All hedge fund managers, in a manner of speaking, are in the information business – the business of collecting, analyzing and acting on a significant volume of complex information. At a similar level of generality, many of the federal securities laws and rules govern the use that may and may not be made of certain categories of information. At one end of the spectrum of permissibility is material, nonpublic information. Generally, hedge fund managers may not trade securities based on such information where it is obtained from someone with a fiduciary duty to the issuer of those securities. At the other end of the spectrum is public information, such as that gleaned from public filings such as annual or quarterly reports. Somewhere in the middle is so-called “market color,” generally understood to refer to information that is more specific to a company, industry or market than public information, but that does not rise to the level of material, nonpublic information. In other words, if information is market color, a hedge fund manager can trade on it, whereas if information crosses the line from market color to inside information, a manager cannot trade on it. However, the distinction is easier to draw in hindsight, and the line is often blurry. Moreover, as recent insider trading charges have demonstrated, the practical standard of proof in the court of institutional investor opinion is significantly lower than in a civil or administrative proceeding: insider trading charges alone, even if unproven, are sufficient to unravel a hedge fund business that may have taken years to build. 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); “SEC Sues Hedge Fund CFO and Venture Capital Fund CFO Alleging Insider Trading in Tempur-Pedic and Acxion Stock
,” Hedge Fund Law Report, Vol. 2, No. 45 (Nov. 11, 2009); “A Pequot Postmortem: What is Headline Risk and How Can it be Avoided or Mitigated?
,” Hedge Fund Law Report, Vol. 2, No. 24 (Jun. 17, 2009). At the same time, many traders, analysts and others at hedge fund managers have to determine on a day-to-day basis whether certain categories of information they receive, alone or in combination with other information possessed by them or their firms, constitutes market color that may be acted upon, or material, nonpublic information that may not be acted upon. Given that distinguishing between market color and inside information can have profound consequences, is infamously difficult and is a labor routinely practiced by many in the hedge fund industry, this article seeks to provide guidance in making that distinction in various contexts. In particular, this article discusses: the definition of market color; who provides market color and the channels via which it is provided; the interaction of soft dollars and market color; factors to consider in determining whether and when a particular piece of information crosses the line from market color to inside information; and regulatory precedents that may provide insight into how the SEC may treat market color.