A few days ago, I saw a Tweet from Francine McKenna that sent me down a rabbit hole that raises many fundamental questions. Doubtless, you've heard the splashy news that both Pfizer and Moderna have announced COVID-19 vaccines said to be 95% effective in the preliminary trials. How awesome is that, given that we're looking at development that, if proven safe, will have demonstrated how to condense a decade's worth of innovation into less than a year.
What is less well known is that executives at both companies used what's called the 10b5-1 rule to trouser millions in profits very shortly after the blockbuster announcement. Fierce Pharma reported that: Lucky Pfizer CEO Bourla cashes out $5.6M worth of stock—perfectly legally—as COVID-19 vaccine data lift market. Market Insider headlined with Pfizer's CEO cashed out 60% of his stock on the same day the company unveiled the results of its COVID-19 vaccine trial. On YahooFinance we find: INSIGHT-How Moderna execs are cashing in on COVID-19 vaccine stock speculation while StatNews trumpets that Moderna executives have cashed out $89M in shares this year, as stock price has soared on vaccine hopes.
To its credit, StatNews asks:
The top five executives at the biotech company Moderna have sold more than $89 million of stock so far this year — initiating nearly three times as many stock transactions than in all of 2019 — as the company's share price has soared on hopes for its Covid-19 vaccine.
The trades, which led to about $80 million in profits, were prescheduled through a legal program that allows company insiders to buy and sell shares at a later date.
But the volume and timing might prove alarming to Moderna's shareholders, especially in light of the company's May decision to raise more than $1 billion in a stock offering. If Moderna's early-stage vaccine can one day prevent coronavirus infection and the company's best days lay ahead, why are insiders selling?
But there's a more important element to this that I wanted to pick up with Francine, and that's the whole issue of stock compensation plans that include the use of rule 10b5-1. I like to think that I have a fair understanding of how US comp plans work even though this is a movable feast. Rule 10b5-1, though, was a new one on me. And here is the problem as outlined in the CLS Blue Sky Blog story titled: SEC Needs to Rewrite its 10b5-1 Safe Harbor Rules
While it is illegal for insiders to trade on material, non-public information, the SEC has created a safe harbor Rule 10b5-1 since October 2000 by allowing insiders to set up trading plans in advance of actual trading. Since these planned trades are set up in advance of subsequent trading, they allow insiders to buy and sell shares despite possessing material non-public information at the time of the trade. Consequently, they can serve as an affirmative defense in case of litigation. However, these plans are not foolproof. There is growing suspicion among both finance and legal experts that significant loopholes exist in the design and execution of these plans and that the plans are being abused to hide more informed insider trading.
You don't need me to give you more of a pointer to know where I'm going with this. But because I don't understand this topic, I called up Francine to get her take. For those that don't know, Ms. McKenna is one of a tiny number of people who not only understand the minutiae of SEC reporting but are focused on the role auditors play in sometimes enabling bad behavior. We have known each other for many years. We are in regular contact on these topics as it helps me understand the financial reports better, or more importantly, the filings that tech companies submit to the SEC.
In our conversation, Francine pointed out that the way 10b5-1 was written allows companies and their leaders to drive a coach and horses through the original intent, which was to enable execs to establish plans that provide a degree of comp certainty. Here are three problems identified by the CLS Sky Blue Blog:
One potential concern with Rule 10b5-1 is that executives can possess material, non-public information when they set up these plans. If true, this would undermine the entire foundation for the SEC Rule, which rests on a requirement that the plans be set up before the insider becomes aware of such information. A second concern is that insiders can incorporate their material non-public information into the plans' trading formulas at the initial stage. These plans allow the insiders to condition their planned trades on future market conditions (such as future stock price), which can create problems. A third concern is that the insiders can subsequently cancel or modify their existing 10b5-1 plans or set-up additional new plans as they come into new material non-public information.
The reason this is an issue in the Pfizer and Moderna cases is because the timing of stock disposals under this plan arrangement is so close to the announcements related to the vaccine that it is impossible for the executives to say they didn't know what would likely happen. So far so safe but what of the plans themselves. In the Pfizer case, Firce Pharma reported that:
Bourla’s 10b5-1 was set up on August 19, according to the SEC filing. That was a few weeks before Pfizer and its development partner BioNTech announced positive results from animal trials of their vaccine. The phase 3 human trial of the vaccine began July 27.
Bourla was making some noise at the time about the possibility of getting a vaccine approved before the election, but he later tempered his predictions. And the company did not solidify its status as the front-runner in the race to end the COVID-19 pandemic with a vaccine until it released the efficacy data in people this week.
It is an open question as to why the plan was set up so late in the vaccine development cycle and the extent to which the CEO knew the likely timeline for an announcement at the time the plan was established. It may well be that Pfizer did indeed act reasonably within the current interpretation of the rules, but Francine is not so sure. Even then she doubts very much whether the SEC will take any action unless there is a massive investor outcry.
Most of these plans are set up to automatically trigger buy and sell plans at pre-determined dates so that stock option holders can cash out in accordance with the agreement they've reached in the comp plans. That's fine, But what we're seeing here is different. This is where the relative secrecy given by 10b5-1 can act to help enrich executives well beyond what you might usually expect. In my view, this is out of control but the SEC won't do anything - at least not under the current administration.
It's that central 'won't likely do anything' that causes me concern. I have no problem with executives who work hard and take outsized risks receiving outsized rewards. Where I have a problem is when elements of financial engineering enter the equation with the near certainty that there will be little or no effort to enforce the rules. I see this as a particularly American problem because that country works on rules rather than principles. Wherever there are rules then people will find ways around them. That is to be expected, and more so when the guardrails expected by the public are flimsy or non-existent .
That mindset opens up a whole argument around ethics in technology. This is an active discussion that Neil Raden has documented for the last 18 months. If there is no morally bound ethical compass on the topic of executive compensation, then why would any company involved in this oft controversial area take the question of an ethical approach seriously? The topic itself is mired in many difficulties. For example, in his latest story, Raden says:
There is an overemphasis on the topic of ethics, per se, rather than the pragmatics of how to do this work ethically. It's complicated by the many and emerging declarations of "principles" by governments, regulators, academics, and now, "ethicists." This bumper-crop of well-meaning academics do provide needed counsel and guidance on the foundational concepts of ethics and moral philosophy. But the tendency of them to wade into implementation guidance is, well, unethical.
If that's as good as it gets, making progress that satisfies all stakeholders is hard to see.