PLEDGING OF SHARES
CS. Rachana Bairagra, Company Secretary, Jindal Worldwide Ltd.
Pledging of shares in order to avail the loan is neither a new concept for promoters nor for investors. In brief, when the promoters want to raise the funds for the personal or the company’s needs, they pledge their shares with the financial or non-financial institution.
For many years now, lending against shares was a common practice amongst promoters. As long as share prices were rising, there was little danger. Lenders such as nonbanking finance companies (NBFCs) and banks were comfortable doling out such loans. These loans typically have tenure of between one and three years, and carry a margin of 2-3 times, which means that the value of the promoters’ shares pledged is 2-3 times the amount of the loan. For the NBFCs and banks, it’s a low-risk business as they can charge a mark-up of 3-4 per cent over the prime lending rate. Hence the lender has to ensure that his market risk is covered as the shares being pledged should be liquid enough to ensure recovery of dues from the borrower.
Before the Satyam debacle, there were no disclosure norms made by the SEBI (Securities and Exchange Board of India) for the promoters to disclose their pledged shares. In developed countries like US, not just promoters but directors too are required to disclose their pledged shares. In
Bankers or financiers give loan taking the shares as collateral. Hence, whenever the price of the share come down to a certain level in the secondary market, the promoter is required to either make some payment or pledge more shares.
If the promoter can not do either, the lender keeps the right to sell pledged shares in the market. Apart from this, promoters always have the risk of a hostile takeover.
Hence the certain disclosures were necessary regarding the pledging of shares by promoters as pledging of shares could result in a change of ownership if the promoter is unable to redeem those shares by repaying the loan.
This is critical, as many investors consider promoter holding and management structure of the company as a critical aspect of their investment decision.
Promoters of many listed companies have raised finances by pledging their shareholdings. When they pledge their shares, they pledge their voting rights as well and hence it becomes a risk factor. And deleveraging of such positions has the potential of deteriorating the company's valuation.
As in the recent times, the Stock prices have been on a downtrend for some time due to adverse market conditions. So when such situation happens, lenders ask for either additional shares, or margin payment to cover the shortfall.
In the event of promoters being unable to meet these conditions, lenders dump the shares in the market to recover their dues. As the sale of these pledged shares usually happens in huge quantities, it has a cascading impact on the stock price.
However, till now the information regarding the pledging of the shares by the promoters was not made public, as there were no rules mandating them to do so. The pledging of shares by promoters was not considered a major issue in the bull market, as nobody thought that the market could slide so rapidly. The non-availability of cheaper money in recent months has made the buying back of the pledged shares by promoters difficult.
While promoters try to raise the money, even though for the development of the business of the Company, they should not get into the habit of pledging all shares at one go. As when they pledge the shares, the market is high but if the opposite happens, then there could be great trouble which can be set off by either pledging more shares or through other means. As such a practice could work well in a rising market but in a falling market that often leads to dilution of promoter holding in the company whose shares are pledged. In a falling market, if the value of the collateral falls below the quantum of the loan taken by promoters, lenders often sell those shares to recover their loans, partly or fully.
Reasons for opting for pledging of shares by the promoters
There can be several reasons. It can be for either personal needs or business expansion. Sometimes, promoters collateralise their shares for converting warrants into shares.
When the promoter has exhausted all other sources to raise funds, he pledges his holding in the company as a last resort, which is a clear indication that it is not an ideal situation. In developed markets, the pledging of shares by promoters, or insiders, as collateral for a loan is equivalent to a sale of the stock to the pledge.
Pledging of shares by general shareholders and promoters
When a shareholder/investor needs loan from bank or financial institution, he can pledge his shares to them.
Banks and financial institutions give loan against shares. To avail such loans any shareholder can pledge shares to the lender. But unlike promoters, small shareholders are not required to disclose. For taking a loan against shares, the investors have to collateralise the physical shares to the bank.
Pledging of shares or Acquisition
It would be really interesting to note that pledging of the shares of listed company and/or exercise of such pledge and acquisition of such shares would amount to acquisition requiring an open offer under the SEBI Takeover Regulations or not. The issue thus has to be examined in two stages - First is, whether at the time of pledging the shares, there is an acquisition. Second stage is when the pledge is exercised and the shares transferred to the name of the pledgee.
It may be tempted to believe that the answer is quite clear cut. The first stage of pledge, unless it amounts to unconditional and full transfer of shares, is not an acquisition of shares attracting the Takeover Regulations. The second stage would however clearly amount to an acquisition and thus attract the Regulations. In support of this, one may point out that Regulation 3(1)(f) is also explicit in exempting only acquisition by banks and public financial institutions as pledgees. Arguably, thus, all other acquisitions as pledges would not be exempted.
Other Acts/Guidelines for pledging of shares
Banking Regulation Act
Under Section 19(2) of the Banking Regulation Act 1949, it is provided that no banking company shall hold shares in any company whether as pledgee, mortgagee or absolute owner of an amount exceeding 30% of the paid-up capital of that company or 30% of its own paid-up capital and reserves, whichever is less. The shares of any company are taken as security by the banks and financial institutions in following cases:
1. Overdraft facility against listed and approved shares of any public limited company.
2. Pledge of shares of listed companies as an additional or collateral security for a loan or overdraft given against some other prime security.
Pledge of promoter’s shares in cases of project finance where the loans and advances are secured by a charge over the entire block of assets of the borrower and the pledge of shares is taken by the bank to ensure that the promoter continues to be involved in the project and does not transfer his interest without the consent or knowledge of the bank. Such a pledge also enables the lender to sell or dispose off the securities along with management of the company by exercising the rights as a pledgee although in practice such rights are rarely exercised.
While the requirement of the provisions of Section 19 placing a ceiling of 30% of the share capital of the company may be justified in respect of loans referred to at sub-paras (i) & (ii) above, there is no justification for placing that restriction in respect of pledge of promoter’s share holding with the lender. Further, in terms of the RBI instructions, it is necessary that the bank holding shares as a pledgee or mortgagee must get such shares transferred in its own name (refer to RBI circular no.DBOD.BC.90/13.07.05/98 dated 28th August, 1998). This means that promoter’s shares in excess of 30% cannot be accepted in pledge. Further, where the bank takes promoter’s share holding in pledge, if such shares are transferred in the name of the bank, the effect will be that the bank itself will become the promoter and may have to face various liabilities as the owner of the company. Such liability may be environmental or other statutory liabilities relating to labour dues, workmen compensation etc. This particular aspect of taking promoter’s shares as a pledge by the banks has arisen for consideration because the provisions of Section 19(2) of Banking Regulation Act do not apply to financial institutions and the practice of taking pledge of shares is prevalent among the development financial institutions and the banks were only participating as a consortium member in the term lending. With the development of the concept of universal banking and banks’ entry into the field of term lending on a very large scale, it will become necessary for the banks also to take pledge of promoter’s shares as a collateral security along with other securities. The Group therefore recommends that restriction on holding of such shares exceeding 30% be withdrawn in respect of pledge of promoters shares and dispense with the requirement of transfer of such shares in the name of the bank.
ECB (External Commercial Borrowing) Guidelines
Under the ECB guidelines, the choice of security to be provided to the overseas
lender / supplier for securing ECB is left to the borrower. However, creation of charge over immoveable assets and financial securities, such as shares, in favour of the overseas lender is subject to Regulation 8 of Notification No. FEMA 21/RB-2000 dated May 3, 2000 and Regulation 3 of Notification No. FEMA 20/RB-2000 dated May 3, 2000, respectively, as amended from time to time. Accordingly, proposals for creation of charge on immovable assets, financial securities and issue of corporate or personal guarantees, on behalf of the borrower in favour of the overseas lender, to secure the ECB under automatic / approval route, are considered by the Reserve Bank.
As a measure of rationalisation of the existing procedures, it has been decided to allow AD (Authorised Dealers) Category - I banks to convey ‘no objection’ under the Foreign Exchange Management Act (FEMA), 1999 for creation of charge on immovable assets, financial securities and issue of corporate or personal guarantees in favour of overseas lender / security trustee, to secure the ECB to be raised by the borrower. Before according ‘no objection’ under FEMA, 1999, AD Category - I banks may ensure and satisfy themselves that
(i) the underlying ECB is strictly in compliance with the extant ECB guidelines,
(ii) there exists a security clause in the Loan Agreement requiring the borrower to create charge on immovable assets / financial securities / furnish corporate or personal guarantee,
(iii) the loan agreement has been signed by both the lender and the borrower, and
(iv) the borrower has obtained Loan Registration Number (LRN) from the
On compliance of the above conditions, AD Category - I banks may convey their ‘No objection’, under FEMA, 1999 for creation of charge on immovable assets, financial securities and issue of personal or corporate guarantee, subject to the conditions mentioned below:
Creation of Charge over Financial Securities
AD Category – I banks may convey their 'no objection' under FEMA, 1999 to the resident ECB borrower for pledge of shares of the borrowing company held by promoters as well as in domestic associate companies of the borrower to secure the ECB subject to the following conditions :
(i) The period of such pledge shall be co-terminus with the maturity of the underlying ECB.
(ii) In case of invocation of pledge, transfer shall be in accordance with the extant FDI policy.
(iii) A certificate from the Statutory Auditor of the company that the ECB proceeds have been / will be utilized for the permitted end-use/s.
Issue of Corporate or Personal Guarantee
The ‘no objection’ to the resident ECB borrower for issue of corporate or personal guarantee under FEMA, 1999 may be conveyed after obtaining –
(i) Board Resolution for issue of corporate guarantee from the company issuing such guarantees, specifying names of the officials authorised to execute such guarantees on behalf of the company or in individual capacity.
(ii) Specific requests from individuals to issue personal guarantee indicating details of the ECB.
(iii) Ensuring that the period of such corporate or personal guarantee is co-terminus with the maturity of the underlying ECB.
AD Category – I banks may invariably specify that the ‘no objection’ is issued from the foreign exchange angle under the provisions of FEMA, 1999 and should not be construed as an approval by any other statutory authority or Government under any other laws / regulations. If further approval or permission is required from any other regulatory / statutory authority or Government under the relevant laws / regulations, the applicant should take the approval of the authority concerned before undertaking the transaction. Further, the 'no objection' should not be construed as regularizing or validating any irregularities, contravention or other lapses, if any, under the provisions of FEMA or any other laws or
These amendments to the ECB guidelines shall come into force with immediate effect, subject to review from time to time.
Necessary amendments to the Notification No. FEMA 3/2000-RB dated May 3, 2000, Notification No. FEMA 8/2000-RB dated May 3, 2000, Notification No. FEMA 20/2000-RB dated May 3, 2000 and Notification No. FEMA 21/2000-RB dated May 3, 2000 are being issued separately.
Obtaining of loan by NRIs by pledging shares
NRIs can pledge the shares to obtain loan, only after the specific approval of RBI is received. The application has to be made through the same bank in which the NRE/NRO account was opened.
Amendment by SEBI
Sebi has come out with new disclosure, in a bid to protect the interest of existing and potential shareholders, as pledging of shares could result in a change of ownership if the promoter is unable to redeem those shares by repaying the loan.