Advertisement

Springer Nature is making SARS-CoV-2 and COVID-19 research free. View research | View latest news | Sign up for updates

Insider Share-Pledging and Equity Risk

Abstract

Corporate insiders frequently borrow from lending institutions and pledge their personal equity as collateral for the loan. This borrowing, or pledging, potentially affects shareholder risk through changing managerial incentives or contingency risk. Using an exogenous shock to lending supply, we document a significant increase in risk arising from pledging. Difference-in-differences regressions indicate that insider pledging corresponds with a 16.5% relative increase in risk despite unchanged firm fundamentals. The empirical analysis supports contingency risk in linking pledging to volatility. Overall, our findings suggest that pledging allows influential insiders to extract private benefits of control at the expense of outside shareholders.

This is a preview of subscription content, log in to check access.

Fig. 1

Notes

  1. 1.

    We cannot confirm insiders’ use of borrowed funds as current regulation does not require this disclosure. Depth of disclosure varies across firms and we record all pledge details provided (i.e. bank loans versus margin borrowings, contract terms, use of proceeds, and etcetera).

  2. 2.

    For further description, see Lopez, Linette. “Valeant Really Wanted Its CEO to Stop Putting His Shares up as Collateral for Loans.” Business Insider. November 6, 2015. The financial press provides several ill-fated examples of insider pledging. Robert Stiller, founder of Green Mountain Coffee Roasters, Inc., had a considerable ownership stake pledged in May 2012 when the share price declined sharply, triggering a margin call on Stiller’s pledged shares. To meet the margin call, Stiller was forced to sell five million shares (3.2% of common shares outstanding) worth an estimated $125.5 million. This insider selling further depressed the stock price. Further, Stiller was subsequently removed from his role as Chairman (but retained his CEO role). For further reading on these examples, see: Green Mountain Coffee: Murphy, M. (2012, May 15). Margin Call: The Most Exposed. The Wall Street Journal; CBS Corp.: Ronald, Grover. “John Malone Sells Low.” Bloomberg.com. October 15, 2008. Chesapeake: Driver, Anna. “Special Report: Chesapeake CEO Took $1.1 Billion in Shrouded Personal Loans.” Reuters. April 18, 2012.

  3. 3.

    An alternative argument suggests pledging can impair the principal-agent relationship if changes in incentives motivate risk-reducing corporate decisions. Because insiders’ pledged shares serve as collateral on personal loans, pledging managers may take actions that reduce the likelihood of the stock price falling below the loan-to-value ratio to mitigate the risk of additional capital calls or share liquidations (May, 1995; Amihud and Lev, 1981). By pursuing such risk-reducing activities however, pledging managers extract private benefits of control at the expense of outside shareholders.

  4. 4.

    Pledgers unwilling to provide additional shares because of high pledging costs will default and trigger lender liquidation of collateralized shares. Note that a margin call indicates that the value of the pledged shares is near (or below) the required collateral value, so the lender must liquidate all (or nearly all) pledged shares to settle the loan if the pledger defaults. Similarly, pledgers unable to access funding to pledge additional shares will be forced to sell shares at depressed prices to restore margin requirements. Both cases indicate increases in fire sales and volatility.

  5. 5.

    Additionally, our online appendix can be found at: https://drive.google.com/file/d/1RkevLElt_ki4ifk4jFBPGVJUxR-xGkjg/view?usp=sharing

  6. 6.

    Of the 712 total observations in our matched sample, 160 occur pre-crisis (74 pledging and 86 non-pledging) and 512 post-crisis (282 pledging and 270 non-pledging).

  7. 7.

    We compute the reported treatment effects (ATU) as the difference-in-difference coefficient (β3) divided by the mean pre-crisis (pre-pledging) firm-year change in risk for the estimation sample (α). Because the baseline average firm-year change in risk (α) takes a negative value, we assign the treatment effect the same sign as the difference-in-difference coefficient (β3). For initiations (column 2), β3 = 0.924 /|-5.587| = 16.5%. For terminations (column 3), β3 = −1.584/ |-5.093| = 31.1%.

References

  1. Aboody D, Lev B (2000) Information asymmetry, R&D, and insider gains. J Financ 55(6):2747–2766

  2. Amihud Y, Lev B (1981) Risk reduction as a managerial motive for conglomerate mergers. Bell J Econ 12(2):605–617

  3. Anderson RC, Reeb DM, Zhao W (2012) Family-controlled firms and informed trading: evidence from short sales. J Financ 67(1):351–385

  4. Barclay MJ, Warner JB (1993) Stealth trading and volatility: which trades move prices? J Financ Econ 34(3):281–305

  5. Basu S (1983) The relationship between Earnings' yield, market value and return for NYSE common stocks: further evidence. J Financ Econ 12(1):129–156

  6. Bertrand M, Duflo E, Mullainathan S (2004) How much should we trust differences-in-differences estimates? Q J Econ 119(1):249–275

  7. Bettis JC, Bizjak JM, Lemmon ML (2001) Managerial ownership, incentive contracting, and the use of zero-cost collars and equity swaps by corporate insiders. J Financ Quant Anal 36(03):345–370

  8. Bettis C, Bizjak J, Kalpathy S (2015) Why do insiders hedge their ownership? An empirical examination. Financ Manag 44(3):655–683

  9. Boyer B, Mitton T, Vorkink K (2010) Expected idiosyncratic Skewness. Rev Financ Stud 23(1):169–202

  10. Brunnermeier MK, Pedersen LH (2009) Market liquidity and funding liquidity. Rev Financ Stud 22(6):2201–2238

  11. Carhart MM (1997) On persistence in mutual fund performance. J Financ 52(1):57–82

  12. Chava S, Purnanandam A (2011) The effect of banking crisis on Bank-dependent borrowers. J Financ Econ 99(1):116–135

  13. Christensen BJ, Prabhala NR (1998) The relation between implied and realized volatility. J Financ Econ 50(2):125–150

  14. Christie AA (1982) The stochastic behavior of common stock variances: value, leverage and interest rate effects. J Financ Econ 10(4):407–432

  15. Coles JL, Daniel ND, Naveen L (2006) Managerial incentives and risk-taking. J Financ Econ 79(2):431–468

  16. Core JE, Larcker DF (2002) Performance consequences of mandatory increases in executive stock ownership. J Financ Econ 64(3):317–340

  17. Cornett MM, McNutt JJ, Strahan PE, Tehranian H (2011) Liquidity risk management and credit supply in the financial crisis. J Financ Econ 101(2):297–312

  18. Dehejia RH, Wahba S (2002) Propensity score-matching methods for nonexperimental causal studies. Rev Econ Stat 84(1):151–161

  19. Faccio M, Marchica MT, Mura R (2011) Large shareholder diversification and corporate risk-taking. Rev Financ Stud 24(11):3601–3641

  20. Fama EF (1990) Stock returns, expected returns, and real activity. J Financ 45(4):1089–1108

  21. Fama EF, French KR (1993) Common risk factors in the returns on stocks and bonds. J Financ Econ 33(1):3–56

  22. Fama EF, French KR (1998) Value versus growth: the international evidence. J Financ 53(6):1975–1999

  23. Fernandes N, Ferreira MA (2009) Insider trading Laws and Stock Price Informativeness. Rev Financ Stud 22(5):1845–1887

  24. French KR, Schwert GW, Stambaugh RF (1987) Expected stock returns and volatility. J Financ Econ 19(1):3–29

  25. Garvey G, Milbourn T (2003) Incentive compensation when executives can hedge the market: evidence of relative performance evaluation in the cross section. J Financ 58(4):1557–1582

  26. Gompers PA, Ishii JL, Metrick A (2003) Corporate governance and equity prices. Q J Econ 118(1):107–155

  27. Jagolinzer AD, Matsunaga SR, Yeung P (2007) An analysis of Insiders' use of prepaid variable forward transactions. J Account Res 45(5):1055–1079

  28. Jensen MC, Meckling WH (1976) Theory of the firm: managerial behavior, agency costs, and ownership structure. J Financ Econ 3(4):78–79

  29. John K, Litov L, Yeung B (2008) Corporate governance and risk-taking. J Financ 63(4):1679–1728

  30. Larcker, D. F., & Tayan, B. (2010). Pledge (and Hedge) Allegiance to the Company. Rock Center for Corporate Governance at Stanford University Closer Look Series: Topics, Issues and Controversies in Corporate Governance No. CGRP-11

  31. Lee TS, Yeh YH (2004) Corporate governance and financial distress: evidence from Taiwan. Corporate Governance: An International Review 12(3):378–388

  32. Lilienfeld-Toal UV, Ruenzi S (2014) CEO ownership, stock market performance, and managerial discretion. J Financ 69(3):1013–1050

  33. MacKinlay AC (1997) Event studies in economics and finance. J Econ Lit 35(1):13–39

  34. May DO (1995) Do managerial motives influence firm risk reduction strategies? J Financ 50(4):1291–1308

  35. McConnell JJ, Servaes H (1990) Additional evidence on equity ownership and corporate value. J Financ Econ 27(2):595–612

  36. Mendoza EG (2010) Sudden stops, financial crises, and leverage. Am Econ Rev 100(5):1941–1966

  37. Mitton T, Vorkink K (2007) Equilibrium Underdiversification and the preference for Skewness. Rev Financ Stud 20(4):1255–1288

  38. Morck R, Shleifer A, Vishny RW (1988) Management ownership and market valuation: an empirical analysis. J Financ Econ 20:293–315

  39. Panousi V, Papanikolaou D (2012) Investment, idiosyncratic risk, and ownership. J Financ 67(3):1113–1148

  40. Shleifer A, Vishny R (2011) Fire sales in finance and macroeconomics. J Econ Perspect 25(1):29–48

  41. Whitelaw RF (1994) Time variations and Covariations in the expectation and volatility of stock market returns. J Financ 49(2):515–541

Download references

Acknowledgements

The authors graciously thank Lalitha Naveen, Sudipta Basu, David Reeb, and Pavel Savor for valued advice. The authors also thank seminar participants from the Temple University, Fairfield University, California State University, and St. Mary’s University.

Author information

Correspondence to Michael Puleo.

Additional information

Publisher’s Note

Springer Nature remains neutral with regard to jurisdictional claims in published maps and institutional affiliations.

Rights and permissions

Reprints and Permissions

About this article

Verify currency and authenticity via CrossMark

Cite this article

Anderson, R., Puleo, M. Insider Share-Pledging and Equity Risk. J Financ Serv Res (2020). https://doi.org/10.1007/s10693-020-00332-x

Download citation

Keywords

  • Pledged shares
  • Financial crisis
  • Corporate ownership
  • Financial risk

JEL Codes

  • G01
  • G18
  • G32
  • G34