How does Standard II protect capital markets? What exactly counts as insider trading?

Standard II protects the integrity of capital markets through two sub-standards:

Standard II(A) — Material Nonpublic Information (MNPI):

You must not act on or cause others to act on material nonpublic information.

Three-part test for MNPI:

1. Is it material? Would a reasonable investor consider it important in making an investment decision? (e.g., earnings surprises, merger plans, regulatory decisions)
2. Is it nonpublic? Has it been disseminated broadly to the marketplace? If only a few people know, it's nonpublic.
3. Would you trade on it? Acting on or sharing MNPI for trading purposes violates the standard.

The Mosaic Theory (your defense):

Analysts are ALLOWED to piece together publicly available information and non-material nonpublic information to form an investment thesis. This is called the mosaic theory.

Example — Permissible (Mosaic):

Rohan visits 15 retail stores and counts foot traffic (public observation). He reads industry reports (public). He talks to a store manager who says "business has been pretty good" (non-material, non-specific). He concludes the company will beat earnings and buys the stock. This is fine — mosaic theory applies.

Example — Violation:

Rohan's college friend is the CFO of the same company and tells him at dinner: "We're going to announce a 40% earnings beat next Tuesday." Rohan buys the stock. This is insider trading — the information is both material and nonpublic.

Standard II(B) — Market Manipulation:

Prohibits actions designed to distort prices or trading volume:

• Information-based manipulation: Spreading false rumors to move a stock price
• Transaction-based manipulation: Wash trades, painting the tape, pump-and-dump schemes

What to do if you receive MNPI:

1. Do NOT trade
2. Do NOT share it with others (even colleagues)
3. Contact your compliance department
4. Place the security on a restricted list
5. Wait until the information becomes public before acting

Exam tip: The CFA exam loves testing the boundary between mosaic theory and insider trading. The key distinction: mosaic uses public + non-material nonpublic information; insider trading involves material nonpublic information.

Practice ethics scenarios in our CFA Level I question bank.