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July 28, 2010
Timing of stock sales by Moody's chief raises questions
How Moody's contributed to the economic collapse
Moody's CEO profits from timing of stock sales
By Kevin G. Hall | McClatchy Newspapers
WASHINGTON — The chief executive of Moody's Investors Service sold almost $3 million in company stock this year, and $7.1 million last year, both times right before his company's stock price fell from its peak levels, a McClatchy analysis has found.
In one case, CEO Ray McDaniel sold 100,000 shares of Moody's stock on the same day that the Securities and Exchange Commission notified Moody's that it was under investigation. The notice followed months of federal inquiries into Moody's business practices.
Moody's said that McDaniel's sales are within the scope of an SEC rule that's designed to protect executives from accusations of insider trading.
The rule permits executives to sell stock in their own firms under special 10b5-1 plans that trigger prearranged sales automatically, such as in set time intervals throughout the year, or when the stock hits a specified price.
However, experts question McDaniel's sales because he had key information about the company's finances that ordinary investors didn't have, because his stock sales' timing is curious, and because Moody's won't disclose when he set the terms of his plan's prearranged stock sales, or whether he changed those terms.
"If you look at his major sales in 2007, 2009, 2010, they are all around price peaks and followed by large declines. The likelihood that this is just 'lucky' is very low — it appears he is using inside information to time his trades," said Jesse Fried, a Harvard University law professor who studies stock trading by CEOs.
Insider trading can be illegal, but it isn't defined in any statute or regulation, and the courts determine on a case-by-case basis whether it occurred.
When McDaniel sold his stock, he clearly had information about Moody's financial profile that the public lacked. However, his trades may have been in compliance with the controversial rule permitting 10b5-1 plans. While that rule's designed to discourage insider trading, critics think it may camouflage it instead.
McDaniel disclosed to the SEC that the sales last year and in March were done under a 10b5-1 Plan. The SEC in 2000 encouraged corporate executives to use them to protect themselves from charges of insider trading, giving them what lawyers call an affirmative defense.
However, Stanford University accounting professor Alan Jagolinzer, who researches these plans, has found that executives such as McDaniel routinely outperform the market when they sell stock under these prearranged plans. His research also has found that executives tend to sell near a stock's peak price, shortly before it tumbles. In short, his findings suggest that these 10b5-1 plans can be "gamed" to reward savvy executives who may have inside information by changing the terms or the sale triggers.
Jagolinzer reviewed McClatchy's compilation and analysis of McDaniel's trades over the past eight years — some disclosed under the 10b5-1 plan and some not. From 2005 to 2008, McDaniel sold Moody's stocks in modest amounts at regular intervals. In 2009 and 2010, however, he shifted to selling large volumes at irregular intervals. Jagolinzer found the timing of the recent sales curious.
"His general history of sales transactions timing does appear fortuitous," Jagolinzer said. He added that McDaniel's large concentrated transactions last year and this March are "material outliers" to typical stock sales by executives.
That means McDaniel's recent stock sales were atypical, but it's difficult to determine whether he traded using inside information because 10b5-1 plans require so little disclosure.
Under SEC rules, it's unlawful for a CEO to trade his company's stock while he or she is aware of material, non-public information, even if that information isn't used in deciding to trade. An exception is allowed if the executive is trading under terms of a prearranged 10b5-1 plan. That's where the lack of disclosure surrounding McDaniel's 10b5-1 plan raises questions.
McDaniel sold 100,000 shares of Moody's stock this past March 18. He revealed the sale to investors a day later in a filing with the SEC.
It wasn't until almost two months later, however, that investors learned from a Moody's quarterly report that the company had received a Wells Notice from the SEC on the same day McDaniel sold his stock. A Wells Notice usually precedes civil action by the SEC, and means the regulators have been probing the company. That's not good news for a company's stock price.
In its May 7 quarterly report, Moody's made no mention of the stock sale's timing. Although ordinary investors weren't immediately told of the Wells Notice, the law doesn't require such a disclosure.
Investors also didn't know another piece of relevant information: McDaniel sold his stock eight days after the Financial Crisis Inquiry Commission requested key e-mail records and documents from Moody's. Congress formed the commission to report on the causes of the financial crisis.
Frustrated by Moody's lack of response to that March 10 request, the commission issued a subpoena on April 21 for the e-mails and documents. Moody's stock price subsequently skidded.
The subpoena came two days before an April 23 hearing by the Senate Permanent Subcommittee on Investigations that documented what a McClatchy investigation had reported late last year — that Moody's and its competitors had inflated investment grade ratings on complex mortgage bonds to win lucrative business from Wall Street banks.
Moody's rates McClatchy's debt and assigns it quite low value, downgrading it to a negative outlook in April 2009.
Rating mortgage-backed bonds had become the main engine of Moody's earnings during the housing boom, and McDaniel had promoted officials from the division that rated these bonds to top positions in the company. Analysts and executives who voiced concerns were pushed out.
The financial crisis panel later called McDaniel to appear at a hearing solely on Moody's on June 2 in New York. Following the two hearings, Moody's stock price slumped to year-to-date lows.
The panel's request for documents was an important piece of information that Moody's management team knew about on March 10, but the outside investing public didn't find out about until the panel announced on April 21 that it had subpoenaed the records.
On March 18, eight days after his company got the financial crisis panel's request, McDaniel exercised stock options under his 10b5-1 plan for 100,000 shares at $14.06 a share and to sell them immediately for $29 a share. McDaniel netted more than $1.4 million from the sale.
There was another important piece of information that McDaniel knew that investors didn't. McDaniel and the Moody's legal team had been in talks with the Senate Permanent Subcommittee on Investigations for months prior to his March 18 sale.
After the June 2 financial crisis panel hearing, in which McDaniel got only lukewarm support from Warren Buffett, his company's biggest investor, Moody's stock price took a sharp dive and hit a year-to-date low of $18.50 a share on June 8. Had McDaniel sold at the low instead of the high, his net profit would have been about $444,000, almost $1 million less than he made by selling on March 18.
Michael Adler, a Moody's spokesman in New York, said that McDaniel has done nothing wrong because the shares were sold in a prearranged sale under his 10b5-1 Plan.
"The plan resulted in an automated exercise of stock options by a third-party administrator when Moody's stock price reached a predetermined level of $29 (a share)," Adler said. "Mr. McDaniel had a similar 10b5-1 trading plan in place in 2009 for options that were approaching the end of their 10-year life."
The company has revealed little else about the plan, and some experts question the wisdom of that.
"The failure of a company to disclose details about a 10b5-1 plan is not inappropriate or nefarious. It is a missed opportunity," said Priya Cherian Huskins, who advises about these plans for the San Francisco risk management consultancy Woodruff-Sawyer & Co. She advises firms to err on the side of disclosure to diminish the appearance of insider trading.
Moody's spokesman Adler declined to disclose key details, such as when McDaniel entered into the 10b5-1 plan for 2010, or for 2009. Moody's didn't rule out the possibility that McDaniel had entered into the 10b5-1 plan shortly before he made the sales, thus possibly exploiting information the public lacked.
To avoid the appearance of trading on inside information, consultants who work on executive compensation recommend a cooling-off period of up to 90 days between when a plan is entered and when stocks are sold.
Moody's wouldn't disclose whether McDaniel observed such a cooling-off period.
Additionally, experts who help design executive compensation packages discourage large stock sales such as McDaniel's with a price trigger, favoring instead a series of prearranged and staggered sales at fixed intervals throughout the year to minimize the appearance of insider trading.
"This would seem to me to be a common-sense thing," said Richard H. Moore, a former North Carolina state treasurer who called national attention to the problems of 10b5-1 plans in 2007.
Back then, Moore wrote to the SEC to complain about irregularities in the stock sales under such a plan by Angelo Mozilo, the former chief executive of Countrywide, a once highflying California subprime lender that collapsed along with the housing market.
The SEC has accused Mozilo of a "tale of two companies." It alleges that he told investors his that company was healthy, while privately he was making numerous changes to his 10b5-1 plan to dump his stock in it more quickly.
McDaniel's $2.9 million stock sale in March and the $7.1 million sale over a week in the spring of 2009 pale in comparison to the hundreds of millions of dollars in sales made by Mozilo. However, in both cases, the CEOs sold unusually large volumes of their own company's stock during a turbulent period when they or their lawyers had information that the public didn't have.
Law firms that advise on 10b5-1 plans recommend against making frequent changes to them. Moody's wouldn't disclose whether McDaniel made such changes.
An exception to that advice is amending a 10b5-1 plan if material information becomes known that will benefit the executive. For example, if an executive learned that Congress or an inquiry commission were investigating his company, it would be acceptable for him to cancel a prearranged stock sale to avoid the appearance of benefiting from such information.
McDaniel didn't cancel his sales. That's why critics such as Moore think that the SEC should modify the guidance on 10b5-1 plans to make it clear that trading under these plans shouldn't occur when congressional probes or similar outside influences are likely to affect stock prices.
Moore and others warn that the lack of transparency on 10b5-1 plans may actually foster insider trading.
"Do we really want this to be a protection in an instance where an executive is hiding behind it?" Moore asked.
In response to complaints by Moore and research by Stanford's Jagolinzer that found that executives timed stock sales under their 10b5-1 plans at price peaks, the SEC promised in March 2007 to take a deep look at the plans.
Linda Chatman Thomsen, then the SEC director of enforcement, addressed a conference of corporate lawyers and warned that a thorough review was coming.
"We're going to look at this — hard," she promised.
More than three years later, if that hard look by the SEC took place, the public isn't privy to it.
"Nothing in the way of a report or staff study has been made public on this subject," confirmed John Heine, an agency spokesman.
Now a practicing lawyer with Davis Polk & Wardwell LLP, Chatman Thomsen declined comment through an aide.
The SEC doesn't keep statistics on how many 10b5-1 plans are in place at the roughly 10,000 publicly traded companies in the United States. The plans are often a defense for executives who might be accused of wrongdoing by shareholders in civil lawsuits rather than SEC charges. The SEC couldn't say how many cases it's brought involving these plans.
"It's just another example of how tough it is for them (SEC) to be a cop on the beat right now," Moore said.
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