In the midst of recent, high-profile insider trading investigations and prosecutions, the Seventh Circuit issued a decision marking “unchartered territory” in the SEC’s continuing crackdown on insider trading: mutual fund redemptions, but it sidestepped the critical question.
In SEC v. Bauer,1 a federal court explored for the first time, but left unresolved, the important question of whether the misappropriation theory of insider trading may be used to impose Section 10(b) liability in connection with the redemption of mutual fund shares. While the Seventh Circuit appears to have expressed some skepticism regarding the applicability of the misappropriation theory in the mutual fund context, the court did not rule out the possibility that the SEC may be able to utilize Section 10(b) in this context, which may have serious implications not only for mutual fund advisers, broker-dealers, underwriters and investors but also for other companies, fiduciaries and individuals in the asset management and financial services industries.
Theories of Insider Trading
The law of insider trading is nuanced and evolving and requires careful consideration of the legal issues and facts of each case in consultation with counsel. Generally speaking, claims or charges of insider trading arise where a security is traded while in possession of material nonpublic information, and the trader has breached a duty of trust or confidence owed to the issuer of the security, the issuer’s shareholders or the source of the information and is aware of the breach, or, more recently, where the trader has made an affirmative misrepresentation.2
Such conduct has been held to violate the proscriptions of Section 10(b) of the Exchange Act, which makes it unlawful to “use or employ, in connection with the purchase or sale of any security . . . any manipulative or deceptive device or contrivance in contravention of” any rules or regulations promulgated by the SEC.3 The SEC’s Rule 10b-5 provides as may be relevant here that it is unlawful, “in connection with the purchase or sale of any security,” to “employ any device, scheme, or artifice to defraud” or “engage in any act, practice or course of business which operates or would operate as a fraud or deceit upon any person.”4 Courts have recognized the following theories of insider trading pursuant to Section 10(b) and Rule 10b-5:
- “Classical” Theory – The classical theory of insider trading generally may be applied where a company insider trades in the company’s securities on the basis of material nonpublic information obtained by reason of the insider’s fiduciary relationship to the company.5 SEC Rule 10b5-1, which became effective on October 23, 2000, defines the concept of trading “on the basis of” material nonpublic information to mean that the insider merely was “aware” of the information at the time of the trade.6
- “Tipper-Tippee” Theory – Liability for insider trading may be imposed based upon the “tipper-tippee” theory in situations where: (1) a person (the “tipper”) discloses material nonpublic information about a company in breach of his fiduciary duty to its shareholders; (2) the person receiving the information (the “tippee”) “knows or should know” of the breach; (3) the tippee uses the information in connection with a securities transaction; and (4) the tipper receives a direct or indirect “personal benefit” in return,7 such as receipt of “a pecuniary gain or a reputational benefit that will translate into future earnings” or the conferral of a “gift of confidential information to a trading relative or friend.”8
- “Misappropriation” Theory – Under the “misappropriation” theory, a person who is not an insider may be liable for insider trading when he or she trades based on (or discloses to another person to trade) material nonpublic information in violation of a duty of trust or confidence owed to the source of the information.9
- “Outsider Trading” or the “Affirmative Misrepresentation” Theory – This theory was articulated by the Second Circuit in a case involving an alleged computer hacker who had accessed Thomson Financial’s computer system and obtained and traded on the unpublished earnings information of a company to which the defendant owed no duty. In that particular case, SEC v. Dorozkho, the Second Circuit held that “an affirmative misrepresentation is a distinct species of fraud” and may violate Section 10(b) regardless of the existence of a fiduciary duty.10 This theory therefore may permit liability for insider trading in the absence of a fiduciary duty where an affirmative misrepresentation, rather than a nondisclosure, is made in connection with the purchase or sale of securities.11
The “Unusual” Insider Trading Case Involving Mutual Fund Redemptions: SEC v. Bauer
Jilaine Bauer (“Bauer” or “Defendant”) was employed by Heartland Advisors, Inc., an investment advisor and broker-dealer in Milwaukee, Wisconsin (the “Investment Adviser”).12 The Investment Adviser managed the portfolios for Heartland Group, Inc., an open-end management investment company (the “Investment Company”).13 It also underwrote and distributed shares of the Investment Company’s mutual funds, which included certain municipal bond funds (the “Funds”), including the Fund in which Defendant ultimately invested.14 During the relevant time period, Defendant served as general counsel, chief compliance officer and chairperson of the pricing committee of the Investment Adviser.15 She also served as a vice president and secretary of the Investment Company.16
Beginning in 1999 and continuing up until and after the time at which Defendant redeemed her shares,17 the Funds experienced significant liquidity problems as a result of substantial redemptions and the fact that a growing number of bonds in the Funds’ portfolio had defaulted or were at risk of default.18 At the same time, the Funds were unable to sell the bonds at book value, which also led to reservations regarding the accuracy of the securities’ valuations and the discussion of possible reductions to price.19 In the midst of these liquidity, redemption and credit problems and the “internal speculation” regarding valuation and pricing, one of the Fund managers tendered his resignation, and Defendant imposed trading restrictions on all Investment Adviser personnel (including herself) who had become aware of the tendered resignation.20 The resignation was deferred until late September 2000, at which point the Investment Adviser issued a press release announcing the departure of the Fund manager and the hiring of a replacement.21 Defendant then lifted the trading restrictions, after informing the Investment Company’s board and its independent counsel, as well as the President of both the Investment Company and the Investment Adviser and the Vice President and Chief Operating Officer of the Investment Adviser.22 A few days later, on October 3, 2000, Defendant redeemed all of her shares in the fund, for approximately $45,000.23 In a call requesting redemption of her shares, Defendant identified herself by name and stated that she was an employee of the Investment Adviser.24 Approximately two weeks later, the Investment Adviser’s pricing committee applied “haircuts” to all of the Funds’ securities, resulting in further significant markdowns to the Funds’ net asset values.25 The Funds entered into receivership several months later.26
In December 2003, the SEC sued the Investment Manager and several executives, including Defendant, for insider trading and other securities law violations.27 All defendants but Bauer ultimately settled with the SEC.28 In May 2011, the district court granted the SEC summary judgment on the insider trading charges and, in September 2011, dismissed the remaining claims against Defendant.29 The district court granted summary judgment based on: (1) a stipulation that Defendant was an insider who possessed nonpublic information regarding the Funds and their underlying securities, including (a) the Funds’ liquidity, redemption and credit problems, (b) details regarding the bonds that had defaulted and those that were deemed at risk of default, (c) details regarding the sale of certain non-performing bonds to another entity (which had been provided a put option that would allow it to sell the bonds back to the Investment Adviser after two years at a 20% return), (d) the internal dispute as to whether the bonds in the Funds’ portfolio should be sold at “distressed prices” and (e) the fact that a sale or merger of the Funds was being contemplated;30 and (2) the district court’s findings that there existed no genuine issue of material fact as to the elements of materiality and scienter.31 Defendant appealed.
On appeal, Defendant argued that mutual fund redemptions cannot constitute deception under the classical theory of insider trading because the counterparty (i.e., the mutual fund) “is always fully informed and cannot be duped through disclosure.”32 As the court explained, the SEC “apparently recogniz[ed] some merit to this argument” and dropped the classical theory on appeal, arguing only the misappropriation theory in its response.33 In that regard, the SEC claimed that Defendant: (1) owed a fiduciary duty to the Funds and its shareholders given her position as an officer of the Investment Company, and thus had a duty to refrain from using material nonpublic information in the redemption of her shares; and (2) owed a fiduciary duty to the Investment Company based on the client relationship arising from her position as an employee of the Investment Adviser, which required that she disclose to the Investment Company her intentions to trade based on confidential information.34 Defendant argued on reply that her redemption could not constitute a deceptive breach of her duty to the Investment Company because: (1) the Investment Company had approved the opening of the trading window; and (2) she had identified herself as an Investment Adviser employee when redeeming shares, which constituted disclosure to the principal.35
The Seventh Circuit in its decision acknowledged that this action is “one of the few instances in which the SEC has brought insider trading claims in connection with a mutual fund redemption” and is thus “unusual.”36 The court explained that “[n]o federal court has opined on the applicability of insider trading prohibitions to the trade of mutual fund shares”37—adding later that this is “largely because the SEC has never brought a § 10(b) claim in the mutual fund context.”38 The court then made several critical observations. First, the Seventh Circuit observed that the district court had not been “alert[ed]” to the “novelty” of the claims and the “threshold” legal issues;39 specifically, “whether, and to what extent, the [classic and misappropriation] insider trading theories apply to mutual fund redemptions.”40 Thus, the district court had not been called upon to “explain how Bauer’s alleged conduct may fit under either theory of insider trading.”41 Second, the Seventh Circuit observed that while the district court had relied on the classical theory of insider trading, it “did not, however, weigh the novelty of the SEC’s claims in the mutual fund context. As such, it did not explain how, exactly, a mutual fund redemption could fit under the classical theory of insider trading.”42 Third, the Seventh Circuit found that the misappropriation theory had never been presented to the district court. Thus, the “upshot” was that the Seventh Circuit had been asked to affirm summary judgment based on a theory of insider trading that was never presented to the district court and an opinion that did not “consider that a mutual fund redemption has never been recognized to fit under either theory.”43
Accordingly, the Seventh Circuit reversed and remanded, on several grounds. With regard to the question of whether Defendant’s conduct constituted deception under insider trading theories, the court declined to consider the classical theory of insider trading given the SEC’s failure to brief the issue and, thus, its forfeiture of that argument, on appeal.44 With respect to the misappropriation theory, the court concluded that it would be “fundamentally unfair” to deprive Defendant of the opportunity to fully develop and present to the district court arguments and evidence regarding the misappropriation theory.45 The court reasoned that remand was warranted given the novelty of the issue presented, expressing some skepticism regarding the SEC’s position but making clear that it was not ruling out the viability of an insider trading claim involving the buying and selling of mutual fund shares based on the misappropriation theory:
[W]e think the SEC’s briefing to this court on the applicability of the misappropriation theory may overlook certain structural realities of a mutual fund. For example, the Commission might unravel for the district court how an officer at a mutual fund investment adviser can be fairly considered a corporate “outsider” given the investment adviser’s deeply entwined role as sponsor and external manager of the fund.
The application of insider trading theories to mutual fund redemptions is uncharted territory, and the approaches fashioned in other areas may not be appropriate analytical models in the mutual fund context. We certainly do not rule out the applicability of § 10(b) to the mutual fund industry; we simply emphasize the need for conceptual clarity to explain how the core elements of insider trading might arise in the trade of mutual fund shares. It is the SEC’s task to develop a sound application of the misappropriation theory to the facts of this case.46
The court added that, “[i]f the SEC’s position is that the misappropriation theory needs to be adjusted or expanded to ‘effectuate’ § 10(b)’s remedial purposes in the mutual fund context, it should present that argument to the district court.”47 The court therefore remanded for a determination of the threshold question of whether Defendant’s alleged conduct “properly fit under the misappropriation theory of insider trading.”48
Finally, the court found that remand was appropriate for the additional reasons that Defendant was entitled to a trial on the questions of materiality and scienter. On the issue of materiality, the court found, for instance, that the district court had committed error in failing to weigh the nonpublic information that Defendant had possessed against “the considerable publicly available information regarding the Funds’ poor performance.”49 As regards scienter, the court found, among other things, that the district court had erred in concluding that no reasonable juror could find that Defendant’s concerns regarding price volatility were based on the Funds’ declining net asset values and “publicly understood risks of future uncertainty.”50 Observing again that the case was “unusual”—this time for the reason that Defendant had been “charged with insider trading for a sale that took place after a series of price declines”—the court concluded that “[t]his muddies the scienter analysis because insiders are permitted to make rational investment choices based on information available in the market; § 10(b) certainly does not require an insider to go down with the company ship when the public knows just as well that it is sinking.”51
Potential Ramifications and Best Practices
The questions raised by the potential application of existing theories of insider trading to transactions in mutual fund shares would appear to extend to the redemption of investments in other investment vehicles such as hedge funds, money market funds and funds of funds.
The Seventh Circuit’s decision and a forthcoming decision by the district court on remand have the potential to lead to serious ramifications for both the funds themselves—especially in situations where the funds invest in other funds and may come into possession of nonpublic valuation information—as well as fund insiders such as general counsel, officers and directors who may be presumed to be aware of nonpublic information and thus may be susceptible to allegations of insider trading (just as such insiders of other companies or financial services firms are susceptible to such claims). Much of the concern may be cured through carefully crafted public disclosures prior to any trading. If a fund discloses in advance of any trading the potentially material information related to valuation, redemption or liquidity issues, then any insider trading concerns should be eliminated.
Another possible solution for individuals is a 10b5-1 plan. A 10b5-1 plan is a written plan to buy or sell securities that is adopted by an insider at a time when the insider is unaware of material nonpublic information.52 Entering into such a plan provides the insider with an affirmative defense to insider trading relating to the execution of any predetermined transactions pursuant to the plan, even if such trades are executed at a time when the individual is aware of material nonpublic information that would otherwise subject him or her to Section 10(b) liability.53
The question becomes far more complex when the fund itself is faced with a trading decision while possessing nonpublic information with respect to the valuation of some of the fund’s holdings, redemptions or liquidity concerns. While the question of whether there has been insider trading depends heavily on the materiality analysis (the SEC must prove that the non-public information possessed by the fund insider was important to the investment decision of a reasonable investor),54 the underlying conduct in Bauer seems to have been egregious and there is a concern that the adage “bad facts make bad law” may come into play on remand. If the district court fails to set parameters around the application of the misappropriation theory in the mutual fund context, funds might be frozen from making important, strategic trading decisions to protect investors simply because the fund itself possesses nonpublic information that the SEC alleges is material—an unintended consequence with dangerous ramifications to the fund industry. Although courts traditionally have required a breach of some duty in order for there to be insider trading—and, in the preceding example, the trading would be in accordance with a duty—the Second Circuit’s decision in Dorozhko has allowed the SEC to bring cases where no duty was breached so long as the trader made an affirmative misrepresentation.55 To date, Dorozhko has not been applied to issues in the fund industry, but the law of insider trading remains constantly evolving.
Finally, this case, as other recent high-profile civil and criminal cases involving insider trading, illustrates the need for caution. While the law may be unsettled in this area, companies and individuals in the financial services industry and beyond should expect that the SEC will continue to enforce insider trading laws, at potentially considerable financial loss and reputational damage to businesses and individuals that are the targets of the SEC’s inquiries. Accordingly, a prudent course of action for companies and individuals confronted with trading decisions while in the possession of nonpublic information is to seek the advice of independent counsel. In addition, companies should establish robust and comprehensive insider trading policies and procedures, and exercise vigilance in implementing and monitoring compliance with such programs. Effective policies and procedures are designed to address: (1) the creation of walls or “information barriers” between a company’s public and private business units or sectors; (2) the selection of expert networks and experts, including due diligence, screening and approval protocols; (3) interactions with experts and investment dealers or others who may have agency duties to a public company; (4) the monitoring, surveillance and supervision of interactions with experts and investment advisers and of trading with issuers that are the subjects of such interactions; (5) the internal review of any trading resulting in unusual gains or loss avoidances; (6) the training of all employees on the law of insider trading, the company’s policies and procedures and the process for reporting to the compliance department; (7) violations of insider trading policies and procedures; and (8) the documentation of steps taken in compliance with the foregoing protocols.56 Such programs not only reduce the likelihood that employees will engage in wrongdoing but also enable the company to self-report where necessary and quickly respond in the event that regulators make inquiries.
Whether traditional theories of insider trading can be applied to impose Section 10(b) liability for trading in mutual fund shares remains to be seen. A federal court of appeals has invited the SEC to attempt again to make that argument, based on the theory of misappropriation. Whether or not the SEC prevails, the case of SEC v. Bauer is definitely important to watch.