A rollercoaster ride for Lordstown Motors this week, but its executives are ok

A panel on 10b5-1 plans at the SEC Investor Advisory Committee explained why Gary Gensler is now pointing a finger at insiders' trades. I hope Lordstown is listening.

Happy summer to everyone in the northern hemisphere! This edition of The Dig is a great example of my reporting — a combination of news, original reporting, and analysis with a dash of context from the writing of others and my own clip folder. I connect the dots for you on all the action. So why don’t you take the ride with me and subscribe with a special summer offer I’m making for the paid version of this newsletter, one that has the inside information on financial regulation and regulators as well as news you can use to manage your investments.

Get 20% off for 1 year

Share The Dig

The U.S. Securities and Exchange Commission held an Investor Advisory Committee meeting on June 10, 2021 that included two panels on perennial market structure issues. It seems the more things change the more they stay the same, including the same players. This is from June, 2015, six years ago:

SEC’s panel still at a loss over how to fix ‘broken market’

Equity markets are “broken,” a “complete mess,” or maybe even “rigged.” Luis Aguilar, a commissioner on the Securities and Exchange Commission, was quoting others when he used those words in remarks to the inaugural meeting of the SEC Equity Markets Structure Advisory Committee on May 13. 

There hasn’t been an Equity Market Structure Roundtable at the SEC since 2019. Maybe Jay Clayton thought he had solved all the issues with speeches. Maybe it’s because the Director of Trading and Market Structure who led them wanted to go to work for a contra-equity firm, Coinbase. He got out just in time!

There’s only an acting director of trading and markets in his place so far. So, the market structure folks are bringing the issues to the Investor Advisory Committee.

One more great topic, 10b5-1 plans, brought together Committee member Cambria Allen-Ratzlaff, Corporate Governance Director for UAW Retiree Medical Benefits Trust as moderator, Keir Gumbs, Vice President, Deputy General Counsel and Deputy Corporate Secretary of Uber Technologies, Jeff Mahoney, General Counsel of the Council of Institutional Investors, and Dan Taylor, an Associate Professor at The Wharton School at the University of Pennsylvania.

Mahoney provided the institutional investor view. Gumbs, a former SEC attorney and law firm partner now keeping Uber on the straight and narrow and Dan Taylor went back and forth on what reforms, if any, are needed for a rule that gives executives and board members a “safe harbor” from accusations of insider trading when they sell shares of their company.

The purpose of 10b5-1 plans is to provide a way for insiders to diversify equity positions without violating securities laws. To give the executive or director this “safe harbor” or defense against accusations of insider trading, a Rule 10b5-1 plan must be established in good faith when the person was unaware of material non‐public information. That’s true even if the trades are made while the individual may be aware of material, non‐public information.

Prof. Dan Taylor is the co-author of a paper that provided the statistics for SEC Chairman Gary Gensler’s remarks earlier in the week at The Wall Street Journal’s CFO Network event.

In my view, these plans have led to real cracks in our insider-trading regime.

What’s wrong with 10b5-1 plans, according to Gensler?

First, when insiders or companies adopt 10b5-1 plans, there’s currently no cooling off period required before they make their first trade. I worry that some bad actors could perceive this as a loophole to participate in insider trading.

Taylor’s and his colleagues’ research has shown that 14% of sales of restricted stock in 10b5-1 plans initiate the planned transactions within 30 days of plan adoption, and about two in five plans within the first two months.

Second, there currently are no limitations on when 10b5-1 plans can be canceled. As a result, insiders can cancel a plan when they do have material nonpublic information. This seems upside-down to me. It also may undermine investor confidence. 

Why is this so? Executives or directors subsequent access to material nonpublic information might influence their decision to cancel a pre-established order to sell in the 10b5-1 plan. 

Third, there are no mandatory disclosure requirements regarding Rule 10b5‑1 plans. I believe more disclosure regarding the adoption, modification, and terms of Rule 10b5‑1 plans by individuals and companies could enhance confidence in our markets. Fourth, there are no limits on the number of 10b5-1 plans that insiders can adopt.

Taylor went over these points at the SEC Investor Advisory Committee meeting and dropped another bombshell on the attendees. Taylor said there were 700,000 Form 144s mail-filed between 2001 to 2020 that are not on EDGAR.

What’s a Form 144? Anyone selling $50,000 or more in restricted stock — executives, board members, founders, VCs, etc. —  must report the sale on Form 144. Unlike Form 4 — the one used to disclose all transactions and holdings of directors, officers, and beneficial owners of registered companies — Form 144 requires the filer to indicate whether the sale was part of a 10b5-1 plan and asks for the plan adoption/modification date.

Taylor told the audience that Form 144 can be filed electronically on the SEC’s EDGAR system or via mail. However, 99% of all 144s are mail-filed and many are handwritten. If you file by mail the form never ends up on Edgar. Instead, these forms can only be found for up to 90 days in the SEC reading room.

One of the meeting attendees, Cien Asoera, a financial advisor for Edward Jones, commented that it was incredible that we were talking earlier in the meeting about modern equity market structure that captures data and profits in fractions of a second and now we were talking, in the year 2021, about the lack of transparency of paper forms that document significant trades by control persons.

The meeting recording is not yet up but I encourage you to listen to this last panel, for Taylor’s data and for Gumbs’ and Mahoney’s practical explanations of what happens in the real world and why.

And all that is a set-up to talk about Lordstown Motors, its wild week and its executives’ trades.

It wasn’t that long ago, December 4, 2020, to be exact, when Lordstown Motors Corp. was formed via a SPAC transaction resulting from a merger completed in October with DiamondPeak Holdings Corp.. SPAC stands for special purpose acquisition company and are also commonly referred to as blank check companies. From an SEC Investor Bulletin about investing in SPACS:

These types of transactions, most commonly where a SPAC acquires or merges with a private company, occur after, often many months or more than a year after, the SPAC has completed its own IPO. Unlike an operating company that becomes public through a traditional IPO, however, a SPAC is a shell company when it becomes public.  This means that it does not have an underlying operating business and does not have assets other than cash and limited investments, including the proceeds from the IPO. 

While Gensler and Taylor were talking about trading by insiders last week, one of the hottest stocks in the SPAC world, Lordstown Motors (Nasdaq: RIDE) was making news, but not the good kind.

On Tuesday, June 8, Lordstown’s stock tanked after reporting that it had added a “going concern” warning to an amended annual report, a 10-K/A. Lordstown executives had admitted to concerns about cash in its most recent earnings report but things have now become dire.

The revised 10-K, which had been delayed resulting in a delisting warning from Nasdaq, was required after the company announced it would restate its earnings to incorporate new guidance issued by the SEC in April regarding accounting for warrants. From Lordstown’s amended annual report, or 10-K/A:

The SEC Staff Statement highlighted potential accounting implications of certain terms that are common in warrants issued in connection with initial public offerings of SPACs. The SEC Staff Statement clarified guidance for all SPAC-related companies regarding the accounting and reporting for their warrants that could result in the warrants issued by SPACs being classified as a liability measured at fair value, with non-cash fair value adjustments recorded in earnings at each reporting period, rather than as equity.

In addition to the adjustment for the accounting for warrants, the company also corrected an error that added $24 million more to its expenses. As a result, its new auditor KPMG, hired in October after the merger transaction, took another look at everything including whether the company was likely to be around in a year.

I guess it should not be that surprising that Lordstown’s finances are shaky, especially for a company borne of a SPAC. The company put on a good show for a few months but the numbers are not in its favor.

Back in 2016, I wrote for MarketWatch that almost half of the auditors’ warnings about the near-term survival chances for public companies were made in IPO filings.

It’s not just development-stage companies that have an uncertain future at the time of IPO. Audit Analytics, which provided the latest going-concern figures to MarketWatch, says that the top two reasons auditors cite for giving a going-concern opinion, approximately 30% of the new warnings in the most recent fiscal year are “net losses since inception” or an “absence of significant revenues.”

The amended 10-K now also has a warning that its disclosure controls are ineffective and that there are several material weaknesses in internal control over financial reporting related to the errors over SPAC and other accounting. Three more months of spending since the original 10-K and 1Q earnings report and the impact of the corrections for the warrant accounting and other errors now put the company’s future in jeopardy. From the 10-K/A filed with the SEC June 8:

Disclosure controls (as defined in Rules 13a-15 (e) and 15d-15 (e) under the Exchange Act) are procedures that are designed with the objective of ensuring that information required to be disclosed in our reports filed under the Exchange Act, such as this report, is recorded, processed, summarized and reported within the time period specified in the SEC’s rules and forms. Disclosure controls are also designed with the objective of ensuring that such information is accumulated and communicated to our management, including the Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure.

…As required by paragraph (b) of Rules 13a-15 and 15d-15 under the Exchange Act, our Chief Executive Officer and our Chief Financial Officer carried out an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures as of December 31, 2020.

Based upon their evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were not effective as of December 31, 2020, due to the material weaknesses discussed below.

While preparing the Company’s financial statements, our management identified the following material weaknesses in internal control over financial reporting:

  • We did not have a sufficient number of trained resources with the appropriate technical accounting skills and knowledge with assigned responsibilities and accountability for the design and operation of internal controls over financial reporting;

  • We did not have an effective risk assessment process that successfully identified and assessed risks of material misstatement to ensure controls were designed and implemented to respond to those risks; and

  • We did not have an effective monitoring process to assess the consistent operation of internal control over financial reporting and to remediate known control deficiencies.

Our management is preparing a remediation plan to be instituted in 2021 under the oversight of the Audit Committee. The plan is expected to involve hiring and training additional qualified personnel, performing detailed risk assessments in key process areas to identify risks of material misstatement, further documentation and implementation of control procedures to address the identified risks of material misstatements in key process areas, and the implementation of monitoring activities over the components of our internal controls which would include holding personnel accountable to their responsibilities for the design and implementation of internal controls over financial reporting.

There is no assurance that we will be successful in remediating the material weaknesses.

Material weaknesses in internal controls are also common in IPOs. Back in September of 2019 I analyzed SEC filing data provided by research firm Audit Analytics for MarketWatch showed 100 IPO filings in 2019 year-to-date by companies that use a Big 4 audit firm — Deloitte, Ernst & Young, PricewaterhouseCoopers or KPMG. My analysis of S-1 disclosures for those companies found 20 that had voluntarily disclosed serious issues with internal controls over accounting, financial reporting and the systems.

Lordstown was just waiting for the right time to tell you it was not ready for prime time. Stuffing the admissions into an amended 10-K may have seemed like the way to go.

Lordstown has a habit of delaying disclosures of bad news. 

It didn’t disclose that it had received a request from the SEC on February 17, 2021, for the voluntary production of documents and information, including relating to the merger between DiamondPeak and Legacy Lordstown and pre-orders of vehicles, until its original 10-K on March 25. 

On March 18 and 19, 2021, two related putative class action lawsuits were filed against us and certain of our officers in the U.S. District Court for the Northern District of Ohio (Case Nos. 21-cv-616 and 21-cv-633), asserting violations of federal securities laws under Section 10(b) and Section 20(a) of the Exchange Act. These lawsuits were also not disclosed until the original 10-K on March 25.

Now, in the amended 10-K filed June 8, what was previously characterized as a “request” from the SEC for “voluntary production of documents and information” is now acknowledged as a formal investigation with two subpoenas issued to the company.

For example, we have received two subpoenas from the SEC for the production of documents and information, including relating to the Merger between DiamondPeak and Legacy Lordstown and pre-orders of vehicles.  We are responding to the SEC’s requests and are cooperating with its inquiry. 

Wharton’s Dan Taylor looked at trading by Lordstown’s executives and finds even more red flags.

Most companies have insider trading policies that specify trading blackout windows that extend from the quarter-end through the earnings announcement. A 2020 survey of public companies conducted by Deloitte and the National Association of Stock Plan Professionals says, for example, that 100% of companies surveyed had trading blackout windows that began prior to 10 days after quarter-end. 

Get 20% off for 1 year

I wrote back in June of 2019 at MarketWatch about how Tesla, another electric car company, puts out delivery and production data multiple times during the period between the end of a quarter and when the 10-Q or 10-K is filed. The numbers often change between reports and may give that electric car company’s executives and board members an opportunity to trade in advance on material information that often moves the share price, according to an expert I quoted.

Tesla discloses its insider trading policy in its proxy, but it does not provide any detail about its trading restrictions during blackout periods. A Tesla spokesman told me then that Tesla does have blackout periods that occur prior to the deliveries release that occurs on the day after the quarter closes and that the blackout lasts until after earnings are announced. Like many public companies, the spokesman said, Tesla enforces its trading blackout periods and its executives may also have pre-determined 10b5-1 plans.

Lordstown, however, either does not have such windows, or is not enforcing them.

Lordstown announced earnings for 2020 Q4, which ended December 31, 2020, on March 17. The results were a huge disappointment and share prices declined 13% in response. Taylor looked at the data and found that between the quarter-end and the earnings announcement, Lordstown multiple officers and directors, including the CFO, traded more than $8 million more than one month after the quarter-end, and just 31 business days before the earnings announcement. During the period, i.e., more than a month after the end of Q4-2020, it would be expected that the CFO, the President of the Company, the Chief Product Officer and many others to have insight into the Q4-2020 performance. ‘

Lordstown President Schmidt liquidated 40% of his vested equity, and VP Vo and Chief Product Officer Brown liquidated more than 50% of their vested equity. These trades avoided both the 13% price decline with the earnings announcement and were executed before the revelation of significant negative news in the thirty days before the earnings announcement.

These trades were not disclosed as being pre-planned 10b5-1 trades.

Recall, the company got the request from the SEC on February 27, 2021. This SEC investigation was NOT publicly disclosed until the original 10-K was filed on March 25, 2021. Taylor told me that this timeline is concerning because academic studies find evidence that officers and directors occasionally trade based on correspondence between the SEC, the company, its representatives.

On March 12, 2021, before earnings were announced, Hindenburg Research published a short report with allegation of fake sales, and pre-orders.

Lordstown’s PR firm did not respond to a request for comment by press time.

In an interview, Taylor told me these are the red flags on the Lordstown executives’ trades:

Red Flag #1––Trade size relative to ownership levels. Five executives are dumping significant quantities of shares, that represent a significant fraction of their overall ownership.

Red Flag #2––Timing of the trades. The trades all occur 29 to 31 business days before an earnings announcement, where the company announced a loss that was twice as large as expectations, and where prices declined by 13%. At the time of their trade, it would be customary for the CFO, President, etc to have insight into the Q4-2020 earnings and to be in possession of material non-public information concerning the earnings announcement. For this reason, companies have trading blackout windows that restrict trading from the time of the fiscal quarter-end through the earnings announcement. Such windows would have prevented these trades. By not having such internal control policies––or not enforcing them––executives were able to trade in advance of earnings and avoid considerable losses.

Red Flag #3––Loss avoidance. Based on the price of $13.01 at the close of business after the earnings announcement, loss avoidance was as follows:

Vo: $1.2 million (–48%) Brown $220,000 (–47%)

Schmidt: $2.5 million (–48%) Rodriguez: $130,000 (–52%)

Post: $142,000 (–52%)

When all sales by corporate insiders since 2015 are ranked in terms of loss avoided as a percentage of trade size, all of the above trades are in the top 1% of the distribution of loss avoidance (in %s).

Here’s the data, based on SEC filings:

February 2, 2021: Three executives sell large quantities of shares without using 10B5-1 plans. Days until earnings are announced? 31

VP Vo: Sells 57% of all his vested equity (100,000 shares at $25.21)

President Schmidt: Sells 29% of all his vested equity (161,512 shares at prices between $24.51 and $25.02)

Chief Product Officer Brown: Sells 50% of his vested equity (19,008 shares at prices between $24.63 and $24.67)

February 3, 2021: President Schmidt sells more shares without using 10B5-1 plans. Days until earnings are announced? 30

President Schmidt: Sells another 13% of all his vested equity (50,000 shares at $27.44)

February 4, 2021: Two additional executives, VP and the CFO, sell large quantities of shares without using 10B5-1 plans. Days until earnings are announced? 29

CFO Rodriguez: Sells 1% of all his vested equity (9,300 shares at $27)

VP Post: Sells 11% of all his vested equity (10,000 shares at $27.21)

Postscript: Hindenburg Research cited the executive share sales of Schmidt, Vo, and Post in its original research report dated March 12, 2021. However, that was five days before Lordstown announced disappointing earnings for 2020 Q4 on March 17 and share prices declined 13% in response. The executives’ trades must be viewed with even more concern now that we know how these non-preplanned open sales by key executives occurred so close to the announcement of negative results. In addition, we also now know that executives received a request from the SEC just a couple of weeks later, on February 17, 2021, for the voluntary production of documents and information, including relating to the merger between DiamondPeak and Legacy Lordstown and pre-orders of vehicles. However, again, Lordstown executives did not disclose the SEC investigation until its original 10-K was filed on March 25. The company changed its tune again on June 8 when it filed an amended 10-K and admitted that the SEC had issued subpoenas. By that time executives had long before bailed on millions of company shares.

Share The Dig

© Francine McKenna, The Digging Company LLC, 2021