UPDATE as of October 25, 2022: In an interesting, but not unexpected turn of events, Peloton disclosed on October 25th that beginning in October 2022, its Insider Trading Policy prohibits its employees and directors from using or pledging shares as collateral in a margin account or as collateral for a loan. The disclosure is included in Peloton’s proxy statement for its 2022 annual meeting of stockholders. The considerations and takeaways highlighted in this article remain ever relevant when considering whether to allow hedging and pledging by insiders. Spoiler alert: Avoid it.
Fewer public companies are allowing insiders, including directors and officers, to hedge and/or pledge their shares. These days, insider trading policies will typically include a section covering these practices and either completely prohibit it or allow it in limited circumstances. There’s good reason for this, as Peloton is learning.
What follows is an overview of what hedging and pledging are, why allowing hedging and pledging by insiders should be avoided, and an illustrative discussion of Peloton’s approach to its pledging policy. Lastly, we share some takeaways for boards and individuals who oversee and/or administer insider trading policies.
What is a Hedge?
A hedge is an investment strategy that offsets the risk associated with an equity position in a company by entering an opposite position in a related security. Doing this costs money, but also limits the downside risk of the equity position. Hedging can be accomplished in several ways, including through short sales, equity swaps, collars, and exchange funds. These types of transactions may allow a director, officer, or employee to continue to own shares they obtained through an equity plan or otherwise, but without the full risks and rewards of ownership. This article from Winston & Strawn provides a detailed discussion as to what constitutes hedging.
An insider’s incentive to perform in the best interests of the company could be undermined by hedging. For instance, an officer’s compensation is aligned with stockholders’ interests, in part, through equity-based awards. Those interests can become misaligned if the officer hedges against downside in the company’s share price.
What is a Pledge?
A pledge is an arrangement where an individual uses their shares as a form of collateral to, typically, obtain a loan or fund other trading activities. If the value of those shares declines, so too does the value of the collateral the individual pledged. When the value of the collateral drops below the minimum value agreed to in the contract governing the pledge, a margin call will be triggered. That is, the individual who entered the pledge will either need to pledge additional shares or pay cash to make up for the shortfall.
In the case of insiders who pledge shares in the company they serve, margin calls typically come at inopportune times. For example, these insiders may not have the cash on hand to make up for the shortfall. If they want to sell some of their company shares to raise the cash, they may not be able to do so, for example, if they have material, non-public information or the company’s trading window is closed.
Hedging and Pledging: The Great Recession Shined a Spotlight
In the wake of the Great Recession, The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank), was enacted on July 21, 2010. In addition to overhauling financial regulation, it resulted in new disclosure requirements related to matters ranging from conflict minerals to executive compensation. One of the mandates to come from Dodd-Frank was the implementation of final rules related to the disclosure of company hedging policies.
This focus on hedging policies in Dodd-Frank likely had some origin in the uproar by investors who suffered significant losses in stock value because of the downturn in the market, only to learn that some company insiders hedged against the substantial declines in company share price during the financial crises.
The financial crises also exposed, or at least reminded us, how pledging of securities by insiders can be problematic. For example, when share prices are high, an executive may find pledging a portion of their equity position in the company as an attractive way to access capital without having to sell their shares. If the company’s share price drops significantly, these executives may find themselves on the receiving end of a margin call. The margin call can be addressed, as mentioned earlier, by pledging more shares or selling company shares. Pledging additional shares can make the problem worse, especially in a down market, and selling shares may not even be an option (e.g., if the executive is aware of material non-public information).
In 2018, eight years after the passage of Dodd-Frank, the US Securities and Exchange Commission (SEC) adopted final rules for disclosure of hedging policies. The rules require that a company provide a fair and accurate summary of its practices or policies regarding the ability of covered persons to hedge transactions. Alternatively, the company can disclose the practices or policies in full.
Even before the effectiveness of the final rules, there was a significant focus on hedging and pledging by institutional shareholders and proxy advisory firms. In 2012, and likely a function of a lack of progress by the SEC on issuing final rules, proxy advisory firm Institutional Shareholder Services (ISS) covered hedging and pledging activity in its corporate governance policy updates. In its 2013 policy updates, ISS cited hedging of company stock by executive officers as an example of risk oversight failure by a company board. As a result, many companies that hadn’t already adopted anti-hedging policies did and disclosed as much in their proxy statements. Currently, most companies have an anti-hedging policy.
In terms of pledging, the SEC hasn’t required disclosure in the same vein as hedging. Nevertheless, many companies have disclosed anti-pledging policies in their proxy statements. Institutional shareholders and proxy advisory firms have not generally been as averse to companies allowing pledging as hedging, but there are caveats. For example, ISS and Glass Lewis, two of the leading proxy advisory firms, generally advise that investors should evaluate companies and their pledging policies on a case-by-case basis. Some of the factors that they flag as worthy of consideration include:
- The presence of an anti-pledging policy
- The magnitude of aggregate pledged shares versus total common shares outstanding, market value, and trading volume
- The volatility of the company’s stock
- The company’s current policies regarding pledging and any waiver from these policies for employees and executives
Rather than risk potential issues associated with pledging, including downward pressure on the company’s share price if a director or officer is forced to sell shares to meet a margin call or if they cannot meet a margin call and the lender sells shares to repay the loan, many companies choose to prohibit pledging by directors and officers.
With Stock Price Volatility Comes Scrutiny: Peloton’s Story
When markets are volatile, as they are now, trades by directors and officers can be the subject of significant scrutiny by investors, plaintiff attorneys, the media, and the company’s employees. Peloton is one company that is living through this now.
For those unfamiliar with Peloton’s story, it is one of significant highs, including share price. At its height, Peloton’s shares were trading over $160/share. Fast forward to today, and Peloton shares are trading below $10/share, and the company faces significant headwinds. One headwind is a lawsuit brought by Peloton’s largest shareholder that alleges that Peloton’s CEO and other members of the company’s board profited by selling Peloton shares immediately before Peloton’s major stock price decline began.
The stockholder has asked a Delaware court to force Peloton to turn over financial records, restructuring plans, forecasts, and board communications from April 17, 2020, through the present. This appears to be a follow-up to a similar demand from earlier this year. That demand was made pursuant to a Section 220 books and records request. As we have previously discussed, Section 220 of Delaware General Corporation Law gives stockholders the right to examine corporate documents such as board books and board minutes—and in some cases even emails and notes—when a stockholder is investigating potential wrongdoing by directors or officers. If your company has had to respond to a Section 220 books and records request, you know how costly, time-consuming, and distracting responding to these requests can be.
This latest lawsuit comes as the Wall Street Journal reported that Peloton’s CEO pledged a significant amount of Peloton stock for personal loans from Goldman Sachs when he was a Peloton executive. Pledging by Peloton’s CEO and other executives isn’t late-breaking news. According to Peloton’s 2021 proxy statement, the company prohibited its employees, including its executive officers and members of its board, from hedging Peloton securities. However, the proxy statement also stated that Peloton did allow pledging in certain limited circumstances. The proxy statement reads as follows:
“Finally, our Insider Trading Policy prohibits our employees (including our executive officers) and the non-employee members of our board of directors from using or pledging our securities as collateral in a margin account or as collateral for a loan unless the pledge has been approved by our Insider Trading Policy Administrators, in their sole discretion, provided, however, that an individual may only pledge up to 40% of the value of such individual’s vested and outstanding securities.”
The proxy statement also noted that Peloton’s CEO and other executives pledged company shares as “collateral to secure certain personal indebtedness.” This was also disclosed in Peloton’s 2020 proxy statement. Indeed, the stockholder who is suing had argued in a February 2022 presentation that pledging by Peloton insiders was problematic. That presentation noted that Peloton’s CEO and five other insiders pledged a large portion of their Peloton shares and alleged that this was problematic because “it can lead to forced stock sales in the event of a margin call and accelerate a downward spiral in the stock price.” Lastly, the presentation mentioned that the pledges appeared to violate Peloton’s own insider trading policy.
Given the current macroeconomic environment, volatile stock market, and mounting losses that stockholders are seeing in their equity positions, 401(k) plans, etc., there will likely be other companies that find themselves in Peloton’s position. That is, they may find themselves the subject of lawsuits that may include claims of breaches of fiduciary duty by directors and officers with a focus on their trading activity. Companies are especially at risk if their equity valuations have dropped significantly and further than their industry peers.
Here are a few important takeaways:
- It’s Best to Prohibit Insider Hedging and Pledging. It’s uncommon to find a company that permits hedging of its shares by insiders. As discussed above, allowing hedging by insiders is frowned upon, which may be an understatement, and ISS views hedging by insiders as a failure of risk oversight by the board. Failure of risk oversight by a board could lead proxy advisory firms to a vote against or withhold election recommendations for directors. All said, specific to hedging by insiders, it’s best to prohibit it. Peloton’s decision to permit pledging should serve as a cautionary tale: Pledging by insiders is not an area of focus by third parties when share prices are high, but it can be fodder for investors, plaintiff attorneys, and the media if share prices drop significantly and insiders must respond to margin calls.
If a company permits pledging by insiders, there should be guardrails. Peloton reported certain guardrails in its proxy statements. Peloton stated that its insider trading policy administrators would have to authorize any pledges and that “an individual may only pledge up to 40% of the value of such individual’s vested and outstanding securities.” Taking that approach could become overly burdensome for the person(s) administering the insider trading policy since they would conceivably have to track individual shareholdings to ensure that pledged amounts did not go over the set threshold. This may not be worth the headache for some companies.
- Insider Trading Policy Waivers Should be Infrequent, If Provided at All. Insider trading policies should generally discourage waivers from the policy-mandated restrictions. For example, if an individual is subject to a quarterly trading blackout and they want to trade before the trading window opens, there generally shouldn’t be a way for them to sell early. Some companies may decide to allow the individual to trade early for any host of reasons (e.g., the individual not being aware of material non-public information or financial hardship), but those types of waivers should be rare and subject to significant scrutiny by the insider trading policy administrator(s). When waivers from these types of restrictions are requested by directors and officers, it is especially important to scrutinize the request with an eye to how the waiver may be perceived by third parties in the future.
In Peloton’s case, the stockholder that brought the lawsuit previously alleged that some Peloton executives had pledged as much as 70% of their company shares. If true, this would have been over the threshold permitted by the pledging policy that Peloton referenced in its proxy statements. The stockholder will likely look to dissect how Peloton’s insider trading policy was administered, including whether and how waivers were granted. Companies that use robust processes to govern the administration of their insider trading policy, including how and whether they grant waivers, will be in the best position to respond to these types of claims and inquiries should they arise.
- Review Your Insider Trading Policy. Periodic review of company policies, like an insider trading policy, is an important part of good corporate governance. In the case of an insider trading policy, it should be reviewed on an annual basis or sooner if there are developments in the company’s risk profile, new regulations, etc. For a company that has allowed insiders to hedge or pledge company shares or has policies that are silent on the topic, now may be a good time to consider whether changes are warranted.
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