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Wisconsin District Court Grants Summary Judgment and Dismisses Case Regarding Insider Trading Prohibitions and Mutual Fund Redemptions

On August 29, 2014, the U.S. District Court for the Eastern District of Wisconsin granted Jilaine H. Bauer’s motion for summary judgment in Securities and Exchange Commission v. Bauer and dismissed the SEC’s case, determining that an insider trading claim brought under a “misappropriation theory” was not properly presented to the court and that a “misappropriation theory” did not properly apply to the conduct of Ms. Bauer, who at all relevant times was a corporate insider.

In the fall of 2000, Ms. Bauer served as general counsel, chief compliance officer and chairperson of the pricing committee for Heartland Advisors, Inc. (HAI), and as vice president and secretary of Heartland Group, Inc. (HGI), an open-end fund. 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. Ms. Bauer 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 Ms. Bauer with insider trading, and on May 25, 2011, the district court 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.” In order to expedite the entry of judgment against Ms. Bauer on the insider trading claim, the SEC filed an unopposed voluntary motion to dismiss with prejudice all claims against Ms. Bauer other than the counts of insider trading discussed in the May 25, 2011 opinion. The district court granted the SEC’s voluntary motion to dismiss on September 20, 2011.

On appeal to the U.S. Court of Appeals for the Seventh Circuit, Ms. Bauer argued that the “classical theory” is inapplicable to mutual fund redemptions because the trading counterparty—the mutual fund itself—is inherently fully informed and “cannot be duped through nondisclosure.” The SEC abandoned the “classical theory” on appeal, instead arguing that Ms. Bauer was liable under the “misappropriation theory” of insider trading, whereby the disclosure obligation “runs to the source of the information” rather than the trading counterparty.

On July 22, 2013, the Seventh Circuit reversed the district court’s ruling 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 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” because the SEC had not asserted the “misappropriation theory” of insider trading at the district court level. The Seventh Circuit remanded for further proceedings to consider the applicability of the “misappropriation theory” to Ms. Bauer’s redemptions and to resolve questions of fact related to the materiality of Ms. Bauer’s non-public information and whether Ms. Bauer acted with scienter.

On remand, the district court granted summary judgment to Ms. Bauer and dismissed the remainder of the SEC’s insider trading case. In granting summary judgment, the district court noted that the SEC never properly raised the “misappropriation theory” before the court, and that, as a general matter, any theory not raised before the district court is deemed waived or forfeited. In addition, the district court noted that the “misappropriation theory” was different from the insider trading claim discussed in the court’s May 25, 2011 opinion and, as a result, any claim based on such theory would have been dismissed with prejudice pursuant to the SEC’s voluntary motion to dismiss granted on September 20, 2011. Moreover, the district court refused to extend the “misappropriation theory” of insider trading to Ms. Bauer given her status as an officer of the investment adviser to the Funds at all relevant times. The district court could find no precedent supporting the extension of the “misappropriation theory,” which has generally been interpreted to apply only to conduct by corporate outsiders, to a corporate insider and stated that the SEC did not sufficiently explain “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.”

© 2021 Vedder PriceNational Law Review, Volume IV, Number 253
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About this Author

Vedder Price P.C. attorneys provide a full range of services to a diverse financial services clientele. Attorneys practicing in the firm’s Investment Services Group are experienced in all aspects of investment company and investment adviser securities regulations, broker-dealer regulatory and compliance matters, derivatives and financial product matters, and ERISA and tax matters. Clients include mutual fund complexes, hedge and other private funds, money managers, broker-dealers, independent directors, and many other types of institutions such as banks, savings and loans,...

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