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Share pledges: the biggest risk to non-promoter shareholders

Saturday , 30 January 2016

In this article, we look at why one needs to avoid companies with a high level of share pledge, especially in falling markets

In the past we have said that share pledges impact stock prices substantially. In most cases, retail investors lost a considerable amount of money, in a fairly short period of time. In fact, in its Financial Stability Report, the RBI highlighted the risk caused to minority shareholders due to pledging of shares. In its report, the RBI stated that, ‘In the case of a typical Indian company, the promoters pledge shares not for funding ‘outside’ business ventures but for the company itself. By pledging shares, the promoters have no personal liability other than to the extent of their pledged shares. In some instances the shares pledged by unscrupulous promoters could go down in value and the promoters may not mind losing control of the company as there is a possibility of diversion of funds before the share prices collapse. While a lender has the option of selling the shares when prices fall and hit a point that can be called a default event, this can still have impact on minority shareholders through market impact costs, as with the invoking of the pledge, the pledged shares will have to be sold immediately.’

What happens when a share pledge is invoked?

The following are a couple of examples from different points in time which show what happens when a share pledge is either invoked or rumoured to be invoked. Our first example, Treehouse, is of a company with reasonable fundamentals, while the second company, Glodyne Techno’s fundamentals were on shaky grounds.

Tree House

Tree House Education & Accessories Ltd was incorporated on July 10, 2006. The company ran all types of education facilities for kids on their own and also by using a franchise model in India and abroad. Its stock price dropped from a level of Rs 350-400 in October 2015 to Rs 120 in a relatively short period of a month, due to rumours related to a high level of receivables, viability of its preschool expansion plan after it opened a record number of branches in the second quarter of this financial year and the selling of shareholders pledge. During this phase, Tree House was able to refute allegations. In a filing to the bourses, the company reiterated the health of its business and assured of the progression of its preschool expansion strategy as per schedule. Similarly, one of the credit rating agencies upgraded its bank loan facilities to A from A-, restoring faith in the fundamentals of the company. But by then, the damage was already done. A few unlucky investors had lost almost two-thirds of their stock value and all their hope, in spite of very few changes to the fundamentals. Zee Learn then quickly swooped in with a merger proposal to buy Tree House at a cheap valuation. The stock recovered a bit, but it is still nowhere near its highs of June to September. In this saga, the biggest loser was the retail investor.

Glodyne Techno

Glodyne Technoserve, was started in 1997. It offers technology-led business solutions across two SBUs, including Technology Infrastructure Management Services (Technology IMS) and Application Software Services. Stock fell from Rs 400+ to less than Rs 70, in only 30-40 days of trading. While the firm claimed that the fall was because of invocation of pledge, the reality was a bit different. The fall started a few days before the announcement of change in AGM dates, due to the unavailability of the company’s directors. Its fall was perpetuated by challenging financials including excess leverage, low short-term liquidity and unreliable figures. Further, it had a large amount of goodwill in its books, resulting in a very high debt-to-tangible-equity figure, relative complexity of operations (due to acquisitions) and heavy reliance on government contracts. As a result, it was an unlikely candidate for acquisition, even at lower valuations. Industry players were cognisant of these facts and no one even bothered to bid for it. The stock as of now has not been traded for the last 30 days, causing permanent loss of capital for investors.

Lessons learnt

Companies with high promoters pledge are at risk of market fluctuations, given that even a small fall in price, results in an increased margin call or more stock pledges. Sometimes, overleveraged promoters are in no position to provide either and do not mind losing control of the company, which results in indiscriminate sell-offs by financiers. This fall is further accelerated by opportunistic short-sellers. The fall is even more severe during market conditions like what we witnessed this month. In case the fundamentals of the company are solid, then in all likelihood it will be a target for acquisition or else the stock will go down substantially. In all scenarios though, retail investors are likely to be losers.

All in all, we caution our readers to stay away from such companies. We have provided a list of companies where promoters have pledged over 75% of their holdings. This list has been shortened by considering companies that are trading closer to their 52-week lows, as these companies face the highest risk. As usual though, these names should not be automatic sells, but must be viewed with caution. After all, the foremost rule of investing is, ‘Don’t lose money’.