How Can Hedge Fund Managers Prevent Theft of Proprietary Trading Technology and Other Intellectual Property?

Hedge fund managers who have made or are contemplating significant investments in proprietary technology, such as trading technology, face at least three major issues: (1) whether to develop such technology internally or buy or lease it from a third party; (2) whether to seek to patent it; and (3) how to prevent theft.  The relevance of these issues has been highlighted recently by at least two developments: the debate surrounding flash trading, and the implicit recognition in that debate that sophisticated trading technology has become central to the investment strategies of many hedge funds; and Citadel Investment Group’s recent lawsuit against three former employees and their new firm for alleged theft of Citadel’s trading technology.  On flash orders, see “What Are Flash Orders, and How Might Regulation Curtail the Ability of Hedge Funds Employing High-Frequency Trading Strategies to Profit from Such Orders?,” Hedge Fund Law Report, Vol. 2, No. 32 (Aug. 12, 2009); and on the Citadel suit, see “Citadel Investment Group Sues Former Employees Alleging Violations of Non-Disclosure, Non-Solicitation and Non-Compete Agreements,” Hedge Fund Law Report, Vol. 2, No. 28 (Jul. 16, 2009).  Based on interviews with specialists working at the intersection of technology and hedge fund investments and operations, the consensus answers to these questions appears to be: while every situation is unique and it is difficult to generalize with any reliability, more often than not, hedge funds would be better served by building their own technology than by licensing it, in cases where that technology is central to their trading strategy or operational infrastructure.  Among other things, building versus buying vests more control in the manager over its technology and changes and revisions thereto, and it increases the value of the advisory entity and the case for investors to invest with the manager as opposed to any other licensee of a third-party technology.  As for whether to seek patent protection, the answer, with exceptions, is often no because the process is long, the protection is uncertain, seeking patent protection may require disclosure of information that can undermine the proprietary value of the technology and most hedge fund technology is intended for use only by the manager; it is not intended to generate revenue via licensing.  And as for how to prevent theft, techniques involve confidentiality agreements and similar contractual protections, robust pre-employment (or pre-independent contracting) screening and security measures embedded in the technology itself.  Though as the Citadel case demonstrates, even with carefully thought-out protections, intellectual property (IP) remains uniquely susceptible to theft.  This article explores the three issues identified above – build versus buy; whether to seek to patent; and how to protect; includes an update on and analysis of the Citadel case; and discusses “soft” IP (copyright and trademark) in the hedge fund context.

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