Reading 2-II: Standards of Professional Conduct & Guida

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CFA Institute Area 1-2: Ethical and Professional Standards
Session 1: Code of Ethics and Professional Standards
Reading 2-II: Standards of Professional Conduct & Guidance: Integrity of Capital Markets
LOS A.: Material Nonpublic Information.

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Andrea Waters is an investment analyst who has accumulated and analyzed several pieces of nonpublic information through her contacts with drug firms. Although no one piece of the information she collected is "material," Waters correctly concluded that the earnings of one of the drug companies would be unexpectedly high in the coming year. According to CFA Institute Standards of Professional Conduct, Waters:

A) cannot legally invest or make recommendations based on this information.

B) should urge the drug firm to make public dissemination of the information immediately.

C) may use the information, but only after approval from a compliance officer or supervisor.

D) can use the information to make investment recommendations and decisions.

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Answer and Explanation

Members who can piece together items of nonmaterial nonpublic information with public information can, based upon the mosaic theory, use such information for trading purposes.

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Regarding non-public information, which one of the following statements is FALSE?

A) Disclosing material non-public information would have an impact on the price of a security or be of interest to a reasonable investor.

B) An analyst may use some types of non-public information.

C) Information that has been disseminated to a few select individuals is still non-public.

D) A member can be summarily suspended for having received material non-public information.

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Answer and Explanation

All of these are true except that a member can be suspended for having received material non-public information. The member can receive such information as part of their regular duties or by accident. Neither is punishable in and of itself, and penalties only apply if the member trades or causes others to trade on the information. The member may have certain duties, such as trying to disseminate the information after receiving it. An analyst may use nonmaterial non-public information.

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A brokerage firm has a trading department and an investment-banking department. Often the investment-banking department receives material non-public information that would be valuable in advising the firms brokerage clients. In order to comply with the Standards, the firm:

A) should record the exchange of information between the investment-banking department and the brokerage department.

B) should restrict employee trading in securities for which the firm is in possession of material non-public information.

C) must divest one of the departments.

D) must liquidate the stocks of companies for which the brokerage has material non-public information.

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Answer and Explanation

Restricting employee trading in stocks for which the firm has material non-public information is the best answer. Recording the exchange of information between the two departments is not the best option because there should be no exchange of information between these two departments. The other two answers, divesting a department or liquidating stocks of clients, are not suitable methods for addressing this potential problem.

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Insider trading can be defined as information that is:

A) nonmaterial and nonpublic.

B) material and nonpublic.

C) material and public.

D) nonmaterial and public.

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Answer and Explanation

Information is material if it would be important to the investor in their investment making decision. Information is nonpublic if it is not yet available to the public.

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According to Standard II(A), prohibition against the use of material nonpublic information, which of the following statements is least accurate? Members who possess material nonpublic information related to the value of a security are expected to:

A) not trade on the information.

B) not trade on the information unless it was arrived at through the "mosaic theory."

C) make reasonable efforts to insure the information's accuracy before recommending that others trade on the information.

D) make reasonable efforts to achieve public dissemination of the information.

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Answer and Explanation

Standard II(A), regarding material nonpublic information, prohibits those possessing material nonpublic information from trading or causing others to trade on that information. Members or candidates should make reasonable efforts to make sure the information is disseminated to the public. Trading based on the mosaic theory is acceptable because this is based on the analysis of public and nonmaterial nonpublic information.

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Which one of the following constitutes the illegal use of material nonpublic information?

A) Trading based on your analytical review of the firm's future prospects.

B) Trading immediately after attending the firm's annual shareholders meeting.

C) Trading on information your sister, the firm's attorney, told you over dinner.

D) Trading on overheard remarks made by an unreliable source at a cocktail party.

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Answer and Explanation

Members may not trade on material nonpublic information; therefore, the information conveyed by the firms attorney may not be used by a member for trading purposes.

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A stockbroker who is a CFA Institute member is called on the telephone by the CEO of a large company. The CEO asks to buy shares of the CEOs company for the accounts of the CEOs children. In the course of the conversation, the CEO says this will really pay off when the upcoming takeover goes through. The stockbroker checks her sources and finds no information about the takeover. In this case the broker should:

A) do none of the actions listed here.

B) only execute the order in compliance with Standard III(A), Loyalty, Prudence, and Care. Since the client is buying the stock for the children, there is not a problem.

C) execute the order for all clients as required by Standard III(B), Fair Dealing.

D) first execute the trade for the children and then use public information to recommend the stock to other clients.

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Answer and Explanation

Doing any of these actions would be a violation of Standard II(A), Material Nonpublic Information. Members and Candidates must not act or induce others to act on material nonpublic information.

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An analyst provides services for a charitable organization and in return gets free membership in the organization. Part of her job is to manage the liquid assets of the organization, and those assets include stocks. Her supervisor in the organization calls her and tells her to buy a certain stock for the portfolio based upon insider information from a board member in the organization. The analyst objects, but the supervisor says this is what they have always done and sees no reason for changing now. The analyst complies with the request. With respect to Standards IV(A), Loyalty to Employer, and II(A), Material Nonpublic Information, the analyst violated:

A) only Standard II(A) that prohibits insider trading.

B) both Standards IV(A) and II(A).

C) only Standard IV(A) requiring duty of loyalty.

D) neither Standard since she is working for a charity.

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Answer and Explanation

An employee/employer relationship does not necessarily mean monetary compensation for services. Complying with the request is a violation of II(A) which prohibits trading on insider information.  Standard IV(A) Loyalty deals with going into business for yourself, leaving an employer and continuing to act in the employer's best interest until their resignation becomes effective, and whistleblowing which means that the member's interests and their firm's interests are secondary to protecting the integrity of capital markets and the interests of the clients.

An employee/employer relationship does not necessarily mean monetary compensation for services. Complying with the request is a violation of II(A) which prohibits trading on insider information.  Standard IV(A) Loyalty deals with going into business for yourself, leaving an employer and continuing to act in the employer's best interest until their resignation becomes effective, and whistleblowing which means that the member's interests and their firm's interests are secondary to protecting the integrity of capital markets and the interests of the clients.

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A CFA Institute member is a U.S. citizen living and working in a foreign country. That country has no laws against insider trading. Based on this information, the CFA Institute member may:

A) not trade using insider information based upon the CFA Institute Standards.

B) not trade using insider information based upon the rules of the SEC.

C) trade using insider information as long as it is not with a client with laws against insider trading.

D) trade using insider information.

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Answer and Explanation

CFA Institute Standard II(A) prohibits trading using insider information. A member may not trade using such information regardless of the rules of the country where he/she lives.