Advantages & Disadvantages of Pledge of Stock

Advantages & Disadvantages of Pledge of Stock
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A stock pledge is an agreement to use stock shares to back a loan. The borrower pledges the shares but maintains ownership. The lender can seize the shares if the borrower defaults on the loan. Advantages include possible non-taxed access to cash and lower interest rates. Two disadvantages are adverse effects on shareholders and possible tax liabilities involving foreign subsidiaries.

Advantage: Lower Interest Rates

A secured loan is one in which the borrower pledges collateral, such as stock shares. Secured loans are safer than unsecured ones, because the lender has something of value it can use to recoup losses on a loan default. Secured loans are easier to obtain and charge less interest than do secured loans. If a borrower has a poor credit history, a pledge of stock or some other asset may be the only way to get a loan.

Advantage: Access to Cash

Liquidity is the ability to raise cash. A stockholder who needs cash can achieve liquidity using the stock in two different ways. The first is to sell the shares, but this might create a tax liability if a profit results. In addition, the shareholder loses any dividend income from the shares once they are sold. The alternative is to pledge the shares and receive loan proceeds. No sale occurs, so no tax liability arises. In addition, the borrower continues to receive any dividends on the shares.

Disadvantage: Shareholder Risks

When a borrower who pledged stock defaults on a loan, the lender can sell the shares. If the pledge involves a substantial number of shares, the sale can depress the stock price and therefore disadvantage other shareholders. If the defaulting borrower happens to be an executive of the company that issued the shares, a default takes on the appearance of a stock sale by an insider, which sends a negative signal to the market. This too can depress share value.

Disadvantage: Deemed Dividends

Under certain circumstances, a stock pledge can create a tax liability for an American company with foreign subsidiaries. In 2013, Overseas Shipping Group pledged stock of its foreign subsidiaries, known as controlled foreign corporations or CFCs, as collateral for a loan. Under Section 956 of the Internal Revenue Code, if the U.S. parent pledges two-thirds or more of the CFC shares and meets certain other requirements, then any profits earned by the CFC are taxable as income, because Section 956 deems the income to be a dividend to the parent company. Normally, these profits would not trigger U.S. taxes unless they are repatriated to the parent company in the U.S. Overseas Shipping incurred a $463 million tax liability because of its deemed dividend, a cost that shareholders had to bear.