II. INTEGRITY OF CAPITAL MARKETS

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 that information.

Information is material if its disclosure may affect the price of a security, or if reasonable investors would want to know the information before investing. Topics which should be considered material in an insider trading context include:

• A forthcoming dividend declaration or mission.
• Corporate reorganizations or takeovers.
• The acquisition or loss of a major contract.
• A major purchase or sale of company assets.
• An event of default.
• Knowledge of forthcoming press coverage of a company's affairs, whether positive or negative.
• Substantial increases or decreases in earnings projections.

The source or relative reliability of the information also determines materiality. The less reliable a source, the less likely the information provided would be considered material.

Information is nonpublic if it has not been disseminated to the marketplace in general, or if investors have not had an opportunity to react to the information. Note that disclosing the information to a selected group of analysts does not make it public. For example, a disclosure made to a room full of analysts does not make the disclosed information "public."

Note that this standard prohibits use of material nonpublic information, not:

• Nonmaterial public information.
• Nonmaterial nonpublic information.
• Material public information.

Members are prohibited from seeking out or using any inside information in analyzing investments, making investment recommendations, or making investment decisions if:

• Such trading would breach a duty.
• The information is misappropriated.
• The information relates to a tender offer.
• Members receive material information in confidence.

Mosaic Theory

Insider trading violations should not result when a perceptive analyst reaches a conclusion about a corporate action or event through an analysis of public information and items of nonmaterial nonpublic information (i.e., a "mosaic" of information).

Under mosaic theory, financial analysts are free to act without risking liability. That is, a financial analyst may use nonpublic information as the basis for investment recommendations and decisions even if that conclusion would have been material inside information had it been communicated directly to the analyst by a company.

Procedures for compliance

If members receive inside information in confidence, they shall make reasonable efforts to achieve public dissemination of material nonpublic information disclosed in breach of duty. This effort usually means encouraging the issuing company to make the information public.

Members and their firms should adopt written compliance procedures designed to prevent trading while in the possession of material nonpublic information. The most common and widespread approach to preventing insider trading by employees is an information barrier known as a "fire wall." The purpose of a fire wall is to prevent communication of material nonpublic information and other sensitive information from one department of a firm to other departments. The minimum elements of such a precaution include the following:

• Substantial control (preferably by the compliance department) of relevant interdepartmental communications.
• Review of employee trading through effective maintenance of some combination of "watch," "restricted," and "rumor" lists.
• Documentation of the procedures designed to limit the flow of information between departments and of the enforcement actions taken pursuant to those procedures.
• Heightened review or restriction of proprietary trading while the firm is in possession of material nonpublic information.

Additional procedures, used typically in conjunction with an information barrier, include:

• Restricting or prohibiting personal and proprietary employee trading.
• Careful monitoring of firm and personal employee trading. A pattern of trading on inside information can be more easily detected if employees and firm members are required to make periodic reports of their transactions on their own behalf or on behalf of members of their families.
• Placing securities on a restricted list when the firm has or may have material nonpublic information (unless the placing of a security on a restricted list would itself tend to reveal outside the firm that the firm is engaged in a nonpublic engagement relating to the security).
• Using a stock watch list known only to a limited number of people when the firm has or may have material nonpublic information, to monitor transactions in specified securities.
• Confining the dissemination of material nonpublic information to persons who have a need to know the information in order to carry out their responsibilities.
• Designating a supervisor or compliance officer who will have the specific authority and responsibility to decide whether information is sufficiently public or sufficiently lacking in materiality enough that it may be used as a basis for investment recommendations or decisions.
• Firms should circulate written policies and guidelines to all employees. The policies and guidelines should be coupled with a program of seminars and refresher courses for the employees.

Example 1

An insider tells you that his firm will announce a significant drop in EPS for the upcoming year. The announcement will be released in three days. You can't trade. You can't recommend that your investors sell their positions. You can (and should) encourage the firm to disclose the information immediately.

Example 2

You are at an analysts' briefing for Horton Industries attended by 20 analysts. During the presentation, Horton's president indicates that the firm is considering closing its Alberta operations because of difficulty controlling costs at that location. He asks the audience not to act on this information yet because a final decision will not be made for at least another week. The analysts' briefing does NOT qualify as a public disclosure. You can not inform your clients of the new information and trade on their behalf.

Example 3

Barnes, the president of XYZ decides to accept a proposed tender offer. He tells this decision to his sister, who tells her daughter, who tells her husband, who tells his broker, who buys stocks for himself. The broker is prohibited from trading the XYZ stock because the information involves tender offer. However, the broker has no reason to believe a duty was breached in the transmission of the information.

Example 4

A passenger in an elevator overhears a conversation between two executives of a publicly traded company. The passenger trades the stock based on that information. The passenger does not violate the standard because the executives do not breach any duty and the information is not misappropriated.

Example 5

Walsh overhears that someone sneaked into the CEO's office and discovered information about a pending tender offer. Walsh subsequently trades the stock. Walsh violates the standard because the information is misappropriated and it concerns tender offer.

Example 6

An analyst fails to protect privacy when discussing nonpublic information in a conference call. Another employee overhears the information, and subsequently trades for his clients' accounts. The analyst violates the standard for lack of adequate procedures. The firm should have established information barriers, also called fire walls, between departments.

Example 7

A magazine has a weekly investment column. A magazine employee trades on information in the column before it is published. The employee violates the standard because the information is misappropriated.