Reconciling Hedge Funds, the SEC and Material Non-Public Information

Tu·mul·tu·ous (adjective) marked by violent or overwhelming turbulence or upheaval.

Imagine for a moment a European bullet train speeding at 250 km/hr along the Washington – Boston Northeast Corridor which was designed to support the Acela Express with an average speed of 140 km/hr. Many hedge fund managers may be feeling the same way; that they are on a tumultuous ride. Who can blame these managers?


In recent speeches regarding hedge fund insider trading, the Securities Exchange Commission (“SEC”) has highlighted that the SEC is “expanding the [Enforcement] Division’s investigative toolbox” which the regulator believes is a potential “game-changer for the Enforcement Division”.

At the same time, who can fault the SEC? The regulator has uncovered massive deceit by large and diverse groups of market participants involving insider trading and they have also taken the heat over their failure to uncover some long running scams. They simply can’t take a light approach to regulation during these times.

Where does that leave us? How do we reconcile, what appears to be two opposing forces? A likely overzealous SEC on one hand and a hedge fund manager’s fiduciary duty to its investors on the other. Hard-nosed, fundamental research often involves managers developing vast networks of industry professionals or utilizing one of the dozens of expert networks that exist. It is these networking arrangements that are now deemed to be “red flags” to the SEC.

Raj Rajaratnam developed and benefited from a significant network, albeit allegedly based on unfair practices. But what about the “look-under-every-stone” fundamental manager? As part of their due diligence when developing an investment thesis, managers often speak with analysts, company executives, suppliers, competitors, customers and other managers. Consider the three-part roundtable in Barron’s the last three weekends. Early each year, Barron’s interviews well recognized investment professionals. These experts exchange “ideas”, sometimes disagreeing on global markets, individual securities and macro trends. Whether at a conference or through informal meetings such as Barron’s annual roundtable, investment professionals often exchange ideas. The issue now becomes, when do these idea exchanges and “networking” arrangements start blinking bright on the SEC’s radar screen? We suspect they all will for the foreseeable future.

We hope the SEC considers the potential unintended consequences. Clearly, the regulator does not want to restrict legitimate hardnosed research. Without doubt, advisers should expect to be questioned about their networking arrangements and what controls they have in place around them.

What happens when a manager knowingly or unknowingly is in possession of material non-public information? The best defense a manger can have is properly designed policies and procedures based on a firm’s risk assessment including oversight of all existing and potential conflicts of interest. In the regulated world, the SEC can, and has brought enforcement actions against advisers who do not have “written policies and procedures reasonably designed to prevent violations by the Adviser and its supervised persons” even if no violation occurred. Yes, you did read that correctly. An actual violation does not have to occur in order for an enforcement action to be brought against an adviser.

Registered or not, hedge fund managers should adopt policies and procedures that include staff training and forensic testing of both personal trading and trading by the hedge fund. Hedge fund employees should also be logging contact with certain “high-risk” individuals such as company executives, directors, certain service providers and other managers. Notes should be maintained summarizing what was discussed during related meetings. This does not have to be an over-bearing, daunting task.

The best policies are of no use if they are not monitored and enforced. A hedge fund should identify someone at their firm as Chief Compliance Officer and he or she should be spending some time on compliance. Whether viewed as an insurance premium or not, devoting some resources to compliance upfront, can prevent the catastrophic loss of reputation. It can also stabilize the tracks so the bullet train’s journey is much smoother.

The best policies and procedures may not prevent “determined” deceit and dishonesty. An individual dead-set on illegally trading (or causing others to do so) on material non-public information may be impossible for the firm to identify. However, being able to demonstrate a culture of compliance and adopting “firm-specific” customized policies and procedures can protect a firm even if one bad apple emerges.

Coming Soon To A Theater Near You: SEC Compliance Consultants will be hosting an educational webinar with industry experts on protecting your firm specific to dealing with material non-public information. Look for information on our website and in upcoming Communiqués.