ABSTRACT
Pledging of shares is a quick money to raise money and is adopted by a diaspora of investors at different levels of hierarchy, from individual investors to promoters. This method is adopted globally in different jurisdictions such as and is considered efficient to aid in financial distress situation. The practice is prevalent in India. It is guided by India Contract Act, 1872. It has its own merits and demerits. The stakeholder should use this practice responsibly because the risks associated with it not only increase personal leverage but affect other shareholders of the company and share market as whole. To prevent and mitigate risks the Securities Exchange Board of India furnished strict guidelines which are amended to close loopholes and ensure transparency. rom a legal perspective, the Indian judiciary has set precedents to clarify the rights and duties of parties involved as well the punishment for fraudulent activities relating to it.
KEYWORDS
Share Pledging, Risks, Stock Price, Promoters, SEBI.
INTRODUCTION
What is Pledging of shares?
Pledge is defined in section 173 of Indian Contract Act, 1872. It is type of bailment where the purpose of bailing goods is to secure payment. On repayment the pledge comes to an end and if the payment is not made then there are rights of the aggrieved party that can be exercised in court. Similarly, shares are pledged for a loan called collateral margin. Since the value of the share changes due to various factors, if the value is less than the amount agreed for the pledge then Margin call is triggered. In such a case the pledgor has to make up for the shortfall or the pledgee has the right to sell the shares. .
How is pledging of shares created?
It consists of multiple stages. First, the promoters request pledging from trading terminal in Pledge Request For (PRF). Then, the confirmation is received from NSDL or CDSL and subsequently it is authenticated. When all the requisites are met, the approval is granted. This causes change in entry of accounts of the company. The shares are moved from free balances to pledged balances and upon release of pledge the entry is reversed.
What is haircut margin?
It is a way to secure the interests of the lender. The difference between actual value and collateral value of the shares is called haircut margin. It is done due the volatile nature of market. In case of sharp reduction in market value of shares, in absence of haircut margin, the lender would suffer losses.
Why is it done?
Pledging of shares is one of the ways to raise capital in a company by promoters. Promoters are defined as person who is acting alone or in conjunction with other persons directly or indirectly takes the initiative in founding or organising the business empire. This method is however discouraged as it is considered the last resort for the promoters. The practice is alternately implemented with the intent of pay third part liabilities or float new businesses that help development of better capital management strategies.
Examples in India?
Promoters of family as well as non-family companies, in India, hold stake in firm exceeding 50%, and exercise enormous control over the company’s operations. In companies such as Z Entertainment, Reliance ADA group and Cafe Coffee Day that had pledged shares of the company had lost ownership and sometimes management control of their companies. However, some evidences also suggest that business groups such as Asian paints, Apollo hospitals, Granules India have benefited significantly from the use of pledging the shares by promoters of the company. Therefore, focused shareholding results in higher personal stake, which is risky for company and its long-term value. These instances evidence, the paradox of substantial negative perception of pledging and yet its popularity.
What is the Indian legal impact?
In India, there have been multiple cases and scandals in relation to pledging of shares. The Supreme Court of India and other lower courts along with the market regulator and supervisor, Securities Exchange Board of India (SEBI) declared some guidelines for ease of investors. The amendments concerning pledging of stock was brought in various regulations such as SEBI (Prohibition of Insider Trading) regulations, 2015, SEBI (Depositories and Participants) Regulations, 2018 and SEBI (Substantial Acquisition of shares and Takeover) Regulations, 2011.
RESEARCH METHODOLOGY
The method of research used in this paper is doctrinal in nature. It is descriptive and uses primary and secondary sources for research. The viewpoints of policymakers, scholarly articles, government guidelines and newspapers are referred to provide the analysis and derive the conclusion.
REVIEW OF LITERATURE
This paper comprehensively defines share pledging, the in-depth methodological approach used for its creation and its profound impact on company’s business. The paper will also mention the legal framework through Indian perspective and entail recent legal developments. It will delve into the regulatory requirements and disclosure obligations. The paper will critically examine the list of advantages and disadvantages of such practice to present a balanced assessment. It will also aim to provide international perspective by referring to practices adopted by capital market of various jurisdictions. The research states some points to take under consideration by a stakeholder to make a responsible choice and arrive at a conclusion.
METHOD
Earlier, dematerialisation of shares was not made mandatory. The shareholders had physical certificate to authenticate their ownership for the relevant number of shares. For the pledging the shares, the physical certificate was surrendered to the pledgee, which could be recovered upon repayment of money. In current scenario, all the transaction are made by registered depository. This makes the method easier to monitor or supervise and prevents malpractices. However, the concept of ‘revolving pledge’ is similar to the older practice, i.e., surrendering of relevant documents.
The advantages are as following:
- The process is quick and efficient which helps significantly in financial distress situation. It also allows the investors to unlock latent liquidity benefits.
- There is no dilution of ownership and the rights associated with such shares, such as receiving dividend and voting can be exercised by either of the parties as mentioned in the contract.
- This option is also cost efficient as the interest rates can be flexible as well making it cheaper as compared to other ways of raising money.
- There is no tax liability associated with it.
- Pledging shares also allows strategic use of assets as shareholders can benefit later from rising market value of shares.
The disadvantages are:
- The promoters holding majority of shares can pledge their shares for personal benefit at the stake of interests of minority shareholders.
- Upon triggering of margin call, the promoters may be unable to repay and cause forced liquidation. This would make share prices volatile and create downward pressure in stock price. This causes lack in faith of investors and existing shareholders.
- Lastly, pledging shares increases firm’s risk and affect corporate decisions.
Following is a global stance of this practice:
United States
In the United States, share pledging is a common practice predominantly among high-net-worth individuals, corporate insiders, and executives. It serves as a mechanism to unlock liquidity from existing equity holdings while maintaining ownership rights. Share pledging activities are governed by federal securities laws and regulations enforced by the Securities and Exchange Commission (SEC).
The SEC mandates disclosure requirements to ensure transparency in pledging activities, aiming to prevent market manipulation and insider trading. Shareholders pledging significant portions of their holdings are required to disclose these transactions to the public, enabling investors to assess potential risks associated with concentrated share pledging.
European Union
Across the European Union (EU), share pledging is widespread among entrepreneurs, major shareholders, and corporate executives seeking financial flexibility. EU directives and national regulations harmonize the disclosure requirements for share pledging to safeguard investor interests and maintain market integrity.
Regulatory bodies such as the European Securities and Markets Authority (ESMA) oversee the implementation of EU directives related to securities transactions, including share pledging. These regulations aim to ensure that pledged shares are properly disclosed to stakeholders, mitigating risks associated with market volatility and shareholder disputes.
China
In China, share pledging has become a common practice among founders, major shareholders, and corporate insiders of publicly listed companies. It serves as a crucial mechanism for accessing capital to fund corporate expansion, strategic investments, or personal financial obligations. The China Securities Regulatory Commission (CSRC) regulates share pledging activities, imposing stringent disclosure requirements and monitoring potential risks to market stability.
Chinese regulatory authorities emphasize transparency and accountability in share pledging transactions to prevent market manipulation and maintain investor confidence. They require detailed disclosure of pledged shares and monitor changes in shareholding structures to detect potential risks of default or market disruption.
Japan
Share pledging is a customary practice in Japan among corporate executives, major shareholders, and business leaders. It allows shareholders to leverage their equity holdings for financing purposes while retaining ownership control. The Financial Services Agency (FSA) oversees Japan’s securities market, implementing regulations to ensure the transparency and legality of share pledging transactions.
Japanese regulations emphasize the disclosure of pledged shares to protect investor interests and maintain market stability. The FSA imposes strict guidelines on the disclosure of major shareholdings and requires timely reporting of changes in pledged shares to prevent market manipulation or insider trading activities.
Emerging Markets
In emerging markets such as Brazil, and Russia, share pledging has gained popularity among entrepreneurs, promoters, and major shareholders of publicly listed companies. These markets offer diverse opportunities for capital mobilization through share pledging, facilitating business growth, and strategic investments.
Regulatory authorities in emerging markets regulate share pledging activities to ensure compliance with local securities laws and protect investor interests. For instance, Brazil’s Securities and Exchange Commission (CVM) oversees share pledging transactions, requiring transparency and disclosure of pledged shares to prevent market abuse and maintain investor confidence.
Indian scenario:
In 2009, the infamous Satyam Scam took place. The chairman and directors of Satyam Computer Services falsified the financial documents, inflated the share price and stole from the company to invest in property. Later, they did not disclose the number of shares pledged which lowered the market value of shares. It was found that inflated revenue was around 7000 crores. Post this, SEBI provided guidelines to disclose the number of shares pledged by promoters in Takeover Regulations, 2007. This helps in monitoring the business closely and ensuring transparency between the decision makers of the company and rest of the world. It also helps in taking immediate actions if required, making regulatory work more time efficient.
This scam was discussed in the case of SRSR Holdings ltd. Vs. Securities Exchange Board of India wherein, it was also observed that pledging of securities will be consider as ‘dealing’ in securities for the purpose of Insider Trading guidelines. According to these guidelines, the section 6(d) any ‘insider’ is not allowed to deal during the trading window if such person is in presence of Unpublished Price Sensitive Information. This resulted, in prohibition of share pledging in trading window if the relevant person is in presence of UPSI. In absence of such interpretation, the insider could gain higher return from increased share prices by pledging the shares.
Similarly, another case of PTC India Financial Services Ltd. (PIFSL) discussed the further issues. The facts of the case are, PIFSL, is a Non-Banking Financial Company which advanced a loan to NSL Nagapatnam Power and Infratech ltd. (borrower). To raise money, the promoter of the company Mandava Holdings Private. Ltd. pledged shares of NSL Energy Private Ltd. (NEVPL) as collateral. Subsequently, due the default of the borrower the pledged was invoked and PIFSL was recognised as beneficial owner by the Depository Participant. Upon acceptance of borrower’s request of Corporate Insolvency Resolution Process, MHPL contended that it will step in as a financial creditor as it no longer holds the shares. PIFSL claimed money from the borrower and therefore approached the interim resolution professional but did not take the value of pledged shares under consideration while determining the amount to be claimed. The professional rejected the claims and the matter was taken to NCLT. The tribunal ruled that MHPL should be considered as financial creditor and the claim of PIFSL should be reduced to the amount of value of shares. The case went for appeal to the National Company Law Appellate tribunal that dismissed the case on the grounds that selling of shares will not determine the ownership. PIFSL appealed to Supreme court. The judgement was the section 176 of Indian Contract Act and Depository regulations are not in harmony. For it to be read harmoniously, the court clarified that that invocation of pledge will not amount to sale of pledged good and therefore the appeal was allowed.
To sum it up we can take an example, A ltd., B ltd. and C ltd. to explore the implications of regulatory requirements, important disclosures and compliances. A ltd. holds more than 50% of shares of B ltd. and has controlling interest in it. Thus, A ltd. is qualified as promoter of B ltd. I a situation where there is an urgent requirement of funds the promoter pledges the shares to C ltd. C ltd. is a financial institution that has agreed to the contract provided necessary capital. Under ICDR regulations enforced by Securities Exchange Board A ltd has to disclose the information to SEBI and stock exchanges where the shares are listed. The material facts should adhere to the rules and contain, number of shares pledged, rights of parties along with the market value and duration of the agreement. This would create transparency between the management of the company, minority shareholders and potential investors. Additionally, if the promoter is a connected person as per the definition by SEBI and has UPSI then they cannot pledge the shares in trading window except according to the trading plan. In a scenario where a default by A ltd. takes place, C ltd as the pledgee, can invoke pledge and can registered as beneficial owner in depository but it will not automatically be considered as sale and thus will only have right to sell under relevant laws of Indian contract Act and SEBI regulations.
SUGGESTION
Generation accountability: In presence of a transparent and accountable mechanism, the investor will repose more faith in actions of promoters. This could be achieved by timely disclosures of relevant information like number and value of shares pledged.
Periodic supervision: This practice will generate liability of defaulters on- time and in a more efficient way which is less time consuming and hassle- free.
Improvement in corporate governance standards: The standards are to ensure the best levels that can achieved by adhering to rules and adopting methods that yield results.
Educational initiatives: Creating awareness among investors about the risks and benefits of such practice will result in better decision- making skills.
In- depth risk assessment: Aversion of unforeseeable losses can be attained by assessing the situation and determining the course of action for every possible outcome.
Legal compliance: Following the SEBI regulations and being compliant will not generate personal liability of either party of the pledge upon default.
Regular amendments: Keeping up with the demand of stricter legal system can be accomplished through changes and making the law more dynamic.
CONCLUSION
In conclusion, share pledging has a significant role role in global financial markets, that offers shareholders an opportunity to leverage their equity holdings for diverse financial objectives. While it provides liquidity and flexibility, share pledging entails risks that require careful consideration and proactive management by stakeholders.
Regulatory frameworks, legal precedents, and market practices vary across jurisdictions, influencing the transparency, accountability, and governance of share pledging transactions. Stakeholders, including shareholders, corporate executives, regulatory authorities, and financial institutions, must collaborate to promote responsible practices and mitigate risks associated with share pledging.
By adhering to regulatory guidelines, adopting best practices in corporate governance, and enhancing investor education, stakeholders can harness the benefits of share pledging while safeguarding market integrity and protecting shareholder interests in an evolving global financial landscape. Continued innovation, collaboration, and regulatory vigilance will shape the future of share pledging, ensuring its sustainability and contribution to global economic growth.
Diya Mogra
O.P. Jindal University, Sonipat.