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.
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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).
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.
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.
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.
Additionally, our online appendix can be found at: https://drive.google.com/file/d/1RkevLElt_ki4ifk4jFBPGVJUxR-xGkjg/view?usp=sharing
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).
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/α = 0.924 /|-5.587| = 16.5%. For terminations (column 3), β3/α = −1.584/ |-5.093| = 31.1%.
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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.
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Anderson, R., Puleo, M. Insider Share-Pledging and Equity Risk. J Financ Serv Res (2020). https://doi.org/10.1007/s10693-020-00332-x
- Pledged shares
- Financial crisis
- Corporate ownership
- Financial risk