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Pledging risks serious

Bloomberg

WeWork impresario Adam Neumann, Chinese latte mogul Lu Zhengyao and, now, Markus Braun, the fallen star of German fintech – all have exposed the perils of one of the biggest money maneuvers in the C-suite: borrowing money against stock in your own company.

Braun was forced to sell much of his stake in Wirecard to meet margin calls on a $170 million loan he’d secured against about half of his ownership. When the company’s share price collapsed as an accounting scandal came to light last month, he ended up liquidating two-thirds of his holdings over two days to meet margin calls, pushing the stock even lower. Wirecard subsequently filed for insolvency.

Neumann’s $500 million loan – secured by WeWork shares – proved problematic for investor SoftBank Group, which extended credit to Neumann as part of a 2019 rescue deal that was subsequently withdrawn. A soured margin loan to Lu, the founder of Luckin Coffee, forced lenders to raise about $210 million selling Luckin shares that he had pledged as collateral. They still face a $300 million shortfall.

They are, of course, extreme examples. Few companies and executives will face scandals and struggles of such magnitude, and there’s plenty of safeguards to reduce the risk of margin calls. Loans are typically a fraction of the value of the pledge.

But while such lending is now part of the mainstream – prominent executives and founders including Tesla’s Elon Musk, Masa Son of SoftBank and Oracle’s Larry Ellison have been relying on it – the recent high-profile flame-outs highlight the risks that can come with it if the market turns.

What’s at stake is sobering: The combined value of the five largest share pledges disclosed in filings tracked by the Bloomberg Billionaires Index is about $60 billion.

“It certainly raises eyebrows,” said Brett Miller, head of data solutions for ISS ESG, the responsible investment arm of proxy adviser Institutional Shareholder Services. “Not that every case is problematic, but it is going to warrant even more scrutiny.”

ISS has identified 307 companies among the Russell 3000 Index with at least one executive or director pledging shares, Miller said. It’s particularly common at founder-led firms.

Pledging is big in Asia, where state-owned banks dominate financial markets and high-growth companies are more common. Tycoons in China and India often turn to lenders and other financial-services firms that offer cash in exchange for committed shares.

But concerns over the potential market repercussions have pushed both countries to curb the practice recently. India now requires stricter disclosures, and Chinese companies started issuing risk alerts when controlling shareholders pledge most of their stakes.

Still, secured lending in various forms has become increasingly common as banks look to deepen relationships with their wealthiest – and most lucrative – clients and bring in new sources of revenue. The technique enables executives and wealthy investors to unlock cash without giving up control of their holdings.

Both Credit Suisse and UBS, two of the world’s largest wealth managers, have used lending to rich clients to boost net income in recent years as they’ve shifted away from volatile investment banking.

Lombard lending, which typically involves providing a loan collateralized by a broader pool of assets than a single stock, has become a favored tool among wealth managers because of the fees it generates to structure the loans, which also pay out interest. Moreover, it helps get rid of idle cash deposits that are now costlier than ever to hold in a world of low – and even negative – interest rates.

Such lending made up more than half of Credit Suisse’s credit volume in the division for the first nine months of 2019, according to a December investor presentation. Crosstown rival UBS set a target of achieving $20 billion to $30 billion in net new loans a year and increase lending penetration by 40%, according to its last strategic update to investors in October 2018. A revamp of the unit in January sought to give managers more autonomy in granting loans to rich clients and accelerating approvals.

And across the wealth-management industry, the market turmoil induced by the pandemic resulted in some margin calls as stocks and other assets plummeted. Some clients had to stump up collateral to avoid defaulting, and others had to liquidate at depressed prices. This has also prompted some banks to review the set up of their lending practice and risk appetite for wealthy and corporate clients.

When executives are pledging their own company’s stock, the risks are even more concentrated.

“It’s a negative feedback loop,” said Michael Puleo, assistant professor of finance at the Dolan School of Business at Fairfield University. “The selling causes the share price to fall further and precipitates more margin calls, which can push the price lower.”

Braun’s forced Wirecard disposals took place over the two days where his company’s stock cratered 75%. His sales made up 2.1% of stock trading on June 18 and 3.5% the following day, according to a Bloomberg analysis.

His high-profile implosion means investors are even less likely to welcome pledging, according to Miller of ISS.

“A lot of investors do not like the idea,” he said.

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