What's wrong with pledged shares?

Post SEBI's directive requiring "promoters" to declare if the shares they own are pledged, markets are reacting unkindly to the disclosures. The disclosures itself suffer from serious limitations - most arising out of the definition of "promoter" groups. Since many sponsors continue to hold shares in the name of front companies that are not classified as "promoter" companies, it is entirely possible that the disclosures are inadequate at best and misleading at worst.

The more fundamental question, however, arises on whether the market is correct in selling off shares of companies where promoters have pledged shares, or, does this behaviour present a buying opportunity. In my view, the latter.

For the most part, companies in India are still largely owned by a family or by a first generation entrepreneur. Resources for investment are clearly limited. That being the case, if a new investment opportunity were to present itself, what is the man to do other than to pledge assets (in this case the shareholding) and raise funds. Why should that not be viewed as a case of being bullish on the prospects of the investment opportunity?

A possible reaction to this argument would be that this increases the risk in the business, since the equity is essentially debt in disguise. This may well be. However, is it substantially different if the equity of one venture is pledged to raise finances for another - say like in the case of the Tata Group. Isn't this too a case of overleverage, and prone to the same risks? Afterall, most "promoters" do not distinguish between companies that belong to the group - when it comes to crunch time, the cash flows of all companies are used to feed the weak - notwithstanding the presence of minority shareholders that may be and most likely are - different. That this practice is wide spread, and the market is aware of it and tolerates it itself points to the inconsistency of the current response.

An alternate to pledging shares would be that the "promoter" find ways to cheat the minority shareholder of his due share by extracting an unfair proportion of the cash in the business to fund his own investment needs. To me, a pledge is anyday more palatable. So, next time a share price falls sharply because of pledge disclosure, and the business does not look to be in trouble - go BUY.