Many corporations borrow money by pledging or creating an encumbrance on their promoter shareholdings. However, if the encumbrances (pledged shareholding) exceed a threshold, it indicates that the company maybe borrowing excessively, a potential red flag for financial distress. As the percentage of shares encumbered increases, the risk of default associated with the firm also increases. Simultaneously, creation of any encumbrance on shares affects their tradability.

In the event of default in servicing of the debt, the lender may invoke the encumbrance and resort to distress sale of shares which may see free fall in the share prices. This will in turn result in massive erosion of value of the shares held by the other shareholders. The SEBI Takeover Regulations require the promoters to disclose the details of encumbered shares to the stock exchanges where the shares of the company are listed. Further, the existing regulations define the term ‘encumbrance’ to include a pledge, lien or any other transaction, by whatever name called.

It has been noted that certain practices of creation of encumbrances by using terminologies other than pledge or lien have increasingly been used in the market so as to remain outside the scope of current definition of encumbrance in the SEBI Takeover Regulations. The methodologies adopted include creation of negative lien or signing non-disposal undertakings/agreements (NDUs).

The fact of the matter is that any type of encumbrance on shares, whether direct or indirect, affects the tradability of shares and as a result of the practice of creating indirect encumbrances through use of innovative terms or agreements, there have been growing number of instances seeing free fall in share prices due to default distress sale of encumbered shares by lenders. Jet airlines is a glaring example. Taking a serious note of the developments and with a view to protect the interests of investors, SEBI has decided to widen the definition of the term ‘encumbrance’ which will now include any restriction on the free and marketable title to shares, by whatever name called, whether executed directly or indirectly. It shall also include pledge, lien, negative lien, NDUs, any covenant, transaction, condition or arrangement in the nature of encumbrance, by whatever name called, whether executed directly or indirectly.

Now, in addition to existing disclosure requirements, the promoters shall be required to disclose separately detailed reasons for encumbrance whenever the combined encumbrance by the promoters and persons acting in concert (PACs) crosses 20% of the total share capital in the company or 50% of their shareholding in the company. The stock exchanges will maintain the details of such encumbrances along with purpose of encumbrance, on their websites and the promoters shall be required to declare to the audit committee of the company and to the stock exchanges on a yearly basis, that they along with PACs, have not made any encumbrance directly or indirectly, other than already disclosed, during the financial year.

The disclosures are very important for the market to understand and appreciate the risk factors. These are salutary measures and would certainly go a long way in curbing the malpractices and safeguarding the interests of other shareholders at large.