Pledge of shares by promoter entities
– concerns involved, regulatory framework and need for additional disclosures
– Anushka Vohra, Manager | corplaw@vinodkothari.com
Background
It is common for promoter / promoter companies (HoldCo) to raise funds by way of pledging their shares held in operating companies (OpCo). This is known as loan against securities (LAS). LAS enables borrowers to raise funds from banks / NBFCs by keeping shares, mutual funds or life insurance policies as collateral. There are specific regulations issued by RBI with respect to LAS.
As on March 6, 2023[1], there are 239 companies that have reported promoter pledge on BSE. Pledging of shares by promoter companies held in operating companies does not raise a red flag per-se, however one has to know, (i) the percentage of shareholding pledged by promoters / promoter companies viz-a-viz the paid up share capital held, that is to say the unencumbered shares, (ii) leverage at the group level; (iii) impact of default.
In this article, the author tries to highlight the concerns arising from pledging of shares held in OpCo by HoldCo, the disclosure provisions currently prevailing w.r.t. the pledged shares, and the need for additional disclosures.
Disguised leverage
In financial terms, leverage means to use borrowed money to buy an investment or company. When shares are pledged by the HoldCo, the equity component of the OpCo comprises some part of debt, that the HoldCo has leveraged. At the OpCo level, the debt to equity ratio may not have the impact of the leverage created as the equity would remain the same, however, this would have an impact at the group level.
To take an example, assume an OpCo, with total equity of Rs 1000 crores, for the sake of illustration, entirely held by promoter entities. The OpCo has borrowings of, say, Rs 3000 crores, and therefore, a leverage of 3 times. The promoter entity, in turn, has borrowed against the equity infused by it, say with a LTV ratio[2] of 50% – therefore, Rs 500 crores out of the Rs 1000 crores invested in OpCo is debt. Effectively, therefore, at a group level, there is debt of Rs 3500 crores, and equity of only Rs 500 crores, taking the debt equity to 7 times. Thus, loan against pledge of promoters’ shares disguises leverage at the OpCo level.
RBIs Financial Stability Report, 2014[3] highlights the prevalence of a practice known as ‘double leveraging’. It states that, In a typical double leveraging, a holding company raises debt on its balance sheet and infuses it as equity in SPVs. From the lenders’ perspective, a debt-to-equity ratio of 2:1 at the holding company level could transform into a leverage of 8:1 at the SPV level.
Ways to service by OpCos
Pledging of shares is resorted by the HoldCo when there are no significant cash flows and thus promoters / promoter companies are dependent on return from OpCos to service the debt obligations arising from pledging of shares.
This creates pressure on the OpCos to provide returns to the HoldCos. The OpCos meet the same in two ways; (i) by payment of dividend; (ii) by keeping the market price from falling.
The Companies Act, 2013 has provisions allowing companies to pay dividends from profits that are carried forward as reserves, subject to certain restrictions. However, paying dividends where there are losses in the company becomes a cause of worry and demands cautiousness on the part of the directors.
Talking about (ii), if the market price of the shares of the operating companies plunges, the promoters / promoter companies would be required to provide additional collateral to maintain the LTV ratio. This again creates pressure on the operating companies to keep the market prices of shares from falling. The promoter shareholders would thus be focused on short-term market cap of the OpCo, thereby pursuing strategies focused on the short-term, at the cost of the long-term.
Risks involved
- Fall in market prices
Considering the above example, if the market price of the equity shares fall, the HoldCo will have to provide additional collateral to maintain the LTV or will have to repay some amount of loan. In case of breach of covenant by the promoters / promoter companies, the lender will have to invoke the pledge. It is a possible situation where promoters have engaged in multiple pledge transactions with several lenders, default may result in multiple lenders invoking the pledge and selling the shares in open market. Increase in supply of shares in the market, would lead to fall in market price of shares.
- Loss of control
When the shares are pledged, the ownership remains with the promoters, it is only at the time of invocation of pledge that the ownership gets transferred to the lender. Upon invocation of pledge the promoters would lose control over the operating entity. This is not a rare occurrence and the first instance happened in 2009 when the promoter of Great Offshore Limited lost control over the shareholding due to invocation of pledge.
- Difficult to sustain profit
As mentioned earlier, in order to keep the market price from falling, the OpCos would focus more on increasing short term profitability so that shares prices increase after quarterly results and therefore engage in short term strategies. This makes it difficult for the operating companies to sustain profits.
Regulatory framework
SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 1997 (“Erstwhile Regulations”) was amended in 2009 to mandate disclosure of details regarding pledging of shares by promoters. This requirement continues in the present day SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 2011 (“SAST”). The current regulatory provision requires the following w.r.t. pledge of shares by promoters:
- Disclosure of shares encumbered
Reg. 31 of SAST- the promoter of every target company is required to disclose details of shares encumbered by him or by PACs with him.
The SAST Regulations were amended by way of SEBI (Substantial Acquisition of Shares and Takeovers) Second Amendment Regulations, 2021 to introduce automated disclosures in line with SEBI circulars on system driven disclosure in this regard. SEBI circular on Automation of disclosure requirements under SAST dated Mar 7, 2022 further clarified on no requirement of manual disclosure for Reg. 31 except for transactions as mentioned therein.
- Reasons for encumbrance
As per SEBI circular Disclosure of reasons for encumbrance by promoter of listed companies dated August 7, 2019, the promoter has to disclose detailed reasons for encumbrance, to the stock exchange(s) and to the listed entity, if the combined encumbrance by the promoter along with PACs with him equals or exceeds:
- 50% of their shareholding in the company; or
- 20% of the total share capital of the company
within 2 working days of creation of encumbrance.
This disclosure is to be given manually.
- Declaration regarding no encumbrance
Reg. 31(4) of SAST- the promoter of every target company shall declare on a yearly basis that he, along with his PAC, has not made any encumbrance, directly or indirectly, other than those already disclosed during the financial year.
- Consolidated debt to equity ratio
Under Companies Act, 2013, 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.
As per Reg. 52(4) of SEBI LODR, the listed entity while submitting quarterly and annual standalone / consolidated financial results, has to disclose debt equity ratio, along with other ratios as mentioned therein.
Concluding remarks
CRISIL, in its report of 2019, Covering the pledge[4] highlights on the implication of pledge for the lender community stating that, ‘… debt raised through pledge of promoter shares should be assessed based on the overall cover available through promoter holdings – both pledged and unencumbered – on the overall debt that the promoter has raised in various holding/ investment companies, and not on the pledge and structure of a specific transaction alone’
SEBI Regulations 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, release of pledge i.e. the repayment schedule irrespective of whether these promoter entities are based in India or overseas.
[1] https://www.bseindia.com/corporates/Pledge_new.aspx
[2] RBI directions require NBFCs to have a LTV of not less than 50% in case of loan against shares
[3] https://rbidocs.rbi.org.in/rdocs/PublicationReport/Pdfs/FSR29122014_FL.PDF
[4]https://www.crisil.com/content/dam/crisil/our-analysis/reports/Ratings/documents/2019/march/covering-the-pledge.pdf
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