I have blogged a couple times already on ISS' release of its 2013 Draft Policies for Comment earlier this month. One of the proposed changes that many seem to have overlooked is under the section "Management Say-On-Pay Proposals (U.S.)," one of the "Key Changes Under Consideration" is:
3. Add pledging of shares as a factor that may lead to negative recommendations under the existing problematic pay practices evaluation.
This addition, without qualifications and exceptions, could result in an unjustified increase in the number of adverse vote recommendations on management say-on-pay proposals. The pledging of shares is not a uniformly deleterious practice that warrants the inclusion on the list of problematic pay practices. We are asking that ISS not include the pledging of shares in the new 2013 policies. If ISS determines to include the pledging of shares in the 2013 final policies, we are asking them to recognize the important distinctions between:
- The pledging of shares and hedging (pledging arrangements are often inappropriately characterized as hedging),
- Reasonable and limited share pledging arrangements and unlimited pledging,
- Pledging arrangements by founders (or other substantial holders who are not executives) and pledging shares that the executive or director acquired through the company's program compensation, and
- Pledging by executives and by directors.
If, for some reason, ISS declines to recognize these important distinctions and label all pledging arrangements as "problematic," we are asking ISS to revise its Draft Policies at least to recognize a distinction between new pledging arrangements and reasonable pledging arrangements that are already in place.
The Draft Policies note that pledging of company stock by company directors and executives, which ISS highlighted as a concerning practice beginning in 2012, is a "practice that is increasingly raising investor concerns." Certainly, some level of investor concern over this practice is justified in light of the recent, widely-publicized debacles involving Green Mountain Coffee Grinders, where the founder and chairman apparently had pledged 75% of his company stock holdings, and Chesapeake Energy, where the CEO apparently had pledged, and was forced to sell, 94% of his company stock holdings. However, ISS should not label all share pledging arrangements by executives and directors as problematic because a few individuals at the 450 companies that allow pledging seem to have used it to excess.
In the Background and Overview section, the Draft Policies observe that: "Pledging of company stock as collateral for a loan may have a detrimental impact on shareholders if the officer is forced to sell company stock, for example to meet a margin call." This is true. However, in our extensive experience, not all share pledging arrangements involve a leveraged margin account, most arrangements do not involve a majority of the executive's or director's total holdings, and many involve circumstances unique to founders. A policy that labels all share pledging arrangements as "problematic" paints with too broad a brush.
Pledging of Shares vs. Hedging
Hedging potentially unwinds the incentives imposed by the company on executives and directors. Pledging does the opposite. Pledged shares generally are used as collateral for a loan. Title to the shares remains with the executive or director. The interests of the executive or director who pledges shares continue to be aligned with those of other shareholders. Hedging protects the executive or director from the risk of price drops. By its nature, pledging requires that the executive/director continue to hold the company stock. According to an October 2010 paper by the Stanford Graduate School of Business, "Pledge (And Hedge) Allegiance To The Company," by David F. Larcker and Brian Tayan:
Large equity ownership positions can produce desirable incentives because they constitute "skin in the game." At the same time, holding an undiversified portfolio of wealth may encourage an executive to become excessively risk averse. In this case, the CEO might pass up promising (but risky) investments in order to select safer investments with lower potential payoff. This is detrimental to diversified shareholders that expect a balance of risk and reward.
With concentration of wealth in a single financial asset, an executive may want to limit his or her exposure. It is also conceivable that the board may also encourage diversification if they believe that concentrated exposure can lead to excessive risk aversion. There are at least three ways to do so: the executive can 1) sell shares outright, 2) hedge a portion of the ownership position through financial instruments (such as a prepaid variable forward or zero-cost collar), or 3) pledge a portion of the ownership position as collateral for a loan which is used to purchase other assets.
Distinguishing Between Companies with Appropriate Limits on Share Pledging and Those Without Such Limits -- Reasonable Pledging vs. Unlimited Pledging
ISS should revise the Draft Policies to distinguishing between companies with appropriate limits on share pledging and those without such limits. In the section "Request for Comment" of the Draft Policies, ISS invited additional information and comments on the proposed policy changes, including: "What would you consider a 'significant' level of pledging of company stock that causes concern for investors?" I am suggesting that the following levels of pledging of company stock should not cause concern for investors:
- Pledging by an executive or director of less than 33% of his or her owned shares
- Pledging by executives and directors in the aggregate, excluding founders, of less than 20% of the company's total market value.
General counsel approval always should be required for pledging (and hedging) transactions.
Note: In August 2006, the SEC amended Item 403(b) of Regulation S-K and Item 403(b) of Regulation S-B by adding a requirement for footnote disclosure of the number of shares pledged as security by named executive officers, directors, and director nominees. Currently, companies are not required to disclose when pledged shares are in margin accounts, although some do.
I will be submitting a comment on these points, as a concerned executive compensation professional. The comment period for the 2013 Draft Policies closes on October 31, so if you have any comments, speak now or forever hold you peace.
October 29, 1929, was "Black Tuesday," when the Dow Jones Industrial Average closed down -30.57, or 11.73%, at 230.07 (after falling -38.33 or 12.82% the day before). There will be no repeat in 2012, as all of the major exchanges are closed for "Sandy."