Pledged securities – shares of a public company that are pledged by their owner as collateral – present a potentially serious risk to a company’s governance and share price. When a major owner of a company pledges their shares, it exposes the company to the risk that the shareholder might have to sell a substantial holding in the company if those shares are ever called as collateral.
The risk of pledged securities was apparent in the aftermath of the 2008 financial crisis. Prior to the crisis, some CEOs of large companies had pledged their ownership shares in the company as collateral; when the crisis occurred, those positions were exposed as unmet margin calls, forcing those CEOs to sell their shares.
If pledged shares are exposed as unmet margin calls, it could lead to a significant change in ownership of control, possibly violating insider trader policies and regulations. Share pledging may also be used in hedging or monetization strategies aimed at immunizing an executive against economic exposures to a company’s stock, while still allowing the executive to maintain voting rights.
The SEC requires disclosure about securities pledged by certain beneficial owners and directors to be indicated – “by footnote or otherwise” – the amount of ownership shares that have been pledged. This information is inconsistently disclosed in either a 10-K or in a company’s proxy, and it’s often buried in a footnote to a complicated table full of numbers, making the information difficult to both find and decipher.
As can be seen in the table below, some entities or stakeholders have pledged 100% of their beneficially owned stock as collateral; in some cases, this means that more than 50% of shares outstanding have been pledged.
When taken in context, the information about pledged securities can reveal a great deal about corporate risk and the implications of pledging securities, particularly if an entity beneficially owns a significant amount of company stock.
For example in the most recent proxy statement for technology company Ubiquiti [NYSE: UI], this disclosure was included as a footnote regarding the beneficially owned shares of the Company’s founder and CEO:
“As previously disclosed, Mr. Pera has entered into arrangements under which he has pledged up to 25% of the shares of common stock that he beneficially owns to secure loans with financial institutions. Mr. Pera had also indicated these loans have or will have various requirements to repay all or portion of the loan upon the occurrence of various events, including when the price of common stock goes below certain specified levels. Mr. Pera may need to sell shares of our common stock to meet these repayment requirements. Upon a default under one or more of these loans, the lender could sell the pledged shares into the market without limitation on volume or manner of sale. Sales of shares by Mr. Pera to reduce his loan balance or the lenders upon foreclosure are likely to adversely affect our stock price.”Ubiquiti Inc, DEF14A filed on October 26, 2020
In this scenario, the CEO of Ubiquiti beneficially owns 89.5% of company stock, of which he has pledged 25% as collateral to secure loans. In the event of default on one of these loans, the financial institution could sell those shares into the market, which could significantly adversely affect Ubiquiti’s stock price.
Despite the risk associated with the practice, many large companies still permit the pledging of securities.
For example, several top executives and directors at Tesla [NYSE: TSLA] have pledged their ownership shares; collectively, four individuals have pledged 10.1% of their ownership shares in relation to total Tesla shares outstanding. This includes Tesla’s high-profile CEO, Elon Musk, who has pledged 47.8% of company shares that he beneficially owns to secure certain personal indebtedness, amounting to nearly 10% of Tesla’s total shares outstanding.
Tesla’s Board believes their share pledging policy “to be in the best interests of Tesla and our stockholders by providing directors and executive officers flexibility in financial planning without having to rely on large cash compensation or the sale of Company shares, thus keeping their interests well aligned with those of our stockholders, while also mitigating risk exposure to Tesla.” Tesla’s policy does cap the amount of stock able to be pledged as collateral for loans and investments at 25% of the total value of the pledged stock.
Post 2008-financial crisis, several institutions have expressed concern over the risk of pledged securities and the potential effect on stock prices. Institutional Shareholder Services expresses the view that “any amount of pledged stock is not a responsible use of company equity.”
Considering this practice still exists and is associated with significant risk, this is an area of corporate governance that would benefit from monitoring.
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