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.

13 thoughts on “Selling Frist Short”

  1. Most likely, this will just fade into the background of ‘general sense of ethical shortcomings’ which will be believed by those who dislike him, and ignored by those who like him – sort of like Hillary’s extremely fortuitous past investments. Since I think Frist has no shot as a Presidential candidate anyway, I doubt it will be an important story.

  2. Crank – one thing you ignore in your discussion of misappropriation is that, subsequent to Chestman, the SEC adopted Rule 10b5-2, which (non-exclusively) defines when someone has a duty of trust and confidence. This is especially true with respect to family members (see (b)(3) of the Rule).
    If the theory is that he got some information from a family member, this Rule could very well apply. As I commented on Bainbridge’s post, I would love to see the Rule litigated.

  3. Also, per the NYTimes today, Frist now says that the stock sale was first planned in April – the very beginning of the fiscal quarter in question. If that’s true, I don’t see any way he could have had material nonpublic information about the quarter’s financial results.

  4. Like all the other “scandals” it’s hardly the crime, it’s the cover-up. You’re an expert, and you make some compelling points above about the intricacies of convicting someone of insider trading. Frist will likely never be indicted or charged with anything, much less convicted, but he is already making stupid excuses and lies all over the place. That’s all it takes to doom him. Looking guilty is often as bad as being guilty.
    As a guy so wealthy he can’t keep track of this stuff, it’s not like he cuts a sympathetic figure either. On top of that, those “leaping to his defense” aren’t always helping matters.
    From the WaPo:
    …Republicans expressed confidence in Frist and his ability to weather the controversy. “Democrats will try to make a lot out of this and pounce on whatever they can,” said Nicholas E. Calio, a former aide to both Presidents Bush. “To me, it’s inconceivable that he [Frist] would sell stock based on inside information. He doesn’t need the money.”
    Um, did Martha Stewart need the 40K her stock dump netted her? She took an $85 million hit to her net worth because of that scandal. Not a savvy move.
    It’s never about the need it’s about power and a sense of invulnerability. People at this level start to feel like they are above it all, and they will never face consequences. Couple that with the fact that they know more than everyone else, and need to micromanage. Of course Frist doesn’t need to risk his whole career over a 15 percent drop in share value—but that doesn’t mean he didn’t do it.
    I hope this is the best defense they come up with…

  5. “Have you noticed how unhappy Democrats are with Harry Reid? “
    Not THIS Democrat. Reid’s not perfect, but after years of Daschle, I am positively enchanted with Reid. Most everyone I know with an opinion on the matter feels the same way. Careful with your speculation on the other side…

  6. Crank, I seldom disagree with you, but I have to on this: “the SEC can’t change the meaning of the statute.”
    As I’m sure you’re aware, the statute – Section 10(b) – in fact doesn’t say anything about insider trading. Insider trading law is made from Rule 10b-5 and judge-made law interpreting it. And the SEC can certainly clarify what Rule 10b-5 means.
    Indeed, in the release proposing 10b5-2, the SEC specifically said that it was adopting the rule in response to Chestman, which it thought was an overly narrow interpretation of 10b-5. The SEC said:
    In our view, however, the Chestman majority’s approach does not fully recognize the degree to which parties to close family and personal relationships have reasonable and legitimate expectations of confidentiality in their communications. For this reason, we believe the Chestman majority view does not sufficiently protect investors and the securities markets from the misappropriation and resulting misuse of inside information. …
    Chestman thus leads to the following anomalous result. A family member who receives a “tip” (within the meaning of Dirks) and then trades violates Rule 10b-5. A family member who trades in breach of an express promise of confidentialityalso violates Rule 10b-5. A family member who trades in breach of a reasonable and legitimate expectation of confidentiality, however, does not necessarily violate Rule 10b-5. We think that this anomalous result harms investor confidence in the integrity and fairness of the nation’s securities markets. …
    Accordingly, we believe that there is good reason for the broader approach we propose today for determining when family or personal relationships create “duties of trust or confidence” under the misappropriation theory.
    As between an earlier judicial interpretation of 10b-5 and the SEC’s subsequent attempt to broaden the scope of the misappropriation theory, I’m betting that the latter controls. But, as I said, I’d love to see it litigated.

  7. The latter might control, depending on the extent to which the court finds that the statute is susceptible of multiple interpretations. But as the Supreme Court held in Ernst & Ernst v. Hochfelder, 425 U.S. 185, 213-14 (1976):

    The rulemaking power granted to an administrative agency charged with the administration of a federal statute is not the power to make law . . . [t]hus, despite the broad view of the Rule advanced by the [SEC] in this case, its scope can not exceed the power granted the [SEC] by Congress under § 10(b).

  8. And isn’t everybody entitled to the presumption of innocence anyway?

    Baseball Crank: 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. Sen. Bill First, R-TN, is a sorry…

  9. Thank you Messr Crank for the hefty analysis. But you failed to cite the most important case in determining Senator Frist’s fate: US v. Martha Stewart. Every American knows the domestic diva served hard time for committing this same crime. You may note that Martha was only a tippee with no responsibility to IMClone, and that she actually was sent away for obstruction, and that Frist, as the scion of the company’s founders, may actually have committed a more egregious crime. But that matters not. If Senator Frist wants to hold his job or any job that requires even a scintilla of public approval, he must explain with Oprah Winfrey-like clarity why Martha Stewart went to jail and he did not.

  10. For the purposes of this post, I’ll assume that Frist had material nonpublic information. If he didn’t, the legal discussion can end there.
    The notion that he had planned to sell the stock in advance is a classic red herring. If he was aware of the nonpublic material information when he traded, he’s t-o-a-s-t unless he had entered into a BINDING contract to sell the stock. So long as he had discretion in the sale of the stock, he would be violating SEC rules by selling while aware of material nonpublic information.


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