Material Nonpublic Information (Standard II(A)): CFA® Level 1 Exam Traps

Material nonpublic information is the subject of Standard II(A), and in exam-style vignettes the hard part is rarely the rule itself. The rule is short: if you hold information that is both material and nonpublic, you do not act on it and you do not cause anyone else to act on it. The difficulty is deciding whether a fact in a vignette is material, whether it is nonpublic, and whether the person in the story actually acted. This guide takes each of those tests in turn, then walks through the traps that send a reader to the wrong answer.

What Standard II(A) covers

Standard II(A) sits under Integrity of Capital Markets. It applies to members and candidates who possess information that is material and nonpublic and that could affect the value of an investment. Two things are prohibited:

• Acting on it. Buying, selling, or changing a recommendation because of the information.
• Causing others to act on it. Passing it to a friend, a relative, a client, or a colleague who then trades, or who might.

Both tests have to be met. Information that is material but already public can be used freely. Information that is nonpublic but not material can be used too, and it is the raw material of legitimate research.

Test one: is it material?

Information is material if its release would be likely to affect the price of the security, or if a reasonable investor would want to know it before making an investment decision. A pending acquisition, an earnings figure well away from expectations, a regulator's decision on a key product, or the loss of a major customer would usually qualify.

Two qualities decide a lot of exam questions:

Specificity. "The company has a few things in the works" is vague. "The company will announce a takeover offer at a 30% premium on Monday" is specific. The more specific the information, the more likely it is material.

Reliability. A rumor from an unknown source on a message board carries less weight than a statement from the company's chief financial officer. Information from a source close to the event, such as an executive, a lawyer working on the deal, or a printer typesetting the announcement, is more reliable and more likely to be material.

Test two: is it nonpublic?

Information is nonpublic until it has been disseminated to the marketplace in general and investors have had a chance to act on it. The test is broad availability, not how many people already know.

That means information shared with a select group is still nonpublic. A company that briefs a handful of analysts in a private meeting, or on a call that the wider market cannot access, has not made the information public. Once the same information appears in a press release or a public regulatory filing, it is public.

The mosaic theory: where analysts stay safe

Analysts are expected to dig. Standard II(A) does not stop an analyst from combining public information with nonpublic information that is not material, and reaching a conclusion that the market has not reached yet. That is the mosaic theory, and a conclusion built that way can be acted on even if it turns out to match an insider's secret.

The condition is that no single piece of the mosaic is itself material nonpublic information. Counting delivery trucks at a fictional manufacturer's loading dock, reading its public filings, and talking to its suppliers about general demand can add up to a strong view. One sentence from an executive about next week's unannounced earnings figure turns the mosaic into a violation.

Seven material nonpublic information traps

Every person and firm below is fictional.

Trap 1: "Only a few people know, so it's basically public." Lena Okafor, an analyst at Northcrest Capital, attends a closed meeting where the chief executive of a fictional retailer tells six analysts that quarterly sales fell sharply. The figure has not been released. Six people knowing it does not make it public. Lena cannot act on it or pass it on until the company discloses it to the market.

Trap 2: "She didn't trade, so there's no violation." Suppose Lena does not trade but mentions the sales figure to her brother, who sells his shares. Causing someone else to act is prohibited too. The violation does not depend on Lena profiting.

Trap 3: "He overheard it by accident." Theo Delaney, a portfolio manager at Meridian Securities, overhears two strangers in a coffee shop discussing an unannounced merger in convincing detail. How he came by the information does not matter. If it is material and nonpublic, he cannot act on it. A distractor will suggest that information obtained innocently is fair game.

Trap 4: "It's just a rumor." The flip side of Trap 3. An unsourced message board post saying a takeover "might happen someday" is neither specific nor reliable. Acting on a rumor like that is not a Standard II(A) violation, because the information fails the materiality test. Read how specific the information is and where it came from before deciding.

Trap 5: the mosaic with one bad tile. Priya Natarajan builds a careful sell recommendation from public filings, industry data and conversations with former employees about general working conditions. Then a current executive confirms, privately, that a product recall will be announced next month. Everything before that call was legitimate. The recall confirmation is material nonpublic information, and the recommendation can no longer rest on it.

Trap 6: II(A) versus II(B). Standard II(B), Market Manipulation, is about distorting prices or trading volume with the intent to mislead, for example by spreading false information or trading to create a misleading appearance of activity. If the story is about using true but confidential information, think II(A). If it is about creating a false impression in the market, think II(B).

Trap 7: what the firm and the individual should do. When someone comes into possession of material nonpublic information, the expected step is to encourage the issuer to make the information public, not to quietly trade around it. At the firm level, information barriers between departments, restricted or watch lists for affected securities, and reviews of employee trading are the standard tools for keeping such information contained. A distractor may suggest that a firewall makes any trade acceptable. A barrier helps contain information; it does not make acting on material nonpublic information acceptable for the person who holds it.

A three-question check for any II(A) vignette

1. Is it specific and reliable enough that a reasonable investor would care? If not, it is not material.
2. Has it reached the market as a whole? If it is limited to a select group, it is nonpublic.
3. Did the person act, or cause someone else to act? Trading, recommending and tipping all count.

If the answer to all three is yes, Standard II(A) has been violated. If the information was built from public pieces and non-material ones, check for the mosaic theory before choosing "violation."

The complete guide to Ethics shows where Integrity of Capital Markets sits among the other Standards, and how to study Ethics covers a step-by-step method for working vignettes.

Practice with mixed Ethics questions

Standard II(A) questions are easier to spot in isolation than in a mixed set, where they sit next to market manipulation, duties to clients and conflicts of interest. The free 90-question practice exam at Totten Prep covers all ten topic areas and includes an explanation for every question. It takes a free account.

FAQ

What makes information material under Standard II(A)? Information is material if its release would be likely to affect the price of a security or if a reasonable investor would want to know it before deciding. Specific information from a reliable source is more likely to be material than a vague rumor.

Is information shared with a small group of analysts public? No. Information is public only once it has been disseminated to the marketplace in general. A private meeting or a limited call does not make it public.

Is the mosaic theory allowed on the exam? Yes. Combining public information with nonpublic information that is not material is legitimate analysis, and the conclusion can be acted on. It stops being allowed if any single piece is material nonpublic information.

Is passing information to someone else a violation even without trading? Yes. Standard II(A) prohibits causing others to act on material nonpublic information, so tipping a friend, relative or client is a violation whether or not the member or candidate trades.

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