LM03 Guidance for Standards I-VII

Part 4

Standard II: Integrity of Capital Markets

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.

 Guidance:

• What is material information? This is information that, if disclosed, can have an impact on the price of a security, or information that investors would want to know before making an investment decision. For example, information that the CEO of a company was involved in a scandal to manipulate financial statements and is going to be arrested, is material information. Other common examples include mergers and acquisitions, new product licenses, changes in management, bankruptcies, legal disputes, etc.
• What constitutes “nonpublic” information? As the name implies, information that has not been made public is called nonpublic information. For instance, if a pharmaceutical company has just received news that a particular drug has been approved by FDA and it is not made public yet, then it constitutes nonpublic information. This is also material information as it is something investors would like to know before investing in the company.
• Mosaic theory: As per the Mosaic theory, analysts are free to act on public and nonmaterial nonpublic information without risking violation. Let’s take an example from the curriculum. An analyst is researching a company in the furniture industry. He analyzes the public disclosures, and speaks with many furniture retailers on which he bases his recommendation report. The information gathered from furniture retailers is an example of nonmaterial nonpublic information because the information is not public, and not material by itself to influence the stock prices in any way.
• Social media: Members and candidates must ensure that information obtained from closed groups on social media (Facebook, LinkedIn) is accessible to the public through other sources.
• Using industry experts: Using experts is appropriate as long as members are not requesting or acting on material nonpublic information.
• Investment research reports: Assume you are a well-known analyst and your recommendation reports might impact stock prices. Since you are not an insider and did not base your report on insider information, Standard II (A) does not apply. In this case, you are not required to make the report public. If the public wants access to the report, they can be asked to pay for your services.

Recommended Procedures for Compliance:

• Achieve public dissemination: Take steps to publicly disseminate material nonpublic information. Ensure no investment action is taken based on the information.
• Adopt compliance procedures: Adopt compliance procedures to prevent the misuse of material nonpublic information. Ex: review employee trading, investment recommendations, and interdepartmental recommendations.
• Adopt disclosure procedures: Same information should be communicated to the market in an equitable manner. The information received by buy-side clients should be the same as sell-side clients, and the same goes for large firms and small firms.
• Issue press releases: Press releases must be made before conference calls and analyst meetings so that new information is disclosed at such gatherings.
• Firewall elements: A firewall is an information barrier created to prevent the flow of material nonpublic information within a firm; for instance, between the brokerage and investment banking departments of a firm. Listed below are a few ways a firewall is implemented:
  • Review of employee trading.
  • Route interdepartmental communications through the compliance or legal department.
  • Document how to enforce procedures to limit information flow within the firm.
  • Review/restrict proprietary trading when a firm is in possession of material nonpublic information.
• Appropriate interdepartmental communications: Document procedures for how interdepartmental communications must occur, review trading activity, and what actions to take if violations occur.
• Physical separation of departments: To prevent sensitive information flowing from one department to another. Ex: IB/corporate finance to be physically separated from sales and research of a brokerage firm.
• Prevention of personnel overlap: An employee should be on only one side of the firewall. For instance, an employee working in the commercial lending department of a bank must not be associated with its trust/research departments.
• A reporting system: Have a reporting system in which authorized people can review and approve communications between departments. If sharing of certain information is necessary across the firewall, then a designated officer must ascertain whether sharing is essential and must monitor the process.
• Personal trading limitations: Enforce restrictions on personal trading by employees. Monitor both proprietary and personal trading.
• Record maintenance: Maintain records of interdepartmental communication.
• Proprietary trading procedures: Outline procedures for under what situations there should be restrictions on proprietary trading:
  • Market making: Restrictions on trading if the firm is a market maker can be counterproductive as it may be a signal to traders that the firm is in possession of some material nonpublic information. The firm must take the contra side of unsolicited customer trades.
  • Arbitrage trading: Must not engage in proprietary trading if it is in possession of sensitive information.
• Communicate to all employees: Educate employees through trainings on how to identify material nonpublic information and how to act (consult a supervisor/compliance officer) if they possess such information. Circulate written compliance policies and procedures to all employees.

Standard II (B) Market Manipulation

Members and Candidates must not engage in practices that distort prices or artificially inflate trading volume with the intent to mislead market participants.

What it includes:

• Disseminating false information into the market.
• Misleading market participants by distorting prices.

Guidance:

• Information-based manipulation: Spreading false rumors to induce trading by others. For example, an analyst may pump false information into the market through blogs or some other media to artificially inflate stock prices.
• Transaction-based manipulation: Transactions that artificially affect the prices or volume of a security. For example, if transactions show a security to be more liquid, then market participants perceive it favorably and may buy. For example, a large firm may have offices in Tokyo and Chicago. One office may sell a large number of shares and the other office may buy. While it may appear as if the liquidity/trading volume of the security is up. But, in reality, the trading was within the firm.

Share on :