The capital markets are where transactions between two parties occur—the place where participants want to buy or sell a security, or enter into a contract. The expansion of the capital markets into a global marketplace because of the Internet, together with the proliferation of financial products, has resulted in more opportunities to trade globally, but has also added to the potential for abuses and actions that destroy the integrity of the capital markets. Maintaining the integrity of the capital markets is crucial for buyers and sellers to willingly come together: They need to trust that the transaction is fair and that neither party has an advantage or special access to information. Transactions should be based on each party doing its homework—performing due diligence and research. Information gleaned from that research is the basis on which the decision to buy or sell is made. Decisions made for other reasons such as having inside information are not only unfair, but illegal in many regions. The integrity of the capital markets is violated when participants use fraudulent or illegal means as the basis for their transaction. It erodes confidence in the markets and may result in investors avoiding them. Since the introduction of the web and the proliferation of financial news, the dissemination of company news is more widely available. Taken together with Regulation Fair Disclosure (Reg FD), investors should never use material information that is non-public to form the basis for investment decisions. Any leaked information should become public immediately.

Material and Non-public

The words “material” and “non-public” are often used when referring to insider trading. According to the professional organization, CFA Institute, “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. In other words, information is material if it would significantly alter the total mix of information currently available about a security in such a way that the price of the security would be affected.” Non-public refers to information that has not been widely disseminated, such as on a company’s website, at an industry conference, in a press release or through a Securities Exchange Commission filing.

Maintaining Capital Market Integrity

Investors need to understand what is allowable and what is not permitted to ensure the integrity of the capital markets. Possessing material non-public information in itself is not destroying the integrity. But the “use” of that information can be. For example, using information to indirectly buy securities or bonds is prohibited. Indirect buying can be in the form of derivatives (swaps, options or contracts), in mutual funds, exchange-traded funds or alternative investments. Using the information by telling another party and causing it to act on the information is also not permitted.

The kind or substance of information is crucial in determining if it is material or not. Examples of material information include earnings, mergers and acquisitions, new products and services, new regulatory approvals or changes, change in management, bankruptcy and legal proceedings, and information related to sales, among a few. The determination of materiality may also depend on the source of the information, and how specific and timely it is.

Research-based investment decisions are the key to ensuring the integrity of the capital markets is upheld. Often investors will compile a mosaic theory. That is where investors gather and interpret various pieces of information, compiling and deciphering the information in such a way that they arrive at a conclusion that leads to a buy or sell decision. As long as the information is derived from public sources, an investor can use any piece of information he gathers. If an investor happens upon material, non-public information, he may not use that information to make his investment decision. The capital markets are efficient; they depend on accurate, timely and intelligible communication of information. But as soon as an information advantage is gained by one party because of non-public information, then the market is no longer efficient and the integrity of the market becomes at risk. It is crucial for all investors to document their research and give a roadmap of how they arrive at their investment decision in case their transactions are called into question.

The Bottom Line

The integrity of the capital markets needs to be kept at utmost importance for all investors. Without the confidence that the capital markets are fair, they will cease to exist. Participants should not use any material, non-public information in their investment decision making; rather they should perform research using mosaic theory to compile various sources of information to arrive at an investment conclusion.

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