Insider trading law is rife with counterintuitive presumptions. Notable among them is the presumption that if one employee of a hedge fund management company receives material nonpublic information (MNPI), all employees of that management company are in possession of MNPI for insider trading purposes, and any trade in the subject security will be “on the basis of” that information. See “Hedge Funds in the Crosshairs: The Law of Insider Trading in an Active Enforcement Environment
,” Hedge Fund Law Report, Vol. 3, No. 7 (Feb. 17, 2010). However, that presumption can be rebutted by the presence of well-designed information barriers. An information barrier, in this context, is a set of physical, operational, legal and technological structures and processes used to prevent the flow of information from one part of a firm to another, thereby preserving the ability of one part of the firm to trade securities that another part of the firm may not trade. For example, assume that a single manager has a distressed debt fund that trades bank debt and a separate high-yield credit fund that trades bonds. If the investment team for the distressed debt fund receives nonpublic earnings projections of an issuer based on service on that issuer’s creditor committee, the investment team for the high-yield credit fund would be prohibited – as a default – from trading in the public bonds of the same issuer because the whole firm would be presumed to be in possession of MNPI of that issuer. However, if the firm had implemented a legally sufficient information barrier between the distressed debt and high-yield credit fund teams prior to receipt by the distressed fund team of MNPI, the high-yield credit fund team would still be able to trade public bonds of the issuer, even after receipt by the distressed fund team of MNPI. This legal issue matters to investment performance because a good and legitimate investment opportunity may arise anytime. In the foregoing example, the high-yield credit fund team may wish to purchase bonds of the issuer based on immaterial or public information received after the receipt of MNPI by the distressed fund team. In the presence of a legally sufficient information barrier, the high-yield credit fund team would be able to execute on the opportunity. Absent such an information barrier, the high-yield credit fund team would have to forego the opportunity or assume heightened insider trading risk. Implicit in the foregoing hypothetical is the notion that an information barrier is useful to the extent that it is legally, operationally and otherwise sufficient. Which of course begs the question: How can a hedge fund manager structure, implement and enforce sufficient information barriers? This is the first article in a four-part series that aims to answer this question, or at least provide the rudiments of an answer and direction for further analysis. In particular, this article provides an overview of various insider trading controls, including restricted lists, watch lists and information barriers, explaining how they can work together; describes four principal benefits available from the use of robust information barriers; highlights the types of firms that can benefit most from the implementation of information barriers; and describes the types of firms that will find the implementation of robust information barriers most challenging. The second article in this series will describe the regulatory environment surrounding the use of information barriers and discuss the building blocks of an effective information barrier control environment. The third installment will describe how a firm can limit access to MNPI within the information barrier control environment and outline policies and procedures designed to bolster the effectiveness of information barriers. The fourth installment will discuss the benefits of training and compliance surveillance related to information barriers and describe the four most significant challenges faced by hedge fund managers in structuring, implementing and enforcing robust information barriers.