Stocks fall like Nine Pins:

The recent action on the Indian stock markets, where stocks like GTL lost 70% market capitalsation in a single day again, showed investors the peril of over leveraging by promoters.

Over leveraging here involves the promoter share holding being pledged to financers as security against loans availed from them. The problem is fundamental here, in the sense that unscrupulous promoters by this mechanism are able to pledge their shareholding and are able to use the money as they want for their personal use and not necessarily for the use of the company.

The mechanism is simple - say a promoter starts a venture with Rs.500 million divided into 50 million shares of Rs.10 each. In three years time, he builds a so called sustainable business around which he creates a hype and drives the share price to Rs.500 per share by listing the company and holding say 70% of the shares. His valuation is now worth Rs.17,500 million which is 35 times his initial investment. Considering that a financer is going to charge a margin of 50%, his worth becomes 8,750 million and even if he pledges 10%, he takes home Rs.875 million. This will cover his initial investment of Rs.500 million plus the costs involved in driving the price to Rs.500 per share. The beauty is that when he pledges another say 10% and takes home another Rs.875 million, he is suddenly not concerned about what the company is doing. Even if the company now goes down, he has still made a cool Rs.875 million on an investment of Rs.500 million in three years.

I am not for a moment saying that all promoters are like that, but separating the scrupulous from the unscrupulous is very difficult in India, given the lack of regulations governing the promoter shareholding.

Unless SEBI wakes up to the reality and brings tough norms to regulate how the funds from pledged promoter shareholding can be used, many a unscrupulous and scrupulous promoters may be tempted to adopt the above mechanism and loot the Investors for their own personal benefit.