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1381Seventh Circuit Remands Mutual Fund Insider Trading Case

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  • Baker, John
    Jul 24, 2013
      Does it violate the federal securities laws when a mutual fund insider relies on inside information in redeeming shares? It's an open question, according to a decision from the U.S. Court of Appeals for the Seventh Circuit. SEC v. Bauer, No. 12-2860 (7th Cir. July 22, 2013). The decision remands the case for further proceedings to the district court, which previously had granted summary judgment for the Securities and Exchange Commission.

      According to the SEC's allegations, the general counsel of the investment adviser to a bond fund was aware that the fund would likely have to sell portfolio securities into an illiquid market to meet redemption demands, which would result in significant markdowns and a reduction in the fund's net asset value per share. She redeemed her own holdings in the fund, avoiding this loss. The SEC brought a civil enforcement action for insider trading and in 2011 obtained a summary judgment against her on the insider trading issue, which she appealed.

      The Seventh Circuit, in an opinion by District Judge James Zagel, sitting by designation, ruled that the threshold issue was whether, and to what extent, the insider trading theories apply to mutual fund redemptions. The district court apparently considered the defendant guilty of insider trading under the traditional or classical theory, under which Section 10(b) of the Securities Exchange Act of 1934 is violated when a corporate insider trades in the securities of his corporation on the basis of material, nonpublic information. The insider's fiduciary relationship gives rise to an affirmative duty to disclose to the trading counterparty or abstain from trading. On appeal, however, the defendant argued that mutual fund redemptions cannot entail the type of deception targeted by the classical theory because the counterparty to the transaction, the mutual fund itself, is always fully informed and cannot be duped through nondisclosure. The SEC then sought instead to justify its position under the misappropriation theory, under which Section 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.

      The Seventh Circuit ruled that the SEC never presented the misappropriation theory to the district court, which did not weigh the novelty of the SEC's claims in the mutual fund context, and it declined to rule on them in the first instance. It ruled that the SEC failed to brief the classical theory on appeal and therefore was deemed to have abandoned it. The Seventh Circuit also concluded that the defendant had raised substantial issues on materiality and scienter, making summary judgment inappropriate. It remanded the case to the district court for a ruling on whether the defendant's alleged conduct properly fits under the misappropriation theory of insider trading and, if so, for trial.

      The Seventh Circuit's opinion is available online at


      John M. Baker
      Stradley Ronon Stevens & Young, LLP http://www.stradley.com
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