Ethics Helper: Standard 2: Integrity of Capital Markets Flashcards
What is Standard 2A?
INTEGRITY OF CAPITAL MARKETS -
MATERIAL NONPUBLIC INFORMATION
What is the language of Standard 2A?
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.
Why does insider trading affect the integrity of capital markets?
erodes confidence in capital markets, institutions, and investment professionals by supporting the idea that those with inside information and special access can take unfair advantage of the general investing public
What is “material” information?
Information is “material” if its disclosure would probably have an impact on the price of a security or if reasonable investors would want to know the information before making an investment decision.
What are key factors in determining the materiality of information?
- Specificity
- Extent of difference from current public information
- Reliability of the Source Information
What is “nonpublic” information?
Information is “nonpublic” until it has been disseminated or is available to the marketplace in general (as opposed to a select group of investors).
True or False:
Analysts should also be alert to the possibility that they are selectively receiving material nonpublic information when a company provides them with guidance or interpretation of such publicly available information as financial statements or regulatory filings.
True
What is “Mosaic Theory”?
The mosaic theory is an approach to financial security analysis that involves the analysis of a variety of resources, including public and non-public material and non-material information, to determine the underlying value of a security.
Is an analyst in violation of Section 2A when he/she uses material public and non-material non-public information to come up with unique trading insights?
No. Since he/she did not use material non-public information, he/she is fine.
Is information shared on social media considered public information?
It depends.
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).
Can analysts confer with outside experts?
Yes.
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.
If an analysts research report could be market-moving, does it necessarily need to be made public?
No, not if the conclusions were drawn without material non-public information.
What must an analyst do if he/she has access to material non-public information?
- 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 such as 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.
What should a company do if material non-public information is released during an analysts call?
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.
What is a “firewall”?
An information barrier used to prevent the communication of material nonpublic information within firms.
What are the key elements to a firewall?
- substantial control of relevant interdepartmental communications
- review of employee trading
- documentation of the procedures designed to limit the flow of information between departments and of the actions taken to enforce those procedures
- heightened review or restriction of proprietary trading while a firm is in possession of material nonpublic information
- physical separation of departments
- No personell overlap
Has Frank Barnes done anything wrong?
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.
Yes.
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.
Has Peter done anything wrong?
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.
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.
Elizabeth Levenson is based in Hanoi and covers the Vietnamese 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”?
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.
Can Fechtman act on 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.
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.
Are Teja’s actions permissible on Section 2A?
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.
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).
Analyze the following situation:
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;
(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.
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.
Analyze the following situation:
Roger Clement is a senior financial analyst who specializes in the European automobile sector at Rivoli Capital.
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.
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.
Analyze the following situation:
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%.
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).
