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.

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.

Seemingly in response to the CNBC column, Larsen said 6,853,192 of his VirnetX shares are pledged to Deutsche Bank for a personal line of credit of $5 million, in a July 24 filing with the Securities and Exchange Commission. Previously, he had pledged nearly 8 million shares for a $3.5 million loan, the filing stated, signaling that a recent rise in VirnetX shares increased their value as collateral. Larsen also reported 1,783,068 in restricted stock units in VirnetX's shares and options that can't be sold, according to the filing, putting his total stake at 18.4% of the company's outstanding shares.

According to VirnetX's trading price of $24.24 as of Monday's close, Larsen's $5 million loan is secured by over $166 million in pledged stock, likely giving the CEO ample room to withstand a share drop. Some Wall Street analysts are comfy cozy with Larsen's use of pledging after the new disclosure.

Cowen & Co analyst Matthew Hoffman wrote in a research note that the filing confirmed Larson's past statement that he never sold company shares, in a disclosure that put controversy over margin accounts "to bed." Gilford Securities analyst Robert Tango added that since the shares are seemingly pledged to a personal loan and not an account for securities purchases, the prospect of margin calls may be overstated.

Still, VirnetX's share volatility, its recent disclosures regarding CEO Larson's share pledge and the enduring uncertainty over margin calls, taken with actual share firesales at Green Mountain Coffee Roasters and Chesapeake Energy stand as a clear indication that minimal disclosure surrounding collateralized share holdings can impact investors.

The risk of more market implosions triggering margin calls is significant, according to May 2012 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.

In May, 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. 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.

In the fall of 2008, Aubrey 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.

"At least we know that they are learning from their mistakes," says Hodgson of GMI Ratings of Green Mountain Coffee Roasters and Chesapeake Energy's implementation of a retroactive prohibition on executive margin accounts.

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, exceptions are rampant.

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.

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.

-- Written by Antoine Gara in New York

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