A biotech company called Seres Therapeutics (MCRB) got some bad news late last month: Its all-important infectious disease drug failed in a clinical trial, sending its stock price down roughly 70 percent. Investors took a bath.
But in the two days before that failure became public, three top Seres executives sold a combined $2.5 million worth of the company’s stock. They made a tidy profit. They avoided nearly $2 million in paper losses.
And it was entirely legal.
That’s because the executives took advantage of an obscure federal regulation that allows insiders to buy and sell shares as long they set up the trades in advance.
In theory, it prevents company leaders from profiting off information not yet made public. But researchers digging through thousands of such trades have shown that they consistently outperform the broader market, suggesting biotech bigwigs might be gaming the system at the expense of everyday investors.
“Biotech often has very turbulent events, and whenever you see any type of insider trading around the same time, it just stinks,” said Brad Loncar, an independent biotech investor. “It makes you wonder if the system is fair.”
There’s a litany of examples in recent biotech history. Last month, Juno Therapeutics disclosed that three patients died in its lead trial of a novel cancer therapy, forcing it to temporarily pause development and sending its stock price plummeting more than 30 percent. Days before, CEO Hans Bishop sold $4.4 million worth of Juno stock, dodging what would have been more than $1 million in losses. Juno and Bishop declined to comment.
A similar story played out when Tetraphase’s lead antibiotic failed last fall, and when Vertex (VRTX) released some disappointing cystic fibrosis data in 2015. Executives at those companies and at Seres also declined to comment.
Each insider stock sale, however irksome to investors, was done legally through what’s called a 10b5-1 plan.
Some background: It’s against the law for executives to sell shares when they have important company information that isn’t yet known to the public, like the failure of a drug trial. But C-suite dwellers, especially in biotech, get a lot of their compensation in the form of stock, and the Securities and Exchange Commission acknowledges that it would be a bit over the top to make them hang onto it until they quit or get fired.
So the SEC came up with a solution in 2000 with the invention of 10b5-1 plans. Under such plans, executives can schedule trades ahead of time, automating them to buy or sell shares either at specific dates or whenever the stock reaches a certain price. But they can only establish the plans when they don’t have any valuable secrets, like right after their company releases its quarterly earnings. If the SEC later comes calling about a suspicious trade, companies have to demonstrate that the plans were set up in good faith.
It’s meant to be a tidy mechanism that allows executives to exercise their rights as shareholders without playing an unfair advantage. But either there are exploitable holes in that idea, or executives are remarkably fortunate.
How CEOs beat the spread
A 2006 study from Stanford University looked at more than 3,000 planned insider trades across all industries and found that executives’ stock sales systematically came just before bad news and right on the heels of good, helping them maximize returns and minimize losses.
And if you subtract trades that some executives schedule to be executed at the same time each year, it looks even fishier. A 2012 Harvard University study examined two decades of irregularly timed insider trades. Those transactions beat the market by as much as 25 percent each year, researchers found, suggesting insiders have a serious edge over external investors.
Those two findings are particularly pertinent in biotech, an industry known for its stock volatility, said Alan Jagolinzer, who authored the Stanford study and is now a professor of finance at the University of Colorado. A company can be completely wiped out by a bad clinical trial and boosted fivefold by a good one; the timing of a trade can swing tens of millions of dollars.
So how are executives beating the spread?
One possibility, Jagolinzer said, is by taking advantage of a wrinkle in the law: Holders of 10b5-1 plans are allowed to cancel them at any time and for any reason, and they don’t have to disclose that to the public. (They also aren’t required to disclose the existence of their plans ahead of time.)
Let’s say a biotech CEO learns that, in two days, her company is going to announce clinical results that will surely boost its stock price. She can’t legally buy up a bunch of the company’s shares right then — that would be the bad kind of insider trading — but she can cancel a scheduled 10b5-1 sale to avoid dumping stock just before its price soars.
“That is a strategy that can be technically compliant with the rule,” Jagolinzer said.
‘An easy target’ for criticism
Some biotech executives and insiders say concerns about 10b5-1s are overblown.
The majority of legal insider trades do nothing to arouse suspicion, said David Sable, a biotech investor at Special Situations Life Sciences Fund. And if there’s ever a whiff of impropriety, “as an investor, you can vote with your portfolio,” Sable said.
Ron Renaud, who was CEO of the publicly traded Idenix Pharmaceuticals before Merck bought it in 2014, never used a 10b5-1 plan himself. But many of his colleagues did, he said, and for understandable reasons. They needed cash for tuition bills, house payments, and maybe the odd divorce.
Some trades that look suspicious may not be, Renaud said. For instance, investors might bid up a biotech’s stock in the week leading up to an anticipated release of clinical trial data. That could trigger a sale the CEO had long ago set to be executed at a certain share price.
If the company announced the next day that the clinical trial had failed, the stock would likely plunge. That would make the executive’s recent stock sale look dubious, but it wasn’t necessarily ill-intentioned, Renaud said.
The 10b5-1 plans are “an easy target” for criticism, but in reality, “they’re difficult to game,” he said.
Academics who have studied them aren’t so sure.
While executives don’t control the winds and rains of clinical trial results, they do have a say in when news gets disclosed. A CEO might choose to time a press release before or after a pre-planned trade, depending on how it will affect the stock price. Companies have four business days to announce important information after they learn it, according to SEC rules, creating a potential window for gamesmanship.
That’s why some critics press for more transparency about 10b5-1 plans, including public disclosure when an executive cancels a pre-planned trade.
“In the same way they have to disclose trades, they should have to disclose these plans and when they’re terminated,” said Lauren Cohen, a Harvard finance professor who coauthored the 2012 study.
A series of fortuitous trades
Back to Seres. The company disclosed its clinical failure in a press release before the market opened July 29. CEO Roger Pomerantz and Chief Technology Officer John Aunins executed pre-planned stock sales on July 27, records show, and Chief Medical Officer Michele Trucksis did so the next day.
How long did they know about the failed trial before Seres issued its press release? In an emailed statement, the company said it publicized the results “very soon” after receiving them and declined to comment further. The executives’ 10b5-1 plans were set up months before the trial concluded, SEC records show.
Similarly, the Juno CEO’s fortuitous trade was scheduled more than three months before the company’s trial was put on hold, according to SEC filings. Juno said it disclosed that hold, which sent stocks plunging, the day after the Food and Drug Administration ordered the trial halted because three patients taking the company’s experimental cancer therapy had died.
Other lucrative trades planned in advance include Tetraphase Chief Operating Officer Craig Thompson’s sale of $440,000 worth of company stock last September, just hours before a bad trial result sent the price down about 70 percent. At Vertex, executives sold more than $4 million in stock in the days before announcing study data in March of 2015 that would send the highly valued stock down about 6 percent. Both companies declined to comment.
While all that may sound suspicious, conspiracies are easier described than actualized, said biotech veteran Michael Gilman, who bought and sold shares through 10b5-1 plans when he was an executive at Biogen (BIIB). In general, he said, the plans do their job: allowing executives to diversify their holdings and balance risk.
“But, you know, I’m sure these things can be squirrelly if someone really wants to be squirrelly with them,” said Gilman, whose last company, Padlock Therapeutics, sold to Bristol-Myers Squibb in April.
And biotech’s inherent volatility creates plenty of opportunity for at least the appearance of impropriety compared with other industries, he said. “You look at Procter & Gamble — the stock is not going to be moved by the successful or unsuccessful launch of a new toothpaste or whatever,” Gilman said.
Some executives seem to have “a marvelous sense of timing,” said Ira Loss, who covers biotech and pharma stocks at Washington Analysis. “But this is the way the system is.”