Did Holly violate any CFA Institute Standards of Professional Conduct with respect to his report on BlueNote or BigTime, as it relates to potential use of material nonpublic information?

Pat Wilson, CFA, is the chief compliance officer for Excess Investments, a global asset management and investment banking services company. Wilson is reviewing two investment reports written by Peter Holly, CFA, an analyst and portfolio manager who has worked for Excess for four years. Holly’s first report under compliance review is a strong buy recommendation for BlueNote Inc., a musical instrument manufacturer. The report states that the buy recommendation is applicable for the next 6 to 12 months with an average level of risk and a sustainable price target of $24 for the entire time period. At the bottom of the report, an e-mail address is given for investors who wish to obtain a complete description of the firm’s rating system. Among other reasons supporting the recommendation, Holly’s report states that expected increases in profitability as well as increased supply chain efficiency provide compelling support for purchasing BlueNote.

Holly informs Wilson that he determined his conclusions primarily from an intensive review of BlueNote’s filings with the SEC but also from a call to one of BlueNote’s suppliers who informed Holly that their new inventory processing system would allow for more efficiency in supplying BlueNote with raw materials. Holly explains to Wilson that he is the only analyst covering BlueNote who is aware of this information and that he believes the new inventory processing system will allow BlueNote to reduce costs and increase overall profitability for several years to come.

Wilson must also review Holly’s report on BigTirae Inc., a musical promotions and distribution company. In the report, Holly provides a very optimistic analysis of BigTime’s fundamentals. The analysis supports a buy recommendation for the company. Wilson finds one problem with Holly’s report on BigTime related to Holly’s former business relationship with BigTime Inc. Two years before joining Excess, Holly worked as an investment banker and received 1,000 restricted shares of BigTime as a result of his participation in taking the company public. These facts are not disclosed in the report but are disclosed on Excess Investment’s Web site. Wilson decides, however, that the timeliness of the information in the report warrants overlooking this issue so that the report can be distributed.

Just before the report is issued. Holly mentions to Wilson that BigTime unknowingly disclosed to him and a few other analysts who were wailing for a conference call to begin that the company is planning to restructure both its sales staff and sales strategy and may sell one of its poorly performing business units next year.

Three days after issuing his report on BigTime, which caused a substantial rise in the price of BigTime shares, Holly sells all of the BigTirne shares out of both his performance fee-based accounts and asset-based accounts and then proceeds to sell all of the BigTime shares out of his own account on the following day. Holly obtained approval from Wilson before making the trades.

Just after selling his shares in BigTime, Holly receives a call from the CEO of BlueNote who wants to see if Holly received the desk pen engraved with the BlueNote company logo that he sent last week and also to offer two front row tickets plus limousine service to a sold-out concert for a popular band that uses BlueNote’s instruments. Holly confirms that the desk pen arrived and thanks the CEO for the gift and tells him that before he accepts the concert tickets, he will have to check his calendar to see if he will be able to attend. Holly declines the use of the limousine service should he decide to attend the concert.

After speaking with the CEO of BlucNote, Holly constructs a letter that he plans to send by e-mail to all of his clients and prospects with e-mail addresses and by regular mail to all of his clients and prospects without e-mail addresses. The letter details changes to an equity valuation model that Holly and several other analysts at Excess use to analyze potential investment recommendations. Holly’s letter explains that the new model, which will be put into use next month, will utilize Monte Carlo simulations to create a distribution of stock values, a sharp contrast to the existing model which uses static valuations combined with sensitivity analysis. Relevant details of the new model are included in the letter, but similar details about the existing model are not included. The letter also explains that management at Excess has decided to exclude alcohol and tobacco company securities from the research coverage universe. Holly’s letter concludes by stating that no other significant changes that would affect the investment recommendation process have occurred or are expected to occur in the near future.

Did Holly violate any CFA Institute Standards of Professional Conduct with respect to his report on BlueNote or BigTime, as it relates to potential use of material nonpublic information?
A . Holly has violated Standard on material nonpublic information in the case of both reports.
B . There is a violation regarding the Blue Note report, but no violation with the Big Time report.
C . There is a violation regarding the Big Time report, but no violation with the Blue Note report.

View Answer

Answer: C

Explanation:

Standard 11(A). Holly has utilized public information to conduct an intensive analysis of BlueNote and has also utilized information obtained from a supplier that, while nonpublic, is not by itself material. When combined with his knowledge of BlueNote s material public information, however, the information from the supplier allows Holly to make a significant and material conclusion that would not be known to the public in general. This situation falls under the Mosaic Theory. Holly is free to make recommendations based on her material nonpublic conclusion on BlueNote since the conclusion was formed using material public information combined with nonmaterial nonpublic information. Thus, the BlueNote report did not violate Standard 11(A) Integrity of Capital Markets – Material Nonpublic Information, and since there appears to be a reasonable and adequate basis, does not appear to violate any other Standards either. Holly’s report on BigTime, however, is based in part on a conversation that he overheard between executives at BigTime. The information he overheard related to the sale of one of BigTimes business units was both material and nonpublic. The fact that several other analysts overheard the conversation as well does not make the information public. Because Holly is in possession of material nonpublic information, he is prohibited by Standard 11(A) from acting or causing others to act on the information. Therefore, his report on BigTime violates the Standard.