Are Side Letters Granting Preferential Transparency and Liquidity Terms to One Investor Ipso Facto Illegal?

We recently analyzed a decision of an SEC administrative law judge (ALJ) holding that fund-level information, as opposed to portfolio-level information, can constitute material nonpublic information (MNPI) for insider trading purposes.  See “SEC Administrative Decision Holds That, For Insider Trading Purposes, Fund-Level Information, as Opposed to Investment-Level Information, May Constitute Material Nonpublic Information,” Hedge Fund Law Report, Vol. 4, No. 14 (Apr. 29, 2011).  Specifically, the ALJ held that information regarding a major fund redemption, fund management’s decision to increase cash levels and efforts to sell a large portion of the bonds in the fund’s portfolio each constituted MNPI.  Accordingly, the ALJ found that the fund manager’s recommendation to his daughter to sell fund shares while the manager was aware of the foregoing three categories of MNPI constituted insider trading under a tipper-tippee theory.  On the scope of the tipper-tippee theory, see the heading “Insider Trading Law” in “How Can Hedge Fund Managers Avoid Insider Trading Violations When Using Expert Networks?  (Part One of Two),” Hedge Fund Law Report, Vol. 4, No. 5 (Feb. 10, 2011).  As explained in our analysis, while that decision arose in the mutual fund context, it has direct relevance for hedge fund managers and investors.  One of the more provocative questions raised by the decision is: are side letters granting preferential transparency and liquidity terms to one investor ipso facto illegal?  For more on side letters, see “What Is the Legal Effect of a Side Letter That Contains Specific Terms More Favorable Than a Hedge Fund’s General Offering Documentation?,” Hedge Fund Law Report, Vol. 4, No. 16 (May 13, 2011).

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