The Securities and Exchange Commission (the SEC) has brought its first insider trading case involving an exchange-traded fund (ETF), filing a complaint against Spencer Mindlin and his father, Alfred Mindlin, in its second ever administrative insider trading enforcement proceeding.1 The complaint, dated September 21, 2011, alleges that Spencer Mindlin, through his former position on the ETF desk at a financial institution from 2007 to 2009, learned the size of trades the financial institution intended to make in the securities underlying an ETF that the institution was hedging because it had a large stake in that fund. The Mindlins allegedly used this nonpublic information to buy and sell those underlying securities in advance of the financial institution’s orders, which the complaint asserts yielded them a profit of $57,000.2

This case is noteworthy for a number of reasons. First, it represents the SEC’s first insider trading case involving an ETF, which is an investment fund that is intended to track an index that includes securities for a number of companies in an industry or at a particular market capitalization level.3 The structure of an ETF poses a challenge in an insider trading case as insider knowledge about an individual company is not likely to have the same impact on the value of the ETF as it would on the individual company’s stock. Second, while the SEC has styled the complaint as an insider trading case, the charges alleged appear to be more characteristic of front-running, an area of previous interest to the agency. Third, the large amount of publicly known information about the securities in the ETF at issue creates a question as to whether the information that the Mindlins allegedly used to their advantage, namely the size of the financial institution’s intended trades, was material. Lastly, the case is also significant as it marks the only other time, aside from the complaint against Rajat Gupta that the SEC later withdrew, that the SEC has chosen to pursue an administrative complaint for insider trading, an approach that may be reflective of the challenging issues that the cases poses.

A Summary of the Allegations

The SEC’s complaint alleges that while Spencer Mindlin worked on the ETF trading desk, he and his father bought and sold securities underlying a specific ETF (the Fund) based on the financial institution’s plans to buy and sell the same underlying securities. The Fund was an ETF designed to replicate the Standard and Poor’s Retail Select Industry Index (S&P Index). The Fund rebalanced quarterly to mirror the S&P Index, and the securities that were added or deleted from the S&P Index were published before each quarterly rebalance. On the day of the quarterly rebalance, the Fund added and deleted the same securities that the S&P Index recently added and deleted.4

Starting in late 2007, the financial institution, as the largest institutional holder of the Fund, sought to limit its exposure by placing trades as a hedge against the securities that were deleted and added during the quarterly rebalancing, a strategy that was accomplished by cataloging the securities added and deleted from the S&P Index. On the day the Fund was set to rebalance for that quarter, the financial institution bought the securities it knew the Fund was going to sell and sold short the securities it knew the Fund was going to buy. The SEC alleges that Spencer Mindlin obtained nonpublic information through his position and then, with his father’s help, used the information to successfully trade ahead of financial institution’s orders. The nonpublic information that Spencer Mindlin obtained was how large the financial institution’s trades would have to be in order to properly perfect its hedges against the Fund’s securities. In December 2007 and March 2008, the Mindlins bought and sold options and shares in four securities that Spencer Mindlin knew the financial institution would place large orders for on the quarterly rebalance date. The Mindlins made their trades through a family member’s account for the net profit of $57,000.5

Is This Really a Front- Running Case?

The SEC’s decision to bring an insider trading case involving an ETF poses several challenges. ETFs in general allow investors and financial firms to access baskets of stocks and commodities through a single security, similar to a mutual fund. ETFs are pegged to financial indexes; they differ from mutual funds in that they can be traded throughout the day, whereas mutual funds generally price only once at the end of each business day. Typically, insider trading cases involve a claim of an individual trading for personal gain in a company’s stock or other security based on access to material nonpublic information about the company at issue. ETFs are comprised of the securities of numerous companies pooled together as a whole to create one new security. As a result, information that could cause an individual security to rise or fall in value is not likely to have the same impact on the value of the ETF as it would on the individual security. Thus, ETFs are not typically a fertile ground for insider trading cases because the significance of information about one of the securities in the ETF is minimal.

This difficulty is reflected in the Mindlin complaint, which harkens back to previous enforcement actions based on brokerages “front-running” large client trades. As described in the complaint, the Mindlins bought a long position in securities underlying the Fund just before the financial institution executed a large order for the same securities and, conversely, took a short position in securities on which the institution later placed large sell orders. In short, the Mindlins allegedly placed trades ahead of the trades they knew the financial institution would make. As the complaint alleged, this inside information allowed them to benefit from the impact that the financial institution’s large trades had on the securities’ value.

The SEC has a history of bringing cases involving front-running. For example, on January 25, 2011, another financial institution settled claims brought by the SEC alleging that the firm’s equity strategy desk improperly learned of trades the firm’s institutional clients were making and placed the same trades on their own account.6 A representative of the SEC was quoted in response to the settlement stating, “Investors have the right to expect that their brokers won’t misuse their order information.”7

The Challenge of Materiality

The critical issue in the Mindlin case is whether the information that the Mindlins allegedly used to place their trades was material. The entire market knew exactly which securities were going to be added to or dropped from the Fund because the S&P Index, which the Fund mirrors, published that information a few weeks before the Fund’s quarterly rebalance.8 The financial institution was the largest institution holding an interest in the Fund, but it was not the only institution, and it is likely that other financial institutions engaged in similar hedging practices to protect their own interests. The only information that was not publicly known was the size of the institution’s hedging trades. Thus, the case rises or falls solely on the issue of whether the size of the institution’s anticipated hedges, without more, was sufficiently important to a reasonable investor to meet the requirement of materiality; all other pertinent information was already known to the marketplace.

The SEC faced a similar challenge in SEC v. Rorech, its first case involving credit default swaps.9 In Rorech, the SEC charged a hedge fund portfolio manager and a bond salesman with insider trading involving a credit default swap based on insider information relating to changes in the structure of a bond offering by a Dutch company.10 The defendants prevailed in a bench trial because the SEC was unable to prove that the information was material.11 The court found that the information was “a generalized confirmation of an event that is ‘fairly obvious’ to every market participant who was knowledgeable about the company or the particular instrument at issue is not material information.”12 A similar hurdle is present in Mindlin, where the nature of the financial institution’s hedging practices regarding the Fund were widely known and the only piece of information lacking was the size of the firm’s trades. The SEC could attempt to distinguish Rorech by demonstrating that the institution’s hedges were so large and significant that information of its size would be material in and of itself, but that is a tall order.

A Possible Test of the SEC’s Administrative Forum?

This case also marks only the second time that the SEC has elected to file an administrative insider trading complaint rather than bringing suit in United States District Court, and it may present the first true test of the SEC’s new forum.13 The only previous administrative insider trading complaint was the SEC’s action against Rajat K. Gupta for allegedly tipping Raj Rajaratnam.14 Mr. Gupta challenged the SEC’s choice of an administrative proceeding, which he alleged deprived him of the broader discovery enjoyed by litigants in federal court and the right to a jury trial. Since the SEC later withdrew its complaint,15 the Mindlin case is an opportunity once again to address the viability of the SEC’s administrative forum, and many of the arguments raised by Mr. Gupta are likely to be renewed by the Mindlins. Additionally, the charges brought against the Mindlins stem from trades that took place in 2007 and 2008,16 while the SEC’s authority to bring such charges in an administrative proceeding did not originate until 2010 when the Dodd-Frank Act was passed.17 As a result, the issue of the SEC’s authority to retroactively apply the Dodd-Frank Act to bring charges in an administrative proceeding is squarely presented.

Conclusion

The SEC’s first-ever insider trading case involving an ETF is noteworthy in several respects. Initially, it will serve as a guidepost to the effectiveness of enforcement actions in the ETF environment and whether, over time, the SEC’s real focus turns out to be front running. Additionally, the case may set some parameters around the often elusive boundaries of “materiality,” particularly in an environment where nearly all of the most pertinent information was publicly known. Lastly, the case promises to provide further guidance on the legal viability of the SEC’s use of its administrative forum, as well as the circumstances in which the agency is likely to make the strategic calculation to forego filing an insider trading complaint in Federal District Court. Only time will tell if any of these issues sink the SEC’s maiden voyage into ETF insider trading.