CFA Program Level I

Material nonpublic information and mosaic theory: CFA Level I

Standard II(A) bars members and candidates who hold material nonpublic information from acting on it or causing others to act on it. Information is material if its release would likely move the price or a reasonable investor would want it, and it stays nonpublic until it reaches the market generally. Under the mosaic theory, an analyst may act on a conclusion built from public facts and nonmaterial nonpublic details, even if the conclusion itself would be material.

Is it material?

Information is material if disclosing it would likely affect the price of a security, or if reasonable investors would want it before making an investment decision. Examples on CFA Institute's II(A) page include earnings, mergers and acquisitions, management changes, dividend changes, bankruptcies, major legal disputes and large pending trade orders.

Four factors decide close cases. Specific, detailed information is more likely to be material. A factual statement from a corporate insider is likely material, while a competitor's speculation usually is not. Trial results from people working on the trial are likely material, while guesses from unconnected experts usually are not. Information whose price effect is unclear, or that has gone stale, may not be material.

Is it public?

Information stays nonpublic until it has been disseminated to the market generally, not just to a select group. An earnings release that is posted, widely distributed and filed counts as disseminated. You need a reasonable expectation that people have received it, but you do not have to wait for the slowest channel.

Telling analysts is not telling the market. A briefing or call for a room of analysts does not make information public, and guidance given to a select group can be selective disclosure. Information from a membership-restricted social media group may also be nonpublic, so check that it is available from a public source first.

Paying an industry expert for insight is allowed, but a member must not request or act on confidential information from the expert. A signed expert-network agreement does not remove that duty. If the expert passes on material nonpublic information, the member may not trade until it is public.

The mosaic theory

An analyst may combine public information with nonmaterial nonpublic information to reach a conclusion, even when that conclusion would be material if the company announced it directly. CFA Institute encourages gathering information from company contacts, customers, suppliers, contractors and competitors.

Keep records of all the research. Documentation of the public and nonmaterial sources shows that the conclusion came from proper methods rather than from inside information.

Example: an analyst counts store traffic herself, reads suppliers' published results and hears shop staff say stores are quiet. She concludes quarterly sales will miss forecasts and issues a sell. No single input was material nonpublic information, so the sell does not violate II(A). If instead the CFO had told her privately that sales missed, she could not act on it.

What to do when you hold it

Encourage the company to disclose the information publicly. If that fails, share it only with designated supervisory and compliance staff, and do not trade on it or change recommendations because of it.

Firms control the flow of information with firewalls: a compliance clearance area, watch, restricted and rumor lists, documented procedures, extra review of proprietary trading, and separation of investment banking from sales and research. Standard I(A) adds that where local law is looser than the Code and Standards, members follow the stricter rule, so the absence of an insider-trading law does not permit trading.

Where the exam catches people

Believing information is public once dozens of analysts have heard it: it stays nonpublic until it reaches the market generally, for example through a press release and filing.
Believing any unannounced fact about a company is material: a competitor's speculation or a vague rumor is usually not material, because the source and specificity matter.
Believing a conclusion that would be material can never be acted on: under the mosaic theory it can, if it was built from public and nonmaterial nonpublic inputs.
Believing an expert-network agreement protects the member: if the expert discloses material nonpublic information, the member still may not trade on it until it is public.
Believing the duty applies only to stocks: II(A) also covers bonds, derivatives, mutual funds and alternative investments.

Written from CFA Institute's documentation

Try 3 questions on this

Pick an answer to see why each option is right or wrong.

Sara Lund, CFA, covers Brightway Retail. Combining store-traffic counts she collected herself, suppliers' published results and remarks from Brightway shop staff about how busy stores have been, she correctly concludes that Brightway's quarterly sales will miss forecasts. Brightway has yet to report the quarter. Lund then issues a sell recommendation to clients. Did Lund violate Standard II(A) Material Nonpublic Information?
Right. In the game that’s Renown for your Ethical and Professional Standards building.
Not that one: A is right. In the game your Ethical and Professional Standards building would lose a little Renown, and this question would come back later.
The answerA.NoUnder the mosaic theory, an analyst may build recommendations on conclusions she reaches by combining public facts with nonpublic details that are individually immaterial, even if the same conclusion, told to her directly by the company, would count as material inside information.Your answerB.Yes, because she used suppliers' resultsPublished results from suppliers are public information. Using public information in an analysis is exactly what Standard II(A) permits.Your answerC.Yes, because her conclusion is material and still undisclosedHer conclusion does match news Brightway has yet to release, but she reached it by piecing together public and nonmaterial nonpublic information. The mosaic theory lets her act on that conclusion even though the same fact, told to her by the company, would be material inside information.
Show the full explanation and doc quotes
Lund's inputs were her own counts, published supplier results and staff remarks of no material weight, so her sell recommendation does not violate Standard II(A).
Written from www.cfainstitute.org/standards/professionals/code-ethics-standards/standards-of-practice-ii-a
On an invitation-only call for 40 sell-side analysts, the chief financial officer of Brenmoor Foods says Brenmoor has just lost its largest customer, a third of its revenue. Brenmoor has issued no press release or filing. Straight after the call, Omar Haddad, CFA, sells Brenmoor shares from client accounts. Did Haddad violate Standard II(A) Material Nonpublic Information?
Right. In the game that’s Renown for your Ethical and Professional Standards building.
Not that one: C is right. In the game your Ethical and Professional Standards building would lose a little Renown, and this question would come back later.
Your answerA.No, because losing one customer is immaterialLosing a customer that supplies a third of revenue is the kind of news a reasonable investor would want and that would likely move the share price. CFA Institute names the loss of a customer contract as an example of potentially material information.Your answerB.No, because the company told dozens of analysts at onceThe tempting reading: once the company itself has told a large group, the news is out. CFA Institute says information given to a room of analysts does not thereby become public; it stays nonpublic until it is available to investors in general.The answerC.Yes, because the news is yet to reach the market generallyUnder Standard II(A), information stays nonpublic until it has been made known or made available to the market as a whole, not just to a select group.
Show the full explanation and doc quotes
CFA Institute warns that telling a room full of analysts in a briefing or call does not by itself make information public. With no press release or filing, the lost customer was still material nonpublic information, and Haddad acted on it.
Written from www.cfainstitute.org/standards/professionals/code-ethics-standards/standards-of-practice-ii-a
At an industry dinner, a portfolio manager hears a sales executive from a rival firm speculate that Delta Mining will win a large government contract next month. No award has been announced. The next day the manager buys Delta shares for client accounts. Did the manager violate Standard II(A) Material Nonpublic Information?
Right. In the game that’s Renown for your Ethical and Professional Standards building.
Not that one: A is right. In the game your Ethical and Professional Standards building would lose a little Renown, and this question would come back later.
The answerA.NoUnder Standard II(A), the source and reliability of information help decide whether it is material: the less reliable the source, the less likely the information is material.Your answerB.Yes, because the contract award is still unannouncedThe tempting reading: news of an unannounced contract is nonpublic and could move the price. But information is material only if it is reliable enough, and a competitor's speculation is too unreliable to be material.Your answerC.Yes, because the speculation came from a rival firm's employeeThe competitor source cuts the other way. CFA Institute treats a competitor's speculation about a contract as unreliable and therefore immaterial, so the source is why there is no violation.
Show the full explanation and doc quotes
CFA Institute contrasts a corporate insider's factual statement about a significant new contract, which is likely material, with a competitor's speculation about the same contract, which is not. Acting on speculation from a rival firm's executive is therefore no violation of Standard II(A).
Written from www.cfainstitute.org/standards/professionals/code-ethics-standards/standards-of-practice-ii-a