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The Problem with Pledging

Last fall, at its annual meeting, FedEx (NYSE: FDX) shareholders and the Board of Directors debated the issue of pledging. FedEx policy prohibits share pledging, but allows the company’s general counsel to grant exceptions on a case-by-case basis. A sole but noteworthy exception had been granted for Chair and CEO Fred W. Smith, who pledged 21% of his shares (over 4 million shares, with a value of $594 million) as collateral for loans to fund other business ventures and prior purchases of FedEx shares.

The stockholders proposed a hedging and pledging policy specifically for equity-based compensation plans, which included, among other things, prohibiting directors and officers from holding shares in a margin account or pledging shares as collateral for a loan. The shareholders’ concerns included the large number of shares pledged by Mr. Smith, and the need for stronger anti-pledging policies to align the interests of shareholders with directors and officers, particularly given the risk that a margin call could result in shares being dumped on the market.

Ultimately, the Board won: it rejected the proposal, arguing that the anti-pledging policy in the FedEx Securities Manual reasonably and adequately balanced the interests of shareholders to protect the value of shares with the flexibility and liquidity needs of directors and officers to use shares as collateral.

As shown by the FedEx debate, arguments against pledging are primarily built on possible risks to shareholders, including the potential for a decline in stock value, and changes in ownership because of margin calls or loan defaults. However, pledging is also risky for executives, who may find themselves faced with a margin call, and unwittingly forced to sell the securities or raise more collateral during “black-out periods,” in potential violation of insider trading regulations. The recent example of Green Mountain Coffee Roasters in 2012 highlights the risks to executives. Founder Robert Stiller had held in margin accounts and pledged as collateral against loans nearly 75% of his shares. Faced with a margin call, he was forced to sell millions of shares during a black-out period, and subsequently lost his position as company chairman.

Recognizing the various risks of pledging and the need for proper disclosure, the Securities and Exchange Commission requires public companies to report, either in a 10-K or in a proxy statement, whether shares have been pledged or held in margin accounts by directors and executive officers. (See Rule 403(b)(3) of Regulation S-K, 17 CFR §229.403(b)(3), “Describe any arrangements, known to the registrant, including any pledge by any person of securities of the registrant or any of its parents, the operation of which may at a subsequent date result in a change in control of the registrant.”) These disclosures provide shareholders and other interested parties important insight into whether, how, and to what extent a company’s shares are pledged.

A review of these proxy statements conducted by Audit Analytics reveals hundreds of companies that allow their directors and officers to pledge their stock as collateral or in margin accounts. Some of these companies allow pledging without limit, while other companies have anti-pledging policies but allow exceptions. The amount of pledged shares can be astronomically high, as in the millions pledged at FedEx and Green Mountain Coffee Roasters, and also at Wendy’s Co. Regarding the latter, Wendy’s 2014 proxy showed over 23.7 million shares pledged, which has invoked reactions from concerned investors. Change to Win Investment Group sent the following e-mail to investors on May 23, 2014:

(NasdaqGS: WEN) annual meeting next Wednesday, May 28.

Wendy’s Chairman Nelson Peltz has pledged nearly his entire personal equity
stake in Wendy’s, a holding equal to around 4% of the company’s stock.
Recent history shows that such pledging can pose profound risks to investors
as these holdings may be subject to quick liquidation in response to a
margin call.

Investors should recall how in 2008 the Chairman/CEO of Chesapeake Energy,
having pledged virtually all of his Chesapeake shares as loan collateral
(about 5% of outstanding shares), was forced to liquidate almost his entire
stake in response to a margin call. Chesapeake stock sagged in response to
this sudden dumping of nearly 5% of outstanding shares. This episode was a
key element in the governance crisis that hung over the company until last
year, when the board named a new CEO.

If Peltz were forced to sell this stake, not only would Wendy’s shares
suffer, but there would be serious questions about board leadership. It is
inappropriate for almost the entire stake of such a significant shareholder,
and key figure thus far at Wendy’s, to be pledged and thus put at risk.

But even smaller companies with pledged securities could pose risks for investors, particularly where the pledged shares constitute a large portion of the company’s total shares. When this happens, companies sometimes (but not always) explicitly state in their proxy statements that a default under the loans could result in a change in ownership.

Pledging can raise serious red flags regarding a company’s stock ownership and risks to investors. SEC reports like proxy statements provide the keys to knowing a company’s pledging status, including past and current pledges, and changes in pledging policies and practices. Potential investors, shareholders and auditing firms would all be well-advised to be aware of those companies that allow pledging (whether explicitly or by exceptions), and the extent to which those companies’ shares are pledged. To this end, a thorough review of SEC filings like proxy statements provides a wealth of information regarding the various pledging practices of companies and the potential risks posed to investors by a company’s executive pledges.

In a follow-up post, we will take a deeper look at trends in pledged securities, including a sample of companies with a high percentage of pledged securities.

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