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What is pledging of shares? Why is it dangerous for investors?

Promoters of companies generally hold a significant percentage of their company’s shares. Many times, to meet business expenses or sometimes even for personal obligations, promoters use the pledge of shares as collateral security to raise funds. As per the market practice, pledging shares is the last resort for promoters to raise funds, and this route is explored when raising funds through equity or by taking debt is ruled out.

What happens when promoter shares are pledged?

Pledging of shares can lead to a vicious cycle. Till the share price rises, things are under control. However, often, a scenario arises wherein the promoters may have overburdened their position by heavily pledging their holdings. The stock market generally react to such news by having lesser confidence in the company, resulting in a drop in prices.

Why is pledging of shares dangerous for investors?

A price drop is where the troubles begin for promoters, the company, and its investors. As the share price drops, the value of the collateral offered in the form of pledged shares also drops. It results in the lender asking for cash to cover the difference or extra security in terms of more pledged shares, leading to a domino effect.

Is pledging of shares always a bad sign?

Pledging of promoters’ shares may not always be a bad sign. When promoters’ shareholding is high and funds are needed for genuine reasons like expansion, they may approach financial institutions to raise funds by keeping their shares as collateral security.

As per market norms, for the pledging of shares procedure, most banks offer about 50% of the market value of the pledged shares as a loan.

Release of pledged shares is good or bad?

Mostly, it is a good sign when a company manages to release its pledged shares, and it is an indication that its operations are back on track and funds are now available.

But investors looking to make stock market investments need to be cautious and check whether the release of pledged shares has been done from the right source of funds like business income or some other favourable debt creation. If such funds have been raised through any dubious means like liquidating company assets or by more personal borrowing done by the promoters, then the company can end up being in a more dire state.

How to check pledged shares before deciding on stocks to buy?

Promoters’ share pledging data is readily available on websites of stock exchanges such as the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE). Concerned companies also release such information through their financial statements. You, as an investor, should always exercise caution before deciding on stocks to invest in.

Final takeaway

The market hypothesis says that companies with more than 50% of promoters’ share pledging are more likely to be in trouble. Some healthy companies resort to such funding, but they usually restrict the quantum to 10-20%. Raising funds against shares could be beneficial for a company when in need of urgent finances. But investors need to keep a vigilant eye to see that the percentage of such shares does not keep increasing and that the release of the pledge does not get delayed.  One thing to aid this is being abreast of developments in the stock market today.

 

You could also reach out to a financial expert before you decide to take the plunge of investing in stock market.

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