Raising debt by pledging shares is a common practice in the banking and finance industry. However, pledging the shares of a listed company has a direct impact on the marketability of those shares, and affects investments of retail investors.
The calling in of a pledge by the lenders following a borrower’s default can lead to a distress sale, which will eventually reduce the value of the assets in the hands of investors.
To minimize the impact of pledged shares, the Securities and Exchange Board of India (SEBI) in 2009 introduced a requirement that the promoters of a listed company should disclose the pledge of shares, and an ensuing
disclosure by the company to stock exchanges. Many changes have since been made, both in the format and timing of these required disclosures.
An important change in disclosure requirements followed the Satyam scam. The price of shares in that company crashed following a series of revelations, including that the shares of the promoter had been pledged to banks. The term pledge was replaced with encumbrance to include pledges, liens and other restrictions placed on promoters’ shares of listed companies. However, companies and their promoters have managed to structure transactions in creative ways to evade this requirement. In August 2019, the SEBI announced an amendment to its Substantial Acquisition and Takeover of Shares Regulations, 2011, making the scope of encumbrances all-encompassing. This change was brought into effect following the distress sale of pledged shares by the lenders of Zee Entertainment, Sun Pharma and Reliance Group.
In accordance with the amendment, the term encumbrance now includes:
- Any restriction on the free and marketable title of shares, by whatever name called, whether executed directly or indirectly;
- Any pledge, lien, negative lien, non-disposal undertaking; and
- Any covenant, transaction, condition or arrangement in the nature of encumbrance, however described, whether executed directly or indirectly.
In order to make shareholders of a listed company, including the minority shareholders, aware of the reasons why the promoters have pledged their shares, especially where promoters have pledged a significant portion of their holding, the SEBI has laid down a stricter disclosure requirement in respect of any transaction that impacts the marketability and the freedom of title of those shares. Promoters are also required to state if the encumbrance is related to any debt instrument, and to give its credit rating.
Further, the SEBI prescribed a threshold limit. Only if the encumbrances created by the promoters exceed the prescribed limit of 50% of the shareholding of the promoters in the company, or 20% of the total share capital of the company, shall the promoters be required to disclose to the stock exchanges such details in the format prescribed by the SEBI within two working days from creation of such encumbrances.
Any further increase in the encumbrance shall also have to be disclosed. Promoters shall also be liable to disclose details of any invocation of such encumbrance, or release of such encumbrance of shares. In view of this amendment, a commonly offered security will now become rarer than ever. Usually, lenders prescribe a condition as part of the sanction terms that the promoters of the company shall not dilute their shareholding in the company below a certain threshold throughout the period of the facility.
Given the stringent disclosure regulations in place, it is now binding on the promoters to make disclosures with regard to encumbrances created on the shares held by them and any persons acting in concert, as defined under the SEBI takeover code.
However, if the company enters into any covenants or restrictions in the loan documentation undertaking to ensure that any promoter would maintain a minimum shareholding, such undertaking shall not be binding on the promoter acting in his capacity as such. As a result, the promoters could not be required to make disclosures in accordance with any undertakings given by the company.
It is abundantly clear that company promoters looking to raise money by pledging shares have been caught unprepared by the amendment of August 2019. With the widening of the definition of encumbrance, there is no doubt that such promoters will now have to make appropriate disclosures to the stock exchanges, no matter if such encumbrance is in the form of a covenant, condition, arrangement or transaction.
SNG & Partners has offices in New Delhi, Mumbai and Singapore. Jyotika Bajaj is a senior associate and Medha Unadkat is a legal consultant.