ALERT: The Impact of Margin Calls on Insiders

What follows is an alert from Akin Gump’s corporate practice. For information, please contact—

• Kerry Berchem, 212.872.1095, New York

The recent market downturn has forced some corporate insiders to involuntarily sell shares of their companies to satisfy margin calls or otherwise cover debts.  For example, the chairman and CEO of Chesapeake Energy was recently  forced to sell $569 million of Chesapeake securities to cover a margin call, while the co-founders of Boston Scientific were forced to sell $292 million of Boston Scientific securities that were pledged as collateral for a loan.   These forced sales have focused attention on whether or not companies should allow insiders to hold company securities in a margin account or to pledge company securities as collateral for a loan.  Recent forced sales have also highlighted the potential for insider trading and short swing profit liability resulting from such involuntary sales of company securities.  Each of these issues is discussed in more detail below.

Whether Pledging Company Securities Should be Allowed

Should a company allow its insiders to pledge company securities to secure a margin loan or to serve as collateral for another type of loan?  Some executives want this option because it allows them to borrow money to buy stock in the company.  Other executives may have significant holdings of company stock and want to use the shares as collateral for a loan.  On the one hand, the ability of an insider to use company securities to secure a margin loan may allow the insider to demonstrate his or her commitment to the company by buying company stock.  Most companies encourage their executives to buy stock in the company because such purchases by insiders can signal confidence in the company and possibly drive up the stock price.  On the other hand, particularly with the deflated stock prices in today’s market, these actions could subject the insider to insider trading or short swing profit liability if the insider is forced to make an involuntary sale.  Further, a major sale of company shares by an insider is likely to create a negative reaction by investors in the marketplace and drive down the company’s stock price.  Also, the board of directors could be placed in a difficult position if the insider asks the board for help to avoid a massive sell-off that could depress the company’s stock price.  Although companies are all over the map on whether or not to prohibit or allow insiders to pledge company stock, companies may want to revisit their corporate governance and insider trading policies in light of the current market situation in order to determine whether or not it is now prudent to prohibit their insiders from pledging company stock.

Insider Trading

An insider’s pledge of stock as security for a loan could subject the insider to insider trading liability.  For purposes of the antifraud provisions of the securities laws, the pledging of stock as collateral for a loan is equivalent to a “sale” of the stock to the pledgee.[1] Therefore, if the insider is in possession of material non-public information that is adverse to the company at the time the securities are pledged, the insider may be liable to the pledgee if the securities decline in value and the insider defaults on the loan.

Even if the shares were pledged at a time when the insider was not in possession of material non-public information, the insider risks insider trading liability if the insider is in possession of material non-public information at the time of the forced sale.  Although Rule 10b5-1 provides an affirmative defense to insider trading liability pursuant to certain written plans, forced sales by a broker or pledgee may not be eligible for this defense.  To be eligible, the margin agreement or pledge agreement cannot permit the insider to exercise any influence over the sale after entering into the agreement, and the agreement or pledgee cannot provide the insider with any discretion to substitute or provide additional collateral or cash, or to repay the loan before the pledged securities may be sold.[2] Because the insider can generally prevent such a sale of securities by repaying the loan or pledging additional collateral, the insider is typically deemed to control and have discretion over the sale.

In addition to the potential insider trading liability, an insider could also violate the company’s insider trading policy if the sale occurred during a blackout period.

Short Swing Profit Liability

An insider forced to sell off company shares may also be subject to short swing profit liability under Section 16 of the Exchange Act.  While the initial pledge of securities as collateral for a margin or other type of loan is not a reportable event under Section 16, an insider’s sale of pledged securities following a margin shortfall or loan default is a reportable and perhaps matchable transaction under Section 16.[3] Such a sale could, therefore, subject the insider to short swing profit liability if the insider has any matchable purchase within less than a six-month period before or after the sale.  In any event, the forced sale must be reported on Form 4.  Although no disclosure regarding the purpose of the sale is required, many recent filings include explanatory footnotes stating that the reported transaction was an involuntary sale made pursuant to a margin call or an involuntary sale of shares pledged as collateral for a loan.[4]

[2] See U.S. Securities and Exchange Commission, Division of Corporation Finance:  Manual of Publicly Available Telephone Interpretations, Fourth Supplement, Rule 10b5-1, Question 9 (October 2000).  A link to the material is available here.

[3] See Alloys Unlimited, Inc. v. Gilbert, 319 F. Supp.  617 (SDNY 1970).  Harrison ex rel. FPA Corp. v. Orleans, 755 F. Supp.  592 (SDNY 1991).  Although an insider may try to avoid liability under Section 16(b) by claiming the sale was an involuntary, forced transaction, courts have generally rejected this defense where the insider could have prevented the sale by, for example, substituting cash or other collateral, or where the insider otherwise has an opportunity for speculative abuse by influencing the timing of the transaction.

[4] Examples of recently filed Form 4s with explanatory footnotes are available here, here, here and here.