The suicide of Cafe Coffee Day’s V.G. Siddhartha in July this year; the roller-coaster ride that Yes Bank Ltd’s stock went through when its former promoter Rana Kapoor dealt with lenders; and even the unfolding financial scandal at Karvy Stock Broking Ltd have one thing in common—the use, or rather, overuse of a humble instrument called LAS (loan against shares).
The product has been in existence since trading began in Indian markets. It was primarily meant as a tool for stock market operators, who used their existing shares as security to borrow and speculate in the market. It was meant to be short term. And the sums were supposed to be small. Traditional banks even have an upper limit: ₹20 lakh, if the collateral is purely shares (not applicable to brokerage firms). But mutual funds and non-banking financial companies (NBFCs) have no such limit.
Caught in a credit squeeze and a slowdown in traditional bank lending, promoters increasingly began to rely on pledged share to raise funds. In many cases, those funds came in through channels that are relatively less regulated than traditional banks, setting up a perfect storm.
When economic growth began to fall and “sentiments" began to collapse, lenders inevitably began calling in on the pledge or, in some cases, even selling the equity, reducing company promoters to minor shareholders in their own firms. The fortunes of at least six big promoters are on the line, including Zee Entertainment Enterprises Ltd’s Subhash Chandra and Reliance Group’s Anil Ambani.
The sparkling diamonds, or shares, which are forever, are usually never meant to be sold. It is the equivalent of bringing out the family silver. “How do you get funding in any market—you borrow, beg or steal," said Amit Tandon, managing director of Institutional Investors Advisory Services (IIAS). “In a bad market such as this, borrowing is not happening because no one will lend. You are too proud to beg. So, you steal from your existing pool which is shares, pledge them, and borrow."
Perhaps, the promoters never thought they would lose control. Perhaps, corporate India never anticipated a multi-quarter economic slowdown. Perhaps, internal risk-management mechanisms were extremely weak resulting in risky hedges and abuse of LAS. One thing is certain though: The unfolding saga of India Inc.’s troubled dalliance with LAS captures, in many ways, the degree of desperation among certain sections of the business community. It is a cautionary tale which could only get worse before it gets any better.
How big is it?
Experts Mint spoke to said that the rated LAS market is estimated to be around ₹30,000-40,000 crore. Non-banks and mutual funds are the biggest lenders in this market. Though banks do lend to promoters on the basis of shares pledged, shares are usually not the sole collateral and, therefore, does not technically qualify as LAS.
However, the total amount of pledged promoter shares as on 9 December for 838 firms is about ₹2.25 trillion. While the sums involved have come down somewhat from a peak of ₹3.04 trillion in January 2018, a series of defaults could send ripples across the whole financial system.
With NBFCs already under significant stress, if a big corporate does not service its interest, it could add to the stress. Interest rates on outstanding loans from non-banks are high, ranging from 9-15%. NBFCs also do not have any ceiling on the amount of loans they can sanction against shares.
Several borrowers have also preferred to raise money through mutual funds, through an instrument called zero coupon bonds. It is essentially a debt instrument that does not pay interest, but instead trades at a deep discount, rendering a profit at maturity when the bond is redeemed for its full face value.
The reason behind the new-found popularity of instruments like zero coupon bonds over the last few years is simple: while banks have several restrictions imposed by the Reserve Bank of India (RBI), mutual funds do not. The hassle of a regular interest payment is also absent.
“In an NBFC or a bank loan, the promoter has to keep repaying the interest every month, but for mutual funds, he/she can pay on maturity of the zero coupon bonds," said Anil Gupta, vice president and sector head of financial sector ratings at Icra Ltd.
Yes Bank co-founder Kapoor is an example of how fortunes of promoters have changed over time due to overleverage. Kapoor now owns only about 900 shares in the lender through Yes Capital after his direct holding of 3.92% in pledged shares was invoked by Reliance Nippon Life Asset Management Ltd in October. In Yes Bank, the pledged levels (ratio of shares used as collateral to raise loans) increased from 3.64% in the June quarter to 35.05% by the end of September.
The storm of abuse of LAS did not leave even its original users, the stock brokers, untouched. Karvy, a brokerage firm, faces a ban on acquiring new clients and a trade suspension for misusing client securities as a pledge to raise funds from banks. This threw up a unique issue of banks losing their pledges as the shares were returned back to the original investors.
In the Karvy case, banks and NBFCs gave more than ₹1,400 crore of loans against ₹2,830 crore worth of shares as collateral. Since the shares belonged to clients, the National Securities Depository Ltd returned these shares to client accounts, leaving the banks with no shares to invoke.
Similarly, Zee Entertainment Enterprises, Fortis Healthcare Ltd, CG Power and Industrial Solutions Ltd and Reliance Group’s firms all have one thing in common—the erstwhile promoters are no longer controlling the companies.
In most of these companies, promoter shareholding was at a reasonable level (mostly below 50%) all through 2017. As a liquidity squeeze began to hit companies after the collapse of Infrastructure Leasing and Financial Services Ltd in September 2018, the promoter pledges kept increasing.
The shares were either pledged to an NBFC at a 2:1 cover, or a mutual fund as collateral on their debt issuances at a cover of 1.5-1.7, and to banks as a part of corporate loans.
Simply put, a cover means the value of securities against the quantum of loan extended. For instance, if the lenders extend ₹100, then a 2:1 cover entails that the lender will take securities worth ₹200 as collateral.
As the stock price of some companies fell, the cover diminished, and anxious investors began calling in on the pledge.
In the quarter ended September 2019, 96% of Chandra’s holdings in Zee Enterprises was pledged with lenders. Chandra then lost control of the business when lenders called in the pledge and sold down the equity.
“Promoters have inherently assumed that the pledge on their controlling stake will not be invoked. If and when the pledge is invoked, investors are left with a change in control that they didn’t bargain for," said Hetal Dalal, chief operating officer at IIAS.
Lack of disclosures
The ensuing mess can thus hit the average retail investor too. As per regulations issued by capital market regulator Securities and Exchange Board of India (Sebi), a company needs to disclose the amount of pledged shares, when the pledge is created, to whom the shares are pledged, and for what reason they have been pledged.
However, an analysis done by Mint shows that despite regulatory tightening, the disclosures are missing. In the case of at least four companies including Yes Bank, firms have not even disclosed to whom the shares have been pledged—a clear violation of disclosure norms.
Other companies such as Zee Entertainment, the Adani Group, GMR Group and Vedanta Ltd practice a more innovative strategy. They disclose the name of the trustee but not the pledgee, giving investors no indication regarding the purpose of the pledge.
For quite some time, Sebi and RBI have been on the same page regarding the need to crack down on excessive pledging. The capital market regulator has expressed concern particularly about how regulated mutual funds have now assumed the role of lenders, rather than acting on behalf of investors.
Several mutual funds have begun to invest in LAS products in their fixed maturity plan schemes, that is, papers with pledged shares as the underlying collateral. Due to a fear of default, the funds sometimes roll over the maturity date in the hope that a stake sale would result in realization of dues. Sebi has taken one step after another to stem this practice.
“Now, we need to ask for a 4:1 cover for papers which have shares as underlying, which is at least twice of the previous ask," said Lakshmi Iyer, chief information officer (debt) and head (products) at Kotak Mahindra Asset Management Co. Ltd. A 4:1 cover means securities would need to be four times the loan value.
The recent increased scrutiny and regulatory tightening has forced private sector companies to start looking for other sources of financing.
“In a market such as this where funding avenues have dried up, pledging shares with MFs (mutual funds) and NBFCs was an easy avenue," said the chief financial officer of a mid-sized manufacturing firm that specializes in industrial parts.
“But recent Sebi norms have made going to MFs too expensive. NBFCs are themselves facing a credit crunch and are unable to lend and RBI frowns upon loans with too much reliance on pledges. We might have to seriously look at other avenues such as corporate bonds," added the person on condition of anonymity.
Companies with better credit profile are now looking at corporate bond issuances to raise money from the public. But Indian regulators seem to have hardly addressed the question at the heart of the LAS debacle: what forms of fundraising can reduce systemic risk and protect shareholders?
India vs the world
The practice of taking loans against a portfolios of stocks and bonds has been growing steadily even in the UK and US. The regulators in these jurisdictions typically view these loans as carrying little risk as these are backed by stocks or bonds and, hence, over-collateralized.
In contrast, RBI believes that the nature of pledging shares in India is fundamentally different from that in advanced economies. The central bank had, in its Financial Stability Reports in December 2013 and December 2014, raised concerns about over-pledging of shares by promoters.
In the case of a typical Indian company, RBI observed, the promoters pledge shares not for funding “outside" business ventures but for the company itself. By pledging shares, the promoters have no personal liability other than to the extent of their pledged shares.
“In some instances, the shares pledged by unscrupulous promoters could go down in value and the promoters may not mind losing control of the company as there is a possibility of diversion of funds before the share prices collapse," the RBI report had said.
Many of those worries came to pass just three-four years after they were first strung together in words. The banking regulator still maintains that prevalent pledging of a substantial portion of shares by promoters, and the resultant leverage, is a concern not only for shareholders but also for the health of the financial system.
“Such loans are meant for genuine individual investors, and banks should not support collusive action by a large group of individuals belonging to the same corporate or their inter-connected entities to take multiple loans in order to support particular scrip or stock-broking activities of the connected firms," warns RBI’s Master Circular on Loans and Advances.
Whether these well-founded worries result in actual changes in regulation before the next financial crisis erupts, remains to be seen.