Novelty of Mutual Fund Charges Need 2nd Look

     CHICAGO (CN) – A federal judge must re-examine the novel charges a lawyer faces for the alleged inside trading of mutual fund shares, the 7th Circuit ruled.
     Jilaine Bauer worked as general counsel and chief compliance officer for investment brokerage company Heartland Advisors from 1998 to 2002. Previously she served as the Milwaukee company’s senior vice president and secretary. Heartland Group, a related mutual fund management company, also previously employed Bauer as a vice president and secretary.
     In her final capacity of chief compliance officer, Bauer was responsible for implementing Heartland’s policy against insider trading.
     The Securities and Exchange Commission took interest in Bauer’s involvement with two Heartland mutual funds, the Short Duration Fund and High Yield Fund, which were primarily invested in medium- and lower-quality municipal bonds designed to generate federally tax-exempt income.
     As a senior manager, Bauer was encouraged to invest in the funds. She maintained approximately 5,000 shares in the Short Duration Fund, but none in the High Yield Fund.
     Trouble began in 1999, as the funds struggled to maintain their required 15 percent liquidity in spite of substantial redemptions by investors. In the first six months of 2000, the Short Duration Fund’s net assets shrunk by $21.5 million. The High Yield Fund saw a $7.6 million decrease during this time.
     Since a growing number of the funds’ bonds had defaulted or had been placed on a “watch list” for default, the funds had trouble selling off securities to maintain liquidity.
     Heartland’s attempts to revive the funds included the resignation of a co-manager for the municipal bond funds, a deal with the State of Wisconsin Investment Board, and an in-house valuation of the funds’ assets. During this time, Bauer imposed trading restrictions on Heartland personnel.
     But in September 2000, Bauer emailed Heartland executives “advising them to ‘only keep those records that you are required to maintain, and eliminate on a regular basis any other material in your files.'” Bauer then lifted the employee trading restrictions. Both funds saw a significant decrease in value the same day.
     Bauer soon redeemed all of her shares, receiving almost $45,000 total.
     Additional across-the-board “haircuts” caused the funds’ values to plummet: 44 percent for the Short Duration and 70 percent for the High Yield. The funds entered receivership in early 2001.
     On Dec. 11, 2003, the SEC charged Heartland and several of its personnel with insider trading, as well as violations of the Investment Company Act and Investment Advisers Act.
     All defendants except Bauer entered into settlement agreements. The SEC won summary judgment against her on insider trading, but dismissed all other charges.
     A three-judge panel for the 7th Circuit reversed on appeal, finding that the trial court had failed to address the novelty of the SEC’s claims.
     “This case is unusual,” according to the decision signed by U.S. District Judge James Zagel, sitting in by designation from the Northern District of Illinois. “It is one of few instances in which the SEC has brought insider trading claims in connection with a mutual fund redemption. No federal court has opined on the applicability of insider trading prohibitions to the trade of mutual fund shares.”
     There are two categories of insider trading claims, Zagel pointed out. Under the “classical theory,” an insider makes trades on the basis of “material, non-public information.” Under the “misappropriation theory,” a corporate outsider gains an unfair advantage on the basis of such information.
     Although neither theory has ever been applied to mutual fund transactions before, the SEC appeared to argue that both theories could apply to Bauer. The agency largely pursued the classical theory before the District Court, but relied instead on the misappropriation theory on appeal.
     Bauer in turn argued that her redemption was not “a deceptive breach of her loyalty and confidentiality” to Heartland Group because the company had already approved the trade window for employees, and Bauer identified herself as a Heartland employee when redeeming her shares, Zagel wrote.
     Instead of addressing the arguments, the 7th Circuit remanded the case for further proceedings.
     “We do not comment on the merits of these arguments,” the 38-page opinion states. “It would be fundamentally unfair to limit Bauer’s defense against the misappropriation theory to a few pages of reply briefing in this court, rather than allow her a full opportunity to develop these arguments before the District Court.”
     Bauer furthermore is entitled to a trial on the question of whether the seven “categories” of nonpublic information she possessed were “material” for the purposes of the insider trading statute, according to the ruling.
     Clevert failed to weigh Bauer’s nonpublic information against the “considerable publicly available information,” which included several news articles criticizing the funds, the court found.
     “It is a close question, but we think an assessment of the marginal impact that negative nonpublic information would have on an already highly pessimistic public forecast is ‘peculiarly’ one for the trier of fact,” Zagel wrote.
     Moreover, Clevert failed to distinguish between information about the Short Duration Fund, in which Bauer had invested, and the High Yield fund.
     “This is troubling because the record suggests that the High Yield Fund was in considerably worse shape than the Short Duration Fund throughout the relevant time period,” Zagel wrote.
     “Investors were on notice that either fund could invest up to 15% of its net assets in illiquid securities, so we think it is wrong to say that Bauer’s insider knowledge of defaulted and watch list securities in the Short Duration Fund is material as a matter of law,” he added.
     Finally, the appeals court held that Bauer is entitled to a trial to determine whether she acted with scienter, or “intent to deceive, manipulate, or defraud.”
     “This case is seems unusual in that Bauer is charged with insider trading for a sale that took place after a series of price declines,” Zagel wrote. “This muddies the scienter analysis because insiders are permitted to make rational investment choices based on information available in the market.”
     Bauer’s two legitimate explanations for redeeming her shares – the fund’s poor performance and an anticipated move to San Francisco – should be evaluated by a jury, the court concluded.
     “We reverse the order entering summary judgment and remand so that the district court can 1) rule on whether Bauer’s alleged conduct properly fits under the misappropriation theory of insider trading; 2) dismiss the insider trading claims against Bauer if it determines the answer to this question is ‘no,’ and hold a trial if it determines the answer is ‘yes.'”

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