Ethics - Standard II - Integrity of Capital Markets

Start - 3:00 PM

I admit, that last one was painful and slow.  It does look like each of the Seven Standards are beefy enough to make a single post.  Standard I - Professionalism took about 30 pages, and seeing as it is the first standard I assume CFAI places a great weight on it, so it is worth knowing well.  It's also a quite broad and far-reaching standard, so it makes sense it must cover a broad range of situations and concepts.

In Standard I we saw some clarification of what might otherwise be grey areas - e.g. personal beliefs resulting in illegal activity are OK, what to do when third party vendors misbehave, things don't need to be illegal to be unethical, omission of a material fact is as bad as lying.  The most technical/logical part of Standard I was certainly when to apply applicable law or CFAI Code and Standards.  Conservatism is the key, as well as a careful reading of the particulars of the situation.  Standard II - Integrity of Capital Markets - seems more straightforward, and it is only 10 pages long.

On the whole though I am looking forward to getting the briefer Schweser Notes as I feel like this is just too much detail to cover everything in 300 hours.  However if there's one section to know a little too much detail on, it's probably Ethics, so no big worries, and I'm sure as I go on my eagerness to know every last detail will wear to a more appropriate level.  One place I can save time is by skimming the lengthy examples for interesting detail rather than reading in full.

Here we go.

Standard II - Integrity of Capital Markets (NM - Nonpublic, Manipulation)

II(A) Material Nonpublic Information 
MCs who possess material nonpublic info that could affect the value of an investment must not act or cause others to act on the information.

Must define 'material', 'nonpublic', and will discuss 'mosaic theory' and investment research reports.

• Material - if its disclosure would probably have an impact on price of a security or if reasonable investors would want to know the information before making an investment
• Determined in large part by substance and specificity - less reliable is less likely to be material - assumed info from a competitor is not as good as facts from company itself
• More ambiguous the effect of information on price is, less likely to be material
• Passage of time may makes things less relevant/material
• Nonpublic - info is nonpublic until it has been disseminated OR is available to the marketplace in general. 
• Ex, knowledge that a document exists is made public via press release
• NOT necessary to wait for slowest method of delivery 
• Analysts should know that info they get in smaller analyst meetings is not necessarily public
• I'll note here that this standard must have a contentious relation to the hedge fund industry - part of a hedge fund analyst's job is to dig deeper to find more information, and act on that, is it not?  Apparently Mosaic Theory takes care of this...but I have to say it seems quite contradictory
• Mosaic Theory - analyst gathers info from many sources, and MAY use conclusions based on public AND nonmaterial nonpublic information and act on it.
• Financial analysis depends on free flow of information
• Analysts must have the greatest amt of information possible to facilitate good decisions
• Beyond company, analysts can get info from suppliers, customers, contractors etc.
• Dirk's vs. the SEC states that since analysts enhance market efficiency 
• Analysts should save and document their research to show that conclusion was not based on material nonpublic information
• Investment analysts who change an opinion (and did so only based on public info - Mosaic Theory) do not need to make their research public, even if the public would change its pricing based on the analysis

Procedures

• If you find nonpublic MATERIAL information, must make effort to disseminate
• Should adopt compliance and disclosure procedures and not discriminate against analysts who give negative research reports
• Physical separation of documents
• Analysts must be quarantined to one side of the firewall until information is public
• Prop trading - it is not appropriate to cease all trading if you are a market maker and you come into contact with material NPI - doing so could compromise confidentiality of the info and market liquidity (act as a tip) - but traders must remain passive to the market
• Risk Arbitrage - there is a stronger case for ceasing trading here.  Most prudent is to suspend activity when a security is on the watch list.  If not, must maintain strict documentation to prove no action on MNPI.

Notes from examples:

• If you get an advance copy of an analyst report, cannot act because it is technically not public yet
• Small group forums do not constitute public dissemination
• Information from a third party is generally not reliable enough to constitute material information
• Analysts can base opinions on public info and nonmaterial nonpublic info
• What is non-material non-public - in this case opinions of designers and retailers
• Might be easier to define what is material (see above)
• After issuing a report, then going on air to discuss, cannot act on the 'on air' reasons until they are 'on air'
• It is an MC's responsibility to determine if info is MNPI - just because it came from someone you trust not to disseminate MNPI doesn't mean it is OK to trade on that info

II(B) Market Manipulation

One that hits near and dear to our hearts as Mr. Falcone's proceedings continue...

MCs must not engage in practices that distort prices OR artificially inflate trading volume with the intent to mislead market participants.

Two types: Information Based and Transaction Based

Information Based manipulation - spreading false rumors, overly optimistic projections only to later 'dump' (the 'pump and dump')

Transaction Based manipulation - MC knew or should have known that actions would impact price - 

• includes transactions that affect artificially price or volume which represent a diversion from expectations of a fair and efficient market
• Likewise, securing a controlling, dominant position to exploit/manipulate the price of a related derivative and or the underlying asset

This is NOT intended to preclude transactions that legitimately trade on mkt inefficiencies - the INTENT of the action is critical in determining if there was a violation

Notes from examples:

• Sensationalization of information during a company mandated quiet period - no no
• Don't cause people to become interested in a stock just so you can sell it
• Entering into agreements to make liquidity look better than it is is not OK unless you disclose your agreements ('pump priming')
• If you disagree with a company's projections, make your own, state your assumptions, and publish it properly

End of Standard II.

Time - 4:30 pm, approx. 1.5 hours