What is Pledging of Shares.

Pledging of shares is nothing but taking a loan against existing shares that an investor is holding . It is a process in which the promoters of the company surrender their shares as guaranty/collateral to fulfil their financial requirements .

During pledging of shares , the borrower or promoter will have the complete ownership of the shares and will continue to earn dividends on the same . Shares can be pledged for any purpose including requirement of working capital, new ventures, to trade in the equity market, futures and options, or even personal financial requirements.

Let’s try to understand pledging of shares with an example:-

There’s a company A who wants a loan for its next plan and they are willing to pledge promoter’s shares for the same. The current market price (CMP) of the share is Rs 100 and company A needs a loan of 1 Lac.

The banks usually offer loans up to 50% of the market price of the share. In this case, if company A pledges its one share then the bank will offer the loan of Rs 50. In such a scenario the company A must pledge 2 thousand shares with the lender. For security purposes, the lender keeps the difference between the current market price and the loan amount.

Check out : How a person transformed Rs 5000 to $5 billion in share market.

According to the rules and regulations led by RBI,LTV ( Loan To Value ) ratio of 50% must be maintained at all the time when lending is based on the pledging of shares. Since the proposed loan amount in the above example is 1 lac, the promoters must pledge 2 lacs worth of shares. It is important to maintain a 50% LTV ratio and if such a scenario occurs where 50% LTV ratio is not maintained then a time of 7 working days is given to promoters else the lender has the right to sell the shares and recover the loan amount.

Advantages of pledging Shares –

• Lower Interest Rates: When a borrower pledges his shares as collateral, he is granted a secured loan. Secured loans are preferred to unsecured loans as the lender can easily recover the amount borrowed, in an event where the borrower defaults, by liquidating the collateral. It is easier to avail a secured loan, and the interest charged on secured loans is much less than that charged on unsecured loans. Additionally if the borrower has a poor credit history, pledging shares as collateral could be the only way to obtain a loan.
• Easy Access to Cash: Liquidity is the ability to easily convert an asset to cash form. A shareholder who requires cash can obtain liquidity using shares in two different ways. Firstly by selling the shares, however this could result in the shareholder having a tax liability if there is a profit. Additionally the shareholder would lose out on dividend income in case the shares are sold. The second option will be for the shareholder to pledge the shares as collateral, and take a secured loan. The shares aren’t sold, so there is no resulting tax liability, and the borrower will continue to receive dividends from the shares.

Disadvantages of Pledging Shares –

Pledging of shares is not completely bad , but it can jeopardise the reputation of the company as it shows lack of funds in the company which breeds fear in the mind of investors and thus the rampant selling of shares start .The main problem comes when the CMP(current market price ) of the company goes down . Then the borrower has to pledge more shares or balance out with cash with the lender (bank) .

So , With more shares pledged , the promoter loses his credibility to be in the board and thus loses all his yay or nay rights.

References :- https://www.kundankishore.in/blog/pledging-of-shares#:~:text=The%20banks%20usually%20offer%20loans,thousand%20shares%20with%20the%20lender.