January 24, 2023
Share Pledging: Look Before You Leap
In our recent webcast on 2023 proxy disclosures, Mark Borges observed anecdotally that more companies appear to be permitting directors and officers to pledge shares. Mark said that these companies should disclose the safeguards they’ve put in place to prevent the pledge from backfiring and ending up with insider trading allegations. Those companies and their directors and officers should also check out this Orrick memo, which reviews some things insiders should consider before pledging shares. This excerpt addresses the risks associated with pledge arrangements:
Various risks may arise for both the insider and the company in connection with pledging shares since share pledging may be utilized as part of hedging or monetization strategies that limit an insider’s economic exposure related to their ownership of the company’s shares, even while the insider maintains voting rights.
The personal risk to the insider in connection with pledging shares is that, if the value of the shares falls below certain contractual minimums set in the agreement by which the shares are pledged, the insider may be subject to a margin call, in which case, the insider may be required to either sell the pledged shares, pledge additional shares, pay cash to make up for the shortfall or reduce the amount of the loan. If the insider sells shares that they are contractually or statutorily prohibited from selling as a result of the margin call, they may expose themselves to liability.
A margin call can have several negative consequences on a company and the affected insiders. The first is that if the insider is forced to sell the shares, the sale could cause the share price of the company to fall. The second is that the act of pledging shares and the risk of a margin call may create a misalignment of interests between the insider and the company’s shareholders, as the insider may be incentivized to take actions that limit his or her exposure to a margin call. Either scenario could potentially subject the company and its insiders to shareholder lawsuits, particularly in an environment of declining share prices.
The “worst case scenario” in the event of a margin call involving a large amount of an insider’s shares can be very bad – and if you remember the Green Mountain Coffee Roasters fiasco from about a decade ago, you know exactly what I mean by “very bad.”
– John Jenkins