The U.S. Securities and Exchange Commission (SEC) initiated preset-trading arrangements known as 10b5-1 plans in 2000 so corporate executives and nonexecutive directors would have a way to announce their plans to sell shares. According to John Nester, a spokesman for the SEC, the 10b5-1 plan was devised “to give executives a way to sell some shares of their own companies despite being exposed to nonpublic information.” Therefore, the plans must be set up when the executive or director does not possess inside information, so as to obviate any potential charges of insider trading. The question I address here is whether the plans are subject to abuse by non-executive directors. Such abuse could involve the exploitation of a conflict of interest.
The SEC’s intent was not that executives and nonexecutive directors would use the plans to dump massive holdings of stock. Nor was it intended that non-executive directors who are also principals at investment funds would make use of the plans to make their funds money by exploiting the conflict of interest. According to Daniel Donoghue, the largest stockholder of Cardiovascular Systems, “(d)umping an entire fund during a tumultuous earnings period is well outside the bounds” of what the 10b5-1 plan was designed to cover.
It is suspicious, therefore, that from 2008 to 2012 the number of nonexecutive directors making use of the 10b5-1 plan increased 55 percent, according to the Wall Street Journal, as compared to a 36% increase among all other corporate insiders. From 2006 through 2011, nearly a quarter of nonexecutive directors using the plan sold more of their company’s stock in one month than in the surrounding two years. Patrick Sinclair, an assistant U.S. attorney in the eastern district of New York, suspected that those directors may have been using the plan as a cover to trade out of stock positions during times of bad corporate news. If so, the plan is not a sufficient device to thwart insider-trading. That the individual companies, rather than the SEC, approve their own 10b5-1 plans without having to disclose them invites potential insider to insider abuse.
Moreover, even if a given director does not use the plan to profit an investment firm in which the director has a financial state, it could be unethical for the director merely to be in the conflict of interest that he or she could exploit. If so, a director with an interest in an investment firm should strenuously avoid using the 10b5-1 plan at all. This might be good advice even if merely being in a conflict of interest is not inherently unethical. As the case of Dendreon demonstrates, it can be difficult to know if a CEO had access to particular information. Additionally, as the case of Cardiovascular Systems illustrates, it can be difficult to discern the motive of a nonexecutive director dumping shares.
Mitchell Gold, who was CEO of Dendreon through January 2012, set up a 10b5-1 plan to sell hundreds of thousands of shares in December 2010. The company’s stock dropped in August of the next year, according to the Wall Street Journal, “after the company pulled sales guidance for its prostate-cancer treatment Provenge.”
According to a whistleblower and other employees, Dendreon offiicals had been aware by late 2010 that Provenge faced significant problems with sales. “The writing was on the wall,” one of the company’s sales reps said. Even so, the Journal reports that it “isn’t clear how much [Mitchell Gold] knew about the sales results when he set up his trading plan. This means it is difficult to enforce 10b502 plans, so they may not be sufficient to eliminate insider trading. If it is difficult to determine what a company’s executive knew, imagine how difficult it must be to isolate the motive of a nonexecutive director who runs an investment fund.
John Friedman, a principal at Easton Capital Group (a private-equity firm) and a nonexecutive director at Cardiovascular Systems, reported the sale of 330,000 shares for $3.3 million that had been held by one of the funds at Easton. That firm had set up the 10b5-1 plan for the transaction on November 30, 2011, a month or so after some volatility began concerning Cardiovascular’s earnings reports and stock. Six days after the end of Friedman’s selling, more bad news came from Cardiovascular. The fund at Easton had been able to liquidate its holdings “prior to full market disclosure of the extent of the problems at the company,” Donoghue complained. “I am challenging the ‘affirmative defense’ that 10b5-1 trading plans provide against any suspicion of improper trading,” he wrote, “recognizing that these plans are not safe harbors with respect to insider trading.” He may have been jumping to conclusions, however, at least to the extent he was relying on Friedman’s actions at Easton.
The Wall Street Journal reports that the fund at Easton had to sell its stake in Cardiovascular Systems in order to repay a debt. Additionally, another fund at Easton retained its holding of Cardiovascular shares—421,000 in total. Furthermore, Friedman and Cardiovascular attest that he did not have any inside information at the time he sold one of the fund’s holdings. If so, however, why did the Cardiovascular board ask him to resign and then retained him nonetheless after he refused. Couldn’t the fund that sold its holdings in the company have sold its long position in another company to repay the pressing debt? If only the Cardiovascular holdings were sufficient, why would the fund not have diversified more at least in terms of company risk? Moreover, if Friedman had set up that fund in order to load it with Cardiovascular, his conflict of interest would be salient. Of course, he could argue that such a conflict is not a problem as long as it is not exploited, but this begs the question: did he exploit it or was he merely raising funds to cover a debt while allowing another fund at Easton to continue a significant position in the company?
Of course, if simply allowing oneself to be in a conflict of interest is unethical, exploitation need not be proved to justify deconstructing such a conflict at its outset. In a conflict of interest, a person’s or institution’s role wherein the exclusive self-interest of the person or institution is salient compromises or thwarts another role of that person or institution—a role whose legitimacy is based on a responsibility relied on or otherwise impacting other parties. In other words, a less official role conflicts with a more official one. Where exploitation occurs, the self-interest gains at the expense of the interests of others, or society itself. Gain eclipses duty.
If a conflict of interest is inherently unethical, it would be because it is unethical to intentionally make it possible for one’s gain to harm one’s duty. By analogy, one might say it is unethical allow one’s kid to walk along the edge of a skyscraper’s roof-top even if the child does not actually fall because subjecting him or her to the possibility is itself blameworthy. “How dare you put your son in such a dangerous situation,” a detractor might say. “If he falls off, it is his fault,” you might counter. “But you set up the particular condition in which he could,” the ethicist might say. In being culpable, the parent should not have allowed the kid to walk near the ledge. Doing so is thus unethical.
Similarly, Thomas Rohback, a lawyer, says, “If you have someone who is a director on a company’s board and he also runs some type of investment firm, he shouldn’t be trading in that company’s stock because of the appearance of impropriety at the very least. It always appears he has an advantage over other investors.” Put another way, both roles in a conflict of interest should not even be allowed—one of the two must go—because even the appearance of impropriety is unethical. To put a person or institution in a position that has the appearance of impropriety is unethical in itself (as an act). Associating a person with the mere possibility of improper self-enrichment at the expense of others negatively impacts the person even if only in him or her being seen in a sordid spot, or “role structure.” At the very least, the person’s reputation could be expected to suffer.
I submit that even apart from any harm—either to the person in a conflict of interest or to those relying on the person’s official duty—the arrangement itself of a person’s or institution’s roles is unethical if a role oriented primarily to the person’s or organization’s gain is inherently contrary to the duty that is so salient in another role. If my thesis is correct, then the designing of such an arrangement would be an unethical act. It would be even more unethical to enter into or stay in such an arrangement oneself, or to pressure or direct another person or an organization to adopt it. As actual harm comes from actual exploitation of a conflict of interest, actually compromising or thwarting a responsibility in order to gain from doing so would be even more unethical still. The fallacy is to suppose that the validity of the no-harm-based ethical principle means that a design cannot itself be inherently unethical because there is no harm. Put another way, the design itself is harmful because it depicts how gain can compromise duty.
Therefore, Thomas Rohback was right, I believe, in saying that a director who has an investment firm should not even trade in the stock or bonds of the director’s company. The question of whether the 10b5-1 plan is sufficient to obviate insider-trading would be moot if directors took Rohback’s advice to heart. Ethically speaking, it is better to sacrifice a bit on one’s financial gain than to be associated with a picture whose foreground has gain deciding whether to take a bite out of duty, or to actually take that bite.
Susan Pulliam and Rob Barry, “Directors Take Shelter inTrading Plans,” The Wall Street Journal, April 25, 2013.
Susan Pulliam, Rob Barry, and Scott Patterson, “Insider-Training Probe Trains Lens on Boards,” The Wall Street Journal, April 30, 2013.