Insider trading prohibitions are based on Exchange Act Section 10(b). That statute requires proof of deception to establish a violation. Absent deception there is no violation of Section 10(b) and no insider trading.
Under the classic theory of insider trading deception is supplied by a corporate insider breaching his or her fiduciary duty. See, e.g., Chiarella v. U.S., 445 U.S. 222 (1980) [an enhanced version of this opinion is available to lexis.com subscribers]. The breach stems from using corporate information entrusted to the for personal benefit. Under the misappropriation theory deception comes from the fact that the person entrusted with the material, non-public information, feigns fidelity to the obligation under which it was entrusted, while disregarding it. See, e.g., U.S. v. O’Hagan, 521 U.S. 642 (1997) [enhanced version]
. Thus, under either theory insider trading is not about a parity of information in the market place – everyone having the same information. Rather, it is about deception and abuse. Nevertheless, the SEC appears to be suggesting a form of insider trading without deception in SEC v. Bauer, No. 12-2860 (7th Cir. Decided July 22, 20123) [enhanced version].
Bauer and mutual fund redemptions
The question presented by SEC v. Bauer is whether an employee of a mutual fund engages in insider trading by redeeming shares in the fund at a time when the trading window is open. Defendant Jilaine Bauer was employed at Heartland Advisors, Inc., an investment adviser and broker-dealer. Heartland advised a series of funds, two of which focused on municipal bonds. Those bonds can be difficult to price. Ms. Bauer was the general counsel and chief compliance officer to the adviser.
Beginning in 1999, and continuing through August 2000, the funds substantial net redemptions. This created liquidity problems. In mid-August 2000 the co-manager of the municipal bond funds tendered his resignation. Ms. Bauer imposed trading restrictions on Heartland personnel aware of that event. On September 28, 2000 a press release announcing the co-manager’s resignation was issued. At the time the municipal bond funds continued to struggle. After the close of business Ms. Bauer lifted the trading ban as approved by the board of directors.
On October 3, 2000 Ms. Bauer redeemed all of her shares in one of the municipal bond funds. At the time the two municipal bond funds continued to have liquidity problems.
The SEC named Ms. Bauer in an insider trading complaint. The district court granted summary judgment in favor of the Commission. That ruling was based on the stipulation of the parties that Ms. Bauer was an insider who possessed non-public information at the time of the redemptions and the court’s conclusion that there was no dispute of fact as to the materiality of that information. The Circuit Court reversed and remanded with instructions.
In the Circuit Court the SEC sought to rely on the misappropriation theory of insider trading. Before the district court the agency initially relied on the classic theory. In addressing the latter Ms. Bauer argued that there was no deception because the redemptions were with the fund which, by definition, could not be deceived by that act. As to the former, she asserted that there cannot be insider trading because the board of directors of the adviser approved lifting the trading ban and, in ordering the redemptions, she identified herself to fund as an employee.
The Seventh Circuit began by noting that the SEC had abandoned the classic theory and now must proceed on the misappropriation theory. The Court then concluded that this is the first case to consider if insider trading applies to mutual fund redemptions. In view of that point and, since the issue was not addressed by the district court, the case was remanded to that court for consideration of the issue.
It is axiomatic that insider trading under Section 10(b) requires the SEC to prove deception. That element is typically – but need not be – established by a breach of duty. See, e.g., SEC v. Dorozhko, 574 F. 3d 42 (2nd Cir. 2009) (deception supplied by hacking a computer) [enhanced version]. Yet the Commission and the courts seem to be rewriting that requirement. In SEC v. Knight, Civ. 2:11-cv-00973 (D. Ariz. Filed May 18, 2011) the Commission filed a settled insider trading action against a company employee who traded while in possession of inside information. Yet the employee placed the trades only after checking with the general counsel’s office which advised that trading was permitted prior to the close of the trading window. The trades were placed before the window closed. The SEC filed suit. Ms. Knight settled.
Similarly, in SEC v. Obus, Docket No. 10-4749 (2nd Cir. Decided Sept. 6, 2012) [enhanced version] the Commission charged a company employee with insider trading under the misappropriation theory despite the fact that the company conducted an internal investigation and concluded that there was no breach of duty to the company. While the employee prevailed in the district court, the Second Circuit reversed, holding that despite the position of the company, there could still be a breach of duty.
Bauer goes beyond Knight and Obus, eviscerating the statutory element of deception. If the case is viewed through the lens of the classic theory, deception cannot come from a breach of duty since the redemption was with the fund. It makes little sense to claim the fund was deceived since whatever knowledge Ms. Bauer had about the fund would be known to the fund which agreed to the redemption. If it is viewed in the context of the misappropriation theory, the source of the information – the fund – granted permission to trade, thus precluding a finding of deception. In Bauer the SEC thus goes beyond expanding the notion of insider trading to effectively rewriting the statute, eliminating the element of deception.
For more commentary on developing securities issues, visit SEC Actions, a blog by Thomas Gorman.
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