One way for an executive or director to realize or lock in value from company stock that he or she owns is to simply sell the stock to a third party. But that, of course, will trigger income tax and dilute economic ownership and voting rights in the company. Besides, it may not be possible (because of a lock-up agreement or a securities-law prohibition, for example) or practical (because of the market for the stock, the potential impact on price, stock-ownership guidelines, etc.) to sell the stock.
An alternative approach to achieving liquidity on company stock is to pledge it as part of securing loan financing, such as margin loans. A loan allows the executive or director to use the stock to obtain cash without any current tax. If locking in stock value without triggering tax is what’s important, the stock position may be hedged without paying any out-of-pocket costs using derivative securities (such as put/calls, prepaid forward contracts, or equity swaps).
Corporate law does not prohibit a director or executive from pledging or hedging stock (although a public company cannot indirectly “arrange” a loan on a director or executive officer’s behalf, under Section 402 of the Sarbanes-Oxley Act). However, disclosure of such transactions is required. In 2006 the Securities and Exchange Commission amended its rules to require that issuers disclose in the annual proxy (as part of the beneficial ownership table) company stock pledged by (i) each director (including director nominees) and named executive officer (NEO) and (ii) all other executive officers (generally those other than NEOs who are subject to SEC Form 4 reporting). As part of its final rules adopting this change, the SEC explained that:
“To the extent that shares beneficially owned by named executive officers, directors and director nominees are used as collateral, these shares may be subject to material risk or contingencies that do not apply to other shares beneficially owned by these persons. These circumstances have the potential to influence management’s performance and decisions. As a result, we believe that the existence of these securities pledges could be material to shareholders.”
With respect to hedging, Congress directed the SEC as part of the Dodd-Frank Act to issue rules requiring public companies to disclose whether directors, executives, and other employees are permitted to buy derivative securities to hedge company stock, whether acquired as compensation from the issuer or on the open market. To date, the SEC has not done so; rules are still “pending action.” Nonetheless, hedging transactions can be tracked (albeit with some difficulty) through other issuer securities filings, as such transactions typically involve purchasing derivative securities that are subject to separate reporting on SEC Form 4. In addition, issuers in some cases have disclosed hedging policies in their annual proxies as part of the Compensation Discussion & Analysis addressing “material” elements of executive compensation.
It appears that a significant number of public companies currently allow directors and executives to pledge and hedge company stock positions. Earlier this year, the Center for Financial Research and Analysis — a business under the umbrella of the parent company, MSCI, that also owns Institutional Shareholder Services (ISS) — reported that one or more executives or directors have pledged shares for loan transactions at approximately 15% of the companies in the Russell 3000 index (roughly 450 companies). More surprising was the reported finding that the average amount of company stock pledged at these companies was more than $57 million (although the median was just over $5 million).
Pledging transactions by management have recently come under scrutiny. Forty-nine percent and 45% of institutional and issuer respondents, respectively, indicated in response to the 2012–2013 ISS policy survey that any pledging of shares by executives or directors is “significantly problematic.” It seems reasonably safe to assume that this survey result was due, in large part, to the possibility that senior management could be pressured or required to sell significant amounts of company stock in order to meet margin calls or other loan requirements. Forced sales at inopportune times could negatively affect the company’s stock prices and/or violate stock-trading prohibitions. In extreme cases, such as occurred at Green Mountain Coffee Roasters earlier this year, management shakeups and litigation may result.
Governance experts have also targeted hedging of company stock as a problematic pay practice. According to the ISS, “Stock-based compensation or open market purchases of company stock should serve to align executives’ or directors’ interests with shareholders” and “hedging of company stock through . . . derivative transactions severs the ultimate alignment with shareholders’ interests.” The ISS and others apparently take this view even if the hedged stock is in addition to stock owned by the executive or director that meets stock-ownership requirements imposed by the issuer to enhance alignment of management’s interest with stockholders’ interest.
ISS policy updates for the 2013 proxy season issued earlier this month now identify “hedging of company stock and significant pledging of company stock” by directors and/or executives as examples of “failures of risk oversight.” (Click here for a copy of the ISS 2013 policy updates.) The ISS warns issuers that this type of failure, “under extraordinary circumstances,” may result in a vote against or a “withhold vote” declaration with respect to “directors individually, committee members, or the entire board.” Interestingly enough, the final policy updates do not call for a negative recommendation with respect to say-on-pay voting, which had been part of the ISS’s original proposal in October.
It’s unclear exactly when the pledging of stock will trigger adverse voting recommendations from the ISS under its 2013 policy updates. The ISS’s original position had been that any pledging of shares was a failure of risk oversight. The ISS received several comments that appropriately objected to such a rigid policy. Certainly not all financing activity involving pledged stock raises the same potential governance risks, and an inflexible position might have effectively pressured executives and directors to sell stock before year-end in ways that might harm the issuer.
Commentators suggested safe-harbor approaches, such as exemptions for de minimis pledges or pledges that are part of a loan where the lender has full recourse against all assets of the executive or director. But the ISS instead opted for a substantive, facts-and-circumstances standard. The ISS will consider the following factors “in determining vote recommendations for election of directors of companies who currently have executives or directors with pledged company stock”:
- Presence in the company’s proxy statement of an antipledging policy that prohibits future pledging activity.
- Magnitude of aggregate pledged shares in terms of total common shares outstanding or market value or trading volume.
- Disclosure of progress or lack thereof in reducing the magnitude of aggregate pledged shares over time.
- Disclosure in the proxy statement that shares subject to stock ownership and holding requirements do not include pledged company stock.
- Any other relevant factors.
The ISS does not consider pledging at any amount to be a “responsible use of equity.” But the above factors, as well as the ISS’s prior practice when a new “problematic pay practice” is added, suggest the ISS will allow issuers in many instances to avoid adverse voting recommendations in 2013 by committing not to allow future pledging of company stock and to clean up existing company stock-pledging arrangements over time.
However, the ISS does not appear to be taking such an approach with respect to hedging of company stock. Explanatory notes to the 2013 policy updates explain that “Any amount of hedging will be considered a problematic practice warranting a negative voting recommendation” (emphasis added). Nothing from the face of the 2013 policy updates suggests that anything less than immediately unwinding hedging arrangements will be acceptable. However, unwinding derivative securities issued to (or by) third parties might be impossible or impractical. As an interim step, it would be fairly easy to include hedging restrictions in upcoming grants of equity compensation or to impose an antihedging policy prospectively.
Some public companies already have self-imposed prohibitions and/or restrictions on pledging and hedging of company stock by executives and directors. Issuers with stock-trading policies that do not already address these transactions, and especially those with management members that in fact have outstanding pledged and/or hedged company stock positions, would well be served to consider what action(s) should be taken before filing next year’s proxy in light of the ISS 2013 policy updates.
Andrew Liazos heads the executive-compensation practice at law firm McDermott Will & Emery.