Learning Module 2 Guidance for Standards I - VII

I. PROFESSIONALISM A. Knowledge of the Law Example 1 (Notification of Known Violations): • Michael Allen works for a brokerage firm and is responsible for an underwriting of securities. A company official gives Allen information indicating that the financial statements Allen filed with the regulator overstate the issuer’s earnings. Allen seeks the advice of the brokerage firm’s general counsel, who states that it would be difficult for the regulator to prove that Allen has been involved in any wrongdoing. • Comment: Although it is recommended that members and candidates seek the advice of legal counsel, the reliance on such advice does not absolve a member or candidate from the requirement to comply with the law or regulation. Allen should report this situation to his supervisor, seek an independent legal opinion, and determine whether the regulator should be notified of the error. Example 2 (Dissociating from a Violation): • Lawrence Brown’s employer, an investment banking firm, is the principal underwriter for an issue of convertible debentures by the Courtney Company. Brown discovers that the Courtney Company has concealed severe third-quarter losses in its foreign operations. The preliminary prospectus has already been distributed. • Comment: Knowing that the preliminary prospectus is misleading, Brown should report his findings to the appropriate supervisory persons in his firm. If the matter is not remedied and Brown’s employer does not dissociate from the underwriting, Brown should sever all his connections with the underwriting. Brown should also seek legal advice to determine whether additional reporting or other action should be taken. Example 3 (Dissocia ng from a Viola on): • Kamisha Washington’s rm adver ses its past performance record by showing the 10-year return of a composite of its client accounts. Washington discovers, however, that the composite omits the performance of accounts that have le the rm during the 10-year period, whereas the descrip on of the composite indicates the inclusion of all rm accounts. This omission has led to an in ated performance gure. Washington is asked to use promo onal material that includes the erroneous performance number when solici ng business for the rm. • Comment: Misrepresen ng performance is a viola on of the Code and Standards. Although she did not calculate the performance herself, Washington would be assis ng in viola ng Standard I(A) if she were to use the in ated performance number when solici ng clients. She must dissociate herself from the ac vity. If discussing the misleading number with the person responsible is not an op on for correc ng the problem, she can bring the situa on to the a en on of her supervisor or the compliance department at her rm. If her rm is unwilling to recalculate performance, she must refrain from using the misleading promo onal material and should no fy the rm of her reasons. If the rm insists that she use the material, she should consider whether her obliga on to dissociate from the ac vity requires her to seek other employment. Example 4 (Following the Highest Requirements): • James Collins is an investment analyst for a major Wall Street brokerage rm. He works in a developing country with a rapidly modernizing economy and a growing capital market. Local securi es laws are minimal—in form and content—and include no puni ve prohibi ons against insider trading. • Comment: Collins must abide by the requirements of the Code and Standards, which might be more strict than the rules of the developing country. He should be aware of the risks that a small market and the absence of a fairly regulated ow of informa on to the market represent to his ability to obtain informa on and make mely judgments. He should include this factor in formula ng his advice to clients. In handling material nonpublic informa on that accidentally comes into his possession, he must follow Standard II(A)–Material Nonpublic Informa on. ti ti fl ti ti ti ti ti ti ti fi ti fi ti ti ti ti ti ti ti tt ti fl ti ti fi ti ti ti ti fi fi ti fi ti ti ft fl ti ti ti ti ff fi ti ti ti ti ti fi Comment: Jameson is in viola on of Standard I(A). As a registered investment adviser in Karramba, Jameson is prevented by Karrambian securi es law from par cipa ng in IPOs regardless of the law of her home country. In addi on, because the law of the country where she is working is stricter than the Code and Standards, she must follow the stricter requirements of the local law rather than the requirements of the Code and Standards. ti • ti Laura Jameson works for a mul na onal investment adviser based in the United States. Jameson lives and works as a registered investment adviser in the ny, but wealthy, island na on of Karramba. Karramba’s securi es laws state that no investment adviser registered and working in that country can par cipate in ini al public o erings (IPOs) for the adviser’s personal account. Jameson, believing that, as a US ci zen working for a US-based company, she should comply only with US law, has ignored this Karrambian law. In addi on, Jameson believes that as a charterholder, as long as she adheres to the Code and Standards requirement that she disclose her par cipa on in any IPO to her employer and clients when such ownership creates a con ict of interest, she is mee ng the highest ethical requirements. fl • ti ti ti fi ti ti ti ti ti fi Example 5 (Following the Highest Requirements): Example 6 (Laws and Regula ons Based on Religious Tenets): • Amanda Janney is employed as a xed-income por olio manager for a large interna onal rm. She is on a team within her rm that is responsible for crea ng and man- aging a xed-income hedge fund to be sold throughout the rm’s distribu on centers to high-net-worth clients. Her rm receives expressions of interest from poten al clients from the Middle East who are seeking investments that comply with Islamic law. The marke ng and promo onal materials for the xed-income hedge fund do not specify whether or not the fund is a suitable investment for an investor seeking compliance with Islamic law. Because the fund is being distributed globally, Janney is concerned about the reputa on of the fund and the rm and believes disclosure of whether or not the fund complies with Islamic law could help minimize poten al mistakes with placing this investment. • Comment: As the nancial market con nues to become globalized, members and candidates will need to be aware of the di erences between cultural and religious laws and requirements as well as the di erent governmental laws and regula ons. Janney and the rm could be proac ve in their e orts to acknowledge areas where the new fund may not be suitable for clients. Example 7 (Repor ng Poten al Unethical Ac ons): • Krista Blume is a junior por olio manager for high-net-worth por olios at a large global investment manager. She observes a number of new por olios and rela onships coming from a country in Europe where the rm did not have previous business and is told that a broker in that country is responsible for this new business. At a mee ng on alloca on of research resources to third-party research rms, Blume notes that this broker has been added to the list and is allocated payments for research. However, she knows the por olios do not invest in securi es in the broker’s country, and she has not seen any research come from this broker. Blume asks her supervisor about the name being on the list and is told that someone in marke ng is receiving the research and that the name being on the list is OK. She believes that what may be going on is that the broker is being paid for new business through the inappropriate research payments, and she wishes to dissociate from the misconduct. • Comment: Blume should follow the rm’s policies and procedures for repor ng poten al unethical ac vity, which may include discussions with her supervisor or someone in a designated compliance department. She should communicate her concerns appropriately while advoca ng for dis- closure between the new broker rela onship and the research payments. Example 8 (Failure to Maintain Knowledge of the Law): fi ti ti ti ti fi ti ti fi fi ti fi tf ti ti ti fl ti tt tf ti ti ti ti tf ti ti ti ti ti tf fi ti ti ti fi fi ti ti ti fi ff tf ti ti fi fi ti Colleen White is excited to use new technology to communicate with clients and poten al clients. She recently began pos ng investment informa on, including performance reports and investment opinions and recommenda ons, to her Facebook page. In addi on, she sends out brief announcements, opinions, and thoughts via her Twi er account (for example, “Prospects for future growth of XYZ company look good! #makingmoney4U”). Prior to White’s use of these social media pla orms, the local regulator had issued new requirements and guidance governing online electronic communica on. White’s communica ons appear to con ict with the recent regulatory announcements. fi ti fi ti ff tf ti ff • • Comment: White is in viola on of Standard I(A) because her communica ons do not comply with the exis ng guidance and regula on governing use of social media. White must be aware of the evolving legal requirements pertaining to new and dynamic areas of the nancial services industry that are applicable to her. She should seek guidance from appropriate, knowledgeable, and reliable sources, such as her rm’s compliance department, external service providers, or outside counsel, unless she diligently follows legal and regulatory trends a ec ng her professional responsibili es. B. Independence and Objec vity Example 1 (Travel Expenses): • Steven Taylor, a mining analyst with Bronson Brokers, is invited by Precision Metals to join a group of his peers in a tour of mining facili es in several western US states. The company arranges for chartered group ights from site to site and for accommoda ons in Spartan Motels, the only chain with accommoda ons near the mines, for three nights. Taylor allows Precision Metals to pick up his tab, as do the other analysts, with one excep on—John Adams, an employee of a large trust company who insists on following his company’s policy and paying for his hotel room himself. • Comment: The policy of the company where Adams works complies closely with Standard I(B) by avoiding even the appearance of a con ict of interest, but Taylor and the other analysts were not necessarily viola ng Standard I(B). In general, when allowing companies to pay for travel and/or accommoda ons in these circumstances, members and candidates must use their judgment. They must be on guard that such arrangements not impinge on a member’s or candidate’s independence and objec vity. In this example, the trip was strictly for business and Taylor was not accep ng irrelevant or lavish hospitality. The i nerary required chartered ights, for which analysts were not expected to pay. The accommoda ons were modest. These arrangements are not unusual and did not violate Standard I(B) as long as Taylor’s independence and objec vity were not compromised. In the nal analysis, members and candidates should consider both whether they can remain objec ve and whether their integrity might be perceived by their clients to have been compromised. Example 2 (Research Independence): • Susan Dillon, an analyst in the corporate nance department of an investment services rm, is making a presenta on to a poten al new business client that includes the promise that her rm will provide full research coverage of the poten al client. • Comment: Dillon may agree to provide research coverage, but she must not commit her rm’s research department to providing a favorable recommenda on. The rm’s recommenda on (favorable, neutral, or unfavorable) must be based on an independent and objec ve inves ga on and analysis of the company and its securi es. Example 3 (Research Independence and Intra rm Pressure): ti ti ti fi ti ti fi ti fi ff ti ti ti fi ti fi fl ti ti ti ti ff fi ti ti fi fl ti ti fi ti ti ti ti fi ti ti Walter Fritz is an equity analyst with Hilton Brokerage who covers the mining industry. He has concluded that the stock of Metals & Mining is overpriced at its current level, but he is concerned that a nega ve research report will hurt the good rela onship between Metals & Mining and the investment banking division of his rm. In fact, a senior manager of Hilton Brokerage has just sent him a copy of a proposal his rm has made to Metals & Mining to underwrite a debt o ering. Fritz needs to produce a report right away and is concerned about issuing a less-than-favorable ra ng. ti ti fl ti fi ti ti ti ti fi • • Comment: Fritz’s analysis of Metals & Mining must be objec ve and based solely on considera on of company fundamentals. Any pressure from other divisions of his rm is inappropriate. This con ict could have been eliminated if, in an cipa on of the o ering, Hilton Brokerage had placed Metals & Mining on a restricted list for its sales force. Example 4 (Research Independence and Issuer Rela onship Pressure): • As in Example 3, Walter Fritz has concluded that Metals & Mining stock is overvalued at its current level, but he is concerned that a nega ve research report might jeopardize a close rapport that he has nurtured over the years with Metals & Mining’s CEO, chief nance o cer, and investment rela ons o cer. Fritz is concerned that a nega ve report might result also in management retalia on—for instance, cu ng him o from par cipa ng in conference calls when a quarterly earnings release is made, denying him the ability to ask ques ons on such calls, and/or denying him access to top management for arranging group mee ngs between Hilton Brokerage clients and top Metals & Mining managers. • Comment: As in Example 3, Fritz’s analysis must be objec ve and based solely on considera on of company fundamentals. Any pressure from Metals & Mining is inappropriate. Fritz should reinforce the integrity of his conclusions by stressing that his investment recommenda on is based on rela ve valua on, which may include qualita ve issues with respect to Metals & Mining’s management. Example 5 (Research Independence and Sales Pressure): • As support for the sales e ort of her corporate bond department, Lindsey Warner o ers credit guidance to purchasers of xed-income securi es. Her compensa on is closely linked to the performance of the corporate bond department. Near the quarter’s end, Warner’s rm has a large inventory posi on in the bonds of Milton, Ltd., and has been unable to sell the bonds because of Milton’s recent announcement of an opera ng problem. Salespeople have asked her to contact large clients to push the bonds. • Comment: Unethical sales prac ces create signi cant poten al viola ons of the Code and Standards. Warner’s opinion of the Milton bonds must not be a ected by internal pressure or compensa on. In this case, Warner must refuse to push the Milton bonds unless she is able to jus fy that the market price has already adjusted for the opera ng problem. ti ti fl ti ti ti ti ti ff fi ti ti fi ti ti ti fl ffi fl fi ti ti ti fi ti fi ti ff ti ff ti fi ti ti ti ti ti ti ti ti ti ti ti ti ti ti ti ti Comment: Jorund must be independent and objec ve in her analysis of Interna onal Airlines. If she believes that her boss’s instruc ons have compromised her, she has two op ons: She can tell her boss that she cannot cover the company under these constraints, or she can take over coverage of the company, reach her own independent conclusions, and if they con ict with her boss’s opinion, share the conclusions with her boss or other supervisors in the rm so that they can make appropriate recommenda ons. Jorund must issue only recommenda ons that re ect her independent and objec ve opinion. fi • ff Jill Jorund is a securi es analyst following airline stocks and a rising star at her rm. Her boss has been carrying a “buy” recommenda on on Interna onal Airlines and asks Jorund to take over coverage of that airline. He tells Jorund that under no circumstances should the prevailing buy recommenda on be changed. ff • ti ti ti tti ti ti ffi Example 6 (Research Independence and Prior Coverage): Example 7 (Gi s and Entertainment from Related Party): • Edward Grant directs a large amount of his commission business to a New York–based brokerage house. In apprecia on for all the business, the brokerage house gives Grant two ckets to the World Cup in South Africa, two nights at a nearby resort, several meals, and transporta on via limousine to the game. Grant fails to disclose receiving this package to his supervisor. • Comment: Grant has violated Standard I(B) because accep ng these substan al gi s may impede his independence and objec vity. Every member and candidate should endeavor to avoid situa ons that might cause or be perceived to cause a loss of independence or objec vity in recommending investments or taking investment ac on. By accep ng the trip, Grant has opened himself up to the accusa on that he may give the broker favored treatment in return. Example 8 (Gi s and Entertainment from Client): • Theresa Green manages the por olio of Ian Knowlden, a client of Tisbury Investments. Green achieves an annual return for Knowlden that is consistently be er than that of the benchmark she and the client previously agreed to. As a reward, Knowlden o ers Green two ckets to Wimbledon and the use of Knowlden’s at in London for a week. Green discloses this gi to her supervisor at Tisbury. • Comment: Green is in compliance with Standard I(B) because she disclosed the gi from one of her clients in accordance with the rm’s policies. Members and candidates may accept bonuses or gi s from clients as long as they disclose them to their employer because gi s in a client rela onship are deemed less likely to a ect a member’s or candidate’s objec vity and independence than gi s in other situa ons. Disclosure is required, however, so that supervisors can monitor such situa ons to guard against employees favoring a gi -giving client to the detriment of other fee-paying clients (such as by alloca ng a greater propor on of IPO stock to the gi -giving client’s por olio). • Best prac ces for monitoring include comparing the transac on costs of the Knowlden account with the costs of other accounts managed by Green and other similar accounts within Tisbury. The supervisor could also compare the performance returns with the returns of other clients with the same mandate. This comparison will assist in determining whether a pa ern of favori sm by Green is disadvantaging other Tisbury clients or the possibility that this favori sm could a ect her future behavior. Example 9 (Travel Expenses from External Manager): ft ti fi ft ti ti ti ti ti ft ft ti ti ff tf ti ti ti fi fi ft tt ft ti ti ti tt ff ti ti ti ft ti ti ti ft ti fi tf ti fi ffi fl ti ff fi fi Tom Wayne is the investment manager of the Franklin City Employees Pension Plan. He recently completed a successful search for a rm to manage the foreign equity alloca on of the plan’s diversi ed por olio. He followed the plan’s standard procedure of seeking presenta ons from a number of quali ed rms and recommended that his board select Penguin Advisors because of its experience, well-de ned investment strategy, and performance record. The rm claims compliance with the Global Investment Performance Standards (GIPS) and has been veri ed. Following the selec on of Penguin, a reporter from the Franklin City Record calls to ask if there was any connec on between this ac on and the fact that Penguin was one of the sponsors of an “investment fact- nding trip to Asia” that Wayne made earlier in the year. The trip was one of several conducted by the Pension Investment Academy, which had arranged the i nerary of mee ngs with economic, government, and corporate o cials in major ci es in several Asian countries. The Pension Investment Academy obtains support for the cost of these trips from a number of investment managers, ti fi ti tf ft ft ti ti ti ti fi ti • including Penguin Advisors; the Academy then pays the travel expenses of the various pension plan managers on the trip and provides all meals and accommoda ons. The president of Penguin Advisors was also one of the travelers on the trip. • Comment: Although Wayne can probably put to good use the knowledge he gained from the trip in selec ng por olio managers and in other areas of managing the pension plan, his recommenda on of Penguin Advisors may be tainted by the possible con ict incurred when he par cipated in a trip partly paid for by Penguin Advisors and when he was in the daily company of the president of Penguin Advisors. To avoid viola ng Standard I(B), Wayne’s basic expenses for travel and accommoda ons should have been paid by his employer or the pension plan; contact with the president of Penguin Advisors should have been limited to informa onal or educa onal events only; and the trip, the organizer, and the sponsor should have been made a ma er of public record. Even if his ac ons were not in viola on of Standard I(B), Wayne should have been sensi ve to the public percep on of the trip when reported in the newspaper and the extent to which the subjec ve elements of his decision might have been a ected by the familiarity that the daily contact of such a trip would encourage. This advantage would probably not be shared by rms compe ng with Penguin Advisors. Example 10 (Research Independence and Compensa on Arrangements): • Javier Herrero recently le his job as a research analyst for a large investment adviser. While looking for a new posi on, he was hired by an investor-rela ons rm to write a research report on one of its clients, a small educa onal so ware company. The investor-rela ons rm hopes to generate investor interest in the technology company. The rm will pay Herrero a at fee plus a bonus if any new investors buy stock in the company as a result of Herrero’s report. • Comment: If Herrero accepts this payment arrangement, he will be in viola on of Standard I(B) because the compensa on arrangement can reasonably be expected to compromise his independence and objec vity. Herrero will receive a bonus for a rac ng investors, which provides an incen ve to dra a posi ve report regardless of the facts and to ignore or play down any nega ve informa on about the company. Herrero should accept only a at fee that is not ed to the conclusions or recommenda ons of the report. Issuer-paid research that is objec ve and unbiased can be done under the right circumstances as long as the analyst takes steps to maintain his or her objec vity and includes in the report proper disclosures regarding poten al con icts of interest. ti ti ti ti ti ti ti ti ti ti fl ti tt ti fi fi ti ti ti tt fl fl ti ti ti fi fl ti ti ff tf ff fi ti fi ti ft ti ti ti ff ft Now, two years later, the funds managed by Western begin to underperform their peers. Wade is coun ng on the fees to reach his pro tability targets and con nues to push these funds as acceptable investments for Central’s clients. ti • ti Two years ago, Bob Wade, trust manager for Central Midas Bank, was approached by Western Funds about promo ng its family of funds, with special interest in the service-fee class of funds. To en ce Central to promote this class, Western Funds o ered to pay the bank a service fee of 0.25%. Without disclosing the fee being o ered to the bank, Wade asked one of the investment managers to review Western’s funds to determine whether they were suitable for clients of Central Midas Bank. The manager completed the normal due diligence review and determined that the new funds were fairly valued in the market with fee structures on a par with compe tors. Wade decided to accept Western’s o er and instructed the team of por olio managers to exclusively promote these funds and the service-fee class to clients seeking to invest new funds or transfer from their current investments. ti • ti ft ti tf ti ti ff ti ti ti ti ti ti ti Example 11 (Recommenda on Objec vity and Service Fees): • Comment: Wade is viola ng Standard I(B) because the fee arrangement has a ected the objec vity of his recommenda ons. Wade is relying on the fee as a component of the department’s pro tability and is unwilling to o er other products that may a ect the fees received. See also Standard VI(A)– Disclosure of Con icts. Example 12 (Recommenda on Objec vity): • Bob Thompson has been doing research for the por olio manager of the xed-income department. His assignment is to do sensi vity analysis on securi zed subprime mortgages. He has discussed with the manager possible scenarios to use to calculate expected returns. A key assump on in such calcula ons is housing price apprecia on (HPA) because it drives “prepays” (prepayments of mortgages) and losses. Thompson is concerned with the signi cant apprecia on experienced over the previous ve years as a result of the increased availability of funds from subprime mortgages. Thompson insists that the analysis should include a scenario run with –10% for Year 1, –5% for Year 2, and then (to project a worst-case scenario) 0% for Years 3 through 5. The manager replies that these assump ons are too dire because there has never been a me in their available database when HPA was nega ve. • Thompson conducts his research to be er understand the risks inherent in these securi es and evaluates these securi es in the worst-case scenario, an unlikely but possible environment. Based on the results of the enhanced scenarios, Thompson does not recommend the purchase of the securi za on. Against the general market trends, the manager follows Thompson’s recommenda on and does not invest. The following year, the housing market collapses. In avoiding the subprime investments, the manager’s por olio outperforms its peer group that year. • Comment: Thompson’s ac ons in running the worst-case scenario against the protests of the por olio manager are in alignment with the principles of Standard I(B). Thompson did not allow his research to be pressured by the general trends of the market or the manager’s desire to limit the research to historical norms. See also Standard V(A)–Diligence and Reasonable Basis. ti ti fi ti ti ti ti ti ff ti fi fi ti ti ft ti fi ti fi fi tf ti ff ti ti ti ft tt ti ti tf ti tf ti ti ff ti ti ti fi ti ti Comment: Mandel not only o ered but actually gave monetary gi s, bene ts, and other considera ons that reasonably could be expected to compromise Gomez’s objec vity. Therefore, Mandel was in viola on of Standard I(B). ff • ti Adrian Mandel, CFA, is a senior por olio manager for ZZYY Capital Management who oversees a team of investment professionals who manage labor union pension funds. A few years ago, ZZYY sought to win a compe ve asset manager search to manage a signi cant alloca on of the pension fund of the United Doughnut and Pretzel Bakers Union (UDPBU). UDPBU’s investment board is chaired by a recognized key decision maker and long- me leader of the union, Ernesto Gomez. To improve ZZYY’s chances of winning the compe on, Mandel made signi cant monetary contribu ons to Gomez’s union reelec on campaign fund. Even a er ZZYY was hired as a primary manager of the pension, Mandel believed that his rm’s posi on was not secure. Mandel con nued to contribute to Gomez’s reelec on campaign chest as well as to entertain lavishly the union leader and his family at top restaurants on a regular basis. All of Mandel’s outlays were rou nely handled as marke ng expenses reimbursed by ZZYY’s expense accounts and were disclosed to his senior management as being instrumental in maintaining a strong close rela onship with an important client. ti • fl fl ti fi ti ti ti ti ti ti ti ti ti tf Example 13 (In uencing Manager Selec on Decisions): Example 14 (In uencing Manager Selec on Decisions): • Adrian Mandel, CFA, had heard about the manager search compe on for the UDPBU Pension Fund through a broker/dealer contact. The contact told him that a well-known re red professional golfer, Bobby “The Bear” Finlay, who had become a licensed broker/dealer serving as a pension consultant, was orchestra ng the UDPBU manager search. Finlay had gained celebrity status with several labor union pension fund boards by entertaining their respec ve board members and regaling them with colorful stories of fellow pro golfers’ an cs in clubhouses around the world. Mandel decided to improve ZZYY’s chances of being invited to par cipate in the search compe on by befriending Finlay to curry his favor. Knowing Finlay’s love of entertainment, Mandel wined and dined Finlay at highpro le bistros where Finlay could glow in the fan recogni on lavished on him by all the other patrons. Mandel’s endeavors paid o handsomely when Finlay recommended to the UDPBU board that ZZYY be entered as one of three nalist asset management rms in its search. • Comment: Similar to Example 13, Mandel lavished gi s, bene ts, and other considera ons in the form of expensive entertainment that could reasonably be expected to in uence the consultant to recommend the hiring of his rm. Therefore, Mandel was in viola on of Standard I(B). Example 15 (Fund Manager Rela onships): • Amie Sco is a performance analyst within her rm with responsibili es for analyzing the performance of external managers. While comple ng her quarterly analysis, Sco no ces a change in one manager’s reported composite construc on. The change concealed the bad performance of a par cularly large account by placing that account into a new residual composite. This change allowed the manager to remain at the top of the list of manager performance. Sco knows her rm has a large alloca on to this manager, and the fund’s manager is a close personal friend of the CEO. She needs to deliver her nal report but is concerned with poin ng out the composite change. • Comment: Sco would be in viola on of Standard I(B) if she did not disclose the change in her nal report. The analysis of managers’ performance should not be in uenced by personal rela onships or the size of the alloca on to the outside managers. By not including the change, Sco would not be providing an independent analysis of the performance metrics for her rm. fi ti fi ti fi ti ti tt tt fi ti ti ti tt fl ft fi ti ti fi ti ti ti fl fi ti ti ti fi fi ft ti ti fi fi ti ti tt ti ti ti ti fi fi fi Comment: Pressure from other internal departments can create situa ons that cause a member or candidate to violate the Code and Standards. Stein must maintain her independence and objec vity and refuse to exclude speci c accounts from the rm’s performance composites to which they belong. As long as the client invested under a strategy similar to that of the de ned composite, it cannot be excluded because of the poor stock selec ons that led to the underperformance and asset withdrawal. ff • fi Jill Stein is head of performance measurement for her rm. During the last quarter, many members of the organiza on’s research department were removed because of the poor quality of their recommenda ons. The subpar research caused one larger account holder to experience signi cant underperformance, which resulted in the client withdrawing his money a er the end of the quarter. The head of sales requests that Stein remove this account from the rm’s performance composite because the performance decline can be a ributed to the departed research team and not the client’s adviser. ti • fi fl tt ti ti ti ti tt fi ti Example 16 (Intra rm Pressure): C. Misrepresenta on Example 1 (Disclosure of Issuer-Paid Research): • McGuire is an issuer-paid analyst hired by publicly traded companies to electronically promote their stocks. McGuire creates a website that promotes his research e orts as a seemingly independent analyst. McGuire posts a pro le and a strong buy recommenda on for each company on the website indica ng that the stock is expected to increase in value. He does not disclose the contractual rela onships with the companies he covers on his website, in the research reports he issues, or in the statements he makes about the companies in internet chat rooms. • Comment: McGuire has violated Standard I(C) because the website is misleading to poten al investors. Even if the recommenda ons are valid and supported with thorough research, his omissions regarding the true rela onship between himself and the companies he covers cons tute a misrepresenta on. McGuire has also violated Standard VI(A)–Disclosure of Con icts by not disclosing the existence of an arrangement with the companies through which he receives compensa on in exchange for his services. Example 2 (Correc on of Uninten onal Errors): • Hijan Yao is responsible for the crea on and distribu on of the marke ng materials for his rm, which claims compliance with the GIPS standards. Yao creates and dis- tributes a presenta on of performance by the rm’s Asian equity composite that states the composite has ¥350 billion in assets. In fact, the composite has only ¥35 billion in assets, and the higher gure on the presenta on is a result of a typographical error. Nevertheless, the erroneous material is distributed to a number of clients before Yao catches the mistake. • Comment: Once the error is discovered, Yao must take steps to cease distribu on of the incorrect material and correct the error by informing those who have received the erroneous informa on. Because Yao did not knowingly make the misrepresenta on, however, he did not violate Standard I(C). Because his rm claims compliance with the GIPS standards, it must also comply with the GIPS Guidance Statement on Error Correc on in rela on to the error. ti ti ti ti ti fi ti ti ti ti fl ti fi ti ti fi ti ff ti ti ti ti ti fi fi ti ti ti ti ti ti ti ti fi fi tt ti Comment: Even though Muhammad may not have been directly responsible for the misrepresenta on of his creden als in the rm’s promo onal material, he used this material numerous mes over an extended period and should have known of the misrepresenta on. Thus, Muhammad has violated Standard I(C). fi • fi Syed Muhammad is the president of an investment management rm. The promo onal material for the rm, created by the rm’s marke ng department, incorrectly claims that Muhammad has an advanced degree in nance from a pres gious business school in addi on to the CFA designa on. Although Muhammad a ended the school for a short period of me, he did not receive a degree. Over the years, Muhammad and others in the rm have distributed this material to numerous prospec ve clients and consultants. ti • fi ti ti ti ti ti ti ti fi Example 3 (Non-correc on of Known Errors): Example 4 (Plagiarism): • Cindy Grant, a research analyst for a Canadian brokerage rm, has specialized in the Canadian mining industry for the past 10 years. She recently read an extensive research report on Je erson Mining, Ltd., by Jeremy Barton, another analyst. Barton provided extensive sta s cs on the mineral reserves, produc on capacity, selling rates, and marke ng factors a ec ng Je erson’s opera ons. He also noted that ini al drilling results on a new ore body, which had not been made public, might show the existence of mineral zones that could increase the life of Je erson’s main mines, but Barton cited no speci c data as to the ini al drilling results. Grant called an o cer of Je erson, who gave her the ini al drilling results over the telephone. The data indicated that the expected life of the main mines would be tripled. Grant added these sta s cs to Barton’s report and circulated it within her rm as her own report. • Comment: Grant plagiarized Barton’s report by reproducing large parts of it in her own report without acknowledgment. Example 5 (Misrepresenta on of Informa on): • When Ricki Marks sells mortgage-backed deriva ves called “interest-only strips” (IOs) to public pension plan clients, she describes them as “guaranteed by the US government.” Purchasers of the IOs are en tled only to the interest stream generated by the mortgages, however, not the no onal principal itself. One par cular municipality’s investment policies and local law require that securi es purchased by its public pen- sion plans be guaranteed by the US government. Although the underlying mortgages are guaranteed, neither the investor’s investment nor the interest stream on the IOs is guaranteed. When interest rates decline, causing an increase in prepayment of mortgages, interest payments to the IOs’ investors decline, and these investors lose a por on of their investment. • Comment: Marks violated Standard I(C) by misrepresen ng the terms and character of the investment. ti ti fi ti ff ti ti ti ff ti fi ff ti ti ffi fi ti ff ti fi ff ti ff ti ti ti ti ti ti ti ti ti ti Comment: Although there is risk that the ins tu on o ering the cer cates of deposits and money market accounts could go bankrupt, in the United States, these accounts are insured by the US government through the Federal Deposit Insurance Corpora on. Therefore, using the term “guaranteed” in this context is not inappropriate as long as the amount is within the governmentinsured limit. Abdrabbo should explain these facts to the clients. ti • ti Khalouck Abdrabbo manages the investments of several high-net-worth individuals in the United States who are approaching re rement. Abdrabbo advises these individuals that a por on of their investments be moved from equity to bank-sponsored cer cates of deposit and money market accounts so that the principal will be “guaranteed” up to a certain amount. The interest is not guaranteed. ti • ti ti ti ti fi ti Example 6 (Poten al Informa on Misrepresenta on): • Steve Swanson is a senior analyst in the investment research department of Ballard and Company. Apex Corpora on has asked Ballard to assist in acquiring the majority ownership of stock in the Campbell Company, a nancial consul ng rm, and to pre- pare a report recommending that stockholders of Campbell agree to the acquisi on. Another investment rm, Davis and Company, had already prepared a report for Apex analyzing both Apex and Campbell and recommending an exchange ra o. Apex has given the Davis report to Ballard o cers, who have passed it on to Swanson. Swanson reviews the Davis report and other available material on Apex and Campbell. From his analysis, he concludes that the common stocks of Campbell and Apex represent good value at their current prices; he believes, however, that the Davis report does not consider all the factors a Campbell stockholder would need to know to make a decision. Swanson reports his conclusions to the partner in charge, who tells him to “use the Davis report, change a few words, sign your name, and get it out.” • Comment: If Swanson does as requested, he will violate Standard I(C). He could refer to those por ons of the Davis report that he agrees with if he iden es Davis as the source; he could then add his own analysis and conclusions to the report before signing and distribu ng it. Example 8 (Plagiarism): • Claude Browning, a quan ta ve analyst for Double Alpha, Inc., returns from a seminar in great excitement. At that seminar, Jack Jorrely, a well-known quan ta ve analyst at a na onal brokerage rm, discussed one of his new models in great detail, and Browning is intrigued by the new concepts. He proceeds to test the model, making some minor mechanical changes but retaining the concepts, un l he produces some very posi ve results. Browning quickly announces to his supervisors at Double Alpha that he has discovered a new model and that clients and prospec ve clients should be informed of this posi ve nding as ongoing proof of Double Alpha’s con nuing innova on and ability to add value. • Comment: Although Browning tested Jorrely’s model on his own and even slightly modi ed it, he must s ll acknowledge the original source of the idea. Browning can certainly take credit for the nal, prac cal results; he can also support his conclusions with his own test. The credit for the innova ve thinking, however, must be awarded to Jorrely. fi ti ti ti ti fi tt ti ti ti ti ti fi ti ti ti ffi ti fi ti ti ti ti ti ti fi fi ti ti ti ti ti ti ti Comment: Copying verba m any material without acknowledgement, including plain-language descrip ons of the P/E mul ple and standard devia on, violates Standard I(C). Even though these concepts are general, best prac ce would be for Zubia to describe them in his own words or cite the sources from which the descrip ons are quoted. Members and candidates would be viola ng Standard I(C) if they either were responsible for crea ng marke ng materials without a ribu on or knowingly use plagiarized materials. ti • fi Fernando Zubia would like to include in his rm’s marke ng materials some “plain-language” descrip ons of various concepts, such as the price-to-earnings (P/E) mul ple and why standard devia on is used as a measure of risk. The descrip ons come from other sources, but Zubia wishes to use them without reference to the original authors. Would this use of material be a viola on of Standard I(C)? fi • ti ti ti ti ti ti ti ti ti Example 9 (Plagiarism): ti fi Example 7 (Plagiarism): Example 10 (Plagiarism): • Through a mainstream media outlet, Erika Schneider learns about a study that she would like to cite in her research. Should she cite both the mainstream intermediary source as well as the author of the study itself when using that informa on? • Comment: In all instances, a member or candidate must cite the actual source of the informa on. Best prac ce for Schneider would be to obtain the informa on directly from the author and review it before ci ng it in a report. In that case, Schneider would not need to report how she found out about the informa on. For example, suppose Schneider read in the Financial Times about a study issued by CFA Ins tute; best prac ce for Schneider would be to obtain a copy of the study from CFA Ins tute, review it, and then cite it in her report. If she does not use any interpreta on of the report from the Financial Times and the newspaper does not add value to the report itself, the newspaper is merely a conduit of the original informa on and does not need to be cited. If she does not obtain the report and review the informa on, Schneider runs the risk of relying on second-hand informa on that may misstate facts. If, for example, the Financial Times erroneously reported some informa on from the original CFA Ins tute study and Schneider copied that erroneous informa on without acknowledging CFA Ins tute, she could be the object of complaints. Best prac ce would be either to obtain the complete study from its original author and cite only that author or to use the informa on provided by the intermediary and cite both sources. Example 11 (Misrepresenta on of Informa on): • Paul Ostrowski runs a two-person investment management rm. Ostrowski’s rm subscribes to a service from a large investment research rm that provides research reports that can be repackaged by smaller rms for those rms’ clients. Ostrowski’s rm distributes these reports to clients as its own work. • Comment: Ostrowski can rely on third-party research that has a reasonable and adequate basis, but he cannot imply that he is the author of such research. If he does, Ostrowski is misrepresen ng the extent of his work in a way that misleads the rm’s clients or prospec ve clients. ti ti ti ff ti ti ti fi ti ti fi ff fi ti ti ti ti fi ti ti tt ti fi ti ti ff fi tf tf fi ti ti ti fi ti ti ti ff ti ti Comment: As a member of the investment team, Sta ord is quali ed to recognize the degree of accuracy of the materials that characterize the por olio, and he is correct to be worried about Appleton’s responsibility for a misrepresenta on of the risks. Thus, he should con nue to pursue the issue of Open Air’s inaccurate promo on of the por olio according to the rm’s policies and procedures. ti • fi Tom Sta ord is part of a team within Appleton Investment Management responsible for managing a pool of assets for Open Air Bank, which distributes structured securi es to o shore clients. He becomes aware that Open Air is promo ng the structured securi es as a much less risky investment than the investment management policy followed by him and the team to manage the original pool of assets. Also, Open Air has procured an independent ra ng for the pool that signi cantly overstates the quality of the investments. Sta ord communicates his concerns to his supervisor, who responds that Open Air owns the product and is responsible for all marke ng and distribu on. Sta ord’s supervisor goes on to say that the product is outside of the US regulatory regime that Appleton follows and that all risks of the product are disclosed at the bo om of page 184 of the prospectus. ti • ti ti ti fi ti ti ff ti ti Example 12 (Misrepresenta on of Informa on): • The Code and Standards stress protec ng the reputa on of the rm and the sustainability and integrity of the capital markets. Misrepresen ng the quality and risks associated with the investment pool may lead to nega ve consequences for others well beyond the direct investors. Example 13 (Avoiding a Misrepresenta on): • Trina Smith is a xed-income por olio manager at a pension fund. She has observed that the market for highly structured mortgages is the focus of salespeople she meets and that these products represent a signi cant number of trading opportuni es. In discussions about this topic with her team, Smith learns that calcula ng yields on changing cash ows within the deal structure requires very specialized vendor so ware. A er more research, they nd out that each deal is unique and that deals can have more than a dozen layers and changing cash ow priori es. Smith comes to the conclusion that, because of the complexity of these securi es, the team cannot e ec vely dis nguish between poten ally good and bad investment op ons. To avoid misrepresen ng their understanding, the team decides that the highly structured mortgage segment of the securi zed market should not become part of the core of the fund’s por olio; they will allow some of the less complex securi es to be part of the core. • Comment: Smith is in compliance with Standard I(C) by not inves ng in securi es that she and her team cannot e ec vely understand. Because she is not able to describe the risk and return pro le of the securi es to the pension fund bene ciaries and trustees, she appropriately limits the fund’s exposure to this sector. Example 14 (Misrepresen ng Composite Construc on): • Robert Palmer is head of performance for a fund manager. When asked to provide performance numbers to fund ra ng agencies, he avoids men oning that the fund manager is quite liberal in composite construc on. The reason accounts are included/ excluded is not fully explained. The performance values reported to the ra ng agencies for the composites, although accurate for the accounts shown each period, may not present a true representa on of the fund manager’s ability. • Comment: “Cherry picking” accounts to include in either published reports or informa on provided to ra ng agencies con icts with Standard I(C). Moving accounts into or out of a composite to in uence the overall performance results materially misrepresents the reported values over me. Palmer should work with his rm to strengthen its repor ng prac ces concerning composite construc on to avoid misrepresen ng the rm’s track record or the quality of the informa on being provided. ti ti fi ti ti ti ti ti ti ti ff ti ti ti fi ti ti ti ti ff ti fi fl ti ti fi ti fl ti ti ti ti ti ti fi tf ti fi ti fi ti ti ti tf ft fi ti ti ti fl ft ti Finch knows that some of the fact sheets are out of date; for example, one long-only fund approved the use of signi cant leverage last quarter as a method to enhance returns. He con nues to provide the sheets to the sales team without updates because the bank has no control over the marke ng material released by the mutual fund rms. ti • ti David Finch is a sales director at a commercial bank, where he directs the bank’s client advisers in the sale of third-party mutual funds. Each quarter, he holds a division-wide training session where he provides fact sheets on investment funds the bank is allowed to o er to clients. These fact sheets, which can be redistributed to poten al clients, are created by the fund rms and contain informa on about the funds, including investment strategy and target distribu on rates. ti • fi fi ti ff fi ti ti ti fl Example 15 (Presen ng Out-of-Date Informa on): • Comment: Finch is viola ng Standard I(C) by providing informa on that misrepresents aspects of the funds. By not providing the sales team and, ul mately, the clients with the updated informa on, he is misrepresen ng the poten al risks associated with the funds with outdated fact sheets. Finch can instruct the sales team to clarify the de ciencies in the fact sheets with clients and ensure they have the most recent fund prospectus document before accep ng orders for inves ng in any fund. Example 16 (Overemphasis of Firm Results): • Bob Anderson is chief compliance o cer for Op ma Asset Management Company, a rm currently o ering eight funds to clients. Seven of the eight had 10-year returns below the median for their respec ve sectors. Anderson approves a recent adver se- ment, which includes this statement: “Op ma Asset Management is achieving excellent returns for its investors. The Op ma Emerging Markets Equity fund, for example, has 10-year returns that exceed the sector median by more than 10%.” • Comment: From the informa on provided it is di cult to determine whether a viola on has occurred as long as the sector outperformance is correct. Anderson may be a emp ng to mislead poten al clients by ci ng the performance of the sole fund that achieved such results. Past performance is o en used to demonstrate a rm’s skill and abili es in comparison to funds in the same sectors. • However, if all the funds outperformed their respec ve benchmarks, then Anderson’s asser on that the company “is achieving excellent returns” may be factual. Funds may exhibit posi ve returns for investors, exceed benchmarks, and yet have returns below the median in their sectors. • Members and candidates need to ensure that their marke ng e orts do not include statements that misrepresent their skills and abili es to remain compliant with Standard I(C). Unless the returns of a single fund re ect the performance of a rm as a whole, the use of a singular fund for performance comparisons should be avoided. D. Misconduct Example 1 (Professionalism and Competence): • Simon Sasserman is a trust investment o cer at a bank in a small a uent town. He enjoys lunching every day with friends at the country club, where his clients have observed him having numerous drinks. Back at work a er lunch, he clearly is intoxicated while making investment decisions. His colleagues make a point of handling any business with Sasserman in the morning because they distrust his judgment a er lunch. • Comment: Sasserman’s excessive drinking at lunch and subsequent intoxica on at work cons tute a viola on of Standard I(D) because this conduct has raised ques ons about his professionalism and competence. His behavior re ects poorly on him, his employer, and the investment industry. Example 2 (Fraud and Deceit): ti ti ti ti ti ti fi ti ti ti ti ti ti tt ffl ff ti ti ti ti ti ti ti ffi ti ti ti fi ti ffi fi fi fi ffi ti ti fi fl ti ti ft Howard Ho man, a security analyst at ATZ Brothers, Inc., a large brokerage house, submits reimbursement forms over a two-year period to ATZ’s self-funded health insurance program for more than two dozen bills, most of which have been altered to increase the amount due. An inves ga on by the rm’s director of employee bene ts uncovers the inappropriate conduct. ATZ subsequently terminates Ho man’s employment and no es CFA Ins tute. ft fl ff ti ti ff ti fi ti ti ff ft • • Comment: Ho man violated Standard I(D) because he engaged in inten onal conduct involving fraud and deceit in the workplace that adversely re ected on his integrity. Example 3 (Fraud and Deceit): • Jody Brink, an analyst covering the automo ve industry, volunteers much of her spare me to local chari es. The board of one of the charitable ins tu ons decides to buy ve new vans to deliver hot lunches to low-income elderly people. Brink o ers to donate her me to handle purchasing agreements. To pay a long-standing debt to a friend who operates an automobile dealership—and to compensate herself for her trouble—she agrees to a price 20% higher than normal and splits the surcharge with her friend. The director of the charity ul mately discovers the scheme and tells Brink that her services, donated or otherwise, are no longer required. • Comment: Brink engaged in conduct involving dishonesty, fraud, and mis- representa on and has violated Standard I(D). Example 4 (Personal Ac ons and Integrity): • Carmen Garcia manages a mutual fund dedicated to socially responsible inves ng. She is also an environmental ac vist. As the result of her par cipa on in nonviolent protests, Garcia has been arrested on numerous occasions for trespassing on the property of a large petrochemical plant that is accused of damaging the environment. • Comment: Generally, Standard I(D) is not meant to cover legal transgressions resul ng from acts of civil disobedience in support of personal beliefs because such conduct does not re ect poorly on the member’s or candidate’s professional reputa on, integrity, or competence. ti fi fl ti ti fi ti ti fl ti ti ti ti fi ti ti ti ti ti fi ti ti ti ti ti ti fi fl ff ti ti ti ti ff ti ti Comment: Rasmussen has clearly come across an error in policies, procedures, and compliance prac ces within the rm’s opera ons. According to the rm’s procedures for repor ng poten ally unethical ac vity, she should pursue the issue by gathering some proof of her reason for doubt. Should all internal communica ons within the rm not sa sfy her concerns, Rasmussen should consider repor ng the poten al unethical ac vity to the appropriate regulator. See also Standard IV(A) for guidance on whistleblowing and Standard IV(C) for the du es of a supervisor. ti • ti Meredith Rasmussen works on a buy-side trading desk of an investment management rm and concentrates on in-house trades for a hedge fund subsidiary managed by a team at the investment management rm. The hedge fund has been very successful and is marketed globally by the rm. From her experience as the trader for much of the ac vity of the fund, Rasmussen has become quite knowledgeable about the hedge fund’s strategy, tac cs, and performance. When a dis nct break in the market occurs and many of the securi es involved in the hedge fund’s strategy decline markedly in value, Rasmussen observes that the reported performance of the hedge fund does not re ect this decline. In her experience, the lack of e ect is a very unlikely occurrence. She approaches the head of trading about her concern and is told that she should not ask any ques ons and that the fund is big and successful and is not her concern. She is fairly sure something is not right, so she contacts the compliance o cer, who also tells her to stay away from the issue of the hedge fund’s repor ng. fi • ti ti ff fi ffi ti ti ti Example 5 (Professional Misconduct): II. INTEGRITY OF CAPITAL MARKETS A. Material Nonpublic Informa on Example 1 (Ac ng on Nonpublic Informa on): • Frank Barnes, the president and controlling shareholder of the SmartTown clothing chain, decides to accept a tender o er and sell the family business at a price almost double the market price of its shares. He describes this decision to his sister (SmartTown’s treasurer), who conveys it to her daughter (who owns no stock in the family company at present), who tells her husband, Staple. Staple, however, tells his stockbroker, Alex Halsey, who immediately buys SmartTown stock for himself. • Comment: The informa on regarding the pending sale is both material and nonpublic. Staple has violated Standard II(A) by communica ng the inside informa on to his broker. Halsey also has violated the standard by buying the shares on the basis of material nonpublic informa on. Example 2 (Controlling Nonpublic Informa on): • Samuel Peter, an analyst with Scotland and Pierce Incorporated, is assis ng his rm with a secondary o ering for Bright Ideas Lamp Company. Peter par cipates, via telephone conference call, in a mee ng with Scotland and Pierce investment bank- ing employees and Bright Ideas’ CEO. Peter is advised that the company’s earnings projec ons for the next year have signi cantly dropped. Throughout the telephone conference call, several Scotland and Pierce salespeople and por olio managers walk in and out of Peter’s o ce, where the telephone call is taking place. As a result, they are aware of the drop in projected earnings for Bright Ideas. Before the conference call is concluded, the salespeople trade the stock of the company on behalf of the rm’s clients and other rm personnel trade the stock in a rm proprietary account and in employees’ personal accounts. • Comment: Peter has violated Standard II(A) because he failed to prevent the transfer and misuse of material nonpublic informa on to others in his rm. Peter’s rm should have adopted informa on barriers to prevent the communica on of nonpublic informa on between departments of the rm. The salespeople and por olio managers who traded on the informa on have also violated Standard II(A) by trading on inside informa on. fi ti tf fi ti ti fi fi fi ti ti ti ti fi ti ti fi ti ti ti ti fi ti ti ti ti ti ffi ti ti ti fi ti ti fi tf Comment: Levenson must rst determine whether the material informa on is public. According to Standard II(A), if the company has not made this informa on public (a small group forum does not qualify as a method of public dissemina on), she cannot use the informa on. fi • ti During the mee ng, the nance director states that the company expects its workforce to strike next Friday, which will cripple produc vity and distribu on. Can Levenson use this informa on as a basis to change her ra ng on the company from “buy” to “sell”? fi • ff Elizabeth Levenson is based in Hanoi and covers the Vietnamese market for her rm, which is based in Singapore. She is invited, together with the other 10 largest share- holders of a manufacturing company, to meet the nance director of that company. ti • ti ti ti ti ff Example 3 (Selec ve Disclosure of Material Informa on): Example 4 (Determining Materiality): • Leah Fechtman is trying to decide whether to hold or sell shares of an oil-and-gas explora on company that she owns in several of the funds she manages. Although the company has underperformed the index for some me already, the trends in the industry sector signal that companies of this type might become takeover targets. While she is considering her decision, her doctor, who casually follows the markets, men ons that she thinks that the company in ques on will soon be bought out by a large mul na onal conglomerate and that it would be a good idea to buy the stock right now. A er talking to various investment professionals and checking their opinions on the company as well as checking industry trends, Fechtman decides the next day to accumulate more stock in the oil-and-gas explora on company. • Comment: Although informa on on an expected takeover bid may be of the type that is generally material and nonpublic, in this case, the source of informa on is unreliable, so the informa on cannot be considered material. Therefore, Fechtman is not prohibited from trading the stock on the basis of this informa on. Example 5 (Applying the Mosaic Theory): • Jagdish Teja is a buy-side analyst covering the furniture industry. Looking for an a rac ve company to recommend as a buy, he analyzes several furniture makers by studying their nancial reports and visi ng their opera ons. He also talks to some designers and retailers to nd out which furniture styles are trendy and popular. Although none of the companies that he analyzes are a clear buy, he discovers that one of them, Swan Furniture Company (SFC), may be in nancial trouble. SFC’s extravagant new designs have been introduced at substan al cost. Even though these designs ini ally a racted a en on, the public is now buying more conserva ve furniture from other makers. Based on this informa on and on a pro t-and-loss analysis, Teja believes that SFC’s next quarter earnings will drop substan ally. He issues a sell recommenda on for SFC. Immediately a er receiving that recommenda on, investment managers start reducing the SFC stock in their por olios. • Comment: Informa on on quarterly earnings data is material and nonpublic. Teja arrived at his conclusion about the earnings drop on the basis of public informa on and on pieces of nonmaterial nonpublic informa on (such as opinions of designers and retailers). Therefore, trading based on Teja’s correct conclusion is not prohibited by Standard II(A). Example 6 (Applying the Mosaic Theory): ti ti ti ti ti ti ti tt tf ft fi fi fi ti ti ti ti ti ti ti ffi ti ti ft ti ti ti ti fi ti ti fi ti ti ft ti ti ti Roger Clement is a senior nancial analyst who specializes in the European automobile sector at Rivoli Capital. Because he has been repeatedly nominated by many leading industry magazines and newsle ers as a “best analyst” for the automobile industry, he is widely regarded as an authority on the sector. A er speaking with representa ves of Turgot Chariots—a European auto manufacturer with sales primarily in South Korea—and a er conduc ng interviews with salespeople, labor leaders, his rm’s Korean currency analysts, and banking o cials, Clement analyzed Turgot Chariots and concluded that (1) its newly introduced model will probably not meet sales expecta ons, (2) its corporate restructuring strategy may well face serious opposi on from unions, (3) the deprecia on of the Korean won should lead to pressure on margins for the industry in general and Turgot’s market segment in par cular, and (4) banks could take a tougher-than-expected stance in the upcoming round of credit renego a ons with the company. For these reasons, he changes his conclusion about the company from “market outperform” to “market underperform.” Clement retains the support material used to reach his conclusion in case ques ons later arise. ti ti ti ti ti ti ft tt tt ti fi tt • • Comment: To reach a conclusion about the value of the company, Clement has pieced together a number of nonmaterial or public bits of informa on that a ect Turgot Chariots. Therefore, under the mosaic theory, Clement has not violated Standard II(A) in dra ing the report. Example 7 (Analyst Recommenda ons as Material Nonpublic Informa on): • The next day, Clement is preparing to be interviewed on a global nancial news television program where he will discuss his changed recommenda on on Turgot Chariots for the rst me in public. While preparing for the program, he men ons to the show’s producers and Mary Zito, the journalist who will be interviewing him, the informa on he will be discussing. Just prior to going on the air, Zito sells her holdings in Turgot Chariots. She also phones her father with the informa on because she knows that he and other family members have investments in Turgot Chariots. • Comment: When Zito receives advance no ce of Clement’s change of opinion, she knows it will have a material impact on the stock price, even if she is not totally aware of Clement’s underlying reasoning. She is not a client of Clement but obtains early access to the material nonpublic informa on prior to publica on. Her trades are thus based on material nonpublic informa on and violate Standard II(A). • Zito further violates the Standard by relaying the informa on to her father. It would not ma er if he or any other family member traded; the act of providing the informa on violates Standard II(A). The fact that the informa on is provided to a family member does not absolve someone of the prohibi on of using or communica ng material nonpublic informa on. ti tt ti ti ti ti ti fi fi tf fi ti ti ti ti fi ft ti ff fi ti ti fi ti ti ti ti ti ti ti ti fi ti ti ti ti Comment: Even though Kellogg believes that May eld would not break the law by disclosing inside informa on and money was lost on the purchase, Kellogg should not have purchased addi onal shares of Na onal. It is the member’s or candidate’s responsibility to make sure, before execu ng investment ac ons, that comments about earnings are not material non- public informa on. Kellogg has violated Standard II(A). ti • ti Ashton Kellogg is a re red investment professional who manages his own por olio. He owns shares in Na onal Savings, a large local bank. A close friend and gol ng buddy, John May eld, is a senior execu ve at Na onal. Na onal has seen its stock price drop considerably, and the news and outlook are not good. In a conversa on about the economy and the banking industry on the golf course, May eld relays the informa on that Na onal will surprise the investment community in a few days when it announces excellent earnings for the quarter. Kellogg is pleasantly surprised by this informa on, and thinking that May eld, as a senior execu ve, knows the law and would not disclose inside informa on, he doubles his posi on in the bank. Subsequently, Na onal announces that it had good opera ng earnings but had to set aside reserves for an cipated signi cant losses on its loan por olio. The combined news causes the stock to go down 60%. ti • ti ti ti ti ti ti ti ti ti ti ti ti fi ti tf Example 8 (Ac ng on Nonpublic Informa on): • John Doll is a research analyst for a hedge fund that also sells its research to a select group of paying client investment rms. Doll’s focus is medical technology companies and products, and he has been in the business long enough and has been successful enough to build up a very credible network of friends and experts in the business. Doll has been working on a major research report recommending Boyce Health, a medical device manufacturer. He recently ran into an old acquaintance at a wedding who is a senior execu ve at Boyce, and Doll asked about the business. Doll was drawn to a statement that the execu ve, who has responsibili es in the new products area, made about a product: “I would not get too excited about the medium-term prospects; we have a lot of work to do rst.” Doll incorporated this and other informa on about the new Boyce product in his long-term recommenda on of Boyce. • Comment: Doll’s conversa on with the senior execu ve is part of the mosaic of informa on used in recommending Boyce. When holding discussions with a rm execu ve, Doll would need to guard against solici ng or obtain- ing material nonpublic informa on. Before issuing the report, the execu ve’s statement about the con nuing development of the product would need to be weighed against the other known public facts to determine whether it would be considered material. Example 10 (Materiality Determina on): • Larry Nadler, a trader for a mutual fund, gets a text message from another rm’s trader, whom he has known for years. The message indicates a so ware company is going to report strong earnings when the rm publicly announces in two days. Nadler has a buy order from a por olio manager within his rm to purchase several hundred thousand shares of the stock. Nadler is aggressive in placing the por olio manager’s order and completes the purchases by the following morning, a day ahead of the rm’s planned earnings announcement. • Comment: There are o en rumors and whisper numbers before a release of any kind. The text message from the other trader would most likely be considered market noise. Unless Nadler knew that the trader had an ongoing business rela onship with the public rm, he had no reason to suspect he was receiving material nonpublic informa on that would prevent him from comple ng the trading request of the por olio manager. ti ti ti ti fi ti fi tf fi ti ti fi ti fi ti ti ft ti ti ti ti ti ti ti ti Comment: McCoy is appropriately using the expert networks to enhance her evalua on process. She has neither asked for nor received informa on that may be considered material and nonpublic, such as preliminary trial results. McCoy is allowed to seek advice from professionals within the industry that she follows. tf • ft Mary McCoy is the senior drug analyst at a mutual fund. Her rm hires a service that connects her to experts in the treatment of cancer. Through various phone conversa ons, McCoy enhances her understanding of the latest therapies for successful treatment. This informa on is cri cal to Mary making informed recommenda ons of the companies producing these drugs. ti • fi ti ti ti ti fi Example 11 (Using an Expert Network): tf fi fi Example 9 (Mosaic Theory): Example 12 (Using an Expert Network): • Tom Watson is a research analyst working for a hedge fund. To stay informed, Watson relies on outside experts for informa on on such industries as technology and pharmaceu cals, where new advancements occur frequently. The mee ngs with the industry experts o en are arranged through networks or placement agents that have speci c policies and procedures in place to deter the exchange of material non- public informa on. • Watson arranges a call to discuss future prospects for one of the fund’s exis ng technology company holdings, a company that was tes ng a new semiconductor product. The scien st leading the tests indicates his disappointment with the performance of the new semiconductor. Following the call, Watson relays the insights he received to others at the fund. The fund sells its current posi on in the company and buys many put op ons because the market is an cipa ng the success of the new semiconductor and the share price re ects the market’s op mism. • Comment: Watson has violated Standard II(A) by passing along material nonpublic informa on concerning the ongoing product tests, which the fund used to trade in the securi es and op ons of the related company. Watson cannot simply rely on the agreements signed by individuals who par cipate in expert networks that state that he has not received informa on that would prohibit his trading ac vity. He must make his own determina on whether informa on he received through these arrangements reaches a materiality threshold that would a ect his trading abili es. B. Market Manipula on Example 1 (Independent Analysis and Company Promo on): • The principal owner of Financial Informa on Services (FIS) entered into an agreement with two microcap companies to promote the companies’ stock in exchange for stock and cash compensa on. The principal owner caused FIS to disseminate e-mails, design and maintain several websites, and distribute an online investment newsle er—all of which recommended investment in the two companies. The systema c publica on of purportedly independent analyses and recommenda ons containing inaccurate and highly promo onal and specula ve statements increased public investment in the companies and led to drama cally higher stock prices. • Comment: The principal owner of FIS violated Standard II(B) by using inaccurate repor ng and misleading informa on under the guise of independent analysis to ar cially increase the stock price of the companies. Furthermore, the principal owner violated Standard V(A)–Diligence and Reasonable Basis by not having a reasonable and adequate basis for recommending the two companies and violated Standard VI(A)–Disclosure of Con icts by not disclosing to investors the compensa on agreements (which cons tuted a con ict of interest). Example 2 (Personal Trading Prac ces and Price): ti ti ti ti ti ti tt ti ti ti ti ti ft ti ti fi ti ti ti ti ti ff ti fl ti fl ti fi ti ti ti ti tt ti fl ti ti ti ti ti ti ti John Gray is a private investor in Belgium who bought a large posi on several years ago in Fame Pharmaceu cals, a German small-cap security with limited average trading volume. He has now decided to signi cantly reduce his holdings owing to the poor price performance. Gray is worried that the low trading volume for the stock may cause the price to decline further as he a empts to sell his large posi on. ti ti fi ti ti ti ti ti • • Gray devises a plan to divide his holdings into mul ple accounts in di erent brokerage rms and private banks in the names of family members, friends, and even a private religious ins tu on. He then creates a rumor campaign on various blogs and social media outlets promo ng the company. • Gray begins to buy and sell the stock using the accounts in hopes of raising the trading volume and the price. He conducts the trades through mul ple brokers, selling slightly larger posi ons than he bought on a tac cal schedule, and over me, he is able to reduce his holding as desired without nega vely a ec ng the sale price. • Comment: John violated Standard II(B) by fraudulently crea ng the appearance that there was a greater investor interest in the stock through the online rumors. Addi onally, through his trading strategy, he created the appearance that there was greater liquidity in the stock than actually existed. He was able to manipulate the price through both misinforma on and trading prac ces. cial Price Vola lity): ti ti ti ti fi ti ti ti ti fi fi ti ff ti fi ti ti ti ti ti ti ti ti ti ti ti ffi ti ti ti Comment: Murphy violated Standard II(B) by aiming to create ar cial price vola lity designed to have a material impact on the price of an issuer’s stock. Moreover, by lacking an adequate basis for the recommenda on, Murphy also violated Standard V(A)–Diligence and Reasonable Basis. fi • ti Before Wirewolf ’s investor-rela ons department can assess the damage on the nal trading day of the quarter and refute Murphy’s report, its stock opens trading sharply lower, allowing Divisadero’s clients to cover their short posi ons at substan al gains. ti • fi Knowing that Wirewolf has already entered its declared quarter-end “quiet period” before repor ng earnings (and thus would be reluctant to respond to rumors), Murphy mes the release of his research report speci cally to sensa onalize the nega ve aspects of the message in order to create signi cant downward pressure on Wirewolf’s stock—to the dis nct advantage of Divisadero’s hedge fund clients. The report’s conclusions are based on specula on, not on fact. The next day, the research report is broadcast to all of Divisadero’s clients and to the usual newswire services. ti • fi Ma hew Murphy is an analyst at Divisadero Securi es & Co., which has a signi cant number of hedge funds among its most important brokerage clients. Some of the hedge funds hold short posi ons on Wirewolf Semiconductor. Two trading days before the publica on of a quarter-end report, Murphy alerts his sales force that he is about to issue a research report on Wirewolf that will include the following opinions: quarterly revenues are likely to fall short of management’s guidance, earnings will be as much as 5 cents per share (or more than 10%) below consensus, and Wirewolf’s highly respected chief nancial o cer may be about to join another company. ti • ti ti ti ff ti fi tt Example 3 (Crea ng Ar Example 4 (Personal Trading and Volume): • Rajesh Sekar manages two funds—an equity fund and a balanced fund—whose equity components are supposed to be managed in accordance with the same model. According to that model, the funds’ holdings in stock of Digital Design Inc. (DD) are excessive. Reduc on of the DD holdings would not be easy, however, because the stock has low liquidity in the stock market. Sekar decides to start trading larger por ons of DD stock back and forth between his two funds to slowly increase the price; he believes market par cipants will see growing volume and increasing price and become interested in the stock. If other investors are willing to buy the DD stock because of such interest, then Sekar will be able to get rid of at least some of his overweight posi on without inducing price decreases. In this way, the whole transac on will be for the bene t of fund par cipants, even if addi onal brokers’ commissions are incurred. • Comment: Sekar’s plan would be bene cial for his funds’ par cipants but is based on ar cial distor on of both trading volume and the price of the DD stock and thus cons tutes a viola on of Standard II(B). Example 5 (“Pump-Priming” Strategy): • ACME Futures Exchange is launching a new bond futures contract. To convince investors, traders, arbitrageurs, hedgers, and so on, to use its contract, the exchange a empts to demonstrate that it has the best liquidity. To do so, it enters into agreements with members in which they commit to a substan al minimum trading volume on the new contract over a speci c period in exchange for substan al reduc ons of their regular commissions. • Comment: The formal liquidity of a market is determined by the obliga ons set on market makers, but the actual liquidity of a market is be er es mated by the actual trading volume and bid–ask spreads. A empts to mislead par cipants about the actual liquidity of the market cons tute a viola on of Standard II(B). In this example, investors have been inten onally misled to believe they chose the most liquid instrument for some speci c purpose, but they could eventually see the actual liquidity of the contract signi cantly reduced a er the term of the agreement expires. If the ACME Futures Exchange fully discloses its agreement with members to boost transac ons over some ini al launch period, it will not violate Standard II(B). ACME’s intent is not to harm investors but, on the contrary, to give them a be er service. For that purpose, it may engage in a liquidity-pumping strategy, but the strategy must be disclosed. Example 6 (Crea ng Ar ti ti ti fi tt ti ti ti ti ti ti ti ti ti fi ti tt ft ti ti ti ffi fi fi ti ft fi ti fi tt ti fi ti ti ti ti fi tt fi ti ti ti Emily Gordon, an analyst of household products companies, is employed by a research bou que, Picador & Co. Based on informa on that she has gathered during a trip through La n America, she believes that Hygene, Inc., a major marketer of personal care products, has generated be er-thanexpected sales from its new product ini a ves in South America. A er modestly boos ng her projec ons for revenue and for gross pro t margin in her worksheet models for Hygene, Gordon es mates that her earnings projec on of US$2.00 per diluted share for the current year may be as much as 5% too low. She contacts the chief nancial o cer (CFO) of Hygene to try to gain con rma on of her ndings from her trip and to get some feedback regarding her revised models. The CFO declines to comment and reiterates management’s most recent guidance of US$1.95– US$2.05 for the year. fi ti ti ti tt ti ti ti ti ti ti fi ti • cial Price Vola lity): • Gordon decides to try to force a comment from the company by telling Picador & Co. clients who follow a momentum investment style that consensus earnings projec ons for Hygene are much too low; she explains that she is considering raising her published es mate by an ambi ous US$0.15 to US$2.15 per share. She believes that when word of an unrealis cally high earnings projec on lters back to Hygene’s investor-rela ons department, the company will feel compelled to update its earnings guidance. Meanwhile, Gordon hopes that she is at least correct with respect to the earnings direc on and that she will help clients who act on her insights to pro t from a quick gain by trading on her advice. • Comment: By exaggera ng her earnings projec ons in order to try to fuel a quick gain in Hygene’s stock price, Gordon is in viola on of Standard II(B). Furthermore, by virtue of previewing her inten ons of revising upward her earnings projec ons to only a select group of clients, she is in viola on of Standard III(B)–Fair Dealing. However, it would have been acceptable for Gordon to write a report that framed her earnings projec on in a range of possible outcomes, outlined clearly the assump ons used in her Hygene models that took into considera on the ndings from her trip through La n America, and was distributed to all Picador & Co. clients in an equitable manner. Example 7 (Pump and Dump Strategy): • In an e ort to pump up the price of his holdings in Moosehead & Belfast Railroad Company, Steve Weinberg logs on to several investor chat rooms on the internet to start rumors that the company is about to expand its rail network in an cipa on of receiving a large contract for shipping lumber. • Comment: Weinberg has violated Standard II(B) by dissemina ng false informa on about Moosehead & Belfast with the intent to mislead market par cipants. ti fi ti ti ti ti ffi ti ti ti fi ti ti ti ti ti ti fl ti ti fi ti ti ti ti ti fi ti ti ti ti ti ti Mandeville is extremely successful and leads Superior as the top originator of structured investment products for the next two years. In the third year, the economy experiences di cul es and the values of the assets underlying structured products signi cantly decline. The subsequent defaults lead to major turmoil in the capital markets, the demise of Superior Investment Bank, and the loss of Mandeville’s employment. ti • ti Bill Mandeville supervises a structured nancing team for Superior Investment Bank. His responsibili es include packaging new structured investment products and man- aging Superior’s rela onship with relevant ra ng agencies. To achieve the best ra ng possible, Mandeville uses mostly posi ve scenarios as model inputs—scenarios that re ect minimal downside risk in the assets underlying the structured products. The resul ng output sta s cs in the ra ng request and underwri ng prospectus support the idea that the new structured products have minimal poten al downside risk. Addi onally, Mandeville’s compensa on from Superior is par ally based on both the level of the ra ng assigned and the successful sale of new structured investment products but does not have a link to the long-term performance of the instruments. ti • fi ti ti ti ti ff ti ti ti ti ti Example 8 (Manipula ng Model Inputs): • Comment: Mandeville manipulates the inputs of a model to minimize associated risk to achieve higher ra ngs. His understanding of structured products allows him to skillfully decide which inputs to include in support of the desired ra ng and price. This informa on manipula on for short-term gain, which is in viola on of Standard II(B), ul mately causes signi cant damage to many par es and the capital markets as a whole. Mandeville should have realized that promo ng a ra ng and price with inaccurate informa on could cause not only a loss of price con dence in the par cular structured product but also a loss of investor trust in the system. Such loss of con dence a ects the ability of the capital markets to operate e ciently. Example 9 (Informa on Manipula on): • Allen King is a performance analyst for Torrey Investment Funds. King believes that the por olio manager for the rm’s small- and microcap equity fund dislikes him because the manager never o ers him ckets to the local baseball team’s games but does o er ckets to other employees. To incite a poten al regulatory review of the manager, King creates user pro les on several online forums under the por olio manager’s name and starts rumors about poten al mergers for several of the smaller companies in the por olio. As the prices of these companies’ stocks increase, the por olio manager sells the posi on, which leads to an inves ga on by the regulator as King desired. • Comment: King has violated Standard II(B) even though he did not personally pro t from the market’s reac on to the rumor. In pos ng the false informa on, King misleads others into believing the companies were likely to be acquired. Although his intent was to create trouble for the por olio manager, his ac ons clearly manipulated the factual informa on that was available to the market. III. DUTIES TO CLIENTS A. Loyalty, Prudence, and Care ti ti tf tf ti fi ti fi ti ff ti ti fi ti ti fi ti ti ffi fi ff ff ti ti fi ti fi ti ti ti ff fi ti tt ti ti ti ti tf ti ti ffi ti ti tf ti ti Comment: Standard III(A) requires that a member or candidate, in evalua ng a takeover bid, act prudently and solely in the interests of plan par cipants and bene ciaries. To meet this requirement, a member or candidate must carefully evaluate the long-term prospects of the company against the short-term prospects presented by the takeover o er and by the ability to invest elsewhere. In this instance, Wiley, ac ng on behalf of his employer, which was the trustee for a pension plan, clearly violated Standard III(A). He used the pension plan to perpetuate exis ng management, perhaps to the detriment of plan par cipants and the company’s shareholders, and to bene t himself. Wiley’s responsibili es to the plan par cipants and bene ciaries should have taken precedence over any es of his bank to corporate managers and over his self-interest. Wiley had a duty to examine the takeover o er on its own merits and to make an independent decision. The guiding principle is the ti • tt First Country Bank serves as trustee for the Miller Company’s pension plan. Miller is the target of a hos le takeover a empt by Newton, Inc. In a emp ng to ward o Newton, Miller’s managers persuade Julian Wiley, an investment manager at First Country Bank, to purchase Miller common stock in the open market for the employee pension plan. Miller’s o cials indicate that such ac on would be favorably received and would probably result in other accounts being placed with the bank. Although Wiley believes the stock is overvalued and would not ordinarily buy it, he purchases the stock to support Miller’s managers, to maintain Miller’s good favor toward the bank, and to realize addi onal new business. The heavy stock purchases cause Miller’s market price to rise to such a level that Newton retracts its takeover bid. fi • ti ti ti ti ti ti ff ti ti ti tf ti ff Example 1 (Iden fying the Client—Plan Par cipants): appropriateness of the investment decision to the pension plan, not whether the decision bene ted Wiley or the company that hired him. Example 2 (Client Commission Prac ces): • JNI, a successful investment counseling rm, serves as investment manager for the pension plans of several large regionally based companies. Its trading ac vi es generate a signi cant amount of commission-related business. JNI uses the brokerage and research services of many rms, but most of its trading ac vity is handled through a large brokerage company, Thompson, Inc., because the execu ves of the two rms have a close friendship. Thompson’s commission structure is high in comparison with charges for similar brokerage services from other rms. JNI considers Thompson’s research services and execu on capabili es average. In exchange for JNI direc ng its brokerage to Thompson, Thompson absorbs a number of JNI overhead expenses, including those for rent. • Comment: JNI execu ves are breaching their responsibili es by using client brokerage for services that do not bene t JNI clients and by not obtaining best price and best execu on for their clients. Because JNI execu ves are not upholding their duty of loyalty, they are viola ng Standard III(A). Example 3 (Brokerage Arrangements): • Charlo e Evere , a struggling independent investment adviser, serves as investment manager for the pension plans of several companies. One of her brokers, Sco Company, is close to consumma ng management agreements with prospec ve new clients whereby Evere would manage the new client accounts and trade the accounts exclusively through Sco . One of Evere ’s exis ng clients, Crayton Corpora on, has directed Evere to place securi es transac ons for Crayton’s account exclusively through Sco . But to induce Sco to exert e orts to send more new accounts to her, Evere also directs transac ons to Sco from other clients without their knowledge. • Comment: Evere has an obliga on at all mes to seek best price and best execu on on all trades. Evere may direct new client trades exclusively through Sco Company as long as Evere receives best price and execu on the trades or receives a wri en statement from new clients that she is not to seek best price and execu on and that they are aware of the consequence for their accounts. Evere may trade other accounts through Sco as a reward for direc ng clients to Evere only if the accounts receive best price and execu on and the prac ce is disclosed to the accounts. Because Evere does not disclose the directed trading, Evere has violated Standard III(A). fi ti tt tt ti ti fi ti ti fi ti tt ti ti tt ti ti fi tt tt tt ti ti ti ti ff ti tt tt tt tt ti fi ti tt ti tt ti ti ti ti ti ti ti ti ffi tt fi ti ti ti Comment: Rome is viola ng her duty of loyalty to the bank’s trust accounts by using Gray for brokerage transac ons simply because Gray trades Rome’s personal account on favorable terms. Rome is placing her own interests before those of her clients. ti • fi Emilie Rome is a trust o cer for Paget Trust Company. Rome’s supervisor is responsible for reviewing Rome’s trust account transac ons and her monthly reports of personal stock transac ons. Rome has been using Nathan Gray, a broker, almost exclusively for trust account brokerage transac ons. When Gray makes a market in stocks, he has been giving Rome a lower price for personal purchases and a higher price for sales than he gives to Rome’s trust accounts and other investors. ti • tt ti tt tt ti tt tt tt tt Example 4 (Brokerage Arrangements): Example 5 (Client Commission Prac ces): • Lauren Parker, an analyst with Provo Advisors, covers South American equi es for her rm. She likes to travel to the markets for which she is responsible and decides to go on a trip to Chile, Argen na, and Brazil. The trip is sponsored by SouthAM, Inc., a research rm with a small broker/dealer a liate that uses the clearing facili es of a larger New York brokerage house. SouthAM specializes in arranging South American trips for analysts during which they can meet with central bank o cials, government ministers, local economists, and senior execu ves of corpora ons. SouthAM accepts commission dollars at a ra o of 2 to 1 against the hard-dollar costs of the research fee for the trip. Parker is not sure that SouthAM’s execu on is compe ve, but without informing her supervisor, she directs the trading desk at Provo to start giving com- mission business to SouthAM so she can take the trip. SouthAM has conveniently med the brie ng trip to coincide with the beginning of Carnival season, so Parker also decides to spend ve days of vaca on in Rio de Janeiro at the end of the trip. Parker uses commission dollars to pay for the ve days of hotel expenses. • Comment: Parker is viola ng Standard III(A) by not exercising her duty of loyalty to her clients. She should have determined whether the commissions charged by SouthAM are reasonable in rela on to the bene t of the research provided by the trip. She also should have determined whether best execu on and prices could be received from SouthAM. In addi on, the ve extra days are not part of the research e ort because they do not assist in the investment decision making. Thus, the hotel expenses for the ve days should not be paid for with client assets. Example 6 (Excessive Trading): • Vida Knauss manages the por olios of a number of high-net-worth individuals. A major part of her investment management fee is based on trading commissions. Knauss engages in extensive trading for each of her clients to ensure that she a ains the minimum commission level set by her rm. Although the securi es purchased and sold for the clients are appropriate and fall within the acceptable asset classes for the clients, the amount of trading for each account exceeds what is necessary to accomplish the client’s investment objec ves. • Comment: Knauss has violated Standard III(A) because she is using the assets of her clients to bene t her rm and herself. fi ffi ti ti ffi fi fi ti fi fi fi ti ti fi ti ti ti fi ti ti ti ti ti ti fi fi tt ti fi ti ti tf Comment: Dill has violated Standard III(A) because he is not ac ng for the bene t of his brother’s account as well as his other accounts. The brother’s account is a regular fee-paying account comparable to the accounts of his other clients. By not alloca ng the shares propor onately across all accounts for which he thought the IPO was suitable, Dill is disadvantaging speci c clients. ti • ti A er several years, the number of Dill’s clients has grown, but he s ll manages the original accounts of his family members. An IPO is coming to market that is a suitable investment for many of his clients, including his brother. Dill does not receive the amount of stock he requested, so to avoid any appearance of a con ict of interest, he does not allocate any shares to his brother’s account. ti • fl Adam Dill recently joined New Investments Asset Managers. To assist Dill in building a book of clients, both his father and brother opened new fee-paying accounts. Dill followed all the rm’s procedures in no ng his rela onships with these clients and in developing their investment policy statements. ti • fi ff ti fi ti fi ti ft Example 7 (Managing Family Accounts): • Dill would have been correct in not alloca ng shares to his brother’s account if that account was being managed outside the normal fee structure of the rm. Example 8 (Iden fying the Client): • Donna Hensley has been hired by a law rm to tes fy as an expert witness. Although the tes mony is intended to represent impar al advice, she is concerned that her work may have nega ve consequences for the law rm. If the law rm is Hensley’s client, how does she ensure that her tes mony will not violate the required duty of loyalty, prudence, and care to one’s client? • Comment: In this situa on, the law rm represents Hensley’s employer and the aspect of “who is the client” is not well de ned. When ac ng as an expert witness, Hensley is bound by the standard of independence and objec vity in the same manner as an independent research analyst would be bound. Hensley must not let the law rm in uence the tes mony she provides in the legal proceedings. Example 9 (Iden fying the Client): • Jon Miller is a mutual fund por olio manager. The fund is focused on the global nancial services sector. Wanda Spears is a private wealth manager in the same city as Miller and is a friend of Miller. At a local CFA Ins tute society mee ng, Spears men ons to Miller that her new client is an investor in Miller’s fund. She states that the two of them now share a responsibility to this client. • Comment: Spears’ statement is not totally correct. Because she provides the advisory services to her new client, she alone is bound by the duty of loyalty to this client. Miller’s responsibility is to manage the fund according to the investment policy statement of the fund. His ac ons should not be in uenced by the needs of any par cular fund investor. Example 10 (Client Loyalty): • A er providing client account investment performance to the external-facing departments but prior to it being nalized for release to clients, Teresa Nguyen, an investment performance analyst, no ces the repor ng system missed a trade. Correc ng the omission resulted in a large loss for a client that had previously placed the rm on “watch” for poten al termina on owing to underperformance in prior periods. Nguyen knows this news is unpleasant but informs the appropriate individuals that the report needs to be updated before releasing it to the client. • Comment: Nguyen’s ac ons align with the requirements of Standard III(A). Even though the correc on may lead to the rm’s termina on by the cli- ent, withholding informa on on errors would not be in the best interest of the client. Example 11 (Execu on-Only Responsibili es): ti ti ti ti fi ti ti ti fi ti ti ti fl ti ti fi ti ti fi fi fi ti ti ti tf ti ti fi fi fi ti ti ti fi fi Ba ija Sulejman recently became a candidate in the CFA Program. He is a broker who executes clientdirected trades for several high-net-worth individuals. Sulejman does not provide any investment advice and only executes the trading decisions made by clients. He is concerned that the Code and Standards impose a duciary duty on him in his dealing with clients and sends an e-mail to the CFA Ethics Helpdesk (ethics@ cfains tute.org) to seek guidance on this issue. ti ti ti ti fi ti ti ti fl ft ft • Comment: In this instance, Sulejman serves in an execu on-only capacity and his duty of loyalty, prudence, and care is centered on the skill and diligence used when execu ng trades—namely, by seeking best execu on and making trades within the parameters set by the clients (instruc ons on quan ty, price, ming, etc.). Ac ng in the best interests of the client dictates that trades are executed on the most favorable terms that can be achieved for the client. Given this job func on, the requirements of the Code and Standards for loyalty, prudence, and care clearly do not impose a duciary duty. B. Fair Dealing Example 1 (Selec ve Disclosure): • Bradley Ames, a well-known and respected analyst, follows the computer industry. In the course of his research, he nds that a small, rela vely unknown company whose shares are traded over the counter has just signed signi cant contracts with some of the companies he follows. A er a considerable amount of inves ga on, Ames decides to write a research report on the small company and recommend purchase of its shares. While the report is being reviewed by the company for factual accuracy, Ames schedules a luncheon with several of his best clients to discuss the company. At the luncheon, he men ons the purchase recommenda on scheduled to be sent early the following week to all the rm’s clients. • Comment: Ames has violated Standard III(B) by dissemina ng the purchase recommenda on to the clients with whom he has lunch a week before the recommenda on is sent to all clients. ti ti ti ti ft ti fi ti fi ti ti ti tf tt ti ti ti ti ti ti ti ti ti ti ti fi ti fi ti ti Comment: The bank’s policy does not treat all customers fairly, and Jackson has violated her duty to her clients by giving priority to the growth-oriented commingled fund over all other funds and to discre onary accounts over non-discre onary accounts. Jackson must execute orders on a systema c basis that is fair to all clients. In addi on, trade alloca on procedures should be disclosed to all clients fi • ti Seeing that Rivers is neither sa s ed nor pleased by the explana on, Jackson quickly adds that nondiscre onary pension accounts and personal trust accounts have a lower priority on purchase and sale recommenda ons than discre onary pension fund accounts. Furthermore, Jackson states, the company’s pension fund had the opportunity to invest up to 5% in the commingled fund. ti • ti Spencer Rivers, president of XYZ Corpora on, moves his company’s growth-oriented pension fund to a par cular bank primarily because of the excellent investment performance achieved by the bank’s commingled fund for the prior ve-year period. Later, Rivers compares the results of his pension fund with those of the bank’s com- mingled fund. He is startled to learn that, even though the two accounts have the same investment objec ves and similar por olios, his company’s pension fund has signi cantly underperformed the bank’s commingled fund. Ques oning this result at his next mee ng with the pension fund’s manager, Rivers is told that, as a ma er of policy, when a new security is placed on the recommended list, Morgan Jackson, the pension fund manager, rst purchases the security for the commingled account and then purchases it on a pro rata basis for all other pension fund accounts. Similarly, when a sale is recommended, the security is sold rst from the commingled account and then sold on a pro rata basis from all other accounts. Rivers also learns that if the bank cannot get enough shares (especially of hot issues) to be meaningful to all the accounts, its policy is to place the new issues only in the commingled account. ti • fi ti fi ti ti ti ti Example 2 (Fair Dealing between Funds): fi fi • when they become clients. Of course, in this case, disclosure of the bank’s policy would not change the fact that the policy is unfair. Example 3 (Fair Dealing and IPO Distribu on): • Dominic Morris works for a small regional securi es rm. His work consists of corporate nance ac vi es and inves ng for ins tu onal clients. Arena, Ltd., is planning to go public. The partners have secured rights to buy an arena football league franchise and are planning to use the funds from the issue to complete the purchase. Because arena football is the current rage, Morris believes he has a hot issue on his hands. He has quietly nego ated some op ons for himself for helping convince Arena to do the nancing through his securi es rm. When he seeks expressions of interest, the ins tu onal buyers oversubscribe the issue. Morris, assuming that the ins tu ons have the nancial clout to drive the stock up, then lls all orders (including his own) and decreases the ins tu onal blocks. • Comment: Morris has violated Standard III(B) by not trea ng all customers fairly. He should not have taken any shares himself and should have prorated the shares o ered among all clients. In addi on, he should have disclosed to his rm and to his clients that he received op ons as part of the deal [see Standard VI(A)–Disclosure of Con icts]. Example 4 (Fair Dealing and Transac on Alloca on): • Eleanor Preston, the chief investment o cer of Porter Williams Investments (PWI), a medium-size money management rm, has been trying to retain a client, Colby Company. Management at Colby, which accounts for almost half of PWI’s revenues, recently told Preston that if the performance of its account did not improve, it would nd a new money manager. Shortly a er this threat, Preston purchases mortgage-backed securi es (MBSs) for several accounts, including Colby’s. Preston is busy with a number of transac ons that day, so she fails to allocate the trades immediately or write up the trade ckets. A few days later, when Preston is alloca ng trades, she notes that some of the MBSs have signi cantly increased in price and some have dropped. Preston decides to allocate the pro table trades to Colby and spread the losing trades among several other PWI accounts. • Comment: Preston has violated Standard III(B) by failing to deal fairly with her clients in taking these investment ac ons. Preston should have allocated the trades prior to execu ng the orders, or she should have had a systema c approach to alloca ng the trades, such as pro rata, as soon as prac cal a er they were executed. Among other things, Preston must disclose to the client that the adviser may act as broker for, receive commissions from, and have a poten al con ict of interest regarding both par es in agency cross-transac ons. A er the disclosure, she should obtain from the client consent authorizing such transac ons in advance. Example 5 (Selec ve Disclosure): ti ti fi fi ti fi ti ti ti ti fl ti ft ti ff ti ti ti ti fi ti ti ti fi ti ft ti fi ti ffi ti ti ti fi ti ti fi fl ti fi ti ff ti ti ti ff fi Saunders Industrial Waste Management (SIWM) publicly indicates to analysts that it is comfortable with the somewhat disappoin ng earnings-per-share projec on of US$1.16 for the quarter. Bernard Roberts, an analyst at Co ey Investments, is con dent that SIWM management has understated the forecasted earnings so that the real announcement will cause an “upside surprise” and boost the price of SIWM stock. The “whisper number” (rumoured) es mate based on extensive research and discussed among knowledgeable analysts is higher than US$1.16. Roberts repeats the US$1.16 gure in his research report to all Co ey clients but informally tells his large clients that he expects the earnings per share to be higher, making SIWM a good buy. ti ti ti fi fi ti ti ti ti ti fi ti ft • Comment: By not sharing his opinion regarding the poten al for a signi cant upside earnings surprise with all clients, Roberts is not trea ng all clients fairly and has violated Standard III(B). Example 6 (Addi onal Services for Select Clients): • Jenpin Weng uses e-mail to issue a new recommenda on to all his clients. He then calls his three largest ins tu onal clients to discuss the recommenda on in detail. • Comment: Weng has not violated Standard III(B) because he widely disseminated the recommenda on and provided the informa on to all his clients prior to discussing it with a select few. Weng’s largest clients received addi onal personal service because they presumably pay higher fees or because they have a large amount of assets under Weng’s management. If Weng had discussed the report with a select group of clients prior to distribu ng it to all his clients, he would have violated Standard III(B). Example 7 (Minimum Lot Alloca ons): • Lynn Hampton is a well-respected private wealth manager in her community with a diversi ed client base. She determines that a new 10-year bond being o ered by Healthy Pharmaceu cals is appropriate for ve of her clients. Three clients request to purchase US$10,000 each, and the other two request US$50,000 each. The mini- mum lot size is established at US$5,000, and the issue is oversubscribed at the me of placement. Her rm’s policy is that odd-lot alloca ons, especially those below the minimum, should be avoided because they may a ect the liquidity of the security at the me of sale. • Hampton is informed she will receive only US$55,000 of the o ering for all accounts. Hampton distributes the bond investments as follows: The three accounts that requested US$10,000 are allocated US$5,000 each, and the two accounts that requested US$50,000 are allocated US$20,000 each. • Comment: Hampton has not violated Standard III(B), even though the distribu on is not on a completely pro rata basis because of the required minimum lot size. With the total alloca on being signi cantly below the amount requested, Hampton ensured that each client received at least the minimum lot size of the issue. This approach allowed the clients to e ciently sell the bond later if necessary. fi ti ti ti ti ti ti fi ti ffi fi ti ti ff ff ti ti ff ti ti fi ti ti ti ti ti ti Comment: Chan is viola ng Standard III(B) because his trading ac ons are disadvantaging his clients to enhance a rela onship with a preferred client. All clients are bene ng from the research being provided and should incur their fair por on of the costs. This does not mean that addi onal trading should occur if a client has not paid an equal por on of the commission; trading should occur only as required by the strategy. ti • ti Ling Chan manages the accounts for many pension plans, including the plan of his father’s employer. Chan developed similar but not iden cal investment policies for each client, so the investment por olios are rarely the same. To minimize the cost to his father’s pension plan, he inten onally trades more frequently in the accounts of other clients to ensure the required brokerage is incurred to con nue receiving free research for use by all the pensions. ti • ti fi ti ti ti ti fi Example 8 (Excessive Trading): tf ti • Example 9 (Limited Social Media Disclosures): • Mary Burde e was recently hired by Fundamental Investment Management (FIM) as a junior auto industry analyst. Burde e is expected to expand the social media presence of the rm because she is ac ve with various networks, including Facebook, LinkedIn, and Twi er. Although Burde e’s supervisor, Joe Graf, has never used social media, he encourages Burde e to explore opportuni es to increase FIM’s online presence and ability to share content, communicate, and broadcast informa on to clients. In response to Graf’s encouragement, Burde e is working on a proposal detailing the advantages of ge ng FIM onto Twi er in addi on to launching a company Facebook page. • As part of her auto industry research for FIM, Burde e is comple ng a report on the nancial impact of Sun Drive Auto Ltd.’s new solar technology for compact auto- mobiles. This research report will be her rst for FIM, and she believes Sun Drive’s technology could revolu onize the auto industry. In her excitement, Burde e sends a quick tweet to FIM Twi er followers summarizing her “buy” recommenda on for Sun Drive Auto stock. • Comment: Burde e has violated Standard III(B) by sending an investment recommenda on to a select group of contacts prior to distribu ng it to all clients. Burde e must make sure she has received the appropriate training about FIM’s policies and procedures, including the appropriate business use of personal social media networks before engaging in such ac vi es. See Standard IV(C) for guidance related to the du es of the supervisor. Example 10 (Fair Dealing between Clients): • Paul Rove, performance analyst for Alpha-Beta Investment Management, is describing to the rm’s chief investment o cer (CIO) two new reports he would like to develop to assist the rm in mee ng its obliga ons to treat clients fairly. Because many of the rm’s clients have similar investment objec ves and por olios, Rove suggests a report detailing securi es owned across several clients and the percentage of the por olio the security represents. The second report would compare the monthly performance of por olios with similar strategies. The outliers within each report would be submi ed to the CIO for review. • Comment: As a performance analyst, Rove likely has li le direct contact with clients and thus has limited opportunity to treat clients di erently. The recommended reports comply with Standard III(B) while helping the rm conduct a er-the-fact reviews of how e ec vely the rm’s advisers are dealing with their clients’ por olios. Reports that monitor the fair treatment of clients are an important oversight tool to ensure that clients are treated fairly. C. Suitability Example 1 (Investment Suitability—Risk Pro le): ti ti ti fi tt ti fi fi fi ti ti fi ti tt ti tt tf tt ti ti ti ff fi tt tt tt tt ti ti fi ti ff tt ft ti tf tf tt tf tt ffi Caleb Smith, an investment adviser, has two clients: Larry Robertson, 60 years old, and Gabriel Lanai, 40 years old. Both clients earn roughly the same salary, but Robertson has a much higher risk tolerance because he has a large asset base. Robertson is willing to invest part of his assets very aggressively; Lanai wants only to achieve a steady rate of return with low vola lity to pay for his children’s educa on. Smith recommends inves ng 20% of both por olios in zero-yield, small-cap, high-technology equity issues. tf tt fi tti ti ti tt ti ti tt fi ti • Comment: In Robertson’s case, the investment may be appropriate because of his nancial circumstances and aggressive investment posi on, but this investment is not suitable for Lanai. Smith is viola ng Standard III(C) by applying Robertson’s investment strategy to Lanai because the two clients’ nancial circumstances and objec ves di er. Example 2 (Investment Suitability—En re Por olio): • Jessica McDowell, an investment adviser, suggests to Brian Crosby, a risk-averse client, that covered call op ons be used in his equity por olio. The purpose would be to enhance Crosby’s income and par ally o set any un mely deprecia on in the por olio’s value should the stock market or other circumstances a ect his holdings unfavorably. McDowell educates Crosby about all possible outcomes, including the risk of incurring an added tax liability if a stock rises in price and is called away and, conversely, the risk of his holdings losing protec on on the downside if prices drop sharply. • Comment: When determining suitability of an investment, the primary focus should be the characteris cs of the client’s en re por olio, not the characteris cs of single securi es on an issueby-issue basis. The basic characteris cs of the en re por olio will largely determine whether investment recommenda ons are taking client factors into account. Therefore, the most important aspects of a par cular investment are those that will a ect the characteris cs of the total por olio. In this case, McDowell properly considers the investment in the context of the en re por olio and thoroughly explains the investment to the client. Example 3 (IPS Upda ng): • In a regular mee ng with client Seth Jones, the por olio managers at Blue Chip Investment Advisors are careful to allow some me to review his current needs and circumstances. In doing so, they learn that some signi cant changes have recently taken place in his life. A wealthy uncle le Jones an inheritance that increased his net worth fourfold, to US$1 million. • Comment: The inheritance has signi cantly increased Jones’s ability (and possibly his willingness) to assume risk and has diminished the average yield required to meet his current income needs. Jones’s nancial circumstances have de nitely changed, so Blue Chip managers must update Jones’s investment policy statement to re ect how his investment objec ves have changed. Accordingly, the Blue Chip por olio managers should consider a somewhat higher equity ra o for his por olio than was called for by the previous circumstances, and the managers’ speci c common stock recommenda ons might be heavily lted toward low-yield, growth-oriented issues. tf fi tf tf ft ti fi ti ti ti ti fi ti ti ti tf ff tf tf fi ti ff ti tf fi ti ti tf ti tf fi ti ti fl ti fi ti ti ti Comment: A zero-dividend stock does not seem to t the mandate of the fund that Perkowski is managing. Unless Perkowski’s investment ts within the mandate or is within the realm of allowable investments the fund has made clear in its disclosures, Perkowski has violated Standard III(C). ti • ti Louis Perkowski manages a high-income mutual fund. He purchases zero-dividend stock in a nancial services company because he believes the stock is undervalued and is in a poten al growth industry, which makes it an a rac ve investment. tt • ti ff ti fi tf ti ti ff fi ti ti Example 4 (Following an Investment Mandate): ti fi • • Max Gubler, chief investment o cer of a property/casualty insurance subsidiary of a large nancial conglomerate, wants to improve the diversi ca on of the subsidiary’s investment por olio and increase its returns. The subsidiary’s investment policy statement provides for highly liquid investments, such as large-cap equi es and government, suprana onal, and corporate bonds with a minimum credit ra ng of AA and maturity of no more than ve years. In a recent presenta on, a venture capital group o ered very a rac ve prospec ve returns on some of its private equity funds that provide seed capital to ventures. An exit strategy was already contemplated, but investors would have to observe a minimum three-year lockup period and a subsequent laddered exit op on for a maximum of one-third of their shares per year. Gubler does not want to miss this opportunity. A er extensive analysis, with the intent to op mize the return on the equity assets within the subsidiary’s current por olio, he invests 4% in this seed fund, leaving the por olio’s total equity exposure s ll well below its upper limit. • Comment: Gubler is viola ng Standard III(A)–Loyalty, Prudence, and Care as well as Standard III(C). His new investment locks up part of the subsidiary’s assets for at least three years and up to as many as ve years and possibly beyond. The IPS requires investments in highly liquid investments and describes accepted asset classes; private equity investments with a lockup period certainly do not qualify. Even without a lockup period, an asset class with only an occasional, and thus implicitly illiquid, market may not be suitable for the por olio. Although an IPS typically describes objec ves and constraints in great detail, the manager must also make every e ort to understand the client’s business and circumstances. Doing so should enable the manager to recognize, understand, and discuss with the client other factors that may be or may become material in the investment management process. tt ft ti ti ti fi ti ti fi tf ti ti fi ti fi ti ff fi ti ti tf fi ti ti ti tf ti fi ti ti ti ti ti ti tt ffi ti When clients ask to diversify into interna onal products, it is an appropriate me to review and update the clients’ IPSs. Ostrowski’s review may determine that the risk of interna onal investments modi es the risk pro les of the clients or does not represent an appropriate investment. See also Standard V(A)–Diligence and Reasonable Basis for further discussion of the review process needed in selec ng appropriate submanagers. ti • ff Comment: When selec ng an external manager or subadviser, Ostrowski needs to ensure that the new manager’s services are appropriate for his clients. This due diligence includes comparing the risk pro le of the clients with the investment strategy of the manager. In basing the decision on the fee structure alone, Ostrowski may be viola ng Standard III(C). ti • fi Paul Ostrowski’s investment management business has grown signi cantly over the past couple of years, and some clients want to diversify interna onally. Ostrowski decides to nd a submanager to handle the expected interna onal investments. Because this will be his rst subadviser, Ostrowski uses the CFA Ins tute model “request for proposal” to design a ques onnaire for his search. By his deadline, he receives seven completed ques onnaires from a variety of domes c and interna onal rms trying to gain his business. Ostrowski reviews all the applica ons in detail and decides to select the rm that charges the lowest fees because doing so will have the least impact on his rm’s bo om line. ti • ti tf fi ti fi fi Example 6 (Sub manager and IPS Reviews): fi fi Example 5 (IPS Requirements and Limita ons): Example 7 (Investment Suitability—Risk Pro le): • Samantha Snead, a por olio manager for Thomas Investment Counsel, Inc., specializes in managing public re rement funds and de ned bene t pension plan accounts, all of which have long-term investment objec ves. A year ago, Snead’s employer, in an a empt to mo vate and retain key investment professionals, introduced a bonus compensa on system that rewards por olio managers on the basis of quarterly performance rela ve to their peers and to certain benchmark indexes. In an a empt to improve the short-term performance of her accounts, Snead changes her investment strategy and purchases several high-beta stocks for client por olios. These purchases are seemingly contrary to the clients’ investment policy statements. Following their purchase, an o cer of Gri n Corpora on, one of Snead’s pension fund clients, asks why Gri n Corpora on’s por olio seems to be dominated by high-beta stocks of companies that o en appear among the most ac vely traded issues. No change in objec ve or strategy has been recommended by Snead during the year. • Comment: Snead violated Standard III(C) by inves ng the clients’ assets in high-beta stocks. These high-risk investments are contrary to the long-term risk pro le established in the clients’ IPSs. Snead has changed the investment strategy of the clients in an a empt to reap short-term rewards o ered by her rm’s new compensa on arrangement, not in response to changes in clients’ investment policy statements. See also Standard VI(A)–Disclosure of Con icts. Example 8 (Investment Suitability): • Andre Shrub owns and operates Conduit, an investment advisory rm. Prior to opening Conduit, Shrub was an account manager with Elite Investment, a hedge fund man- aged by his good friend Adam Reed. To a ract clients to a new Conduit fund, Shrub o ers lower-than-normal management fees. He can do so because the fund consists of two top-performing funds managed by Reed. Given his personal friendship with Reed and the prior performance record of these two funds, Shrub believes this new fund is a winning combina on for all par es. Clients quickly invest with Conduit to gain access to the Elite funds. No one is turned away because Conduit is seeking to expand its assets under management. • Comment: Shrub has violated Standard III(C) because the risk pro le of the new fund may not be suitable for every client. As an investment adviser, Shrub needs to establish an investment policy statement for each client and recommend only investments that match each client’s risk and return pro le in the IPS. Shrub is required to act as more than a simple sales agent for Elite. • Although Shrub cannot disobey the direct request of a client to purchase a speci c security, he should fully discuss the risks of a planned purchase and provide reasons why it might not be suitable for a client. This requirement may lead members and candidates to decline new customers if those customers’ requested investment decisions are signi cantly out of line with their stated requirements. See also Standard V(A)–Diligence and Reasonable Basis. D. Performance Presenta on Example 1 (Performance Calcula on and Length of Time): ffi ti ff tf ffi tf ti fi ti ti fi fi ffi tf fl ff tt fi tt ti ti fi ti ft ti fi ti ti fi ti ti fi ti ti tf Kyle Taylor of Taylor Trust Company, no ng the performance of Taylor’s common trust fund for the past two years, states in a brochure sent to his poten al clients, “You can expect steady 25% annual compound growth of the value of your investments over the year.” Taylor Trust’s common trust fund did increase at the rate of 25% per year for the past year, which mirrored the increase of the en re ti ti tt ti ti fi fi tt • • Comment: Taylor’s brochure is in viola on of Standard III(D). Taylor should have disclosed that the 25% growth occurred only in one year. Addi onally, Taylor did not include client accounts other than those in the rm’s common trust fund. A general claim of rm performance should take into account the performance of all categories of accounts. Finally, by sta ng that cli- ents can expect a steady 25% annual compound growth rate, Taylor is also viola ng Standard I(C)–Misrepresenta on, which prohibits assurances or guarantees regarding an investment. Example 2 (Performance Calcula on and Asset Weigh ng): • Anna Judd, a senior partner of Alexander Capital Management, circulates a performance report for the capital apprecia on accounts for the years 1988 through 2004. The rm claims compliance with the GIPS standards. Returns are not calculated in accordance with the requirements of the GIPS standards, however, because the composites are not asset weighted. • Comment: Judd is in viola on of Standard III(D). When claiming compliance with the GIPS standards, rms must meet all of the requirements, make mandatory disclosures, and meet any other requirements that apply to that rm’s speci c situa on. Judd’s viola on is not from any misuse of the data but from a false claim of GIPS compliance. Example 3 (Performance Presenta on and Prior Fund/ Employer): • Aaron McCoy is vice president and managing partner of the equity investment group of Mastermind Financial Advisors, a new business. Mastermind recruited McCoy because he had a proven six-year track record with G&P Financial. In developing Mastermind’s adver sing and marke ng campaign, McCoy prepares an adver sement that includes the equity investment performance he achieved at G&P Financial. The adver sement for Mastermind does not iden fy the equity performance as being earned while at G&P. The adver sement is distributed to exis ng clients and prospec ve clients of Mastermind. • Comment: McCoy has violated Standard III(D) by distribu ng an adver sement that contains material misrepresenta ons about the historical performance of Mastermind. Standard III(D) requires that members and candidates make every reasonable e ort to ensure that performance informa on is a fair, accurate, and complete representa on of an individual’s or rm’s performance. As a general ma er, this standard does not prohibit showing past performance of funds managed at a prior rm as part of a performance track record as long as showing that record is accompanied by appropriate disclosures about where the performance took place and the person’s speci c role in achieving that performance. If McCoy chooses to use his past performance from G&P in Mastermind’s adver sing, he should make full disclosure of the source of the historical performance. Example 4 (Performance Presenta on and Simulated Results): fi ti ti ti ti ti ti fi fi ti ti ti ti ti fi ti ti ti ti fi ti ti ti ff ti fi ti ti fi ti ti ti ti ti ti fi ti ti ti ti ff Jed Davis has developed a mutual fund selec on product based on historical informa on from the 1990–95 period. Davis tested his methodology by applying it retroac vely to data from the 1996– 2003 period, thus producing simulated performance results for those years. In January 2004, Davis’s employer decided to o er the product and Davis began promo ng it through trade journal adver sements and direct dissemina on to clients. The adver sements included the performance results for the 1996–2003 period but did not indicate that the results were simulated. ti ti fi ti • tt fi market. The fund has never averaged that growth for more than one year, however, and the average rate of growth of all of its trust accounts for ve years is 5% per year. • Comment: Davis violated Standard III(D) by failing to clearly iden fy simulated performance results. Standard III(D) prohibits members and candidates from making any statements that misrepresent the performance achieved by them or their rms and requires members and candidates to make every reasonable e ort to ensure that performance informa on presented to clients is fair, accurate, and complete. Use of simulated results should be accompanied by full disclosure as to the source of the performance data, including the fact that the results from 1995 through 2003 were the result of applying the model retroac vely to that me period. Example 5 (Performance Calcula on and Selected Accounts Only): • In a presenta on prepared for prospec ve clients, William Kilmer shows the rates of return realized over a ve-year period by a “composite” of his rm’s discre onary accounts that have a “balanced” objec ve. This composite, however, consisted of only a few of the accounts that met the balanced criterion set by the rm, excluded accounts under a certain asset level without disclosing the fact of their exclusion, and included accounts that did not have the balanced mandate because those accounts would boost the investment results. In addi on, to achieve be er results, Kilmer manipulated the narrow range of accounts included in the composite by changing the accounts that made up the composite over me. • Comment: Kilmer violated Standard III(D) by misrepresen ng the facts in the promo onal material sent to prospec ve clients, distor ng his rm’s performance record, and failing to include disclosures that would have clari ed the presenta on. ti ti ti tt ti tt ti ti ti ti tt tt fi ti ti ti ti fi ti tt fi ti ti ti ti ti fi ti tt tt ti ff fi ti ti ff tt fi fi ti ti fi ti ti ti ti ti ti ti ti ti Had Purell believed the new methodology o ered improvements to the original model, then he would have needed to report the results of both calcula ons to the client. The report should also include the reasons why the new methodology is preferred, which would allow the client to make a meaningful comparison to prior results and provide a basis for comparing future a ribu ons. tt • tt Comment: Modifying the a ribu on methodology without proper no ca ons to clients would fail to meet the requirements of Standard III(D). Purrell’s recommenda on is being done solely for the interest of the rm to improve its perceived ability to meet the stated investment strategy. Such changes are unfair to clients and obscure the facts regarding the rm’s abili es. ff • ti Through running several di erent scenarios, Purell discovers that calcula ng a ribu on by comparing each stock with its industry and then rolling the e ect to the sector level improves the appearance of the manager’s stock selec on ac vi es. Because the rm de nes the a ribu on terms and the results be er re ect the stated strategy, Purell recommends that the client reports should use the revised methodology. ti • fi Art Purell is reviewing the quarterly performance a ribu on reports for distribu on to clients. Purell works for an investment management rm with a bo om-up, fundamentals-driven investment process that seeks to add value through stock selec on. The a ribu on methodology currently compares each stock with its sector. The a ribu on report indicates that the value added this quarter came from asset alloca on and that stock selec on contributed nega vely to the calculated return. fi ti • fl fi ff ti tt fi ti Example 6 (Performance A ribu on Changes): Example 7 (Performance Calcula on Methodology Disclosure): • While developing a new repor ng package for exis ng clients, Alisha Singh, a performance analyst, discovers that her company’s new system automa cally calculates both me-weighted and moneyweighted returns. She asks the head of client services and reten on which value would be preferred given that the rm has various investment strategies that include bonds, equi es, securi es without leverage, and alterna ves. Singh is told not to label the return value so that the rm may show whichever value is greatest for the period. • Comment: Following these instruc ons would lead to Singh viola ng Standard III(D). In repor ng inconsistent return values, Singh would not be providing complete informa on to the rm’s clients. Full informa on is provided when clients have su cient informa on to judge the performance generated by the rm. Example 8 (Performance Calcula on Methodology Disclosure): • Richmond Equity Investors manages a long–short equity fund in which clients can trade once a week (on Fridays). For transparency reasons, a daily net asset value of the fund is calculated by Richmond. The monthly fact sheets of the fund report month-to-date and year-to-date performance. Richmond publishes the performance based on the higher of the last trading day of the month (typically, not the last business day) or the last business day of the month as determined by Richmond. The fact sheet men ons only that the data are as of the end of the month, without giving the exact date. Maggie Clark, the investment performance analyst in charge of the calcula ons, is concerned about the frequent changes and asks her supervisor whether they are appropriate. • Comment: Clark’s ac ons in ques oning the changing performance metric comply with Standard III(D). She has shown concern that these changes are not presen ng an accurate and complete picture of the performance generated. E. Preserva on of Con den ality ti ti ti fi ti ti fi ti fi ti ti ti ti ti ti ti ti ti ti ti ti ti fi ti ffi ti ti ti ti ti ti ti ti fi ti fi ti ti Comment: The trustees gave Connor the internal reports so she could advise them on how to manage their endowment funds. Because the informa on in the reports is clearly both con den al and within the scope of the con den al rela onship, Standard III(E) requires that Connor refuse to divulge informa on to Kasey. ti • fi Sarah Connor, a nancial analyst employed by Johnson Investment Counselors, Inc., provides investment advice to the trustees of City Medical Center. The trustees have given her a number of internal reports concerning City Medical’s needs for physical plant renova on and expansion. They have asked Connor to recommend investments that would generate capital apprecia on in endowment funds to meet projected capital expenditures. Connor is approached by a local businessman, Thomas Kasey, who is considering a substan al contribu on either to City Medical Center or to another local hospital. Kasey wants to nd out the building plans of both ins tu ons before making a decision, but he does not want to speak to the trustees. fi • fi ti fi ti ti ti Example 1 (Possessing Con den al Informa on): Example 2 (Disclosing Con den al Informa on): • Lynn Moody is an investment o cer at the Lester Trust Company. She has an advisory customer who has talked to her about giving approximately US$50,000 to charity to reduce her income taxes. Moody is also treasurer of the Home for Indigent Widows (HIW), which is planning its annual giving campaign. HIW hopes to expand its list of prospects, par cularly those capable of substan al gi s. Moody recommends that HIW’s vice president for corporate gi s call on her customer and ask for a dona on in the US$50,000 range. • Comment: Even though the a empt to help the Home for Indigent Widows was well intended, Moody violated Standard III(E) by revealing con den al informa on about her client. Example 3 (Disclosing Possible Illegal Ac vity): • Government o cials approach Casey Samuel, the por olio manager for Garcia Company’s pension plan, to examine pension fund records. They tell her that Garcia’s corporate tax returns are being audited and the pension fund is being reviewed. Two days earlier, Samuel had learned in a regular investment review with Garcia o cers that poten ally excessive and improper charges were being made to the pension plan by Garcia. Samuel consults her employer’s general counsel and is advised that Garcia has probably violated tax and duciary regula ons and laws. • Comment: Samuel should inform her supervisor of these ac vi es, and her employer should take steps, with Garcia, to remedy the viola ons. If that approach is not successful, Samuel and her employer should seek advice of legal counsel to determine the appropriate steps to be taken. Samuel may well have a duty to disclose the evidence she has of the con nuing legal viola ons and to resign as asset manager for Garcia. Example 4 (Disclosing Possible Illegal Ac vity): • David Bradford manages money for a family-owned real estate development corpora on. He also manages the individual por olios of several of the family members and o cers of the corpora on, including the chief nancial o cer (CFO). Based on the nancial records of the corpora on and some ques onable prac ces of the CFO that Bradford has observed, Bradford believes that the CFO is embezzling money from the corpora on and pu ng it into his personal investment account. • Comment: Bradford should check with his rm’s compliance department or appropriate legal counsel to determine whether applicable securi es regula ons require repor ng the CFO’s nancial records. Example 5 (Accidental Disclosure of Con den al Informa on): ft ti fi ti ti ti fi ti tf ffi ti ti ti ti ft ti ti ti fi ti ti ti tf fi tf fi ti ti ti ti tti ti fi ti ti ti fi fi ti ti fi ti ti ti ti ti ffi fi ffi ffi tt ffi tf fi tf ti fi ti Lynn Moody is an investment o cer at the Lester Trust Company (LTC). She has stewardship of a signi cant number of individually managed taxable accounts. In addi on to receiving quarterly wri en reports, about a dozen high-net-worth individuals have indicated to Moody a willingness to receive communica ons about overall economic and nancial market outlooks directly from her by way of a social media pla orm. Under the direc on of her rm’s technology and compliance departments, she established a new group page on an exis ng social media pla orm speci cally for her clients. In the instruc ons provided to clients, Moody asked them to “join”the group so they may be granted access to the posted content. The instruc ons also advised clients that all comments posted would be available to the public and thus the pla orm was not an appropriate method for communica ng personal or con den al informa on. ti ffi ti ti ti fi tt • • Six months later, in early January, Moody posted LTC’s year-end “Market Outlook.” The report outlined a new asset alloca on strategy that the rm is adding to its recommenda ons in the new year. Moody introduced the publica on with a note informing her clients that she would be discussing the changes with them individually in their upcoming mee ngs. • One of Moody’s clients responded directly on the group page that his family recently experienced a major change in their nancial pro le. The client described highly personal and con den al details of the event. Unfortunately, all clients that were part of the group were also able to read the detailed pos ng un l Moody was able to have the comment removed. • Comment: Moody has taken reasonable steps for protec ng the con den ality of client informa on while using the social media pla orm. She provided instruc ons clarifying that all informa on posted to the site would be publically viewable to all group members and warned against using this method for communica ng con den al informa on. The accidental disclosure of con den al informa on by a client is not under Moody’s control. Her ac ons to remove the informa on promptly once she became aware further align with Standard III(E). • In understanding the poten al sensi vity clients express surrounding the con den ality of personal informa on, this event highlights a need for further training. Moody might advocate for addi onal warnings or controls for clients when they consider using social media pla orms for two-way communica ons. IV. DUTIES TO EMPLOYERS A. Loyalty Example 1 (Solici ng Former Clients): • Samuel Magee manages pension accounts for Trust Assets, Inc., but has become frustrated with the working environment and has been o ered a posi on with Fiduciary Management. Before resigning from Trust Assets, Magee asks four big accounts to leave that rm and open accounts with Fiduciary. Magee also persuades several prospec ve clients to sign agreements with Fiduciary Management. Magee had previously made presenta ons to these prospects on behalf of Trust Assets. • Comment: Magee violated the employee–employer principle requiring him to act solely for his employer’s bene t. Magee’s duty is to Trust Assets as long as he is employed there. The solicita on of Trust Assets’ current clients and prospec ve clients is unethical and violates Standard IV(A). Example 2 (Former Employer’s Documents and Files): ti ti ti ti ti ti fi tf ti ti ti ti fi fi ti tf ti ti ti fi fi ti ti ti ti tt ti ti fi ti ti ti ti ti ti ff ti ti ti fi ti tf ti ti ti ti fi fi James Hightower has been employed by Jason Investment Management Corpora on for 15 years. He began as an analyst but assumed increasing responsibili es and is now a senior por olio manager and a member of the rm’s investment policy commi ee. Hightower has decided to leave Jason Investment and start his own investment management business. He has been careful not to tell any of Jason’s clients that he is leaving; he does not want to be accused of breaching his duty to Jason by solici ng Jason’s clients before his departure. Hightower is planning to copy and take with him the following documents and informa on he developed or worked on while at Jason: (1) the client list, with addresses, telephone numbers, and other per nent client informa on; (2) client account statements; (3) sample marke ng presenta ons to prospec ve clients containing Jason’s performance record; (4) Jason’s recommended list of securi es; (5) computer models to determine asset fi ti fi ti ti ti ti ti ti • alloca ons for accounts with various objec ves; (6) computer models for stock selec on; and (7) personal computer spreadsheets for Hightower’s major corporate recommenda ons, which he developed when he was an analyst. • Comment: Except with the consent of their employer, depar ng members and candidates may not take employer property, which includes books, records, reports, and other materials, because taking such materials may interfere with their employer’s business opportuni es. Taking any employer records, even those the member or candidate prepared, violates Standard IV(A). Employer records include items stored in hard copy or any other medium (e.g., home computers, portable storage devices, cell phones). Example 3 (Addressing Rumors): • Reuben Winston manages all-equity por olios at Target Asset Management (TAM), a large, established investment counselor. Ten years previously, Philpo & Company, which manages a family of global bond mutual funds, acquired TAM in a diversi ca on move. A er the merger, the combined opera ons prospered in the xed-income business but the equity management business at TAM languished. Lately, a few of the equity pension accounts that had been with TAM before the merger have terminated their rela onships with TAM. One day, Winston nds on his voice mail the following message from a concerned client: “Hey! I just heard that Philpo is close to announcing the sale of your rm’s equity management business to Rugged Life. What is going on?” Not being aware of any such deal, Winston and his associates are stunned. Their internal inquiries are met with denials from Philpo management, but the rumors persist. Feeling le in the dark, Winston contemplates leading an employee buyout of TAM’s equity management business. • Comment: An employee-led buyout of TAM’s equity asset management business would be consistent with Standard IV(A) because it would rest on the permission of the employer and, ul mately, the clients. In this case, however, in which employees suspect the senior managers or principals are not truthful or forthcoming, Winston should consult legal counsel to determine appropriate ac on. ti ti ffi ft ti ti ti ti fl ti tti ti ti ft fi ti tt tt ti ti ti ti ff ft ti fi fi fi ti ti ti tf tt ti ti fi ti Comment: Although she is under no wri en contractual obliga on to Bradley, Clay has an obliga on to let Bradley act on the output of her study before Winston & Company or Clay uses the informa on to their advantage. That is, unless Bradley gives permission to Clay and waives its rights to her wireless report, Clay would be in viola on of Standard IV(A) if she were to immediately recommend to Winston the same transac ons recommended in the report to Bradley. Furthermore, Clay must not take from Bradley any research le material or other property that she may have used. ti • ti Laura Clay, who is unemployed, wants part- me consul ng work while seeking a full- me analyst posi on. During an interview at Bradley Associates, a large ins tu onal asset manager, Clay is told that the rm has no immediate research openings but would be willing to pay her a at fee to complete a study of the wireless communica ons industry within a given period of me. Clay would be allowed unlimited access to Bradley’s research les and would be welcome to come to the o ces and use whatever support facili es are available during normal working hours. Bradley’s research director does not seek any exclusivity for Clay’s output, and the two agree to the arrangement on a handshake. As Clay nears comple on of the study, she is o ered an analyst job in the research department of Winston & Company, a brokerage rm, and she is pondering submi ng the dra of her wireless study for publica on by Winston. fi • ti fi tt ti ti fi ti Example 4 (Ownership of Completed Prior Work): • Emma Madeline, a recent college graduate and a candidate in the CFA Program, spends her summer as an unpaid intern at Murdoch and Lowell. The senior managers at Murdoch are a emp ng to bring the rm into compliance with the GIPS standards, and Madeline is assigned to assist in its e orts. Two months into her internship, Madeline applies for a job at McMillan & Company, which has plans to become GIPS compliant. Madeline accepts the job with McMillan. Before leaving Murdoch, she copies the rm’s so ware that she helped develop because she believes this so ware will assist her in her new posi on. • Comment: Even though Madeline does not receive monetary compensa on for her services at Murdoch, she has used rm resources in crea ng the so ware and is considered an employee because she receives compensa on and bene ts in the form of work experience and knowledge. By copying the so ware, Madeline violated Standard IV(A) because she misappropriated Murdoch’s property without permission. Example 6 (Solici ng Former Clients): • Dennis Elliot has hired Sam Chisolm, who previously worked for a compe ng rm. Chisolm le his former rm a er 18 years of employment. When Chisolm begins working for Elliot, he wants to contact his former clients because he knows them well and is certain that many will follow him to his new employer. Is Chisolm in viola on of Standard IV(A) if he contacts his former clients? • Comment: Because client records are the property of the rm, contact- ing former clients for any reason through the use of client lists or other informa on taken from a former employer without permission would be a viola on of Standard IV(A). In addi on, the nature and extent of the con- tact with former clients may be governed by the terms of any noncompete agreement signed by the employee and the former employer that covers contact with former clients a er employment. • Simple knowledge of the names and existence of former clients is not con den al informa on, just as skills or experience that an employee obtains while employed are not “con den al” or “privileged” informa on. The Code and Standards do not impose a prohibi on on the use of experience or knowledge gained at one employer from being used at another employer. The Code and Standards also do not prohibit former employees from contac ng clients of their previous rm, in the absence of a noncompete agreement. Members and candidates are free to use public informa on about their former rm a er depar ng to contact former clients without viola ng Standard IV(A). • In the absence of a noncompete agreement, as long as Chisolm maintains his duty of loyalty to his employer before joining Elliot’s rm, does not take steps to solicit clients un l he has le his former rm, and does not use material from his former employer without its permission a er he has le , he is not in viola on of the Code and Standards. Example 7 (Star ng a New Firm): ft ft ff ti ti ti ft ti tt ft ti ft ti fi ti fi ft ti fi fi ti ti ti ti ti ti ti fi ti ti ft ti ti ti fi ti ti fi ti fi ti Geraldine Allen currently works at a registered investment company as an equity analyst. Without no ce to her employer, she registers with government authori es to start an investment company that will compete with her employer, but she does not ac vely seek clients. Does registra on of this compe ng company with the appropriate regulatory authori es cons tute a viola on of Standard IV(A)? ft ti ti ti ft ft ft ti fi fi ti fi ti fi • ti fi Example 5 (Ownership of Completed Prior Work): Comment: Allen’s prepara on for the new business by registering with the regulatory authori es does not con ict with the work for her employer if the prepara ons have been done on Allen’s own me outside the o ce and if Allen will not be solici ng clients for the business or otherwise opera ng the new company un l she has le her current employer. Example 8 (Compe ng with Current Employer): • Several employees are planning to depart their current employer within a few weeks and have been careful to not engage in any ac vi es that would con ict with their duty to their current employer. They have just learned that one of their employer’s clients has undertaken a request for proposal (RFP) to review and possibly hire a new investment consultant. The RFP has been sent to the employer and all of its compe tors. The group believes that the new en ty to be formed would be quali ed to respond to the RFP and be eligible for the business. The RFP submission period is likely to conclude before the employees’ resigna ons are e ec ve. Is it permissible for the group of depar ng employees to respond to the RFP for their an cipated new rm? • Comment: A group of employees responding to an RFP that their employer is also responding to would lead to direct compe on between the employees and the employer. Such conduct violates Standard IV(A) unless the group of employees receives permission from their employer as well as the en ty sending out the RFP. Example 9 (Externally Compensated Assignments): • Alfonso Mota is a research analyst with Tyson Investments. He works part me as a mayor for his hometown, a posi on for which he receives compensa on. Must Mota seek permission from Tyson to serve as mayor? • Comment: If Mota’s mayoral du es are so extensive and me-consuming that they might detract from his ability to ful ll his responsibili es at Tyson, he should discuss his outside ac vi es with his employer and come to a mutual agreement regarding how to manage his personal commitments with his responsibili es to his employer. ti ti ti ti ti ti ti ti fi ti ti ti fl ti ff ti ft ti ti ti ti ti ti ti ti ti ti ti ti ti ti fi Comment: McQuillen is not in viola on of Standard IV(A) because she has not used informa on or records from her former employer and is not prevented by an agreement with her former employer from solici ng her former clients. ti • ffi A er leaving her employer, Shawna McQuillen establishes her own money management business. While with her former employer, she did not sign a noncompete agreement that would have prevented her from solici ng former clients. Upon her departure, she does not take any of her client lists or contact informa on and she clears her personal computer of any employer records, including client contact informa on. She obtains the phone numbers of her former clients through public records and contacts them to solicit their business. ti • ti ti fl ti ti fi ti Example 10 (Solici ng Former Clients): ft ti • Example 11 (Whistleblowing Ac ons): • Meredith Rasmussen works on a buy-side trading desk and concentrates on in-house trades for a hedge fund subsidiary managed by a team at the investment management rm. The hedge fund has been very successful and is marketed globally by the rm. From her experience as the trader for much of the ac vity of the fund, Rasmussen has become quite knowledgeable about the hedge fund’s strategy, tac cs, and performance. When a dis nct break in the market occurs, however, and many of the securi es involved in the hedge fund’s strategy decline markedly in value, Rasmussen observes that the reported performance of the hedge fund does not re ect this decline. In her experience, the lack of any e ect is a very unlikely occurrence. She approaches the head of trading about her concern and is told that she should not ask any ques ons and that the fund is big and successful and is not her concern. She is fairly sure something is not right, so she contacts the compliance o cer, who also tells her to stay away from the issue of this hedge fund’s repor ng. • Comment: Rasmussen has clearly come upon an error in policies, procedures, and compliance prac ces in the rm’s opera ons. Having been unsuccessful in nding a resolu on with her supervisor and the compliance o cer, Rasmussen should consult the rm’s whistleblowing policy to determine the appropriate next step toward informing management of her concerns. The poten ally unethical ac ons of the investment management division are appropriate grounds for further disclosure, so Rasmussen’s whistleblowing would not represent a viola on of Standard IV(A). See also Standard I(D)–Misconduct and Standard IV(C)–Responsibili es of Supervisors. Example 12 (Solici ng Former Clients): • Angel Crome has been a private banker for YBSafe Bank for the past eight years. She has been very successful and built a considerable client por olio during that me but is extremely frustrated by the recent loss of reputa on by her current employer and subsequent client insecurity. A locally renowned headhunter contacted Crome a few days ago and o ered her an interes ng job with a compe ng private bank. This bank o ers a substan al signing bonus for advisers with their own client por olios. Crome gures that she can solicit at least 70% of her clients to follow her and gladly enters into the new employment contract. • Comment: Crome may contact former clients upon termina on of her employment with YBSafe Bank, but she is prohibited from using client records built by and kept with her in her capacity as an employee of YBSafe Bank. Client lists are proprietary informa on of her former employer and must not be used for her or her new employer’s bene t. The use of writ- ten, electronic, or any other form of records other than publicly available informa on to contact her former clients at YBSafe Bank will be a viola on of Standard IV(A). Example 13 (No ti ti ti ti ti fi ti fl ti fi ti ti ti fi ti ff ti ti ti ti fi ti fi ti ti fi ti tf ff ti ffi tti ti ff ti ti ti ti ti ti ti Krista Smith is a rela vely new assistant trader for the xed-income desk of a major investment bank. She is on a team responsible for structuring collateralized debt obliga ons (CDOs) made up of securi es in the inventory of the trading desk. At a mee ng of the team, senior execu ves explain the opportunity to eventually separate the CDO into various risk-rated tranches to be sold to the clients of the rm. A er the senior execu ves leave the mee ng, the head trader announces various responsibili es of each member of the team and then says, “This is a good me to unload some of the junk we have been stuck with for a while and disguise it with ra ngs and a thick, unreadable prospectus, so don’t be shy in pu ng this CDO together. Just kidding.” Smith is worried by this remark and asks some of her colleagues what the head trader meant. They all respond that he was fi fi fi ti ti ffi ft ti ti ti ti fi ti ti tf • ca on of Code and Standards): just kidding but that there is some truth in the remark because the CDO is seen by management as an opportunity to improve the quality of the securi es in the rm’s inventory. • Concerned about the ethical environment of the workplace, Smith decides to talk to her supervisor about her concerns and provides the head trader with a copy of the Code and Standards. Smith discusses the principle of placing the client above the interest of the rm and the possibility that the development of the new CDO will not adhere to this responsibility. The head trader assures Smith that the appropriate analysis will be conducted when determining the appropriate securi es for collateral. Furthermore, the ra ngs are assigned by an independent rm and the prospectus will include full and factual disclosures. Smith is reassured by the mee ng, but she also reviews the company’s procedures and requirements for repor ng poten al viola ons of company policy and securi es laws. • Comment: Smith’s review of the company policies and procedures for report- ing viola ons allows her to be prepared to report through the appropriate whistleblower process if she decides that the CDO development process involves unethical ac ons by others. Smith’s ac ons comply with the Code and Standards principles of placing the client’s interests rst and being loyal to her employer. In providing her supervisor with a copy of the Code and Standards, Smith is highligh ng the high level of ethical conduct she is required to adhere to in her professional ac vi es. Example 14 (Leaving an Employer): • Laura Webb just le her posi on as por olio analyst at Research Systems, Inc. (RSI). Her employment contract included a non-solicita on agreement that requires her to wait two years before solici ng RSI clients for any investment-related services. Upon leaving, Webb was informed that RSI would contact clients immediately about her departure and introduce her replacement. • While working at RSI, Webb connected with clients, other industry associates, and friends through her LinkedIn network. Her business and personal rela onships were intermingled because she considered many of her clients to be personal friends. Realizing that her LinkedIn network would be a valuable resource for new employment opportuni es, she updated her pro le several days following her departure from RSI. LinkedIn automa cally sent a no ca on to Webb’s en re network that her employment status had been changed in her pro le. • Comment: Prior to her departure, Webb should have discussed any client informa on contained in her social media networks. By upda ng her LinkedIn pro le a er RSI no ed clients and a er her employment ended, she has appropriately placed her employer’s interests ahead of her own personal interests. In addi on, she has not violated the non-solicita on agreement with RSI, unless it prohibited any contact with clients during the two-year period. Example 15 (Con den al Firm Informa on): ti ft ti ti ti ti ti ti fi ti fi ti ti ti ti fi ti fi ti ti ti ti ft fi fi ti fi ti fi ti ti ti fi ti ti ti ti tf ti ti ti ti ti ti Sanjay Gupta is a research analyst at Naram Investment Management (NIM). NIM uses a team-based research process to develop recommenda ons on investment opportuni es covered by the team members. Gupta, like others, provides commentary for NIM’s clients through the company blog, which is posted weekly on the NIM password-protected website. According to NIM’s policy, every contribu on to the website must be approved by the company’s compliance department before pos ng. Any opinions expressed on the website are disclosed as represen ng the perspec ve of NIM. ft ti fi ti ti ti • • Gupta also writes a personal blog to share his experiences with friends and family. As with most blogs, Gupta’s personal blog is widely available to interested readers through various internet search engines. Occasionally, when he disagrees with the team-based research opinions of NIM, Gupta uses his personal blog to express his own opinions as a counterpoint to the commentary posted on the NIM website. Gupta believes this provides his readers with a more complete perspec ve on these investment opportuni es. • Comment: Gupta is in viola on of Standard IV(A) for disclosing con den al rm informa on through his personal blog. The recommenda ons on the rm’s blog to clients are not freely available across the internet, but his personal blog post indirectly provides the rm’s recommenda ons. • Addi onally, by pos ng research commentary on his personal blog, Gupta is using rm resources for his personal advantage. To comply with Standard IV(A), members and candidates must receive consent from their employer prior to using company resources. B. Addi onal Compensa on Arrangements Example 1 (No ca on of Client Bonus Compensa on): • Geo Whitman, a por olio analyst for Adams Trust Company, manages the account of Carol Cochran, a client. Whitman is paid a salary by his employer, and Cochran pays the trust company a standard fee based on the market value of assets in her por olio. Cochran proposes to Whitman that “any year that my por olio achieves at least a 15% return before taxes, you and your wife can y to Monaco at my expense and use my condominium during the third week of January.” Whitman does not inform his employer of the arrangement and vaca ons in Monaco the following January as Cochran’s guest. • Comment: Whitman violated Standard IV(B) by failing to inform his employer in wri ng of this supplemental, con ngent compensa on arrangement. The nature of the arrangement could have resulted in par ality to Cochran’s account, which could have detracted from Whitman’s performance with respect to other accounts he handles for Adams Trust. Whitman must obtain the consent of his employer to accept such a supplemental bene t. Example 2 (No ca on of Outside Compensa on): • Terry Jones sits on the board of directors of Exercise Unlimited, Inc. In return for his services on the board, Jones receives unlimited membership privileges for his family at all Exercise Unlimited facili es. Jones purchases Exercise Unlimited stock for the client accounts for which it is appropriate. Jones does not disclose this arrangement to his employer because he does not receive monetary compensa on for his services to the board. • Comment: Jones has violated Standard IV(B) by failing to disclose to his employer bene ts received in exchange for his services on the board of directors. The non-monetary compensa on may create a con ict of interest in the same manner as being paid to serve as a director. Example 3 (Prior Approval for Outside Compensa on): ti fi ti fl ti ti fi ft ti fi ti fi fi ti ffi ti ti ti fi tf fi ti ti ti ti ti ti ti ti tf ti ti ti Jonathan Hollis is an analyst of oil-and-gas companies for Specialty Investment Management. He is currently recommending the purchase of ABC Oil Company shares and has published a long, wellthought-out research report to substan ate his recommenda on. Several weeks a er publishing the report, Hollis receives a call from the investor-rela ons o ce of ABC Oil saying that Thomas Andrews, ti fi fi ti ti ti tf ti ti ti ti ff fl • CEO of the company, saw the report and really liked the analyst’s grasp of the business and his company. The investor-rela ons o cer invites Hollis to visit ABC Oil to discuss the industry further. ABC Oil o ers to send a company plane to pick Hollis up and arrange for his accommoda ons while visi ng. Hollis, a er gaining the appropriate approvals, accepts the mee ng with the CEO but declines the o ered travel arrangements. • Several weeks later, Andrews and Hollis meet to discuss the oil business and Hollis’s report. Following the mee ng, Hollis joins Andrews and the investment rela ons o cer for dinner at an upscale restaurant near ABC Oil’s headquarters. • Upon returning to Specialty Investment Management, Hollis provides a full review of the mee ng to the director of research, including a disclosure of the dinner a ended. • Comment: Hollis’s ac ons did not violate Standard IV(B). Through gaining approval before accep ng the mee ng and declining the o ered travel arrangements, Hollis sought to avoid any poten al con icts of interest between his company and ABC Oil. Because the loca on of the dinner was not available prior to arrival and Hollis no ed his company of the dinner upon his return, accep ng the dinner should not impair his objec vity. By disclosing the dinner, Hollis has enabled Specialty Investment Management to assess whether it has any impact on future reports and recommenda ons by Hollis related to ABC Oil. C. Responsibili es of Supervisors Example 1 (Supervising Research Ac vi es): • Jane Ma ock, senior vice president and head of the research department of H&V, Inc., a regional brokerage rm, has decided to change her recommenda on for Timber Products from buy to sell. In line with H&V’s procedures, she orally advises certain other H&V execu ves of her proposed ac ons before the report is prepared for publica on. As a result of Ma ock’s conversa on with Dieter Frampton, one of the H&V execu ves accountable to Ma ock, Frampton immediately sells Timber’s stock from his own account and from certain discre onary client accounts. In addi on, other personnel inform certain ins tu onal customers of the changed recommenda on before it is printed and disseminated to all H&V customers who have received previous Timber reports. • Comment: Ma ock has violated Standard IV(C) by failing to reasonably and adequately supervise the ac ons of those accountable to her. She did not prevent or establish reasonable procedures designed to prevent dissemina on of or trading on the informa on by those who knew of her changed recommenda on. She must ensure that her rm has procedures for reviewing or recording any trading in the stock of a corpora on that has been the subject of an unpublished change in recommenda on. Adequate procedures would have informed the subordinates of their du es and detected sales by Frampton and selected customers. Example 2 (Supervising Research Ac vi es): ti ti ti ff ti ti ti ti ti tf ti ti ti ti ti tf ffi tt tt ti tt ti ti ti ff fi ti ff ti ti fi ti ti ti ti ffi ti ff ti ti ti ti ti Deion Miller is the research director for Jamestown Investment Programs. The por olio managers have become cri cal of Miller and his sta because the Jamestown por olios do not include any stock that has been the subject of a merger or tender o er. Georgia Ginn, a member of Miller’s sta , tells Miller that she has been studying a local company, Excelsior, Inc., and recommends its purchase. Ginn adds that the company has been widely rumored to be the subject of a merger study by a well-known conglomerate and discussions between them are under way. At Miller’s request, Ginn prepares a ti ti ft tt ti ti ti ti fi ff ti ti tt ff fl ti ti • memo recommending the stock. Miller passes along Ginn’s memo to the por olio managers prior to leaving for vaca on, and he notes that he has not reviewed the memo. As a result of the memo, the por olio managers buy Excelsior stock immediately. The day Miller returns to the o ce, he learns that Ginn’s only sources for the report were her brother, who is an acquisi ons analyst with Acme Industries, the “well-known conglomerate,” and that the merger discussions were planned but not held. • Comment: Miller violated Standard IV(C) by not exercising reasonable supervision when he disseminated the memo without checking to ensure that Ginn had a reasonable and adequate basis for her recommenda ons and that Ginn was not relying on material nonpublic informa on. Example 3 (Supervising Trading Ac vi es): • David Edwards, a trainee trader at Wheeler & Company, a major na onal broker- age rm, assists a customer in paying for the securi es of Highland, Inc., by using an cipated pro ts from the immediate sale of the same securi es. Despite the fact that Highland is not on Wheeler’s recommended list, a large volume of its stock is traded through Wheeler in this manner. Roberta Ann Mason is a Wheeler vice president responsible for supervising compliance with the securi es laws in the trading department. Part of her compensa on from Wheeler is based on commission revenues from the trading department. Although she no ces the increased trading ac vity, she does nothing to inves gate or halt it. • Comment: Mason’s failure to adequately review and inves gate purchase orders in Highland stock executed by Edwards and her failure to supervise the trainee’s ac vi es violate Standard IV(C). Supervisors should be especially sensi ve to actual or poten al con icts between their own selfinterests and their supervisory responsibili es. Example 4 (Supervising Trading Ac vi es and Record Keeping): tt ti ti ti fi ffi ft ti fi tf ti fi ti ti ti ti ti fl ti ti fi tf ti ti ti fi tf ti ti ft ti ti ti ti ti ti ti ti ti ti fi ti ti ti ft Samantha Tabbing is senior vice president and por olio manager for Crozet, Inc., a registered investment advisory and registered broker/dealer rm. She reports to Charles Henry, the president of Crozet. Crozet serves as the investment adviser and principal underwriter for ABC and XYZ public mutual funds. The two funds’ prospectuses allow Crozet to trade nancial futures for the funds for the limited purpose of hedging against market risks. Henry, extremely impressed by Tabbing’s performance in the past two years, directs Tabbing to act as por olio manager for the funds. For the bene t of its employees, Crozet has also organized the Crozet Employee Pro t-Sharing Plan (CEPSP), a de ned contribu on re rement plan. Henry assigns Tabbing to manage 20% of the assets of CEPSP. Tabbing’s investment objec ve for her por on of CEPSP’s assets is aggressive growth. Unbeknownst to Henry, Tabbing frequently places S&P 500 Index purchase and sale orders for the funds and the CEPSP without providing the futures commission merchants (FCMs) who take the orders with any prior or simultaneous designa on of the account for which the trade has been placed. Frequently, neither Tabbing nor anyone else at Crozet completes an internal trade cket to record the me an order was placed or the speci c account for which the order was intended. FCMs o en designate a speci c account only a er the trade, when Tabbing provides such designa on. Crozet has no wri en opera ng procedures or compliance manual concerning its futures trading, and its compliance department does not review such trading. A er observing the market’s movement, Tabbing assigns to CEPSP the S&P 500 posi ons with more favorable execu on prices and assigns posi ons with less favorable execu on prices to the funds. ti ti ti ti ti ti fi fi tf fi • • Comment: Henry violated Standard IV(C) by failing to adequately supervise Tabbing with respect to her S&P 500 trading. Henry further violated Standard IV(C) by failing to establish record-keeping and repor ng procedures to prevent or detect Tabbing’s viola ons. Henry must make a reasonable e ort to determine that adequate compliance procedures covering all employee trading ac vity are established, documented, communicated, and followed. Example 5 (Accep ng Responsibility): • Meredith Rasmussen works on a buy-side trading desk and concentrates on in-house trades for a hedge fund subsidiary managed by a team at the investment management rm. The hedge fund has been very successful and is marketed globally by the rm. From her experience as the trader for much of the ac vity of the fund, Rasmussen has become quite knowledgeable about the hedge fund’s strategy, tac cs, and performance. When a dis nct break in the market occurs and many of the securi es involved in the hedge fund’s strategy decline markedly in value, however, Rasmussen observes that the reported performance of the hedge fund does not at all re ect this decline. From her experience, this lack of an e ect is a very unlikely occurrence. She approaches the head of trading about her concern and is told that she should not ask any ques ons and that the fund is too big and successful and is not her concern. She is fairly sure something is not right, so she contacts the compliance o cer and is again told to stay away from the hedge fund repor ng issue. • Comment: Rasmussen has clearly come upon an error in policies, procedures, and compliance prac ces within the rm’s opera ons. According to Standard IV(C), the supervisor and the compliance o cer have the responsibility to review the concerns brought forth by Rasmussen. Supervisors have the responsibility of establishing and encouraging an ethical culture in the rm. The dismissal of Rasmussen’s ques on violates Standard IV(C) and undermines the rm’s ethical opera ons. See also Standard I(D)–Misconduct and, for guidance on whistleblowing, Standard IV(A)–Loyalty. ff tt ti tt ti ti ti ti fl ti fi fi ti fi tt ti fl ti ti fi ti ff tt tt ti ti tt tt ff ti ti fi ti ti ti fi Comment: Allowing the report submi ed by Wi to be posted highlights a lack of compliance procedures by the research rm. Wi ’s supervisor needs to work with the management of On-line to develop an appropriate review process to ensure that all contracted analysts comply with the requirements. See also Standard V(A)–Diligence and Reasonable Basis because it relates to Wi ’s responsibility for substan a ng a recommenda on. ti • ti Brendan Wi , a former junior sell-side technology analyst, decided to return to school to earn an MBA. To keep his research skills and industry knowledge sharp, Wi accepted a posi on with On-line and Informed, an independent internet-based research company. The posi on requires the publica on of a recommenda on and report on a di erent company every month. Ini ally, Wi is a regular contributor of new research and a par cipant in the associated discussion boards that generally have posi ve comments on the technology sector. Over me, his ability to manage his educa onal requirements and his work requirements begin to con ict with one another. Knowing a recommenda on is due the next day for On-line, Wi creates a report based on a few news ar cles and what the conven onal wisdom of the markets has deemed the “hot” security of the day. ti • ti ti ffi ti tt ti ti ti ti ti ffi Example 6 (Inadequate Procedures): Example 7 (Inadequate Supervision): • Michael Papis is the chief investment o cer of his state’s re rement fund. The fund has always used outside advisers for the real estate alloca on, and this informa on is clearly presented in all fund communica ons. Thomas Nagle, a recognized sell-side research analyst and Papis’s business school classmate, recently le the investment bank he worked for to start his own asset management rm, Accessible Real Estate. Nagle is trying to build his assets under management and contacts Papis about gaining some of the re rement fund’s alloca on. In the previous few years, the performance of the re rement fund’s real estate investments was in line with the fund’s benchmark but was not extraordinary. Papis decides to help out his old friend and also to seek be er returns by moving the real estate alloca on to Accessible. The only no ce of the change in adviser appears in the next annual report in the lis ng of associated advisers. • Comment: Papis’s ac ons highlight the need for supervision and review at all levels in an organiza on. His responsibili es may include the selec on of external advisers, but the decision to change advisers appears arbitrary. Members and candidates should ensure that their rm has appropriate policies and procedures in place to detect inappropriate ac ons, such as the ac on taken by Papis. See also Standard V(A)–Diligence and Reasonable Basis, Standard V(B)–Communica on with Clients and Prospec ve Clients, and Standard VI(A)–Disclosure of Con icts. Example 8 (Supervising Research Ac vi es): • Mary Burde e was recently hired by Fundamental Investment Management (FIM) as a junior auto industry analyst. Burde e is expected to expand the social media presence of the rm because she is ac ve with various networks, including Facebook, LinkedIn, and Twi er. Although Burde e’s supervisor, Joe Graf, has never used social media, he encourages Burde e to explore opportuni es to increase FIM’s online presence and ability to share content, communicate, and broadcast informa on to clients. In response to Graf’s encouragement, Burde e is working on a proposal detailing the advantages of ge ng FIM onto Twi er in addi on to launching a company Facebook page. • As part of her auto industry research for FIM, Burde e is comple ng a report on the nancial impact of Sun Drive Auto Ltd.’s new solar technology for compact auto- mobiles. This research report will be her rst for FIM, and she believes Sun Drive’s technology could revolu onize the auto industry. In her excitement, Burde e sends a quick tweet to FIM Twi er followers summarizing her “buy” recommenda on for Sun Drive Auto stock. • Comment: Graf has violated Standard IV(C) by failing to reasonably supervise Burde e with respect to the contents of her tweet. He did not establish reasonable procedures to prevent the unauthorized dissemina on of company research through social media networks. Graf must make sure all employees receive regular training about FIM’s policies and procedures, including the appropriate business use of personal social media networks. See Standard III(B) for addi onal guidance. Example 9 (Supervising Research Ac vi es): ti ti fi ti ti ti tt fi fi tf tt fi ti tt ti tt fl ti tt ti ti ti ti ti tt ti tt tt tf ff ti ti ti ti ti ti ffi ti ti tt ti ti tt ti ft ti ti Chen Wang leads the research department at YYRA Re rement Planning Specialists. Chen supervises a team of 10 analysts in a fast-paced and understa ed organiza on. He is responsible for coordina ng the rm’s approved process to review all reports before they are provided to the por olio management team for use in rebalancing client por olios. tt ti tti ti tt ti ti ti fi fi ti ti • One of Chen’s direct reports, Huang Mei, covers the banking industry. Chen must submit the latest updates to the por olio management team tomorrow morning. Huang has yet to submit her research report on ZYX Bank because she is uncomfortable pro- viding a “buy” or “sell” opinion of ZYX on the basis of the completed analysis. Pressed for me and concerned that Chen will reject a “hold” recommenda on, she researches various websites and blogs on the banking sector for whatever she can nd on ZYX. One independent blogger provides a new interpreta on of the recently reported data Huang has analyzed and concludes with a strong “sell” recommenda on for ZYX. She is impressed by the originality and resourcefulness of this blogger’s report. • Very late in the evening, Huang submits her report and “sell” recommenda on to Chen without any reference to the independent blogger’s report. Given the late me of the submission and the competence of Huang’s prior work, Chen compiles this report with the recommenda ons from each of the other analysts and meets with the por olio managers to discuss implementa on. • Comment: Chen has violated Standard IV(C) by neglec ng to reasonably and adequately follow the rm’s approved review process for Huang’s research report. The delayed submission and the quality of prior work do not remove Chen’s requirement to uphold the designated review process. A member or candidate with supervisory responsibility must make reasonable e orts to see that appropriate procedures are established, documented, communicated to covered personnel, and followed. V. INVESTMENT ANALYSIS, RECOMMENDATIONS, AND ACTIONS A. Diligence and Reasonable Basis Example 1 (Su cient Due Diligence): • Helen Hawke manages the corporate nance department of Sarkozi Securi es, Ltd. The rm is an cipa ng that the government will soon close a tax loophole that currently allows oil-and-gas explora on companies to pass on drilling expenses to holders of a certain class of shares. Because market demand for this tax-advantaged class of stock is currently high, Sarkozi convinces several companies to undertake new equity nancings at once, before the loophole closes. Time is of the essence, but Sarkozi lacks su cient resources to conduct adequate research on all the prospec ve issuing companies. Hawke decides to es mate the IPO prices on the basis of the rela ve size of each company and to jus fy the pricing later when her sta has me. • Comment: Sarkozi should have taken on only the work that it could adequately handle. By categorizing the issuers by general size, Hawke has bypassed researching all the other relevant aspects that should be considered when pricing new issues and thus has not performed su cient due diligence. Such an omission can result in investors purchasing shares at prices that have no actual basis. Hawke has violated Standard V(A). Example 2 (Su cient Scenario Tes ng): ti ffi fi ti ti ti ti ti ti ti ti ff fi ti fi ti ti ti ff ti tf ti fi fi fi ti fi ffi ti ti ti Babu Dhaliwal works for Heinrich Brokerage in the corporate nance group. He has just persuaded Feggans Resources, Ltd., to allow his rm to do a secondary equity nancing at Feggans Resources’ current stock price. Because the stock has been trad- ing at higher mul ples than similar companies with equivalent produc on, Dhaliwal presses the Feggans Resources managers to project what would be the maximum produc on they could achieve in an op mal scenario. Based on these numbers, he is able to jus fy the price his rm will be asking for the secondary issue. During a sales pitch to the tf ffi ffi ti ti ti ti fi • ti fi • brokers, Dhaliwal then uses these numbers as the base-case produc on levels that Feggans Resources will achieve. • Comment: When presen ng informa on to the brokers, Dhaliwal should have given a range of produc on scenarios and the probability of Feggans Resources achieving each level. By giving the maximum produc on level as the likely level of produc on, he has misrepresented the chances of achieving that produc on level and seriously misled the brokers. Dhaliwal has violated Standard V(A). Example 3 (Developing a Reasonable Basis): • Brendan Wi , a former junior sell-side technology analyst, decided to return to school to earn an MBA. To keep his research skills and industry knowledge sharp, Wi accepted a posi on with On-line and Informed, an independent internet-based research company. The posi on requires the publica on of a recommenda on and report on a di erent company every month. Ini ally, Wi is a regular contributor of new research and a par cipant in the associated discussion boards that generally have posi ve comments on the technology sector. Over me, his ability to manage his educa onal requirements and his work requirements begin to con ict with one another. Knowing a recommenda on is due the next day for On-line, Wi creates a report based on a few news ar cles and what the conven onal wisdom of the markets has deemed the “hot” security of the day. • Comment: Wi ’s knowledge of and exuberance for technology stocks, a few news ar cles, and the conven onal wisdom of the markets do not cons tute, without more informa on, a reasonable and adequate basis for a stock recommenda on that is supported by appropriate research and inves ga on. Therefore, Wi has violated Standard V(A). See also Standard IV(C)–Responsibili es of Supervisors because it relates to the rm’s inadequate procedures. tt ti ti ti ft ti ti ti ti ti ti fi ti fi ti fi tt ti fl ffi ffi ti ti ff tt ti ti ti ti ti fi ti fi ti ti ti tt ft tf fl ti fi ti Comment: Chandler has failed to sa sfy the requirement of Standard V(A). Although Dalton updated the manager ra ngs to re ect the personnel turnover at one of the rms, Chandler did not update her report to re ect the new informa on. ti • ti Kristen Chandler is an investment consultant in the London o ce of Dalton Securi es, a major global investment consultant rm. One of her UK pension funds has decided to appoint a specialist US equity manager. Dalton’s global manager of research relies on local consultants to cover managers within their regions and, a er conduc ng thorough due diligence, puts their views and ra ngs in Dalton’s manager database. Chandler accesses Dalton’s global manager research database and conducts a screen of all US equity managers on the basis of a match with the client’s desired philosophy/style, performance, and tracking-error targets. She selects the ve managers that meet these criteria and puts them in a brie ng report that is delivered to the client 10 days later. Between the me of Chandler’s database search and the delivery of the report to the client, Chandler is told that Dalton has updated the database with the informa on that one of the rms that Chandler has recommended for considera on lost its chief investment o cer, the head of its US equity research, and the majority of its por olio managers on the US equity product—all of whom have le to establish their own rm. Chandler does not revise her report with this updated informa on. fi • ti ti fl tt ti tt ti ti ti ti ti ti ti Example 4 (Timely Client Updates): • Evelyn Mastakis is a junior analyst who has been asked by her rm to write a research report predic ng the expected interest rate for residen al mortgages over the next six months. Mastakis submits her report to the xed-income investment commi ee of her rm for review, as required by rm procedures. Although some commi ee members support Mastakis’s conclusion, the majority of the commi ee disagrees with her conclusion, and the report is signi cantly changed to indicate that interest rates are likely to increase more than originally predicted by Mastakis. Should Mastakis ask that her name be taken o the report when it is disseminated? • Comment: The results of research are not always clear, and di erent people may have di erent opinions based on the same factual evidence. In this case, the commi ee may have valid reasons for issuing a report that di ers from the analyst’s original research. The rm can issue a report that is di erent from the original report of an analyst as long as there is a reasonable and adequate basis for its conclusions. • Generally, analysts must write research reports that re ect their own opinion and can ask the rm not to put their name on reports that ul mately di er from that opinion. When the work is a group e ort, however, not all members of the team may agree with all aspects of the report. Ul mately, members and candidates can ask to have their names removed from the report, but if they are sa s ed that the process has produced results or conclusions that have a reasonable and adequate basis, members and candidates do not have to dissociate from the report even when they do not agree with its contents. If Mastakis is con dent in the process, she does not need to dissociate from the report even if it does not re ect her opinion. Example 6 (Reliance on Third-Party Research): • Gary McDermo runs a two-person investment management rm. McDermo ’s rm subscribes to a service from a large investment research rm that provides research reports. McDermo ’s rm makes investment recommenda ons on the basis of these reports. • Comment: Members and candidates can rely on third-party research but must make reasonable and diligent e orts to determine that such research is sound. If McDermo undertakes due diligence e orts on a regular basis to ensure that the research produced by the large rm is objec ve and reasonably based, McDermo can rely on that research when making investment recommenda ons to clients. Example 7 (Due Diligence in Submanager Selec on): ti fi ti fi ff ti tt ti fi fi tt fi fi tt ti tt tt fi fi fi fi fi ff fi tt ti fl ff fi fi ti ti ti ti fi fi fi tt ti ti fl tt fi ff ff ti Paul Ostrowski’s business has grown signi cantly over the past couple of years, and some clients want to diversify interna onally. Ostrowski decides to nd a sub- manager to handle the expected interna onal investments. Because this will be his rst subadviser, Ostrowski uses the CFA Ins tute model “request for proposal” to design a ques onnaire for his search. By his deadline, he receives seven completed ques onnaires from a variety of domes c and interna onal rms trying to gain his business. Ostrowski reviews all the applica ons in detail and decides to select the rm that charges the lowest fees because doing so will have the least impact on his rm’s bo om line. ti tt tt ff ti ti fi ff ti ff • ff fi Example 5 (Group Research Opinions): • Comment: The selec on of an external adviser or subadviser should be based on a full and complete review of the adviser’s services, performance history, and cost structure. In basing the decision on the fee structure alone, Ostrowski may be viola ng Standard V(A). See also Standard III(C)–Suitability because it relates to the ability of the selected adviser to meet the needs of the clients. Example 8 (Su cient Due Diligence): • Michael Papis is the chief investment o cer of his state’s re rement fund. The fund has always used outside advisers for the real estate alloca on, and this informa on is clearly presented in all fund communica ons. Thomas Nagle, a recognized sell-side research analyst and Papis’s business school classmate, recently le the investment bank he worked for to start his own asset management rm, Accessible Real Estate. Nagle is trying to build his assets under management and contacts Papis about gaining some of the re rement fund’s alloca on. In the previous few years, the performance of the re rement fund’s real estate investments was in line with the fund’s benchmark but was not extraordinary. Papis decides to help out his old friend and also to seek be er returns by moving the real estate alloca on to Accessible. The only no ce of the change in adviser appears in the next annual report in the lis ng of associated advisers. • Comment: Papis violated Standard V(A). His responsibili es may include the selec on of the external advisers, but the decision to change advisers appears to have been arbitrary. If Papis was dissa s ed with the current real estate adviser, he should have conducted a proper solicita on to select the most appropriate adviser. See also Standard IV(C)–Responsibili es of Supervisors, Standard V(B)– Communica on with Clients and Prospec ve Clients, and Standard VI(A)–Disclosure of Con icts. Example 9 (Su cient Due Diligence): • Andre Shrub owns and operates Conduit, an investment advisory rm. Prior to opening Conduit, Shrub was an account manager with Elite Investment, a hedge fund man- aged by his good friend Adam Reed. To a ract clients to a new Conduit fund, Shrub o ers lower-than-normal management fees. He can do so because the fund consists of two top-performing funds managed by Reed. Given his personal friendship with Reed and the prior performance record of these two funds, Shrub believes this new fund is a winning combina on for all par es. Clients quickly invest with Conduit to gain access to the Elite funds. No one is turned away because Conduit is seeking to expand its assets under management. • Comment: Shrub violated Standard V(A) by not conduc ng a thorough analysis of the funds managed by Reed before developing the new Conduit fund. Shrub’s reliance on his personal rela onship with Reed and his prior knowledge of Elite are insu cient jus ca on for the investments. The funds may be appropriately considered, but a full review of their opera ng procedures, repor ng prac ces, and transparency are some elements of the necessary due diligence. See also Standard III(C)–Suitability. Example 10 (Su cient Due Diligence): fi fi ti ti fl ti ti ti ti ti ti tt fi fi ti fi ff ti ti ti ti ti fi ti ti ti tf ti ti ffi ti ti ti ti ti ffi ti ti ti ti ft Bob Thompson has been doing research for the por olio manager of the xed-income department. His assignment is to do sensi vity analysis on securi zed subprime mortgages. He has discussed with the manager possible scenarios to use to calculate expected returns. A key assump on in such calcula ons is housing price apprecia on (HPA) because it drives “prepays” (prepayments of mortgages) and losses. Thompson is concerned with the signi cant apprecia on experienced over the previous ve years as a result of the increased availability of funds from subprime mortgages. Thompson insists that the analysis should include a scenario run with –10% for Year 1, –5% for Year 2, ti ti tt ffi ffi ffi fi ti ti ti ti • and then (to project a worst-case scenario) 0% for Years 3 through 5. The manager replies that these assump ons are too dire because there has never been a me in their available database when HPA was nega ve. • Thompson conducts his research to be er understand the risks inherent in these securi es and evaluates these securi es in the worst-case scenario, a less likely but possible environment. Based on the results of the enhanced scenarios, Thompson does not recommend the purchase of the securi za on. Against the general market trends, the manager follows Thompson’s recommenda on and does not invest. The following year, the housing market collapses. In avoiding the subprime investments, the manager’s por olio outperforms its peer group that year. • Comment: Thompson’s ac ons in running the scenario test with inputs beyond the historical trends available in the rm’s databases adhere to the principles of Standard V(A). His concerns over recent trends provide a sound basis for further analysis. Thompson understands the limita ons of his model, when combined with the limited available historical informa on, to accurately predict the performance of the funds if market condi ons change nega vely. See also Standard I(B)– Independence and Objec vity. Example 11 (Use of Quan ta vely Oriented Models): • Espacia Liakos works in sales for Hellenica Securi es, a rm specializing in developing intricate deriva ve strategies to pro t from par cular views on market expecta ons. One of her clients is Eugenie Carapalis, who has become convinced that commodity prices will become more vola le over the coming months. Carapalis asks Liakos to quickly engineer a strategy that will bene t from this expecta on. Liakos turns to Hellenica’s modeling group to ful ll this request. Because of the ght deadline, the modeling group outsources parts of the work to several trusted third par es. Liakos implements the disparate components of the strategy as the rms complete them. • Within a month, Carapalis is proven correct: Vola lity across a range of commodi es increases sharply. But her deriva ves posi on with Hellenica returns huge losses, and the losses increase daily. Liakos inves gates and realizes that although each of the various components of the strategy had been validated, they had never been evaluated as an integrated whole. In extreme condi ons, por ons of the model worked at cross-purposes with other por ons, causing the overall strategy to fail drama cally. • Comment: Liakos violated Standard V(A). Members and candidates must understand the sta s cal signi cance of the results of the models they recommend and must be able to explain them to clients. Liakos did not take adequate care to ensure a thorough review of the whole model; its components were evaluated only individually. Because Carapalis clearly intended to implement the strategy as a whole rather than as separate parts, Liakos should have tested how the components of the strategy interacted as well as how they performed individually. Example 12 (Successful Due Diligence/Failed Investment): ti ti ti ti ti ti ti ti fi ti ti ti fi ti ti fi fi ti ti ti ti fi ti ti fi ti tt ti tf ti ti ti fi ti ti ti Alton Newbury is an investment adviser to high-net-worth clients. A client with an aggressive risk pro le in his investment policy statement asks about inves ng in the Top Shelf hedge fund. This fund, based in Calgary, Alberta, Canada, has reported 20% returns for the rst three years. The fund prospectus states that its strategy involves long and short posi ons in the energy sector and extensive leverage. Based on his analysis of the fund’s track record, the principals involved in managing the fund, the fees charged, and the fund’s risk pro le, Newbury recommends the fund to the client and ti fi ti ti ti ti ti ti ti ti fi ti fi • secures a posi on in it. The next week, the fund announces that it has su ered a loss of 60% of its value and is suspending opera ons and redemp ons un l a er a regulatory review. Newbury’s client calls him in a panic and asks for an explana on. • Comment: Newbury’s ac ons were consistent with Standard V(A). Analysis of an investment that results in a reasonable basis for recommenda on does not guarantee that the investment has no downside risk. Newbury should discuss the analysis process with the client while reminding him or her that past performance does not lead to guaranteed future gains and that losses in an aggressive investment por olio should be expected. Example 13 (Quan ta ve Model Diligence): • Barry Cannon is the lead quan ta ve analyst at CityCenter Hedge Fund. He is responsible for the development, maintenance, and enhancement of the proprietary models the fund uses to manage its investors’ assets. Cannon reads several high-level mathema cal publica ons and blogs to stay informed of current developments. One blog, run by Expert CFA, presents some intriguing research that may bene t one of CityCenter’s current models. Cannon is under pressure from rm execu ves to improve the model’s predic ve abili es, and he incorporates the factors discussed in the online research. The updated output recommends several new investments to the fund’s por olio managers. • Comment: Cannon has violated Standard V(A) by failing to have a reasonable basis for the new recommenda ons made to the por olio managers. He needed to diligently research the e ect of incorpora ng the new factors before o ering the output recommenda ons. Cannon may use the blog for ideas, but it is his responsibility to determine the e ect on the rm’s proprietary models. See Standard VII(B) regarding the viola on by “Expert CFA” in the use of the CFA designa on. ti ff tf fi ti fi ti ti fi ff tt ti ti ti ff fi fi ft ti ti ft ti ti ff ffi ti ti ti ti ti ff ti tf ti ti fi ti ti ti ti ti ti ti ti tt ti ti ti Comment: Smith’s ac ons do not demonstrate a su cient level of diligence in reviewing this product to make a recommenda on for selec ng the service. Besides not reviewing or considering the other four poten al systems, she did not determine whether the “black box” a ribu on process aligns with the investment prac ces of the rm, including its investments in di erent countries and currencies. Smith must review and understand the process of any so ware or system before recommending its use as the rm’s a ribu on system. ti • ti Ellen Smith is a performance analyst at Ar c Global Advisors, a rm that manages global equity mandates for ins tu onal clients. She was asked by her supervisor to review ve new performance a ribu on systems and recommend one that would more appropriately explain the rm’s investment strategy to clients. On the list was a system she recalled learning about when visi ng an exhibitor booth at a recent conference. The system is highly quan ta ve and something of a “black box” in how it calculates the a ribu on values. Smith recommended this op on without researching the others because the sheer complexity of the process was sure to impress the clients. tt • ti tf fi ti ti ti fi ti ti tt Example 14 (Selec ng a Service Provider): • Craig Jackson is working for Adams Partners, Inc., and has been assigned to select a hedge fund subadviser to improve the diversi ca on of the rm’s large fund-of-funds product. The alloca on must be in place before the start of the next quarter. Jackson uses a consultant database to nd a list of suitable rms that claim compliance with the GIPS standards. He calls more than 20 rms on the list to con rm their poten al interest and to determine their most recent quarterly and annual total return values. Because of the short turnaround, Jackson recommends the rm with the greatest total return values for selec on. • Comment: By considering only performance and GIPS compliance, Jackson has not conducted su cient review of poten al rms to sa sfy the requirements of Standard V(A). A thorough inves ga on of the rms and their opera ons should be conducted to ensure that their addi on would increase the diversity of clients’ por olios and that they are suitable for the fund-of-funds product. Example 16 (Manager Selec on): • Timothy Green works for Peach Asset Management, where he creates proprietary models that analyze data from the rm request for proposal ques onnaires to iden fy managers for possible inclusion in the rm’s fund-of-funds investment pla orm. Various criteria must be met to be accepted to the pla orm. Because of the number of respondents to the ques onnaires, Green uses only the data submi ed to make a recommenda on for adding a new manager. • Comment: By failing to conduct any addi onal outside review of the informa on to verify what was submi ed through the request for proposal, Green has likely not sa s ed the requirements of Standard V(A). The amount of informa on requested from outside managers varies among rms. Although the requested informa on may be comprehensive, Green should ensure su cient e ort is undertaken to verify the submi ed informa on before recommending a rm for inclusion. This requires that he goes beyond the informa on provided by the manager on the request for proposal ques onnaire and may include interviews with interested managers, reviews of regulatory lings, and discussions with the managers’ custodian or auditor. ti ff ti ti fi fi fi fi ffi ti ti fi fi fi ti fi ti ti fi ti ti tf fi fi ti tf ti ti ti ti ti ti ti fi ti ti tt ti fi ti ti ti Dupont’s recently assigned objec ve is to develop a new emerging market corporate credit risk model. The rm is planning to expand into emerging credit, and the development of such a model is a cri cal step in this process. Because Smith seems to follow the model’s recommenda ons without much concern for its quality as he develops his clients’ investment strategies, Dupont decides to focus his me on the development of the new emerging market model and neglects to update the US model. ti • ti Dupont does not interact with or manage money for any of the rm’s clients. He is in contact with the rm’s US corporate bond fund manager, John Smith, who has only very super cial knowledge of the model and who from me to me asks very basic ques ons regarding the output recommenda ons. Smith does not consult Dupont with respect to nalizing his clients’ investment strategies. ti • fi Jérôme Dupont works for the credit research group of XYZ Asset Management, where he is in charge of developing and upda ng credit risk models. In order to perform accurately, his models need to be regularly updated with the latest market data. ti • fi fi fi fi tt fi tf ti tt ti ti ti ffi Example 17 (Technical Model Requirements): ti fi Example 15 (Subadviser Selec on): • A er several months without regular updates, Dupont’s diagnos c sta s cs start to show alarming signs with respect to the quality of the US credit model. Instead of conduc ng the long and complicated data update, Dupont introduces new codes into his model with some limited new data as a quick “ x.” He thinks this change will address the issue without needing to complete the full data update, so he con nues working on the new emerging market model. • Several months following the quick “ x,” another set of diagnos c sta s cs reveals nonsensical results and Dupont realizes that his earlier change contained an error. He quickly corrects the error and alerts Smith. Smith realizes that some of the prior trades he performed were due to erroneous model results. Smith rebalances the por olio to remove the securi es purchased on the basis of the ques onable results without repor ng the issue to anyone else. • Comment: Smith violated standard V(A) because exercising “diligence, independence, and thoroughness in analyzing investments, making investment recommenda ons, and taking investment ac ons” means that members and candidates must understand the technical aspects of the products they provide to clients. Smith does not understand the model he is relying on to manage money. Members and candidates should also make reasonable enquiries into the source and accuracy of all data used in comple ng their investment analysis and recommenda ons. • Dupont violated V(A) even if he does not trade securi es or make investment decisions. Dupont’s models give investment recommenda ons, and Dupont is accountable for the quality of those recommenda ons. Members and candidates should make reasonable e orts to test the output of pre-programmed analy cal tools they use. Such valida on should occur before incorpora ng the tools into their decision-making process. See also Standard V(B)–Communica on with Clients and Prospec ve Clients. B. Communica on with Clients and Prospec ve Clients ti ti ti tf ti ti ti ti ti ti ff ti ti ti ti ti ff ti ti ti ti fl tt ti ti tt ti tt ti tf ti ti fi ti Comment: Williamson’s plans for the newsle er violate Standard V(B). Williamson need not describe the investment system in detail in order to implement the advice e ec vely, but she must inform clients of Country Technicians’ basic process and logic. Without understanding the basis for a recommenda on, clients cannot possibly understand its limita ons or its inherent risks. ti • ti Sarah Williamson, director of marke ng for Country Technicians, Inc., is convinced that she has found the perfect formula for increasing Country Technicians’ income and diversifying its product base. Williamson plans to build on Country Technicians’ reputa on as a leading money manager by marke ng an exclusive and expensive investment advice le er to high-net-worth individuals. One hitch in the plan is the complexity of Country Technicians’ investment system—a combina on of technical trading rules (based on historical price and volume uctua ons) and por olio construc on rules designed to minimize risk. To simplify the newsle er, she decides to include only each week’s top ve “buy” and “sell” recommenda ons and to leave out details of the valua on models and the por olio structuring scheme. ti • ti ffi ti ti ti fi ti ti ti fi tf ti ft Example 1 (Su cient Disclosure of Investment System): Example 2 (Providing Opinions as Facts): • Richard Dox is a mining analyst for East Bank Securi es. He has just nished his report on Boisy Bay Minerals. Included in his report is his own assessment of the geological extent of mineral reserves likely to be found on the company’s land. Dox completed this calcula on on the basis of the core samples from the company’s latest drilling. According to Dox’s calcula ons, the company has more than 500,000 ounces of gold on the property. Dox concludes his research report as follows: “Based on the fact that the company has 500,000 ounces of gold to be mined, I recommend a strong BUY.” • Comment: If Dox issues the report as wri en, he will violate Standard V(B). His calcula on of the total gold reserves for the property based on the company’s recent sample drilling is a quan ta ve opinion, not a fact. Opinion must be dis nguished from fact in research reports. Example 3 (Proper Descrip on of a Security): • Olivia Thomas, an analyst at Government Brokers, Inc., which is a brokerage rm specializing in government bond trading, has produced a report that describes an investment strategy designed to bene t from an expected decline in US interest rates. The rm’s deriva ve products group has designed a structured product that will allow the rm’s clients to bene t from this strategy. Thomas’s report describing the strategy indicates that high returns are possible if various scenarios for declining interest rates are assumed. Ci ng the proprietary nature of the structured product underlying the strategy, the report does not describe in detail how the rm is able to o er such returns or the related risks in the scenarios, nor does the report address the likely returns of the strategy if, contrary to expecta ons, interest rates rise. • Comment: Thomas has violated Standard V(B) because her report fails to describe properly the basic characteris cs of the actual and implied risks of the investment strategy, including how the structure was created and the degree to which leverage was embedded in the structure. The report should include a balanced discussion of how the strategy would perform in the case of rising as well as falling interest rates, preferably illustra ng how the strategies might be expected to perform in the event of a reasonable variety of interest rate and credit risk–spread scenarios. If liquidity issues are relevant with regard to the valua on of either the deriva ves or the underlying securi es, provisions the rm has made to address those risks should also be disclosed. ca on of Fund Mandate Change): fi ti ti ti ti tt ti ti ti fi fi ti ff ti fi ti ti fi ti ti ti fi ft fi ti fi ti ti ti tt ti ti ti ti ti ft ti Comment: Although May’s CIO is correct about informing poten ally interested par es as to the change in investment process, he must also no fy May’s exis ng clients. Among the la er group might be a number of clients who not only retained May as a small-cap manager but also retained mid-cap and large-cap specialists in a mul ple-manager approach. Such clients could regard May’s change of criteria as a style change that distorts their overall asset alloca ons. ti • ti May & Associates is an aggressive growth manager that has represented itself since its incep on as a specialist at inves ng in small-cap US stocks. One of May’s selec on criteria is a maximum capitaliza on of US$250 million for any given company. A er a string of successful years of superior performance rela ve to its peers, May has expanded its client base signi cantly, to the point at which assets under management now exceed US$3 billion. For liquidity purposes, May’s chief investment o cer (CIO) decides to li the maximum permissible market-cap ceiling to US$500 million and change the rm’s sales and marke ng literature accordingly to inform prospec ve clients and thirdparty consultants. ti • fi ti ti fi ti ti fi ffi Example 4 (No ca on of Fund Mandate Change): • Rather than li ing the ceiling for its universe from US$250 million to US$500 million, May & Associates extends its small-cap universe to include a number of non-US companies. • Comment: Standard V(B) requires that May’s CIO advise May’s clients of this change because the rm may have been retained by some clients speci cally for its prowess at inves ng in US small-cap stocks. Other changes that require client no ca on are introducing deriva ves to emulate a certain market sector or relaxing various other constraints, such as por olio beta. In all such cases, members and candidates must disclose changes to all interested par es. Example 6 (No ca on of Changes to the Investment Process): • RJZ Capital Management is an ac ve value-style equity manager that selects stocks by using a combina on of four mul factor models. The rm has found favorable results when back tes ng the most recent 10 years of available market data in a new dividend discount model (DDM) designed by the rm. This model is based on projected in a on rates, earnings growth rates, and interest rates. The president of RJZ decides to replace its simple model that uses price to trailing 12-month earnings with the new DDM. • Comment: Because the introduc on of a new and di erent valua on model represents a material change in the investment process, RJZ’s president must communicate the change to the rm’s clients. RJZ is moving away from a model based on hard data toward a new model that is at least partly dependent on the rm’s forecas ng skills. Clients would likely view such a model as a signi cant change rather than a mere re nement of RJZ’s process. Example 7 (No ca on of Changes to the Investment Process): • RJZ Capital Management loses the chief architect of its mul factor valua on system. Without informing its clients, the president of RJZ decides to redirect the rm’s tal- ents and resources toward developing a product for passive equity management—a product that will emulate the performance of a major market index. • Comment: By failing to disclose to clients a substan al change to its invest- ment process, the president of RJZ has violated Standard V(B). ca on of Changes to the Investment Process): fi ft ti ti fi tf fi ti tt tf ti ti ti ti fi ti fi tf ti ti ff ti ti ti ti ti fi ti fi fi fl ti tf ti ti ft ti fi ti ti ti ti ti fi Comment: Morales must disclose the process change to all her clients. Some of Fundamental’s clients might be concerned about the morale and mo va on among the rm’s best research analysts a er such a change. Moreover, clients might challenge the stock-picking track record of the por olio managers and might even want to monitor the situa on closely. fi • fi At Fundamental Asset Management, Inc., the responsibility for selec ng stocks for addi on to the rm’s “approved” list has just shi ed from individual security analysts to a commi ee consis ng of the research director and three senior por olio managers. Eleanor Morales, a por olio manager with Fundamental Asset Management, thinks this change is not important enough to communicate to her clients. fi • fi ti ti ti ti ft ti Example 8 (No fi fi Example 5 (No • Amanda Chinn is the investment director for Diversi ed Asset Management, which manages the endowment of a charitable organiza on. Because of recent sta departures, Diversi ed has decided to limit its direct investment focus to large-cap securi es and supplement the needs for small-cap and mid-cap management by hiring outside fund managers. In describing the planned strategy change to the charity, Chinn’s update le er states, “As investment director, I will directly oversee the investment team man- aging the endowment’s large-capitaliza on alloca on. I will coordinate the selec on and ongoing review of external managers responsible for alloca ons to other classes.” The le er also describes the reasons for the change and the characteris cs external managers must have to be considered. • Comment: Standard V(B) requires the disclosure of the investment pro- cess used to construct the por olio of the fund. Changing the investment process from managing all classes of investments within the rm to the use of external managers is one example of informa on that needs to be communicated to clients. Chinn and her rm have embraced the principles of Standard V(B) by providing their client with relevant informa on. The charity can now make a reasonable decision about whether Diversi ed Asset Management remains the appropriate manager for its fund. Example 10 (No Michael Papis is the chief investment o cer of his state’s re rement fund. The fund has always used outside advisers for the real estate alloca on, and this informa on is clearly presented in all fund communica ons. Thomas Nagle, a recognized sell-side research analyst and Papis’s business school classmate, recently le the investment bank he worked for to start his own asset management rm, Accessible Real Estate. Nagle is trying to build his assets under management and contacts Papis about gaining some of the re rement fund’s alloca on. In the previous few years, the performance of the re rement fund’s real estate investments was in line with the fund’s benchmark but was not extraordinary. Papis decides to help out his old friend and also to seek be er returns by moving the real estate alloca on to Accessible. The only no ce of the change in adviser appears in the next annual report in the lis ng of associated advisers. • Comment: Papis has violated Standard V(B). He a empted to hide the nature of his decision to change external managers by making only a limited dis- closure. The plan recipients and the fund’s trustees need to be aware when changes are made to ensure that opera onal procedures are being followed. See also Standard IV(C)–Responsibili es of Supervisors, Standard V(A)–Diligence and Reasonable Basis, and Standard VI(A)–Disclosure of Con icts. ca on of Errors): fi ti ti tt fi fi ti tt ti fi ff ti ti ti ti ti fl ti ti fi ti tt ti fi ti ti ti fi ti ffi ti tt ti ti ti fi ti ti ti ft ti fi Dupont does not interact with or manage money for any of the rm’s clients. He is in contact with the rm’s US corporate bond fund manager, John Smith, who has only very super cial knowledge of the model and who from me to me asks very basic ques ons regarding the output recommenda ons. Smith does not consult Dupont with respect to nalizing his clients’ investment strategies. fi • ti Jérôme Dupont works for the credit research group of XYZ Asset Management, where he is in charge of developing and upda ng credit risk models. In order to perform accurately, his models need to be regularly updated with the latest market data. ti • ti ffi fi ti tf ca on of Changes to the Investment Process): • Example 11 (No ti fi Example 9 (Su cient Disclosure of Investment System): • Dupont’s recently assigned objec ve is to develop a new emerging market corporate credit risk model. The rm is planning to expand into emerging credit, and the development of such a model is a cri cal step in this process. Because Smith seems to follow the model’s recommenda ons without much concern for its quality as he develops his clients’ investment strategies, Dupont decides to focus his me on the development of the new emerging market model and neglects to update the US model. • A er several months without regular updates, Dupont’s diagnos c sta s cs start to show alarming signs with respect to the quality of the US credit model. Instead of conduc ng the long and complicated data update, Dupont introduces new codes into his model with some limited new data as a quick “ x.” He thinks this change will address the issue without needing to complete the full data update, so he con nues working on the new emerging market model. • Several months following the quick “ x,” another set of diagnos c sta s cs reveals nonsensical results and Dupont realizes that his earlier change contained an error. He quickly corrects the error and alerts Smith. Smith realizes that some of the prior trades he performed were due to erroneous model results. Smith rebalances the por olio to remove the securi es purchased on the basis of the ques onable results without repor ng the issue to anyone else. • Comment: Smith violated V(B) by not disclosing a material error in the investment process. Clients should have been informed about the error and the correc ve ac ons the rm was undertaking on their behalf. See also Standard V(A)–Diligence and Reasonable Basis. ca on of Risks and Limita ons): ti ti ti ti ti ti ffi ff ti fi ti ti ti ti fi ti ti ti ti ti ti ti ti fi ti ti tf ti ti ff fi ti ti ti ti ti ti Alan Wellard, the manager of the marke ng team, is a partner with 30 years of marke ng experience and explains to Yakovlev that these are complex technical issues that will muddy the marke ng message. According to Wellard, the o ering material should focus solely on the great track record of the fund. Yakovlev does not object because the fund has only US$12 million of capital, very far from the US$100 million threshold. ti • ti A er two years, the strategy has generated performance returns greater than the appropriate benchmark and the Sharpe ra o of the fund is close to 1.0. On the basis of these results, QSC decides to ac vely market the fund to large ins tu onal investors. While crea ng the o ering materials, Yakovlev informs the marke ng team that the capacity of the strategy is limited. The extent of the limita on is di cult to ascertain with precision; it depends on market liquidity and other factors in his model that can evolve over me. Yakovlev indicates that given the current market condi ons, investments in the fund beyond US$100 million of capital could become more di cult and nega vely a ect expected fund returns. ti • ti Quan ta ve analyst Yuri Yakovlev has developed an investment strategy that selects small-cap stocks on the basis of quan ta ve signals. Yakovlev’s strategy typically iden es only a small number of stocks (10–20) that tend to be illiquid, but according to his backtests, the strategy generates signi cant risk-adjusted returns. The partners at Yakovlev’s rm, QSC Capital, are impressed by these results. A er a thorough examina on of the strategy’s risks, stress tes ng, historical back tes ng, and scenario analysis, QSC decides to seed the strategy with US$10 million of internal capital in order for Yakovlev to create a track record for the strategy. fi • ti ffi fi fi ft ti ti ti ti fi ti ti ti ft ft ff Example 12 (No • Comment: Yakovlev and Wellard have not appropriately disclosed a signi cant limita on associated with the investment product. Yakovlev believes this limita on, once reached, will materially a ect the returns of the fund. Although the fund is currently far from the US$100 million mark, current and prospec ve investors must be made aware of this capacity issue. If signi cant limita ons are complicated to grasp and clients do not have the technical background required to understand them, Yakovlev and Wellard should either educate the clients or ascertain whether the fund is suitable for each client. Example 13 (No ca on of Risks and Limita ons): • Brickell Advisers o ers investment advisory services mainly to South American clients. Julie a Ramon, a risk analyst at Brickell, describes to clients how the rm uses value at risk (VaR) analysis to track the risk of its strategies. Ramon assures clients that calcula ng a VaR at a 99% con dence level, using a 20-day holding period, and applying a methodology based on an ex ante Monte Carlo simula on is extremely e ec ve. The rm has never had losses greater than those predicted by this VaR analysis. • Comment: Ramon has not su ciently communicated the risks associated with the investment process to sa sfy the requirements of Standard V(B). The losses predicted by a VaR analysis depend greatly on the inputs used in the model. The size and probability of losses can di er signi cantly from what an individual model predicts. Ramon must disclose how the inputs were selected and the poten al limita ons and risks associated with the investment strategy. Example 14 (No ca on of Risks and Limita ons): • Lily Smith a ended an industry conference and no ced that John Baker, an investment manager with Baker Associates, a racted a great deal of a en on from the conference par cipants. On the basis of her knowledge of Baker’s reputa on and the interest he received at the conference, Smith recommends adding Baker Associates to the approved manager pla orm. Her recommenda on to the approval commi ee included the statement “John Baker is well respected in the industry, and his insights are consistently sought a er by investors. Our clients are sure to bene t from inves ng with Baker Associates.” • Comment: Smith is not appropriately separa ng facts from opinions in her recommenda on to include the manager within the pla orm. Her ac ons con ict with the requirements of Standard V(B). Smith is relying on her opinions about Baker’s reputa on and the fact that many a endees were talking with him at the conference. Smith should also review the requirements of Standard V(A) regarding reasonable basis to determine the level of review necessary to recommend Baker Associates. C. Record Reten on Example 1 (Record Reten on and IPS Objec ves and Recommenda ons): tf ti ff ti ti tt ti fi ti ti ti tt ff fi fi ti fi fi ti tf ti ti fl ti ti fi ti ti ti ti ti ti ti ti tt ff tf ti ft ffi ti fi ti ti tt tt ff One of Nikolas Lindstrom’s clients is upset by the nega ve investment returns of his equity por olio. The investment policy statement for the client requires that the port- folio manager follow a benchmark-oriented approach. The benchmark for the client includes a 35% investment alloca on in the technology sector. The client acknowledges that this alloca on was appropriate, but over the past three years, technology stocks have su ered severe losses. The client complains to the investment manager for alloca ng so much money to this sector. ti fi fi ti ti ti ti ti ti ff tt ti ti • Comment: For Lindstrom, having appropriate records is important to show that over the past three years, the por on of technology stocks in the benchmark index was 35%, as called for in the IPS. Lindstrom should also have the client’s IPS sta ng that the benchmark was appropriate for the client’s investment objec ves. He should also have records indica ng that the investment has been explained appropriately to the client and that the IPS was updated on a regular basis. Taking these ac ons, Lindstrom would be in compliance with Standard V(C). Example 2 (Record Reten on and Research Process): • Malcolm Young is a research analyst who writes numerous reports ra ng companies in the luxury retail industry. His reports are based on a variety of sources, including interviews with company managers, manufacturers, and economists; on-site company visits; customer surveys; and secondary research from analysts covering related industries. • Comment: Young must carefully document and keep copies of all the informa on that goes into his reports, including the secondary or third-party research of other analysts. Failure to maintain such les would violate Standard V(C). Example 3 (Records as Firm, Not Employee, Property): • Mar n Blank develops an analy cal model while he is employed by Green Partners Investment Management, LLP (GPIM). While at the rm, he systema cally documents the assump ons that make up the model as well as his reasoning behind the assump ons. As a result of the success of his model, Blank is hired to be the head of the research department of one of GPIM’s compe tors. Blank takes copies of the records suppor ng his model to his new rm. • Comment: The records created by Blank suppor ng the research model he developed at GPIM are the records of GPIM. Taking the documents with him to his new employer without GPIM’s permission violates Standard V(C). To use the model in the future, Blank must re-create the records suppor ng his model at the new rm. VI. CONFLICTS OF INTEREST A. Disclosure of Con icts fi ti ti ti ti ti ti ti ti ffi ff ti ti ti fi ti ti ti ti ti ti fi ti ti ti ti ti ti Comment: Weiss must disclose in his research report Farmington’s special rela onship with Vimco. Broker/dealer management of and par cipa on in public o erings must be disclosed in research reports. Because the posi on of underwriter to a company entails a special past and poten al future rela onship with a company that is the subject of investment advice, it threatens the independence and objec vity of the report writer and must be disclosed. ti • fi Hunter Weiss is a research analyst with Farmington Company, a broker and invest- ment banking rm. Farmington’s merger and acquisi on department has represented Vimco, a conglomerate, in all of Vimco’s acquisi ons for 20 years. From me to me, Farmington o cers sit on the boards of directors of various Vimco subsidiaries. Weiss is wri ng a research report on Vimco. ti • fl fl ti ti ti ti Example 1 (Con ict of Interest and Business Rela onships): ti fi • Example 2 (Con ict of Interest and Business Stock Ownership): • The investment management rm of Dover & Roe sells a 25% interest in its partnership to a mul na onal bank holding company, First of New York. Immediately a er the sale, Margaret Hobbs, president of Dover & Roe, changes her recommenda on for First of New York’s common stock from “sell” to “buy” and adds First of New York’s commercial paper to Dover & Roe’s approved list for purchase. • Comment: Hobbs must disclose the new rela onship with First of New York to all Dover & Roe clients. This rela onship must also be disclosed to clients by the rm’s por olio managers when they make speci c investment recommenda ons or take investment ac ons with respect to First of New York’s securi es. Example 3 (Con ict of Interest and Personal Stock Ownership): • Carl Fargmon, a research analyst who follows rms producing o ce equipment, has been recommending purchase of Kincaid Prin ng because of its innova ve new line of copiers. A er his ini al report on the company, Fargmon’s wife inherits from a distant rela ve US$3 million of Kincaid stock. He has been asked to write a follow-up report on Kincaid. • Comment: Fargmon must disclose his wife’s ownership of the Kincaid stock to his employer and in his follow-up report. Best prac ce would be to avoid the con ict by asking his employer to assign another analyst to dra the follow-up report. Example 4 (Con ict of Interest and Personal Stock Ownership): • Be y Roberts is specula ng in penny stocks for her own account and purchases 100,000 shares of Drew Mining, Inc., for US$0.30 a share. She intends to sell these shares at the sign of any substan al upward price movement of the stock. A week later, her employer asks her to write a report on penny stocks in the mining industry to be published in two weeks. Even without owning the Drew stock, Roberts would recommend it in her report as a “buy.” A surge in the price of the stock to the US$2 range is likely to result once the report is issued. • Comment: Although this holding may not be material, Roberts must dis- close it in the report and to her employer before wri ng the report because the gain for her will be substan al if the market responds strongly to her recommenda on. The fact that she has only recently purchased the stock adds to the appearance that she is not en rely objec ve. Example 5 (Con ict of Interest and Compensa on Arrangements): ti ffi ft tf ffi tf ti ti ti ti ft tf ti ffi ffi tf ti tt fi fl ti ti ti ti fi ti ti ti fi ti ti ti fi fi ti ti ti tf Samantha Snead, a por olio manager for Thomas Investment Counsel, Inc., specializes in managing public re rement funds and de ned bene t pension plan accounts, all of which have long-term investment objec ves. A year ago, Snead’s employer, in an a empt to mo vate and retain key investment professionals, introduced a bonus compensa on system that rewards por olio managers on the basis of quarterly performance rela ve to their peers and to certain benchmark indexes. In an a empt to improve the short-term performance of her accounts, Snead changes her investment strategy and purchases several high-beta stocks for client por olios. These purchases are seemingly contrary to the clients’ investment policy statements. Following their purchase, an o cer of Gri n Corpora on, one of Snead’s pension fund clients, asks why Gri n Corpora on’s por olio seems to be ft ti fl fl fl fl ti ti ti ti ti fi ti ti tt tt • dominated by high-beta stocks of companies that o en appear among the most ac vely traded issues. No change in objec ve or strategy has been recommended by Snead during the year. • Comment: Snead has violated Standard VI(A) by failing to inform her clients of the changes in her compensa on arrangement with her employer, which created a con ict of interest between her compensa on and her clients’ IPSs. Firms may pay employees on the basis of performance, but pressure by Thomas Investment Counsel to achieve short-term performance goals is in basic con ict with the objec ves of Snead’s accounts. See also Standard III(C)–Suitability. Example 6 (Con ict of Interest, Op ons, and Compensa on Arrangements): • Wayland Securi es works with small companies doing IPOs or secondary o erings. Typically, these deals are in the US$10 million to US$50 million range, and as a result, the corporate nance fees are quite small. To compensate for the small fees, Wayland Securi es usually takes “agent op ons”—that is, rights (exercisable within a two-year me frame) to acquire up to an addi onal 10% of the current o ering. Following an IPO performed by Wayland for Falk Resources, Ltd., Darcy Hunter, the head of corporate nance at Wayland, is concerned about receiving value for her Falk Resources op ons. The op ons are due to expire in one month, and the stock is not doing well. She contacts John Fitzpatrick in the research department of Wayland Securi es, reminds him that he is eligible for 30% of these op ons, and indicates that now would be a good me to give some addi onal coverage to Falk Resources. Fitzpatrick agrees and immediately issues a favorable report. • Comment: For Fitzpatrick to avoid being in viola on of Standard VI(A), he must indicate in the report the volume and expira on date of agent op ons outstanding. Furthermore, because he is personally eligible for some of the op ons, Fitzpatrick must disclose the extent of this compensa on. He also must be careful to not violate his duty of independence and objec vity under Standard I(B). fl ti ti ti ti fi ti ti ti ff ti ti fl ti ti ff ti ft ti ti ti ti ti ti ff ti ti ti fi ti ti Comment: Carter has violated Standard VI(A) by failing to disclose to clients that he is receiving addi onal compensa on for recommending and selling Badger stock. Because he did not disclose the arrangement with Badger to his clients, the clients were unable to evaluate whether Carter’s recommenda ons to buy Badger were a ected by this arrangement. Carter’s conduct also violated Standard VI(A) by failing to disclose to his employer monetary compensa on received in addi on to the compensa on and bene ts conferred by his employer. Carter was required by Standard VI(A) to disclose the arrangement with Badger to his employer so that his employer could evaluate whether the arrangement a ected Carter’s objec vity and loyalty. ti • ti Gary Carter is a representa ve with Bengal Interna onal, a registered broker/dealer. Carter is approached by a stock promoter for Badger Company, who o ers to pay Carter addi onal compensa on for sales of Badger Company’s stock to Carter’s clients. Carter accepts the stock promoter’s o er but does not disclose the arrangements to his clients or to his employer. Carter sells shares of the stock to his clients. ti • ff fl ti fl ti ti ff ti ti ti fi ti ti ti ti ff Example 7 (Con ict of Interest and Compensa on Arrangements): Example 8 (Con ict of Interest and Directorship): • Carol Corky, a senior por olio manager for Universal Management, recently became involved as a trustee with the Chelsea Founda on, a large not-for-pro t founda on in her hometown. Universal is a small money manager (with assets under management of approximately US$100 million) that caters to individual investors. Chelsea has assets in excess of US$2 billion. Corky does not believe informing Universal of her involvement with Chelsea is necessary. • Comment: By failing to inform Universal of her involvement with Chelsea, Corky violated Standard VI(A). Given the large size of the endowment at Chelsea, Corky’s new role as a trustee can reasonably be expected to be me consuming, to the possible detriment of Corky’s por olio responsi- bili es with Universal. Also, as a trustee, Corky may become involved in the investment decisions at Chelsea. Therefore, Standard VI(A) obligates Corky to discuss becoming a trustee at Chelsea with her compliance o cer or supervisor at Universal before accep ng the posi on, and she should have disclosed the degree to which she would be involved in investment decisions at Chelsea. Example 9 (Con ict of Interest and Personal Trading): • Bruce Smith covers eastern European equi es for Marlborough Investments, an investment management rm with a strong presence in emerging markets. While on a business trip to Russia, Smith learns that inves ng in Russian equi es directly is di cult but that equity-linked notes that replicate the performance of underlying Russian equi es can be purchased from a New York–based investment bank. Believing that his rm would not be interested in such a security, Smith purchases a note linked to a Russian telecommunica ons company for his own account without informing Marlborough. A month later, Smith decides that the rm should consider inves ng in Russian equi es by way of the equity-linked notes. He prepares a write-up on the market that concludes with a recommenda on to purchase several of the notes. One note he recommends is linked to the same Russian telecom company that Smith holds in his personal account. • Comment: Smith has violated Standard VI(A) by failing to disclose his pur- chase and ownership of the note linked to the Russian telecom company. Smith is required by the standard to disclose the investment opportunity to his employer and look to his company’s policies on personal trading to determine whether it was proper for him to purchase the note for his own account. By purchasing the note, Smith may or may not have impaired his ability to make an unbiased and objec ve assessment of the appropriate- ness of the deriva ve instrument for his rm, but Smith’s failure to disclose the purchase to his employer impaired his employer’s ability to decide whether his ownership of the security is a con ict of interest that might a ect Smith’s future recommenda ons. Then, when he recommended the par cular telecom notes to his rm, Smith compounded his problems by not disclosing that he owned the notes in his personal account—a clear con ict of interest. Example 10 (Con ict of Interest and Requested Favors): ti fi ti ti ti tf ti tt fl ti ti ti fi ti ti ffi fi ti fi fi ti ff ti ti ti ti ffi ti fi ti tf ti ti ti ft Michael Papis is the chief investment o cer of his state’s re rement fund. The fund has always used outside advisers for the real estate alloca on, and this informa on is clearly presented in all fund communica ons. Thomas Nagle, a recognized sell-side research analyst and Papis’s business school classmate, recently le the investment bank he worked for to start his own asset management rm, Accessible Real Estate. Nagle is trying to build his assets under management and contacts Papis about gaining some of the re rement fund’s alloca on. In the previous few years, the performance of the re rement fund’s real estate investments was in line with the fund’s benchmark but was not extraordinary. Papis decides to help out his old friend and also to seek be er returns by moving the ti fl fl fl fl fi ffi ti ti ti • real estate alloca on to Accessible. The only no ce of the change in adviser appears in the next annual report in the lis ng of associated advisers. • Comment: Papis has violated Standard VI(A) by not disclosing to his employer his personal rela onship with Nagle. Disclosure of his past his- tory with Nagle would allow his rm to determine whether the con ict may have impaired Papis’s independence in deciding to change managers. See also Standard IV(C)–Responsibili es of Supervisors, Standard V(A)–Diligence and Reasonable Basis, and Standard V(B)–Communica on with Clients and Prospec ve Clients. Example 11 (Con ict of Interest and Business Rela onships): • Bob Wade, trust manager for Central Midas Bank, was approached by Western Funds about promo ng its family of funds, with special interest in the service-fee class. To en ce Central to promote this class, Western Funds o ered to pay the bank a service fee of 0.25%. Without disclosing the fee being o ered to the bank, Wade asked one of the investment managers to review the Western Funds family of funds to determine whether they were suitable for clients of Central. The manager completed the normal due diligence review and determined that the funds were fairly valued in the market with fee structures on a par with their compe tors. Wade decided to accept Western’s o er and instructed the team of por olio managers to exclusively promote these funds and the service-fee class to clients seeking to invest new funds or transfer from their current investments. So as to not in uence the investment managers, Wade did not disclose the fee o er and allowed that income to ow directly to the bank. • Comment: Wade is viola ng Standard VI(A) by not disclosing the por on of the service fee being paid to Central. Although the investment managers may not be in uenced by the fee, neither they nor the client have the proper informa on about Wade’s decision to exclusively market this fund family and class of investments. Central may come to rely on the new fee as a component of the rm’s pro tability and may be unwilling to o er other products in the future that could a ect the fees received. See also Standard I(B)–Independence and Objec vity. fi fi ff ti ff ti ti ti ti ti ti ti ti ti ti fl ti fi fi ti ti tf fi ft ff fi ff ti ti ti fl ti ti ti fi ti ti tf ti ti Comment: Standard VI(A) would not require Dagan to disclose her personal or re rement investments in large diversi ed mutual funds, unless speci cally required by her employer. For prac cal reasons, the standard does not require Dagan to gain preclearance for ongoing payroll deduc on contribu ons to re rement plan account investment op ons. ff • ti Yehudit Dagan is a por olio manager for Risk Management Bank (RMB), whose cli- ents include re rement plans and corpora ons. RMB provides a de ned contribu on re rement plan for its employees that o ers 20 large diversi ed mutual fund investment op ons, including a mutual fund managed by Dagan’s RMB colleagues. A er being employed for six months, Dagan became eligible to par cipate in the re rement plan, and she intends to allocate her re rement plan assets in six of the investment op ons, including the fund managed by her RMB colleagues. Dagan is concerned that joining the plan will lead to a poten ally signi cant amount of paperwork for her (e.g., disclosure of her re rement account holdings and needing preclearance for her transac ons), especially with her inves ng in the in-house fund. fl • fl ff fl ti ff fl ti ti ti ti ti ti fi ti ti Example 12 (Disclosure of Con icts to Employers): Dagan should ensure that her rm does not have a speci c policy regarding investment—whether personal or in the re rement account—for funds managed by the company’s employees. These mutual funds may be subject to the company’s disclosure, preclearance, and trading restric on procedures to iden fy possible con icts prior to the execu on of trades. B. Priority of Transac ons Example 1 (Personal Trading): • Research analyst Marlon Long does not recommend purchase of a common stock for his employer’s account because he wants to purchase the stock personally and does not want to wait un l the recommenda on is approved and the stock is purchased by his employer. • Comment: Long has violated Standard VI(B) by taking advantage of his knowledge of the stock’s value before allowing his employer to bene t from that informa on. Example 2 (Trading for Family Member Account): • Carol Baker, the por olio manager of an aggressive growth mutual fund, maintains an account in her husband’s name at several brokerage rms with which the fund and a number of Baker’s other individual clients do a substan al amount of business. Whenever a hot issue becomes available, she instructs the brokers to buy it for her husband’s account. Because such issues normally are scarce, Baker o en acquires shares in hot issues but her clients are not able to par cipate in them. • Comment: To avoid viola ng Standard VI(B), Baker must acquire shares for her mutual fund rst and acquire them for her husband’s account only a er doing so, even though she might miss out on par cipa ng in new issues via her husband’s account. She also must disclose the trading for her husband’s account to her employer because this ac vity creates a con ict between her personal interests and her employer’s interests. ti fi ti ti ti ti ti fl ti fi ti ti ti fi ti ft ti fi fi fl fi ti ti ti ffl ti fi ti Comment: To er has violated Standard VI(B) by breaching her duty to her parents by trea ng them di erently from her other accounts simply because of the family rela onship. As fee-paying clients of Esposito Investments, To er’s parents are en tled to the same treatment as any other client of the rm. If To er has bene cial ownership in the account, however, and Esposito Investments has preclearance and repor ng requirements for personal transac ons, she may have to preclear the trades and report the transac ons to Esposito. ti • tf Erin To er, a por olio manager at Esposito Investments, manages the re rement account established with the rm by her parents. Whenever IPOs become available, she rst allocates shares to all her other clients for whom the investment is appropriate; only then does she place any remaining por on in her parents’ account, if the issue is appropriate for them. She has adopted this procedure so that no one can accuse her of favoring her parents. ti • tf ffl ti ffl ti fi ft ffl ti Example 3 (Family Accounts as Equals): ff fi • • Gary Michaels is an entry-level employee who holds a low-paying job serving both the research department and the investment management department of an ac ve investment management rm. He purchases a sports car and begins to wear expensive clothes a er only a year of employment with the rm. The director of the investment management department, who has responsibility for monitoring the personal stock transac ons of all employees, inves gates and discovers that Michaels has made substan al investment gains by purchasing stocks just before they were put on the rm’s recommended “buy” list. Michaels was regularly given the rm’s quarterly personal transac on form but declined to complete it. • Comment: Michaels violated Standard VI(B) by placing personal transac ons ahead of client transac ons. In addi on, his supervisor violated Standard IV(C)–Responsibili es of Supervisors by permi ng Michaels to con nue to perform his assigned tasks without having signed the quarterly personal transac on form. Note also that if Michaels had communicated informa on about the rm’s recommenda ons to a person who traded the security, that ac on would be a misappropria on of the informa on and a viola on of Standard II(A)–Material Nonpublic Informa on. Example 5 (Trading Prior to Report Dissemina on): • A brokerage’s insurance analyst, Denise Wilson, makes a closed-circuit TV report to her rm’s branches around the country. During the broadcast, she includes nega ve comments about a major company in the insurance industry. The following day, Wilson’s report is printed and distributed to the sales force and public customers. The report recommends that both short-term traders and intermediate investors take pro ts by selling that insurance company’s stock. Seven minutes a er the broadcast, however, Ellen Riley, head of the rm’s trading department, had closed out a long “call” posi on in the stock. Shortly therea er, Riley established a sizable “put” posi on in the stock. When asked about her ac vi es, Riley claimed she took the ac ons to facilitate an cipated sales by ins tu onal clients. • Comment: Riley did not give customers an opportunity to buy or sell in the op ons market before the rm itself did. By taking ac on before the report was disseminated, Riley’s rm may have depressed the price of the calls and increased the price of the puts. The rm could have avoided a con ict of interest if it had waited to trade for its own account un l its clients had an opportunity to receive and assimilate Wilson’s recommenda ons. As it is, Riley’s ac ons violated Standard VI(B). C. Referral Fees Example 1 (Disclosure of Referral Arrangements and Outside Par es): fi fi ft fi ti ti fl ti fi ti ti ti ti ti ti ti fi ti ti ti ti ti ti ft ti fi fi ti ti ti ti ff ti fi ti fi ti ft ti ti ti fi fi ti ti ti ti ti ti Brady Securi es, Inc., a broker/dealer, has established a referral arrangement with Lewis Brothers, Ltd., an investment counseling rm. In this arrangement, Brady Securi es refers all prospec ve taxexempt accounts, including pension, pro t-sharing, and endowment accounts, to Lewis Brothers. In return, Lewis Brothers makes available to Brady Securi es on a regular basis the security recommenda ons and reports of its research sta , which registered representa ves of Brady Securi es use in serving customers. In addi on, Lewis Brothers conducts monthly economic and market reviews for Brady Securi es personnel and directs all stock commission business generated by referral accounts to Brady Securi es. ti ti ti ti ti ti ti ti tti ti fi ti • ti fi Example 4 (Personal Trading and Disclosure): • Willard White, a partner in Lewis Brothers, calculates that the incremental costs involved in func oning as the research department of Brady Securi es are US$20,000 annually. • Referrals from Brady Securi es last year resulted in fee income of US$200,000 for Lewis Brothers, and direc ng all stock trades through Brady Securi es resulted in addi onal costs to Lewis Brothers’ clients of US$10,000. • Diane Branch, the chief nancial o cer of Maxwell Inc., contacts White and says that she is seeking an investment manager for Maxwell’s pro t-sharing plan. She adds, “My friend Harold Hill at Brady Securi es recommended your rm without quali ca on, and that’s good enough for me. Do we have a deal?” White accepts the new account but does not disclose his rm’s referral arrangement with Brady Securi es. • Comment: White has violated Standard VI(C) by failing to inform the prospec ve customer of the referral fee payable in services and commissions for an inde nite period to Brady Securi es. Such disclosure could have caused Branch to reassess Hill’s recommenda on and make a more cri cal evalua on of Lewis Brothers’ services. Example 2 (Disclosure of Interdepartmental Referral Arrangements): • James Handley works for the trust department of Central Trust Bank. He receives compensa on for each referral he makes to Central Trust’s brokerage department and personal nancial management department that results in a sale. He refers several of his clients to the personal nancial management department but does not disclose the arrangement within Central Trust to his clients. • Comment: Handley has violated Standard VI(C) by not disclosing the referral arrangement at Central Trust Bank to his clients. Standard VI(C) does not dis nguish between referral payments paid by a third party for referring clients to the third party and internal payments paid within the rm to a ract new business to a subsidiary. Members and candidates must disclose all such referral fees. Therefore, Handley is required to disclose, at the me of referral, any referral fee agreement in place among Central Trust Bank’s departments. The disclosure should include the nature and the value of the bene t and should be made in wri ng. tt ti ti ti fi ti ti fi fi ti fi ti fi ti fi ti ti ti fi ti fi ti ti ffi ti fi Comment: Roberts is viola ng Standard VI(C) by failing to inform her employer of the referral arrangement. ti • ti Katherine Roberts is a por olio manager at Katama Investments, an advisory rm specializing in managing assets for high-net-worth individuals. Katama’s trading desk uses a variety of brokerage houses to execute trades on behalf of its clients. Roberts asks the trading desk to direct a large por on of its commissions to Naushon, Inc., a small broker/dealer run by one of Roberts’ business school classmates. Katama’s traders have found that Naushon is not very compe ve on pricing, and although Naushon generates some research for its trading clients, Katama’s other analysts have found most of Naushon’s research to be not especially useful. Nevertheless, the traders do as Roberts asks, and in return for receiving a large por on of Katama’s business, Naushon recommends the investment services of Roberts and Katama to its wealthiest clients. This arrangement is not disclosed to either Katama or the clients referred by Naushon. tf • fi ti ti ti ti fi ti ti Example 3 (Disclosure of Referral Arrangements and Informing Firm): Example 4 (Disclosure of Referral Arrangements and Outside Organiza ons): • Alex Burl is a por olio manager at Helpful Investments, a local investment advisory rm. Burl is on the advisory board of his child’s school, which is looking for ways to raise money to purchase new playground equipment for the school. Burl discusses a plan with his supervisor in which he will donate to the school a por on of his service fee from new clients referred by the parents of students at the school. Upon ge ng the approval from Helpful, Burl presents the idea to the school’s advisory board and directors. The school agrees to announce the program at the next parent event and asks Burl to provide the appropriate wri en materials to be distributed. A week fol- lowing the distribu on of the yers, Burl receives the rst school-related referral. In establishing the client’s investment policy statement, Burl clearly discusses the school’s referral and outlines the plans for distribu ng the dona on back to the school. • Comment: Burl has not violated Standard VI(C) because he secured the permission of his employer, Helpful Investments, and the school prior to beginning the program and because he discussed the arrangement with the client at the me the investment policy statement was designed. ti ti fi ti ti ti fi ti ti ti ti ti ti fi ti ti fi ti ti ti ti ti ft ti fi ti tt ti ti fi Regulators and governmental agencies may adopt requirements concerning allowable consultant ac vi es. Local regula ons some mes include having a consultant register with the regulatory agency’s ethics board. Regulator policies may include a prohibi on on acceptance of payments from investment managers receiving alloca ons and require regular report- ing of contribu ons made to poli cal organiza ons and candidates. Arrow would have to adhere to these requirements as well as the Code and Standards. ti • ti Comment: Arrow has violated Standard VI(C) because he did not disclose the fee being paid by Overseas. Withholding this informa on raises the ques on of a poten al lack of objec vity in the recommenda on of Overseas by Arrow; this aspect is in addi on to ques ons about the legality of having rms pay to be considered for an alloca on. ti • ti The following year, news breaks that Arrow is under inves ga on by the local regulator for accep ng kickbacks from investment managers a er they are awarded new pension alloca ons. Overseas Investments is included in the list of rms allegedly making these payments. Although the sponsor is happy with the performance of Overseas since it has been managing the pension plan’s emerging market funds, the sponsor s ll decides to have an independent review of the proposals and the selec on process to ensure that Overseas was the appropriate rm for its needs. This review con rms that, even though Arrow was being paid by both par es, the recommenda on of Overseas appeared to be objec ve and appropriate. tti • ti The sponsor of a state employee pension is seeking to hire a rm to manage the pen- sion plan’s emerging market alloca on. To assist in the review process, the sponsor has hired Thomas Arrow as a consultant to solicit proposals from various advisers. Arrow is contracted by the sponsor to represent its best interest in selec ng the most appropriate new manager. The process runs smoothly, and Overseas Investments is selected as the new manager. tf • ti ti ti fl fi ti ti ti ti ti Example 5 (Disclosure of Referral Arrangements and Outside Par es): VII.RESPONSIBILITIES AS A CFA INSTITUTE MEMBER OR CFA CANDIDATE A. Conduct as Par cipants in CFA Ins tute Programs Example 1 (Sharing Exam Ques ons): • Travis Nero serves as a proctor for the administra on of the CFA examina on in his city. In the course of his service, he reviews a copy of the Level II exam on the evening prior to the exam’s administra on and provides informa on concerning the exam ques ons to two candidates who use it to prepare for the exam. • Comment: Nero and the two candidates have violated Standard VII(A). By giving informa on about the exam ques ons to two candidates, Nero provided an unfair advantage to the two candidates and undermined the integrity and validity of the Level II exam as an accurate measure of the knowledge, skills, and abili es necessary to earn the right to use the CFA designa on. By accep ng the informa on, the candidates also compromised the integrity and validity of the Level II exam and undermined the ethical framework that is a key part of the designa on. Example 2 (Bringing Wri en Material into Exam Room): • Loren Sullivan is enrolled to take the Level II CFA examina on. He has been having di culty remembering a par cular formula, so prior to entering the exam room, he writes the formula on the palm of his hand. During the a ernoon sec on of the exam, a proctor no ces Sullivan looking at the palm of his hand. She asks to see his hand and nds the formula. • Comment: Because Sullivan wrote down informa on from the Candidate Body of Knowledge (CBOK) and took that wri en informa on into the exam room, his conduct compromised the validity of his exam performance and violated Standard VII(A). Sullivan’s conduct was also in direct contradic on with the rules and regula ons of the CFA Program, the Candidate Pledge, and the CFA Ins tute Code and Standards. ti ti ti fi ti ffi ti ti ti ft ti ti ti ti ti ti ti ti ti ti ti ft fi ti fi ti ti ti ti ti ft ti ti tt ti ft ti Comment: By con nuing to complete his exam a er me was called, Davis has violated Standard VII(A). By con nuing to write, Davis took an unfair advantage over other candidates, and his conduct compromised the validity of his exam performance. Addi onally, by not heeding the proctor’s repeated instruc ons, Davis violated the rules and regula ons of the CFA Program ti • tt At the conclusion of the morning sec on of the Level I CFA examina on, the proctors announce, “Stop wri ng now.” John Davis has not completed the exam, so he con nues to randomly ll in ovals on his answer sheet. A proctor approaches Davis’s desk and reminds him that he should stop wri ng immediately. Davis, however, con nues to complete the answer sheet. A er the proctor asks him to stop wri ng two addi onal mes, Davis nally puts down his pencil. ti • ti ti ti ti ti ti ti ti ti ti Example 3 (Wri ng a er Exam Period End): Example 4 (Sharing Exam Content): • A er comple ng Level II of the CFA exam, Annabelle Rossi posts on her blog about her experience. She posts the following: “Level II is complete! I think I did fairly well on the exam. It was really di cult, but fair. I think I did especially well on the deriva ves ques ons. And there were tons of them! I think I counted 18! The ethics ques ons were really hard. I’m glad I spent so much me on the Code and Standards. I was surprised to see there were no ques ons at all about IPO alloca ons. I expected there to be a couple. Well, o to celebrate ge ng through it. See you tonight?” • Comment: Rossi did not violate Standard VII(A) when she wrote about how di cult she found the exam or how well she thinks she may have done. By revealing por ons of the CBOK covered on the exam and areas not covered, however, she did violate Standard VII(A) and the Candidate Pledge. Depending on the me frame in which the comments were posted, Rossi not only may have assisted future candidates but also may have provided an unfair advantage to candidates yet to sit for the same exam, thereby undermining the integrity and validity of the Level II exam. Example 5 (Sharing Exam Content): • Level I candidate E enne Gagne has been a frequent visitor to an internet forum designed speci cally for CFA Program candidates. The week a er comple ng the Level I examina on, Gagne and several others begin a discussion thread on the forum about the most challenging ques ons and a empt to determine the correct answers. • Comment: Gagne has violated Standard VII(A) by providing and solici ng con den al exam informa on, which compromises the integrity of the exam process and violates the Candidate Pledge. In trying to determine correct answers to speci c ques ons, the group’s discussion included ques onspeci c details considered to be con den al to the CFA Program. ti fi ti ti ti ti tt ti ti ti ti ti ffi fi ti ti ti fi ffi ti ti ti ft ti ti ti ti tti ti ti ti ti fi ti ti ti ti ft tt fi ff If the CFA4Sure employees who par cipated in the solicita on of con den al CFA Program informa on are CFA Ins tute members or candidates, they also have violated Standard VII(A). fi • ti Comment: Pena has violated Standard VII(A) by disclosing a por on of the exam ques ons. The informa on provided is considered con den al un l publicly released by CFA Ins tute. CFA4Sure is likely to use such feedback to re ne its review materials for future candidates. Pena’s sharing of the speci c ques ons undermines the integrity of the exam while poten ally making the exam easier for future candidates. fi • ti CFA4Sure is a company that produces test-prepara on materials for CFA Program candidates. Many candidates register for and use the company’s products. The day a er the CFA examina on, CFA4Sure sends an e-mail to all its customers asking them to share with the company the hardest ques ons from the exam so that CFA4Sure can be er prepare its customers for the next exam administra on. Marisol Pena e-mails a summary of the ques ons she found most di cult on the exam. ti • ti ti ti ti ti ti fi fi ffi ft Example 6 (Sharing Exam Content): • Prior to par cipa ng in grading CFA examina ons, Wesley Whitcomb is required to sign a CFA Ins tute Grader Agreement. As part of the Grader Agreement, Whitcomb agrees not to reveal or discuss the exam materials with anyone except CFA Ins tute sta or other graders. Several weeks a er the conclusion of the CFA exam grading, Whitcomb tells several colleagues who are candidates in the CFA Program which ques on he graded. He also discusses the guideline answer and adds that few candidates scored well on the ques on. • Comment: Whitcomb violated Standard VII(A) by breaking the Grader Agreement and disclosing informa on related to a speci c ques on on the exam, which compromised the integrity of the exam process. Example 8 (Compromising CFA Ins tute Integrity as a Volunteer): • Jose Ramirez is an investor-rela ons consultant for several small companies that are seeking greater exposure to investors. He is also the program chair for the CFA Ins tute society in the city where he works. Ramirez schedules only companies that are his clients to make presenta ons to the society and excludes other companies. • Comment: Ramirez, by using his volunteer posi on at CFA Ins tute to bene t himself and his clients, compromises the reputa on and integrity of CFA Ins tute and thus violates Standard VII(A). Example 9 (Compromising CFA Ins tute Integrity as a Volunteer): • Marguerite Warrenski is a member of the CFA Ins tute GIPS Execu ve Commi ee, which oversees the crea on, implementa on, and revision of the GIPS standards. As a member of the Execu ve Commi ee, she has advance knowledge of con den al informa on regarding the GIPS standards, including any new or revised standards the commi ee is considering. She tells her clients that her Execu ve Commi ee membership will allow her to be er assist her clients in keeping up with changes to the Standards and facilita ng their compliance with the changes. • Comment: Warrenski is using her associa on with the GIPS Execu ve Commi ee to promote her rm’s services to clients and poten al clients. In de ning her volunteer posi on at CFA Ins tute as a strategic business advantage over compe ng rms and implying to clients that she would use con den al informa on to further their interests, Warrenski is com- promising the reputa on and integrity of CFA Ins tute and thus viola ng Standard VII(A). She may factually state her involvement with the Execu ve Commi ee but cannot infer any special advantage to her clients from such par cipa on. B. Reference to CFA Ins tute, the CFA Designa on, and the CFA Program Example 1 (Passing Exams in Consecu ve Years): ti ti ti ti ti tt tt fi ti tt ti ti ti ff ti fi fi ti ti tt ti ti fi tt ti ti ti fi fi ti ti ti ti ti ti ti ti ti ti ti ti ti ti ti fi tt ti ti ti ti An adver sement for AZ Investment Advisors states that all the rm’s principals are CFA charterholders and all passed the three examina ons on their rst a empt. The adver sement prominently links this fact to the no on that AZ’s mutual funds have achieved superior performance. ti tt ti ti ti ti ti ti ti ti tt ti fi ti ti • ft fi Example 7 (Discussion of Exam Grading Guidelines and Results): Comment: AZ may state that all principals passed the three examina ons on the rst try as long as this statement is true, but it must not be linked to performance or imply superior ability. Implying that (1) CFA charterholders achieve be er investment results and (2) those who pass the exams on the rst try may be more successful than those who do not violates Standard VII(B). Example 2 (Right to Use CFA Designa on): • Five years a er receiving his CFA charter, Louis Vasseur resigns his posi on as an investment analyst and spends the next two years traveling abroad. Because he is not ac vely engaged in the investment profession, he does not le a completed Professional Conduct Statement with CFA Ins tute and does not pay his CFA Ins tute member- ship dues. At the conclusion of his travels, Vasseur becomes a selfemployed analyst accep ng assignments as an independent contractor. Without reinsta ng his CFA Ins tute membership by ling his Professional Conduct Statement and paying his dues, he prints business cards that display “CFA” a er his name. • Comment: Vasseur has violated Standard VII(B) because his right to use the CFA designa on was suspended when he failed to le his Professional Conduct Statement and stopped paying dues. Therefore, he no longer is able to state or imply that he is an ac ve CFA charterholder. When Vasseur les his Professional Conduct Statement, resumes paying CFA Ins tute dues to ac vate his membership, and completes the CFA Ins tute reinstatement procedures, he will be eligible to use the CFA designa on. Example 3 (“Re red” CFA Ins tute Membership Status): • A er a 25-year career, James Simpson re res from his rm. Because he is not ac vely engaged in the investment profession, he does not le a completed Professional Conduct Statement with CFA Ins tute and does not pay his CFA Ins tute membership dues. Simpson designs a plain business card (without a corporate logo) to hand out to friends with his new contact details, and he con nues to put “CFA” a er his name. • Comment: Simpson has violated Standard VII(B). Because he failed to le his Professional Conduct Statement and ceased paying dues, his membership has been suspended and he has given up the right to use the CFA designa on. CFA Ins tute has procedures, however, for reclassifying a member and charterholder as “re red” and reducing the annual dues. If he wants to obtain re red status, he needs to le the appropriate paperwork with CFA Ins tute. When Simpson receives his no ca on from CFA Ins tute that his membership has been reclassi ed as re red and he resumes paying reduced dues, his membership will be reac vated and his right to use the CFA designa on will be reinstated. ti fi ti ti ti ti ti ti ti ti fi ti ti ti fi ti ti ti ti ti ti fi fi ti fi ti ti ti ti ti tt ti ti fi ft fi ti ti fi ti Comment: Reese’s comments comply with Standard VII(B). Her statements refer to facts: The CFA Program enhanced her knowledge, and many rms require the CFA designa on for their investment professionals. fi • ti Rhonda Reese has been a CFA charterholder since 2000. In a conversa on with a friend who is considering enrolling in the CFA Program, she states that she has learned a great deal from the CFA Program and that many rms require their employees to be CFA charterholders. She would recommend the CFA Program to anyone pursuing a career in investment management. fi • ti ti ti ti ti ft ft fi fi ti ti Example 4 (Sta ng Facts about CFA Designa on and Program): ft fi • Example 5 (Order of Professional and Academic Designations): • Tatiana Prittima has earned both her CFA designation and a PhD in finance. She would like to cite both her accomplishments on her business card but is unsure of the proper method for doing so. • Comment: The order of designations cited on such items as resumes and business cards is a matter of personal preference. Prittima is free to cite the CFA designation either before or after citing her PhD. Multiple designations must be separated by a comma. Example 6 (Use of Fictitious Name): • Barry Glass is the lead quantitative analyst at CityCenter Hedge Fund. Glass is responsible for the development, maintenance, and enhancement of the proprietary models the fund uses to manage its investors’ assets. Glass reads several high-level mathematical publications and blogs to stay informed on current developments. One blog, run by Expert CFA, presents some intriguing research that may benefit one of CityCenter’s current models. Glass is under pressure from firm executives to improve the model’s predictive abilities, and he incorporates the factors discussed in the online research. The updated output recommends several new investments to the fund’s portfolio managers. • Comment: “Expert CFA” has violated Standard VII(B) by using the CFA designation inappropriately. As with any research report, authorship of online comments must include the charterholder’s full name along with any reference to the CFA designation. See also Standard V(A), which Glass has violated for guidance on diligence and reasonable basis.