Insider Stock Pledges and Shareholder Wealth

Abstract

While pledging shares as collateral for personal loans is commonly practiced in many countries that protect minority shareholders, the empirical evidence has shown only its value destruction to shareholders. This paper offers an (partial) explanation of this puzzle by documenting a positive shareholder wealth effect of this practice. We find sizeable, significant, and positive stock market reactions to the regulation that facilitates share pledges (2.17%, 87 billion USD) and the effect is larger for (32~43 bps) for financially constrained firms and firms whose controlling shareholders have more shares to pledge. Similar effects are found for pledge transactions and the reverse for the regulation that reduces share pledges. Financial constraint and controlling ownership jointly determine the share pledge purpose to finance listed firms. Following pledge transactions with the purpose of financing listed firms (to purchase shares or for consumption), inter-corporate borrowing increases (insider ownership increases or decreases), and the CARs upon disclosures are significantly positive (negative). While the ratio of shares pledged is positively associated with crash risk, we find that pledging shares for the purpose of financing is negatively associated with crash risk.

Keywords: financial constraints, stock pledge, insider debt financing, shareholder wealth

JEL Classification: G32, G38