Standard II Flashcards
What is Standard II?
Integrity of Capital Markets
What are the subsections of Standard II: Integrity of Capital Markets?
II-A: Material Nonpublic Information
II-B: Market Manipulation
What is 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.
What does ‘material’ information mean?
This means the information would be considered relevant to an investor who is considering
:-investing in this stock,
:- or to a current shareholder wishing to sell.
If a stock reflects all public information, does adding this new information significantly alter the perception of that stock?
The source of the information also impacts its materiality. Overhearing a CEO on the train (material) versus your dentist sharing their opinion (non-material).
What are some example of material information?
Material information would include the following:
•Dividend increase, decrease or omission
•Quarterly earnings or sales significantly different from consensus
•Gain or loss of a major customer
•Changes in management
•Major development specific to that industry
•Government reports of economic trends (housing starts, employment etc.)
•Major acquisition or divestiture
•Offer is made to tender shares (acquisition)
What are the types of exam questions you can expect regarding Standard II-A?
Exam questions covering this Standard are likely to test whether a CFA candidate can understand and identify violations of the Standard and understand and identify actions (e.g. the mosaic theory, firewalls) that help prevent a violation of the Standard.
1: -Understand/Identify Violations
2: -Conflicts to Fiduciary Duty
3: -Mosaic Theory
What are the types of exam questions you can expect regarding Standard II-A?
Understand/Identify Violations
Hundreds of real-life situations can touch on a possible violation of the insider trading laws, and frequently it is not obvious whether a person has acted inappropriately.
As a rule, if you obtain information that is not public and it is considered material, contains a tender offer, was misappropriated, or would violate a breach of confidence you should not trade the security. If the material is already public, (or if the material is not public but contains immaterial information), you are generally free and clear of a violation.
What are the types of exam questions you can expect regarding Standard II-A?
Conflicts to Fiduciary Duty
Questions on the exam are likely to address a CFA member’s fiduciary duty to, for example, act in the best interests of pension fund holders, and whether the member is really doing his or her duty if he or she doesn’t trade on insider information. Indeed, some earlier Standards require placing client interests ahead of personal interests (e.g. with personal transactions or participation in IPOs). However, the guiding principle is that a CFA member’s duty to the investing public (by not acting on inside information) is greater than other duties.
What are the types of exam questions you can expect regarding Standard II-A?
Mosaic Theory
A securities analyst will be motivated to identify mispriced stocks and will be gathering information to such an extent that exposure to nonpublic information is a possibility. However, the work of an analyst depends on the free flow of information.
As a defense to a charge that nonpublic information is being used to trade on a stock, the mosaic theory suggests that the analysis of a company form a mosaic; that is, by assembling small bits of nonpublic information together, large and meaningful conclusions can be drawn.
The idea behind the mosaic theory is that each individual piece of information is nonmaterial by itself: an individual piece of information would not move the price of the security if disseminated in a public press release. Taken together, however, the bits of information can form a meaningful mosaic. This practice is perfectly legitimate, and it is encouraged.
Think of the mosaic theory as a way for analysts to do their jobs and use nonpublic information without feeling like they are at risk for liability under insider trading law. On the exam, hypothetical examples will carry identifying words - i.e. “material” or “nonmaterial” - to guide you to the right answer (material: trading restricted, non-material: no trading restrictions).
How can you comply with Standard II-A?
A compliance program is incomplete if all it does is create awareness of the definition of insider trading and the fines and jail sentences to which the employee could be liable. The real work of the compliance program should be to reduce and eliminate the possibility of a violation. In the real world, there will always be temptation to either profit from (or avoid loss through) knowledge of material nonpublic information.
The most sensible approach is control: prevent the information from being disseminated widely, thus removing the issue of temptation for all but a few.
1: - Firewalls
2: - Training and Continuing Education
3: -Communicate Receipt of Information
4: -Make Reasonable Efforts to Make Nonpublic Information Public
5: - Keep Record of Research and a Rationale for Each Investment Decision
6: - Watch List
How can you comply with Standard II-A?
1
Firewalls
“Firewall” is a common term applied to the barriers created to prevent sensitive information from being disseminated between departments of a firm. As applied to insider trading, the assumption is that certain departments (e.g. corporate underwriting) may have access to material nonpublic information that would be useful to those in other departments (e.g. investment management and research). The guiding principle is that only certain individuals need to know certain things, and thus no one else should have any access.
How can you comply with Standard II-A?
2
Training/Continuing Education
Some employees will be more knowledgeable about insider trading laws (and the need to have them) than others. A comprehensive agenda needs to outline all issues related to insider trading, identify both individual and firm liability under these regulations and summarize procedures for compliance, such as the reporting of personal transactions.
How can you comply with Standard II-A?
3
Communicate Receipt of Information
Companies come into contact with material nonpublic information in a variety of ways. When such a situation occurs, the recipient must be obligated to inform his or her supervisor or compliance officer and not disclose any additional information to coworkers.
How can you comply with Standard II-A?
4
Make Reasonable Efforts to Make Nonpublic
Information Public
If material nonpublic information was received, particularly in breach of a duty or as a result of a misappropriation, it is possible that this information was eventually going to be made public.
While Standard II-A prevents acting on that information while it is not public, the duty to client requires that investment action (should it be required) be made in light of the new information.
For example, if new, nonpublic information makes it clear that a firm will be in violation of a bond covenant and its fixed-income securities will be downgraded to junk status, that security may no longer meet the investment objectives of the client.
However, the bond cannot be sold until the information is made public. In such an instance, reasonable measures may involve a written request between the firm’s compliance department and a legal representative of the firm that issued the bond.
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How can you comply with Standard II-A?
4
Keep Record of Research
and
a Rationale for Each Investment Decision
This procedure, most applicable to Standard V-A, Reasonable Basis, can help protect an analyst who has employed the mosaic theory and used several items of nonmaterial, nonpublic information to form an investment opinion.
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