by Cydney Posner
Many company policies prohibit (or severely limit) officers and directors from pledging their company shares against margin loans, and, as discussed in an article in last week’s WSJ, there seems to be good reason for that practice.
The article describes an officer that had pledged a large proportion of his shares of his company’s stock – about a quarter of the company’s outstanding shares – as collateral for margin loans or in sale/loan-like transactions (variable prepaid forwards). According to the article, the officer apparently leveraged his stake in the company to help fund other business pursuits. When the stock price slumped, the officer faced demands for more loan collateral, which led him to exceed, at various times, the limits imposed by company policy on the extent of his pledging. (Notably, his prepaid forwards were not covered by company policy.) The officer’s situation was salvaged to a limited extent when the share price rose after the board approved a stock buyback plan. But the price dropped again, and the officer again had to increase the number of shares pledged, finally leading the independent directors to sanction him (loss of salary and annual bonus) as a result of the policy violation. The directors delayed imposition of an even lower limit on pledged shares to allow the officer time to reduce his position to get into compliance in an orderly fashion. The officer then called for another much larger buyback. Of course, there are a number of good reasons to engage in stock buybacks when a company’s stock price drops, and the company flatly denied that the buyback had anything to do with the officer’s stock pledges; nevertheless, the inference from the article of at least the appearance of a conflict of interest is clear.
As the article notes, margin calls on pledged stock are not exactly unknown and have famously occurred during periods of stock drops, such as the 2008 meltdown. Typically, in the event of a margin call, a debtor can add more company stock, substitute other collateral or reduce the amount of the loan, but if none of these is done or done sufficiently to satisfy the margin call, the lender may be forced to sell the pledged shares. And that sale could occur at a particularly inconvenient time, such as in the midst of a significant company transaction. Moreover, the impact on the market of a quick sale by the lender of a substantial block of shares – especially on shares that have already taken a dive – can be significant.
That’s just one of the reasons that share pledges by insiders are not only disfavored by many companies, but also by some institutional investors and proxy advisory firms, such as ISS and Glass Lewis. Another concern for these groups is that loans secured by pledged stock can undermine one of the purposes of equity incentive compensation by potentially shielding the executive from the effects of poor company performance. Under some circumstances, ISS will recommend a vote against or withhold from directors due to material failures of risk oversight, including significant pledging of company stock. When considering a recommendation regarding a shareholder proposal, ISS will also generally recommend a vote for proposals seeking policies that prohibit executives from pledging stock as collateral for a loan. And still another concern is the possibility of conflict of interest illustrated in the story: while Glass Lewis does not apply a one-size-fits-all policy to pledging prohibitions and therefore considers a variety of factors in making a vote recommendation, its 2016 policy guidelines do “recognize that the pledging of shares can present a risk that, depending on a host of factors, an executive with significant pledged shares and limited other assets may have an incentive to take steps to avoid a forced sale of shares in the face of a rapid stock price decline. Therefore, to avoid substantial losses from a forced sale to meet the terms of the loan, the executive may have an incentive to boost the stock price in the short term in a manner that is unsustainable, thus hurting shareholders in the long-term.”
Where pledging by insiders is permitted, another factor that companies and pledging insiders need to take into account is the potential exposure to liability that could result from pledges and sales of shares by the lender when margin calls go unsatisfied. Depending on the circumstances, just the pledge itself could be viewed as a sale for purposes of the antifraud rules. Moreover, the sale of the pledged shares can be attributed to the insider and could lead to insider trading charges where material inside information is implicated. The SEC has also indicated (in its CDIs) that the affirmative defense set forth in Rule 10b5-1(c) related to contracts, plans or instructions that do not permit the insider to exercise any subsequent influence over how, when, or whether to effect purchases or sales is not available – even if the insider did not have material inside information when the shares were pledged – if the insider does not satisfy a margin call and the pledged shares are sold, so long as the insider retained any discretion to substitute or provide additional collateral, or to repay the loan before the pledged securities were sold. And, while the pledge itself is not reportable under the Section 16 short-swing trading rules (because it is not viewed to result in a change in beneficial ownership), the sale of the pledged shares by the lender is reportable by the insider and the sale is attributable to the insider for 16(b) liability purposes.