Answers - Reading 44 Application of the Code and Standards Level II

Question #1 of 12 Question ID: 1474482 Patricia Spraetz is the chief financial officer and compliance officer at Super Selection Investment Advisors. Super Selection is a medium-sized money management firm which has incorporated the CFA Institute Code of Ethics and Standards of Practice into the firm's compliance manual. Karen Jackson is a portfolio manager for Super Selection. She is not a CFA charterholder. Jackson is friendly with David James, president of AMD, a rapidly growing biotech company. James has provided Jackson with recommendations in the biotech industry, which she buys for her own portfolio before buying them for her clients. For three years, Jackson has also served on AMD's board of directors. She has received options and fees as compensation. Recently, the board of AMD decided to raise capital by voting to issue shares to the public. This was attractive to board members (including Jackson) who wanted to exercise their stock options and sell their shares to get cash. When the demand for initial public offerings (IPO) diminished, just before AMD's public offering, James asked Jackson to commit to a large purchase of the offering for her portfolios. Jackson had previously determined that AMD was a questionable investment but agreed to reconsider at James' request. Her reevaluation confirmed the stock to be overpriced, but she nevertheless decided to purchase AMD for her clients' portfolios. Which of the following actions are most appropriate for Spraetz? If, after her investigation Spraetz finds that Jackson has committed violations, Spraetz must report them to senior management and seek legal counsel for A) possible legal and regulatory implications. If the upper management does not follow through and take action, Spraetz has fulfilled her supervisory duties and need not take any further action. Spraetz, as the chief compliance officer, must set company policy in clear terms and monitor the actions of the employees. In case of violations, she should B) investigate thoroughly, initiate disciplinary action, and issue guidelines that must be followed in order to prevent future violations. She must not only detect violations through a continuous monitoring process but also provide guidance for proper conduct consistent with the firm's policy manual. Even though Spraetz does not supervise Jackson, as the compliance officer of the firm she is responsible for identifying violations. Spraetz is not responsible C) for preventing them and should not go beyond their documentation for senior management. Thus, she should record the violations but need not take any further action. Explanation Since Spraetz has the authority to hire, fire, reward, and punish Jackson, Spraetz has supervisory duties in addition to being the chief compliance officer of Superior Selection. She must investigate Jackson and report her findings to her superiors and possibly the board. If no action is taken, Spraetz must consider resigning under the CFA Institute Code and Standards. Spraetz is also responsible for setting the policy, preventing and detecting violations, and putting into place reasonable procedures to monitor employees' actions. Her role as the chief compliance officer requires her to take disciplinary actions in order to deter further violations. (Module 44.1, LOS 44.b) Glenarm Case Study (Refer to CFA Institute Standards of Practice Casebook for details.) Peter Sherman, CFA, has recently joined Glenarm Company after spending 5 years at Pearl Investment Management. He is responsible for identifying potential Latin American investments. Previously, Sherman held jobs as a consultant for many Latin American companies and had plans to continue such consulting jobs without disclosing anything to Glenarm. After resigning, but before leaving his employment at Pearl, Sherman had encouraged Pearl customers to move their accounts to Glenarm. He contacted accounts Pearl had been soliciting for business. He also contacted potential clients that Pearl had rejected in the past as too small or incompatible with the firm's business. Furthermore, he convinced several of Pearl's clients and prospects to hire Glenarm after he joined Glenarm. He also identified materials from Pearl to take with him, such as: 1. Sample marketing presentations he had prepared. 2. Computer program models for stock selection. 3. Research materials on companies he had been following. 4. A list of companies recommended by Sherman for potential investment which were rejected by Pearl. 5. News articles for potential research ideas. Question #2 - 3 of 12 Question ID: 1474479 Which of the following statements concerning Sherman's actions is CORRECT? Sherman did not violate Standard IV(A) by soliciting clients that were rejected by A) Pearl either because they were too small or unsuitable as long as winning their business did not adversely affect Pearl. B) Sherman did not violate any Standard by taking away the news articles from his previous employer, Pearl, for potential research ideas. Sherman did not violate Standard IV(A) since members can engage in C) independent consulting practice as long as their employer policy does not specifically prohibit it. Explanation Standard IV(A) addresses Loyalty to the Employer and depriving the employer of profit opportunities is a violation of this standard. Because Pearl had no interest in rejected clients and had turned their profit potential down already, soliciting them is not a violation. Taking away news articles and computer program models is a violation of Standard IV(A) because Sherman took away employer property, which could be used by Pearl or Sherman's replacement. Engaging in independent consulting practice is a violation IV(A) because Sherman not only compromised his independence and objectivity, but also did not obtain explicit written consent of his new employer, Standard IV(B), Additional Compensation Arrangements. (Module 44.1, LOS 44.b) Question #3 - 3 of 12 Question ID: 1474480 Sherman's attempt to lure away clients from Pearl while he was still employed at Pearl is: A) B) C) not a violation of Standard V(A) because it was conducted "after hours" on Sherman's own time. not a violation of Standard IV(A) because they would have followed Sherman to his new firm anyway, and no harm to Pearl was done as a result. a violation of Standard IV(A) because it undermined Pearl's business and its profit opportunities and caused damage to Pearl's business. Explanation An attempt, successful or not, to lure away existing clients of the current employer is a violation of Standard IV(A) as it causes damage to the employer's business. Others are incorrect because: "After hours" solicitation is not an excuse if it damages the employer's business; the fact that Pearl's clients were agreeable does not absolve Sherman of Standard IV(A) violation; even if Pearl's clients would have followed Sherman to his new employer anyway, Sherman, by soliciting such clients, damaged his employer's business. The focus is on Sherman's actions. (Module 44.1, LOS 44.b) Question #4 of 12 Question ID: 1474471 Patricia Spraetz is the chief financial officer and compliance officer at Super Selection Investment Advisors. Super Selection is a medium-sized money management firm which has incorporated the CFA Institute Code of Ethics and Standards of Practice into the firm's compliance manual. Karen Jackson is a portfolio manager for Super Selection. She is not a CFA charterholder. Jackson is friendly with David James, president of AMD, a rapidly growing biotech company. James has provided Jackson with recommendations in the biotech industry, which she buys for her own portfolio before buying them for her clients. For three years, Jackson has also served on AMD's board of directors. She has received options and fees as compensation. Recently, the board of AMD decided to raise capital by voting to issue shares to the public. This was attractive to board members (including Jackson) who wanted to exercise their stock options and sell their shares to get cash. When the demand for initial public offerings (IPO) diminished, just before AMD's public offering, James asked Jackson to commit to a large purchase of the offering for her portfolios. Jackson had previously determined that AMD was a questionable investment but agreed to reconsider at James' request. Her reevaluation confirmed the stock to be overpriced, but she nevertheless decided to purchase AMD for her clients' portfolios. Which of the following statements concerning Super Selection is CORRECT? All employees of a firm are bound by CFA Institute's Code and Standards if they A) are incorporated in the company's policies manual, and the firm subscribes to them explicitly. B) Spraetz, in her capacity as a supervisor, violated Standard IV(C) by not preventing violations by Jackson. C) Jackson did not violate the CFA Institute Code of Ethics and Standards since she is not a CFA charterholder. Explanation Even though Jackson is not a CFA charterholder, she is nevertheless required to follow the Code and Standards since her firm subscribes to them and has incorporated them in its policy manual. Standard IV(C) violation is not clear or obvious since the case does not say much about a lack of guidelines or explicit gaps in the policy manual. Under this assumption, Spraetz is not guilty of any supervisory violation. Even though Jackson did not personally trade ahead of purchasing AMD shares for her clients, she had done so in the past and is in violation of Standard VI(B). Spraetz needs to act on it because this violation has only just come to light. (Module 44.1, LOS 44.a) Question #5 of 12 Question ID: 1474481 Patricia Spraetz is the chief financial officer and compliance officer at Super Selection Investment Advisors. Super Selection is a medium-sized money management firm which has incorporated the CFA Institute Code of Ethics and Standards of Practice into the firm's compliance manual. Karen Jackson is a portfolio manager for Super Selection. She is not a CFA charterholder. Jackson is friendly with David James, president of AMD, a rapidly growing biotech company. James has provided Jackson with recommendations in the biotech industry, which she buys for her own portfolio before buying them for her clients. For three years, Jackson has also served on AMD's board of directors but has never notified Super Selection of this fact. She has received options and fees as compensation. Recently, the board of AMD decided to raise capital by voting to issue shares to the public. This was attractive to board members (including Jackson) who wanted to exercise their stock options and sell their shares to get cash. When the demand for initial public offerings (IPO) diminished, just before AMD's public offering, James asked Jackson to commit to a large purchase of the offering for her portfolios. Jackson had previously determined that AMD was a questionable investment but agreed to reconsider at James' request. Her reevaluation confirmed the stock to be overpriced, but she nevertheless decided to purchase AMD for her clients' portfolios. Which of the following statements is NOT correct? Jackson did not violate Standard III(A) on Fiduciary Duty to clients because she was bound by her fiduciary duty to AMD and its stockholders as a board A) member. Therefore, when she reversed her decision to buy AMD shares for Super Selection's clients, portfolios on James' request, her obligation to AMD took precedence. Jackson violated Standard IV(B) regarding Disclosure of Additional B) Compensation by not disclosing additional compensation in the form of cash and stock options received from AMD, as its board member to her employer. C) Jackson violated Standard VI(A) regarding Conflicts of interest by not disclosing her board membership and ownership of stock options to her employer. Explanation Jackson has violated Standard III(A) because her first obligation is to her firm's clients. Standard VI(A) addresses precisely these kinds of situations regarding potential conflict of interest. Given this conflict of interest, Jackson also compromised her objectivity in violation of Standard I(B). Her fiduciary duty to her clients takes precedence over her fiduciary duty to AMD's stockholders under the CFA Institute Code and Standards. By not disclosing her relationship with AMD, she also violated Standard IV(B). Making past personal security transactions ahead of purchase of the same securities for her clients has put Jackson in violation of Standard VI(B). This standard clearly prohibits such actions. (Module 44.1, LOS 44.b) Question #6 of 12 Question ID: 1474470 Alpha Asset Management manages portfolios for clients with more than $10 million in assets. Bob Smith, a portfolio manager at Alpha, is planning to leave Alpha to set up company Beta Investment Management, to focus exclusively on clients with less than $10 million in assets. While he is still employed at Alpha, Smith begins to solicit (on his own time) potential clients with less than $10 million in assets – clients that Alpha has previously rejected for being too small. According to the Standards of Professional Conduct IV(A) related to duties to employer, Smith's solicitation of these clients is: A) B) unacceptable since the fact the Beta will not be in competition with Alpha is irrelevant. unacceptable as he may not engage in any activities to go into business while he is still employed by Alpha. C) acceptable as he is not in competition with his current employer. Explanation It is acceptable for Smith to solicit clients for his new employer on his own time as long as he is not in any way competing with his employer. Standard IV(A) prohibits only actions that have the potential to cause harm to Smith's employer. (Module 44.1, LOS 44.a) Question #7 of 12 Question ID: 1474472 Jim Jones is an equity research analyst at Gamma funds. Because of his expertise in the telecommunications field, a Chinese telecommunications provider hires Jones as a consultant to help them identify potential investors. According to the Standards of Professional Conduct IV(A) related to duties to employer, Jones must: A) B) describe to his employer in detail the activities related to this consulting arrangement. obtain verbal permission from his employer to engage in this consulting arrangement. C) refuse this consulting arrangement. Explanation According to the Standards of Professional Conduct, Jones must disclose to his employer all outside compensation arrangements, describe to his employer in detail the activities that give rise to outside compensation, and obtain written permission from his employer in advance. (Module 44.1, LOS 44.b) Question #8 of 12 Question ID: 1474483 Karen Jackson is a portfolio manager. Jackson is friendly with David James, president of Acme Medical, a rapidly growing biotech company. James has provided Jackson with recommendations in the biotech industry, which she buys for her own portfolio before buying them for her clients. For three years, Jackson has also served on Acme Medical's board of directors. She has received options and fees as compensation. Recently, the board of Acme Medical decided to raise capital by voting to issue shares to the public. This was attractive to board members (including Jackson) who wanted to exercise their stock options and sell their shares to get cash. When the demand for initial public offerings (IPO) diminished, just before Acme Medical's public offering, James asked Jackson to commit to a large purchase of the offering for her portfolios. Jackson had previously determined that Acme Medical was a questionable investment but agreed to reconsider at James' request. Her reevaluation confirmed the stock to be overpriced, but she nevertheless decided to purchase Acme Medical for her clients' portfolios. Did Jackson violate Standard III(C) Suitability concerning portfolio recommendations and actions? A) Yes, because she did not deal fairly with all clients. B) No. C) Yes, because she did not consider the appropriateness and suitability of investment recommendations or actions for each portfolio or client. Explanation Jackson violated Standard III(C) Suitability because she did not consider her clients' financial situation, investment experience, and investment objectives. (Module 44.1, LOS 44.b) Jacques Claudel, a CFA Institute member, represents Vector Funds, a U.S.-based fund manager, in Canada. Although Vector Funds is properly licensed to deal in all Canadian and U.S. securities, its primary objective is to sell United States funds to Canadian institutional investors seeking diversification into the U.S. dollar. While it would be willing to do so if requested by its clients, Vector has not placed trades in Canadian securities since Claudel began working there two years ago. Prior to joining Vector's Canadian operations, Claudel was an independent asset manager handling the funds of wealthy individuals and small institutions. Most of these accounts remain under his management, under the business name Coup de Gras. Claudel is unclear as to whether his consulting work is in competition with his new employer, as the accounts under his management are invested strictly in Canadian securities, while Vector has not traded Canadian securities. However, just to be on the safe side, he obtained written permission from Vector to continue serving his former clients. His former clients were not notified. Claudel receives cash compensation for most of the accounts he handles independently, but for one he receives a new car for his personal use every two years, and for another he is compensated with a one-week, expenses-paid holiday in the European country of his choice. As part of his responsibility, Claudel makes trades for some of his Canadian clients. He runs all of his trades through two brokers, Ace Equity Traders and the Parlay Group. Ace offers some of the best research available on health-care stocks, but charges fairly hefty commissions. Parley has some of the cheapest commissions in Toronto, but provides no research of value to Claudel. Henri Bonnet, CFA, a friend of Claudel's, works on the floor of the Vancouver Stock Exchange. He asks Claudel to establish an account for him at Coup de Gras. Claudel learns that it is Bonnet's intention to manipulate the prices of penny stocks he trades on the exchange, and profit from the price movements in the account at Coup de Gras. Claudel sets up the account, but advises Bonnet that he "will have nothing to do" with the manipulation scheme beyond placing trades as Bonnet directs. Claudel is currently pursuing a master's degree in financial economics in the evenings. During the interview with Vector and on his resume he indicated that he "attended Victoria University," giving his estimated date of graduation. He is not sure whether Vector understood that he did not have his master's degree. Question #9 - 12 of 12 Question ID: 1474474 Which of the following statements about consulting work is CORRECT? In some circumstances the employee must receive the employer's written A) permission prior to receiving additional compensation from parties other than the firm. This requirement applies to both monetary and non-monetary compensation. In all cases the employee must receive the employer's written permission prior B) to receiving additional compensation from parties other than the firm. This requirement applies to both monetary and non-monetary compensation. In some circumstances the employee must receive the employer's written C) permission prior to receiving additional compensation from parties other than the firm. This requirement applies to monetary compensation only. Explanation Standard IV(A): Loyalty to Employer requires written permission from both the employer and the consulting customer if the work involves competition with the employer. An example of an instance not requiring permission would be if a CFA charterholder who works for a broker wishes to write grants for a nonprofit foundation. In such case, he need not get permission, nor does he need to disclose the compensation. This Standard applies for work that provides either monetary or nonmonetary compensation. (Module 44.1, LOS 44.b) Question #10 - 12 of 12 Question ID: 1474475 Claudel's statement about his education background is: A) truthful, but not in accord with the Code and Standards. B) truthful, and in accord with the Code and Standards. C) not truthful, and not in accord with the Code and Standards. Explanation Standard I(C) Misrepresentation states that "members shall not make any statements, orally or in writing, that misrepresent the member's academic or professional credentials." In this case, Claudel's statements are truthful, and are not a violation of the Standard. He could have been more clear, but what he said is undeniably correct. Whether Vector understood what he told them is not his problem, as long as he was truthful and did not attempt to deceive them. (Module 44.1, LOS 44.b) Question #11 - 12 of 12 Question ID: 1474476 Which of the following statements is CORRECT? A) B) C) Bonnet has violated Standard III(B): Fair Dealing, and Claudel has violated Standard I(B): Independence and Objectivity. Bonnet has violated Standard II(A): Material Nonpublic Information, and Claudel has not violated Standard III(A): Loyalty, Prudence, and Care. Bonnet has violated Standard IV(A): Loyalty to Employer, and Claudel has violated Standard I(A): Knowledge of the Law. Explanation Bonnet violated several Standards, including IV(A) and II(B), by manipulating stock prices and profiting from that manipulation at the expense of other purchasers. Standard IV(A) requires that employees not act to injure the firm or deprive it of profits, and Bonnet's personal trading and market manipulation crosses well over that line. However, Bonnet did not violate Standard II(A) Material Nonpublic Information because no nonpublic information was involved. Claudel violated Standard I(A) by contributing to Bonnet's plans to break the law. Under the Code and Standards, Claudel cannot knowingly assist others who are violating the Standards or the law, even if he does not profit personally. While Claudel's ethics are in question, nothing he did for Bonnet is likely to affect his independence, and he did not violate Standard I(B) Independence and Objectivity. (Module 44.1, LOS 44.b) Question #12 - 12 of 12 Question ID: 1474477 Assuming that both Ace Equity Traders and the Parlay Group offer best execution, Claudel: A) B) C) must disclose to clients whether client-directed brokerage will prevent him from getting the best execution. must direct all the trades for clients who do not wish to own health-care stocks to the Parlay Group. can select the broker that refers the most business back to him, as long as any research purchased benefits the client whose account is being traded. Explanation The Standards require that purchased brokerage directly benefits the client. Clients who do not hold health-care stocks get no benefit from Ace's research, so Claudel is obligated to send their trades to the broker with the lowest transaction costs. While disclosing the risks of client-directed brokerage is a good idea, it is not relevant in this case because we are not given any information about client directed trades. Referrals can play no part in the broker-selection process. (Module 44.1, LOS 44.b)