Understanding the consequences of pledging shares

Satyam, India’s number four software services exporter is now caught in a tight spot. Well, it has all happened due to the general practice of the art of pledging shares to raise funds. In India, this act of pledging shares to raise funds is considered as a very common practice. It is now a known fact that the family shares of Satyam were consolidated so that they could be pledge to institutional investors in the bargain for loans. As long as the markets kept going up, everything seems to be fine. However, the problem began when the markets started tumbling. When the share price sank beyond 70% of the price at which they had pledged, the lenders asked Satyam promoter to start making up the losses. However, the Raju’s were unable to build additional cash in order to meet the shortfall. This present situation has led to the resignation of independent directors: Vinod Dham, Krishna Palepu and M Ram Mohan Rao. All of them left Satyam Computer Services with only five directors on the board. It is only The January 10th meeting which will tell how many members will be left by then.

Most Institutional lenders want assurance from the borrower that it will repay the debt. In the above scenario, it is the promoter who has to repay the debt. The assurance comes in the form of collateral such as shares and then the lender and the borrower enter into an agreement. So, when there is a default whenever the value of the shares falls, it is understood that the collateral will be collectible.

I am of the opinions that while promoters try to raise the money, they should not get into the habit of pledging all shares at one go. Also, there is a common tendency where promoters check the high stock price and then pledge the shares for loan. However, when the opposite happens the promoter goes to a further extent by pledging more shares with the same lender. Now, this is a wrong step to take and we have already seen a similar situation which happened with Satyam who is now facing the consequences of pledging Shares.