Level I — Practice Set

Ethics: Material Nonpublic Information & Soft Dollars

Each topic includes two difficult multiple-choice questions. The answer key is at the bottom.

Material Nonpublic Information

Question 1

An analyst is touring a supplier’s factory as part of public investor day events. During a group walk-through, a production manager—speaking loudly—mentions that a key customer’s order was cancelled yesterday, forcing the plant to idle two lines for the quarter. No NDAs are signed, and media representatives are present but do not publish anything. The analyst immediately shorts the customer’s stock. Under the Standard on material nonpublic information, the analyst’s action is:

  1. Permissible, because the information was obtained through legitimate inquiry and mosaic theory applies.
  2. Permissible, because the information was broadly disseminated to anyone attending the tour, including media.
  3. Not permissible, because the information is material and not yet public despite being audible on a tour.
  4. Not permissible, because company factory tours always create a duty of confidentiality regardless of content.

Question 2

A portfolio manager receives an unsolicited encrypted file from a former college classmate who now works in investor relations at Issuer X. The file’s title is “Prelim_Q4_XYZ.” Without opening the file, the manager increases the fund’s position in Issuer X ahead of earnings, believing the market will interpret any “prelim” leak as good news. The manager’s conduct most likely:

  1. Complies, because the manager never opened the file and relied only on market expectations.
  2. Violates, because trading on the reasonable expectation of receiving MNPI creates misuse even if the file wasn’t read.
  3. Complies, because there is no proof that the file contains MNPI.
  4. Violates only if the position size is “material” relative to the portfolio.

Soft Dollars

Question 3

An adviser directs client trades to Broker A, who provides research reports, access to expert-network calls, and a software license for the adviser’s internal portfolio accounting system. Broker A’s commission schedule is higher than alternatives offering execution only. Assuming safe-harbor provisions apply, which bundled item is least likely to be eligible as a permissible soft-dollar benefit paid with client commissions?

  1. Research reports directly supporting the adviser’s investment decisions.
  2. Expert-network calls used to evaluate industries under coverage.
  3. Portfolio accounting software primarily used for client reporting and billing.
  4. Raw market data feeds integrated into the adviser’s research process.

Question 4

A CIO documents a broker-selection policy that prioritizes best execution and requires periodic evaluation of soft-dollar arrangements. The firm uses Broker B for superior execution and Broker C for specialized research. The CIO aggregates client orders and allocates them pro-rata across B and C to “balance” soft-dollar credits quarter-to-quarter. The best description of the policy’s compliance issues is:

  1. Approach is acceptable because disclosure of the practice in ADV/engagement letters cures potential issues.
  2. Approach is acceptable if clients opt in to research sharing; otherwise, cease allocations to Broker C.
  3. Problematic: Order routing should be driven by best execution for each trade; credit-balancing may subordinate client interests.
  4. Problematic only if Broker C’s research is not “substantive” research as defined by the safe harbor.

Answer Key

Notes:
• Q1: Loud disclosure at a tour doesn’t make information “public” until broadly disseminated and time has elapsed; still material & nonpublic ⇒ not permissible.
• Q2: Trading on the expectation of MNPI misuse violates the Standard even without opening the file.
• Q3: Client-commission soft dollars should primarily benefit investment decision-making; billing/reporting software is typically ineligible.
• Q4: Client interests and best execution must drive routing each time; balancing research credits is a red flag unless it coincides with best execution.