Pledged shares sell off: More pain in the offing?

Santosh Nair

Moneycontrol.com

What will drive the final round of bull capitulation for the stock market to bottom out? Panic selling by foreign institutional investors seems to be most logical answer. After all, they have been the biggest buyers of Indian shares in the last couple of years. Anecdotal evidence as well as shareholding data over the past many quarters point that very little domestic money—retail and institutional—has gone into equities during this period.

But some of the veteran players of the industry have a different take; they feel it could be the margin call-triggered liquidation of shares pledged by promoters that could mark the final sell-off.

Don't be fooled the numbers disclosed by companies to stock exchanges. An overwhelming majority of promoters hold shares in benami accounts, that don’t show up in disclosures of shareholding pattern to stock exchanges. Brokers and fund managers say this number could be anywhere between 3-10%.

With share prices steadily on the decline for some months now, promoters are faced with a difficult choice between either repaying a part of those loans-against-shares, or depositing additional shares as margin. If they fail to do either, the lender will dump the shares in the open market, sending the stock price into a free-fall, which in turn could trigger further margin calls. The promoter of Orchid Chemical nearly got thrown out of his own company in 2008 after the lender liquidated the pledged shares.

So, stock exchange data may show the promoters as holding a certain percentage in the company, while the actual holdings could be much higher.

It is the benami accounts through which promoters buy shares of their company whenever there is a panic selling in their stock, or when they have information about some development that could drive up the stock price. It is through these accounts that large blocks of shares are offered to fund managers for a premium, or dumped in the open market in tranches.

Many promoters pledge shares through unofficial accounts, to shield the stocks from attacks by bear traders. Bears target shares where a sizeable chunk of the promoters’ holdings is pledged. The strategy is weaken the stock price below a point that could then trigger margin calls.

In January 2009, the Securities and Exchange Board of India (SEBI) ruled that promoters should disclose details of shares pledged with lenders, to stock exchanges. The rule was prompted by sharp falls in many stocks where promoters had pledged shares with non-banking finance companies. Promoters have managed to work around the rule, by pledging their shares in the benami accounts.

This is not to say that pledging of shares is always for the promoters’ personal needs. Many promoters routinely pledge shares to fund working capital requirements, or some other requirement of the company.

But there are enough promoters who have been raising money to play the ‘market capitalization’ game. In fact, the stock market rally in many mid and small companies around Diwali last year had to do with promoters raising money by pledging a part of their holdings, and using that money to purchase shares through the open market in collusion with some market operator. That game is now up. There are far too many negatives at the macro level—both globally and locally—and the stock market is set for a downturn in the near term. Stock prices could fall even sharper than the benchmark indices, unless the companies manage to report spectacular earnings, which again looks difficult given rising interest costs, high raw material costs and falling consumer demand.

Pledging of shares is not a bad thing, but unless they were for the right reasons, some promoters will have to be ready for a dramatic fall in their stock price. Or who knows, maybe even losing control of their companies.