In 1967, Messrs Ramgopal Indraprasad, which ran two cotton ginning factories besides polishing pulses, went bankrupt. The business had suffered losses and the owner family owed Rs 6 lakh to friends and relatives.
The family's eldest son, then 17 years old, was asked to discontinue studies due to financial difficulties and help with the business. A chance meeting with an official of Food Corporation of India (FCI) helped the teenager strike a deal with the government's grain-handling arm - to supply polished dal and clean barley to the Indian Army, one of the biggest buyers of grains and pulses. Two years later, the company was renamed Subhash Chandra Laxmi Narain and continued to scale new heights with new businesses.
Over half a century later, the enterprising boy, now 69-year-old Subhash Chandra, finds himself in another fiscal turmoil. At risk this time is the jewel in his empire's crown, Zee Entertainment Enterprises, owned by the Essel Group. Its promoters, including Chandra, have pledged nearly 60 per cent stake in Zee Enterprises to raise money for some risky businesses, including infrastructure.
Chandra is not alone in the pledged share saga of listed Indian companies. In fact, Zee ranks a lowly 22nd among the BSE 500 companies whose promoters have pledged their shareholding. On top is the Avantha Group, where promoters have given 100 per cent of their equity in CG Power and Industrial Solutions as collateral. For Zee, the figure is 58.3 per cent (end of December 2018).
The percentage of pledged shares for many others is also rising. Promoters of Coffee Day Enterprises have increased the percentage of their pledged shares from 57.6 per cent in December 2017 to 79.4 per cent in December 2018. For Anil Ambani's Reliance Infrastructure, this has gone up from 66.1 per cent to 83.6 per cent, while Reliance Capital is up from 70 per cent to 83 per cent.
Moreover, promoters are at present facing a bearish market, and their share prices are falling. As a result, their collateral's value is eroding, putting pressure on promoters to pledge even more equity to make up for the shortfall. This further weakens their hold over companies and assets.
"Thousands of stocks have lost anywhere between 30 and 90 per cent of market value, and mostly they are the ones where pledging was high," says G. Chokkalingam, Founder, Equinomics Research and Advisory. He adds that most of the pledging has been done outside of the top 15 Nifty stocks. Apart from these, about 4,000 stocks have lost Rs 27 lakh crore between August 2018 and February 2019.
In the case of CG Power and Industrial Solutions, where 100 per cent of promoter shareholding is pledged, the value of promoter's pledged shares is down to one-third from Rs 2,000 crore in December 2017 to Rs 625 crore in January 2019. In the case of Reliance Power, it is down to Rs 2,387 crore from Rs 10,569 crore in December 2017.
To make up for the difference in the collateral value, promoters have to either give additional cash or pledge more shares to the lender. As the vicious cycle continues, the end result is that the promoter loses control over the company.
BT wrote to 15 companies that have the highest percentage of pledging by promoters. Only Max India responded: "The funds generated through pledging some shareholding was to invest in listed companies of Max Group and other private ventures of Max Sponsors, which have since then created significant value. We are well aware that there has been concern amongst investors recently about the level of sponsor (share) pledge. We have a clear plan to reduce this within the next few months using measures such as selling a couple of privately held real estate assets and diluting 5 per cent stake in the anticipated merged Max Healthcare-KKR-Radiant entity. We may also sell a small percentage of stake in Max Financial Services if the need arises. We are committed to ensuring that there is no shareholder value erosion due to a perceived high promoter share pledge."
Most other companies, however, don't seem to have a roadmap in place for revoking of pledged shares.
A Brewing Storm
The current situation did not arise overnight. Pledging was working very well in a bullish market when prices were going up. Promoters borrowed after pledging shares, pumped the money into another venture, which generated cash and that was used to redeem shares.
U.R. Bhat, Investment Manager at Dalton Capital Investors, says a lot of investments went into the infrastructure sector after it was opened up for private players. "Over the past 10 years, the infrastructure sector saw a lot of growth. Promoters borrowed money to invest in infrastructure, thinking they will be able to sell and make profits or earn through annuity. There is reasonable certainty about annuity and future cash flows are ensured but that has not happened in India," he says.
Since private participation in infrastructure was new in India, those who raised money, mostly first generation entrepreneurs, were unable to assess the risks adequately. "Problems like land acquisition, clearances or availability of natural resources increased the project gestation tenure. Interest outgo increased and rates also moved up, leading to highly leveraged promoters. The equity began to erode and they had to pledge more shares," says Bhat.
In an open letter, Zee's Chandra admitted that Essel Infra was a wrong bet. "As most of the infra companies, even we have made some incorrect bids. In usual cases, infra companies have raised their hands and left their lenders with non-performing assets, but in our case, my obsession of not walking away from the situation, has made me bleed Rs 4,000 crore to Rs 5,000 crore. Despite the loss making projects, we continued to pay the interest and the principal, by borrowing funds against our shareholdings in listed companies," he stated in a letter dated January 25, 2019.
The same has been the case with Jaypee Infratech, promoted by the Gaurs, which has a debt of over Rs 10,000 crore and has been referred for insolvency. The Nairs of Leela Hotels have been grappling with a debt of nearly Rs 4,000 crore following rapid expansion in the past decade.
Apart from wrong bets, the drying up of liquidity in the system also played a role in increasing the number of default cases. "By 2017, the banks had stopped lending to most promoters after running out of liquidity. At that point, mutual funds (MFs) stepped in to lend by using promoter shares as collateral. MFs were buying commercial papers (CPs) and when they matured, the next tranche would be issued to repay the preceding tranche and the rollover continued," explains a source in the mutual funds industry. However, after the IL&FS fiasco, the CPs could no longer by refinanced. There was no choice but to sell the shares, he adds.
The biggest risk in this saga is of promoters losing control. Since most have pledged shares in their best assets, it is these core assets that run the risk of being lost forever. "The stock price can fall heavily on the news that lenders are selling shares in the open market that are pledged by the company's promoters. This may result in a further decline in the collateral value because of panic selling by the public," says Bhat.
Moreover, selling pledged shares can alter the company's shareholding pattern and affect promoters' voting powers as well as decision-making ability. And where promoter holding has fallen due to pledging of shares, even a well managed company comes into the risky zone. "A company derives value by the virtue of an entrepreneur being in charge. If it goes to someone else, there is a high possibility that it may collapse if the new promoter is not well versed with the business," says Bhat.
While the turmoil due to pledged shares is at its peak in India Inc now, the practice has been in vogue for many years. A decade back, in 2009, Vijay Kantilal Sheth, Vice Chairman and Managing Director of Great Offshore, an offshore oilfield services firm, lost control over his company because of the shares he had pledged for loans. The company went to Bharati Shipyard (now Bharati Defence), which is ironically itself facing liquidation.
In 2014, Vijay Mallya lost control of Mangalore Refinery and Petrochemicals after he pledged nearly 90 per cent of the promoters' shareholding in the company. Following a two-year battle, the company was taken over by Zuari Fertilisers and Chemicals.
There are some red flags that stakeholders can watch out for before a company changes hands. "One sure red flag is when a promoter has pledged over 80 or 85 per cent of his holding," says Bhat.
At the end of January 2019, BSE-listed companies where 80 per cent or more of promoters' equity is pledged include CG Power and Industrial Solutions (100 per cent), Sterlite Technologies, Jindal Stainless, Jindal Stainless (Hisar), Max Financial, and Reliance Power. For Reliance Capital, the percentage has gone up from 68.4 per cent in December 2017 to 79.4 per cent in January 2019.
Chokkalingam says two ratios are crucial to gauge the future of a company - debt to equity ratio and debt to annual sales. A high debt-equity ratio implies that the company has been aggressive in financing its growth with debt, which can mean volatile earnings as a result of the additional interest cost. The debt-to-annual sales ratio helps assess a company's ability to manage payments and repay debts.
"It may be very difficult for promoters to get back control if pledge level is too high," he adds.
Scrips Down, Disputes Up
In a market where lenders are jittery about recovering their money, disputes among parties come out in the open. While Chandra assuaged feelings of all stakeholders by writing another letter after Zee's stock price fell over 30 per cent in a day, Anil Ambani's Reliance Group alleged foul play by Edelweiss in invoking pledged shares in group companies soon after Reliance Communications filed for insolvency. The Bombay High Court subsequently rejected a plea by Anil Ambani's group, claiming damage of Rs 2,700 crore from the Edelweiss Group, for allegedly maliciously dumping the shares of three group companies, which resulted in a plunge in its prices.
Akil Hirani, Managing Partner at law firm Majmudar & Partners, says there has been an increase in the number of disputes around this issue. "This increase is not due to any ambiguity in the law, but a function of market volatility, which is making investors nervous. Lenders are willing to quickly offload pledged shares if promoters don't meet margin requirements. Promoters are starting to come to terms with the risk of pledging their shares," he says.
According to Securities and Exchange Board of India regulations, in the event of a default, a creditor is entitled to invoke the pledge and transfer the pledged shares, in the absence on anything contrary in the pledge agreement. Hirani says unless specifically mentioned in the pledge agreement, a creditor is not required to obtain the promoter's consent prior to selling the shares. "Recent judicial rulings have held that the pledge of dematerialised shares is governed solely by Sebi regulations and no prior consent of the promoters is needed," he adds.
With companies still reeling under a financial crunch and no improvement in the liquidity position, Saurabh Mukherjea, Founder of Marcellus Investment Managers, believes there is need for government intervention. "At some stage, the government should intervene and bail out the promoters if they are unable to repay their loans. It is a serious situation and to my mind, the only viable solution is for the government to step in," he suggests.
However, despite these incidents, Mukherjea does not believe that taking shares as collateral will disappear as an asset class. "That being said, any person who gives a loan and takes a correlated asset as collateral is taking a big risk. This has become clear after the current situation," he adds.
For now, Zee's Chandra has sought time from lenders till September 2019. Whether the government will come to his rescue is yet to be seen.