Proskauer’s Practical Guide to the Regulation of Hedge Fund Trading Activities offers a concise, easy-to-read overview of the trading issues and questions we commonly encounter when advising hedge funds and their managers. It is written not only for lawyers, but also for investment professionals, support staff and others interested in gaining a quick understanding of the recurring trading issues we tackle for clients, along with the solutions and analyses we have developed over our decades-long representation of hedge funds and their managers.

In Chapter 2: Insider Trading: Focus on Subtle and Complex Issues, we examine insider trading as it relates to hedge funds, including a focus on specific problems and challenges that funds confront with frequency.

Chapter 1: When Passive Investors Drift into Activist Status

Chapter 2: Insider Trading: Focus on Subtle and Complex Issues

Chapter 3: Special Issues under Sections 13(d) and 16 for Hedge Funds

Chapter 4: Key Requirements and Timing Considerations of Hart-Scott-Rodino

Chapter 5: Rule 105 of Regulation M, New Short Sale Disclosure Rules, and Tender Offer Rules

Chapter 6: Swaps and Other Derivatives

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A Practical Guide to the Regulation of Hedge Fund Trading Activities

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Many hedge funds routinely face insider trading concerns as they trade equity or debt. Sometimes these issues are fairly obvious, such as where the fund has learned material, non-public information or MNPI directly from the company. Perhaps the company solicited the fund as an investor in a new debt offering and brought the fund manager “over the wall.” However, in many cases, insider trading issues are more subtle and complex.

For example, the recent case SEC v. Panuwat has been highly publicized because it involves the SEC’s first enforcement action against “shadow trading.” A corporate officer learned that his company would be acquired by another company, and he promptly purchased options in a third-party company. The third party company was not a competitor or business partner of the officer’s company, but (i) the two companies allegedly shared a similar market space, (ii) market analysts had speculated that the third-party company’s stock price could be affected by an acquisition of the target company, (iii) the SEC’s expert witness also testified that an acquisition of the target could be expected to have a spillover effect on the third-party company’s stock price, and (iv) the third-party company’s stock price did in fact rise by 7.7% when the target’s acquisition was announced. The SEC sued the officer on the theory that he had “misappropriated” material, non-public information about the target’s impending acquisition from his employer and that the non-public information was material to the third-party company. In April 2024, the SEC prevailed in a jury trial. It is unclear whether the verdict will be appealed.

In this chapter, we summarize the law that applies to insider trading issues, including the practical impact, if any, of the relatively recent court decisions. We then trace through a factual scenario to focus on more complex issues, including:

• Third-Party Sourcing: When a fund learns information from a source other than the issuer of the equity or debt in question, such as from a supplier, as noted in the example above;
• Big Data (a derivative of third-party sourcing): When fund managers gather information from outside sources rather than directly from a public company to gain insight and inform their investment, using vendors or information generated internally.

For example, “web scraping” or “spidering” refers to the practice of gathering data from websites using software. Big data also includes information from credit and debit card receipts, geolocational data, information from IoT, satellite imagery and information from app developers for cell phones;

• Mosaic Theory: When a fund gathers a piece of immaterial information that, when combined with other public information, completes a mosaic that provides material trading insight. For example, assume that one of your employees took a photo of the CEO of a public company walking to his car in the evening wearing an Abu Dhabi baseball cap, thereby perhaps providing some confirmation of market rumor that the company is doing a deal with an oil company in that country;
• Shadow Trading: When a person trades the securities of Company B because the person expects its stock price to be affected by material, non-public information about Company A;
• Hot Potatoes: Handling non-public information that you possess but don’t want to have;
• “Almost” Public Information: Material information that is theoretically accessible by the public but

is not obvious, such as where an issuer posts the information in an unexpected website location. An example is when, several years ago, the CEO of Netflix posted new growth in monthly online viewing data on his personal Facebook account without having given notice that the market could find this information in that place; and

• “Big Boy” Letters: Where the buyer acknowledges that the seller may have MNPI and purports to waive its right to such information.

Today’s Insider Trading Laws: Quick Primer

Before we get to more current, complex issues, here is a brief synopsis of the insider trading laws as they stand today.

Bases for Insider Trading Liability

In the United States, with a few exceptions, trading on the basis of material, non-public information does not —without more — violate the law. This distinguishes the United States from other countries such as the UK, where the laws effectively require that buyer and seller have parity of information. In the U.S., there must be fraud, deceit or some other breach of duty in order for a violation of the federal securities laws to occur. For example, the information must have been obtained in breach of a fiduciary duty or a duty of trust and confidence owed to shareholders or the company (where the breach is by an insider of the company) or owed to the source of the information even if the source is not an insider (for example, the duty of confidentiality that an employee owes to his or her employer).

“Classical Theory”

The “classical theory” of insider trading involves a breach of fiduciary duty to the issuer and its shareholders. This situation occurs when a company insider provides material, non-public information to an investor without authorization to do so. For example, assume that a vice president for investor relations meets with a personal friend and hints at a down quarter before quarterly earnings have been released, expecting or suspecting that the friend will trade on the information. The friend then trades. The officer clearly breached his fiduciary duty to his company’s shareholders by tipping his friend.

“Misappropriation Theory”

The “misappropriation theory” is an alternative basis for insider trading claims. Under this theory, the duty at issue is owed to the source of the non-public information, even if the source is not the corporation or an insider. Thus, no breach of fiduciary duty to the company or its shareholders needs be involved because the person who traded on the information might not have received the information directly or indirectly from a company insider. One well-known case involved R. Foster Winans, a Wall Street Journal columnist responsible for the “Heard on the Street” column. As it does today, the column discusses individual public companies, and its contents can impact the price of a stock positively or negatively.

Mr. Winans leaked information about his articles to a stockbroker and to his roommate prior to publication, and they traded profitably on the news. Mr. Winans’ defense to insider trading charges was that he may have violated conflict-of-interest policies at The Wall Street Journal, but he had not committed a crime because he had not obtained MNPI from a corporate insider. The Court of Appeals for the Second Circuit upheld his conviction on grounds that he had “misappropriated” information belonging to his employer and that the misappropriation was a sufficient basis for his conviction. (The court speculated, however, that misappropriation might not have occurred if the Journal itself had traded on the information because the information belonged to the Journal — although the court observed that no self respecting news organization would do such a thing.) The Supreme Court affirmed the conviction under the wire-fraud statute and split 4-4 on the securities-law conviction because the Court had not yet developed the misappropriation theory of insider trading.

The Panuwat “shadow trading” case also illustrates how the “misappropriation theory” can play out. In denying Panuwat’s pretrial motion for summary judgment, the court held that a jury could find that Panuwat had breached his duty to his employer on both contractual and common-law agency grounds.

Panuwat was bound by his employer’s insider- trading policy which specifically prohibited trading the securities of any public company based on information learned from his employment. He also was bound by a confidentiality agreement. But in addition, and apart from those agreements, Panuwat had a duty under his employment relationship not to use his employer’s non-public information for his personal benefit without telling his employer that he intended to do so. The court therefore concluded that a jury could find that Panuwat misappropriated his employer’s confidential business information when he traded on it.

What About All the Fuss About “Pecuniary Interest” in the Headlines A Few Years Ago?

For insider trading prosecutions in the Second Circuit, which includes New York, it temporarily became significantly more difficult for the government to prevail in a criminal insider trading case under the federal securities laws. That is because the Second Circuit, in its 2014 “Newman” decision, held that, in proving a breach of duty by a tipper providing the information to a tippee, the government had to prove that the tipper received a tangible personal benefit “of some consequence,” such as something of economic or “pecuniary” value — and the tippee could not be held liable for trading on the tip unless he or she knew of the tipper’s breach of duty, including the tipper’s receipt of the personal benefit. The required “nature” of the personal benefit went to the Supreme Court in 2016 in the “Salman” case, and the Supreme Court rejected the “Newman” decision “to the extent [it] held that the tipper must also receive something of a ‘pecuniary or similarly valuable nature’ in exchange for a gift to family or friends.” The Salman case thus undermined one aspect of the Newman decision.

A subsequent Second Circuit decision in 2018 in the “Martoma” case undermined another aspect of Newman, which had held that where the personal benefit to the tipper is inferred from the nature of the relationship between the tipper and tippee (as, for example, in a gift-giving situation), “a meaningfully close personal relationship” is required. Martoma held that the requisite relationship between the tipper and the tippee can be established through proof “either that the tipper and tippee shared a relationship suggesting a quid pro quo or that the tipper gifted confidential information with the intention to benefit the tippee.”

The combination of Salman and Martoma has eased the burden of proof in criminal insider trading cases against tippers and their direct tippees, but neither Salman nor Martoma undercut what the Martoma court called “the central question in Newman”: A tippee must have known (or at least been reckless in not knowing) that there was a breach of fiduciary duty in providing MNPI in exchange for a personal benefit. While this burden might not create a big hurdle in cases involving direct tippees, it could prove insurmountable in cases involving remote tippees.

Tippees at the end of a long chain might have no idea of what happened at the top of that chain between the tipper and the direct tippee. If the government cannot prove the remote tippees’ knowledge (or their conscious avoidance of knowledge), the prosecution will fail — as it did on appeal in Newman.

More Stringent Laws Might Apply

The Sarbanes-Oxley Act added a new criminal insider trading provision (18 U.S.C. § 1348) that has been applied by a few lower courts to criminal prosecutions without requiring the government to prove some of the elements in a traditional insider trading case, such as knowledge of a personal benefit to the tipper. In one recent case in New York (United States v. Blaszczak), the defendants were acquitted of the traditional insider trading charges but convicted under the new law. The new law is modeled after the mail and wire fraud statutes and subjects to criminal prosecution:

Whoever knowingly executes, or attempts to execute, a scheme or artifice to defraud any person in connection with . . . any security of an issuer with a class of securities registered under section 12 of the [Exchange Act] or to obtain, by means of false or fraudulent pretenses, representations or promises, any money or property in connection with . . . any security of an issuer with a class of securities registered under section 12 of the [Exchange Act] . . . .

It remains to be seen whether appellate courts will agree with the lower court judges’ interpretations and whether prosecutors will use the new law more frequently to try to avoid some of the doctrinal constraints under traditional insider trading law. The Blaszczak case illustrates the uncertainty. The Second Circuit, in a split 2-1 decision, affirmed the conviction under the insider-trading statute, but the Supreme Court vacated and remanded the judgment on a separate issue (whether the non-public information that underlay the conviction was the government’s “property” for purposes of the statute). When the case returned to the Second Circuit in 2022, the Supreme Court’s ruling on the “property” issue required overturning the conviction on that ground.

Nevertheless, two of the three judges on the panel wrote a separate “concurrence” to criticize the first panel’s original holding that insider-trading liability can be established under § 1348 without proof that the tipper had received a personal benefit and that the tippee had known about it. Those two judges objected to the “asymmetry” between liability under the securities laws and liability under § 1348. This “concurrence” could cause prosecutors and courts to think harder about whether § 1348 can be used to avoid some of the difficult issues of proof under the securities laws.

Tender Offers

There is one other exception in the U.S. where the law does essentially require parity of information between the buyer and seller, and that is in the context of a tender offer. The SEC’s Rule 14e-3 provides that, if any person has taken “a substantial step or steps” to commence a tender offer (or has already commenced a tender offer), Section 14 of the Exchange Act prohibits any other person who has material, non public information relating to that tender offer to buy or sell the potential target’s securities if such person knows or has reason to know that the information is non-public and has acquired it directly or indirectly from someone associated with either the potential offer or the potential target. Assume, for example, that a fund manager has learned indirectly about a potential merger. Assume also that a potential merger partner had begun discussions with banks about financing a tender offer and had hired an attorney who put together deal scenarios that included a friendly tender offer. The manager may have liability under Rule 14e-3 after trading on the information, or, at least, the SEC may take such a position, even if the manager traded on the information without any breach of duty.

Certain state laws could also create liability (at least in enforcement actions, rather than private damages suits) for trading based on MNPI even without a breach of duty. Some state Attorneys General have used state laws (such as the Martin Act in New York) to threaten enforcement actions based on general principles of unfairness where parity of information did not exist.

Laws Outside the U.S.

Beware if your transaction has contacts with jurisdictions outside the United States. The insider trading laws of other countries differ from ours, and, as noted above, some of them more simply proscribe trading on MNPI, without regard to whether a breach of duty has occurred. The European Union’s Market Abuse Regulation (the “MAR”), for example, prohibits trading on material, non-public information as long as the trader knows or has reason to know that the information is non-public. The MAR applies not only to trading within the EU, but also to any securities that are listed for trading on an EU market. Thus, for example, if a stock is cross-listed in the United States and the EU, the MAR applies even to transactions on the U.S. exchange. While the MAR does not yet appear to have been enforced as to U.S. trading of a cross-listed security, you do not want to be the poster child for a first-ever enforcement action.

What Is “Material?”

Analysis of materiality is complex in part because there are multiple approaches, all of which should be considered. The first approach is to consider the rather open-ended language contained in the opinions of federal courts. The Supreme Court has stated that materiality depends on whether there is a substantial likelihood that a reasonable shareholder would consider the information important in deciding whether to buy, sell or hold the securities. The information need not be dispositive — i.e., the investment decision need not turn on it. But it needs to be something a reasonable investor would consider significant. An alternative formulation is whether the reasonable investor would have viewed the information as having significantly altered the “total mix” of information made available. These are thoughtful and logical formulations, but often unhelpful in solving difficult problems. And the Supreme Court has repeatedly refused to draw bright lines, because it considers materiality to be fact-specific.

Second, there is a balancing test for uncertain future events. The Supreme Court has held that materiality depends on a balance of the indicated probability that the event will occur and the anticipated magnitude of the event for the issuer if the event does occur. In other words, the less likely the occurrence, the less likely the materiality. But if the contingent event would be enormously significant to the issuer (for example, a merger), materiality might exist even at a lower level of probability than would be the case for a less-significant event.

Third, there is the quantitative test, expressed as a percentage of assets or revenues. In some respects, the SEC has sanctioned the use of quantitative tests, at least in certain circumstances. For example, the requirement to disclose civil litigation in periodic reports is qualified by an exception where the “amount involved” does not exceed 10% of current assets. Where available, quantitative measures are important factors in many analyses of materiality, often the most important. However, the SEC has made clear that quantitative measures cannot alone determine materiality. For example, assume that a retailer’s revenues have dropped 1% for the quarter in a period where sales should have been strong given the overall economic environment. The drop occurred because the company was having inventory problems resulting from its adoption of new inventory software that is dysfunctional. While the 1% drop may not be material to the company in isolation, two related, intangible facts likely are material. First, the fact that sales are declining when they should be increasing. Second, the fact that the company is experiencing inventory problems that may continue into the future. The SEC thus applies qualitative as well as quantitative considerations; it does not necessarily view quantitative results in isolation. Courts also reject quantitative bright lines. For example, the Third Circuit recently held that a jury could rationally view information about only 2% of an issuer’s revenues as material for purposes of an insider trading conviction.

Finally, another factor is the anticipated impact on stock price. If the event is anticipated to impact the stock price, that factor suggests materiality. Because markets are not perfect, nor always rational, stock price should not always be a significant factor. We have all heard the warning that materiality is judged in hindsight, meaning that a material change in stock price could create a strong presumption of materiality. Indeed, the SEC enforcement cases focusing on compliance with Regulation FD some years ago did pay a lot of attention to stock price movements.

Because materiality is so fact-specific and is viewed in hindsight, after the trading has produced a profit or avoided a loss, we often counsel our clients to avoid making trading decisions based on the conclusion that specific non-public information is not material.

In some cases, the information might objectively be viewed as immaterial, but an objective interpretation is not always possible, and we frequently cannot help but feel that, if our clients are so interested in the information that they are asking us about it, then they themselves might consider the information to be material.

Shadow Trading

As noted at the beginning of this article in the discussion of the recent case of SEC v. Panuwat, shadow trading is where a person trades the securities of Company B because the person expects that Company B’s stock price will be affected by material, non-public information about Company A. Assume, for example, that a fund learns from one of its consultants that companies that produce solar panels are having a down quarter due to developments and trends that logically should impact sales of other renewable energy products. Can the fund short the common stock of a portfolio company that produces the blades for wind turbines that generate electricity? The analysis could focus on at least two issues.

First, can the fund properly use information obtained from its consultant when making trading decisions? Without breach of a legal duty to refrain from using the information for one’s personal benefit or for other than specified purposes, there can be no liability for insider trading. The analysis often depends on factors such as the terms of any agreements between the manager and its consultant or whether the manager had reason to believe the consultant was breaching a duty to third parties (such as the solar- panel producers) in providing the information to the manager.

Second, is the information about makers of solar panels material to a producer of wind-turbines blades, or is the connection is too speculative or attenuated to be considered material? If the fund does trade, the fact pattern might suggest that it believed the information material, unless the manager relied on other information as well in making its trading decision. And, as always, materiality can be judged in hindsight, so, if the blade producer’s stock price falls when news about the adverse news about the solar panel producers is disclosed, the information about the solar-panel producers would appear to have been material to the turbine-blade producers. Moreover, the SEC takes the position that awareness of MNPI suffices to establish its use, so the fund manager who has MNPI might not succeed in contending he or she relied on other information in making the trading decision and did not “use” the MNPI.

The “Mosaic Theory” — When Immaterial Facts Complete a Puzzle

The “mosaic theory” is the view that collecting individual pieces of immaterial non-public information cannot violate the laws against insider trading, even if those pieces of information effectively add up to material insight into trading decisions. Indeed, by definition, if the information in question is not material, then there can be no insider trading liability. The problem in implementing this theory is being certain that the information in question is not material.

The “mosaic theory” has some logic, but the SEC has not endorsed it in the context of insider trading. It has adopted it in a related area of the law: Regulation FD. Regulation FD prohibits public companies from selectively disclosing MNPI to analysts and investors. In adopting Regulation FD, the SEC stated that “an issuer is not prohibited from disclosing a non-material piece of information to an analyst, even if, unbeknownst to the issuer, that piece helps the analyst complete a “mosaic” of information that, taken together, is material.”

Let’s consider an example that illustrates the “mosaic theory” as well as how issues of materiality can be intertwined with the other elements of insider trading, such as whether the information is non- public. Assume that it is public knowledge that significant tariffs will be imposed on the importation of specialized rubber that is not currently available in the United States. A fund manager has invested equity in a public company that manufactures Zamboni machines that groom the ice at skating rinks. It is public knowledge that the specialized rubber in question is often used in Zamboni tires, as it results in superior performance. A fund employee calls an acquaintance who works as a salesman at the public company and learns that the company in fact uses the rubber to manufacture its tires. The manager shorts the common stock of the company, anticipating a price drop when the increased price of the rubber causes an increase in manufacturing costs and a decrease in revenue and profit. Did the fund manager violate the federal insider trading laws (especially if the shorts prove profitable)?

Is confirmation that the company uses the rubber in question “non-public,” given that it is known that some manufacturers use the rubber in their tires because it improves performance? Assume also that the company in question is only one of four manufacturers of ice clearing machines in the world and that it produces the most high-end, and most expensive, models. The probability that the company uses the rubber is therefore high. On the other hand, the company’s oral confirmation to the manager removes any uncertainty and changes the information from speculative to certain. Thus, the only non public information is the final confirmation from the company. A conclusion that the information is already “public” would appear to be clearer if the manufacturer provides the information on the tire ingredients to anybody who calls its customer service number.

Even if the information were non-public, is it material? The nature of the ingredients that the company uses to make its tires is arguably immaterial in isolation.

The information provided trading insight only when coupled with the high probability that the company uses the rubber in question and the already public news about the proposed tariffs. On the other hand, one could argue that the oral confirmation about the composition of that particular company’s tires became material in light of the news about anticipated tariffs.

While it is not the focus on this sub-section, there may also be arguments that there was no breach of duty or misappropriation when the company employee confirmed the identity of the rubber to the fund manager, depending on the facts and circumstances. Indeed, as noted above, Regulation FD does not preclude a company from disclosing immaterial information even if, unbeknownst to the employee, it completes a “mosaic” that provides material trading insight. Also, Regulation FD does not apply to all employees but only to senior officials or persons who regularly communicate with investors or the press. If the employee in question was both unaware of the materiality of the information and outside the scope of Regulation FD (i.e., was not a senior official or a person who regularly communicates with investors or the press), there would seem not to have been any breach of Regulation FD.

We advise clients not to rely on the “mosaic theory” except where non-materiality is clear-cut. The SEC has not formally endorsed the theory in the context of insider trading, and it relies on determinations of “materiality” that are subject to after-the-fact second guessing. Some of the “expert network” firms have purported to rely on this approach by collecting non-material information that could, in the aggregate, provide useful investment guidance. The SEC has focused on a handful of these firms in the course of insider trading investigations.

Is the Information “Public”?

The analysis of whether information is “public” or “non public” in some cases determines whether a manager can trade on material information. For example, assume that a technology company, perhaps accidentally, makes available select elements of a new product in background materials prepared for an industry conference. The information is included in the conference materials that are provided to participants to review later; it is not part of the actual presentation at the conference. An institutional investor that specializes in this area of technology discovers the information in the background materials but doubts that many other investors have noticed it. The information is clearly in the public domain, but is it really “public” for purposes of the federal insider trading laws?

Just as there is no absolute rule requiring parity of information between buyer and seller, there is no rule requiring that the dissemination of material information has actually reached both buyer and seller at the time of a trade. The focus instead is the degree or manner to which the information has become available to the trading market and the amount of time the market has had to absorb it.

In the context of Regulation FD, the SEC has identified two prongs to the analysis of this question, mainly focusing on what information is “non-public.” Of course, what is “public” for purposes of insider trading is not necessarily “public” for Regulation FD purposes, and vice versa. For purposes of the insider trading laws, the information need only be sufficiently publicly available to avoid being considered “non public,” while under Regulation FD, the information must be publicly disclosed “in a manner reasonably designed to provide broad, non exclusionary distribution of the information to the public.” Further, under Regulation FD, the bar should be a higher one because the company is in control of the manner in which it releases the information, and the policy objective is to ensure that every investor has a fair opportunity to access the information.

Nonetheless, as a benchmark, it is useful to understand what is “public” for purposes of Regulation FD. If information is sufficiently available for these purposes, it should normally also be for insider trading purposes. For Regulation FD purposes, a filing on a Form 8-K is always enough, normally coupled with a press release. If a conference is webcast with open access, a statement made at the conference should be “public” if there was adequate advance notice of the conference. Unconfirmed market rumors are not enough because rumors are not the same as confirmed information, nor are social media posts sufficient unless investors have a reasonable expectation and practice of finding material information in the location where the posts are made. For example, the SEC has stated that a company’s posting of financial information on Facebook should suffice if the company has provided notice that it will post such information in that location and investors actually expect to find it there and, in practice, do find it there.

Depending on the manner of dissemination, the SEC might also focus on whether the information has had time to reach the marketplace.

We now return to the example summarized above, where new product information was included in the background materials for the conference. The information arguably is “public.” However, a plaintiff or regulator may contend that the unexpected inclusion of the product information among the conference materials does not render the information immediately “public,” absent the passage of time. Such conference materials are often viewed only later by conference participants to learn more about a specific subject.

On the other hand, some participants, like the manager in our example, will be motivated to review the materials expeditiously. Moreover, the materials may be available only to the conference attendees rather than the public at large (unless the company later posts them on its website), and the conference site is not an official governmental site nor a site that necessarily sees a lot of “traffic.” With the passage of time, however, the information should become more clearly “public.”

Extinguishing MNPI

Sometimes fund managers obtain information that they don’t want to have. For example, it is not as unusual as one would think for a manager to obtain information by receiving an accidental email from a public company or statement by a company officer, or the company may have deliberately communicated to the manager information about a potential debt offering, hoping the investor will participate. We are often asked how to “cleanse” the information, meaning how to reverse the fact that the fund has the information.

If a manager obtains MNPI, it is frozen from trading. There are two ways to cleanse the information: (1) the company can publicly disclose the information, and/or (2) the information could become stale. If the issuer discloses the information (or the portion of the information that it views as material), then the manager’s knowledge might be cleansed (although the fund itself needs to be comfortable that the issuer has disclosed all MNPI, regardless of what the issuer thinks). Information can become stale because the company disclosed it in the ordinary course or because sufficient time has elapsed to make the information out of date (although factual questions could arise about whether old information is or is not still material). For example, if the manager received a preview of quarterly earnings before the quarterly earnings conference, the information is cleansed once the company holds its quarterly earnings conference.

“Big Boy” Letters

If a trade occurs privately with an identified buyer rather than on the public markets, there is an opportunity to enter into a “Big Boy” letter. That is a letter signed by the buyer in which the buyer acknowledges that the seller may have material non public information that it is not sharing with the buyer, and the buyer waives any right to pursue a claim based on it, as well as any assertion of detrimental reliance on the non-disclosure. These letters can be helpful as a practical matter, as they reduce the likelihood that a buyer will decide to bring a lawsuit or complain to regulators. However, waivers of rights under the federal securities laws are not enforceable as a matter of law, so the general waiver of claims may not be available for use as a defense in court or in a regulatory or criminal action. Section 29(a) of the Exchange Act states that “[a]ny condition, stipulation, or provision binding any person to waive compliance with any provision of the [Exchange Act] or of any rule or regulation thereunder. . . shall be void.” Moreover, the government is not a party to a “Big Boy” letter, so it would not be contractually bound by the letter in any event.

Elements of the letter, however, might provide a defense to a traditional insider trading fraud claim, because “deception” and “reliance” are both elements of such a claim. The disclosure of the possibility of having material non-public information can undermine a claim of “deception,” and the non reliance language would tend to undermine “reliance.” The strength of these arguments is less than clear, depending on the circumstances, and some state laws might have exceptions for situations where one party has “peculiar knowledge” unavailable to the other party.

Nevertheless, a “Big Boy” letter, where it is possible to obtain one, can be helpful even if it does not eliminate risk. As a practical matter, we believe that it is more likely to be helpful in the context of civil litigation than it is in a regulatory or criminal matter.

Now It Gets Complicated: An Illustrative Scenario

We now focus on specific problems and challenges that fund managers confront with frequency. In doing so, we will run through a factual scenario involving fictional entities.

The Scenario

Assume that Emerging Growth, LLC has a 9% equity stake in Unicorn Pharmaceuticals, a small public company listed on NASDAQ. Unicorn’s most promising drug in development is Cressacilin. In developing Cressacilin, Unicorn is using a new advanced-technology process called “Incubus,” which is faster and more efficient than previously used methods.

Emerging Growth uses a software developer for its own trading and compliance software, called SoftDevCo. A representative from SoftDevCo was working in Emerging Growth’s offices and was chatting with one of the fund manager’s employees. The SoftDevCo representative mentioned that she had heard rumors in the industry that Incubus has some defects and that some drug developers have already had to suspend development while they consider whether to give the software developer more time to fix it or whether to abandon the new process.

The representative did not have specifics. Emerging Growth isn’t sure whether Unicorn is using Incubus but believes it likely that Incubus is the only software option at this point for the new development process and that Unicorn is therefore using it, too. Emerging Growth also cannot be sure of the accuracy of the information the representative has provided, as it was qualified as “rumor,” and the representative lacked specifics.

Despite the uncertainties, Emerging Growth would like to sell (or sell short) Unicorn to hedge against the risk that Unicorn will be forced to suspend development of its principal drug. Can Emerging Growth sell Unicorn’s stock?

Materiality

There can be no insider trading unless (among other things) the information about the Incubus software problem is material to Unicorn. One could posit that the information about the software defect is immaterial to Unicorn. The information does not relate directly to Unicorn; the information was merely “rumor;” and, if the rumor is accurate, Emerging Growth is not sure whether Unicorn is using Incubus. Under this analysis, using the “mosaic theory,” Emerging Growth could take the position that it has simply combined new non material information with already public material information about the drugs under development at Unicorn.

But this is where the “mosaic theory” often begins to fall apart. If the information about the software defect is correct, and if it applies to Unicorn because Unicorn in fact uses the same software as the other companies subject to the rumor, is the information really immaterial? In hindsight, let’s assume the information is correct, and the defect proves catastrophic to Unicorn, whose stock price plummets. In hindsight, the information will appear material (especially because Emerging Growth has perhaps made a lot of money — or avoided substantial losses — by selling or shorting Unicorn’s stock), and arguments could be made along those lines. As noted above, information about a future event can be discounted by the probability of its occurring. In this case, the future event is that Unicorn will be forced to suspend development because it uses the defective software, and there is substantial uncertainty as to both the reliability of the information and its applicability to Unicorn. However, even discounted by uncertainty that the information is relevant to Unicorn, the magnitude of the contingent event (if it occurs) would be enormous because the drug in question is critical to Unicorn’s success, so there would be arguments that the information is material. While the arguments in favor of materiality may not prevail, the outcome would be less than certain.

Is the Information Non-Public?

If the information about the potential difficulties with the software is in the public domain, it may be sufficiently public to eliminate any insider trading risk. The information need not necessarily be widely disseminated. It need only be sufficiently in the public domain under all the circumstances such that it is no longer considered “non-public.” The information about the software defect may be sufficiently public if it has been reported, for example, in the trade press. Let’s assume it has not been reported as “hard news,” but the same rumors that Emerging Growth heard from its software developer have been reflected in the online trade press and/or blog posts. That might not suffice to make the information public, since unconfirmed speculation is not the same as the hard facts.

Breach of Duty/Misappropriation

In order for there to be insider trading, there has to be a breach of duty to the issuer or a breach of duty to the source of the MNPI under the “misappropriation theory.”

Was there a breach of duty? Emerging Growth did not obtain the information about the software defect from Unicorn, but rather from a third party. That means that the fund manager did not receive it as a result of a breach of fiduciary duty at the issuer of the equity (Unicorn), the first basis for insider trading liability. An officer of Unicorn was not involved, so no one at Unicorn breached his or her fiduciary duty in providing the information to Emerging Growth.

The only possible basis for Emerging Growth’s potential liability is the “misappropriation theory” — a potential breach of duty to the source of the information (SoftDevCo).

• The manager did not “misappropriate” the information either, in the traditional sense of the word. The SoftDevCo representative willingly provided the information to Emerging Growth — let’s assume the representative hoped to give Emerging Growth a heads-up as a major investor in Unicorn and to retain its goodwill. However, there could be counterarguments, depending on the details and nuances. While it seems like a stretch, it would not be unsurprising to hear a regulator argue that while SoftDevCo shared the information with Emerging Growth as a “friendly heads-up,” it expected Emerging Growth to hold it in confidence, or, at least, it did not intend that Emerging Growth would use the information for any specific purpose (e.g., trading Unicorn’s equity). This argument seems inconsistent with the fact that the information was “rumor,” something rarely shared in confidence, and with the fact that the representative was trying to be helpful to Emerging Growth. Nonetheless, if the information had been provided in express or implied confidence, one could argue that Emerging Growth’s use of the information to trade shares of Unicorn for its own benefit amounts to a misappropriation of SoftDevCo’s information because Emerging Growth breached a potential duty of confidence owed to SoftDevCo. We are not saying that we expect that the SEC or DOJ would take this position, but, in past cases, those agencies have taken the position that a duty of confidentiality was implied from the circumstances and past practice and that such duty of confidence restricted use of the information.

Some of these same issues are reflected in fund managers’ use of “Big Data” to make trading decisions, although the analysis is more complex. “Big Data” also involves obtaining information about an issuer from third parties (or at least from outside sources, such as the Internet) rather than from the issuer itself. We elaborate on that subject below.

Cleansing MNPI

What if Emerging Growth, decides not to trade on the basis of the rumor about the software defect and instead wishes it had never received the information in the first place? In other words, possessing the information could preclude the fund manager from ordinary-course trading decisions, such as perhaps acquiring additional shares of Unicorn when the price dips with an overall market decline. The options for cleansing information, and their relative merits, depend on the facts and circumstances in each case.

In this case, several ways might be available to cleanse the information. Emerging Growth could obtain confirmation that the rumor about Incubus’s defect is false, or Emerging Growth could confirm that Unicorn does not use Incubus, or Unicorn or some other company that uses Incubus might disclose the problem with Incubus and its potential impact on product development, or Emerging Growth could wait for the information to become stale in some other way. Perhaps Emerging Growth could approach Unicorn in hopes that Unicorn would confirm that the information is false, or investigate the question. Perhaps one of the other issuers that are experiencing problems with Incubus could disclose the information, but even if it identified such issuers, Emerging Growth lacks control over their disclosure practices. The problem with waiting for information to become stale is that it is hard to predict when that time will arrive. It could occur in the short term, such as if the Incubus software developer expressly denies the rumors, or it could take longer, such as when an issuer that uses Incubus discloses problems with the software or alternatively discloses the timely success of its product.

Big Data: More Information from Third-Party Sources

“Big Data” refers to the efforts to refine and analyze data available from sources other than the issuer of the equity in question to assist in investment decisions. As noted above, this is a unique application of the analysis where an investor receives potentially material information from third parties, rather than from the issuer, either by buying the data from a vendor or generating and analyzing it in-house. Sources of data may include e-commerce receipts and credit-card transaction data, geolocational data, satellite images, sensors from internet-connected machines or smart devices, data from cell phone apps and online data collected via “screen scraping” (or “web scraping” or “spidering”).

Assume, for example, that Emerging Growth has also invested in a public company named Small Business Loans, Inc., which (unsurprisingly) makes loans to small businesses. Emerging Growth engages a “Big Data” firm, BD Enterprises, which gathers information from a variety of sources to gain a better understanding of trends in small-business practices for raising capital. BD Enterprises in turn uses a combination of all of the sources noted above in gathering and analyzing data for Emerging Growth.

Let’s assume that Emerging Growth uses the data and analyses it receives from BD Enterprises in deciding to increase its investment in Small Business Loans, as well as in other companies involved in the same industry. Six months later, Emerging Growth sees solid capital gains and takes some profits.

Is Emerging Growth taking any risk in using the analyses provided by BD Enterprises to buy common stock in Small Business Loans and related businesses? As in the example above, where Emerging Growth obtained information relevant to Unicorn from a vendor, this isn’t a classic breach of fiduciary duty case because the information did not come from the issuers of the equity being purchased. No officer or director of an issuer provided the information to BD Enterprises. Here as well, the only possible basis for insider trading liability is the “misappropriation theory.” Since Emerging Growth obtained the information through a legitimate commercial relationship with BD Enterprises, it would not seem to have misappropriated anything — at least on initial consideration.

There is a risk, however, and it derives not from the relationship between Emerging Growth and BD Enterprises, but from how BD Enterprises gathered the information. The law in this area is still developing, but, in theory, BD Enterprises could be found to have misappropriated the data upon which Emerging Growth relied.

How can Emerging Growth be exposed to liability in these circumstances? Let’s focus on “web scraping,” as an example. Assume that BD Enterprises “scraped” relevant data from the website of an online business that provided relatively small but quick revolving loans to small businesses. This business model is different from Small Business Loan’s model, but the business is similar, and the client base is comparable. The “scraped” data tends to show that clients of the online business are taking out fewer loans, but that loans are growing in size, suggesting growth in Small Business Loan’s business involving larger, stand- alone loans.

The online business’s website has several paragraphs of “terms of use,” which could limit use of the website to the business’s own marketing and sales. Many websites have terms that preclude “web scraping,” such as the following craigslist term:

USE: You agree not to use or provide software (except for general purpose web browsers and email clients, or software expressly licensed by us) or services that interact or interoperate with CL, e.g., for downloading, uploading, posting, flagging, emailing, search or mobile use. Robots, spiders, scripts, scrapers, crawlers, etc. are prohibited, as are misleading, unsolicited, unlawful and/or spam postings/email. You agree not to collect users’ personal and/or contact information (“PI”).

It is unclear whether a given website will enforce such a term, or at this point, whether a court will view it as being enforceable, or whether violation of this term of use would be sufficient to amount to a “misappropriation” for insider trading purposes. There are weighty policy issues involved, including the open nature of the Internet, as well as proprietary, privacy and property rights. Nonetheless, although we are not aware of an insider trading case against a Big Data vendor or its client, one could imagine an argument that BD Enterprises somehow deceived the online business’s website when it entered the website under the guise of a legitimate business purpose but then proceeded to scrape the site in violation of the “terms of use.” If BD Enterprises did misappropriate information from the website, and if Emerging Growth knew or was reckless in not knowing about BD Enterprise’s misappropriation, then Emerging Growth could theoretically be held liable by trading on MNPI obtained from the online business through BD Enterprise’s breach of duty.

Other “terms of use” could also be relevant. In addition, there is a laundry list of possible legal violations, each of which may (or may not) form the basis of a “misappropriation”. These include, for example, violations of copyright laws, the Computer Fraud and Abuse Act, privacy laws and/or common- law conversion or trespass.

Does it insulate the fund manager from liability if it engages a third party to gather the data, so that any legal violations are committed by the vendor? It might help but may not prove a solid firewall, for a variety of legal and practical reasons that are beyond the scope of this chapter. For insider trading purposes, however, the fund manager might not be insulated if it knows or is reckless in not knowing about the vendor’s misappropriation. Any fund manager or other potential trader that wishes to obtain trading information from a third-party vendor should therefore engage in appropriate due diligence before hiring the vendor and in monitoring the vendor’s activities.

In April of last year, craigslist obtained a $60.5 million judgment against a real-estate listings site that had allegedly received scraped craigslist data from an independent vendor. In addition, craigslist reached a $31 million settlement and stipulated judgment with Instamotor, an online and app-based used-car listing service, over claims that Instamotor had scraped craigslist content to create listings on its own service and sent unsolicited emails to craigslist users for promotional purposes.

We recommend that investors ensure that agreements with vendors include appropriate representations and other terms, and that they conduct due diligence, asking the following types of questions:

• Who is the vendor? Is it credible, established, respected?
• What are the vendor’s data sources?
• Where is the data coming from, government or private sources?
• What is the nature of the data? What techniques does the vendor use?
• Personal identifying information (“PII”)? Child PII? Sensitive Information?
• Any MNPI or other “confidential” information? (Spot-check!)
• Is the vendor collecting the same data for anybody else?
• Has there been any litigation involving the vendor or its sources?
• How does the vendor provide the data? Is the vendor a collector, packager, analyzer, aggregator?
• Does the vendor have the right to provide the data to you? Consider requesting documentation and indemnity.
• If using drones, does the vendor employ or contract with drone operators possessing proper commercial licenses acting in compliance with state and federal laws and NTIA best practices?
• Does the vendor have adequate insurance?

Does the Vendor spider? If so:

• Do the targeted websites have restrictive “terms of use?” Does the vendor check regularly?
• Does the vendor use technology to simulate the creation of any user accounts?
• Does the vendor circumvent any “captchas” or similar technologies?
• Does the vendor respect the “robots.txt” parameters?
• Does the vendor identify its “User-Agent” in the site logs?
• How does the vendor structure IP addresses for spidering?
• Does the vendor throttle/pause/alternate times to simulate human interaction?

“Big Boy” Letters

Assume that Emerging Growth instead decides to sell some of its common stock in Unicorn after hearing the rumor about the Incubus software defect. Emerging Growth finds a single buyer for a block representing 2% of the outstanding common stock of Unicorn. Because Emerging Growth may have material, non public information about the development software (and is also a 9% equity holder in Unicorn), it asks the buyer to execute a “Big Boy” letter that waives any claims and disclaims reliance on the omission of any material, non-public information. For the reasons discussed above, the waiver of claims may not have any definitive protective effect. However, it may have some protective properties, and it could dissuade the buyer from pursuing legal action.

Concluding Thoughts

The scenarios described above, even with their variations, present complex issues under the federal insider trading laws. While we describe these issues to help fund managers to better identify and understand the insider trading questions that they face routinely, we do not intend to suggest that any fund trade where there is any material uncertainty as to compliance with the federal securities laws. In advising our clients, we consistently recommend a conservative approach when it comes to insider trading issues.

The mere public announcement of even an informal SEC investigation could have a significant negative impact on a fund and its manager. A conservative approach means not engaging in any trades even if there are reasonable arguments that information is not material and/or that no duty has been breached.

In addition to business reputational issues, the risks include SEC enforcement, which can include injunctions, fines and other penalties, such as disgorgement. The Department of Justice could pursue criminal charges against the fund manager or specific individuals. We want our clients to know the defenses to claims of insider trading, but, more importantly, we want them to have a basic understanding of the law so as to be able to avoid being in a position where they need defenses. Once a client needs defenses, the larger game — the ability to engage in business with a sterling reputation — might already be lost.

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Chapter 3: Sections 13(d) and 16 for Hedge Funds

In the next chapter, we summarize the SEC’s recent Section 13(d) amendments — the most significant amendments to these rules in decades — and dive deeper into reporting and liability issues under these Sections of the Exchange Act from the straightforward recurrent issues, traps for the unwary and new developments for hedge funds.