- Under the federal code-of-ethics requirements for SEC-registered investment advisers, which of the following statements about an access person's personal securities reporting is true?
Answer: An access person must submit an initial holdings report within 10 days after becoming an access person and quarterly transaction reports within 30 days after the end of each calendar quarter.
Governing authority: SEC Rule 204A-1. The correct statement is that an initial holdings report is due within 10 days after a person becomes an access person, and quarterly transaction reports are due within 30 days after each calendar quarter. Preclearance is required for initial public offerings and private placements, not every personal securities transaction. The 45-day and before-first-trade deadlines are wrong, and registration with an unrelated broker-dealer does not satisfy the adviser's reporting obligations.
An IAR at an SEC-registered adviser with several access persons wants to invest $50,000 in a private placement of a technology start-up offered by a client. The offering is exempt from SEC registration. The IAR will hold the interest in a personal account.
Under SEC personal trading rules, what must occur before the IAR makes this investment? Answer: The IAR must obtain prior approval from the adviser's chief compliance officer because a private placement is a limited offering subject to preclearance.
Governing authority: SEC Rule 204A-1(c). A private placement is a limited offering, so an access person must obtain the adviser's chief compliance officer's prior approval before acquiring the interest. The Securities Act exemption from registration does not exempt the personal transaction from the code-of-ethics rule. State Administrator preclearance is not required, and a report made after the purchase is not a substitute for prior approval.
An IAR at a state-registered adviser is responsible for executing client trades. At 9:50 a.m. she receives a large order to buy 50,000 shares of a thinly traded issuer for a client account. Before placing that order, she buys 1,000 shares of the same issuer in her personal brokerage account. The client order is then placed and the price rises. The IAR's personal trade was too small to affect the market price.
Which statement is correct about the IAR's personal trade? Answer: It is prohibited because the IAR traded on material nonpublic information about a client's imminent order.
Governing authority: Exchange Act Rule 10b-5, the Uniform Securities Act antifraud provisions, and the adviser's fiduciary duty. Trading ahead of a known client order is front-running and is a fraudulent, deceptive practice because the IAR used material nonpublic information about the client's imminent trading. The small size of the personal trade, later reporting, the absence of profit, and the fact that the client order was filled do not make the trade lawful.
- Which of the following statements regarding tipper and tippee liability under federal insider trading law is true?
Answer: A tipper may be liable if the tipper gives material nonpublic information as a gift intended to benefit the recipient, even if the tipper neither trades nor receives cash, and the recipient trades.
Governing authority: Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5, as interpreted in Dirks v. SEC. Under the gift theory, a tipper may breach a duty by giving material nonpublic information as a gift intended to benefit the recipient, even if the tipper does not trade and receives no cash, so long as the recipient trades. The statement that a tipper must personally trade or receive a pecuniary benefit from the tippee is wrong because a gift intended to benefit the recipient is itself a personal benefit. The statement that a tippee must know with certainty that the information came from an insider is wrong; a tippee must know or have reason to know of the insider's breach, and reckless disregard of the source can suffice. The statement that a tippee is liable only if the tipper also trades or receives a profit from the tippee's trade is wrong for the same reason: the tipper's personal benefit may be a gift, not a profit from the trade.
Celia Grant is an IAR of an SEC-registered investment adviser and an access person under the firm's code of ethics, which complies with SEC requirements. Her brother, Marcus, is the chief executive officer of Northern Lights Industries, a public company held in several of the firm's client accounts. At a private family dinner, Marcus tells Celia, in confidence, that Northern Lights is in advanced negotiations to be acquired at a substantial premium. Marcus has never shared company information with her before, receives no money from her, and does not himself trade in Northern Lights stock. The next morning, Celia buys 1,000 shares of Northern Lights in her personal online brokerage account. When the firm's next quarterly transaction-report deadline arrives, she does not report the trade, believing that personal trades away from the firm are not covered by the code of ethics.
Which of the following statements is correct under the federal securities laws? Answer: Both Marcus and Celia are liable for insider trading, and Celia also breached her firm's code of ethics by failing to report the trade.
SEC Rule 10b-5 and the Supreme Court's tipper/tippee personal-benefit standard (Dirks v. SEC, as applied in Salman v. United States) govern the insider-trading analysis, and SEC Rule 204A-1 governs the access-person reporting duty. Marcus, as CEO, is a corporate insider; his confidential tip to his sister was a gift of inside information. Under the gift rule, a tip to a close relative who trades is itself a personal benefit even without cash, so Marcus breached his duty to Northern Lights and its shareholders. Celia knew the information was material, nonpublic, and given in confidence by an insider, so she inherited the duty and is liable as a tippee for her purchase. Because she is an access person, the firm's code, as required by SEC Rule 204A-1, also required her to report the personal trade; using a personal online brokerage account does not take the trade outside the code. The statement that Marcus is not liable because he received no cash treats a financial payment as the only possible benefit, ignoring the family-gift rule. The statement that Celia is not liable because she lacked knowledge of a financial benefit misstates the tippee standard: knowledge that the information was confidential and disclosed in breach is what matters. The statement that neither is liable repeats the no-benefit error, and while the reporting duty is real, it does not displace insider-trading liability.
An IAR has a close personal friend who is the CFO of a public company. The CFO tells the IAR in confidence, "I cannot tell you why, but sell any shares you own in my company before the end of the month." The IAR knows the CFO is disclosing confidential company information and is not authorized to reveal it. The IAR sells his shares before the company announces a surprise earnings restatement. The CFO receives nothing and does not trade.
Under federal insider trading law, which statement is correct? Answer: The CFO breached a duty, and the IAR is liable as a tippee because he traded on the tip.
Governing authority: SEC Rule 10b-5 and the tipper/tippee liability standard under Dirks. A corporate insider breaches a fiduciary duty by disclosing material nonpublic information for a personal benefit, and a gift of confidential information to a close personal friend is a personal benefit; the absence of cash or other tangible benefit does not protect the CFO. Because the IAR knew the information was confidential and unauthorized, and he traded on the tip, he is liable as a tippee. The CFO was not required to reveal the exact amount of the earnings shortfall, and the instruction to sell was a directive to trade, not a mere warning.
An officer of a public company adopted a written personal trading plan more than a year ago to sell a fixed number of shares on the first trading day of each quarter. The plan was adopted in good faith and has not been modified. Last week, the officer learned material nonpublic information about the company. The next scheduled sale under the plan is Monday.
Under federal insider trading law, which statement is correct about Monday's scheduled sale? Answer: The sale is protected because the plan was adopted in good faith before the officer learned the information.
Governing authority: SEC Rule 10b5-1. A trade made under a written plan adopted in good faith before the trader became aware of the material nonpublic information, and not modified, is not made 'on the basis of' that information; the affirmative defense is not destroyed by post-adoption awareness. Preclearance after learning the information is not part of the Rule 10b5-1 defense, and public disclosure is not required for the defense to apply.
- Which of the following statements regarding a prearranged trading plan under federal insider trading law is true?
Answer: A trade made under a written plan can avoid liability if the plan was adopted in good faith before the trader became aware of the material nonpublic information and the trade occurs according to the plan's terms.
Governing authority: SEC Rule 10b5-1. A trade that would otherwise be made on the basis of material nonpublic information can qualify for the affirmative defense if it is made under a written plan adopted in good faith before the trader became aware of the information and the trade follows the plan's terms. Adoption after awareness is not cured by compliance approval, cancellation is not the required response, and the defense is not limited to officers, directors, or 10 percent owners.
- Under federal securities law, which of the following statements regarding the materiality of information for insider trading purposes is true?
Answer: The materiality of preliminary merger negotiations depends on a balancing of the probability that the transaction will occur and the anticipated magnitude of the transaction.
Governing authority: Rule 10b-5 and Basic Inc. v. Levinson. Materiality is judged by whether a reasonable investor would consider the information important in the total mix of available information. For preliminary merger discussions, courts balance the probability that the transaction will occur against the anticipated magnitude of the transaction. A nonpublic source alone does not make information material, materiality is not limited to earnings or mergers, and public announcement or a price change is not the test.
An attorney at a law firm representing a public acquirer is reviewing documents for a confidential tender offer. The attorney learns the acquirer will announce a bid for a target company within the week. The attorney has no relationship with the target company or its shareholders. Before the announcement, the attorney buys call options on the target company for a personal account.
Under federal insider trading law, is the attorney's purchase a violation? Answer: Yes, under the misappropriation theory, because the attorney breached his duty by trading on confidential client information.
Governing authority: SEC Rule 10b-5 and the misappropriation theory. A person violates the insider trading rules when he misappropriates confidential information for personal gain in breach of a duty of trust and confidence owed to the source, even if he owes no duty to the issuer's shareholders. The attorney owed that duty to the acquirer and his law firm. The classical theory is not needed because he did not become a temporary insider of the target. Options are securities, so the statement that option trading is outside the insider trading rules is wrong.
- Which of the following statements regarding an investment adviser representative's personal securities trading ahead of a client order is true?
Answer: An IAR who trades ahead of a client order while aware of the client's pending order commits front-running, which is prohibited even if the trade is later reported and disclosed to the client.
Governing authority: the antifraud provisions of the Investment Advisers Act of 1940 (§ 206), Securities Exchange Act Rule 10b-5, and, for state-registered advisers, Uniform Securities Act § 102 and the NASAA Unethical Business Practices of Investment Advisers Model Rule. Trading ahead of a client order while aware of the client's pending order is front-running, a fraudulent practice. The violation is not cured by later reporting or after-the-fact disclosure to the client. The statement that front-running violates the rules only if the client's order is executed at a worse price is wrong: the prohibited act is the misuse of the client's pending order information, regardless of the resulting execution price. The statement that equal broker-dealer, commission, and execution terms make the trade permissible is wrong because those terms do not eliminate the misuse of the client's order information. The statement that the client's prior written consent and after-execution disclosure make the trade permissible is wrong because a client cannot consent to or waive the antifraud protection against front-running.
- Which of the following statements is true regarding the code-of-ethics obligations of an SEC-registered investment adviser that has only one access person?
Answer: The adviser must keep a written code of ethics, and the sole access person need not preclear initial public offering or private placement purchases.
Governing authority: SEC Rule 204A-1. Every SEC-registered adviser must establish, maintain, and enforce a written code of ethics. The rule's preclearance requirement for initial public offering and private placement purchases is not needed when the firm has only one access person, but the code and the reporting requirements still apply. The statements excusing the code, requiring preclearance of every trade, or excusing the reporting requirements are wrong.
An SEC-registered adviser has only one employee, who is the firm's portfolio manager, its chief compliance officer, and its only access person. The adviser has no board of directors and no other officers. The employee wants to buy shares in an upcoming IPO for a personal account.
Under SEC personal trading rules, which statement is correct? Answer: The employee may participate without the usual prior-approval requirement because the adviser has only one access person.
Governing authority: SEC Rule 204A-1(c). Access persons generally must preclear acquisitions of IPO and limited-offering securities, but the preclearance requirement does not apply where the adviser has only one access person. Because this adviser has a single employee and access person, the usual need for a separate approval is absent. Requiring approval from an outside person, treating IPO participation as an absolute bar, or requiring an SEC filing has no basis in the rule.
On June 1, an IAR becomes an access person of an SEC-registered adviser and timely files the initial holdings report required by the firm's code of ethics. On July 15, she buys 500 shares of a large public company in a personal brokerage account she owns and controls. The adviser has several access persons and its code satisfies SEC personal trading requirements.
Under SEC rules on personal securities transactions, when must the IAR's July 15 purchase be reported to the adviser? Answer: On the quarterly transaction report for the quarter ending September 30, which must be filed by October 30.
Governing authority: SEC Rule 204A-1. An access person must report personal securities transactions in a quarterly transaction report no later than 30 days after the end of the calendar quarter in which the transaction occurred. The July 15 purchase falls in the quarter ending September 30, so the report is due by October 30. The initial holdings-report deadline applies only to the report filed when the person becomes an access person, not to later trades. The annual holdings report is not a transaction report. Holding the account at an outside broker does not exempt the trade from reporting.
- Under the misappropriation theory of insider trading, which of the following statements is true?
Answer: A person violates Section 10(b) by trading on material nonpublic information in breach of a duty of trust and confidence to the source, even without any duty to the issuer's shareholders.
Governing authority: Section 10(b), Rule 10b-5, and the misappropriation theory. Liability can arise when a person misappropriates confidential information in breach of a duty owed to the source of the information, such as an employer or client, and then trades on it. The misappropriation theory does not require a duty to the issuer or its shareholders, and it does not require the trader to be an officer, director, or 10 percent owner. Merely overhearing information in a public place does not create the necessary duty.
