Eduzan

Eduzan / MODULE 01 — Ethics (Ethical and Professional Standards)

ETH 4 Guidance for Standard II: Integrity of Capital Markets

Worked examples are fully visible. Check-yourself items are study aids you can reveal one at a time.

How Standard II keeps markets fair: it bars trading on inside information and bars manipulating prices or trading volume. Check-yourself items are study aids.

Standard II(A) states that a member or candidate who holds material nonpublic information that could move the value of an investment must neither act on it nor cause anyone else to act on it. The reasoning is about trust. When outsiders believe that insiders and a favored few can trade ahead of everyone else, they conclude the game is rigged and withdraw from the market. Trading on inside knowledge may pay off once, but over time the whole profession loses, because thin, distrusted markets allocate capital poorly and weaken the economy they are supposed to serve. Protecting confidence in market integrity is one reason the standard exists.

The prohibition is broad. It is not limited to buying or selling the individual shares or bonds an insider knows about. Members and candidates also must not let material nonpublic information shape decisions in derivatives, in mutual funds, or in other alternative investments. Any investment action driven by such information breaches the standard.

When is information material?

Information counts as material when releasing it would likely move a security’s price, or when a reasonable investor would want it in hand before deciding to buy or sell. Put another way, material information is anything that would meaningfully shift the overall mix of what the market already knows, to the point that the price responds. Judging materiality depends on how specific the item is, how far it departs from what is already public, its nature, and how trustworthy it is.

Categories that are frequently material include the following, though the list is not exhaustive:

earnings figures and guidance;
mergers, acquisitions, tender offers, or joint ventures;
notable changes in a firm’s assets or in asset quality;
new products, processes, or discoveries, such as product trials or research results;
new licenses, patents, trademarks, or a regulator approving or rejecting a product;
major customer or supplier developments, such as winning or losing a contract;
changes in senior management;
a change of auditor, or the news that an issuer can no longer rely on a prior audit report or opinion;
events touching the issuer’s own securities, such as defaults, redemption calls, buybacks, stock splits, dividend changes, changes to holder rights, and new sales of securities;
bankruptcy filings;
serious legal disputes;
government data on economic trends, such as employment, housing starts, or currency figures;
large orders that have not yet been executed; and
new or revised debt or equity ratings from a third party, such as a sell-side call or a credit rating.

Reliability of the source shapes materiality as much as substance does. The weaker the source, the less likely the item is material. A concrete fact from a company insider about a major new contract is probably material; a competitor’s guesswork about the same contract is not. Trial data from qualified staff running a drug study is likely material, while an outside expert’s informed guess about that study usually is not. The vaguer the price impact, the less material the information becomes: if it is unclear whether or by how much the price would move, the information may fall short of material. Time can also drain materiality, since news that once mattered can become stale and unimportant.

When is information nonpublic?

Information stays nonpublic until it has been distributed to the market as a whole rather than to a select circle. Disseminated simply means made known. A profit report placed on the internet and pushed out through a wide press release or a regulatory filing has reached the market. Members and candidates need a reasonable basis to believe that recipients have actually received the news before treating it as public, although they need not wait for the slowest possible channel. Once the market has it, the information is public and the standard no longer restricts trading on it.

Selective disclosure is the trap to watch. Information handed to a narrow set of investors or analysts stays nonpublic until it reaches investors generally, and a firm that briefs only a chosen few creates the conditions for an insider-trading breach. A manager should not assume that a company remark made to a full room of analysts is therefore public. The same caution applies when a company privately walks an analyst through how to read its filings or statements, since that guidance can itself be selectively disclosed material information.

There is a legitimate exception. When a source company shares inside information for the specific purpose of a business engagement, such as due diligence for a merger, loan underwriting, a credit rating, or an offering, the professional may use it for that assignment without breaching Standard II(A). Using that same inside information for another purpose, above all to trade or to prompt others to trade the company’s securities, is a violation.

Example 1 · Worked

Fechtman manages several funds that hold shares in a small oil-and-gas exploration company. The stock has lagged its index, but sector trends suggest firms like it could become takeover targets. While she weighs whether to add or sell, her doctor, a casual market watcher, mentions a hunch that a large multinational will soon acquire the company and that buying now looks smart. Fechtman then consults various investment professionals, reviews their views on the company, and checks the industry data. The next day she decides to accumulate more of the stock.

1. Does buying more shares breach Standard II(A)?

Solution. No. Takeover news can, in general, be both material and nonpublic, but here the source is a doctor with no real link to the deal and no reliable basis for the claim. Because the source is unreliable, the tip does not meet the materiality threshold, so Fechtman is not barred from trading. Her decision also rests on her own follow-up research into professionals’ opinions and industry trends, not on the casual remark.

2. Nadler, a fund trader, gets a text from a long-known trader at another firm saying he thinks a software company will post strong earnings when it reports in two days. Nadler already holds a portfolio manager’s buy order for several hundred thousand shares and completes the purchases the next morning, a day before the announcement. Violation?

Solution. No, on these facts. Rumors and whisper numbers circulate constantly before any release, so the text reads as market noise rather than genuine inside information. Unless Nadler had reason to believe the other trader held an ongoing business relationship with the issuer, he had no cause to suspect the tip was material nonpublic information, and he may complete the manager’s order.

Check yourself

A company briefs its ten largest shareholders that a strike will halt production next Friday, but issues no public release. May an attending analyst cut her rating on that basis?

No. A closed meeting with a small group is not a method of public dissemination, so the strike news is still material and nonpublic. She must not act on it until the company makes it public.

A retail company’s finance chief tells a friend during a round of golf that sales are running almost 10 percent above estimates. The friend then buys a large stake in an exchange-traded retail fund that holds the company. Any violation?

Yes. The tip is material and nonpublic, and it clearly drove the purchase, so the friend breaches Standard II(A) even though the trade was in a fund rather than the stock itself. The executive also violates the standard by sharing the information, since a private conversation between friends is not public disclosure.

Analysts pull together vast amounts of information from many places and interpret it. Under the mosaic theory, an analyst may act on significant conclusions built from public information combined with nonmaterial nonpublic information, even where those same conclusions would have counted as material inside information had a company handed them over directly. Assembling scattered, individually harmless pieces into a meaningful picture is exactly what skilled analysis does, and reaching a view that way does not breach Standard II(A).

This freedom rests on the idea that markets work best when information flows freely. Analysts and investors need as much material as possible to judge where capital should go, and useful disclosure reaches past the bare legal minimum into specifics about products, capital projects, and the competitive landscape. Much of that raw material comes straight from companies, through investor relations staff, financial officers, press releases, executive presentations, conference calls, and site visits. To round out the picture, analysts also gather information from customers, contractors, suppliers, and competitors. By discovering and interpreting facts that are not obvious to the general public and passing their findings to clients, analysts make markets more efficient, which benefits every investor.

One practical safeguard follows: analysts should keep and document their research. A record showing the public and nonmaterial nonpublic inputs behind a conclusion supports the claim that the view was reached by proper analysis rather than by using material nonpublic information.

Social media

Technology lets professionals share information faster than ever, and members may use social media to reach clients or the public without breaching the standard, provided the message reaches all clients or the investing public much as any other broadcast would. The catch is that not everything found on the internet is truly public. Some platforms require membership in a closed group to see the content. Before relying on material found inside a members-only group, a member should confirm that the same information can also be obtained from a genuinely public source.

Expert networks

Members may hire outside specialists to understand complex fields, and firms exist specifically to connect analysts with experts in areas such as technology or pharmaceuticals. Paying these experts for their insight is permitted. What the member remains responsible for is not soliciting or acting on confidential information the expert may pass along, which could break securities rules and would breach this standard. Networks often make both sides sign agreements about not disclosing material nonpublic information, but even with those safeguards, if an expert does convey material nonpublic information, the member may not trade on it until the market has it.

Well-known analyst reports

When a prominent, respected analyst publishes a report or changes a recommendation, that move alone can shift the market and so may itself be material. This analyst is no company insider and has no access to inside information; presumably the report was built from public inputs through the mosaic theory and the analyst’s own skill, paid for by clients. The fact that the wider public would find the conclusions valuable does not force the analyst to publish them for free. Non-clients can either do the analysis themselves or become clients to gain access.

Example 2 · Worked

Clement is a senior analyst who covers the European automobile sector and is widely seen as an authority. After speaking with representatives of Turgot Chariots, a European manufacturer that sells mostly in the Asia-Pacific region, and after interviewing salespeople, labor leaders, his firm’s currency analysts, and banking officials, he concludes that the firm’s new model will likely miss sales targets, that its restructuring may draw serious union opposition, that a weakening South Korean won should squeeze industry margins, and that banks may take a tough line in upcoming credit talks. He cuts his call to market underperform from market outperform, and keeps every piece of his supporting material.

1. Does the downgrade breach Standard II(A)?

Solution. No. Clement stitched together many public and nonmaterial nonpublic pieces to form a view about the company’s value. That is precisely the mosaic theory at work, so the report does not violate the standard. Keeping the support material is the documentation habit that protects him if questions arise later.

2. The next day, before airing his new view publicly on a financial television program, Clement tells the show’s producers and the interviewing journalist, Zito, what he will say. Just before going live, Zito sells her own holding in Turgot Chariots and phones her father, who also owns the stock. Any violation?

Solution. Yes, by Zito. Learning the change of opinion in advance, she knows it will move the price even without following the reasoning, and she is not Clement’s client. Trading on that early access is trading on material nonpublic information, a breach of Standard II(A). Passing the information to her father breaches it again; it does not matter whether he or anyone else actually trades, because the act of tipping is itself the violation.

Example 3 · Worked

Consider two analysts who use expert networks.

1. McCoy, a senior drug analyst at a mutual fund, uses a network to reach cancer-treatment experts. Through several calls she deepens her grasp of the newest therapies, which helps her recommend the companies that make the drugs. Is she in the clear?

Solution. Yes. McCoy is using the network appropriately to sharpen her evaluation. She neither requested nor received anything that would count as material nonpublic information, such as preliminary trial results, so seeking advice from industry professionals she follows is permitted.

2. Watson, a hedge fund analyst, arranges a network call about a technology holding that is testing a new semiconductor. The scientist running the tests says he is disappointed with the product’s performance. Watson relays this to the fund, which sells the position and buys many put options while the market still expects the product to succeed. Violation?

Solution. Yes. The scientist’s disappointment with the ongoing tests is material nonpublic information, and Watson passed it on so the fund could trade the stock and options. He cannot hide behind the network’s signed agreements; he must judge for himself whether what he received crosses the materiality line, and here it plainly does.

Why documentation is the analyst’s best defense

Because the mosaic theory turns on how a conclusion was reached, the paper trail matters. An analyst who saves interview notes, models, public filings, and the nonmaterial nonpublic scraps behind a call can show that the view came from assembling many small, lawful pieces. Without that record, a well-timed and correct recommendation can look, in hindsight, like it was built on a single piece of inside information, even when it was not.

The standard is supported by a set of recommended practices for members and for their firms. They aim to keep material nonpublic information from being misused, whether through personal trades, through leaks between departments, or through selective disclosure by the companies analysts follow.

Push for public disclosure

A member who comes into material nonpublic information should make a reasonable effort to get it disclosed to the market, usually by urging the issuer to release it. If public release is not achievable, the member must limit the information to designated supervisory and compliance staff inside the firm, and must not trade or change any recommendation based on it. Members also must not knowingly do anything that would coax insiders into privately leaking material nonpublic information.

Follow firm compliance procedures

Members must observe every procedure their employer sets to prevent misuse of material nonpublic information. Such procedures may cover checks on employee and firm proprietary trades, checks on recommendations, oversight of cross-department communication in multiservice firms, and alerting compliance staff to suspected misuse.

Encourage press releases

Members should press the companies they follow to issue a press release before analyst meetings or calls and to script those events so that little extra slips out. If material nonpublic information does surface for the first time in a meeting or call, the member should urge the company to put out a release, or otherwise make the information public, without delay.

Respect information barriers (firewalls)

Members must honor any information barrier their firm imposes. A firewall, the most common tool for stopping material nonpublic information from moving around a firm, confines confidential information to the people who genuinely need it to do their jobs. Typical elements include:

tight control of interdepartmental communication, ideally routed through a clearance area in compliance or legal;
review of employee trading using watch lists, restricted lists, and rumor lists;
written documentation of the procedures that limit information flow between departments and of the steps taken to enforce them; and
closer review or restriction of proprietary trading while the firm holds material nonpublic information.

Staff should not straddle the wall. There should be no overlap of people between investment banking or corporate finance on one side and sales and research on the other, nor between a bank’s commercial lending arm and its trust and research units; at any moment an employee belongs on one side only. Inside knowledge is not confined to a specific deal or a company’s current finances. An analyst brought over to help investment bankers on a transaction may learn about product plans or budget forecasts that count as inside knowledge, and must then be treated as an investment banker, staying on that side of the wall until the information becomes public. Until then the analyst cannot use what was learned for research and cannot share it with the research team.

A working firewall also needs a clearance process in which authorized people review and approve cross-department communication. An employee behind the wall who believes confidential information must reach the other side should consult a designated compliance officer, who decides whether the sharing is necessary and how much may pass. When it is necessary, the compliance officer runs an over-the-wall review so that only what is needed crosses and the barrier stays intact.

Respect personal trading limits

Members must follow their employers’ restrictions or bans on personal trading. Firms commonly monitor employee trades, require periodic reports of personal transactions, and maintain restricted lists and watch lists of companies.

Example 4 · Worked

Barnes runs the SmartTown clothing chain, which he controls as president and majority owner. He decides to accept a tender offer that would sell the family business at almost double the share’s market price. He tells his sister, the company treasurer; she tells her daughter, who owns no SmartTown stock; the daughter tells her husband, Staple; and Staple tells his broker, Halsey, who at once buys SmartTown shares for himself.

1. Who breaches Standard II(A)?

Solution. News of the pending sale is material and nonpublic. Staple breaches the standard by relaying that inside information to his broker, and Halsey breaches it by buying shares while holding material nonpublic information. Simply being told inside information is not itself a trade, but tipping it onward and trading on it are both violations.

2. Peter, assisting his firm on a secondary offering for a lamp company, joins a video call and learns that the issuer’s earnings projections have dropped sharply. Salespeople and portfolio managers wander in and out of his office during the call, pick up the news, and trade the stock for clients and the firm’s account before the call ends. Who violated the standard, and what should the firm have done?

Solution. Peter breaches Standard II(A) by failing to stop the material nonpublic information from spreading to and being misused by others in the firm. The firm should have used information barriers to keep such nonpublic information from crossing between departments. Any of the salespeople and managers who are members or candidates, and who dealt on the news, also breach the standard.

Check yourself

An investment banking department routinely receives material nonpublic information valuable to the firm’s brokerage clients. What is the best policy to stay within the Code and Standards?

Build physical and informational barriers between investment banking and brokerage so information cannot pass between them. A permanent ban on recommending banking clients’ stocks goes too far, because recommendations can resume once the information is public, and merely monitoring an exchange that should never happen is not an effective control.

A retired investor is told by a friend, a senior bank executive, that the bank will surprise the market with excellent quarterly earnings. He doubles his position, then the bank reveals large loan-loss reserves and the stock falls 60 percent. Did he violate the standard?

Yes. Buying on the executive’s tip is trading on material nonpublic information, a breach of Standard II(A). Believing that the insider would not break the law does not excuse him, and losing money on the trade does not absolve him either; the responsibility to confirm that a comment is not material nonpublic information rests with the member before he acts.

Standard II(B) bars members and candidates from practices that skew prices or pump up trading volume in order to mislead other market participants. Manipulation deceives the people and institutions who rely on market information, disrupts the smooth working of markets, and lowers investor confidence. As trust in fair pricing erodes, risk premiums rise and participation falls, which can drag on the growth of a local market and, through interconnected global markets, reach well beyond it. Manipulation is generally less common in mature markets than in emerging ones, but cross-border investing exposes everyone to the risk.

The standard covers two broad routes: spreading false or misleading information, and carrying out transactions that deceive or would likely mislead others by distorting how prices are set. New products and technologies keep expanding the incentives, means, and opportunities for both, and sophisticated communication tools open fresh channels for abuse.

Information-based manipulation

This route works by spreading falsehoods to trigger trading. A classic form is pumping up a security with misleading positive claims or wildly optimistic valuations, waiting for the misinformation to drive the price to an artificial high, and then dumping the holding into that inflated price.

Transaction-based manipulation

This route works through trades that a member knows, or should know, could distort a security’s price. It includes:

transactions that artificially affect price or volume to fake the appearance of activity or price movement, departing from what a fair and efficient market would produce; and
seizing a controlling or dominant position in an instrument to rig the price of a related derivative, of the underlying asset, or of both.

The standard is not meant to block legitimate strategies that exploit genuine market inefficiencies. Real trading can look abusive, especially in thin or volatile markets, so intent is the deciding factor in whether conduct crosses the line. Manipulative tactics also vary by asset class and by the features of the particular market. A nonexhaustive set of warning signs includes:

Possible signals of transaction-based manipulation

Signal	What it can suggest
Orders live for an unusually short time	Activity meant to be seen, not filled
Orders priced above the market	An attempt to move the quoted price
Orders with no change in beneficial ownership	Trading with oneself to fake volume
Orders that shift the bid or offer, then cancel before execution	Painting a false price picture
Orders on both sides of a trade across different platforms	Coordinated self-dealing
Two or more traders acting together in a thin market	Collusive price or volume distortion

To curb these practices, firms adopt policies that members must follow. They may include procedures that block placing and canceling orders meant to trick others into dealing at artificial prices; cross-platform real-time monitoring or systematic surveillance to spot suspicious orders, improper coordination among customers, wash trading, and cross-product schemes; automated order management with pretrade controls; controls over trading algorithms used for manipulation; and trade exception reporting.

Example 5 · Worked

Gray, a private investor, holds a large position in a German small-cap pharmaceutical stock with thin average volume. Wanting to cut the position without pushing the price down, he splits his holdings across accounts at several brokers and banks in the names of family, friends, and even a religious institution. He then seeds a rumor campaign promoting the company across blogs and social media, and begins buying and selling the stock through multiple brokers, selling slightly more than he buys on a planned schedule, until he has quietly reduced his position without hurting the sale price.

1. Which parts of Gray’s plan breach Standard II(B)?

Solution. Both parts. The online rumor campaign is information-based manipulation, fabricating the appearance of investor interest with false claims. The back-and-forth trading is transaction-based manipulation, faking liquidity that did not really exist. Gray manipulated the stock through misinformation and through his trading pattern, so he violates the standard on both fronts.

Example 6 · Worked

Murphy is an analyst at a broker whose important clients include hedge funds, some of which are short Wirewolf Semiconductor. Two trading days before a quarter-end report, and knowing Wirewolf has entered its quiet period and will be reluctant to respond, Murphy tells his sales force he is about to publish a report opining that quarterly revenue will miss guidance, that earnings will land up to 5 cents a share (more than 10 percent) under consensus, and that the respected chief financial officer may be leaving. The conclusions rest on speculation, not fact, and he times the release to maximize downward pressure to his hedge fund clients’ benefit. The stock opens sharply lower the next day and the clients cover their shorts at large gains.

1. Did Murphy violate Standard II(B)?

Solution. Yes. Murphy set out to create artificial price volatility intended to move the issuer’s stock, using a speculative report timed to sensationalize the negatives. Manufacturing that price impact to benefit favored clients is market manipulation.

2. Separately, Gordon lifts her earnings model for a personal-care company to a figure of US$2.00 per diluted share after a research trip, versus company guidance of US$1.95 to US$2.05. To force a comment, she tells momentum-style clients that consensus is far too low and that she is considering lifting her published figure by US$0.15 to US$2.15, hoping the buzz drives a quick gain. Violation?

Solution. Yes. Exaggerating projections to spark a fast rise in the share price is a breach of Standard II(B). It would have been acceptable instead to publish a report that framed the earnings figure as a range of possible outcomes and that spelled out the assumptions, including the findings from her trip.

Check yourself

A bank president, hired to find a merger partner, places a personal buy order for 2,000 shares, roughly four times the average weekly volume, to lift the price and draw a buyer to the table. Which standard, if any, does this breach?

It breaches Standard II(B). An outsized personal order designed to push the share price up is transaction-based market manipulation. By contrast, instructing the bank to announce that it has retained an adviser, or to reaffirm prior earnings guidance after checking with the finance chief, are ordinary informative announcements and not violations.

To offload an overweight, illiquid holding, a manager trades the stock back and forth between two funds he runs to lift both price and volume, hoping to attract outside buyers, and argues the plan benefits his fund holders. Acceptable?

No. Even though it might help his own fund holders, the plan rests on artificially distorting both the volume and the price of the stock, which violates Standard II(B).

Intent is the dividing line

Standard II(B) does not outlaw aggressive but legitimate trading, and honest strategies can look abusive in thin or volatile markets. What separates manipulation from legitimate activity is the purpose behind it: an intent to deceive market participants by distorting prices or volume. Spreading a false rumor to pump a holding, faking liquidity through wash trades, or timing a speculative report purely to move a price all share that deceptive intent; a well-founded trade that merely exploits a real inefficiency does not.

End of lesson.

Back to MODULE 01 — Ethics (Ethical and Professional Standards)

ETH 4 Guidance for Standard II: Integrity of Capital Markets

Overview

Standard II(A): Material and Nonpublic Information

When is information material?

When is information nonpublic?

Standard II(A): Compliance Practices

Push for public disclosure

Follow firm compliance procedures

Encourage press releases

Respect information barriers (firewalls)

Respect personal trading limits

Standard II(B): Market Manipulation

Information-based manipulation

Transaction-based manipulation

ETH 4 Guidance for Standard II: Integrity of Capital Markets

Overview

Standard II(A): Material and Nonpublic Information

When is information material?

When is information nonpublic?

The Mosaic Theory, Social Media, and Expert Networks

Social media

Expert networks

Well-known analyst reports

Standard II(A): Compliance Practices

Push for public disclosure

Follow firm compliance procedures

Encourage press releases

Respect information barriers (firewalls)

Respect personal trading limits

Standard II(B): Market Manipulation

Information-based manipulation

Transaction-based manipulation