Ethical and Professional Standards · Reading 96
Material Nonpublic Information
CFA Level I · Ethical and Professional Standards · Reading 96: Guidance for Standard II: Integrity of Capital Markets · about 27 min
What you'll learn
- LOS 96.a Apply Standard II(A) Material Nonpublic Information and Standard II(B) Market Manipulation to situations involving professional integrity.
- LOS 96.b Recommend practices and procedures (public dissemination, firewalls, restricted and watch lists, trading review) that prevent violations of Standard II.
- LOS 96.c Identify conduct that conforms to, and conduct that violates, Standards II(A) and II(B).
Module 96.1
Guidance for Standards II(A) and II(B)
This reading covers Standard II, Integrity of Capital Markets, with its two parts, Material Nonpublic Information and Market Manipulation. A candidate must be able to apply both to a fact pattern, including the tests of materiality and of public dissemination and the mosaic theory, recommend procedures such as firewalls that prevent violations, and tell conduct that conforms from conduct that violates.
Standard II protects the integrity of capital markets: prices should reflect information that all investors can obtain, and trading activity should be genuine. It has two parts, Standard II(A) Material Nonpublic Information and Standard II(B) Market Manipulation. The three LOS cover applying the two Standards to a fact pattern (96.a), the procedures that prevent violations (96.b), and sorting conduct into "conforms" and "violates" (96.c).
LOS 96.a — Applying Standards II(A) and II(B) to fact patterns
Standard II(A) Material Nonpublic Information
Members and candidates who possess material nonpublic information that could affect the value of an investment must not act or cause others to act on the information.
The rule exists because investors take part in markets only if they believe everyone trades on the same public information. If insiders could profit from what others cannot know, markets would look rigged, investors would commit less capital and prices would reflect information less well.
The prohibition applies only when the information passes both tests:
Key concept
| Test | Question to ask | Passes when... | Fails when... |
|---|---|---|---|
| Material | Would disclosure move the price, or would a reasonable investor want to know it before investing? | Earnings results or guidance, mergers and tender offers, big contracts won or lost, significant litigation, regulatory decisions, dividend changes, a sudden change in a widely followed analyst's recommendation | The information is vague or ambiguous as to its price effect (e.g., only that two people met), so it may not be material; the less reliable the source, the less likely the information is material |
| Nonpublic | Has it been disseminated to the marketplace in general? | Only insiders, a few analysts, or a closed group know it | It has been released broadly (press release, regulatory filing, general newswire) |
Points to apply:
- Selective disclosure is not public disclosure. When a company releases information to a chosen few, it creates the risk that those who receive it will trade on it. Telling a group of analysts on a conference call, a roadshow audience or a small investor group leaves the information nonpublic for everyone who heard it.
- The source does not matter. Information overheard at a restaurant, passed on by a relative or a housekeeper, or supplied by an outside party such as a supplier or plaintiff is still covered. The Standard applies whether or not the insider breached a duty and whether or not the information was misappropriated. Once a member knows the information is material and nonpublic, the member may not act on it.
- "Act or cause others to act" covers trading for oneself, for clients, for the employer and for family members. It also covers accepting and executing an order from someone the member knows is trading on the information, and recommending or tipping.
- Indirect trades are still trades. The prohibition covers the security itself, mutual funds and exchange-traded funds that hold it, and related swaps and options contracts. Buying funds that hold the affected stock (and shorting similar funds that do not) is still acting on the information.
- Check before acting. The member is responsible for finding out whether information has been publicly disseminated before acting on it or causing others to act on it.
- Information received for a deal. Members involved in transactions such as investment banking assignments may receive material nonpublic information from the firms involved. They may use it for the purpose for which it was provided (working on the deal) and for no other purpose until it becomes public.
- Wait for public dissemination. The prohibition lasts until the information has been made public. Until then, trading on it, publishing a report on it and telling clients are all prohibited.
- Possession alone is not a violation. Analysts often receive nonpublic information by accident or in the course of their work. The violation is acting on it or causing others to act.
- Knowing that an item is false can itself be material nonpublic information. If only one person knows that a market-moving statement is fake, that knowledge is material and nonpublic.
The mosaic theory
Under the mosaic theory, an analyst may reach a conclusion by combining public information with nonmaterial nonpublic information and may act on that conclusion even if the conclusion itself would be material had the company disclosed it. Channel checks with suppliers and customers, counting inventory in a parking lot, reading trade publications and noticing where executives travel are all legitimate research. The mosaic theory never permits using an item that is itself material and nonpublic.
| Public | Nonpublic | |
|---|---|---|
| Material | May act (e.g., earnings in a press release) | May not act or cause others to act until it is public |
| Nonmaterial | May act | May act; a usable input to a mosaic conclusion (e.g., a count of trucks at a plant) |
Analysts should keep records of the research behind a mosaic conclusion.
Standard II(B) Market Manipulation
Members and candidates must not engage in practices that distort prices or artificially inflate trading volume with the intent to mislead market participants.
The Standard is broken in two ways: by spreading false information to affect prices or volume, and by making trades intended to mislead market participants.
Key concept
| Conduct | Examples |
|---|---|
| Spreading false or misleading information to affect prices or volume | False rumors or fabricated posts on social media; overstating an earnings projection to lift a price; promoting a stock one holds with false claims; misrepresenting a product or technology |
| Trades intended to mislead market participants | Matched buy and sell orders between related accounts to inflate volume; buying a dominant position in an asset to move the price of a related derivative (or the reverse) |
The deciding element is the intent to mislead; whether the member profits does not matter. A member's trades can legitimately move prices and volume, and that alone is not a violation. The Standard is violated when the trading or the information is intended to mislead. Conduct with no such intent includes trading strategies that exploit differences in market power, information or other market inefficiencies, transactions made for tax purposes (e.g., selling for a tax loss while holding a synthetic long position), and block trades used to limit the price impact of a large order in a thinly traded security.
Example. A trader holds a large short position in a small biotech stock and then posts invented reports of a failed clinical trial. The short position alone is legitimate. The false posts violate Standard II(B), because they spread false information to move the price. The trade itself was not intended to mislead anyone, so it is not a violation.
LOS 96.b — Procedures that prevent violations
Recommendations for members and candidates who hold material nonpublic information:
- Make reasonable efforts to achieve public dissemination of the information by the company (for example, encourage the issuer to announce it).
- Encourage their firms to adopt procedures that prevent the misuse of material nonpublic information.
Recommendations for firms. The core control is a firewall (information barrier) between departments that receive inside information (investment banking, corporate finance) and sales, trading and research. Its elements:
Key concept
| Firewall element | What it does |
|---|---|
| Clearance area (compliance or legal department) | Exercises substantial control over communications between departments; any necessary contact across the wall is cleared and documented there |
| Review of employee trades | Pre-clearance and reporting of personal trades, so trading on inside information is detected |
| Watch, restricted and rumor lists | A watch list lets compliance quietly monitor trading in securities the firm has sensitive information about; a restricted list prohibits or limits trading in them; a rumor list tracks securities that are the subject of market rumors |
| Monitoring and restricting proprietary trading | Limits the firm's own trading while it holds material nonpublic information |
A blanket ban on all proprietary trading in a security whenever the firm holds inside information may itself be inappropriate, because the sudden absence of the firm's usual trading can signal the information to the market. In such cases the firm should only take the opposite side of unsolicited customer trades.
Other good practice includes written procedures and training on what counts as material and nonpublic information.
LOS 96.c — Conduct that conforms vs. conduct that violates
The points under LOS 96.a already sort most conduct into the two groups. Two further contrasts:
| Conforms | Violates |
|---|---|
| Declining an order from an insider who reveals an unannounced takeover | Executing that order because it is "for the insider's children" |
| Exploiting genuine pricing inefficiencies | Inventing a warning to move futures prices and then trading against it |
Common exam traps
- Standard IV(A) Loyalty concerns duties to the employer (independent practice, leaving an employer, whistleblowing). Trading on an inside tip because a supervisor ordered it violates II(A); it is not a loyalty violation.
Exam shortcuts
- Under Standard II(B), whether the member profited does not matter; the deciding element is the intent to mislead, so a trade that merely moves the price is not a violation without it.
Bottom line
- Standard II(A) applies only when information is both material, meaning disclosure would move the price or a reasonable investor would want to know it, and nonpublic, meaning it has not been disseminated to the marketplace in general.
- Selective disclosure, such as telling a group of analysts on a conference call or a roadshow audience, leaves the information nonpublic for everyone who heard it.
- Acting or causing others to act on material nonpublic information includes trading for oneself, clients, the employer or family members, executing an order from someone known to be trading on it, recommending or tipping, and trading related funds, swaps or options, while possession alone is not a violation.
- Under the mosaic theory, an analyst may act on a conclusion drawn from public information and nonmaterial nonpublic information even if the conclusion would be material had the company disclosed it, but never on an item that is itself material and nonpublic.
- Standard II(B) is violated by spreading false or misleading information to affect prices or volume, or by trades intended to mislead market participants.
- Strategies that exploit market inefficiencies, transactions made for tax purposes and block trades used to limit price impact are not manipulation when they carry no intent to mislead.
- A member who holds material nonpublic information should make reasonable efforts to achieve public dissemination of it by the company.
- The firm's core control is a firewall, with a clearance area, review of employee trades, watch, restricted and rumor lists, and monitoring and restriction of proprietary trading.
Quick check
Adaeze Okafor, CFA, is a broker. The chief executive of Stellan Pharmaceuticals, a listed company, telephones her and asks her to buy Stellan shares for trust accounts he set up for his grandchildren, remarking that the purchase will look very smart "once the merger we're negotiating is announced." Okafor searches news services and finds no public mention of a merger. Okafor should:
Show answer and explanation
Correct answer: C
A pending merger is material, and Okafor has confirmed it has not been made public. Executing the trade would mean acting (and helping the insider act) on material nonpublic information, which Standard II(A) prohibits: Members and Candidates must not act or cause others to act on such information.
Why the other options are wrong
- A. Fair Dealing is about treating clients fairly when disseminating recommendations and executing trades; it never requires a member to execute a trade that violates Standard II(A).
- B. Whose account benefits is irrelevant: buying for trusts set up for family members on the strength of inside information is still acting on material nonpublic information, and no duty to a client overrides Standard II(A).
Key takeaway Once a client reveals material nonpublic information behind an order, the member may not execute it. The identity of the account holder does not change that.
Practice Questions
Colette Brenner is convinced that Lunaris Robotics is overvalued, and three weeks ago she sold short 60,000 Lunaris shares. This week she has been posting false, damaging claims about Lunaris's management on several investment message boards. Under Standard II(B) Market Manipulation, Brenner's conduct is:
Show answer and explanation
Correct answer: A
Posting false, damaging claims to move the share price spreads false information with the intent to mislead, which violates Standard II(B). Her short sale, made weeks earlier on her own view of value, was not intended to mislead anyone, so the trade itself is not a violation.
Why the other options are wrong
- B. A short sale based on a genuine valuation view is not a trade intended to mislead. Only the false postings violate the Standard.
- C. This reverses the facts. The violation lies in the false claims she posted; her trade was legitimate.
Key takeaway Taking a position is legitimate. Spreading false information to move the price toward that position violates Standard II(B).
Tobias Engel, an investment analyst, has gathered several items of nonpublic information through his contacts at medical device makers. None of the items is material on its own, but by putting them together he correctly concludes that one of the companies will report much higher earnings than expected next year. According to the CFA Institute Standards of Professional Conduct, Engel:
Show answer and explanation
Correct answer: B
Engel pieced together nonmaterial nonpublic information to reach a conclusion. Under the mosaic theory, he may use that conclusion for investment recommendations and trading even though the conclusion itself would be material.
Why the other options are wrong
- A. Treats the material conclusion as if it were material nonpublic information received from the company; the mosaic theory permits it.
- C. No compliance approval is required for a legitimate mosaic conclusion (although keeping research records is good practice).
Key takeaway A material conclusion built from nonmaterial pieces may be used under the mosaic theory.
This reading has 32 questions in the full bank. Practice all of them.
Key Takeaways
- Once a client reveals material nonpublic information behind an order, the member may not execute it. The identity of the account holder does not change that.
- Taking a position is legitimate. Spreading false information to move the price toward that position violates Standard II(B).
- A material conclusion built from nonmaterial pieces may be used under the mosaic theory.