SEC Rule 10b5-2

Rule 10b5-2 is a federal securities regulation that clarifies when someone has a legal duty to keep information confidential. This duty becomes important when determining whether someone committed insider trading under what lawyers call the "misappropriation theoryA legal theory of insider trading liability that focuses on whether someone obtained material non-public information in breach of a duty of trust or confidence owed to the source, rather than to the company whose stock is traded.."

The rule is especially important for hedge funds because they frequently receive confidential information through their business relationships. Fund managers need to understand when possessing certain information creates legal trading restrictions.

The rule identifies three specific situations where a legal duty of trust or confidence automatically exists:

First, when someone agrees to keep information confidential. This typically happens through signed confidentiality agreements or non-disclosure agreements. Second, when someone receives material non-public information Material non-public information Material non-public information is data about a company that is not publicly available and would likely affect the market price of its securities if disclosed, which hedge funds must establish policies to identify and prevent trading upon to avoid insider trading violations. and should reasonably understand that the person sharing it expects confidentiality. This covers situations where formal agreements don't exist but the circumstances clearly indicate confidentiality is expected.

Third, when someone receives material non-public information from specific family members. The rule specifically includes spouses, parents, children, and siblings. The law assumes these family relationships naturally create expectations of confidentiality.

When any of these situations occur, the person who received the information faces potential insider trading liability if they trade on that information or share it inappropriately.

Rule 10b5-2 works within the larger system of insider trading law. Federal prosecutors and the Securities and Exchange Commission (SEC) use a three-part test to prove insider trading occurred. They must show that someone traded while possessing information that was: material (important to investors), non-public (not available to everyone), and obtained by violating a duty.

The SEC and federal prosecutors have continued to focus their enforcement efforts on insider trading within the hedge fund industry. Fund managers need to understand the difference between legitimate research activities and prohibited insider trading conduct. Legal research may include gathering publicly available information and conducting lawful interviews, while prohibited conduct involves trading on confidential information obtained through breaches of duty.

Information becomes "material" when reasonable investors would likely consider it important for making investment decisions. Generally, this includes any information that could significantly affect a company's stock price once disclosed.

Material information typically covers several categories related to a company's financial performance and operations. These include earnings results, merger and acquisition activity (both proposed and completed), changes to earnings projections, cash flow problems, dividend changes, significant lawsuits, and major management changes.

Material information can also relate to broader securities market conditions. This might include large orders to buy or sell securities or details about a fund's portfolio holdings. Even information that will soon be published in financial media may qualify as material if it hasn't been released yet.

Rule 10b5-2 becomes practically important for hedge funds in several common scenarios. These include entering confidentiality agreements with companies they're researching, receiving information through expert networksCompanies that connect institutional investors with professionals who have specialized knowledge about particular industries or companies, often providing confidential information that may trigger insider trading restrictions. or consultants, developing business relationships with corporate insiders, and when fund employees have family members who work at public companies.

The rule helps hedge funds understand exactly when receiving information creates trading restrictions. Once they know restrictions apply, they can implement appropriate compliance procedures to prevent violations.

When hedge fund employees might encounter material, non-public information about companies in their portfolios, firms can use several protective measures to prevent information from spreading inappropriately within the organization.

One common approach involves establishing "information barriersProcedures and physical or organizational separations implemented by investment firms to prevent employees with access to material non-public information from sharing it with other firm members, also known as 'Chinese walls'." (sometimes called "Chinese walls"). These barriers prevent employees who have access to confidential information from sharing that information with other firm members. Firms might physically separate these employees into different offices or restrict specific information to only designated staff members.

Recent SEC enforcement actions have included "shadow tradingThe improper practice of using confidential information about one company to trade in related companies or economically linked securities, representing a form of insider trading violation." cases, where firms improperly used confidential information about one company to trade in related companies or economically linked securities. These cases demonstrate why robust information barriers are essential for preventing misuse of confidential information.

When information barriers aren't practical or suitable, hedge funds can still manage the consequences of receiving confidential information through restricted listsA list maintained by investment firms identifying companies whose securities firm employees cannot trade in their personal accounts due to conflicts of interest or possession of material non-public information. and watch lists.

Restricted listsA list maintained by investment firms identifying companies whose securities firm employees cannot trade in their personal accounts due to conflicts of interest or possession of material non-public information. identify companies whose securities firm employees cannot trade in their personal accounts. These lists typically include companies where the firm has received material, non-public information that could create conflicts of interest.

Watch lists identify companies the firm may be evaluating for potential investment. While firms cannot completely prohibit personal trading in watch list securities, they can require employees to get pre-approval before trading in these companies' securities.

Together with information barriers, these tools create a comprehensive compliance framework for managing insider trading risks in hedge fund operations.

Hedge funds must establish written policies and procedures to identify when they have received information that creates duties of trust or confidence under Rule 10b5-2. This includes maintaining up-to-date restricted lists, implementing information barriers when appropriate, and establishing clear procedures for handling confidential information received through various business channels.

Registered investment advisers Registered investment adviser (RIA) A registered investment adviser (RIA) is a hedge fund manager or other investment adviser that has registered with the SEC or state securities regulators. These advisers must follow comprehensive rules including fiduciary duties, compliance requirements, and regular examinations. face additional requirements under federal law. They must adopt codes of ethics that prevent employees from engaging in personal securities transactions that could conflict with client interests or involve misappropriation of confidential information.

Section 204AProvision of the Investment Advisers Act requiring investment advisers to establish, maintain, and enforce written policies and procedures reasonably designed to prevent the misuse of material non-public information. of the Investment Advisers Act of 1940 Investment Advisers Act of 1940 The Investment Advisers Act of 1940 is the primary U.S. legislation regulating investment advisers, including hedge fund managers, establishing registration requirements, fiduciary duties, disclosure obligations, and compliance standards for advisers meeting certain thresholds. requires both registered and exempt reporting advisers Exempt reporting adviser An exempt reporting adviser is an investment adviser that doesn't have to complete full SEC registration, but still must meet some basic reporting requirements. This status typically applies to advisers who only manage private funds with less than $150 million in U.S. assets, or advisers who exclusively manage venture capital funds. to establish insider trading policies. These policies must be designed to detect and prevent misuse of material, non-public information in violation of federal securities laws. The requirement took effect for most advisers and remains an ongoing compliance obligation.