How Can Hedge Fund Managers Talk to Corporate Insiders Without Violating Applicable Insider Trading Laws?

The recent insider trading allegations against Raj Rajaratnam, founder of Galleon Group, and others highlight a predicament faced by many in the hedge fund industry: absent a seer-like insight (a la Buffett) or superior computers (a la Renaissance Technologies and others), the only way to consistently generate alpha is to consistently obtain information that is not available to others, or to apply information that is available to others in unique ways.  See “Billionaire Founder of Hedge Fund Manager Galleon Group, Raj Rajaratnam, Charged in Alleged Insider Trading Conspiracy,” Hedge Fund Law Report, Vol. 2, No. 42 (Oct. 21, 2009).  Especially after promulgation of Regulation Fair Disclosure (Reg FD), everyone can read and internalize the same disclosure documents at roughly the same time.  Therefore, hedge fund managers – especially those that invest in public equity or debt – have to talk to corporate insiders to stay competitive; to stay ahead, they have to talk to a lot of corporate insiders.  And hence the predicament: how to talk to corporate insiders without violating the insider trading laws?  Those laws generally prohibit trading while in possession of material, nonpublic information.  But what constitutes “materiality” for insider trading purposes, and what information is considered “nonpublic”?  For a hedge fund manager, analyst or trader who spends a good portion of each work day talking to corporate insiders, the line can often be blurry, and the consequences can be dire.  Galleon, for example, liquidated in record time in response to as yet unproven allegations of insider trading by its principal.  In recognition of the importance to hedge fund managers of avoiding insider trading allegations, this article examines the facts and allegations of the Galleon case; the statutory and regulatory bases for the prohibition of insider trading; 10b5-1 plans; the categories of financial instruments to which the prohibition applies; insider trading policies and procedures at hedge fund managers; specific best practices that hedge fund managers can employ to prevent insider trading or mitigate its impact; the “mosaic theory” of information gathering and use; and the utility and limitations of expert networks.

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