Firm financing through insider stock pledges
Xiaofei Pan and Meijun Qian
Review of Finance, Volume 28, Issue 2, March 2024, Pages 621–659, https://doi.org/10.1093/rof/rfad030
Insiders pledging company stocks as collateral for personal loans is a worldwide practice. However, existing studies based on firm data from the U.S. and Taiwan (China) show adverse impacts on shareholder wealth, equity risks, and potential distortion in investment incentives and accounting manipulation. This study conjectures that specific financial market conditions might have driven these results, and hence examines the share pledge market in mainland China, where the institutional background, development stage, and firm conditions are different, to provide a more comprehensive understanding.
We find that the number of insider share pledge transactions in China multiplied 38 times from 2003–2017 after the regulation broadened institutional participation and reduced transaction costs. The total amount of pledged loans outstanding multiplied 111 times, reaching 2.9 trillion RMB by the end of 2017, which is more than half of all new equity issuance and a quarter of total bank private credit during the same year. The expansion is mainly driven by controlling shareholders channelling funds from share pledges into the publicly listed firm. This type of transaction counted only for 7% of the controlling shareholders’ transactions in 2003, but rose to 36% by 2017. For each dollar from this type of share pledge, 87 cents flow into the firm through intercorporate borrowing or other account payables. However, for the whole sample period, about 70% of controlling shareholders transactions are for financing other investments, which are likely the controlling shareholders’ other entrepreneurial activities, given the prevalent financing constraints private enterprises face in China.
Controlling shareholders’ high ownership stake in the firms incentivizes them to provide personal loans to the firms. Firms’ financial constraints breed the need for financing sources alternative to bank loans and equity issuance. These two factors are critical determinants for controlling shareholders turn to share pledges to relax firms’ financial constraints. The market also responds positively to this type of transaction but not so for other types of transactions.
This study uses transaction, firm activities, and market return data to comprehensively understand China’s dramatically expanded insider share pledge market and corresponding fund usage. The evidence of its beneficial role in relaxing listed firms’ financial constraints resolves the discrepancy between the previously stylized negative impacts in the literature and regulatory permission of share pledge practices. This study shows that the impacts of share pledges on shareholder wealth are differential concerning fund usage. The net effect of stock pledges in the US and Taiwan (China) is destructive might be due to either firms’ financial constraints are not severe or controlling ownership is not significant enough to motivate financing firms through share pledges. Therefore, the benefits of this financing avenue in these markets are much smaller than those in mainland China. This contrast illustrated the importance of using international data to understand finance practices.