Merchant Capital Partners, a regional investment bank, acts as a market maker for Vital Link Health Services and other small firms listed on an over-the-counter exchange. For those shares for whom Merchant acts as market maker, it trades for its own book as well as engaging in risk arbitrage trading. Merchant allows staff members to trade in shares once clients and the company have traded. Merchant recently obtained material nonpublic information regarding Vital’s planned reverse takeover of a publicly listed competitor. In order to be in compliance with the CFA Institute Code and Standards, which type of trading in Vital shares should Merchant least likely suspend?
- Personal
- Risk arbitrage
- Passive proprietary
Solution
C is correct because according to Standard II(A)–Material Nonpublic Information, Recommended Procedures for Compliance, if Merchant stopped market making, a form of proprietary trading, due to being in possession of material nonpublic information, it could tip off investors that Vital is likely to be making a major announcement in the near future. This would be counterproductive to the goals of maintaining the confidentiality of information and providing market liquidity. The Standard recommends that market makers remain passive when in possession of material nonpublic information. The Standard also requires personal trading to be suspended when in possession of material nonpublic information, and it is prudent to suspend arbitrage trading to prevent profits from insider trading.
A is incorrect because when in possession of material nonpublic information, Standard II(A)–Material Nonpublic Information requires personal trading to be suspended.
B is incorrect because when in possession of material nonpublic information, according to Standard II(A)–Material Nonpublic Information, it is prudent to suspend arbitrage trading to prevent profits from insider trading.
Please explain.
This is a good question that can be taken as new knowledge. However, we can also solve this using elimination. Option A and Option B are clearly incorrect so answer is Option C only.
Now, for the explanation, we need to understand that there are two parts of a MNPI: “Material” and “Non Public”. Material means anything that can affect the market. As we know, our firm is a Market Maker. And hence, if it stops doing Passive trading on that stock, people will understand that something must be going wrong and hence, the action becomes material to the market. Also, remember that passive trading might mean that the company has invested in an index that contains the stocks of the target company, so no active trading is involved here and should be harmless to continue doing it.