CFA READING 3- STANDARD 2
a
A financial analyst gathers and interprets large quantities of information from many sources. The analyst may use significant conclusions derived from the analysis of public and nonmaterial nonpublic information as the basis for investment recommendations and decisions even if those conclusions would have been material inside information had they been communicated directly to the analyst by a company. Under the "mosaic theory," financial analysts are free to act on this collection, or mosaic, of information without risking violation. The practice of financial analysis depends on the free flow of information. For the fair and efficient operation of the capital markets, analysts and investors must have the greatest amount of information possible to facilitate making well-informed investment decisions about how and where to invest capital. Accurate, timely, and intelligible communication is essential if analysts and investors are to obtain the data needed to make informed decisions about how and where to invest capital. These disclosures must go beyond the information mandated by the reporting requirements of the securities laws and should include specific business information about items used to guide a company's future growth, such as new products, capital projects, and the competitive environment. Analysts seek and use such information to compare and contrast investment alternatives. Much of the information used by analysts comes directly from companies. Analysts often receive such information through contacts with corporate insiders, especially investor-relations staff and financial officers. Information may be disseminated in the form of press releases, through oral presentations by company executives in analysts' meetings or conference calls, or during analysts' visits to company premises. In seeking to develop the most accurate and complete picture of a company, analysts should also reach beyond contacts with companies themselves and collect information from other sources, such as customers, contractors, suppliers, and the companies' competitors. Analysts are in the business of formulating opinions and insights that are not obvious to the general investing public about the attractiveness of particular securities. In the course of their work, analysts actively seek out corporate information not generally known to the market for the express purpose of analyzing that information, forming an opinion on its significance, and informing their clients, who can be expected to trade on the basis of the recommendation. Analysts' initiatives to discover and analyze information and communicate their findings to their clients significantly enhance market efficiency, thus benefiting all investors (see Dirks v. Securities and Exchange Commission). Accordingly, violations of Standard II(A) will not result when a perceptive analyst reaches a conclusion about a corporate action or event through an analysis of public information and items of nonmaterial nonpublic information. Investment professionals should note, however, that although analysts are free to use mosaic information in their research reports, they should save and document all their research [see Standard V(C)-Record Retention]. Evidence of the analyst's knowledge of public and nonmaterial nonpublic information about a corporation strengthens the assertion that the analyst reached his or her conclusions solely through appropriate methods rather than through the use of material nonpublic information. a. Mosaic Theory b. Social Media c. Using Industry Experts d. Investment Research Reports
i
A primary objective of an effective firewall procedure is to establish a reporting system in which authorized people review and approve communications between departments. If an employee behind a firewall believes that he or she needs to share confidential information with someone on the other side of the wall, the employee should consult a designated compliance officer to determine whether sharing the information is necessary and how much information should be shared. If the sharing is necessary, the compliance officer should coordinate the process of "looking over the wall" so that the necessary information will be shared and the integrity of the procedure will be maintained. A single supervisor or compliance officer should have the specific authority and responsibility of deciding whether information is material and whether it is sufficiently public to be used as the basis for investment decisions. Ideally, the supervisor or compliance officer responsible for communicating information to a firm's research or brokerage area would not be a member of that area. a. Achieve Public Dissemination b. Adopt Compliance Procedures c. Adopt Disclosure Procedures d. Issue Press Releases e. Firewall Elements f. Appropriate Interdepartmental Communications g. Physical Separation of Departments h. Prevention of Personnel Overlap i. A Reporting System j. Personal Trading Limitations k. Record Maintenance l. Proprietary Trading Procedures m. Communication to All Employees
e (Comment: The formal liquidity of a market is determined by the obligations set on market makers, but the actual liquidity of a market is better estimated by the actual trading volume and bid-ask spreads. Attempts to mislead participants about the actual liquidity of the market constitute a violation of Standard II(B). In this example, investors have been intentionally misled to believe they chose the most liquid instrument for some specific purpose, but they could eventually see the actual liquidity of the contract significantly reduced after the term of the agreement expires. If the ACME Futures Exchange fully discloses its agreement with members to boost transactions over some initial launch period, it will not violate Standard II(B). ACME's intent is not to harm investors but, on the contrary, to give them a better service. For that purpose, it may engage in a liquidity-pumping strategy, but the strategy must be disclosed.)
ACME Futures Exchange is launching a new bond futures contract. To convince investors, traders, arbitrageurs, hedgers, and so on, to use its contract, the exchange attempts to demonstrate that it has the best liquidity. To do so, it enters into agreements with members in which they commit to a substantial minimum trading volume on the new contract over a specific period in exchange for substantial reductions of their regular commissions.
h (Comment: King has violated Standard II(B) even though he did not personally profit from the market's reaction to the rumor. In posting the false information, King misleads others into believing the companies were likely to be acquired. Although his intent was to create trouble for the portfolio manager, his actions clearly manipulated the factual information that was available to the market.)
Allen King is a performance analyst for Torrey Investment Funds. King believes that the portfolio manager for the firm's small- and microcap equity fund dislikes him because the manager never offers him tickets to the local baseball team's games but does offer tickets to other employees. To incite a potential regulatory review of the manager, King creates user profiles on several online forums under the portfolio manager's name and starts rumors about potential mergers for several of the smaller companies in the portfolio. As the prices of these companies' stocks increase, the portfolio manager sells the position, which leads to an investigation by the regulator as King desired. a. Independent Analysis and Company Promotion b. Personal Trading Practices and Price c. Creating Artificial Price Volatility d. Personal Trading and Volume e. "Pump-Priming" Strategy f. Pump and Dump Strategy g. Manipulating Model Inputs h. Information Manipulation
f
Although documentation requirements must, for practical reasons, take into account the differences between the activities of small firms and those of large, multiservice firms, firms of all sizes and types benefit by improving the documentation of their internal enforcement of firewall procedures. Therefore, even at small firms, procedures concerning interdepartmental communication, the review of trading activity, and the investigation of possible violations should be compiled and formalized. a. Achieve Public Dissemination b. Adopt Compliance Procedures c. Adopt Disclosure Procedures d. Issue Press Releases e. Firewall Elements f. Appropriate Interdepartmental Communications g. Physical Separation of Departments h. Prevention of Personnel Overlap i. A Reporting System j. Personal Trading Limitations k. Record Maintenance l. Proprietary Trading Procedures m. Communication to All Employees
e
An information barrier commonly referred to as a "firewall" is the most widely used approach for preventing the communication of material nonpublic information within firms. It restricts the flow of confidential information to those who need to know the information to perform their jobs effectively. The minimum elements of such a system include, but are not limited to, the following: substantial control of relevant interdepartmental communications, preferably through a clearance area within the firm in either the compliance or legal department; review of employee trading through the maintenance of "watch," "restricted," and "rumor" lists; documentation of the procedures designed to limit the flow of information between departments and of the actions taken to enforce those procedures; and heightened review or restriction of proprietary trading while a firm is in possession of material nonpublic information. a. Achieve Public Dissemination b. Adopt Compliance Procedures c. Adopt Disclosure Procedures d. Issue Press Releases e. Firewall Elements f. Appropriate Interdepartmental Communications g. Physical Separation of Departments h. Prevention of Personnel Overlap i. A Reporting System j. Personal Trading Limitations k. Record Maintenance l. Proprietary Trading Procedures m. Communication to All Employees
g
As a practical matter, to the greatest extent possible, firms should consider the physical separation of departments and files to prevent the communication of sensitive information that should not be shared. For example, the investment banking and corporate finance areas of a brokerage firm should be separated from the sales and research departments, and a bank's commercial lending department should be segregated from its trust and research departments. a. Achieve Public Dissemination b. Adopt Compliance Procedures c. Adopt Disclosure Procedures d. Issue Press Releases e. Firewall Elements f. Appropriate Interdepartmental Communications g. Physical Separation of Departments h. Prevention of Personnel Overlap i. A Reporting System j. Personal Trading Limitations k. Record Maintenance l. Proprietary Trading Procedures m. Communication to All Employees
g (Comment: Even though Kellogg believes that Mayfield would not break the law by disclosing inside information and money was lost on the purchase, Kellogg should not have purchased additional shares of National. It is the member's or candidate's responsibility to make sure, before executing investment actions, that comments about earnings are not material nonpublic information. Kellogg has violated Standard II(A).)
Ashton Kellogg is a retired investment professional who manages his own portfolio. He owns shares in National Savings, a large local bank. A close friend and golfing buddy, John Mayfield, is a senior executive at National. National has seen its stock price drop considerably, and the news and outlook are not good. In a conversation about the economy and the banking industry on the golf course, Mayfield relays the information that National will surprise the investment community in a few days when it announces excellent earnings for the quarter. Kellogg is pleasantly surprised by this information, and thinking that Mayfield, as a senior executive, knows the law and would not disclose inside information, he doubles his position in the bank. Subsequently, National announces that it had good operating earnings but had to set aside reserves for anticipated significant losses on its loan portfolio. The combined news causes the stock to go down 60%. a. Acting on Nonpublic Information b. Controlling Nonpublic Information c. Selective Disclosure of Material Information d. Determining Materiality e. Applying the Mosaic Theory f. Analyst Recommendations as Material Nonpublic Information g. Acting on Nonpublic Information h. Mosaic Theory i. Materiality Determination j. Using an Expert Network k. Using an Expert Network
g (Comment: Mandeville manipulates the inputs of a model to minimize associated risk to achieve higher ratings. His understanding of structured products allows him to skillfully decide which inputs to include in support of the desired rating and price. This information manipulation for short-term gain, which is in violation of Standard II(B), ultimately causes significant damage to many parties and the capital markets as a whole. Mandeville should have realized that promoting a rating and price with inaccurate information could cause not only a loss of price confidence in the particular structured product but also a loss of investor trust in the system. Such loss of confidence affects the ability of the capital markets to operate efficiently.)
Bill Mandeville supervises a structured financing team for Superior Investment Bank. His responsibilities include packaging new structured investment products and managing Superior's relationship with relevant rating agencies. To achieve the best rating possible, Mandeville uses mostly positive scenarios as model inputs—scenarios that reflect minimal downside risk in the assets underlying the structured products. The resulting output statistics in the rating request and underwriting prospectus support the idea that the new structured products have minimal potential downside risk. Additionally, Mandeville's compensation from Superior is partially based on both the level of the rating assigned and the successful sale of new structured investment products but does not have a link to the long-term performance of the instruments. Mandeville is extremely successful and leads Superior as the top originator of structured investment products for the next two years. In the third year, the economy experiences difficulties and the values of the assets underlying structured products significantly decline. The subsequent defaults lead to major turmoil in the capital markets, the demise of Superior Investment Bank, and the loss of Mandeville's employment. a. Independent Analysis and Company Promotion b. Personal Trading Practices and Price c. Creating Artificial Price Volatility d. Personal Trading and Volume e. "Pump-Priming" Strategy f. Pump and Dump Strategy g. Manipulating Model Inputs h. Information Manipulation
d
Companies should consider issuing press releases prior to analyst meetings and conference calls and scripting those meetings and calls to decrease the chance that further information will be disclosed. If material nonpublic information is disclosed for the first time in an analyst meeting or call, the company should promptly issue a press release or otherwise make the information publicly available. a. Achieve Public Dissemination b. Adopt Compliance Procedures c. Adopt Disclosure Procedures d. Issue Press Releases e. Firewall Elements f. Appropriate Interdepartmental Communications g. Physical Separation of Departments h. Prevention of Personnel Overlap i. A Reporting System j. Personal Trading Limitations k. Record Maintenance l. Proprietary Trading Procedures m. Communication to All Employees
c (Comment: Levenson must first determine whether the material information is public. According to Standard II(A), if the company has not made this information public (a small group forum does not qualify as a method of public dissemination), she cannot use the information.)
Elizabeth Levenson is based in Taipei and covers the Taiwanese market for her firm, which is based in Singapore. She is invited, together with the other 10 largest shareholders of a manufacturing company, to meet the finance director of that company. During the meeting, the finance director states that the company expects its workforce to strike next Friday, which will cripple productivity and distribution. Can Levenson use this information as a basis to change her rating on the company from "buy" to "sell"? a. Acting on Nonpublic Information b. Controlling Nonpublic Information c. Selective Disclosure of Material Information d. Determining Materiality e. Applying the Mosaic Theory f. Analyst Recommendations as Material Nonpublic Information g. Acting on Nonpublic Information h. Mosaic Theory i. Materiality Determination j. Using an Expert Network k. Using an Expert Network
c (Comment: By exaggerating her earnings projections in order to try to fuel a quick gain in Hygene's stock price, Gordon is in violation of Standard II(B). Furthermore, by virtue of previewing her intentions of revising upward her earnings projections to only a select group of clients, she is in violation of Standard III(B)-Fair Dealing. However, it would have been acceptable for Gordon to write a report that framed her earnings projection in a range of possible outcomes, outlined clearly the assumptions used in her Hygene models that took into consideration the findings from her trip through Latin America, and was distributed to all Picador & Co. clients in an equitable manner.)
Emily Gordon, an analyst of household products companies, is employed by a research boutique, Picador & Co. Based on information that she has gathered during a trip through Latin America, she believes that Hygene, Inc., a major marketer of personal care products, has generated better-than-expected sales from its new product initiatives in South America. After modestly boosting her projections for revenue and for gross profit margin in her worksheet models for Hygene, Gordon estimates that her earnings projection of US$2.00 per diluted share for the current year may be as much as 5% too low. She contacts the chief financial officer (CFO) of Hygene to try to gain confirmation of her findings from her trip and to get some feedback regarding her revised models. The CFO declines to comment and reiterates management's most recent guidance of US$1.95-US$2.05 for the year. Gordon decides to try to force a comment from the company by telling Picador & Co. clients who follow a momentum investment style that consensus earnings projections for Hygene are much too low; she explains that she is considering raising her published estimate by an ambitious US$0.15 to US$2.15 per share. She believes that when word of an unrealistically high earnings projection filters back to Hygene's investor-relations department, the company will feel compelled to update its earnings guidance. Meanwhile, Gordon hopes that she is at least correct with respect to the earnings direction and that she will help clients who act on her insights to profit from a quick gain by trading on her advice. a. Independent Analysis and Company Promotion b. Personal Trading Practices and Price c. Creating Artificial Price Volatility d. Personal Trading and Volume e. "Pump-Priming" Strategy f. Pump and Dump Strategy g. Manipulating Model Inputs h. Information Manipulation
Material Nonpublic Information
Standard II(A)
j
Firms should consider restrictions or prohibitions on personal trading by employees and should carefully monitor both proprietary trading and personal trading by employees. Firms should require employees to make periodic reports (to the extent that such reporting is not already required by securities laws) of their own transactions and transactions made for the benefit of family members. Securities should be placed on a restricted list when a firm has or may have material nonpublic information. The broad distribution of a restricted list often triggers the sort of trading the list was developed to avoid. Therefore, a watch list shown to only the few people responsible for compliance should be used to monitor transactions in specified securities. The use of a watch list in combination with a restricted list is an increasingly common means of ensuring effective control of personal trading. a. Achieve Public Dissemination b. Adopt Compliance Procedures c. Adopt Disclosure Procedures d. Issue Press Releases e. Firewall Elements f. Appropriate Interdepartmental Communications g. Physical Separation of Departments h. Prevention of Personnel Overlap i. A Reporting System j. Personal Trading Limitations k. Record Maintenance l. Proprietary Trading Procedures m. Communication to All Employees
a (Comment: The information regarding the pending sale is both material and nonpublic. Staple has violated Standard II(A) by communicating the inside information to his broker. Halsey also has violated the standard by buying the shares on the basis of material nonpublic information.)
Frank Barnes, the president and controlling shareholder of the SmartTown clothing chain, decides to accept a tender offer and sell the family business at a price almost double the market price of its shares. He describes this decision to his sister (SmartTown's treasurer), who conveys it to her daughter (who owns no stock in the family company at present), who tells her husband, Staple. Staple, however, tells his stockbroker, Alex Halsey, who immediately buys SmartTown stock for himself. a. Acting on Nonpublic Information b. Controlling Nonpublic Information c. Selective Disclosure of Material Information d. Determining Materiality e. Applying the Mosaic Theory f. Analyst Recommendations as Material Nonpublic Information g. Acting on Nonpublic Information h. Mosaic Theory i. Materiality Determination j. Using an Expert Network k. Using an Expert Network
a
If a member or candidate determines that information is material, the member or candidate should make reasonable efforts to achieve public dissemination of the information. These efforts usually entail encouraging the issuing company to make the information public. If public dissemination is not possible, the member or candidate must communicate the information only to the designated supervisory and compliance personnel within the member's or candidate's firm and must not take investment action or alter current investment recommendations on the basis of the information. Moreover, members and candidates must not knowingly engage in any conduct that may induce company insiders to privately disclose material nonpublic information. a. Achieve Public Dissemination b. Adopt Compliance Procedures c. Adopt Disclosure Procedures d. Issue Press Releases e. Firewall Elements f. Appropriate Interdepartmental Communications g. Physical Separation of Departments h. Prevention of Personnel Overlap i. A Reporting System j. Personal Trading Limitations k. Record Maintenance l. Proprietary Trading Procedures m. Communication to All Employees
f (Comment: Weinberg has violated Standard II(B) by disseminating false information about Moosehead & Belfast with the intent to mislead market participants.)
In an effort to pump up the price of his holdings in Moosehead & Belfast Railroad Company, Steve Weinberg logs on to several investor chat rooms on the internet to start rumors that the company is about to expand its rail network in anticipation of receiving a large contract for shipping lumber. a. Independent Analysis and Company Promotion b. Personal Trading Practices and Price c. Creating Artificial Price Volatility d. Personal Trading and Volume e. "Pump-Priming" Strategy f. Pump and Dump Strategy g. Manipulating Model Inputs h. Information Manipulation
e (Comment: Information on quarterly earnings data is material and nonpublic. Teja arrived at his conclusion about the earnings drop on the basis of public information and on pieces of nonmaterial nonpublic information (such as opinions of designers and retailers). Therefore, trading based on Teja's correct conclusion is not prohibited by Standard II(A).)
Jagdish Teja is a buy-side analyst covering the furniture industry. Looking for an attractive company to recommend as a buy, he analyzes several furniture makers by studying their financial reports and visiting their operations. He also talks to some designers and retailers to find out which furniture styles are trendy and popular. Although none of the companies that he analyzes are a clear buy, he discovers that one of them, Swan Furniture Company (SFC), may be in financial trouble. SFC's extravagant new designs have been introduced at substantial cost. Even though these designs initially attracted attention, the public is now buying more conservative furniture from other makers. Based on this information and on a profit-and-loss analysis, Teja believes that SFC's next quarter earnings will drop substantially. He issues a sell recommendation for SFC. Immediately after receiving that recommendation, investment managers start reducing the SFC stock in their portfolios. a. Acting on Nonpublic Information b. Controlling Nonpublic Information c. Selective Disclosure of Material Information d. Determining Materiality e. Applying the Mosaic Theory f. Analyst Recommendations as Material Nonpublic Information g. Acting on Nonpublic Information h. Mosaic Theory i. Materiality Determination j. Using an Expert Network k. Using an Expert Network
h (Comment: Doll's conversation with the senior executive is part of the mosaic of information used in recommending Boyce. When holding discussions with a firm executive, Doll would need to guard against soliciting or obtaining material nonpublic information. Before issuing the report, the executive's statement about the continuing development of the product would need to be weighed against the other known public facts to determine whether it would be considered material.)
John Doll is a research analyst for a hedge fund that also sells its research to a select group of paying client investment firms. Doll's focus is medical technology companies and products, and he has been in the business long enough and has been successful enough to build up a very credible network of friends and experts in the business. Doll has been working on a major research report recommending Boyce Health, a medical device manufacturer. He recently ran into an old acquaintance at a wedding who is a senior executive at Boyce, and Doll asked about the business. Doll was drawn to a statement that the executive, who has responsibilities in the new products area, made about a product: "I would not get too excited about the medium-term prospects; we have a lot of work to do first." Doll incorporated this and other information about the new Boyce product in his long-term recommendation of Boyce. a. Acting on Nonpublic Information b. Controlling Nonpublic Information c. Selective Disclosure of Material Information d. Determining Materiality e. Applying the Mosaic Theory f. Analyst Recommendations as Material Nonpublic Information g. Acting on Nonpublic Information h. Mosaic Theory i. Materiality Determination j. Using an Expert Network k. Using an Expert Network
b (Comment: John violated Standard II(B) by fraudulently creating the appearance that there was a greater investor interest in the stock through the online rumors. Additionally, through his trading strategy, he created the appearance that there was greater liquidity in the stock than actually existed. He was able to manipulate the price through both misinformation and trading practices.)
John Gray is a private investor in Belgium who bought a large position several years ago in Fame Pharmaceuticals, a German small-cap security with limited average trading volume. He has now decided to significantly reduce his holdings owing to the poor price performance. Gray is worried that the low trading volume for the stock may cause the price to decline further as he attempts to sell his large position. Gray devises a plan to divide his holdings into multiple accounts in different brokerage firms and private banks in the names of family members, friends, and even a private religious institution. He then creates a rumor campaign on various blogs and social media outlets promoting the company. Gray begins to buy and sell the stock using the accounts in hopes of raising the trading volume and the price. He conducts the trades through multiple brokers, selling slightly larger positions than he bought on a tactical schedule, and over time, he is able to reduce his holding as desired without negatively affecting the sale price. a. Independent Analysis and Company Promotion b. Personal Trading Practices and Price c. Creating Artificial Price Volatility d. Personal Trading and Volume e. "Pump-Priming" Strategy f. Pump and Dump Strategy g. Manipulating Model Inputs h. Information Manipulation
i (Comment: There are often rumors and whisper numbers before a release of any kind. The text message from the other trader would most likely be considered market noise. Unless Nadler knew that the trader had an ongoing business relationship with the public firm, he had no reason to suspect he was receiving material nonpublic information that would prevent him from completing the trading request of the portfolio manager.)
Larry Nadler, a trader for a mutual fund, gets a text message from another firm's trader, whom he has known for years. The message indicates a software company is going to report strong earnings when the firm publicly announces in two days. Nadler has a buy order from a portfolio manager within his firm to purchase several hundred thousand shares of the stock. Nadler is aggressive in placing the portfolio manager's order and completes the purchases by the following morning, a day ahead of the firm's planned earnings announcement. a. Acting on Nonpublic Information b. Controlling Nonpublic Information c. Selective Disclosure of Material Information d. Determining Materiality e. Applying the Mosaic Theory f. Analyst Recommendations as Material Nonpublic Information g. Acting on Nonpublic Information h. Mosaic Theory i. Materiality Determination j. Using an Expert Network k. Using an Expert Network
d (Comment: Although information on an expected takeover bid may be of the type that is generally material and nonpublic, in this case, the source of information is unreliable, so the information cannot be considered material. Therefore, Fechtman is not prohibited from trading the stock on the basis of this information.)
Leah Fechtman is trying to decide whether to hold or sell shares of an oil-and-gas exploration company that she owns in several of the funds she manages. Although the company has underperformed the index for some time already, the trends in the industry sector signal that companies of this type might become takeover targets. While she is considering her decision, her doctor, who casually follows the markets, mentions that she thinks that the company in question will soon be bought out by a large multinational conglomerate and that it would be a good idea to buy the stock right now. After talking to various investment professionals and checking their opinions on the company as well as checking industry trends, Fechtman decides the next day to accumulate more stock in the oil-and-gas exploration company. a. Acting on Nonpublic Information b. Controlling Nonpublic Information c. Selective Disclosure of Material Information d. Determining Materiality e. Applying the Mosaic Theory f. Analyst Recommendations as Material Nonpublic Information g. Acting on Nonpublic Information h. Mosaic Theory i. Materiality Determination j. Using an Expert Network k. Using an Expert Network
j (Comment: McCoy is appropriately using the expert networks to enhance her evaluation process. She has neither asked for nor received information that may be considered material and nonpublic, such as preliminary trial results. McCoy is allowed to seek advice from professionals within the industry that she follows.)
Mary McCoy is the senior drug analyst at a mutual fund. Her firm hires a service that connects her to experts in the treatment of cancer. Through various phone conversations, McCoy enhances her understanding of the latest therapies for successful treatment. This information is critical to Mary making informed recommendations of the companies producing these drugs. a. Acting on Nonpublic Information b. Controlling Nonpublic Information c. Selective Disclosure of Material Information d. Determining Materiality e. Applying the Mosaic Theory f. Analyst Recommendations as Material Nonpublic Information g. Acting on Nonpublic Information h. Mosaic Theory i. Materiality Determination j. Using an Expert Network k. Using an Expert Network
c (Comment: Murphy violated Standard II(B) by aiming to create artificial price volatility designed to have a material impact on the price of an issuer's stock. Moreover, by lacking an adequate basis for the recommendation, Murphy also violated Standard V(A)-Diligence and Reasonable Basis.)
Matthew Murphy is an analyst at Divisadero Securities & Co., which has a significant number of hedge funds among its most important brokerage clients. Some of the hedge funds hold short positions on Wirewolf Semiconductor. Two trading days before the publication of a quarter-end report, Murphy alerts his sales force that he is about to issue a research report on Wirewolf that will include the following opinions: quarterly revenues are likely to fall short of management's guidance, earnings will be as much as 5 cents per share (or more than 10%) below consensus, and Wirewolf's highly respected chief financial officer may be about to join another company. Knowing that Wirewolf has already entered its declared quarter-end "quiet period" before reporting earnings (and thus would be reluctant to respond to rumors), Murphy times the release of his research report specifically to sensationalize the negative aspects of the message in order to create significant downward pressure on Wirewolf's stock—to the distinct advantage of Divisadero's hedge fund clients. The report's conclusions are based on speculation, not on fact. The next day, the research report is broadcast to all of Divisadero's clients and to the usual newswire services. Before Wirewolf's investor-relations department can assess the damage on the final trading day of the quarter and refute Murphy's report, its stock opens trading sharply lower, allowing Divisadero's clients to cover their short positions at substantial gains. a. Independent Analysis and Company Promotion b. Personal Trading Practices and Price c. Creating Artificial Price Volatility d. Personal Trading and Volume e. "Pump-Priming" Strategy f. Pump and Dump Strategy g. Manipulating Model Inputs h. Information Manipulation
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.
m
Members and candidates should encourage their employers to circulate written compliance policies and guidelines to all employees. Policies and guidelines should be used in conjunction with training programs aimed at enabling employees to recognize material nonpublic information. Such information is not always clearly identifiable. Employees must be given sufficient training to either make an informed decision or to realize they need to consult a supervisor or compliance officer before engaging in questionable transactions. Appropriate policies reinforce that using material nonpublic information is illegal in many countries. Such trading activities based on material nonpublic information undermine the integrity of the individual, the firm, and the capital markets. a. Achieve Public Dissemination b. Adopt Compliance Procedures c. Adopt Disclosure Procedures d. Issue Press Releases e. Firewall Elements f. Appropriate Interdepartmental Communications g. Physical Separation of Departments h. Prevention of Personnel Overlap i. A Reporting System j. Personal Trading Limitations k. Record Maintenance l. Proprietary Trading Procedures m. Communication to All Employees
b
Members and candidates should encourage their firms to adopt compliance procedures to prevent the misuse of material nonpublic information. Particularly important is improving compliance in such areas as the review of employee and proprietary trading, the review of investment recommendations, documentation of firm procedures, and the supervision of interdepartmental communications in multiservice firms. Compliance procedures should suit the particular characteristics of a firm, including its size and the nature of its business. Members and candidates are encouraged to inform their supervisor and compliance personnel of suspected inappropriate use of material nonpublic information as the basis for security trading activities or recommendations being made within their firm. a. Achieve Public Dissemination b. Adopt Compliance Procedures c. Adopt Disclosure Procedures d. Issue Press Releases e. Firewall Elements f. Appropriate Interdepartmental Communications g. Physical Separation of Departments h. Prevention of Personnel Overlap i. A Reporting System j. Personal Trading Limitations k. Record Maintenance l. Proprietary Trading Procedures m. Communication to All Employees
c
Members and candidates should encourage their firms to develop and follow disclosure policies designed to ensure that information is disseminated to the marketplace in an equitable manner. For example, analysts from small firms should receive the same information and attention from a company as analysts from large firms receive. Similarly, companies should not provide certain information to buy-side analysts but not to sell-side analysts, or vice versa. Furthermore, a company should not discriminate among analysts in the provision of information or "blackball" particular analysts who have given negative reports on the company in the past. Within investment and research firms, members and candidates should encourage the development of and compliance with procedures for distributing new and updated investment opinions to clients. Recommendations of this nature may represent material market-moving information that needs to be communicated to all clients fairly. a. Achieve Public Dissemination b. Adopt Compliance Procedures c. Adopt Disclosure Procedures d. Issue Press Releases e. Firewall Elements f. Appropriate Interdepartmental Communications g. Physical Separation of Departments h. Prevention of Personnel Overlap i. A Reporting System j. Personal Trading Limitations k. Record Maintenance l. Proprietary Trading Procedures m. Communication to All Employees
k
Multiservice firms should maintain written records of the communications between various departments. Firms should place a high priority on training and should consider instituting comprehensive training programs, particularly for employees in sensitive areas. a. Achieve Public Dissemination b. Adopt Compliance Procedures c. Adopt Disclosure Procedures d. Issue Press Releases e. Firewall Elements f. Appropriate Interdepartmental Communications g. Physical Separation of Departments h. Prevention of Personnel Overlap i. A Reporting System j. Personal Trading Limitations k. Record Maintenance l. Proprietary Trading Procedures m. Communication to All Employees
l
Procedures concerning the restriction or review of a firm's proprietary trading while the firm possesses material nonpublic information will necessarily depend on the types of proprietary trading in which the firm may engage. A prohibition on all types of proprietary activity when a firm comes into possession of material nonpublic information is not appropriate. For example, when a firm acts as a market maker, a prohibition on proprietary trading may be counterproductive to the goals of maintaining the confidentiality of information and market liquidity. This concern is particularly important in the relationships between small, regional broker/dealers and small issuers. In many situations, a firm will take a small issuer public with the understanding that the firm will continue to be a market maker in the stock. In such instances, a withdrawal by the firm from market-making acts would be a clear tip to outsiders. Firms that continue market-making activity while in the possession of material nonpublic information should, however, instruct their market makers to remain passive with respect to the market—that is, to take only the contra side of unsolicited customer trades. In risk-arbitrage trading, the case for a trading prohibition is more compelling than it is in the case of market making. The impetus for arbitrage trading is neither passive nor reactive, and the potential for illegal profits is greater than in market making. The most prudent course for firms is to suspend arbitrage activity when a security is placed on the watch list. Those firms that continue arbitrage activity face a high hurdle in proving the adequacy of their internal procedures for preventing trading on material nonpublic information and must demonstrate a stringent review and documentation of firm trades. a. Achieve Public Dissemination b. Adopt Compliance Procedures c. Adopt Disclosure Procedures d. Issue Press Releases e. Firewall Elements f. Appropriate Interdepartmental Communications g. Physical Separation of Departments h. Prevention of Personnel Overlap i. A Reporting System j. Personal Trading Limitations k. Record Maintenance l. Proprietary Trading Procedures m. Communication to All Employees
d (Comment: Sekar's plan would be beneficial for his funds' participants but is based on artificial distortion of both trading volume and the price of the DD stock and thus constitutes a violation of Standard II(B).)
Rajesh Sekar manages two funds—an equity fund and a balanced fund—whose equity components are supposed to be managed in accordance with the same model. According to that model, the funds' holdings in stock of Digital Design Inc. (DD) are excessive. Reduction of the DD holdings would not be easy, however, because the stock has low liquidity in the stock market. Sekar decides to start trading larger portions of DD stock back and forth between his two funds to slowly increase the price; he believes market participants will see growing volume and increasing price and become interested in the stock. If other investors are willing to buy the DD stock because of such interest, then Sekar will be able to get rid of at least some of his overweight position without inducing price decreases. In this way, the whole transaction will be for the benefit of fund participants, even if additional brokers' commissions are incurred. a. Independent Analysis and Company Promotion b. Personal Trading Practices and Price c. Creating Artificial Price Volatility d. Personal Trading and Volume e. "Pump-Priming" Strategy f. Pump and Dump Strategy g. Manipulating Model Inputs h. Information Manipulation
e (Comment: To reach a conclusion about the value of the company, Clement has pieced together a number of nonmaterial or public bits of information that affect Turgot Chariots. Therefore, under the mosaic theory, Clement has not violated Standard II(A) in drafting the report.)
Roger Clement is a senior financial analyst who specializes in the European automobile sector at Rivoli Capital. Because he has been repeatedly nominated by many leading industry magazines and newsletters as a "best analyst" for the automobile industry, he is widely regarded as an authority on the sector. After speaking with representatives of Turgot Chariots—a European auto manufacturer with sales primarily in South Korea—and after conducting interviews with salespeople, labor leaders, his firm's Korean currency analysts, and banking officials, Clement analyzed Turgot Chariots and concluded that (1) its newly introduced model will probably not meet sales expectations, (2) its corporate restructuring strategy may well face serious opposition from unions, (3) the depreciation of the Korean won should lead to pressure on margins for the industry in general and Turgot's market segment in particular, and (4) banks could take a tougher-than-expected stance in the upcoming round of credit renegotiations with the company. For these reasons, he changes his conclusion about the company from "market outperform" to "market underperform." Clement retains the support material used to reach his conclusion in case questions later arise. a. Acting on Nonpublic Information b. Controlling Nonpublic Information c. Selective Disclosure of Material Information d. Determining Materiality e. Applying the Mosaic Theory f. Analyst Recommendations as Material Nonpublic Information g. Acting on Nonpublic Information h. Mosaic Theory i. Materiality Determination j. Using an Expert Network k. Using an Expert Network
INTEGRITY OF CAPITAL MARKETS
STANDARD II
b (Comment: Peter has violated Standard II(A) because he failed to prevent the transfer and misuse of material nonpublic information to others in his firm. Peter's firm should have adopted information barriers to prevent the communication of nonpublic information between departments of the firm. The salespeople and portfolio managers who traded on the information have also violated Standard II(A) by trading on inside information.)
Samuel Peter, an analyst with Scotland and Pierce Incorporated, is assisting his firm with a secondary offering for Bright Ideas Lamp Company. Peter participates, via telephone conference call, in a meeting with Scotland and Pierce investment banking employees and Bright Ideas' CEO. Peter is advised that the company's earnings projections for the next year have significantly dropped. Throughout the telephone conference call, several Scotland and Pierce salespeople and portfolio managers walk in and out of Peter's office, where the telephone call is taking place. As a result, they are aware of the drop in projected earnings for Bright Ideas. Before the conference call is concluded, the salespeople trade the stock of the company on behalf of the firm's clients and other firm personnel trade the stock in a firm proprietary account and in employees' personal accounts. a. Acting on Nonpublic Information b. Controlling Nonpublic Information c. Selective Disclosure of Material Information d. Determining Materiality e. Applying the Mosaic Theory f. Analyst Recommendations as Material Nonpublic Information g. Acting on Nonpublic Information h. Mosaic Theory i. Materiality Determination j. Using an Expert Network k. Using an Expert Network
b
The continuing advancement in technology allows members, candidates, and the industry at large to exchange information at rates not previously available. It is important for investment professionals to understand the implications of using information from the internet and social media platforms because all such information may not actually be considered public. Some social media platforms require membership in specific groups in order to access the published content. Members and candidates participating in groups with membership limitations should verify that material information obtained from these sources can also be accessed from a source that would be considered available to the public (e.g., company filings, webpages, and press releases). Members and candidates may use social media platforms to communicate with clients or investors without conflicting with this standard. As long as the information reaches all clients or is open to the investing public, the use of these platforms would be comparable with other traditional forms of communications, such as e-mails and press releases. Members and candidates, as required by Standard I(A), should also complete all appropriate regulatory filings related to information distributed through social media platforms a. Mosaic Theory b. Social Media c. Using Industry Experts d. Investment Research Reports
c
The increased demand for insights for understanding the complexities of some industries has led to an expansion of engagement with outside experts. As the level of engagement increased, new businesses formed to connect analysts and investors with individuals who have specialized knowledge of their industry (e.g., technology or pharmaceuticals). These networks offer investors the opportunity to reach beyond their usual business circles to speak with experts regarding economic conditions, industry trends, and technical issues relating to specific products and services. Members and candidates may provide compensation to individuals for their insights without violating this standard. However, members and candidates are ultimately responsible for ensuring that they are not requesting or acting on confidential information received from external experts, which is in violation of security regulations and laws or duties to others. As the recent string of insider-trading cases displayed, some experts are willing to provide confidential and protected information for the right incentive. Firms connecting experts with members or candidates often require both parties to sign agreements concerning the disclosure of material nonpublic information. Even with the protections from such compliance practices, if an expert provides material nonpublic information, members and candidates would be prohibited from taking investment actions on the associated firm until the information became publicly known to the market. a. Mosaic Theory b. Social Media c. Using Industry Experts d. Investment Research Reports
f (Comment: When Zito receives advance notice of Clement's change of opinion, she knows it will have a material impact on the stock price, even if she is not totally aware of Clement's underlying reasoning. She is not a client of Clement but obtains early access to the material nonpublic information prior to publication. Her trades are thus based on material nonpublic information and violate Standard II(A). Zito further violates the Standard by relaying the information to her father. It would not matter if he or any other family member traded; the act of providing the information violates Standard II(A). The fact that the information is provided to a family member does not absolve someone of the prohibition of using or communicating material nonpublic information.)
The next day, Clement is preparing to be interviewed on a global financial news television program where he will discuss his changed recommendation on Turgot Chariots for the first time in public. While preparing for the program, he mentions to the show's producers and Mary Zito, the journalist who will be interviewing him, the information he will be discussing. Just prior to going on the air, Zito sells her holdings in Turgot Chariots. She also phones her father with the information because she knows that he and other family members have investments in Turgot Chariots. a. Acting on Nonpublic Information b. Controlling Nonpublic Information c. Selective Disclosure of Material Information d. Determining Materiality e. Applying the Mosaic Theory f. Analyst Recommendations as Material Nonpublic Information g. Acting on Nonpublic Information h. Mosaic Theory i. Materiality Determination j. Using an Expert Network k. Using an Expert Network
a (Comment: The principal owner of FIS violated Standard II(B) by using inaccurate reporting and misleading information under the guise of independent analysis to artificially increase the stock price of the companies. Furthermore, the principal owner violated Standard V(A)-Diligence and Reasonable Basis by not having a reasonable and adequate basis for recommending the two companies and violated Standard VI(A)-Disclosure of Conflicts by not disclosing to investors the compensation agreements (which constituted a conflict of interest).)
The principal owner of Financial Information Services (FIS) entered into an agreement with two microcap companies to promote the companies' stock in exchange for stock and cash compensation. The principal owner caused FIS to disseminate e-mails, design and maintain several websites, and distribute an online investment newsletter—all of which recommended investment in the two companies. The systematic publication of purportedly independent analyses and recommendations containing inaccurate and highly promotional and speculative statements increased public investment in the companies and led to dramatically higher stock prices. a. Independent Analysis and Company Promotion b. Personal Trading Practices and Price c. Creating Artificial Price Volatility d. Personal Trading and Volume e. "Pump-Priming" Strategy f. Pump and Dump Strategy g. Manipulating Model Inputs h. Information Manipulation
h
There should be no overlap of personnel between the investment banking and corporate finance areas of a brokerage firm and the sales and research departments or between a bank's commercial lending department and its trust and research departments. For a firewall to be effective in a multiservice firm, an employee should be on only one side of the firewall at any time. Inside knowledge may not be limited to information about a specific offering or the current financial condition of a company. Analysts may be exposed to much information about the company, including new product developments or future budget projections that clearly constitute inside knowledge and thus preclude the analyst from returning to his or her research function. For example, an analyst who follows a particular company may provide limited assistance to the investment bankers under carefully controlled circumstances when the firm's investment banking department is involved in a deal with the company. That analyst must then be treated as though he or she were an investment banker; the analyst must remain on the investment banking side of the wall until any information he or she learns is publicly disclosed. In short, the analyst cannot use any information learned in the course of the project for research purposes and cannot share that information with colleagues in the research department. a. Achieve Public Dissemination b. Adopt Compliance Procedures c. Adopt Disclosure Procedures d. Issue Press Releases e. Firewall Elements f. Appropriate Interdepartmental Communications g. Physical Separation of Departments h. Prevention of Personnel Overlap i. A Reporting System j. Personal Trading Limitations k. Record Maintenance l. Proprietary Trading Procedures m. Communication to All Employees
j (Comment: Watson has violated Standard II(A) by passing along material nonpublic information concerning the ongoing product tests, which the fund used to trade in the securities and options of the related company. Watson cannot simply rely on the agreements signed by individuals who participate in expert networks that state that he has not received information that would prohibit his trading activity. He must make his own determination whether information he received through these arrangements reaches a materiality threshold that would affect his trading abilities.)
Tom Watson is a research analyst working for a hedge fund. To stay informed, Watson relies on outside experts for information on such industries as technology and pharmaceuticals, where new advancements occur frequently. The meetings with the industry experts often are arranged through networks or placement agents that have specific policies and procedures in place to deter the exchange of material nonpublic information. Watson arranges a call to discuss future prospects for one of the fund's existing technology company holdings, a company that was testing a new semiconductor product. The scientist leading the tests indicates his disappointment with the performance of the new semiconductor. Following the call, Watson relays the insights he received to others at the fund. The fund sells its current position in the company and buys many put options because the market is anticipating the success of the new semiconductor and the share price reflects the market's optimism. a. Acting on Nonpublic Information b. Controlling Nonpublic Information c. Selective Disclosure of Material Information d. Determining Materiality e. Applying the Mosaic Theory f. Analyst Recommendations as Material Nonpublic Information g. Acting on Nonpublic Information h. Mosaic Theory i. Materiality Determination j. Using an Expert Network k. Using an Expert Network
d
When a particularly well-known or respected analyst issues a report or makes changes to his or her recommendation, that information alone may have an effect on the market and thus may be considered material. Theoretically, under Standard II(A), such a report would have to be made public at the time it was distributed to clients. The analyst is not a company insider, however, and does not have access to inside information. Presumably, the analyst created the report from information available to the public (mosaic theory) and by using his or her expertise to interpret the information. The analyst's hard work, paid for by the client, generated the conclusions. Simply because the public in general would find the conclusions material does not require that the analyst make his or her work public. Investors who are not clients of the analyst can either do the work themselves or become clients of the analyst to gain access to the analyst's expertise. a. Mosaic Theory b. Social Media c. Using Industry Experts d. Investment Research Reports
a
manipulation includes, but is not limited to, spreading false rumors to induce trading by others. For example, members and candidates must refrain from "pumping up" the price of an investment by issuing misleading positive information or overly optimistic projections of a security's worth only to later "dump" the investment (i.e., sell it) once the price, fueled by the misleading information's effect on other market participants, reaches an artificially high level. a. Information-Based Manipulation b. Transaction-Based Manipulation
b
manipulation involves instances where a member or candidate knew or should have known that his or her actions could affect the pricing of a security. This type of manipulation includes, but is not limited to, the following: artificially affect prices or volume to give the impression of activity or price movement in a financial instrument, which represent a diversion from the expectations of a fair and efficient market, and securing a controlling, dominant position in a financial instrument to exploit and manipulate the price of a related derivative and/or the underlying asset. Standard II(B) is not intended to preclude transactions undertaken on legitimate trading strategies based on perceived market inefficiencies. The intent of the action is critical to determining whether it is a violation of this standard. a. Information-Based Manipulation b. Transaction-Based Manipulation
