Share pledging, where corporate insiders uses shares as collateral for personal loans, has been at the heart of several high-profile corporate scandals in recent years.
One of the most notorious cases was the 2002 WorldCom accounting fraud scandal. From 1999 to 2002, the U.S.-based telecom company inflated profits to maintain its stock price. The scandal was largely driven by the former CEO Bernard Ebbers’ attempts to avoid costly margin calls on his pledged shares.
A similar scenario unfolded in China when Leshi Internet Information and Technology and its founder, Jia Yueting, were fined US$73.6 million for financial fraud committed from 2007 to 2016. Yueting had pledged 97 per cent of his shares to secure funding for his U.S.-backed company, Faraday Future.
To look deeper at this issue, my co-researchers and I analyzed 3,401 Chinese firms from 2003 to 2020, since Chinese controlling shareholders predominately pledge their shares. Our research found a trouble connection between share pledging by controlling shareholders and the likelihood of corporate misconduct.
Our research found that when controlling shareholders engage in pledging, it increases the probability of corporate misconduct. This relationship held true across various types of misconduct and persisted regardless of the severity of penalties imposed.
Share pledging
Corporate insiders frequently pledge their shares as collateral to secure loans for personal investments and other private benefits.
In the U.S., 19 per cent of S&P 1500 firms had insider share pledging, and the average pledging ratio reached 37 per cent in 2012. A notable example is Elon Musk, CEO of Tesla, who pledged 58 per cent of his Tesla shares in 2023 as collateral to secure personal loans.
The trend extends to other developed markets like Australia, Hong Kong, Singapore and the United Kingdom. In western Europe, pledging is common in a number of countries, including Austria, France, Germany, Ireland, Italy, Norway, Portugal and Spain, and among others.
(Shutterstock)
In developing markets like India and Taiwan, between 35 and 50 per cent of publicly listed firms have controlling shareholders who pledge shares. In China, 66 per cent of controlling shareholders pledged their shares between 2003 and 2017, with the value of insider share-pledged loans surging from RMB$26.22 billion (Chinese Yuan) in 2003 to RMB$2.9 trillion in 2017.
Controlling shareholders, which typically hold at least 50 per cent of voting shares, have significant power over firms. Minority shareholders, on the other hand, receive poor legal protection under concentrated corporate ownership.
Concentrated ownership is prevalent in developing markets, particularly in East Asia where more than two-thirds of corporations have only a single large shareholder.
Impacts of deregulation
A pivotal shift occurred on May 24, 2013, when the Shanghai and Shenzhen Stock Exchanges, along with the China Securities Depository and Clearing Corporation, introduced new measures that allowed securities companies to offer funding for share pledgers through the stock exchange trading system. Before this, share pledging was limited to banks and trusts operating in the over-the-counter market.
Securities companies made pledging more accessible by offering lower interest rates, fewer restrictions on loan usage and faster approvals. While the deregulation did not target misconduct by securities firms, it created a unique environment for analyzing the causal link between share pledging by controlling shareholders and corporate misconduct. This is what our research looked at.
We found that firms located in Chinese provinces with more securities firms (treatment firms) were expected to have greater access to share pledging compared to firms in provinces with fewer securities firms (control firms). Our results confirmed that firms with pledging controlling shareholders were more likely to engage in misconduct following the 2013 deregulation.
(AP Photo)
Prior to 2013, treated and control firms showed no significant differences. However, from 2015 onward, firms in provinces with more securities firms demonstrate an increased likelihood of misconduct compared to firms in provinces with fewer securities firms.
This relationship was primarily driven by factors such as financial constraints, stock price inflation, avoidance of margin calls (demands from a broker to fund one’s margin account), and expropriation under weak corporate governance. Factors like political connections, share repurchases and increased bank monitoring didn’t contribute to the link between share pledging and corporate misconduct.
Building better financial systems
Although our study is based on data from China, its findings offer critical insights for countries beyond its borders. The findings are particularly relevant for countries in Asia, western Europe, and Latin America where controlling shareholders play a dominant role in corporate structures.
The study’s conclusions also hold significance for North America, where financial institutions like pension funds and mutual funds invest portions of their portfolios in emerging markets.
For instance, the Ontario Teachers’ Pension Plan has strong momentum in Asia and continues to invest in markets in China. The Canada Pension Plan Investment Board reported that 9.8 per cent of its total fund was invested in China in March 2024.
These institutions should consider governance risks associated with share pledging when developing their investment strategies.
For regulators, our study underscores the importance of monitoring the growing influence of share pledging and its potential to exacerbate corporate misconduct. Weak governance structures can allow controlling shareholders to exploit the system, and strengthened oversight and tailored regulations are needed to alleviate these risks.
Institutional and retail investors can likewise benefit from the study’s findings, using them to make investment decisions from the perspective of corporate governance.
As markets become increasingly integrated, the importance of assessing governance risks associated with share pledging grows. Our research serves as a vital resource for policymakers and regulators who want to maintain ethical, robust financial systems.