Use Of Insider Information
The case of SEC v. Bauer (No. 12-1860) decided by the 7th Circuit Court of Appeals on July 22, 2013 represents an expansive discussion and application of insider trading principals. Bauer was the general counsel of the investment adviser of an open-end bond fund. Open-end funds are required to sell and redeem fund shares at any time. Because they cannot tell when they might be called upon to redeem shares in substantial quantities, they must have substantial cash available. The Fund sold bonds at the time it had a liquidity problem because its cash reserves were low and it had to liquidate shares from its portfolio.
At the time of sale, Bauer was seeking employment in another part of the country and had redeemed bonds of the Fund from her personal portfolio. The bonds had a value of about $44,000.
The SEC learned of Bauer’s sale and sought an injunction against Bauer for violating SEC Rule 10b-5. The District Court for the Eastern District of Wisconsin granted summary judgment to the SEC and Bauer appealed. The case is unusual as one of the few cases the SEC brought insider trading claims in connection with a mutual fund redemption.
The 7th Circuit reversed the granting of summary judgment and remanded to determine if Bauer’s conduct violated the misappropriation theory of insider trading.
After Bauer’s redemption, the SEC filed suit against Bauer and several other key management personnel of the Fund, the investment advisor and the broker dealer. The claims were brought under § 17(a) of the Securities Act, Section 10(b) of the Exchange Act, and SEC Rule 10b-5.
Section 10(b) prohibits fraud in connection with the purchase or sale of a security. The statute in part, provides:
“It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange –
. . .
(b) To use or employ, in connection with the purchase or sale of any security registered on a national securities exchange or any security not so registered, any manipulative or deceptive device or contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors.”
Section 10(b) thus prohibits (1) using any manipulative or deceptive device in contravention of rules prescribed by the SEC (2) in connection with the purchase or sale of securities.
Pursuant to its § 10(b) ruling making authority, the SEC adopted Rule 10b-5, which provides in part:
”It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange,
“(a) To employ any device, scheme, or artifice to defraud, [or]
. . .
(c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person,
In connection with the purchase or sale of any security.”
There are two theories of insider trading: (1) the classical theory, is violated when a corporate insider trades in securities of his corporation on the basis of material, non-public information. The relationship gives rise to an affirmative duty to disclose or abstain from trading so that the insider does not have an unfair advantage over uninformed purchasers or sellers of the companies’ stocks. (2) Under the “misappropriation theory” of insider trading § 10(b) is violated when a corporate outsider “misappropriates confidential information for securities trading purposes in breach of a duty owed to the source of the information.” This qualifies as a “deceptive device” because the outsider trades on confidential information entrusted to him for non-trading purposes, and thereby “defrauds the principal of the exclusive use of that information.” Under the misappropriation theory, the disclosure obligation “runs to the source of the information” rather than the trading counterparty – an outsider entrusted with confidential information must either refrain from trading or disclose to the principal that he plans to trade on the information. The misappropriation theory is “designed to protect the integrity of the securities markets against abuses by ‘outsiders’ to a corporation who have access to confidential information that will affect the corporation’s security price when revealed, but owe no fiduciary or other duty to the corporation’s shareholders.”
The SEC argued that Bauer violated both the classical theory and the misappropriation theory of insider trading. However, according to the 7th Circuit the SEC never presented the misappropriation theory to the district court. The SEC argued that Bauer was a traditional insider which was an invocation of the classical theory.
The Seventh Circuit stated that the relevant question is whether Bauer acted with scienter in abandoning ship – whether she knew or recklessly disregarded the fact that she was unfairly avoiding losses based on her access to non-public information. According to the 7th Circuit, “that is a permissible inference but not a mandatory one.”
The Court then discussed the distinction between when “possession” versus “use” of material non-public information is misapplied. The 7th Circuit then went on to state that the SEC has the burden to prove that insider information played a causal role in the trade and said that step will be up to the jury whether to infer the decision by Bauer to sell was influenced by the information.
In sum, this is a comprehensive opinion by Judge Zagel, a District Court Judge for the Northern District of Illinois, sitting by designation.
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