On July 22, 2013, the U.S. Court of Appeals for the Seventh Circuit reversed the district court ruling in Securities and Exchange Commission v. Bauer and remanded for further proceedings to consider the novel issue of whether and how the “misappropriation theory” of insider trading applies to mutual fund redemptions.
In the fall of 2000, Jilaine H. Bauer (the Defendant) served as general counsel, chief compliance officer, and chairperson of the pricing committee for Heartland Advisors, Inc. (HAI). The Defendant also served as vice president and secretary of Heartland Group, Inc. (HGI), an open-end fund complex. HAI was the investment adviser, principal underwriter and distributor for the HGI mutual funds, including the Short Duration Fund and the High Yield Fund (the Funds). Beginning in 1999 and continuing through October 2000, the Funds experienced substantial net redemptions, resulting in significant decreases in NAV and increased illiquidity. In addition, several of the Funds’ portfolio securities had defaulted or were in danger of default. In order to generate the cash required to meet redemption demands, the Funds began selling off securities at discounted prices. The Defendant redeemed all of her shares in the Short Duration Fund on October 3, 2000. Ten days later, HAI’s pricing committee instituted across-the-board “haircuts” on the Funds’ securities, resulting in NAV decreases of 44.02% and 69.41% for the two Funds, which entered receivership five months later.
On December 11, 2003, the SEC charged the Defendant with insider trading, and on May 25, 2011, the U.S. District Court for the Eastern District of Wisconsin granted summary judgment to the SEC under the “classical theory” of insider trading, which “targets a corporate insider’s breach of duty to shareholders with whom the insider transacts.” However, the SEC abandoned the “classical theory” on appeal, instead arguing that the Defendant was liable under the “misappropriation theory” of insider trading whereby the disclosure obligation “runs to the source of the information”—in this case, the Funds—rather than the trading counterparty. In reversing the district court’s order of summary judgment, the Seventh Circuit found that the lower court did not “weigh the novelty of the SEC’s claims in the mutual fund context” and remanded for further proceedings to consider the applicability of the “misappropriation theory” of insider trading to the Defendant’s redemptions and to resolve questions of fact related to the materiality of the Defendant’s non-public information and whether the Defendant acted with scienter.