Mosaic Theory and MNPI (CFA Ethics): Where the Line Actually Sits

Material nonpublic information produces some of the hardest items on the CFA exam, at every level, because the wrong answers are all things a competent analyst might plausibly do. Nothing in the vignette is obviously criminal. The distinctions are fine, and they are the point.

The two tests

Information triggers Standard II(A) only if it is both material and nonpublic. Test each separately.

Is it material?

Information is material if its disclosure would likely affect the security's price, or if a reasonable investor would want it before making an investment decision.

Two factors matter in borderline cases:

• Specificity. "Earnings will be around 40 cents" is materially different from "the quarter went well".
• Reliability of the source. The same statement from a CFO carries materiality that a rumour from a competitor's junior analyst does not. Information from an unreliable source may simply not be material.

Ambiguity is itself a signal: if you cannot tell whether information is material, the curriculum's guidance is to treat it as though it is, and to seek public dissemination or refrain from acting.

Is it nonpublic?

Information is public once it has been disseminated to the marketplace generally. Selective disclosure does not make it public, and the size of the audience does not settle it.

Disclosure to a small group of analysts on a private call is not public. Disclosure in a filing, a press release, or an open conference call that anyone can access is. The test is whether the market at large had the opportunity to receive it, not whether it in fact did.

Mosaic theory

This is the concept the exam most wants you to apply correctly, and the one candidates most often get backwards.

Mosaic theory holds that an analyst may combine public information with non-material nonpublic information to reach an investment conclusion — and that conclusion is not a violation of Standard II(A), even if the conclusion itself would be material and even if an insider would have paid for it.

The reasoning: this is precisely what analysis is. An analyst who interviews suppliers, counts vehicles in car parks, reads filings and speaks to former employees is assembling a picture from individually innocuous pieces. The value comes from the assembly, and the assembly is the analyst's own work product.

The boundary: every individual piece must be either public or non-material. One material nonpublic piece contaminates the whole conclusion, no matter how much legitimate work surrounds it. Mosaic theory does not launder a single bad input.

The practical protection: keep detailed records of the sources and reasoning behind a conclusion. If a recommendation is questioned later, contemporaneous documentation of how it was reached is what distinguishes a mosaic from a leak.

The situations that generate exam items

Industry experts and expert networks. Consulting experts is permitted and often valuable. The risk is that an expert who currently works for, or consults to, a covered company may disclose material nonpublic information about that company. The analyst must not act on it if they do — and cannot rely on the expert having judged what was appropriate to share.

Overheard information. Hearing a material detail by accident does not make it usable. The obligation attaches to the information, not to how it was obtained. There is no innocent-acquisition exception.

Receiving a tip unsolicited. Being sent information you did not ask for provides no protection. Acting on it, or passing it on, is the violation.

Selective disclosure by an issuer. If a company selectively discloses material information to you, the appropriate response is to encourage the company to make it public, and to refrain from acting or causing others to act until it is.

Trading before publishing a recommendation. A firm's own pending recommendation can itself be material nonpublic information. Personal trading ahead of it is front-running.

What "causing others to act" covers

The Standard prohibits acting or causing others to act, which is broader than trading. It captures:

• Passing information to colleagues, clients, friends or family
• Changing a recommendation or price target on the basis of it
• Advising a client to trade without disclosing why
• Suggesting a position be adjusted, even without naming the information

Restraint is not enough on its own. An analyst who declines to trade personally but tells a colleague has still violated the Standard.

Firm-level procedures

Questions frequently ask what a firm should have in place. The expected answers:

• Information barriers separating departments with access to material nonpublic information from those making investment decisions
• Restricted lists — securities in which the firm will not trade or publish research, typically because of an existing relationship
• Watch lists — confidentially monitored securities, kept narrow precisely because knowledge of the list is itself sensitive
• Review of employee trading against those lists
• Documented procedures for escalating information whose status is unclear

Note the distinction between the two lists, which is examined: restricted lists are typically distributed within the firm, whereas watch lists are held tightly, since broad circulation would itself signal information.

How the exam frames it

Ethics items rarely ask "is this a violation?" directly. They ask what the analyst should most appropriately do, with three defensible-looking options. The answer usually involves one of three actions: encourage public dissemination, refrain from acting until the information is public, or consult compliance.

Where an option involves trading, tipping, or adjusting a recommendation on the information, it is wrong. Where an option involves doing legitimate additional research, it is often right — that is mosaic theory operating.

Because Ethics carries the ethics adjustment on top of its topic weight, items in this area are worth disproportionate attention. The Ethics overview covers how the Standards fit together.