How Promoters use Loopholes to Inflate their Shareholding

The level of promoters’ shareholding in a company is a very important parameter in stock analysis. This is especially important in markets like India where most of the businesses are family-owned. This is because many times, the shareholding level acts as an indicator of the confidence of promoters in the business as well as the strength of leadership control on the company.

A company with a very high promoter shareholding often represents a scenario where the promoters see a bright future for the company and in turn, they plan to benefit from its good growth. On the contrary, when promoters do not see good growth prospects for their companies, then they end up selling their stake or the entire company to competitors.

However, if for any reason, the promoters of a company with good business prospects end up having a low shareholding in the company, then many times, it results in battles for a hostile takeover of the company. Competitors start acquiring shares of the company from the open market or from large public shareholders in order to acquire control of the company.

Moreover, the promoters with low shareholding in the company may find it difficult to implement their leadership vision for the company, as they will have to rely on the support of other key shareholders to pass key board resolutions.

Therefore, it is in the interest of the promoters that they keep a high stake in the company.

In order to maintain a high shareholding in the company, promoters use many methods:

• Keep on purchasing shares of their company from the open market.
• Whenever the company needs money, then they prefer debt from lenders instead of issuing new shares via follow-on public offer (FPO) or qualified institutional placements (QIP) etc. This is because issuing new shares results in equity dilution that might reduce their stake in the company.

These seem genuine steps, which usually promoters take to safeguard their stake in the company.

However, our experience of analysing hundreds of companies for our website and for our personal investment has shown that many times, promoters go beyond these genuine steps. We have come across several instances where the promoters use different tricks, complicated structures, and complex transactions in order to control more stakes than what they actually control or to give an illusion of a higher stake in the company than what they actually control.

The aim of these transactions is usually to:

• Use the money of the company (i.e. public shareholders) to increase their personal shareholding in the company
• Using company resources (trusts) to give an impression to the outside world that they still own a large shareholding in their company, even though they may not actually have a large shareholding.
• Creating complex transaction structures (e.g. ESOPs, stock warrants etc.) to get preferential treatment from the company over other shareholders to get more shares at a cheaper cost than the market or what is available to other shareholders. Therefore, increase their shareholding in the company at a comparatively lower cost.

In the current article, we share some of the cases where promoters have used these methods to increase their shareholding in their companies. These cases may act as live examples and illustrations for investors to learn, be cautious and avoid pitfalls while doing their own analysis.

1) Using money of the company (public shareholders) to increase promoters’ stake in the company

In our analysis of different companies, we have found that this is one of the most common methods used by promoters to inflate their shareholding in the company (A). The key steps involved in such transactions are:

• Move the money of the company (A) to another entity (B). This entity (B) may be a subsidiary of the company or a promoter group entity.
  • If the entity (B) is a subsidiary of the company, then money may be transferred to the subsidiary by way of either investment in the shares of B or as a loan or an advance to B.
  • If the entity (B) is a promoter group entity, then usually, the money is transferred to B by way of a loan or an advance.
• Once the entity (B) has received the money, then it buys shares of the company (A) from the open market or from other large shareholders.
• Thereafter, the promoters include the shares of the company (A) owned by the entity (B) in the Promoters’ Category and disclose a higher promoters’ shareholding in the company (A)

Such transactions result in promoters disclosing a higher shareholding in the company (A) to the stock exchanges. However, an investor would notice that the money used by the promoters to increase their stake is provided by the company (A). This money belonged to all the shareholders of the company, both promoters and public shareholders in their proportionate shareholding of the company (A). However, now the promoters end up taking benefit of all the shares of the company (A) purchased by this money via the entity (B).

In addition, investors will find that the money given by the company (A) to entity (B) remains with B for long. If the money is by way of investment in the equity shares of B (a subsidiary), then there is no need for B to return it ever. Even though, if the money given by company (A) to entity (B) is by way of loans or advances, then promoters as controllers of company (A) do not ask for repayment of the loan from B. In some cases, promoters as controllers of the company (A), make A give new money to B so that it can repay the old loans and still continue to keep the money in one form or another (ever-greening).

Let us see some examples that will help the investors understand how these transactions come up in the annual reports of companies. These cases will help investors understand the sections of the annual reports where they will find the data to identify these transactions. A deeper analysis of these cases will prepare an investor to identify such transactions in the companies that she may analyse in future.

It is advised that instead of focusing on the names of the companies in the article, investors should focus on the concept and the method of structuring the transactions so that they may understand the flow of money.

A) Increasing promoters’ shareholding by buying shares using subsidiaries of the company:

i) Escorts Ltd:

Escorts Ltd is an Indian company involved in the manufacturing of tractors & agricultural machinery, construction equipment and railway equipment. While reading the history of the company and the trend of promoters’ shareholding in the past, an investor notices that in the past, the company has shown shares of the company owned by its subsidiaries under the promoters’ shareholding category.

In FY2011, an investor notices that out of the total shareholding of the promoters in the company 27.57% on Sept 30, 2011, the majority is owned by two companies:

• 12.83% by Escotrac Finance & Investments Private Limited (ESCOTRAC) and
• 6.50% by Escorts Finance Investment & Leasing Private Limited (EFILL)

BSE shareholding pattern filing, Sept 2011 (Source BSE: Click Here)

Therefore, investors would note that 19.33% of the shares of Escorts Ltd were owned by ESCOTRAC and EFILL and classified under promoters’ shareholding.

While analyzing the FY2011 annual report an investor gets to know the ownership pattern of ESCOTRAC and EFILL and she finds that both of these companies are majorly owned by Escorts Ltd.

FY2011 annual report, page 114:

An investor notes that Escorts Ltd owns 49.81% of each of ESCOTRAC and EFILL directly and more shares of these companies by their cross-holding i.e. 49.81% shares owned by ESCOTRAC and EFILL of each other.

Many times understanding the impact of such cross-holding becomes confusing. Therefore, to simplify, we see them in terms of end beneficiaries. In the case of ESCOTRAC and EFILL, we assume two owning parties:

1. Escorts Ltd and
2. Outside shareholders.

In both ESCOTRAC and EFILL, the outside shareholders own 0.38% of shares directly. 0.38 = 100 – 49.81 (Escorts Ltd direct holding) – 49.81 (Cross holdings of ESCOTRAC & EFILL in each other)

In addition, outside shareholders own 0.38% of the cross-holding indirectly i.e. outside shareholders have rights to 0.38% of the stake owned by ESCOTRAC and EFILL in each other, which comes out to be 0.19% (= 49.81% * 0.38%)

Therefore, the total shareholding of outside shareholders in ESCOTRAC and EFILL each is the sum of direct shareholding of 0.38% and indirect shareholding of 0.19%, which sums to 0.57% (= 0.38 + 0.19)

Therefore, an investor would note that both ESCOTRAC and EFILL are owned 99.43% (= 100 – 0.57) by Escorts Ltd and 0.57% by outside shareholders.

In light of the same, when an investor analyses the 19.33% shares of Escorts Ltd held by ESCOTRAC and EFILL, then she realizes that these shares out of these shares about 19.21% are owned by Escorts Ltd itself (19.21% = 19.33% * 99.43%) and only 0.12% is owned by outside shareholders (0.12% = 19.33% * 0.57%).

Therefore, in Sept 2011, it seems that the 19.21% shares, which are effectively held by Escorts Ltd via ESCOTRAC and EFILL, are shown under promoter shareholding.

Moreover, when an investor tries to find the sources of the funds used by ESCOTRAC and EFILL to buy shares of Escorts Ltd, then she notices that these funds have been provided by Escorts Ltd by way of equity and other investments.

FY2011 annual report, page 78:

FY2011 annual report, page 79:

By analyzing the above disclosures, an investor notes that Escorts Ltd has made the following investments in ESCOTRAC and EFILL:

• ESCOTRAC: ₹98.48 cr
  • Equity: ₹40.04 cr and
  • Preference shares: ₹58.44 cr (= 48.44 + 10)
• EFILL: ₹83.82 cr
  • Equity: ₹40.00 cr and
  • Preference shares: ₹43.82 cr

Therefore, an investor realizes that it seems to be the investment of ₹182.30 cr (= 98.48 + 83.82) done by Escorts Ltd in ESCOTRAC and EFILL, which has been used by these companies to buy shares of Escorts Ltd.

While analyzing previous annual reports, an investor notices that in the previous years, whenever Escorts Ltd used to give loans to other companies/subsidiaries, then it used to disclose the utilization of the funds by those companies. E.g. in the FY2003 annual report, Escorts Ltd disclosed that ESCOTRAC and EFILL have invested the money given by it to those companies in Escorts Ltd itself.

FY2003 annual report, page 49:

Therefore, an investor notices that in the case of ESCOTRAC and EFILL, the money provided by Escorts Ltd to these companies was used to buy shares of Escorts Ltd and these shares were shown under promoter shareholding.

It is advised that in the cases of such cross-holdings of shares of the companies, an investor should due deeper due diligence to find out the effective shareholding of different parties. In case of any ambiguity, it is advised to get in touch with the company to enhance the understanding.

An investor may read the complete analysis of Escorts Ltd in the following article: Analysis: Escorts Ltd

ii) Ion Exchange (India) Ltd:

Ion Exchange (India) Ltd is an Indian company involved in water treatment plants, wastewater processing, sewage treatment, packaged drinking water, and seawater desalination etc. While analysing the shareholding pattern of Ion Exchange (India) Ltd, an investor noticed on March 31, 2019, that the list of entities under promoters’ shareholders includes a few subsidiaries and an associate company of Ion Exchange (India) Ltd.

Shareholding pattern, March 2019, BSE website:

On March 31, 2019, the following companies owned shares of the parent company:

1. Aqua Investments (India) Limited (subsidiary, 99.42% holding) owned a 1.73% stake (253,803 shares) in Ion Exchange (India) Ltd.
2. Watercare Investments (India) Ltd (subsidiary, 99.43% holding) owned a 1.26% stake (184,071 shares) of Ion Exchange (India) Ltd.
3. Ion Exchange Financial Products Pvt Ltd (associate company, 24.02% holding) owned a 0.34% stake (50,422 shares) in Ion Exchange (India) Ltd.

FY2019 annual report, page 129 shows the subsidiary status of Aqua Investments (India) Limited and Watercare Investments (India) Ltd along with the stake owned by Ion Exchange (India) Ltd in these companies.

FY2019 annual report, page 129 shows the associate company status of Ion Exchange Financial Products Pvt Ltd along with the stake owned by Ion Exchange (India) Ltd in it.

We believe that where parent companies hold their own shares through subsidiary companies and show these as promoter shareholding, these cases create an illusion of a higher promoter shareholding than it might actually be.

For example, in the case of Ion Exchange (India) Ltd, we see that on March 31, 2019, the promoter shareholding is about 40%, out of which about 3% is owned by two subsidiary companies. These subsidiary companies are not owned 100% by promoters. These subsidiary companies are owned by all the shareholders of Ion Exchange (India) Ltd in proportion to their shareholding. Therefore, the promoters own only 40% of these subsidiaries and as a result, out of the 3% stake owned by these subsidiaries, only 1.2% (= 3% * 40%) belong to the promoters. Therefore, considering the shareholding of these two subsidiaries, the effective stake of promoters comes down to 38.2% from the reported stake of about 40% (= 40% – 3% + 1.2%).

Along similar lines, if we adjust the promoters’ stake reported on March 31, 2019, for the shares owned by the associate company (0.54%) and the Employee Welfare Trusts (2,662,914 shares, 18.16% stake), then the effective stake of promoters will fall further below the reported stake of 40%.

Therefore, we believe that while assessing the promoters’ shareholding in such companies, investors may make relevant adjustments at their own end.

An investor may read the complete analysis of Ion Exchange (India) Ltd in the following article: Analysis: Ion Exchange (India) Ltd

B) Increasing promoters’ shareholding by using loans & advances given by the company to promoter group entities:

i) National Peroxide Ltd (Wadia Group):

National Peroxide Ltd is a Wadia Group company and the largest manufacturer of hydrogen peroxide (H2O2) in India. While reading the FY2017 annual report, an investor notices that one of the promoter group companies, Macrofil Investment Ltd (MIL), increased its stake in National Peroxide Ltd.

FY2017 annual report, page 36:

An investor notices that in FY2017, Macrofil Investments Ltd increased its stake in National Peroxide Ltd by 9,441 shares (=7311+2108+22) in FY2017.

Simultaneously, the investor notices that National Peroxide Ltd has given a loan of ₹30 cr to Marcofil Investments Ltd, which was yet to be repaid in FY2017.

FY2017 annual report, page 84:

[The Company has given Intercorporate Deposits (ICD) for general business purposes to Archway Investments Ltd. ₹ NIL (Previous Year: ₹ 1,400 Lakhs) and Macrofil Investment Ltd. ₹ 3,000 Lakhs (Previous Year: ₹ 3,000 Lakhs). The interest rate of the said ICDs is 12.50% p.a. and these are repayable on demand]

An investor would appreciate that money is a fungible commodity. Therefore, when National Peroxide Ltd (NPL) has given loans to Macrofil Investment Ltd (MIL) and MIL buys shares of NPL, then it amounts to a situation where NPL itself has funded the acquisition of its shares by MIL.

Due to the fungible nature of money, this amounts to a situation where the promoter group has borrowed money from National Peroxide Ltd (NPL) itself to increase its stake in the company.

An investor may read the complete analysis of National Peroxide Ltd in the following article:

Analysis: National Peroxide Ltd

To read more such examples of companies that used the money of public-listed companies (public shareholders) to increase promoters’ stakes, you may read a detailed analysis of:

• Analysis: Ramco Industries Ltd

ii) Dynemic Products Ltd:

Dynemic Products Ltd is an Indian manufacturer of food colours, dye intermediates being used in industries like food, cosmetics, pharmaceutical etc. An analysis of the FY2008 annual report indicates that the company invested ₹1.01 cr. in equity shares of Dynemic Holdings Pvt. Ltd (DHPL) in which it took a 49.22% stake making DHPL an associate of the company.

FY2008 annual report, page 47:

The status of DHPL being an associate company/shareholding of less than 50% (49.22%) means that Dynemic Products Ltd is not in the management control of DHPL. Instead, the party owning the balance of 50.78% stake in DHPL is in the management control.

When an investor analyses the shareholding pattern of Dynemic Products Ltd (e.g. FY2017 annual report), then she notices that the name of DHPL figures in the list of entities through which promoters control their stake in the Dynemic Products Ltd. (FY2017 annual report, page 20):

The presence of DHPL in the list of entities through which promoters own a stake in Dynemic Products Ltd can be used to interpret that the balance 50.78% stake i.e. majority stake in DHPL is held by promoters of Dynemic Products Ltd and they control the management and all the decision making of DHPL.

An investor would notice that DHPL was formed in FY2008 and the investor would further observe while analysing the shareholding pattern of Dynemic Products Ltd that from June 2008, the name of DHPL started appearing in the list of entities through which promoters’ held their stake in Dynemic Products Ltd.

(Please note that the above image has been edited to remove the names of entities from serial numbers 3-39 to reduce the non-relevant data. The complete shareholding pattern of promoters in Dynemic Products Ltd on June 30, 2008, can be accessed on the BSE website here).

An investor may notice the following aspects while analysing this situation:

• the funds used by DHPL to purchase shares of Dynemic Products Ltd are contributed by Dynemic Products Ltd itself to the extent of 49.22%
• assuming the Sept 30, 2017 shareholding structure of promoters vs. public shareholders of about 40:60 in Dynemic Products Ltd, the share of contribution of Dynemic Products Ltd’s funds (49.22%) in DHPL can be bifurcated into promoters (19.69% = 49.22% * 40%) and public shareholders (29.53% = 49.22% * 60%).
• Therefore, an investor would appreciate that out of every rupee being invested by DHPL, 29.53% is indirectly being contributed by the public/retail shareholders of Dynemic Products Ltd by virtue of their 60% shareholding in Dynemic Products Ltd.
• Whereas due to the majority stake of DHPL being controlled by promoters, its management control is with the promoters and the shares of Dynemic Products Ltd owned by DHPL are being shown under full control of promoters as seen in the shareholding details disclosures shown above.
• An investor would appreciate that by virtue of the shareholding structure of DHPL being 50.78% promoters and 49.22% Dynemic Products Ltd, the promoters are effectively able to use the 29.53% funds contribution by public/retail shareholders to increase their ownership stake in Dynemic Products Ltd by way of acquiring shares in the name of DHPL.
• this effectively means that the public/retail shareholders are funding the promoters to increase their equity stake in Dynemic Products Ltd.
• and as the investment by Dynemic Products Ltd (and therefore in turn by retail/public shareholders) in DHPL is in the form of equity shares, therefore, effectively these funds are perpetually available to promoters at zero cost i.e. no interest to be paid and probably never to be repaid as well.

While looking at the corporate information of DHPL in the corporate database Zaubacorp (click here), an investor would notice that DHPL has been using the same email ID as that of Dynemic Products Ltd.

The details of the email ID and the registered address of Dynemic Products Ltd can be found on page 3 of the FY2017 annual report:

Looking at the above information, an investor would appreciate that Dynemic Products Ltd (and in turn public/retail shareholders who are 60% holders of the company) are also contributing the operational infrastructure to DHPL for functioning.

Moreover, looking at the related party transactions section in the FY2017 annual report, page 82, an investor would notice that Dynemic Products Ltd (and in turn public/retail shareholders) are spending money on behalf of the DHPL (associate company).

Therefore, an investor would appreciate that the case of DHPL might be construed as a situation where public/retail shareholders of Dynemic Products Ltd are providing funds, and infrastructure to function and are spending on behalf of DHPL to enable it to hold promoters’ stake in Dynemic Products Ltd.

An investor may read the complete analysis of Dynemic Products Ltd in the following article:

Analysis: Dynemic Products Ltd

2) Using employee welfare trusts to display a higher shareholding of promoters than their actual shareholding

Investors would have noticed that companies usually create welfare trust for their employees. These trusts may hold shares of the company. Many times, the purpose of these trusts is to hold shares, which may be allotted to employees on the exercise of their stock options (ESOPs).

In most cases, the beneficiary of such trusts is the company itself i.e. the shares of the company held by the welfare trusts belong to the entire company meaning that all the shareholders; both promoters and public have a right to these shares in proportion to their shareholding in the company.

However, there have been instances when promoters have included all the shares held by welfare trusts in the promoters’ category and as a result, disclosed a much higher promoters’ shareholding to the public than their actual shareholding.

Let us see some examples:

A) Escorts Ltd:

As per Sept 30, 2019 shareholding pattern of Escorts Ltd, the promoters own a 40.25% stake in the company by holding 4,93,33,680 shares of the company out of a total of 12,25,76,878 shares of the company.

Shareholding pattern, BSE as of Sept. 30, 2019 (Source BSE: Click here)

However, when an investor analyses the details of the promoter shareholding, then she notices that 27.49% (3,37,00,031 shares) out of the above 40.25% (4,93,33,680 shares) are owned by Escorts Benefit and Welfare Trust.

Promoters shareholding pattern, BSE as of Sept. 30, 2019 (Source BSE: Click here)

As per the disclosures in the annual reports, the company (Escorts Ltd) is the sole beneficiary of the trust.

FY2019 annual report, page 181:

A Scheme of Arrangement and Amalgamation under Section 391 to 394 of the Companies Act, 1956 for the amalgamation of Escorts Construction Equipment Limited (‘ECEL’), a subsidiary company and Escotrac Finance and Investments Private Limited (‘Escotrac’) and Escorts Finance Investments and Leasing Private Limited (‘EFILL’), joint ventures of the Company (together referred to as ‘transferor companies’), was sanctioned by the Hon’ble High Court of Punjab and Haryana at Chandigarh vide its order dated 9 August 2012 (hereinafter referred to as ‘the Scheme’). Upon necessary filings with the Registrar of Companies, NCT of Delhi and Haryana by the Transferor Companies and Transferee Company, the Scheme became effective on 12 October 2012. In accordance with the Scheme, 37,300,031 equity shares of the Company comprising (a) equity shares issued in consideration of amalgamation of ECEL and (b) investments held by two amalgamating entities in the Company were transferred to Escorts Benefit and Welfare Trust (‘EBWT’). The beneficiary interest of the Company in EBWT, has been accounted for as an Investment by the Company in the manner prescribed in the Scheme.

EBWT presently holds 33,700,031 (31 March 2018: 33,700,031) equity shares of the Company and 23,497,478 (31 March 2018: 23,497,478) equity shares of Escorts Finance Limited (subsidiary of the Company). The Company is the sole beneficiary of the Trust. The dividend received by the trust on the Company’s shares is credited directly in “Retained earnings” in note 17 – Other equity.

It indicates that the benefit of the shares held by the trust belongs to the company i.e. all the shareholders of the company in proportion to their shareholding.

There are many other aspects, which indicate that the shareholding of the Trust belongs to the company and not the promoters:

a) The company represents the shares held by the Trust as treasury stock in the annual report, which indicates that the company owns its own stocks via Escorts Benefit and Welfare Trust

FY2019 annual report, page 232:

b) The company declares dividends on all the shares excluding the shares held by Escorts Benefit and Welfare Trust.

FY2019 annual report, pages 50-51:

Based on the Company’s performance, your Directors are pleased to recommend, for approval of the members, a Dividend of ₹ 2.50 per Equity Share (25%) on the face value of ₹ 10/- each, aggregating ₹ 22.22 crores (exclusive of tax on dividend) for the financial year ended March 31, 2019 except on the equity shares held by Escorts Benefit and Welfare Trust (EBWT).

c) Shares held by the Trust are excluded while calculating the earnings per share of the company for the year.

FY2019 annual report, page 243:

d) Whenever the shares held by the Trust are sold, then the money received from such sales is taken by the company as a cash inflow.

FY2019 annual report, page 119:

As a result, an investor will appreciate that effectively, the 27.49% of shares held by the trust belong to the company (all shareholders) i.e. these 27.49% of shares belong to the remaining 72.51% of shareholders (including promoters) in the proportion of their shareholding.

This may indicate that if one nullifies the shares held by the trust, then the effective shareholding of the promoters in the company is 17.6% = (40.25-27.49) / (100-27.49)

Moreover, if the company sells the shares held by the Trust in the open market and these shares are bought by non-promoters/public, then the shareholding of the promoters will keep on declining below 17.6%. In a situation, if all the shares held by the Trust are sold in the market and bought by non-promoters/public, then the promoters’ shareholding may fall to 12.76% = (40.25-27.49) / 100

It seems that showing the entire shareholding of the Escorts Benefit and Welfare Trust in the shareholding of promoters is creating an illusion that promoters own a much larger stake in the company. However, as per the disclosures by the company in the annual report, the beneficiary of the trust is the company and not the promoters alone. Therefore, it seems that the promoters’ effective current stake in the company is about 17.6% instead of the reported 40.25%.

Investors may contact the company to know about the effective stake owned by the promoters in Escorts Ltd.

An investor may appreciate that in the case of the Trust, the shares owned by the company seem to be shown under promoter shareholding. In the past as well, there have been instances where the shares effectively owned by the company were shown under promoter shareholding.

An investor may read the complete analysis of Escorts Ltd in the following article:

Analysis: Escorts Ltd

B) Ion Exchange (India) Ltd:

When an investor analyses the changes in the promoters’ shareholding of Ion Exchange (India) Ltd over the years, then she notices that until Sept 30, 2019, the promoters used to include the shares held by employee welfare trust while disclosing their stake in the company. However, from Dec 31, 2019, the company has rectified the disclosure and now; it shows the shares held by the employee welfare trusts separately under the “Non-Promoter-Non-Public” category, which seems the correct classification.

While analysing the stock exchange filings by the company for shareholding patterns on Sept 30, 2019, and Dec 31, 2019, an investor notices that the shareholding of promoters in the company has declined from 44.04% in Sept 2019 to 27.01% in Dec 2019. The key reason for such a sharp decline in promoters’ shareholding is the segregation of shares held by the employee welfare trusts (16.18% stake) under the “Non-Promoter-Non-Public” category”.

Source: BSE, shareholding pattern disclosures of Ion Exchange (India) Ltd, (Sept 30, 2019, and Dec 31, 2019)

Therefore, an investor would appreciate that if she relies on the previously disclosed promoters’ shareholding of 44.04%, then she would make an error in her analysis.

It is advised that an investor should always pay attention while analysing the shareholding of promoters so that she is aware of the actual stake owned by the promoters in the company before making an investment decision.

An investor may read the complete analysis of Ion Exchange (India) Ltd in the following article: Analysis: Ion Exchange (India) Ltd

3) Getting shares from the company at a cheaper price via employee stock options (ESOPs)

Employee stock options (ESOPs) are usually granted by a company to its employees to reward them for good performance. ESOPs allow the employees to get shares of the company after working for a stipulated time with the company. Employees are allotted these shares at a fixed price irrespective of the market price prevailing when the ESOPs are exercised i.e. converted into shares.

ESOPs seem to align the incentives of the management with the shareholders because; good performance by the employees will lead to good financial results for the company, which in turn will result in a higher stock price. A higher stock price will benefit both, the shareholders and the employees that now own ESOPs.

It has normally been noticed that the ESOP cost the employees at a price lower than the ongoing market price. As a result, employees are happy to get the shares from the company at a lower price and then benefit from selling them in the market at a higher price.

Sometimes, promoters of the company use this route (ESOPs) to garner a large number of shares of the company at a low price. The promoters derive a lot of benefits from this allotment of ESOPs as it saves them from the high cost of acquiring shares from the open market. Investors would appreciate that if promoters start buying shares from the open market, then the market takes this as a positive signal about the company’s future prospects and in turn, the market significantly increases the price of the company’s shares.

Let us see an example where the promoters/people in control of the company used the route of ESOPs to increase their shareholding in the company.

A) Ion Exchange (India) Ltd:

In FY2011, Ion Exchange (India) Ltd disclosed in its annual report that it has allotted 950,000 shares to key management personnel (the current promoters) and their relatives on the exercise of employee stock options and private placement.

FY2011 annual report, page 94:

While reading the details of related parties, an investor finds that the relatives of key management personnel are the father, mother, wife and daughter of Mr. Rajesh Sharma, Mr. Dinesh Sharma and Mr. Aankur Patni.

FY2011 annual report, page 93:

Relatives of Key Management Personnel:

• Mr. Mahabir Patni – Father of Mr. Aankur Patni
• Mrs. Nirmala Patni – Mother of Mr. Aankur Patni
• Mrs. Aruna Sharma – Wife of Mr. Rajesh Sharma
• Mrs. Poonam Sharma – Wife of Mr. Dinesh Sharma
• Mrs. Nidhi Patni – Wife of Mr. Aankur Patni
• Ms. Pallavi Sharma – Daughter of Mr. Rajesh Sharma

Therefore, in FY2011, the current senior leadership of the company increased its stake by 950,000 shares via the exercise of employee stock options and private placement.

At the end of FY2011, the company reported a total number of 13,098,011 shares including the 950,000 shares issued to KMP and their relatives.

FY2011 annual report, page 74:

Therefore, an investor would acknowledge that in FY2011, the KMP (current promoters) and their relatives increased their stake in the company by 7.25% (= 950,000/13,098,011) in FY2011 by way of exercise of employee stock options and private placement.

There was strong opposition from minority shareholders against this allotment of ESOPs to the senior management (current promoters). (Minority shareholders protest Esops to Ion Exchange directors: Economic Times, July 5, 2010)

Minority shareholders of Ion Exchange (India), pioneers in water management and home water solutions, are crying foul over what they claim to be outsized allotment of employee stock options (esops) to directors of the company.

An investor may read the complete analysis of Ion Exchange (India) Ltd in the following article: Analysis: Ion Exchange (India) Ltd

4) Getting shares from the company at a cheaper price via stock warrants

One of the most common routes used by promoters to increase their shareholding in the company and to benefit from their access to the “priority lane” is the preferential allotment of warrants.

Stock warrants are a form of option where the person getting the warrants (allottee) pays a token sum to the company at the time of allotment of warrants. In return, the allottee gets a right to approach the company anytime over the next 18 months; pay the balance money and get the shares at a fixed price determined at the time of allotment of warrants. The company has to issue shares to the allottee at the predetermined price irrespective of the market price of shares at the time of exercise of stock warrants i.e. at the time of their conversion into shares.

The stock warrants are allotted by companies to preferred parties (mostly promoters) based on a formula, which is based on the share price levels of the past 6 months. Warrants are allotted by taking 25% of the value at warrants allotment. The balance 75% of the money is collected when the warrant holder converts them into equity shares.

The stock warrants holder (promoters in this case) has got a right to subscribe to the company shares and increase her stake in the company at a predetermined price without worrying about the usual share price increase which happens if the promoters buy shares of their company from the open market.

Many times, an argument is put forth that in case, the share price declines after the allotment of warrants, then the promoters stand to lose the initial 25% of the money paid by them. Therefore, they are taking a risk and as a result, the high payoff in the case of warrants is justified.

However, the entire gimmick of paying 25% now at the time of allotment of stock warrants and then keeping the option to pay 75% at the time of exercise, which the promoters would decide based on whether at the date of exercise, the promoters are making money or not, seems like a facade to us.

If the promoters pay 25% now and let the stock warrants expire due to the market price being consistently lower than the exercise price in future, then it effectively means that the promoters did not have the true intention of infusing 100% of the money in the company. Or that the company did not need 100% of the money. It might be that the company needed only 25% of the money, which promoters put in by way of stock warrants allotment and the right to get shares in future at a discount is the payoff that promoters would enjoy as a consideration for giving 25% to the company. The company might not need the balance 75% at all.

Nevertheless, we believe that if the promoters wish to infuse funds into the company, then the company should straight away issue additional shares to them at the prevailing market price and get 100% of the funds upfront rather than letting the promoters speculate on the company’s share price by holding back 75% of the funds as happens in case of stock warrants.

Investors may read more about the stock warrants in the following article: Stock Warrants to Promoters: How to Analyse

Let us see some examples where promoters increased their stake in the company using the route of warrants, a preferred lane at a lower price than available to the other shareholders.

A) Indo Count Industries Ltd:

Indo Count Industries Ltd is an Indian textile player, which has a significant share in the home textile segment of the USA and has marquee clients like Walmart, JC Penney, Target, etc. as customers.

On Sept 11, 2013, Indo Count Industries Ltd approved the allotment of 28,98,300 stock warrants to promoters at a price of ₹17.25 per share (pre-split price, the post-split equivalent price would be 1/5 of it: i.e. ₹3.45 and the number of shares post-split would be 5 times: i.e. 1,44,91,500).

The Shareholders of the Company in their Extra Ordinary General Meeting held on 11-09-2013 accorded their approval for issue and allotment of 28,98300 equity share warrants at ₹ 17.25 each (including premium of ₹ 7.25 each) on preferential basis to promoter group . The Company alloted 28,98,300 equity shares at a premium of ₹ 7.25 each on 20-12-2014 which shall be subject to a lock-in period of 3 years as specified under Regulation 78 of Chapter VII of the SEBI ICDR Regulations, 2009.

The (post-split) share price of the company on September 11, 2013, was in the range of ₹5.44 meaning that the promoters had a gain of ₹2.9 cr [1.44 cr. Share * (5.44-3.45)] on the very day of allotment.

The stock warrants are allotted by companies based on a formula, which is based on the share price levels of the past 6 months and are allotted by taking 25% of the value at warrants allotment. The balance 75% of the money is collected when the warrant holder converts them into equity shares.

In the case of Indo Count Industries Ltd, the promoters paid the 25% price of allotment i.e. ₹1.25 cr (1.44 cr. Shares * ₹3.45 * 25%), which the company disclosed in the FY2014 annual report, as share price money pending allotment.

The above information indicates that the promoters paid ₹1.25 cr for something which was giving them a profit of ₹2.9 cr right on the day of allotment.

An investor would notice that stock warrants are like call options where the holder has paid a premium of 25% of the value and would convert the warrants into equity shares by paying the balance 75% only at the time of conversion the price of the equity share of the company is higher than the warrant allotment price. Stock warrants are usually convertible within 18 months of the allotment.

An investor would notice that the stock warrants holder (promoter in this case) has got a right to subscribe to the company shares and increase her stake in the company at a predetermined price without worrying about the usual share price increase which happens if the promoters buy shares of their company from the open market. In case the share price does not increase, then the promoter simply lets the warrants expire.

That’s even though the companies say that stock warrants are issued to the promoters in lieu of the capital infusion by them at times when the company needed funds. However, I call stock warrants a legal instrument in the hands of promoters/allottees to speculate on their company share price. And invariably, the persons to bear the cost of such speculation are the minority shareholders.

An investor would see that the promoters infused ₹1.25 cr for the allotment of stock warrants in FY2014. Looking at the financials of the company in FY2014: Sales of about ₹1,468 cr, net profit of ₹110 cr, a debt of ₹434 cr and interest expense of ₹50 cr, the infusion of ₹1.25 cr by promoters seems insignificant in terms of overall financial position of the company and that too by calling a special extraordinary general meeting.

If it was urgent, then Indo Count Industries Ltd could have collected this much amount by making a single phone call to any of their customers so that they may pay ₹1.25 cr from the outstanding trade receivables of ₹127 cr on March 31, 2013, and ₹167 cr at March 31, 2014. Such collection in a time of urgency would not have been difficult from long-standing customer relationships.

Moreover, even if the company needed funds, the promoters did not infuse the balance 75% of the warrants funds i.e. ₹3.73 cr (1.44 cr. Shares * ₹3.45 * 75%), until December 20, 2014, which is good 15 months post allotment. If the stock warrants were allotted supposedly for the urgent requirement of funds by the company, then the balance 75% funds infusion would have come much sooner. However, even the balance 75% (₹3.73 cr) seems insignificant in terms of the overall finance requirement of Indo Count Industries Ltd.

Anyway, the promoters got 1.44 cr. shares (post-split) on December 20, 2014, at an effective price of ₹3.45, which is the original warrant allotment price. The post-split share price of Indo Count Industries Ltd on December 20, 2014, was about ₹60. Therefore, at the time of allotment of equity shares, the promoters had a gain of about ₹56.55 per share (post-split, ₹60 – ₹3.45), amounting to a total gain of ₹81.43 cr (1.44 cr shares * ₹56.55).

Moreover, the conversion of stock warrants allowed the promoters to increase their stake in the company by 3.20%.

The increase in stake in the company for the promoters comes at a very low cost of ₹4.97 cr (1.44 cr shares * warrant allotment price ₹3.45), which otherwise would have cost them about ₹86 cr (1.44 cr share * price at equity conversion date ₹60). This is without considering the almost certain possibility that if the promoters would have bought these additional shares from the open market, then the market would have taken the share price at a much higher level than ₹60.

Further, there is a peculiar observation related to the timing of the conversion of stock warrants into equity shares in December 2014. As per our analysis above, we have observed that from FY2014, the performance of the company had started improving a lot and as a result, the company came out of the corporate debt restructuring (CDR) in March 2015, which is just 3 months after the promoters converted their warrants into equity shares.

No wonder, the promoters converted their stock warrants in December 2014, as they know the best out of all the people, about the financial position of the company at any point in time and that the company would be exiting the CDR very soon. As is normally expected with a company showing improving business performance, after the exit from CDR, the share of Indo Count Industries Ltd raced ahead and touched the lifetime high of ₹249.69 on February 8, 2016, valuing the 1.44 cr shares (post-split) converted by promoters from warrants at ₹360 cr. It must be remembered that promoters got these shares by getting the warrant allotment at ₹4.97 cr. (1.44 cr share * ₹3.45 post-split allotment price).

This is an example of someone having her cake and eating it too.

An investor may read the complete analysis of Indo Count Industries Ltd in the following article: Analysis: Indo Count Industries Ltd

B) Rexnord Electronics & Controls Ltd:

Rexnord Electronics & Controls Ltd, an Indian manufacturer of coolant fans and shaded pole motors mainly used in computer hardware equipment, power supply equipment, textile machines, the refrigeration industry, injection moulding machines, photocopying machines etc.

In its annual general meeting (AGM) on August 30, 2014, Rexnord Electronics & Controls Ltd sought the following permission from its shareholders. The resolution in FY2014 annual report, page 2, mentioned that:

“The Board be and is hereby authorized in its absolute discretion to offer, issue and allot, on preferential basis upto 34,78,800 (Thirty Four Lacs Seventy Eight Thousand Eight Hundred Only) Warrants carrying an entitlement to subscribe to an equivalent number of equity shares of face value of ₹10/- each at a price being not lower than the minimum price calculated in accordance with the Regulations for Preferential Issue contained in Chapter VII of the Securities and Exchange Board of India (Issue of Captial and Disclosure Requirements) Regulations, 2009 (hereinafter referred to as “SEBI (ICDR) Regulations”) as amended, to the allottees mentioned below on a preferential basis.”

The shareholders approved this resolution in the AGM and the company, without much delay, allotted the warrants to the promoters at September 23, 2014, as per the following BSE filing on the same date:

“Rexnord Electronics & Controls Ltd has informed BSE that the Board of Directors of the Company at its meeting held on September 23, 2014 allotted 34,78,800 Warrants carrying an entitlement to subscribe to an equivalent number of equity shares of face value of Rs. 10/- each at a price of Rs. 13.40/- on preferential basis in accordance with SEBI (ICDR) Regulations, 2009 to the Promoters & Non-Promoters, as approved by the members of the Company in the Annual General Meeting held on August 30, 2014.”

However, what seems interesting is the price at which the warrants were offered: ₹13.40/- whereas the closing market price on September 23, 2014, was ₹23.34/-. A discount of 43% (₹9.94) to the then market price. This amounted to handing over of ₹3.36 cr to promoters on a platter (₹9.94 * 34,78,800).

No wonder the promoters exercised their option and converted 10,98,300 warrants into equity shares on December 13, 2014, at the fixed price of ₹13.40/- as per the BSE filing of the same day:

“Rexnord Electronics & Controls Ltd has informed BSE that the Board of Directors of the Company at its meeting held on December 13, 2014, has allotted 10,98,300 Equity Shares of Rs. 10/- each at a premium of Rs. 3.40/- each to promoters and non-promoters on conversion of 10,98,300 Warrants issued on preferential basis, pursuant to approval of Shareholding of the Company accorded on August 30, 2014 in the Annual General Meeting.”

The closing market price of shares of Rexnord Electronics & Controls Ltd on December 12, 2014, was ₹22.85/-

Simultaneously, the promoters of Rexnord Electronics & Controls Ltd increased their shareholding from 46.47% at March 31, 2014, to 51.46% on March 31, 2015, by an increase in their shares by 888,300, which has entirely come from the conversion of warrants into equity shares by promoters.

As discussed above, the promoters attained the majority stake by getting shares at a steep discount to the ongoing share price (₹13.40/- vs ₹22.85/-). If the promoters would have bought these shares in the open market to increase their stake beyond 50%, the share market would not have given them these shares at this discount.

An investor may read the complete analysis of Rexnord Electronics & Controls Ltd in the following article: Analysis: Rexnord Electronics & Controls Ltd

Many times, the opportunity to buy shares and increase a stake in the company at a cheaper price via warrants is so attractive that promoters borrow funds against their existing shares to subscribe to warrants.

Let us see one such case where the promoters of the company funded their purchase of warrants by taking loans against their existing shares.

c) Granules India Ltd

Granules India Ltd is a Hyderabad-based Indian integrated pharmaceutical manufacturer, which focuses on making active pharmaceutical ingredients (API), pharmaceutical formulation intermediates (PFI) and finished dosages (FD) as primary business activities.

The FY2016 annual report (page 47) of Granules India Ltd mentions that the company issued warrants to promoters on two occasions in FY2016:

I, further report that during the audit period:

(i) The company has issued 40,95,230 warrants of ₹84.91/- each on August 28, 2015 to be converted into equal number of equity shares of face value of ₹1/- each out of which all were converted into equity shares on October 31, 2015.

(ii) The company has issued 1,86,56,000 warrants of ₹95.30/- each on September 07, 2015 to be converted into equal number of equity shares of face value of ₹1/- each out of which 72,55,000 warrants were converted into equity shares on March 30, 2016.

a) 40,95,230 warrants allotted on August 28, 2015, at ₹84.91, which were exercised by the promoters in full on October 31, 2015, when the closing market price of Granules India Ltd was ₹147.90 on October 30, 2015, on BSE.

This led to the promoters benefiting by ₹25.7 cr. [40,95,230 * (147.90 – 84.91)]. This is assuming that the promoters would have been able to buy 40,95,230 shares at the market price, without factoring in the usual share price increase that results on the news of promoters buying shares in the company. Additionally, the daily trading of the shares of the company involves buying and selling of about 2.5 to 3.5 lakh shares, which is low considering the number of shares being gained by the promoters.

b) 1,86,56,000 warrants allotted on September 07, 2015, at ₹95.30, out of which 72,55,000 warrants were exercised by the promoters on March 30, 2016, when the closing market price of Granules India Ltd was ₹119.70 on BSE.

This led to the promoters benefiting further by ₹17.7 cr. [40,95,230 * (147.90 – 84.91)]. This is assuming that the promoters would have been able to buy 72,55,000 shares at the market price.

The conversion of about 1.12 cr. warrants by promoters in FY2016 helped them to increase their shareholding from 48.59% to 51.15%

We believe that such usage of warrants by promoters to increase the stake in the company has two aspects:

• The promoters are able to avoid the incremental cost of the acquisition of shares if they would have bought the shares from the market as the market would have taken the share price higher. The share prices increase is even steeper when the market gets to know that the acquisition of shares by promoters would lead them to cross very significant milestones of 50% shareholding.
• The promoters get to buy an asset at a discount as in the above case promoters could benefit by ₹43.4 cr. when the conversion price of warrants is compared to the closing market prices of the shares.

c) As per the exchange filing done by the company on December 28, 2016, the promoters further exercised 39,17,454 warrants on December 28, 2016, when the closing market price of Granules India Ltd was ₹105 on BSE. Promoters currently have about 75,00,000 warrants that remain to be exercised at a fixed price of ₹95.30 irrespective of the prevailing market price.

We believe that warrant issuance to promoters is effectively a way of transferring the economic value from non-promoter shareholders to promoters.

Many times, the logic is given that warrants help the companies raise funds from promoters in difficult times when companies find it difficult to raise funds from other sources. However, in the case of Granules India Ltd, the promoters are funding their warrants purchase by raising loans by pledging their shareholding in the company, which was communicated by the promoters to analysts in the conference call in Oct. 2016 (page 13).

Krishna Prasad: All the share pledging was done exclusively to fund warrants and none of the money has gone out and there could be a little more share pledging for the next tranche that I have to pay. But what we do is, we try to negotiate better rates and when we get a better offer we pay off the old loan and get a better price. So this is a constant endeavor to bring down our cost. So this is the reason releasing of pledge and re-pledging.

If an investor analyses the sequence of events/activities, then it indicates that promoters are using the economic value of shares of Granules India Ltd to raise funds to buy more shares in the company at a discount to the market price.

In case the promoters are not able to service the loans taken by them by pledging shares, then the selling of shares by those lenders would lead to a huge decline in the share price of Granules India Ltd, which would hurt the wealth of all the shareholders whether promoters or non-promoters.

Moreover, such loans taken by promoters incentivise them further to get high salaries from the company as well as get dividend payouts despite negative free cash flows (dividends funded by debt), so that they are able to service these loans.

Effectively, one way or the other, it is the company and the shareholders who end up bearing the cost and repercussions of such loans irrespective of these loans being in the name of promoters. However, the benefit of these loans is primarily enjoyed by promoters as it leads to their increased shareholding in the company.

Therefore, we believe that the allotment of warrants by companies to promoters and then the exercising of the warrants by promoters by paying from the funds raised by pledging shareholding in the company itself is not a good practice. Investors should be fully aware of the dynamics that result in such situations.

Overall, an investor may note that a high shareholding of promoters in any company is seen as a sign of strength, which is especially true for markets like India where most of the companies are family-owned. In such an environment, the promoters attempt to keep their shareholding high in order to have strong control of the company, and its functioning and to avoid hostile takeovers.

If due to any reason, the promoters of a company end up having a low shareholding, then most of the time, the promoters increase their shareholding by purchasing shares from the open market. However, from the above discussion, an investor would notice that at times, promoters use different tools to increase their shareholding in the company. Sometimes, they show shareholding of employee benefit trusts owned by the company as promoter shareholding. At some other times, promoters use the money of the company to buy shares of the company using complex transactions involving subsidiaries or promoter-owned entities. Sometimes, the promoters also use tools like warrants, ESOPs etc. to acquire shares at a cheaper cost using the preferential route.

It is advised that an investor should analyse the promoters’ shareholding of companies and understand their actual holding along with the methods used by the promoters to acquire those shares. Such an analysis will help the investor gain a lot of insights into the management quality of the company.

Further Reading:

• Why Management Assessment is the Most Critical Factor in Stock Investing?
• How to do Management Analysis of Companies?

How do you approach the assessment of promoters’ shareholding in the companies? What are the signs that give you comfort and what are the signs that raise a concern? It would be great if you can share your experience with us as comments to the article. It will be very helpful to the author as well as all the readers.

Answers to Readers’ Queries

Should one invest in companies with low float due to indirect promoters’ shareholding?

Hello Mr Vijay,

My query is about companies (mostly small caps), which have a very low float in the market. Although SEBI has a guideline that stipulates that promoters can only have a certain percentage maximum holding in listed companies, one comes across many firms where large portions (up to 95%) are held by promoters indirectly hence bringing the float to less than 5%.

• Why do firms do this?
• What is the advantage of staying listed for such firms?
• Is it safe to purchase stocks of such companies from the point of view of a minority investor?

Thanks

Author’s Response:

Hi,

Thanks for writing to us!

We give more weight to the management assessment than the float assessment. We believe that if an investor is not finding the management trustworthy, then she should avoid the stock altogether and on the contrary, if she has faith in the management, then she may take different views on the float.

Also read: How to do Management Analysis of Companies

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 a research analyst.

Details of financial interest in the Subject Company:

I do not own stocks of the companies mentioned above in my portfolio at the date of writing this article.