December 4, 2006 Published Work
The Legal Intelligencer
The Securities and Exchange Commission was recently handed a significant defeat in SEC v. Heartland Advisors, Inc., when a U.S. District Judge dismissed civil insider-trading charges levied against an adviser and his client. While the decision was itself a damaging setback to the SEC’s ongoing efforts to deter insider-trading, the court added insult to injury in an opinion riddled with jabs at the SEC counsel’s professional conduct.
The case involved Heartland Advisor Inc., client William Krueger’s sale of $25,000 in shares of the Heartland Short Duration Fund (SDF), which Krueger sold immediately after a lunch meeting with Heartland president William Nasgovitz. In its complaint, the SEC alleged that Nasgovitz must have tipped Krueger about the upcoming devaluation of the SDF, based largely on the timing of the sale and the lunch date, which occurred shortly after Nasgovitz obtained information concerning SDF’s devaluation.
Despite the existence of several key uncontested facts that implied the existence of an insider-trading scheme, the SEC’s counsel apparently could not resist finessing their allegations in what they likely believed to be an exercise in persuasion. The court described the SEC’s actions – the most egregious of which are discussed below – as “playing fast and loose with the facts” and stated that counsel’s “pattern of misquoting an opponent and misrepresenting facts and law is especially distressing.”
First, the court admonished the SEC for misquoting Krueger’s testimony regarding his post-lunch visit to Heartland’s offices, where Krueger admittedly instructed Nasgovitz’s assistant to liquidate his SDF holdings. The SEC claimed that Krueger testified to returning to the Heartland offices after lunch for a tour of the new complex, and placed the word “tour” in quotes in their proposed findings of fact. Upon reviewing Krueger’s testimony and Wells submission, the court found that the word “tour” was never used by Krueger and, therefore, characterized the SEC’s use of quotes as “a misleading indication, at best.” Furthermore, the court pressed the issue in stating, “Perhaps the SEC is not unlike Britney Spears in its ability to use quotation marks correctly,” referring to the pop star’s improper use of air quotes in a recent NBC Dateline interview.
Next, the court addressed the SEC’s position that Nasgovitz’s assistant’s preparation of a summary of Krueger’s holdings prior to the lunch meeting supported an inference of an illegal disclosure. The court criticized the SEC for failing to mention that the assistant had prepared similar summaries in the past for other clients, and further stated, “There is nothing unusual or sinister about preparing a summary of a client’s holdings before the client’s business lunch with her boss.”
Furthermore, the SEC represented to the court that Krueger’s Wells submission explained the sale of his SDF shares as “part of a predetermined plan to sell one-third of his holdings each year for three years.” However, upon reviewing Krueger’s Wells submission, the court found that there was no discussion of a “predetermined plan.” Rather, Krueger’s Wells submission stated that he had established a “prior pattern” of SDF liquidation. (As discussed in Heartland, a prior pattern of trades may in fact negate an inference of insider-trading.)
Finally, the court found that the SEC misquoted Krueger’s testimony regarding Nasgovitz’s role as his account representative. The SEC stated that Krueger testified that he did not know that Nasgovitz was his account representative, but upon reviewing the record, the court found that Krueger merely stated that he did not know what the term “representative” meant.
In addition to being criticized for “playing fast and loose with the facts,” the court censured the SEC for citing an incomplete case holding. Specifically, the court found that the SEC – in citing Freeman v. Decio for the proposition that evidence of suspicious timing of trades relative to contact with an insider gives rise to an inference of insider trading – failed to state that, under Freeman, such an inference may be negated by demonstrating a prior pattern of trades. In reminding the SEC’s attorneys that they are “obligated to quote authorities accurately,” the court instructed them to review the Wisconsin Rule of Professional Responsibility regarding the duty of candor toward the tribunal. The court further urged the SEC to “remember that a suit by the SEC is akin to a criminal prosecution in that it is accusing a private individual of wrong-doing.” Therefore, the SEC’s duty in such a case is to act as the representative of “a sovereignty whose obligation to govern impartially is as compelling as its obligation to govern at all; and whose interest, therefore, in a criminal prosecution is not that it shall win a case, but that justice shall be done.”
The Heartland court’s harsh criticism of the SEC’s attorneys is something that is not often captured in a judicial opinion. However, this is far from the first time the SEC has been rebuked by a court. In U.S. v. Stringer, the SEC’s counsel was accused of “deceit and trickery” by a federal judge for improperly colluding with the U.S. Attorney’s Office and misleading three former executives into believing they were not the targets of a criminal investigation. In In re Brandt, Kelly & Simmons, LLC, an administrative law judge found the SEC had “mistakenly exalted form over substance” in charging an investment adviser and its co-founder with misappropriating client funds. The respondents had actually reimbursed the clients by giving them credit – in excess of the amount allegedly misappropriated – against their management fees.
The court in SEC v. Siebel Systems, Inc., criticized the SEC for “scrutiniz[ing] at an extremely heightened level, every particular word [in private statements by a company’s CFO] . . . including the tense of verbs and the general syntax of each sentence.” In WHX Corporation v. SEC, the court found that the SEC had failed to provide a “rational explanation” for the sanction it had imposed on a corporate defendant.
All of these cases have something in common beyond the tribunal’s harsh words for the positions or tactics taken by the SEC. The SEC lost every one of these cases, and these are far from the only losses sustained by the agency in recent years. For an agency that carefully reviews the cases it selects for prosecution, such results can be disastrous.
One clear message arises from this spate of Commission losses: Challenging the SEC can pay off. Of course, only those defendants with the necessary funds may be able to exonerate themselves, a troubling fact in itself.
Despite the SEC’s setbacks in Heartland Advisors and beyond, the SEC can be expected to vigorously pursue its enforcement agenda. Indeed, while the Heartland court dismissed the insider-trading charges in that case, other securities fraud charges remain against Nasgovitz, Heartland Advisors, and seven current and former Heartland Advisors officers and employees. Presumably, those charges will receive careful scrutiny from a judge already troubled by the Commission’s tactics. Regardless of the outcome in Heartland Advisors, however, litigants should be emboldened by the SEC’s courtroom missteps.
[Note: The full citation for the Heartland case is SEC v. Heartland Advisors, Inc., et al., No. 03-cv-1427, 2006 WL 2547090 (E.D.Wis. Aug. 31, 2006).]
