VirnetX Anything but a Marginal Market Problem

Updated to clarify pledged shares and calculation on Deutsche Bank loan

NEW YORK ( TheStreet) -- Despite VirnetX ( VHC) lighting up message boards and StockTwits over the "patent troll" accusations, the bigger issue for shareholders is the CEO's pledging of shares of his company's stock.

CEOs and board members hocking shares for investments - with the possibility of getting killed in a share rout - is something that stock market regulators have ignored for years.

"I don't think that the current disclosure requirements are in any way satisfactory at all because there aren't any," says Paul Hodgson, a senior research associate at GMI Ratings, a corporate governance research firm.

There's no question that VirnetX, a holding company that is suing the likes of Apple ( AAPL), Cisco ( CSCO)and NEC ( NEC) to commercialize its portfolio of tech patents is a speculative company. It's gone from a penny stock to a company with a $1 billion-plus market cap in under a decade and has long been home to short-term traders trying to catch the prospective spoils of an intensifying Silicon Valley patent war.

However, during a recent stock surge to record highs of nearly $42 and a subsequent tumble as questions of its business model resurfaced, chief executive and founder Kendall Larsen's use of VirnetX's stock as pledged collateral also turned into a key risk to shareholders, forcing the CEO to add new disclosures about the accounts to concerned investors.

Last week, VirnetX CEO Larsen rightfully drew scrutiny from CNBC's Herb Greenberg for the large concentration of his shares in that are pledged against other assets. Greenberg's concerns that those shares could be pledged against volatile personal investments came amid a Seeking Alpha analysis from an anonymous short-seller, who argued that VirnetX may underwhelm in squeezing out IP-related revenue from the likes of Apple and Cisco.

While Larsen disclosed that his accounts are for a personal line of credit and helped to quell margin call worries, the company's late July share volatility underscores a widespread problem where CEOs and large insiders pledge shares as collateral for personal investments, raising the prospect that a drop could lead to margin calls and insider stock firesales -- an unforeseen risk for ordinary investors until it materializes.

Recently, forced insider selling at Green Mountain Coffee Roasters ( GMCR) helped to lop off roughly 50% from the company's stock price, and reminded investors of a similar share crash at Chesapeake Energy ( CHK) in 2008. The use of stock as collateral for personal investments and loans also raised the prospect of share liquidations at Goldman Sachs ( GS), Boston Scientific ( BSX) and Williams Sonoma ( WSM) during the financial crisis.

Currently, companies only have to disclose whether they bar executives from using shares as pledged collateral but not companies that do, making it hard for investors to find stocks without a 'firesale risk.' " The disclosure happens on the wrong end," adds Hodgson of GMI Ratings.

A May 14 Wall Street Journal analysis underscores just how big and opaque the problem is. In the wake of Green Mountain's share rout, WSJ analysts scoured SEC filings and proxy statements for companies that disclose executive and director share holdings pledged to margin accounts or personal loans, uncovering 20 companies highlighted by FedEx ( FDX), Atlantic Tele-Network ( ATNI), Discovery Communications ( DISCA) and Iron Mountain ( IRM) as those with the highest dollar exposure. Still that analysis didn't mention VirnetX, which has roughly 15% of total shares pledged in CEO Larsen's account.

If you liked this article you might like

How to Trade 6 Big-Volume Stocks for Big Gains

How to Trade 6 Big-Volume Stocks for Big Gains

Why VirnetX (VHC) Stock Is Skyrocketing Today

Technology Firms Gear Up to Defend Patent Infringement Cases

'Patent Trolls' Look to Skin Apple and Others

VirnetX (VHC) Stock Plummets After Ruling in Patent Claims Against Apple