How To Draft A Share Pledge Agreement ?

Introduction :

One of the most significant elements to examine before investing in a firm is the pledge of shares. For investors, a company with a big number of pledged shares is a source of concern.

According to a recent news report, the value of promoter shares pledged in BSE 500 businesses fell to 1.95 percent in June 2020, compared to 2.34 percent the previous quarter. Promoters pledged 1.3 trillion in shares at the end of the June quarter, accounting for less than 1% of India's overall market value, according to the study.

We'll try to figure out what pledging of shares is and how it affects the firm's stockholders in this article.

What is Pledging Of Shares Pledging :

Company promoters utilize the pledge of shares as one of their ways for obtaining loans for operating capital, personal purposes, and to support other ventures or acquisitions. A promoter's interest in a firm is used as collateral to receive a loan. When pledging shares, promoters preserve their ownership. The collateral's value, on the other hand, fluctuates with the stock's value. The promoters are compelled to make up the shortfall in the value of the collateral when the value of shares pledged to a lender falls below a certain level.

Whenever the value of the pledge depreciates, the founders are obligated to provide new shares to lenders in order to preserve the collateral's worth.

For businesses, this may be an issue at times. If the entrepreneurs are unable to cover the difference, lenders may be able to recuperate their losses by selling the shares on the open market.This can result in the promoters' shareholding in the firm decreasing, the stock's value depreciating further due to the flood of new paper into the market, and even a rapid change of guard in the company due to the change in shareholding pattern.

Following the Satyam fraud in 2009, India's securities market regulator, Sebi, adopted a set of rules and regulations to ensure that such borrowings are properly disclosed. Fears of a margin call prompted selling in a number of Indian midcap and smallcap equities in February 2013.

What is the procedure for pledging shares? :

The method for pledging shares is identical to that of pledging a property, with the exception that shares of a publicly traded corporation are pledged instead of a house. Stock in a public corporation can be used as collateral for a loan by anybody who owns it. When the company's promoters pledge ownership, investors should be mindful of this.

Assume that 60 percent of XYZ Ltd is owned by the company's promoters. A 60% stake shows that the promoters own 60 lakhs of the 1 crore shares on the market. The market value of each share is $500. As a consequence, the promoters' interest in the company is valued at Rs. 300 crore (60,00,000 x 500).

Assume the promoters want a bank loan to finance Rs.100 crore to expand the company's production capacity.

RBI regulations demand that a loan to value (LTV) ratio of 50% be maintained at all times when lending based on a stock commitment. Because the planned loan amount is 100 crores, the entrepreneurs would have to pledge at least 200 crores worth of shares to the bank, which amounts to 40 lakh shares. It's also worth mentioning that any shortfall in maintaining the 50%  LTV that arises as a consequence of share price fluctuations should be made good within seven working days.

Assume the stock price of XYZ Ltd. falls to 450 as a result of poor financial performance. The LTV has grown to 55 percent (100/180) since the collateral is now only worth (40 X 450) 180 crores. In order to maintain a 50% LTV, the promoters will be requested to commit more shares. By promising an additional 4.44 lakh shares, the value of the collateral may be boosted to 200 crores. The promoters will be obliged to pledge additional 17.14 lakh shares if the price falls to 350. When the price drops to 333, 60 lakh shares must be pledged to guarantee that the collateral value is about 200 crores, which is the whole ownership of the promoter firm.

If the promoters are unable to obtain the collateral by pledging fresh shares or paying cash to reduce the loan debt at any point throughout the process, the financial institution will sell the shares on the open market, receiving the proceeds and decreasing the loan liability.

Let's pretend that XYZ Ltd stock price drops from 500 to 250 in a couple of days due to unanticipated circumstances. Even if the promoters pledge their whole 60 lakh ownership, the collateral will only be worth 150 crores, resulting in an LTV of 66.67 percent (100 / 150). The LTV may only be decreased to 50% by selling the shares, realizing the proceeds, and lowering the loan amount. If 20 lakh shares are sold, 50 crores may be raised.

The outstanding loan will be 50 crores (100 – 50), and the pledged value will be 100 crores (150 – 50), for a 50 percent (50/100) LTV. Putting 20% of the company's outstanding shares on the market, on the other hand, will give a negative impact on the stock price, leading it to fall even lower.

How to pledge shares :

The promoter must make a request for pledging shares using the trading terminal.

The trading terminal transmits the request to NSDL/CDSL for confirmation after receiving it.

NSDL/CDSL employs email/mobile authentication for PAN/BOID authentication. 

Once the collateral margin has been provided, the promoters can trade it.

Angel One will accept a Margin Pledge Request Form from promoters, which must be signed by all holders.

How To Draft A Share Pledge Agreement :

You're pledging your shares as security for a loan when you make a share pledge or a stock pledge arrangement. Although you can formally promise your stocks, a formal pledge agreement is safer since it makes it easy to ascertain the facts if someone becomes confused or forgets the terms.

Terms :

You should be identified as the pledgor as well as the pledgee with whom you're working in your share pledge agreement. It identifies the equities you're referring to as well as the fact that they're being used as collateral. A good pledge agreement explains what happens if the stock is reclassified or altered, as well as the pledgee's choices if the pledge is ruled void. When both you and the pledgee are happy with the terms, both of you sign the document.

Requirements :

When you sign a pledge agreement, you can't put up shares that have already been pledged to another lender or that have any kind of lien or encumbrance on them. They can't be in debt, right? You also can't sign the agreement and then commit your stock to someone else. Signing the pledge has no influence on any voting rights the stock offers you unless you really default and have to give up the shares.

Consequences : 

If you pay off your debt, you'll be finished: The pledgee relinquishes all rights to the shares you promised, and the deal is over. If you don't pay, your lender might sell your shares to reclaim the money you owe. He can sell it himself or put it up for auction. If the note requires you to pay off any remaining debt after the sale, demand that the pledgee sell them at auction to get the highest money. They must be sold at full market value if they must be sold at all.

Considerations :

Read the contract thoroughly before signing it. It doesn't matter what you believed the agreement meant if you and the lender end up in court; what counts is what the printed word says. Some share pledge agreements allow the pledge to accelerate the loan, which means you'll have to pay the entire amount up front. This can happen if you skip even one payment, or if other circumstances arise, such as declaring bankruptcy to discharge your debts.

Points to remember for the pledgee :

• For the pledgee, there are a few things to keep in mind.
• The appropriate board resolutions and corporate licenses have been obtained in order to pledge shares.
• The pledged shares are fully paid up at the moment of pledging.
• There are no additional charges or encumbrances on the pledged shares.
• Stock pledges are permitted under the company's articles of formation.
• The pledged shares are freely tradeable on the NSE, where the underlying firm is listed.
• The lenders have the right to attend any meeting of the company or a meeting of creditors, as well as vote on the pledged shares.
• The borrower will not create any new rights, promises, encumbrances, or transfers of the pledged shares other than the lender's commitment.
• Any arrangement that prohibits the transfer of pledged shares is not or will not be signed by the pledger of shares.
• Upon the formation of the pledge of the Pledged Shares in favour of the Security Trustee, the Pledgor shall cause the charge generated on the Pledged Shares to be noted in its register of charges. As required by the Companies Act, 1956, the Pledgor shall also ensure that the Underlying Company submits the requisite documents proving the charge with the appropriate Registrar of Companies.
• The lender has the ability to sell or purchase the pledged property if the pledger defaults.

Points to remember for pledgor :

The borrower will not establish any extra rights, pledges, encumbrances, or transfers of the pledged shares, with the exception of the lender's promise.

Any arrangement that restricts the transfer of shares pledged is not or will not be signed by the pledger of shares.

On the formation of the pledge of the Pledged Shares in favour of the Security Trustee, the Pledgor shall cause the charge generated on the Pledged Shares to be noted in its register of charges. The Pledgor must also make certain that the Underlying Company files the proper documents proving the charge with the appropriate Registrar of Companies, as required by the Companies Act, 1956.

The lender has the option of selling or acquiring the pledged property if the pledger defaults.

Conclusion :

Share pledging is a frequent way for firms to obtain capital, however bad experiences in the past have tarnished the instrument, since it implies poor cash flow patterns, a company's credit problem, and promoters' failure to meet short-term working capital requirements. Promoters typically make shared promises for personal motives as well. Increased share promises are dangerous for promoters and stockholders alike. The basic result is that investing in firms with 5-10% pledged shares is not a problem, but investors should exercise care beyond that. 

Reference :

Prathamesh More, How to draft a share pledge agreement, ipleaders, https://blog.ipleaders.in/how-draft-share-pledge-agreement/  feb 26,2022.

Legal issues on pledge share agreement,pdf ,https://media.neliti.com/media/publications/26924-ID-legal-issues-on-pledge-share-agreement.pdf accessed on 7/03/2022.

Agreement for pledging share , south india bank, https://www.southindianbank.com/UserFiles/Forms/LD%202141.pdf accessed on 7/03/2022.

Author 

Jagruti Nimbalkar