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Insiders’ Share Sales on Margin on the Rise

When executives own big stakes in the companies they run, investors can rest a little more easily at night, knowing those managers have the shareholders’ best interests at heart.

Except when maybe they don’t.

As the staggering destruction of wealth in the stock market has recently revealed, executives can sometimes appear to own shares in a company, but have actually pledged them as collateral for a loan. And if there is a sharp drop in the stock’s value, the executive may suddenly be forced to dump those shares, very likely adding to the stock’s downdraft.

And the other shareholders probably never saw it coming.

As it turns out, while corporate insiders must disclose their comings and goings in their companies’ shares, experts say there are no hard and fast rules requiring that the public be told when an executive has put a big block of shares at risk by borrowing against them.

Already this month, there have been about $1 billion in sales by company insiders dumping stock to meet margin calls, as lenders’ demands for the stock sales are known. According to Equilar, an executive compensation research firm in Redwood Shores, Calif., executives at three dozen companies have disclosed such sales since October.

One of the companies was Life Time Fitness , a chain of gyms, whose founder and chief executive, Bahram Akradi, had been the company’s largest shareholder. He owned slightly more than 10 percent of the shares outstanding, according to the company’s 2008 proxy statement. A year ago, the company’s shares were trading at about $65. And the stock was still around $40 within the last month, when Mr. Akradi’s stake would have been worth some $164 million.

What the company did not tell investors until about a week ago, when the stock was trading under $20, was that Mr. Akradi had pledged virtually all of his 4.1 million shares as collateral. On Oct. 10, the company disclosed he had sold 582,000 shares of his stock to cover margin loan obligations.

As part of its announcement, the company went on to alert investors that nearly all of Mr. Akradi’s stock was “subject to pledges under these loans.” In all so far, he has sold about 1.5 million shares, worth some $28 million at about $19 a share, according to Equilar. A company spokesman said Mr. Akradi used the money for his personal investing. The spokesman, Jason Thunstrom, said Mr. Akradi and other company officials would not comment further.

Under Securities and Exchange Commission rules, executives are typically required to disclose insider sales within two days of making them and indicate why they were sold, including as a result of a margin call. But experts say there are no rules requiring that the public be told ahead of time that an executive has pledged stock in a margin loan or how the borrowed money is being used. It might be a loan to buy more shares of the company’s stock — which would indicate a vote of confidence in the shares. Or it might be a loan to buy some other company’s stock or something else altogether — possibly a sign that the executive thinks there are better places to invest.

“The disclosure rule is vague,” said Ben Silverman, director of research at InsiderScore, which tracks the buying and selling of company insiders.

Over the last 25 years or so, investors have come to take on faith the need for executives to own significant amounts of company stock, as a way to make sure the interests of the people running a company are aligned with those of the shareholders. But the ability to use the shares as collateral for a loan may change that dynamic, said Charles M. Elson, a corporate governance expert at the University of Delaware.

“It may be at certain levels de-aligning,” he said. Although individual circumstances may not require public disclosure of an executive’s decision to pledge the stock, Mr. Elson said, he argues that the boards of directors should be told.

Paul Hodgson, a senior analyst at the Corporate Library, a governance research group, says it is too easy for investors to be misled when executives are not holding the stock outright. “The disclosure is a problem,” Mr. Hodgson said. Most investors will look at the executives’ holdings in the proxy statement, he said, and say, “ ‘They own a lot of stock — they are really committed.’ ”

Some companies forbid their executives to use their shares as collateral, Mr. Silverman said. Others require at least a certain amount of disclosure. At Boston Scientific , the company alerted investors in its 2008 statement that some of the holdings of its two founders, Pete Nicholas and John Abele, had been pledged as collateral. The two sold about $270 million of stock in October, according to Equilar.

Judgment questions

Mr. Silverman says the use of pledged stock seems to occur mainly at companies where a founder or other senior executive has a particularly large holding. Technology companies do not tend to have executives with margin loans using company stock, he said, because they prefer to use stock options to reward their managers.

For investors who are not aware the stock is pledged, the risk is greatest when an executive is forced to sell a significant position, as the chief executive of Chesapeake Energy was forced to do recently, adding to the downward pressure on the stock, Mr. Silverman said.

The executive, Aubrey K. McClendon, was forced to sell substantially all of his stock this month — some 32 million shares, or more than 5 percent of the company, worth nearly $600 million, according to Equilar.

The company’s largest individual shareholder for the previous three years, Mr. McClendon had bought shares on margin and was subject to margin calls when the stock fell as part of the recent market rout.

Brian M. O’Hara, the chairman of XL Capital , a Bermuda insurer, was forced to sell about 80 percent of his holdings, which he said had been used to buy more shares to avoid the expiration of his stock options. Both he and Mr. McClendon said in public statements that the sales in no way reflected a lack of confidence in the shares.

In those two cases, at least, the executives’ pledged stock represented “super-strong incentives to look out for the shareholders’ interests,” said Wayne R. Guay, a professor who specializes in executive pay at the Wharton School of the University of Pennsylvania.

But he is troubled by borrowing used to make completely unrelated investments — the sort of borrowing that indicates executives see better places to put their money or want to diversify their holdings without telling investors they are selling shares. “It does put the integrity of executive compensation, incentives and corporate governance in jeopardy,” he said.

And when executives borrow so much, even to buy more stock, Mr. Guay and others say, investors have a right to question their judgment. They may be bullish, expecting the stock to be up, but they do not seem to be showing an ability to assess risk, even if it is their own personal risk.

In such cases, Mr. Guay points out, they are like homeowners around the country who became saddled with too much debt through home equity loans, because they thought the price of houses could go only up. “What are they thinking?” he asked.

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