The starting point for investigating any potential investment is a company’s balance sheet. Good analysis of its fundamentals may prompt analysts and portfolio managers to invest in a company, or not. But a healthy-looking balance sheet can still hide liabilities—for example, cash raised by companies or investors pledging company stock as a way of capital can turn a seemingly attractive investment into a potentially risky one. As the practice grows, data vendors are building datasets to shed light on this often murky area.

The practice of pledging shares isn’t uncommon—or necessarily risky—among wealthy investors, who can basically borrow money using their stakeholdings as collateral without needing to sell their shares. In fact, in some markets most listed companies do it. However, if the amounts pledged start to constitute a high percentage of a company’s issued share capital, it can cause concern about the company’s health.

“Pledging securities is not a new phenomenon and has now become common practice to raise funds in different parts of the world, with emerging economies having a wider prevalence of pledged shares,” says Kunal Sawhney, CEO of Sydney-based equity research firm Kalkine Group. “It allows the owner to put the pledged shares as collateral to a third party, like banks, trust firms, or security companies in exchange for cash. At the same time, it becomes a challenge for the analysts analyzing the company, and possesses great risk, as the pledged security can not only bring volatility to the stock prices, but can also impact the future valuation if anything goes wrong,” he says.

For example, if the share price of a company with pledged shares drops, the lender may demand more shares as collateral, or even repayment, putting greater pressure on its stock price, while under common law in England and Wales, a creditor has the right to sell pledged shares if the pledgor defaults on a payment, Sawhney says.

And as it becomes a more “common practice,” creating a more widespread, systemic risk, the availability of data to provide transparency into the practice becomes ever-more important.

But because a pledged share agreement is a private transaction, information is often not readily available, observers say. “Many emerging stock market regulators have made it a case to disclose the pledged share information by the companies in their corporate filing on a corporate or annual basis. Still, the data is not accessible to many,” and is also often not in a transparent form, Sawhney says, adding that the growing importance of this data has prompted vendors to compile datasets and tools to bring greater transparency to pledged shares transactions.

“Pledged equity shares can expose a company to hidden risks and many advisers consider share pledging to be a poor governance practice,” says Nicole Hallas, senior research analyst at Massachusetts-based Audit Analytics, which released its pledged securities database of US companies in December 2020.

“This information about pledged securities can be used by our clients to monitor for risks, perform due diligence, and stay informed of possible impacts to ownership, independence, and insider trading rules. As with many of our databases, it can also be used as a benchmarking tool to compare one company to the entire population of US listed companies. Audit firms, regulators, academic researchers, as well as anyone who is interested in risk, or performing due diligence, will find value in this data,” Hallas says.

Bloomberg last month released a pledged securities dataset aimed at a range of users, including equity analysts and portfolio managers, risk managers, industry analysts, bond and loan originators, bond and loan syndicators, and credit risk analysts. Bloomberg’s dataset initially covers the Chinese market, with plans to expand to other major emerging markets in the future. Officials say that most companies in China commonly use this practice, usually without any ill effects.

“Pledged shares provide an important insight into companies’ creditworthiness and operating stability. In addition to creditworthiness, it is a form of capital raising in China and an indicator around how equities choose to raise capital,” says Vatsan Sudersan, head of Asia-Pacific global data at Bloomberg in Singapore. “It’s not a niche market/method of raising funds in China. Roughly 3,000 out of 4,000 public companies in China have pledged their shares and, in general, it is not deemed a risky way of raising money. It is only really considered risky when a very large portion of a company’s shares are pledged, as the downside risks are significant if the market experiences a significant drop.”

Of course, there are exceptions. For example, according to data from Audit Analytics, US beauty products manufacturer Revlon has had more than 80% of its outstanding shares pledged in each of the past four years. Audit Analytics reports in its “Top 10 in 2021” analysis of US companies with the highest levels of pledged shares that in comparison, Partners Bancorp significantly reduced its exposure from 74% in 2020 to 41% in 2021, while cloud and enterprise software vendor Appian Corp’s amount of pledged shares jumped from less than 5% to almost 40% over the same timeframe.

‘Not always obvious’

Audit Analytics notes in its data, published in January, that the number of companies and individuals reporting pledged securities declined overall during the five-year period between 2016 and 2021. However, the company also warns that “Despite the significance, information about how many beneficial owners of company stock have pledged their shares, and how much, is not always obvious,” adding that while US regulator the Securities and Exchange Commission requires disclosure of pledged shares by certain owners, this information is often inconsistently disclosed or is buried in footnotes and numerical tables, making it “difficult to both find and decipher, especially if multiple individuals pledged shares.”

David Trainer, CEO of New Constructs, a provider of niche research that focuses on finding insight buried in the footnotes of financial statements, says, “There’s no question that companies disclose the minimum and obfuscate the negative—and I say that based on my experience on the Financial Accounting Standards Board’s Investors Advisory Committee. There’s a shift towards moving more information into the footnotes—and there’s alpha in that disconnect.”

“Weaponizing” capital via aggressive fundraising can sustain a company until it becomes profitable, Trainer adds. But it’s also important to know if the cost of that capital raising is increased risk. “The ability to raise money is a competitive advantage, and if people can raise money through pledged securities, then why not? It’s just another way to create leverage in the system,” he says. “But you need to especially focus on companies whose stock price is more volatile.”

In some cases, the shares may be owned by the company or executives and investors and pledged on its behalf. In others, investors may pledge their holdings for their own purposes. In this case, even though the shares are not pledged by the company itself, it still creates potential risk around control of the company’s stock, and should be recognized as an important emerging dataset for use in fundamental analysis.

“There are many aspects [to consider] when one is analyzing a stock, and pledged share information is a piece of vital information that an analyst would always like to focus on. It helps in understanding the financial trouble, if any, that the company is likely to be in, apart from revealing its creditworthiness,” Sawhney says. “One crucial factor that needs to be kept in mind by analysts is that a highly pledged stock of a company trades lower than its intrinsic value and should not be construed as a value buy.”

Hallas says Audit Analytics’ database aims to make it easy for users to discover which companies have shareholders with pledged securities, who those shareholders are, and how much they have pledged. The vendor’s team of research analysts collects and analyzes the data every day, and makes it available as a datafeed or a Microsoft Excel spreadsheet download. The database currently contains data since 2016, though Hallas says the vendor plans to expand its coverage to capture disclosures dating back to 2007 to provide more data for better trend analysis and research.

Bloomberg’s dataset contains information going back to June 2019 and comprises five elements: the number of open contracts for pledged shares, the number of shares outstanding for a company, the percentage rate of shares outstanding being pledged, the number of pledged shares that are restricted from trading on the open market, and the number of unrestricted pledged shares.

The vendor sources the data from Chinese exchanges, where it is publicly available. “After we acquire, clean and publish the data on the Bloomberg Terminal, it is displayed in a format that can be readily analyzed. We made it easier for users to access this type of data so that clients have an additional way of analyzing a company’s risk profile on one efficient workflow,” Sudersan says.

‘Solvency becomes a concern’

The dataset has also struck a chord among market data professionals focused on vendor risk management, for whom it could provide additional insight into a potential supplier’s creditworthiness and reliability.

Ron Troy, a veteran market data manager, says that banks in New York State that operate under Federal Reserve supervision are subject to regulations and guidelines that require firms to understand their risk, including any risk resulting from third parties supplying critical services. Thus, a firm must understand how risky a potential supplier is.

“You have to know your risk and be able to quantify it in terms of what the to-be-purchased service does. There are all sorts of risks to consider: financial stability, cybersecurity, information security, and things like what happens to the firm if the vendor goes down, regardless of the reason, for a short time, or a longer time, etc. What data of yours might be exposed? And once quantified and described, if substantial, management needs to sign off,” Troy says.

One consultant and market data professional who has spent more than 30 years in change management and market data management roles, many of those at major banks, says the pledged securities data could be used to spot red flags at potential suppliers.

“Having worked as a change consultant on a wide range of market data related projects over the years running numerous RFP-type processes, I can say that many organizations perform financial due diligence on potential suppliers,” the consultant says. “When dealing with large multinational companies that have turnover in the range of around $100 million, concerns like this rarely arise. However, when the potential supplier has a turnover of, say, $5 million to $10 million, then solvency becomes a concern when looking to implement a strategic platform.”

If pledged securities data raised red flags about a potential supplier, it would require further investigation and explanation, and—if it qualified as a genuine concern—would need to be balanced by a business justification to use the supplier, the consultant says. A firm may also seek additional guarantees—such as placing rights to the supplier’s product, such as its software IP, into escrow—to ensure that the product or service would still be available if the vendor went into liquidation.

For example, Troy says, “Some years ago, my then-employer was considering how to replace a badly out of date ‘processing’ system. We had two choices: Vendor A, great product, decent price. Vendor B, our incumbent, nowhere near as good a product, worse price. But doing our due diligence, we found that A had a grand total of three employees. If the three got caught in a car crash together, we’d have been up the creek minus the proverbial paddle. We picked B. I’m sure we were not the only firm to be concerned that they were so small, and their product would be for a mission-critical system. Tough problem for such a firm: how do you grow when you are so small that your size is a huge risk? But it is a factor in vendor risk management.”

For companies that small, pledged shares of public stock shouldn’t be an issue since such small firms would most likely be privately held. But even stock in privately held companies can be pledged and constitute a risk—though in private companies, that information would be even harder to find. And for some smaller companies without access to other fundraising sources, pledged shares may be a viable option.

Sawhney notes that pledging of shares should not be assumed to be a negative factor, and indeed “can be used to meet various operational requirements of the company.” But he adds that it is “generally considered a last resort,” and is “a highly risky way to secure funds.” In addition, he acknowledges that companies pledging shares may not be acting transparently towards investors, and may have opted for that method of fundraising to hide potentially high debt and continued borrowing.

“The new datasets can provide an insight into a company’s creditworthiness and bring transparency by providing periodic details of shares pledged to analyze the future performance and valuation of the company. However, it will depend on the market being analyzed and the availability of data,” Sawhney says.