John is a research analyst who discovers non-public information about a merger that could impact stock prices. John does not trade on this information but shares it with a close friend, who makes a significant profit. Which Standard of Professional Conduct has John violated?
- A. Standard II(A): Material Nonpublic Information
- B. Standard III(B): Fair Dealing
- C. Standard I(B): Independence and Objectivity
- D. No violation occurred
Answer:
A. Standard II(A): Material Nonpublic Information. John violated this standard by sharing material, nonpublic information that could affect stock prices, even if he did not trade himself.
In this case, John has violated Standard II(A): Material Nonpublic Information under the CFA Institute’s Code of Ethics and Standards of Professional Conduct. Let’s break down the reasoning behind this in detail:
Concept of Standard II(A): Material Nonpublic Information
This standard states that CFA members, candidates, and charterholders must not act or cause others to act on material, nonpublic information that could affect the value of an investment. To fully understand this, we need to define a few key terms:
- Material Information:
Information is considered material if its disclosure would likely have an impact on the price of a security or be considered important by a reasonable investor in making an investment decision. Essentially, if the information could affect the value of a stock or other security, it is material. - Nonpublic Information:
Information is considered nonpublic if it has not been disseminated to or made available to the general public. Until information is broadly disseminated (such as through a press release or filing with a regulatory body), it is considered nonpublic. - Acting on Nonpublic Information:
Acting on material, nonpublic information refers to engaging in any actions (such as buying or selling a stock) based on that information, which gives an unfair advantage over investors who do not have access to it. Even if a person does not personally trade on the information, causing or encouraging others to trade based on it is also a violation.
Why Did John Violate the Standard?
In this scenario:
- John discovered nonpublic information about a merger. This is classified as material because mergers often significantly impact the stock prices of the companies involved.
- Although John did not personally trade, he shared this sensitive information with a close friend. His friend then traded on this information and profited from it.
- Sharing material, nonpublic information—even without trading on it yourself—constitutes a violation because John “caused others to act” on the information. His friend’s actions were a direct result of John’s disclosure.
The Ethical Dilemma:
Even though John did not profit directly, his action of providing confidential and nonpublic information to another party who acted on it still breaches ethical guidelines. This creates an unfair market advantage, undermines market integrity, and erodes investor confidence.
Consequences of Violating Standard II(A):
Violating this standard, whether directly or indirectly, can have serious consequences, such as:
- Disciplinary action from regulatory bodies or the CFA Institute.
- Legal ramifications, as insider trading is considered a criminal offense in many jurisdictions.
- Damage to personal and professional reputation.
Why Not the Other Options?
- Option B (Standard III(B): Fair Dealing): This standard is about treating all clients fairly and does not apply directly to sharing material nonpublic information.
- Option C (Standard I(B): Independence and Objectivity): This standard refers to maintaining independence and objectivity in professional activities and is not relevant to insider trading or the sharing of nonpublic information.
- Option D (No Violation Occurred): This option is incorrect because John’s action of sharing nonpublic information led to trading based on privileged knowledge, which is a clear violation.
Conclusion:
By sharing material, nonpublic information about the merger, John violated Standard II(A): Material Nonpublic Information. This standard is designed to protect the integrity of the financial markets by ensuring that no one can gain an unfair advantage from undisclosed information.
