ETH 4 Guidance for Standard II: Integrity of Capital Markets
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.
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.
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.
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.
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:
| 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.
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.
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.
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.