Selling Frist Short

Well, the latest Beltway feeding frenzy is on, and Bill Frist is the main course. If you haven’t followed this story, which as Jon Henke notes has already hit the front pages of the New York Times and the Washington Post, Frist

is facing questions from the Justice Department and the Securities and Exchange Commission about his sale of stock in his family’s hospital company one month before its price fell sharply.
The Tennessee lawmaker, who is the Senate’s top Republican and a likely candidate for president in 2008, ordered his portfolio managers in June to sell his family’s shares in HCA Inc., the nation’s largest hospital chain, which was founded by Frist’s father and brother.
A month later, the stock’s price dropped 9 percent in a single day because of a warning from the company about weakening earnings. Stockholders are not permitted to trade stock based on inside information; whether Frist possessed any appears to be at the heart of the probes.
A spokesman said Frist’s office has been contacted by both the SEC and the U.S. attorney’s office in Manhattan about his divestiture of the stock.

In contrast to the Democrats, Republicans have a tendency to panic and throw their leaders under the bus at the first whiff of ethical trouble. Sure enough, even hardy souls like Captain Ed and Leon H, as well as the libertarian Henke, are calling for Frist to step down, and Tom Maguire doesn’t much seem to have his heart in defending Frist. The desire to have nothing to do with this kind of trouble derives from a healthy impulse, and in Frist’s case – as was true with Trent Lott – it is driven in part by unrelated frustrations over his shortcomings as Majority Leader. But based on what we know so far, there is absolutely zero reason to believe that Frist did anything wrong, or that he will or should be in any legal jeopardy.
As an initial matter, some people have questioned whether there was a problem with Frist making any investment decisions at all, given that his assets were supposedly in a “blind trust” to comply with Senate ethics rules. Shockingly, however, Senate ethics rules on the matter turn out to be fairly porous, as Tom Maguire notes: precisely because ethics rules require federal officials to make regular disclosures about their assets, it’s not really possible for them to be entirely unaware of their holdings.
Professor Bainbridge, who was one of the first people on the Right to jump on this story, gives the necessary legal background. Basically, under the securities laws – my own area of practice, by the way – the initial question in an “insider trading” case is whether the trader was aware of information about the company that is material (i.e., information that would be important to an investor making a decision to buy or sell) and nonpublic (which means what it sounds like: information not in the public domain). As Prof. Bainbridge notes:

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.

He goes on to discuss the longstanding dispute over whether the SEC needs to show trading while in possession of material nonpublic information, or whether it needs to show that the trader actually used the information. That is indeed a vexing issue, albeit one that is somewhat theoretical in many cases (the evidence of use is often circumstantial anyway). Prof. Bainbridge suggests that it might matter here if Frist could show a different motivation for selling, such as a desire to eliminate a conflict of interest that would no doubt only become a larger issue if he runs for president. But if Frist can be shown to have had access to information about HCA’s upcoming earnings news before it became public, he is politically toast no matter what the legal outcome.
The same goes, I suspect, for a second part of the legal inquiry that Prof. Bainbridge doesn’t address. Frist, as far as I can tell, has no formal relationship with HCA, so he is not technically an “insider” who owes legal duties to its shareholders. Thus, at least under the securities laws, he can only be prosecuted if (1) he was a “tippee,” i.e., some person inside the company tipped him off to inside information in violation of that person’s own duties to the company and in exchange for some benefit (such as a share in the profits), or (2) he “misappropriated” confidential information that was entrusted to him by the company in some relationship of trust and confidence. The misappropriation theory would likely not apply to information Frist may have received from members of his extended family who were involved in running HCA; the Second Circuit rejected application of the theory in such circumstances to a member of the Waldbaum (grocery chain) family in United States v. Chestman, 947 F.2d 551, 570-71 (2d Cir. 1991).
It’s not entirely clear if the “misappropriation” theory could be extended to, say, someone who learned information in his capacity as a government official. The Fourth Circuit rejected such liability in the case of officials of the West Virginia Lottery who bought stock in a company before awarding it a contract in a lengthy and scholarly opinion by Judge Michael Luttig in 1995, United States v. Bryan, 58 F.3d 933 (4th Cir. 1995), but on grounds of wholesale rejection of the theory, which was later approved by the Supreme Court. It should be noted, however, that in Bryan and United States v. ReBrook, 58 F.3d 961 (4th Cir. 1995), the same court upheld the same defendants’ convictions for mail and wire fraud. Thus, again, the issue of whether Frist is really in any trouble here all comes down to whether he had any inside information about HCA, which he denies.
On that score, what we know now suggests that there’s no reason to be concerned. At the moment, there is only pure speculation that Frist had any material nonpublic information. The suggestion (or assumption) being made by his critics is that if Frist sold a huge, long-held block of stock before bad news made the stock drop, he must have had some inside information, absent some other, rational explanation for why he sold. But Tigerhawk, in a post that’s a must-read for anyone attempting to discuss this issue intelligently (link via Instapundit), looks at the trading history of HCA and provides an obvious explanation: HCA had just had a huge run-up in value, and it was publicly known (due to SEC reporting requirements) that a lot of HCA insiders had sold stock (which can be and often is perfectly legal, by the way, depending on the circumstances):

Bill Frist, if he had any information at all about HCA when he ordered his trustee to sell his shares, knew what everybody else knew: that the management was shoveling stock out the door. That fact alone would be sufficient for many investors to sell their shares, and so it should have been for Frist, who was probably trying to get rid of them anyway in advance of his presidential campaign.
Moreover, we — and HCA investors — should applaud Frist for having handled the transaction the way he did. It was well within his rights to sell his shares much earlier in the spring, before the extent of the selling by insiders (including his own relatives) came to light via filings at the SEC. Instead, he waited to give his instruction to his trustee until after all the management selling had been disclosed. The result was that HCA’s public investors had every opportunity in the world to sell their own shares on the basis of the management selling before Bill Frist. The timing of Frist’s sale benefited those HCA shareholders wise enough to act on the insider selling, insofar as they got out the door before Frist.

Now, this is speculation, just as assumptions of Frist’s guilt are speculation, and maybe we will learn something later that changes this picture. But Tigerhawk’s analysis certainly shows why – in the absence of any evidence to the contrary – the most logical explanation is that Frist, having sound political reasons to want to sell the stock anyway, chose to instruct the trustee to sell at what looked to be an opportune time to sell.
(One final point: while they don’t happen in every case, SEC investigations of trading in advance of big announcements – particularly by people, like Frist, who are related to management – are sufficiently routine that there’s really no significance that should attributed to the existence of the investigation by itself.)
Two concluding notes:
1. I don’t have time here to address the fact that Frist seems rather clearly to have lied in TV interviews about the degree of his knowledge of the HCA stock in his “blind” trust except to say that it’s an incredibly stupid lie, given that his ownership of HCA stock was sufficiently public knowledge that interviewers kept asking him about it.
2. As I commented on Leon H’s post, it’s all too easy to bail on Frist’s ineffectiveness as Majority Leader. Remember how disenchanted we Republicans were with Trent Lott? Remember how disenchanted we were with Bob Dole? Remember how happy we were to see both of them go? Have you noticed how unhappy Democrats are with Harry Reid? How miserable they were with Tom Daschle? (Moreover, neither Reid nor Daschle nor Nancy Pelosi nor Tom DeLay nor Dick Armey nor Dick Gephardt has, within the last several years, been an effective spokesperson for his or her party.)
Face it, being a Senate leader is hard, and on issues where the caucus splinters, I’m not sure that personal leadership can do much to pierce the armor-plated egos of Senators with either fear or persuasion. I think the last really popular Senate leader, within his own party, was George Mitchell.
In short: Frist has been a disappointing Senate leader in a number of ways, and certainly his public statements on this issue haven’t helped him. It will be a good thing for the GOP to get a new Senate leader yet again in 2006. But I wouldn’t call for his head over an investigation that shows no sign of being anything more than a routine inquiry that is likely to clear him.
UPDATE: I should add that the mail/wire fraud theory pursued in the Bryan and ReBrook cases wouldn’t be available here – the government’s theory in those cases was that the defendants defrauded the government because their investments deprived the government of the defendants’ “honest services” in the process for awarding the lottery contract. Here, since there’s no allegation of anything affecting Frist’s performance of his legislative duties, that theory would be unavailable.