This piece originally ran on All About Alpha
Litigation continues to redefine the boundaries of the sometimes slippery concept of “insider trading.”
In a new development worth watching, the U.S. Court of Appeals for the 7th Circuit has reversed a judgment of the district court below and remanded for further proceedings in a dispute over whether insider trading principles apply to the redemption of mutual fund shares. In the process, the panel draws a sharp distinction between corporate stock and mutual fund redemptions for the purpose of a “traditional” insider trading theory. So far as I can tell, the court’s reasoning would apply as well to the act of redeeming an investor’s interest in alternative investment vehicles, hedge funds and the like.
Tentative industry victory
The remand itself, a decision issued on July 22, constitutes a victory, albeit a tentative one, for the asset management industry and for its investors. The district court, in the Eastern District of Wisconsin, had granted summary judgment to the Securities and Exchange Commission in the underlying dispute, with Heartland Advisors Inc. But the appeals court, or a three-judge panel thereof, is now saying that the district court was not fully aware of the “novelty of the claims involved,” and it wants those claims weighed more carefully before any judgment issues. [the 7th Circuit encompasses the federal judicial districts in Illinois, Indiana, and Wisconsin.]
The named defendant is Jilaine Bauer. During the relevant period (1998 to 2002), Bauer was the general counsel and chief compliance officer of Heartland Advisors Inc., the firm that managed the Heartland Group Inc. and that underwrote HGI’s mutual funds. The two funds pertinent to this litigation were invested chiefly in medium and low quality municipal bonds in the expectation that they would produce a “high level of federally tax-exempt current income.”
On Aug. 10, 2000, Bauer attended a meeting of HGI’s board of directors at which several of the problems then facing the muni bond market were discussed. Over the next few days, she exchanged e-mails with key HGI personnel. The appellate court opinion, written by District Judge James B. Zagel (sitting on the three-judge panel by designation) says that she understood that there was a serious difficulty posed by the level of net redemptions from these funds.
As the funds met the redemption demands, HAI found that it had trouble selling off the portfolio securities at carrying prices “because a growing percentage consisted of bonds that had defaulted or were placed on a ‘watch list’ for potential default.”
Almost two months after that meeting, on the morning of October 3, 2000, Bauer placed an order by telephone for the redemption of all the shares she then owned in the Short Duration Fund. In the lawsuit it later filed, the SEC contended that this sale allowed her to avoid more than $20,000 of losses.
Did Bauer commit securities fraud by trading on her knowledge, as a participant in directors’ meetings etc, of the severity of Heartland’s liquidity crunch? Under the classical insider trading theory, §10(b) of the pertinent statute is violated “when a corporate insider trades in the securities of his corporation on the basis of material, nonpublic information.” This is a “deceptive device” because it breaches the relationship of trust between shareholders and insiders.
The district court seems to have relied on that notion, writing when it granted summary judgment that “the parties agree that Bauer was an insider at the time of her trade.”
The problem, though, is that in contrast to a typical trade in the stock of a public corporation, a mutual fund redemption is not a transaction between an insider on the one hand and an outsider, a dupe, on the other. No, the counterparty in redemption is by definition to mutual fund itself, an insider as to its own affairs. The fund “cannot be duped by nondisclosure,” the opinion says, so the traditional argument is at best an awkward fit.
The SEC on appeal pressed the more recent alternative theory in insider-trading law, misappropriation, as in the O’Hagan case. Indeed, it pressed this view so exclusively that the appellate court deemed the agency to have “abandoned and forfeited the classical theory as a basis for liability in this case.
The misappropriation theory would hold that liability is appropriate because Bauer misappropriated confidential information that she received – at the board of directors’ meeting for example – in breach of a duty owed to the source of that information.
But this theory was never properly presented to the district court, so there is no proper record on appeal. Hence the remand: the SEC can try again. And that will be worth watching.