Standard II: Integrity of Capital Markets
Standard II consists of two subsections:
  • II-A: Material Nonpublic Information
  • II-B: Market Manipulation
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.

Reasoning behind Standard II-A
As long as there has been a stock market, buying or selling based on an insider tip has been a common practice. Before there were Securities and Exchange Commission (SEC) guidelines prohibiting the practice - and long before there was a CFA Institute devoted to increasing public awareness of insider dealing - corporate insiders enjoyed a distinct advantage in trading their securities. This advantage has resulted in numerous scandals. On the buy side, an insider whose stock is trading at $25 a share could forge a buyout at $50, but wait to announce the merger until the insider (and a few privileged friends and family) bought the stock aggressively in order to make a quick profit. On the other side, if a company loses a major customer or a key executive, the insiders (in the absence of insider trading laws) could dump all of their shares prior to announcing the negative information, thus avoiding a big loss.

Why Is This Wrong?
In spite of the detailed regulations set out by the SEC and the CFA Institute (among others), the news stories and the public awareness campaigns, some will look at insider dealing and not really see why it should be such a big deal. After all, people know that investing comes with risk, and they assume that certain people will have advantages over others in terms of access to information. Moreover, if we know our stock is about to go down because of a yet-to-be-released news story or event, why shouldn't we avoid our loss and cash in? The issue (at its core) has to do with public confidence and a system requiring fairness. People invest in stocks and bonds because they are confident that the price they are paying reflects all public information on the stock. If the public did not have this confidence, many would not be investing in retirement funds at all, while others would refuse to pay the prices they do. Regulating the system by prohibiting insider dealing has created trillions in market value and helped millions reach their retirement goals. Yes, these laws do have unfair consequences for a few (the people who know a stock is going to go down but can't trade on this information because it's not public), but in the end, far more people benefit from a system that requires fairness.

Definition of Material Nonpublic Information
Can I trade on this? Do I have to wait to trade on that? In order to clarify what conduct is prohibited by Standard II-A, the term "material nonpublic information" has been coined to help guide Members and Candidates in certain situations.

Take each component individually:
  • Material
    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?

    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)
  • Material versus Non-Material
    No statutory definition of "materiality" is available, so it is up to courts that rule on insider trading cases to rule. These cases will often cite the market price impact of the released information to establish that it was indeed material. Say a dividend is cut in half and the shares fall 10%; it was clearly a material event. However, if a company announces a new branch office in Kansas, and the stock performs in line with the market following the announcement, it was a non-material event. An insider with knowledge of the Kansas venture would not be found criminally liable if there were a purchase of shares prior to the public announcement of the Kansas office.

    The source of the information also impacts its materiality. The more reliable the source, the more likely it is that the information is material. For example, if you're riding the commuter train and overhear the CFO of an energy company tell his assistant that he's about to announce a plunge in quarterly corporate earnings, and you immediately call your broker to sell your shares, then the information is material and non-public and standard II(A) has been violated. On the other hand, if you sell your shares based on a recommendation from your dentist, who happens to follow the energy sector as a hobby and thinks this particular company is under strain, that source of information is unreliable and therefore not material.

  • Regarding Analyst Opinion on a Stock
    Ask whether the information is material: i.e. will it have a market impact? If an influential Wall Street analyst is preparing to downgrade his or her investment opinion from a buy to a sell, and we know about it, that's very different from our neighborhood broker/dealer stating he doesn't like it anymore. In the first case, we are required to wait for public disclosure of the change in opinion; the second case requires no trading restrictions.

  • Nonpublic
    The information is yet to be disclosed to the general marketplace.

    Look Out!
    Selective disclosure?
    When information is disclosed selectively, i.e. just to a handful of investment analysts, or perhaps on a conference call, or in an email, the information may still be regarded as nonpublic. Companies are bound by specific procedures designed to make the information truly public and to ensure a system of fairness in which all market participants are given a chance to act on the information.

Did the Insider Breach a Duty?
Standard II-A includes language that prohibits use of information obtained in breach of a duty. Essentially it means that this insider should have avoided disclosing this information but failed to do so.

What was the motivation? Will the insider benefit from this breach in one of the following ways?
  • Pecuniary Benefit - The insider's investment position is affected, or the insider's reputation (and future potential salary) is enhanced.
  • Quid Pro Quo - The tipper expects something in return from the recipient.
  • Gift - An insider wants friends and family to benefit from this information.
The Analyst's Role
In an efficient market, an analyst must retain the freedom to study a company and act on information not always contained in the public press releases. Analysts are encouraged to gather and use two forms of legal information:
  1. Material Public Information - Annual reports can contain volumes of data and discussion that could be material and are perhaps yet to be discovered.

  2. Non-Material Nonpublic Information - Discussions with management may reveal information that isn't obviously material but that may give valuable clues.
Applying 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.

We'll present each of these categories of questions separately.
  • 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.

    For related reading on the legal and illegal forms of insider trading, see Uncovering Insider Tradingand Defining Illegal Insider Trading.
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.

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 to Comply
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.

"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.

Minimum elements of a corporate firewall:
  • Segregation of Personnel - Someone involved with investment banking should not be doing research and trading, and vice versa.

  • Confinement of Material Nonpublic Information - Employees have access only on a need-to-know basis.

  • Control of Interdepartmental Communications - The compliance or legal functions of a firm might serve as a clearing house through which all interdepartmental memoranda are sent.

  • Monitoring of Employee Trading - Those with particularly sensitive jobs might be required to pre-clear, that is, to receive permission in advance.

  • Restricted List - The creation and maintenance of a restricted list can help limit employee trading as needed.

  • Heightened Restrictions under Certain Conditions - For example, additional restrictions might be placed when material nonpublic information is received in the course of underwriting a new preferred stock placement.
The following are some other procedures that may be adopted as part of a compliance program:
  • 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.

  • 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.

  • 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.

  • Watch List - Depending on the size of an organization, the placement of a company on a restricted list can have the unintended side effect of communicating to a wide audience that something is going on at that company. In this case, the firewall may be unintentionally broken, and while employees might be restricted from trading, the leak can find its way outside in a number of ways (it only takes one person to provide an insider tip). In situations where placing a firm on a restricted list is too public, a firm can adopt the use of a watch list, which means the compliance department will monitor activity on the companies on that list, perhaps making inquiries based on an individual's activities, but maintaining the confidentiality needed for a particular circumstance.

  • 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.
Standard II-B: Market Manipulation

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