Senate Majority Leader Bill Frist, a potential presidential candidate in 2008, sold all his stock in his family's hospital corporation about two weeks before it issued a disappointing earnings report and the price fell nearly 15 percent.
Frist held an undisclosed amount of stock in Hospital Corporation of America, based in Nashville, the nation's largest for-profit hospital chain. On June 13, he instructed the trustee managing the assets to sell his HCA shares and those of his wife and children, said Amy Call, a spokeswoman for Frist. Frist's shares were sold by July 1 and those of his wife and children by July 8, Call said. The trustee decided when to sell the shares, and the Tennessee Republican had no control over the exact time they were sold, she said. ... To keep the trust blind, Frist was not allowed to know how much HCA stock he owned, Call said, but he was allowed to ask for all of it to be sold.
Frist, a surgeon first elected to the Senate in 1994, had been criticized for maintaining the holdings while dealing with legislation affecting the medical industry and managed care. Call said the Senate Select Committee on Ethics has found nothing wrong with Frist's holdings in the company in a blind trust. ... "To avoid any appearance of a conflict of interest, Senator Frist went beyond what ethics requires and sold the stock," Call said. Asked why he had not done so before, she said, "I don't know that he's been worried about it in the past."
Insider trading is trading while in possession of material nonpublic information. Although the sale was effected by a trustee on bahelf of a blind trust, Frist could still face insider trading liability because he is the trust beneficiary and retained the power to direct the sale of trust assets.
The left half of the blogosphere is already calling for investigations or even implying guilt.
If some SEC enforcement lawyer in fact were to start looking into this, the first question will be whether Frist had material nonpublic information about HCA at the time he ordered the sale. If he had the common sense God gave gravel, the answer to that will be a resounding no. For somebody in his position to retain access to such information would exacerbate the inherent conflict of interest that arises when he deals with health care issues, as well as potentially exposing him to insider trading liability.
Assuming Frist did not possess such information, there's no legal problem with the sale.
{Related post: Senators and Insider Trading}
Let's assume for the sake of argument, however, that Frist did have such information. In that case, a very interesting doctrinal question would arise; namely, is insider trading liability under Rule 10b-5 properly premised on trading "while in possession of" or trading "on the basis of" material nonpublic information.
The distinction arises here because Frist could argue that even if he possessed material nonpublic information, he didn't trade on the basis of such information. Specifically, he could argue that his trade was motivated by a desire to resolve the long-standing conflict of interest issue and that he did so at this time as part of a process of clearing the decks for a 2008 run for President.
The discussion in the extended post of the legal issue is adapted from pages 568 to 570 of my book Corporation Law and Economics.
The SEC long has argued that trading while in knowing possession of material nonpublic information satisfies Rule 10b-5’s scienter requirement. In United States v. Teicher, the Second Circuit agreed, albeit in a passage that appears to be dictum. ...
In SEC v. Adler, the Eleventh Circuit rejected Teicher in favor of a use standard. Under Adler, “when an insider trades while in possession of material nonpublic information, a strong inference arises that such information was used by the insider in trading. The insider can attempt to rebut the inference by adducing evidence that there was no causal connection between the information and the trade—i.e., that the information was not used.” Although defendant Pegram apparently possessed material nonpublic information at the time he traded, he introduced strong evidence that he had a plan to sell company stock and that that plan predated his acquisition of the information in question. If proven at trial, evidence of such a pre-existing plan would rebut the inference of use and justify an acquittal on grounds that he lacked the requisite scienter.
The choice between Adler and Teicher is difficult. On the one hand, in adopting the Insider Trading Sanctions Act of 1984, Congress imposed treble money civil fines on those who illegally trade “while in possession” of material nonpublic information. In addition, a use standard significantly complicates the government’s burden in insider trading cases, because motivation is always harder to establish than possession, although the inference of use permitted by Adler substantially alleviates this concern. On the other hand, a number of decisions have acknowledged that a pre-existing plan and/or prior trading pattern can be introduced as an affirmative defense in insider trading cases, as such evidence tends to disprove that defendant acted with the requisite scienter. Dictum in each of the Supreme Court’s insider trading opinions also appears to endorse the use standard. In light of the Circuit split that now exists between Teicher and Adler, the Supreme Court may eventually have to resolve the conflict.
To be sure, in 2000, the SEC addressed this issue by adopting Rule 10b5-1, which states that Rule 10b-5’s prohibition of insider trading is violated whenever someone trades “on the basis of” material nonpublic information. Because one is deemed, subject to certain narrow exceptions, to have traded “on the basis of” material nonpublic information if one was aware of such information at the time of the trade, Rule 10b5-1 formally rejects the Adler position. In practice, however, the difference between Adler and Rule 10b5-1 usually should prove insignificant. On the one hand, Adler created a presumption of use when the insider was aware of material nonpublic information. Conversely, Rule 10b5-1 provides affirmative defenses for insiders who trade pursuant to a pre-existing plan, contract, or instructions. As a result, the two approaches should lead to comparable outcomes in most cases.
The Frist hypothetical, however, would seem to be one of those cases in which the validity of the Rule would matter. Under Adler, Frist could rebut the presumption of use if he persuaded the court that trade was effected so as to resolve the conflict of interest issue as part of clearing the decks for a 2008 run for President. Under the Rule, I don't see how that would absolve him. Hence, it would starkly present the question of whether the SEC had the authority to adopt the Rule.
One problem with the Adler test is that it allows a person to use insider info to take advantage of an "up" while still avoiding a "down". For example, if I had a preexisting plan to sell shares and learned via insider info that the shares were headed down, I could go ahead and sell as planned. If however, I learned via insider info that the shares were headed up, I could postpone my sale to take advantage of the price increase. Thus, the Adler test allows a person to take advantage of insider information under certain cirsumstances. To create a level playing field, I believe the SEC's rule is both proper and ethical--a person who comes into possession of insider information who does not already have an irrevocable contract to buy or sell must postpone the sale until the info is public. Under this rule, persons with plans to trade who are concerned their plans may be disrupted by coming into possession of insider info can address this concern in advance by entering into a binding contract to trade (in essense, a future), but once they have the info, they should not be permitted to trade until the info is public.
And another writes:
To me, the 10b5-2 question is even more interesting than the 10b5-1 issue. I, frankly, don't see how Frist could fit into either 10b5-1 or Adler. How could he show there was a pre-existing plan to dump the stock at the moment he dumped it? That is, was there a plan to sell the stock prior to the earnings release? Why didn't he just wait to sell it after the earnings release? Indeed, it is for this very reason that many insider trading plans have window periods for trading, with the window only open after the earnings release (or, really, the 10-Q). And, of course, you can't adopt a "pre-existing plan" while you are in possession of material nonpublic info.
Finally, a third opined:
Frist directed a sale on June 13 at a time when other insiders were also selling. Presumably this was because the "trading window" was open. It was open because the insiders did not have material non-public information (unless you assume HCA was one giant fraud, and if anybody serious (as opposed to a plaintiff's lawyer) is alleging that I have missed it). Had that trade executed on June 13, there would be no problem. If Frist was motivated to send his letter of instruction because he saw all the Form 4s rolling across on June 3-10, then he is doing what you are supposed to do (that is, not front-running the public on the Form 4s). Indeed, selling when the rest of the insiders sell is the compliant way to do it. That's what all the governance gurus say if given an opportunity to bleat.
So, it is probable that the only issue derives from the time lag between June 13 and the date of the actual sale. If Frist's letter of instruction to his trustee was irrevocable (and reading between the lines of the news accounts it may have been), then there is a very good chance that it falls under 10b5-1 by its terms. That takes care of the time lag. And even if the letter doesn't precisely comply with 10b5-1, that rule is only a "safe harbor." Failure to comply with it does not ipso facto result in liability.
Setting aside the politics, on the facts as reported I would argue that Frist did the right thing. He did not front-run the huge pile of Form 4s that came piling in during the first ten days of June. That gave HCA stockholders the opportunity to digest the fact of massive insider selling near the end of HCA's June quarter and sell ahead of Frist if they chose. Then, Frist's trustee delayed the sale another couple of weeks, which further extended the period in which public stockholders might say, "hmmm, why are HCA executives dumping their stock like the tea in Boston Harbor?" Finally, after giving the public much more opportunity to sell ahead of him than was required by law or morality, Frist's trustee sold. Apart from a universal desire on the part of the press to "get" leading Republicans and the public's ignorant association of the phrase "insider trading" with crime, I don't see what the issue is.
