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For many insiders at a newly formed public company, a large portion of their net worth is potentially tied up in holdings of their company’s publicly-traded shares. These insiders often face challenges obtaining liquidity through these holdings as they want to avoid, or may be contractually and statutorily prohibited from, selling their shares. This situation may be particularly acute for insiders of companies that recently completed a de-SPAC transaction, as these insiders may face difficulty finding a broker to administer a Rule 10b5-1 trading plan for a year following the de-SPAC transaction while Rule 144 is unavailable for former shell companies. Share pledging may offer an alternative to selling shares for these insiders, but careful consideration should be given to the risks associated with such an undertaking. We have prepared the below Q&A to help company insiders gain a better understanding of the share pledging process and the associated risks, with an emphasis on insiders of companies that have recently completed a de-SPAC transaction.
Q. What is Share Pledging?
A. The act of pledging shares involves an agreement pursuant to which a person may use their shares in a company as collateral to obtain a loan. This is commonly used by insiders who wish to monetize the value of their shares (for example, in connection with the purchase of a home or the use of a margin account) which allows an accountholder to purchase other securities using their account holdings as collateral.
Q. Who Is Considered An Insider Of A Company?
A. Under Section 16 (“Section 16”) of the Securities Exchange Act of 1934, as amended, a company insider includes a company’s directors and officers and each person or entity who is the beneficial owner of more than 10% of its equity securities. However, for purposes of share pledging, an “insider” is typically defined in the company’s insider trading policy. Often, companies will extend the prohibition on hedging and pledging company shares contained in such policies beyond that of Section 16 insider to cover all employees, contractors, and consultants. Careful consideration should be given to whether a person is covered under a company’s applicable policies.
Q. What Risks Arise When You Pledge Shares?
A. 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 insiders 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.
Q. What Disclosure Requirements Exist for the Company and the Insider?
A. In 2018, the U.S. Securities and Exchange Commission (the “SEC”) adopted final rules relating to the disclosure of hedging practices and policies. The rules included a new Item 407(i) of Regulation S-K which requires a company to provide a fair and accurate summary in its proxy statement of its practices or policies relating to the ability of its employees, including officers, and directors to engage in hedging activities (which includes share pledging), or, alternatively, provide such practices or policies in full. If the company does not have such a policy, Item 407(i) requires the company to state so or state that such transactions are generally permitted.
In addition, Item 403(b) of Regulation S-K requires companies to indicate in their beneficial ownership tables in their annual reports on Form 10-K the number of shares that are pledged, if any. Failure to do so may result in an investigation from the SEC and penalties on the insider and the company.
Lastly, if a margin call is triggered and an insider is forced to sell or pledge a significant portion of their shares, there is a risk that the sale or additional pledge would require disclosure on a current report on Form 8-K. This would be required if the relevant transaction constituted material non-public information that must be disclosed under Regulation FD. An example of this occurred with Inovio Pharmaceuticals, Inc. in 2019, where the company filed a Form 8-K after its CEO was forced to sell a significant portion of his shares pursuant to a margin loan facility following a decline in the company’s share price. The act of entering into such a loan agreement by a company insider or control person may by itself be enough to trigger the filing of a Form 8-K. For example, Bumble Inc. recently filed a Form 8-K after certain significant shareholders entered into an agreement in which they pledged their shares.
Q. How do Proxy Advisors Respond to Share Pledging?
A. One of the items the proxy advisory firms Institutional Shareholder Services (“ISS”) and Glass Lewis consider in their voting recommendations is share pledging by insiders and the policies relating to such share pledging. For example, in its 2022 Voting Guidelines (the “ISS 2022 Voting Guidelines”), ISS recommended voting against the members of a company’s committee that oversee risks related to pledging, or the full board, where a significant level of pledged company shares by executives or directors raises concerns. Whether the share pledging is significant is determined on a case-by-case basis by measuring the aggregate pledged shares in terms of common shares outstanding or market value or trading volume. ISS also stated in the ISS 2022 Voting Guidelines that it will generally support policies that prohibit named executive officers from pledging shares as collateral for a loan.
Glass Lewis, on the other hand, has adopted a case-by-case approach for such policies, noting that shareholders should examine the facts and circumstances of each company rather than apply a one-size-fits-all policy regarding employee share pledging. The factors Glass Lewis identifies for evaluating proposed policies, limitations, and prohibitions on pledging shares in its 2022 voting guidelines includes:
One important additional consideration, which is unclear from the text of ISS’s and Glass Lewis’s voting guidelines, is whether any negative recommendations would be limited to a single year or would extend to multiple years following the pledging activity.
In addition to proxy advisors, companies and their insiders should also consider any relevant shareholder or mutual fund policies relating to share pledging. For example, in its 2023 proxy voting guidelines, BlackRock stated that “boards should establish policies prohibiting the use of equity awards in a manner that could disrupt the intended alignment with shareholder interests, such as the excessive pledging or heading of stock.”
Insider Trading Policies
As a result of recent trends and pressure from proxy advisors, many companies have prohibited the pledging of shares by company officers and directors. According to this ISS article, as of May 2022, more than 90% of companies in the S&P 500 have adopted a policy prohibiting pledging by company insiders with 68% banning it completely and 22% allowing it with certain waivers or exceptions. The article also indicated that it was relatively rare for insiders to pledge their shares, with the number of companies in the S&P 500 with at least one director or executive pledging their shares declining from 13.9% in 2017 to 10% in 2022.
In general, companies that prohibit share pledging do so in their insider trading policies. These policies, which typically apply to company insiders subject to Section 16, generally do not allow such insiders to pledge their company shares or hold company shares in a margin account. As a result of amendments to Item 601 of Regulation S-K adopted in December 2022, companies will also be required to file copies of their insider trading policies and procedures as exhibits to Forms 10-K and 20-F.
Q. What are Other Avenues for Insiders?
For the insiders of public companies that prohibit pledging of their shares, the options for monetizing their share capital may be limited. One option that may be available is the use of a Rule 10b5-1 trading plan (a “10b5-1 plan”). 10b5-1 plans permit public company insiders to establish, at a time when they are not aware of material non-public information, a written trading program for future transactions in the company’s shares. However, the purpose of a 10b5-1 plan is not to enable insiders to time their trades to market fluctuations, but rather to permit insiders to identify specific times to trade in the future, the quantity of shares to be sold, and also establish formula prices or events that would trigger a sale. In addition, recent amendments to Rule 10b5-1, which were discussed in an Orrick client alert that can be found here, were adopted on December 14, 2022 and will take effect on February 27, 2023, establish a “cooling off” period between the date an insider adopted a plan and the first trade and limit insiders to only one such plan.
Conclusion and Best Practices
Because of the risks associated with pledging shares, insiders should be very careful when contemplating pledging shares. If you have any questions regarding share pledging, please contact one of the listed authors of this article, or your regular Orrick contact.
 For example, the SEC recently agreed to settle charges against the CEO of a public company for failing to disclose stock pledges. See the SEC Press Release announcing the settlement.