How Can Hedge Fund Managers Avoid Insider Trading Violations When Using Expert Networks?  (Part One of Two)

The investment returns of hedge funds often depend directly on the depth of their managers’ understanding of companies, industries and trends.  Expert network firms exist to enhance that understanding by providing investment managers with efficient access to persons with deep and difficult-to-replicate domain expertise – persons including corporate managers across a range of industries, doctors, engineers, lawyers, accountants, academics and others.  Specifically, expert network firms provide at least three services on behalf of their investment manager clients: they compile networks; they make relevant connections; and they structure interactions to comply with relevant law, most notably, insider trading law.  These services have generated a range of benefits for a range of parties: hedge fund managers have obtained more relevant and granular research, which has enabled them to allocate capital more effectively, which has improved the efficiency of capital markets generally; experts in expert networks – and there are hundreds of thousands of them – have commercialized expertise and experience that was heretofore confined to their direct job functions; and, recent sound and fury to the side, there is a persuasive argument that expert networks have reduced insider trading on a systemic basis.  Nonetheless, the regulatory investigation of insider trading and expert networks is far from complete.  More broadly, since the line between insider trading and diligent research can be blurry, many hedge fund managers have used the current investigation as an occasion to revisit their insider trading compliance policies and procedures generally, and their compliance policies and procedures with respect to expert networks specifically.  This article is the first in a two-part series undertaken to assist hedge fund managers and others as they revisit and revise their compliance policies and procedures relating to the use of expert networks.  This article provides a detailed overview of the law of insider trading, including detailed discussions of the following subtopics: the definition of “materiality” for insider trading purposes; three SEC pronouncements that provide guidance in making materiality determinations; the definition of “nonpublic” for insider trading purposes; breach of duty as a prerequisite for insider trading liability; the three theories of insider trading: classical, misappropriation and tipper-tippee; the “mosaic” theory (and two very important caveats to the mosaic theory); criminal enforcement of insider trading laws, including a brief discussion of substantially all of the civil and criminal insider trading actions brought in the course of the recent investigation, along with links to the underlying documents; and an underappreciated section of the Sarbanes-Oxley Act of 2002 that may offer regulators a potent enforcement tool.  The second article in this series will provide a detailed analysis of substantially all of the civil and criminal filings alleging insider trading in connection with expert networks.

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