Pledging of shares is done to raise money against one's stake in the company. It can be done by both investors as well as promoters of the company. Promoters can pledge held shares of their company with the financial institution to take a loan and for the lender these shares serve as a collateral. The money can be raised for both personal as well as business needs.
Generally lenders such as banks or NBFCs provide an amount against pledged shares that is less in comparison to the market value of shares. This they do to retain the difference as security amount. And in case, price of the stock falls, lender may ask promoters to provide cash or additional shares to top up the collateral. And in case the promoter fails to do so, banks or lenders in order to maintain the margin money can sell the pledged shares in the open market.
What high pledged promoter holding in a stock means for a retail investor?
Higher pledging of company shares by promoters makes the scrip highly volatile. Though the risk is determined on the basis of number of shares pledged to the total number of shares held. Nonetheless, in case the stock price falls and the lenders continue to sell pledged shares in the open market to make up for the margin amount, huge and sudden supply of shares can further reduce the price of share which can be daunting for retail investors as they may need to square up their position in such a scrip incurring huge losses.
It is advised that retail investors should avoid company stocks in which the number of pledged shares is over 50% of the total outstanding shares as these are highly risky.