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Ethics Case Study of the Week: Overhearing a Friend’s Deal

By Gary Sarkissian posted 08-09-2021 08:00

  

CFA Institute’s Code of Ethics and Standards of Professional Conduct codify the ethical guidelines for the investment profession that are critical to maintaining the integrity of capital markets and investor trust.  Members, candidates, and even firms make a commitment to uphold these standards as they help elevate ethical decision-making universally around the globe.  

As investment professionals, we are certain to face important ethical decisions in our day-to-day activities.  Some scenarios we encounter will be straightforward, while others may be more complex.  No matter what circumstances we face, continuous learning remains imperative in an investment industry that continues to evolve with products undergoing innovation and a regulatory environment continuing to adapt. 

For that reason, each week we feature a sample case from CFA Institute’s Ethics in Practice Casebook.  Many cases are built upon real-life examples that may involve a regulatory matter or even a CFA Institute Professional Conduct investigation.  At the end of each case is a multiple-choice question that addresses the ethical nature of the actions taken in that case.  

This week’s case involves Standard II(A) Material Nonpublic Information.


Overhearing a Friend’s Deal
Khatri plays on a local cricket team with a number of friends from University, including Patel, his brother-in-law and an attorney, and Ahuja, who owns a software company called ZeroPower (ZP). Patel does the legal work for ZP. Over the years, Khatri, Patel, and many other friends in their circle invest in Ahuja’s company. A large global IT company makes an offer to buy ZP at a substantial premium over the company’s current share price. Patel works with lawyers from the acquiring firm to assist in their due diligence.

One weekend, during a particularly intense period of negotiations, while Khatri, Patel, and Ahuja are playing in a cricket tournament, Patel speaks repeatedly with representatives of the acquiring firm on his cell phone between cricket matches. Khatri partially overhears Patel’s discussions. Although it is not explicit that an acquisition of ZP is being considered, Khatri hears Patel mention repeatedly the name of the acquiring firm. Khatri guesses that ZP is likely to be acquired by the firm because he sees Patel and Ahuja huddled in private conversation several times over the course of the weekend. On Monday Khatri calls his broker and increases his investment in ZP by 5,000 shares. One week later, ZP announces its acquisition by the large IT firm and its share price increases by 30%. Khatri’s actions are

A. acceptable because Khatri’s investment was based on his own speculation.
B. acceptable because Khatri is not an insider of ZP or the acquiring firm.
C. acceptable because Khatri received the information in a public environment.
D. acceptable because Khatri used the Mosaic Theory to make his decision to increase his investment in ZP stock.
E. none of the above.

What do you think is the correct choice?  Click the “Analysis” button below to see the analysis for this case, and feel free to discuss in the comments below.  The completion of this case qualifies for 0.25 hour of Standards, Ethics, and Regulation (SER) credit


This case relates to material nonpublic information. CFA Institute Standard of Professional Conduct II(A): Material Nonpublic Information prohibits CFA Institute members from taking investment action based on material nonpublic information in their possession. The prohibition in this standard is not limited to only those who have information because they are “insiders” but applies to anyone who is in possession of material nonpublic information. In this case, Khatri comes into possession of material nonpublic information by overhearing confidential information from Patel’s phone calls and seeing Patel’s interactions with Ahuja that are prompted by those calls. Although the information about the acquisition of ZP was not explicitly stated, and some degree of deduction was required by Khatri, he knew or should have known that this information was confidential, nonpublic, and material. Patel should have been more careful to keep his phone conversations more private, but that does not allow Khatri to use material nonpublic information gleaned from eavesdropping on those conversations. Khatri’s actions are not an example of using the Mosaic Theory (investing based on cumulative nonmaterial or public information) because he uses of confidential, material information that is improperly obtained. Therefore, E is the best response.

This case is based on a July 2019 US SEC Enforcement Action.



Image by Johnnie Shannon from Pixabay

© 2019 CFA Institute. All rights reserved. You may copy and distribute this content, without modification and for non-commercial purposes, provided you attribute the content to CFA Institute and retain this copyright notice.  This case was written as a basis for discussion and is not prescriptive of how a business situation or professional conduct matter should or should not be handled or addressed. Certain characters mentioned are fictional to facilitate discussion, and any resemblance to actual persons is coincidental.


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