Charles Connor, CFA, is a portfolio manager at Apple Investments, LLC. Apple is a U.S.-based firm offering a wide spectrum of investment products and services. Connor manages the Biogene Fund, a domestic equity fund specializing in small capitalization growth stocks. The Biogene Fund generally takes significant positions in stocks, commonly owning 4.5-5% of the outstanding shares. The fund’s prospectus limits positions to a maximum of 5% of the shares outstanding. The performance of the Biogene Fund has been superior over the last few years, but for the last two quarters the fund has underperformed its benchmark by a wide margin. Connor is determined to improve his performance numbers going forward.

Charles Connor, CFA, is a portfolio manager at Apple Investments, LLC. Apple is a U.S.-based firm offering a wide spectrum of investment products and services. Connor manages the Biogene Fund, a domestic equity fund specializing in small capitalization growth stocks. The Biogene Fund generally takes significant positions in stocks, commonly owning 4.5-5% of the outstanding shares. The fund’s prospectus limits positions to a maximum of 5% of the shares outstanding. The performance of the Biogene Fund has been superior over the last few years, but for the last two quarters the fund has underperformed its benchmark by a wide margin. Connor is determined to improve his performance numbers going forward.

The Biogene prospectus allows Connor to use derivative instruments in his investment strategy. Connor frequently uses options to hedge his fund’s exposure as he builds or liquidates positions in his portfolio since Biogene’s large positions often take several weeks to acquire. For example, when he identifies a stock to buy, he often buys call options to gain exposure to the stock. As he buys the stock, he sells off the options or allows them to expire. Connor has noticed that the increased volume in the call options often drives the stock price higher for a few days. He has seen a similar negative effect on stock prices when he buys large amounts of put options.

The end of the quarter is just a few days away, and Connor is considering three transactions:

Transaction A: Buying Put Options on Stock A

The Biogene Fund owns 4,9% of the outstanding stock of Company A, but Connor believes the stock is fully valued and plans to sell the entire position. He anticipates that it will take approximately 45 trading days to liquidate the entire Biogene position in Stock A.

The Biogene Fund owns 5% of the outstanding stock of Company B. Connor believes there is significant appreciation potential for Stock B, but the stock price has dropped in recent weeks. Connor is hoping that by taking an option position, there will be a carryover effect on ihe stock price before quarter end.

Transaction C: Selling the Biogene Fund’s Entire Position in .Stock C

Connor believes that Stock C is still attractive, but he is selling the stock with the idea that he will repurchase the position next month. The motivation for the transaction is to capture a capital loss that will reduce the Biogene Fund’s tax expense for the year.

Apple has an investment banking department that is active in initial public offerings (IPOs). George Arnold, CFA, is the senior manager of the IPO department. Arnold approached Connor about Stock D, a new IPO being offered by Apple. Stock D will open trading in two days. Apple had offered the IPO to all of its clients, but approximately 20% of the deal remained unsold. Having read the prospectus, Connor thinks Stock D would be a good fit for his fund, and he expects Stock D to improve his performance in both the short and long term. Connor is not aware of any information related to Stock D beyond that provided in the prospectus. Connor asked to purchase 5% of the IPO, but Arnold limited Biogene’s share to 2%, explaining:

"With Biogene’s reputation, any participation will make the unsold shares highly marketable. Further, we may need Biogene to acquire more Stock D shares at a later date if the price does not hold up."

Connor is disappointed in being limited to 2% of the offering and suggests to Arnold in an e-mail that, given the 2% limitation, Biogene will not participate in the IPO. Arnold responded a few hours later with the following message:

"I have just spoken with Ms. D, the CFO of Stock D. Although it is too late to alter the prospectus, management believes they will receive a large contract from a foreign government that will boost next year’s sales by 20% or more. I urge you to accept the 2%―you won’t be sorry!"

After reviewing Arnold’s e-mail, Connor agrees to the 2% offer.

Based upon Connor’s acceptance of the 2% limitation after receiving the e-mail from Arnold:

A. Connor has violated Standards relating to material nonpublic information, and Arnold has violated Standards relating to preservation of confidentiality.

B. Connor has not violated Standards relating to material nonpublic information, but Arnold has violated Standards relating to preservation of confidentiality.

C. Connor has not violated Standards relating to material nonpublic information, but Arnold has violated Standards relating to preservation of confidentiality and material nonpublic information.

View Answer

Answer: A

Explanation:

By changing his previous decision and accepting the 2% based on Arnold s e-mail, Connor has violated the Standards related to material nonpublic information. He has acted based upon the receipt of inside information. Arnold has violated the Standards related to both material nonpublic information and preservation of confidentiality. Arnold violated Standard III(E) – Duties to Clients – Preservation of Confidentiality by revealing information he received based upon a special relationship with Stock D. By passing that information to another area of Apple, Arnold has violated Standard 11(A) Integrity of Capital Markets – Material Nonpublic Information as well.