Shareholder Wealth Consequence of Insider Pledging of Company Stock as Collateral for Personal Loans

Jason Zein is Associate Professor at the University of New South Wales (UNSW) Business School. This post is based on a recent paper by Professor Zein; Ronald Masulis, Scientia Professor of Finance at UNSW Business School, University of New South Wales; and Ying Dou. Related research from the Program on Corporate Governance includes Paying for Long-Term Performance by Lucian Bebchuk and Jesse Fried (discussed on the Forum here).

Many publicly listed firms around the world allow their executives and other major shareholders to pledge their company shareholding as collateral for a personal loan. Pledging is valuable to corporate insiders because it allows them to nominally retain their ownership in the firm, while at the same time accessing the liquidity that is tied up in their firm’s stock. These liquidity benefits of pledging allow corporate insiders to enjoy valuable private benefits such as greater consumption or diversification of their personal wealth by funding other private investment opportunities.

While pledging has clear benefits for firm insiders, in our recent study we investigate whether it has any negative effects for outside shareholders. Using a novel database that documents the precise timing, size and identities of each pledge undertaken by a sample of Taiwanese listed firms over an 11-year period, we show that pledging is associated with a significant decline in minority shareholder wealth measured in both the short and long term.

To test whether the negative relationship between insider pledging and firm valuation is causal, we employ a quasi-natural experiment facilitated by a change in legislation placing new restrictions on the voting of pledged shares. Using a difference-in-difference approach, we show that firms subject to an exogenously induced reduction in pledging obtain larger improvements in firm value compared to a matched sample of benchmark firms that have no insider pledging, but are similar in terms of size, industry, ownership structure, sales growth, investment intensity, leverage, volatility and board size and independence.

We provide evidence of pledging acting through two channels to damage outside shareholder wealth. First, we show that insider pledging raises a company’s exposure to negative price shocks and thereby exacerbates its crash risk exposure. In particular, once a margin loan is secured by company stock, any large price declines in the stock will trigger a margin call requiring the pledger to post additional capital. But an executive’s pledging decision is generally driven by a lack of liquid assets, so meeting a margin call is likely to be very costly. As a consequence, a pledger may need to sell substantial amounts of stock to meet the margin requirement. The result is a release of a large block of previously untraded shares into the secondary market, which places further negative pressure on the stock price. This in turn can trigger additional margin calls, with similar effects. By exacerbating price declines in this way, pledging expands the left-tail of the stock’s return distribution, thereby exposing firm shareholders to greater crash risk.

Using the 2008 Global Financial Crisis as an experimental setting that propagates an exogenous negative price shock across pledging and non-pledging firms, we find that firms with significant insider pledging suffered greater stock price declines during the crisis period. We also find pledging firms who experienced significant declines in insider shareholdings during the crisis suffer even greater price declines, which is consistent with the sale of insider stock to cover margin calls being the source of these greater stock price declines during the crisis period.

Second, when pledging agreements are outstanding insiders may become sub-optimally risk averse because significant stock price falls can force them to either relinquish the liquidity benefits of pledging in order to meet margin calls or to forfeit their shares and their associated private benefits of control. In line with these incentives, we show that pledging insiders respond to the threat of costly margin calls by making corporate decisions that substantially reduce a firm’s risk exposure.

Although concerns about pledging are raised in several prior studies (Larcker and Tayan (2010), Larcker, McCall and Tayan (2013)), to our knowledge there is no empirical evidence on the aggregate impact of pledging on minority shareholder wealth. Such evidence is needed to inform policy makers on effective regulatory responses to pledging. Our findings show that insider pledging can be detrimental to CEO incentives and firm value. This suggests that such pledging should be clearly disclosed in a timely manner, and that firms interested in preserving shareholder wealth and maintaining sound corporate governance practices may wish to restrict or ban this activity.

The full paper is available for download here.

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