Insiders such as executives, directors, and large shareholders often use company stock as collateral for personal loans. This practice is widespread but lightly regulated, and to many it has long seemed a harmless perk of wealth and a private decision with little bearing on the firm itself. But what if the consequences of insider-share pledging rippled far beyond their personal finances?

In a  recent study, we posit that this seemingly private financing choice can raise borrowing costs for the whole company and alter how lenders view the company’s risk.

What happens when pledging is curtailed?

To investigate this, we leverage a unique and interesting legal reform in Taiwan, Company Act Article 197-1, enacted in 2011. This regulation stripped voting rights from any director’s pledged shares exceeding 50 percent of the director’s holdings. This exogenous policy shock led to a sharp decline in insider pledging at affected firms, providing a rare opportunity to observe how markets react when insiders’ incentives to pledge shares are curtailed.

We use a difference-in-differences design, comparing firms with insiders who were forced to reduce pledging with matched controls that are less affected by the rule. The results are clear and economically meaningful: Corporate borrowing costs fell significantly for firms whose insiders had been forced to reduce their high pledging levels. These firms also obtained loans with longer maturities, larger principal amounts, and fewer collateral requirements.

Why do lenders care? 

To explain why insider pledging alters lenders’ risk assessments, we provide further evidence that insider share pledging introduces three types of risks.  First, insiders facing potential margin calls have a strong incentive to sustain share prices, which can lead to earnings management or delayed disclosure of bad news, undermining the credibility of financial reporting on which lenders depend. Second, pledging transforms insiders’ payoffs into something resembling stock options; they gain from upside volatility but bear limited downside risk. This imbalance encourages riskier investments and leverage, exposing lenders to greater volatility without commensurate returns. Third, when insiders pledge their shares, they retain voting power but dilute their true economic exposure. The resulting wider gap between control and cash flow rights is a classic agency problem and encourages self-serving decisions, ranging from entrenchment to resource diversion and leaving debtholders more vulnerable. We find these effects are most pronounced in widely held firms – the ownership structure typical in the U.S. public market – where dispersed shareholders are less able to monitor this behavior.

How much pledging is too much?

Our test results indicate a positive but nonlinear relation between insider pledging and borrowing costs. At a firm, loan spreads are essentially flat at low levels of pledging but rise sharply once the overall pledged shares exceed about 6 percent of shares outstanding. When the CEO or board chair personally pledges more than roughly 2.5 percent of total shares, spreads increase in a statistically meaningful way. These empirically derived cutoffs, i.e., ~6 percent firmwide and ~2.5 percent for the CEO or chair, potentially offer practical screens for boards and investors when setting anti-pledging policies, approval thresholds, and disclosure triggers.

Conclusion

Our findings contribute to the debate over how insider share pledging should be governed and disclosed. Insider pledging remains an under-regulated area of executive conduct – one that has significant implications for corporate governance and financial risk but has largely escaped systematic regulatory oversight. Although Congress, through the Dodd-Frank Act, directed the SEC to adopt rules mandating disclosure of insider pledging, the agency has yet to act. In this regulatory vacuum, proxy advisers such as ISS and Glass Lewis have sought to encourage firms and investors to adopt anti-pledging policies, set explicit thresholds, and require board-level preapproval of pledging activity. Proxy advisers have long warned against significant pledging but left thresholds unspecified; our evidence helps pin down them down.

More important, our evidence provides strong support for a general point that is central to effective corporate governance: Management choices that appear personal can have significant  consequences for a firm. Allowing insiders to pledge large equity stakes without adequate oversight imposes a significant cost on the entire firm. Regulators and market participants should therefore ensure that the governance framework treats insider pledging as an institutional-level concern with significant financial consequences, rather than as a private decision shielded from scrutiny.

This post comes to us from professors Carl Hsin-han Shen at Macquarie Business School and Hao Zhang at Rochester Institute of Technology’s Saunders College of Business. It is based on their recent article, “Share Pledging of Insiders and Corporate Debt Contracting,” available here.