India Ratings and Research (Ind-Ra) believes that a quick exit through liquidation for 314 stocks with a total pledged share value of Rs 1,673 billion will be difficult. "This is because their pledged volume is huge compared with the average daily trading volume and the perceived liquidity of share as collateral may prove elusive when needed most."

"Investors could face losses if these stocks are liquidated in the open market either for the final redemption or because of any covenant breach such as borrowers' failure to provide free shares in case of a price correction," it opined. These 314 stocks are almost a third of the total of 917 stocks having a pledged value of around Rs 1,884 billion as reported on the stock exchanges.

The agency feels that in 59 cases with a total pledged value of Rs 317 billion the promoters do not even have enough free shares to provide additional shares as collateral if the price corrects even by 20%. "Typically in these transactions, the borrowers are covenanted to maintain a certain minimum collateral cover by providing additional shares in case the price drops. Failure to provide additional shares may trigger liquidation and it may result in a loss to the lenders owing to the huge pledged volume in these cases."

There are only 96 companies with sizeable market capitalisation whose shares have sufficiently high liquidity and the promoters also have enough free shares to provide a top-up for over 80% drop in prices. The agency is of the view that of these 96 cases, only 82 have shown a satisfactory performance history to be considered as suitable collateral for the credit rating of 'A' or higher with a varying level of cover.

In many cases, promoters group companies holding the shares provide a guarantee or other forms of support such as undertaking which may not equate to a financial obligation. Details of these indirect share backed transaction are not reported in the exchanges.

Ind-Ra is of the opinion that in the absence of formal security of shares and hence of an over-collateralisation, such debentures are likely to be notched down from the rating that would be assigned if the shares had been part of a formal security package.