raises debt on its balance sheet and infuses it as equity in a special purpose vehicle (read Opco). From the lenders’ perspective, a debt-to-equity ratio of 2:1 at the Holdco could transform into a leverage of 8:1 at the Opco. While there could be some merit in such practices, risk assessments by banks need to capture this effectively.

To illustrate, assume an Opco with total equity of Rs 1,000 crore held by promoter entities. The Opco has borrowings of, say, Rs 3,000 crore, and therefore, a leverage of three times. The Holdco, in turn, has borrowed against the equity infused by it, say with a loan-to-value (LTV) ratio of 50 per cent — therefore, Rs 500 crore out of the Rs 1,000 crore invested in the Opco is by way of debt. While at a group level, you have debt of Rs 3,500 crore, and equity of only Rs 500 crore, the debt-to-equity ratio is seven times.

Extant Sebi rules require disclosure of pledge of promoters’ equity, but there’s nothing that requires disclosure of the effective leverage. And consolidated financial statements are prepared only where there is a holding entity or associate relationship, which may not exist if promoter equity is split across entities and individuals. It goes beyond disclosures as well.

According to Vinod Kothari, managing partner of Vinod Kothari and Company, the presence of debt at the promoters’ level creates pressure on the Opco, and in order to service the debt in the Holdco, promoters are likely to pursue a very aggressive dividend distribution policy — because dividends from the Opco are the only way to service the debt at the Holdco. And in order to maintain the LTV ratio at the Holdco level, promoters will be focused on the short-term market cap of the Opco, thereby pursuing short-term strategies. He makes the case that Sebi should appropriately require not merely disclosure of pledge of promoter group holdings, but the extent of debt at promoter entities, and the terms on which the debt has been taken — irrespective of whether these promoter entities are based in India or overseas.

Pledging of shares is legitimate, but when taken together with high levels of leverage, maybe it’s time these issues are looked at afresh.

A new pledge?

• A high level of pledging by promoters is a warning signal of a company’s poor health, and probably a situation where it is unable to access funding through other options
• In some instances, it may be imply poor governance
• A high level of such pledging may come to trouble RBI regulated entities
• It would be simplistic to assume because promoters share are pledged, they may behave better for fear of losing control of company
• Double leveraging, where Holdcos raise debt on their books and infuses it as equity in Opcos, is another troubling matter