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U.S. Court of Appeals Reverses Ruling on Mutual Fund Insider Trading Charges

A Court of Appeals ruled against the SEC recently in a case alleging that Jilaine Bauer, the former General Counsel and CCO of Heartland Advisers, had used inside information to wrongfully sell her mutual fund shares prior to a decline in value of those shares.  This case is unusual, as it is one of the very few times the SEC has brought charges of insider trading in connection with the purchase or sale of mutual fund shares. The Court of Appeals sent the case back to the District Court for more analysis.

The matter began in 2003 when the SEC sued several Heartland executives for insider trading and other violations of securities law. Heartland Advisors ultimately paid $3.5 million to settle the case, but Bauer, who left Heartland in 2002, decided not to settle with the SEC. Bauer argued publicly that her decision to sell her shares were based on information that was available to the public, and that the board had authorized employees to trade fund shares. The lower court ruled against her, finding that she had engaged in insider trading when she sold her Heartland mutual fund shares prior to a massive reduction in valuation of the fund shares.

The Court of Appeals, in overturning the lower court judgment, said that the “threshold issue in this case is whether, and to what extent, the insider trading theories apply to mutual fund redemptions.”  The SEC had relied upon the “misappropriation” theory of insider trading, which generally requires a corporate outsider to misappropriate confidential corporate information for a securities trade, breaching a legal duty to the source of the information. The court appeared skeptical that this insider trading theory could be applied in the mutual fund context.  “For example,” the court said, “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.”

In the ruling reversal, the appeals court did not rule out the possibility that a court could find that an individual had engaged in insider trading by selling mutual fund shares.  Yet, the court wrote, “the application of insider trading theories to mutual fund redemptions is uncharted territory.” The opinion notes that “it is the SEC’s task to develop a sound application of the misappropriation theory to the facts of this case.” The agency did not comment on whether the case will be settled or dropped.