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 "."

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 or non-disclosure agreements. Second, when someone receives 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 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 "" (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 "" 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 and watch lists.

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 .

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.

face additional requirements under federal law. They must adopt that prevent employees from engaging in personal securities transactions that could conflict with client interests or involve misappropriation of confidential information.

of the requires both registered and 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.