You might think that foreign companies would be held to the same standards as U.S. companies, but that is not true, not at all.
The SEC ostensibly enforces its insider trading laws vigorously. Under the Trump Administration, they have increasingly pursued foreign actors, especially the Chinese, for suspected insider trading. The SEC considers its enforcement of the insider trading rules to be a crucial part of its function.
[P]rohibitions against insider trading in our securities laws play an essential role in maintaining the fairness, health, and integrity of our markets. We have long recognized that the fundamental unfairness of insider trading harms not only individual investors but also the very foundations of our markets, by undermining investor confidence in the integrity of the markets
Section 16 of the Exchange Act seeks to deter improper insider trading by requiring directors, officers, and shareholders who hold over 10% of a company’s shares to disclose most transactions of their stock within two business days. However, foreign private issuers like Luckin are exempt. This is no secret as Luckin warned in its prospectus.
Because we qualify as a foreign private issuer under the Exchange Act, we are exempt from certain provisions of the securities rules and regulations in the United States that are applicable to U.S. domestic issuers, including … the sections of the Exchange Act requiring insiders to file public reports of their stock ownership and trading activities and liability for insiders* who profit from trades made in a short period of time … As a result, you may not be afforded the same protections or information that would be made available to you were you investing in a U.S. domestic issuer. (emphasis added)*
Foreign private issues are only required to include their insider trading information in their annual reports—once a year—compared to two business days for U.S. companies. Has Charles Lu or any other insiders dumped their stock? We do not know, as Luckin has delayed releasing their annual report. When initially announcing this delay in late April, they claimed it was due to the impact of the coronavirus.
Public policymakers need to reconsider whether we should be willing to lower our disclosure requirements to encourage foreign companies to access our capital markets. You might think that foreign companies would be held to the same standards as U.S. companies, but that is not true, not at all. A good way for policymakers to prevent foreign insider trading in the first place would be to end the Section 16 exemption for foreign private issuers.
Technology Ought to Make Enforcement Simple
In years past foreign companies faced significant obstacles in complying with the same rules as U.S. companies, but this is no longer the case. It is easier to Zoom with someone in China than to walk to your neighbor’s house and ask for a stick of butter. All trading can be done electronically, which means that enforcing stricter disclosure requirements for foreign companies is feasible.
The exchanges could require that directors, executives, and their proxies register and forbid any trading through unregistered entities. That way insider trades would be flagged and easy to check against disclosures. Attempts to circumvent the system using unregistered proxies would be prosecuted. Perhaps there is a better way to ensure compliance; however, it is not too much to ask for foreign companies to meet the same standards as U.S. companies to get access to U.S. capital markets.
The Problems with Pledged Stock
We do not know if Luckin’s insiders traded on insider information, but we do know that Charles Lu, his sister, and the CEO cashed in their ownership interest by pledging shares for a $518 million dollar loan. They defaulted on this loan a few days after the fraud was revealed.
Luckin disclosed these pledges in its prospectus for its second offering in January, 2020, although they did not reveal how much money was raised through the loans. Insiders are often hesitant to sell stock for a number of reasons, including the need to disclose the sale on SEC Form 4 within two business days, so, sometimes they will pledge their shares as collateral for a loan. This allows them to retain title to the stock and does not change ownership unless they default.
If an insider pledges some or all their holdings, they do not need to report that within two business days under SEC Form 4 because there has been no change in the ownership of the stock and pledged shares are specifically not considered derivative securities. Insiders are only required to disclose whether they have pledged their shares under Regulation S-K Item 403(b) once a year in a footnote. A study of the Russell 3000 index showed that one or more executives at 15% of companies had used their shares as collateral for loans, and that the average amount of these loans was more than $57 million.
Unsurprisingly, these stock pledges have created problems. When directors or executives take out these loans, they risk being forced to put up additional stock as collateral if the price of the company stock declines. For example, Green Mountain Coffee’s founder and chairman of the board initially put up 46% of his shares as collateral for loans, but was forced to increase that amount to 78% when the company’s stock price took a nose-dive. He was eventually forced to sell his shares.
Recently the CEO of Wirecard, Markus Braun, resigned after Wirecard revealed that $2 billion of its supposed cash did not exist. Braun had apparently pledged a little less than half of his personal stake in the company for a 150 million Euro loan. This loan undoubtedly put a lot of personal pressure on Braun to keep stock prices stable as investigative journalists started reporting on irregularities at Wirecard.
These loans can create an enormous conflict of interest for directors and executives. A director who is heavily leveraged could push for a stock buy-back to boost share prices when the stock is in trouble, depleting cash reserves and exposing the company and its stakeholders to unnecessary risk. Or to boost share price through outright fraud. Many companies craft policies that either restrict the practice of pledging, or simply ban it outright.
In accordance with Dodd-Frank, the SEC has implemented a rule that requires companies to disclose their policies concerning stock pledges in their annual proxy statement, and to say they do not have a policy if they do not have one. Every SEC registrant will need to follow this rule starting on July 1, 2020.
Insider stock sales and insider stock pledges, we juxtapose these issues to raise a point. Why are they treated differently? The SEC requires insider sales to be reported within 2 days because that information is highly relevant for the investing public, and it is relevant as soon as it happens, not just when the proxy statement is released annually. The same logic applies for stock pledges.
It is completely mystifying why foreign companies have less rigorous insider trading disclosure requirements than U.S. firms. With advances in technology, there is no reason why a company located in Columbia should be treated differently than a company in Colorado.
Additionally, policymakers should reconsider how stock pledges are treated under the current law. If an insider takes on a large loan and pledges a large amount of their stock as collateral, shouldn’t the other investors know right away?
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