Green Mountain Margin Call Latest Sign Market Is Stuck in 1929

NEW YORK ( TheStreet) -- The recent share tumble of Green Mountain Coffee Roasters ( GMCR) harkens back to the stock crashes of Chesapeake Energy ( CHK) and Goldman Sachs ( GS) during the financial crisis, and in fact, all the way back to the Great Depression.

That's because in each case the issue of whether top executives and board members should be permitted to use their company stock as collateral for personal investments has been raised. It's a question yet to be answered definitively by the corporate world, even after similar problems first surfaced more than 80 years ago.

The risk of more market implosions triggering margin calls is significant, according to data from Institutional Shareholder Services. Approximately 23% of S&P 500 companies have executives or company officers who have pledged company shares. Only 62.4% of S&P 500 companies have a policy in place prohibiting the hedging of shares by executives.

On Monday, Green Mountain Coffee Roasters ousted its chairman and founder Robert Stiller after he was forced to sell $125.5 million in stock to meet margin calls.

The sales, which violated company prohibitions on trading shares during earnings, were made as Green Mountain tumbled 48% on May 2 on a weak first quarter earnings report. Because Stiller had roughly 12.5 million of his Green Mountain shares in margin accounts for personal loans that Bloomberg reports were used to buy a 164-foot yacht, the falling value of Green Mountain shares precipitated margin calls and his stock sale.

Stiller may face Securities and Exchange Commission scrutiny over the sales, according to a Reuters report, because the sales came during a restricted period for insider selling.

However, forced selling of shares pledged in margin accounts for loans were also a problem for Chesapeake Energy CEO Aubrey McClendon in 2008 and led to the departure of a top executive at Goldman Sachs during the financial crisis, in addition to other instances at Boston Scientific ( BSX) and Williams Sonoma ( WSM).

There is uncertainty over whether margin accounts are a problem, and even less clarity on what is and isn't legal.

"Obviously it poses a problem, in so far as you are selling or collateralizing the stock for other purposes, you are diminishing the value of the company," says Kenneth Feinberg, a founder of law firm Feinberg Rozen and special master on executive pay in the Treasury's Troubled Asset Relief Program.

Oftentimes, margin accounts are created so executives can use their stock for personal investments or loans without having to sell shares, which could be viewed negatively by investors and lead to capital gains tax. However, violations of company bylaws by Green Mountain's Stiller, the liquidation of McClendon's stock, and the prospect of a share liquidation by Goldman executives all stand as a clear indication that forced selling can impact investors.

"It's okay for CEOs to leverage their stock if it's used to invest in more shares. But if it's used for personal consumption, then it's probably a problem," adds David Yermack, a professor at NYU's Stern School of Business.

In the event of a share slump or overall market turmoil, though, the distressed sale of those shares can create the potential for insider trading, conflicts of interest and even put boards in the awkward position of bailing out top company officials.

"I don't think there is anything fundamentally wrong with this as long as it's disclosed and the board approves it," says David Larcker, an accounting professor at the Stanford Graduate School of Business and director of its Corporate Governance Research Program. "I think it is very controversial where the board would step up and bail out an executive . Is that in shareholder interests?"

While the Dodd-Frank Act seeks to instill regulation that will prevent a repeat of the Great Depression, little attention has been paid to questionable share liquidations by top corporate officials. Other provisions, such as "Say on Pay," are more widely known and recently led to the shareholder rejection of Citigroup ( C ) CEO Vikram Pandit's pay package.

Prominent proxy voting advisory firm Institutional Shareholder Services recommends to shareholders that they vote to remove the ability for top corporate executives to use their stock based compensation as collateral for margin accounts or personal loans.

"Generally vote FOR proposals seeking a policy that prohibits named executive officers from engaging in derivative or speculative transactions involving company stock, including hedging, holding stock in a margin account, or pledging stock as collateral for a loan," the ISS has advised shareholders.

ISS isn't overreacting in sounding alarm bells about this accepted practice. There aren't standard disclosures for such policies, which vary in the way they are reported from company to company. And even if a company states to its shareholders that margin accounts are prohibited and that stock sales during earnings season violate insider trading policies, a corporate board may still give hardship exceptions to an executive facing a margin call.

Meanwhile, a failure to comply with publicly stated corporate rules isn't necessarily a violation of securities laws. It means that companies may be marketing policies to investors that can be bent during a board vote and may not be enforceable under existing securities law.

Investors may want to push for regulators to ban the practice outright given the problems that have arisen at Green Mountain and Chesapeake, among others.

The Dodd-Frank overhaul of securities laws gives investors the ability to advocate that violations of company policy -- such as Stiller's sale -- are a breach of federal securities laws. Currently, Section 955 of the 2010 Dodd-Frank Act requires that the SEC write rules for disclosures related to corporate policies on margin accounts, a task yet to be completed by the SEC, though an SEC spokesman said the regulator has existing disclosure laws related to executive stock holdings

In the fall of 2008, McClendon of Chesapeake Energy sold "substantially all" of his 33.4 million shares at a $2 billion paper loss after he faced margin calls related to loans he used to buy more of the Oklahoma City-based company's stock. That year, Chesapeake Energy disclosed that it gave McClendon a $75 million cash bonus. As of its 2011 proxy statement, Chesapeake Energy said it's banned the use of margin accounts by corporate executives.

In early 2009, Goldman Sachs said in a proxy statement that it spent tens of millions of dollars to bail out two senior executives who faced similar margin calls in the fall of 2008. Goldman bought back stakes in some internal investment funds from Jon Winkelried, its former co-chief operating officer, and Gregory K. Palm, its general counsel -- two of the bank's largest shareholders at the time. Goldman bought $19.7 million of hedge fund and private equity investments from Winkelreid and $38.3 million from Palm.

According to Goldman Sachs's 2012 proxy, its top executives are prohibited from hedging any shares of common stock. Green Mountain said it banned the practice starting in 2012; however, Stiller and another director's accounts has existed prior to the change.

When Berkshire Hathaway ( BKR.A) made a $5 billion investment in Goldman shortly after the partner-bailouts, the Warren Buffett-run company stipulated that the bank's top four executives couldn't sell more than 10%of their stock for three years. In recommending pay packages for TARP recipients such as Goldman, Kenneth Feinberg mirrored those concerns.

"We were very careful in making sure that there were no options and there was no collateralized use of stock unless it could be redeemed over a three year period," says Feinberg.

While recent margin-based sales are different from Depression-era scandals raised by bank heads who shorted their company's stock, they may represent a lingering fault -- and fault line -- in current corporate governance and securities laws.

Famously, National City Bank chairman Charles E. Mitchell was indicted on tax evasion charges after selling all of his stock to his wife in 1929 to eliminate his income tax liabilities. Mitchell's sale and the short sales of Chase National Bank shares by its head Albert H. Wiggin came amid a stock market meltdown that would last for years and which stemmed from policies of speculation that were promulgated by both bank heads.

Robert Scully Jr. uses Mitchell and Wiggin as a historical background for present-day Dodd Frank executive pay reforms in a Jan 2011 paper for Federal Lawyer published on the SEC's Web site. "Not much has changed in the law of executive compensation over the last 80 years," he writes.

At the time, Sen. (Va.) Carter Glass, a namesake of the now repealed Glass Steagall Act of 1933, called Mitchell the man "more responsible than all others put together for the excesses that have results in this economic disaster." In 1933, Mitchell was indicted for tax evasion and was grilled by Ferdinand Pecora in a Senate commission to investigate the 1929 stock market crash.

While Mitchell was eventually cleared of charges relating to his share sales, more explicit rules in a Dodd Frank rewrite of securities laws may bind corporate executives to their insider trading policies and limit their ability to use margin accounts. Such rules may also remove investor exposure to the potential for conflicts of interest and distressed insider sales that have been a part of recent share tumult.

The New York Times wrote at the time of Mitchell's acquittal, "the Federal Building, scene of much human drama and tragedy in past years, has never witnessed a more dramatic scene." That drama is still playing out today.

For Green Mountain and Chesapeake Energy, large insider share sales and the prospect of improper executive investments linger as just one of many concerns. Green Mountain shares have tumbled on weaker than expected earnings and allegations of improper accounting. Meanwhile, a Reuters investigation recently revealed that Chesapeake CEO McClendon has taken billions in additional loans tied to his holdings in company oil and gas wells. The SEC is currently also looking into whether a commodity trading fund run by McClendon breached insider trading laws.

For more on Chesapeake Energy, see ways Chesapeake Energy can be saved from itself and why its largest shareholder has recommended that the company consider a sale for more on how it can initiate a share turnaround.

-- Written by Antoine Gara in New York

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