May 12, 2017

Preference Shares and Pledging of Shares by Promoters (Q&A)

www.drvijaymalik.com has a section dedicated to answering queries of readers: “Ask Your Queries”. Over time, many readers have asked their queries related to many aspects of stock analysis and sought clarifications about investing. I have responded to these queries as replies to their comments.

“Q&A” series is an attempt to share the queries & their responses, which have featured on “Ask Your Queries” section, with all the readers. The primary aim of this new feature is to share the knowledge with other readers of the website, who might have similar queries.

The current article in this series provides responses related to:
  • Preference shares/Preferred shares
  • Pledging of shares


Answers to readers' queries on preference/preferred shares and pledging of shares by promoters


Preference/Preferred Shares


Query


Hi Vijay,

Hope you are doing well. I was one of the participants in your “Peaceful Investing” workshop in Pune. I have a few questions about redeemable preference shares.
  1. What are the effects of redeemable preference shares on the capital of a company when these shares mature?
  2. How do companies generally deal with the maturity of redeemable preference share? Do they issue fresh equity, bonus or redeem with undistributed profits?
  3. So for an example, for a company that has issued 7% redeemable cumulative preference shares (worth say ₹40 cr) redeemable at par maturing in 10 years (say in March 2018), what options does a company have in order to redeem these shares? How do these options stack up in terms of preference or general practice in the industry and what will be the impact on the capital structure of the company on maturity?

Would appreciate your thoughts and insights on this.

Regards

Author’s Response:

Hi,

Thanks for writing to us!

The fate of the preferred shares along with their impact on capital differs from case to case depending upon the terms of each issued case of preferred shares: 
  1. If the coupon is mentioned and is non-cumulative that would mean regular interest payments like regular debenture.
  2. If the coupon is cumulative, then the entire coupon can be paid at maturity
  3. If premium is mentioned, then preferred shares would be redeemed at a price higher than par value at maturity (Par value + Premium value)
  4. If no premium is mentioned, then preferred shares would be redeemed at a price equal to par value
  5. If it is convertible, then it would depend upon whether it is compulsory or optionally convertible. In the compulsory convertible, the company would not pay anything on maturity and would issue new equity shares, which would get same rights as existing common shares. In optionally convertible, the preferred shares subscriber might or might not choose to convert preferred shares into equity shares. If the preferred shares Subscriber decides to not convert, then the maturity amount would be paid to her without any impact on equity capital structure.
  6. Conversion can be fully or partially, in such cases of fully convertible all the preferred shares on maturity would be convertible into equity shares and no cash outflow. In partially convertible, then as per terms of the agreement, the preferred shares subscriber can convert part of preferred shares into equity shares and get the balance as cash from the company on maturity.


Therefore, in each case of different types of preferred shares, the final impact would be different depending upon the terms of the specific preferred shares agreement between the company and the subscriber.

Hope it answers your queries.

All the best for your investing journey!

Regards

Dr. Vijay Malik

Follow up Query:


Thank you for your response and this information Vijay. Some follow-up questions. In the case of redeemable preferred shares:
  1. Are these considered part of overall outstanding shares or considered as debt?
  2. If considered as part of overall outstanding shares, what happens on the maturity of such preferred shares, does the share capital reduce by the par value of the preference shares redeemed (unless redeemed by issuing fresh equity?)
  3. How do companies pay back the investors holding redeemable preferred shares on maturity? What is the most preferred strategy adopted by companies to redeem such preferred shares?

Regards

Author’s Response:

Hi,

Thanks for writing to us!

1) Are these considered part of overall outstanding shares or considered as debt?

Preferred shares are treated as part of outstanding share capital

2) if considered as part of overall outstanding shares, what happens on the maturity of such preferred shares , does the share capital reduce by the par value of the preference shares redeemed (unless redeemed by issuing fresh equity?)

At maturity, the paid up share capital reduced to that extent.

3) How do companies pay back the investors holding redeemable preferred shares on maturity? What is the most preferred strategy adopted by companies to redeem such preferred shares?

Redemption method depends on the type of preferred shares and its terms as discussed in the previous answer.


Hope it answers your queries.

All the best for your investing journey!

Regards

Dr. Vijay Malik


Query


Hi,

I have noticed that one of the companies, which I hold has put out the following agenda for voting:
(c) Redemption of 250,000 Zero Percent Redeemable Non- Cumulative, Non- Convertible, Nonparticipating Preference Shares of Re. 1/- Each aggregating to Rs 250,000 only.
I am not able to understand what its mean? I know in terms of bonds Redemption means company returning money back on maturity but what does it really means in terms of shares at par value.

Thanks,

Author’s Response:

Hi,

Thanks for writing to us!

Redemption means repaying/settling the liability. Reading about the other terms of these preferred shares in the annual reports would provide more information to you whether any other term also gets triggered along with redemption.

All the best for your investing journey!

Regards,

Dr Vijay Malik

Follow up Query:


Thank you very much. Not only have I learned a great deal of finance from you but also lots of humility.

As per the details in the meeting minutes uploaded by the company on the NSE website, it looks like they gave 250000 Zero Percent Redeemable Non- Cumulative, Non- Convertible, Nonparticipating Preference Shares at Rs 1 to raise money for working capital requirement and now as they have surplus cash in balance sheet they have decided to cash it back.

Now my understanding is that this seems like at buy back? The ₹2.5 lac will go out from the P&L and total outstanding shares should go down as well?

This is the company I am long on.

Thanks,

Author’s Response:

Hi,

Thanks for writing to us. We are happy that you found the articles useful.

As per the NSE filing and the detailed provided by you, it seems that the Rs. 250,000/- is an interest-free loan structured in the form of these preferred shares, which the company is now repaying.

However, the annual report of the company for FY2016 (pg. 37) mentions these preferred shares as 5% interest bearing. We would request you to get this discrepancy clarified from the company.


If the preferred shares do not have any voting rights, then even though the paid up capital would reduce, still it would not be equivalent to buyback of common shares as the shares bearing voting rights are unchanged and the EPS would also remain unchanged.

Non-convertible preferred shares are mostly like a loan.

Also, the accounting entries would not impact Profit and Loss statement. The impact on the balance sheet would be: 1) Asset side: reduction of cash by Rs. 250,000/- 2) Liability side: reduction of shareholder's funds (equity + reserves) by Rs. 250,000/-



We do not have any views on this company.

Hope it answers your queries.

All the best for your investing journey!

Regards

Dr. Vijay Malik


Pledging of Shares


Query 1)


Dear Mr. Vijay Malik,
Is it possible for us to find out whether the proceeds received from the pledging done by the promoter are reinvested into the business i.e. a simple case of the promoter pledging the shares for investing into the business? Thanks and regards

Query 2)


Dear Mr. Vijay Malik,
I came across a news that the promoters have pledged most of their shares but the company’s stocks are still in the rally. In this case, will the proceeds of the pledged shares will come to the company as other income? And how to know that the promoter has really spent that money for business? Thanks and regards

Query 3)


Sir found this data on pledging:
“Promoters, in order to raise funds for either personal or company needs, pledge their holding shares to any financial institution.
Non-banking financial institutions are more active than banks in providing such loans.  Sometimes, promoters collateralize their shares for converting warrants into shares. Also, they might find share prices in the secondary market quite lucrative for fresh purchase and adopt this route for garnering funds for the consideration to be paid for the open market purchase. So there are lots of reasons why promoters pledge their shares. Generally, pledging shares is not a good sign.”
My view: The pledging of shares by the promoter won’t increase the other income. However, it should increase the interest cost in P&L, as it is a kind of loan taken by the promoter against shares collateralize with banks / non-financial institution.

I found the pledging of shares mentioned in long-term borrowing for GMR Infrastructure Limited.

My doubt: If the promoter is taking a personal loan, then I don’t think it will reflect in the balance sheet of the company.

Sir, please give your views and please correct me if I am wrong. Thank you

Author’s Response:

Hi,

Thanks for writing to us! We appreciate the work/effort put in by you incorporate your responses. We request each one of us to first trying to search for the answers independently and if there are still doubts then post the query on this forum. Searching for answers on one's own is a good learning exercise and inculcates a very good habit of seeking solutions.

Please find below our inputs to your queries:

1) My view: The pledging of shares by the promoter won’t increase the other income. However, it should increase the interest cost in P&L, as it is a kind of loan taken by the promoter against shares collateralize with banks / non-financial institution.

Pledging of its shares done by the promoter can be for 2 purposes:

(i)  for raising money for personal use/buying shares/exercising warrants etc.
(ii) as an extra collateral/security when asked by the lender while giving a loan to the company

You're right that pledging won't impact the other income of the company in any manner. Actually, pledging won't impact the P&L on its own at all.

In case (i) above, the loan is taken by the promoter and he would service the interest from his personal money. It's a separate matter that promoters usually increase their salary/dividend payout to meet the funds requirements to pay the interest.

In case (ii) above, the interest in the P&L would be because of the loan is taken by the company from the lender and not due to pledging.


2) I found the pledging of shares mentioned in long-term borrowing for GMR Infrastructure Limited.

In case (ii) above, when pledging is as an extra collateral/security when asked by the lender while giving loan to the company, then the details of pledging would be shown as part of security offered to lenders in the notes/schedules to financial statements under "Long-term borrowings" or "Short-term borrowings", as the case may be.


3) My doubt: If the promoter is taking a personal loan, then I don’t think it will reflect in the balance sheet of the company.

You are right as this case would be the case (i) cited above. Here the loan is a personal loan of the promoter and they are responsible for servicing it from their personal sources. However, as mentioned above, even though the loan is a personal loan of promoters, usually increase their salary/dividend payout or take loans from the company to meet the funds requirements to service these loans. Such actions of the promoters to take the money from the company to service their loans would indirectly impact the company and its financial situation.


Hope it answers your queries.

All the best for your investing journey!

Regards,

Dr Vijay Malik


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DISCLAIMER


Registration Status with SEBI:


I am registered with SEBI as an Investment Adviser under SEBI (Investment Advisers) Regulations, 2013

Details of Financial Interest in the Subject Company:


Currently, I do not own stocks of any of the companies discussed above