What are the 6 components of the CFA Code of Ethics?
Priority - Your client's interests always come first.
Encourage - Practice and encourage others to act professionally and ethically to reflect credit on yourself and the profession.
Judgment - use reasonable care and judgment when
performing all professional activities.
Maintain - keep your knowledge up to date and encourage other professionals to do the same.
Actions - employ integrity, competence, diligence, and respect in an ethical manner with everyone.
Rules - promote the integrity of capital markets by following the rules.
What are the various sections for Standards of Professional Conduct?
There are 7:
II. Integrity of Capital Markets
III. Duties to Clients and Prospective Clients
IV. Duties to Employers
V. Investment Analysis, Recommendations, and Action
VI. Conflicts of Interest
VII. Responsibilities as a CFA Institute Member or CFA Candidate
What is Standard I?
What are the subsections of Standard I: Professionalism?
There are 4:
I-A: Knowledge of the Law
I-B: Independence and Objectivity
What is Standard I-A?
Members and Candidates must understand and comply with all applicable laws, rules, and regulations (including the CFA Institute Code of Ethics and Standards of Professional Conduct) of any government, regulatory organization, licensing agency, or professional association governing their professional activities. In the event of conflict, Members and Candidates must not knowingly participate or assist in and must disassociate from any violation of such laws, rules, or regulations.
"Knowledge of the Law: covers laws, rules and regulations"
What are the types of exam questions you can expect regarding applying Standard I-A?
Since Standard I-A covers laws, rules and regulations, the situations presented to test knowledge of the Standard (and whether the Standard has been violated) will likely involve some possible violation of the law, and how a CFA Member or Candidate should proceed. The following questions may apply:
Did the Member seek the advice of counsel?
Consulting an attorney is typically seen as a good defense against an alleged violation of Standard I-A. Many cases involve someone who works for a firm that has violated the law (made misleading statements on a prospectus, for example). In these cases, look to see if the CFA member or candidate sought and followed the advice of counsel.
Did the member report the violation, and to whom did the member report it?
For any potential violation of a law, rule or regulation, if the situation suggests that the member either went along with it, did nothing, tried to cover it up or was afraid to say anything for fear of losing his or her job that is a clear sign that the Standard has been violated. In any example, look for evidence that the CFA member tried to do the right thing. If that person's firm is potentially guilty of violating a law or regulation, he or she needs to start by reporting this situation to his or her supervisor and/or compliance officer. If the situation is not remedied, he or she should distance him or herself from the potential violation and seek the advice of counsel.
For multinational operations, which country's laws apply to the situation at hand?
In the real world, it can be ambiguous if an advisor is domiciled in one country and operates in another. For the purposes of the CFA Level I exam, the candidate isn't expected to be a lawyer and make a judgment - the exam will indicate which country's laws apply to the situation. If a broker or advisor operates solely or exclusively in a country, assume that those laws apply unless it's stated otherwise. The rule of thumb (which states it's the law that applies if it's stricter than the Standards; otherwise, the Standards apply) is usually going to make it easy to arrive at the right answer.
How can you comply with Standard I-A?
The Standards of Practice Handbook makes a number of suggestions to avoid violating Standard I-A.
•Establish Files - These files would cover all applicable laws, rules, regulations, statutes and important cases that might be relevant to any potential business situation involving the firm. Files must be readily accessible, and a process to manage, distribute and interpret such material should be in place.
•Stay Informed - Laws, rules and regulations frequently change, and key employees in a firm must be informed continually of such changes. CFA members and candidates are obligated to establish, or encourage others to establish, a procedure by which everyone in a firm is kept informed and applicable changes are disseminated in a timely manner. Usually, this procedure is the domain of the firm's counsel or compliance department, but every situation is different. There are a number of real-world cases in which everyone just assumed that a certain person or department was taking care of it.
•Distribution Area Laws - In an increasingly global marketplace, members and candidates must make every effort to understand the laws of the country or region in which they operate, including those where their products or services are distributed across borders.
•Legal or Illegal? - Certain conduct may not in fact be a violation. Members should consult counsel in ambiguous situations.
•Disassociate - This is such a good word and a worthwhile course of action that the CFA Institute decided to include it when it recently revised this Standard. It is good advice: it may have been OK at some time in the past to do nothing if one witnessed illegal or unethical conduct, but in today's environment, the Standards have changed. One must now disassociate from any illegal activity and actively urge the firm (either an immediate supervisor or a compliance officer) to cease any conduct that violates the law or an applicable regulation or standard. Inaction might be judged, (even in a court of law), as participating or assisting, which violates the Standard.
What is Standard I-B?
Members and Candidates must use reasonable care and judgment to achieve and maintain independence and objectivity in their professional activities. Members and Candidates must not offer, solicit, or accept any gift, benefit, compensation, or consideration that reasonably could be expected to compromise their own or another's independence and objectivity.
"Independence & Objectivity: maintain integrity and avoid conflicts of interest"
What are the types of exam questions you can expect regarding applying Standard I-B?
Applying Standard I-B, Complying with standards of independence and objectivity seems simple and straightforward in theory, but in practice there are many scenarios that could potentially conflict with one's objectivity - or create the appearance of doing so. In many cases it is not so easy to define the proper course of action. Here are some of the situations that are more likely to appear on the exam:
•A company sponsors an analyst conference and picks up all the expenses. Consider a situation where a firm invites all Wall Street analysts who are actively covering its company to go on an all-expenses-paid trip to tour facilities, play golf, stay in a swanky resort and so forth, all in the hopes of promoting itself and earning more favorable coverage. For analysts bound by the Code and Standards, would this sort of outing compromise their objectivity? The answer is that it just might. This Standard requires CFA members to assess if such an outing is possible while still maintaining objectivity - would they still be able to write an unfavorable opinion, if warranted by independent analysis? Many firms have created policies that require attendance at such affairs to be paid by the firm and require the itinerary to be substantially business-related as a condition of attending. No specific checklist of right and wrong is written into this Standard, but the mere appearance of conflict is a real issue in today's environment and one must be sensitive to perception.
•A financial firm promises to provide research coverage of a company's stock in return for a potential business relationship. This agreement is acceptable so long as there is absolutely no requirement to make the recommendation a favorable one. This standard requires that any conclusions be made in an independent and objective manner.
•In the previous example, the relationship manager asks for a favorable recommendation for the new corporate client. This case would violate Standard I-B. If the relationship manager is concerned that an unfavorable research opinion will adversely affect the cultivation of this relationship, the research department would need to restrict the company from analyst coverage and only provide factual information without any specific recommendation. Under no circumstances can the corporate client be seen as "buying" a favorable analyst opinion.
•A research analyst assigned to a new sector is told by the director of research not to change the investment opinion on a certain company. This type of supervision would violate the analyst's requirement to reach an independent conclusion. If the analyst is a CFA Member or Candidate, he or she should proceed by informing the supervisor that he or she is bound by the Code and Standards, and that such a restriction is not permitted by the Standard on Independence and Objectivity. Another approach would be to study the company, reach an independent conclusion and share this opinion with the director of research, but leave it to the supervisor to decide the appropriate course of action.
•A portfolio manager receives an expensive vacation package from a brokerage as a sign of gratitude for all the business. Accepting such a perk is a violation, as it compromises the manager's objectivity in regards to choosing brokers that suit the best interests of the clients and the firm (the broker offering the best execution, for example). This manager would be in compliance with Standards if he or she disclosed the perk in writing to his or her immediate supervisor. If the firm required this manager to refuse the vacation package, he or she would be required to abide by the decision of the firm.
•A portfolio manager is sent two extra tickets to a local baseball game (face value $30 each), complements of the same brokerage. Given the rule of thumb that gifts lower than US$100 are perceived as sufficiently modest and are thus acceptable from both clients and business partners, the portfolio manager would not be violating Standard I-B, even if the perk went unreported. At the same time, it's a sensible practice to disclose even gifts of this nature - the Standards of Professional Conduct describe minimum standards, but staying in the habit of full disclosure should always be the preferred course of action.
•A CFA member who is also a member of the local society of financial analysts solicits corporate financial support for an investor conference and issues research reports on some of those same firms. Research opinions must be unbiased. However, when an analyst takes on an outside role, how will these secondary activities influence the research? If a firm pledges generous support to this analyst, will the analyst's future research reports become more favorable? If another firm declines support, will a report on that company be less favorable? The best course of action would be to trade the coverage of those firms with a colleague, or to ask to be excused from seeking sponsors.
How can you comply with Standard I-B?
The Standards of Practice Handbook provides a number of operational suggestions that one should recommend for adoption by the compliance department.
•Highlight the integrity of the research - Establish that research opinions reflect unbiased opinions, and include this wording on all written reports. Salary and bonuses should be independent of any factors that might compromise the degree of independence - i.e. don't tie a quarterly bonus to the fees collected from corporate relationships (which can be affected by a stock recommendation).
•Disclose conflicts of interest - For example, a directorship in a public company would need to be acknowledged by the employer, as this fact may affect research opinions of that company and of competitors. Research reports should disclose whether the analyst owns shares in a company and whether the analyst's firm makes a market in that security or has underwritten the security.
•Limit direct investments in equity or equity-related IPOs - Investment firms should establish formal policies relative to employee purchase of equity and equity-related IPOs and require prior approval.
•Report holdings - Report holdings in all personal accounts, those of one's immediate family and those over which the analyst has formal discretion (e.g. trusts).
•Establish a restricted list - This is to limit research on those firms that have a business relationship with that company. If an adverse opinion would hurt this business relationship, the company stock should be restricted from the research universe, and only factual information on the company should be disseminated.
•Cost reimbursement procedures - Identify what is acceptable and what is unacceptable practice in order to avoid the appearance of a conflict. While there is no specific checklist in the Standards, the general rule of thumb is that air transport, ground transport and hotel accommodations should be the responsibility of the individual and his or her company, and should not be covered by (for example) the issuer of a security that an analyst has started to cover. The reason that no checklist has been developed is that there are always exceptions - for example, if the issuer of a preferred security is an energy company that is headquartered in a sparsely populated area (near its coal mines) and commercial transport is not available, and the only practical way to arrange a face-to-face meeting is by using a corporate jet, then an analyst can accept such an arrangement without violating this Standard.
•Limit gifts - Gifts should be limited to a maximum value of US$100.
•Periodically review guidelines - This is to reinforce dos and don'ts for all employees and determine whether additional guidelines are sensible.
•Compliance Officer - Firms should appoint a senior-level compliance officer who ensures the code of ethics and all regulations are upheld.
What is Standard I-C?
Members and Candidates must not knowingly make any misrepresentations relating to investment analysis, recommendations, actions, or other professional activities.
What are some examples of violations of Standard I-C?
•Putting your name on another analyst's research report.
•Including a large portion of another analyst's report in your own (either verbatim or with slight modifications) without crediting the original author.
•Neglecting to specifically give credit to a person who has been quoted. For example, saying "a top analyst in the field suggests..." would be a violation.
•When including financial data, you neglect to include any caveats that must be included with that data. Although this is not plagiarism, it is still a violation of the Standard.
What are some categories of information that are often misrepresented?
•Average year of experience of investment personnel- someone just left and his info needs to taken out of the average calculation
•Professional services - For example, small financial services firms tend to specialize in a given area, such as 401(k) planning or insurance products or tax preparation. A CFA member in charge of such a firm cannot hold himself out to be a comprehensive provider of all these financial needs.
•Professional credentials - A recent college graduate and CFA candidate passes one of the FINRA licensing exams and then holds herself out as a licensed investment advisor and portfolio management expert, printing these titles on marketing brochures.
•Expected return on an investment - A representative from a bank makes a presentation on a mutual fund that specializes in real estate, saying the following: "You want to allocate a portion of your diversified portfolio to real estate. This fund is up 98% over the last four years, and when you add that 98% gain to your account for the next four years, it will offset the stagnant cash and bond investments and allow you to reach your goals."
•Expected risk on an investment - Derivative securities of fixed income products are sometimes described as "government guaranteed" when in fact the interest portion fluctuates and will decline in periods of high interest rates. Using the idea of a guarantee masks the true risk of the security.
How can you comply with Standard I-C?
•Define firm's limits - Continually reinforce what the company can do, and what it cannot do. Provide clear guidance to sales and marketing specialists who may have an inclination to promote without restraint, if left unsupervised. The line between appropriate and inappropriate exaggerations can be subtle.
•Describe firm's services - Ensure that all contact people are discussing the firm's capabilities in a manner that is accurate and suitable.
•Identify authorized spokespeople - Who can speak on behalf of the organization? The essential message can be controlled by simply limiting who may provide it.
•Assign the support staff - These should be reliable people who will keep written and electronic materials updated and avoid unintentional misrepresentations.
•Prepare a resume - Do this for each key employee, specifying important credentials and capabilities as it relates to the company.
•Maintain research files - By keeping a comprehensive paper trail of the process by which all investment ideas are generated and the specific source of all research materials cited in preparing a report, the analyst protects him or herself from charges that these findings or ideas were plagiarized.
•Use direct quotes - Do this if an idea is going to be borrowed, and attribute the source of all directly quoted passages, as well as all statistics, charts, tables and other material that was developed and published by another source.
•Obtain permission - If the report is to be publicly disseminated, get permission to use any material that is copyrighted by a publisher. In the case of quantitative financial models, the originator of the model may have licensed its use, and a fee may be required in addition to acknowledgment.
•Attribute paraphrased or summarized material - While this material does not necessarily meet the stated definition of plagiarism, it should be attributed to its rightful source. For example, a lengthy research report on General Motors may include summaries on Ford, DaimlerChrysler and Toyota that were written by other analysts, mostly to give some context to the GM analysis. Even in summarized format, these commentaries have been borrowed from others, and in a spirit of fairness, proper credit should be explicitly offered.
What are some potential case studies related to Standard I-C that you should consider?
Plagiarism - Case Studies
As with other Standards, a number of situations could be presented on the exam that may (or may not) violate this Standard, giving rise to a number of potential questions and qualifying explanations. These are the most important to consider.
•Does an owner or managing partner have a responsibility to specifically attribute ideas or information to other members of his or her firm? The short answer: it depends. If the owner is purely acting as a representative of the firm - for example, making a presentation to a client or a prospective client - he or she can disseminate information from the firm's research department without taking the additional time to credit each individual researcher and each particular contribution someone might have made to that presentation. However, take a case where a product from a firm's quantitative research process has become recognized by the public. Let's say Bob Wilson, the owner of this firm and a CFA, is asked to appear in an industry symposium on quantitative techniques. Wilson did not actually develop the ideas or techniques himself; rather, this work was accomplished by members of the research department. However, in the context of the industry symposium, Wilson has been invited as a leading expert on quantitative research methods, and he is thus representing himself, not the firm. At the conference, he would be obligated, under Standard I-C, to give specific credit to the coworkers who were responsible for the advancement. In short, to evaluate these situations, you must determine whether the person in question is purely an agent of the firm, or is there as an expert witness, or is representing him or herself only, apart from the firm.
•If individuals are reassigned within a research department, is the new analyst obligated to acknowledge the old analyst on a published research report? In large research shops, industry coverage is often rotated periodically, yet firms often prefer to publish research with one analyst's name. This situation introduces a dilemma. For example, if a retail analyst completes all of the work on a lengthy study of-Mart, but is then reassigned to work on consumer-products companies, how should the new retail analyst (who is a CFA candidate) handle the dissemination of the Wal-Mart research? It would be improper and a violation of Standard I-C to simply send out the previous analyst's work as if the report were the work of the new analyst (i.e. simply changing the name). At the same time, firm policy asks for published research to contain one contact name. In this case, the new analyst would need to add an appropriate written acknowledgment of the previous analyst's contribution in order to comply with the Standard.
•If the initial idea for a quantitative financial model comes from an outside source, but it is tested and revised prior to being implemented, is it plagiarism to not acknowledge the source? These cases are not always so easy to judge, especially if the original quantitative model was changed - in such a case, the analyst can claim that the revised model actually represents his or her own "innovation". However, the spirit of Standard I-C is to encourage an ethic of fairness to the investment research profession. Modifying someone else's ideas to a certain extent and then passing them off as one's original discovery is a form of plagiarism and is discouraged by this Standard. In this instance, the analyst would need to give credit where credit is due by identifying the source of the new innovation and explaining how the idea originated and the measures taken to backtest or further develop or modify the concept.
•Can an employee plagiarize information from his or her own firm? If an individual uses portions of their employer's in-house publications in a way that they are acting as an agent for another individual or company, it would be considered plagiarism and a violation of Standard I-C.
What is Standard I-D?
Members and Candidates must not engage in any professional conduct involving dishonesty, fraud, or deceit or commit any act that reflects adversely on their professional reputation, integrity, or competence.
What are some traps to avoid in questions relating to Standard I-D?
CFA candidates typically know the difference between right and wrong, so exam questions will try to trap you with various qualifiers to a situation. Be aware that the most important thing to evaluate is what the person actually has done, and avoid the following traps:
Don't rely on the judgment of the individual's supervisor - Many examples will indicate that "a supervisor didn't find that the behavior in question affected day-to-day responsibilities, and the supervisor knew about it but was OK with it as long as it didn't happen again". In these cases, the opinion of the supervisor is not important - it's the actual act that must be your focus. Don't worry about the supervisor. Keep the analysis simple: do the actions of this person violate any facet of the Standards? (Is it a felony? Does it involve fraud or an act of moral turpitude?)
Don't forgive misconduct simply because there is no conviction - In our legal system, most cases get settled out of court. If an activity is fraudulent, if the perpetrator tried to get away with something or tried to deceive, it's a violation of Standard I-D even if the misconduct doesn't result in a conviction. Again, focus on what the person did.
Dishonesty and fraud are possible even when one is engaged in volunteering for charitable causes - Focus on what the person has actually done. If it is fraudulent, if it misrepresents, or if it is deceitful, then it's a violation.
How can you comply with Standard I-D?
*Never do anything you have to hide
*abide by CFA, SEC, FINRA rules
*Code of ethics
Personal integrity and professional conduct start with the individual, with one's sense of right and wrong behavior, and with one's moral character. Improper and inappropriate actions have consequences, but in a position of trust, one is sometimes in a position to get away with fraudulent behavior. If an action provokes the feeling that you hope no one else finds out, it's probably something that shouldn't be done. You should never feel like you have something to hide.
In addition to the CFA Institute, the Securities and Exchange Commission, FINRA, and many other governing and regulatory bodies are in place to provide a regulatory framework and require compliance and full disclosure of one's activities. In addition, CFA Members and Candidates should encourage employers to adopt a code of ethics to cover personal conduct for everyone in the organization, and to adopt background-checking procedures for potential employees, so that an organization is fully aware of any prior legal issues and is confident that potential employees are not ineligible for employment in the investment industry.
What is Standard II?
Integrity of Capital Markets
What are the subsections of Standard II: Integrity of Capital Markets?
II-A: Material Nonpublic Information
II-B: Market Manipulation
What is Standard II-A?
"Material Nonpublic Information"
Members and Candidates who possess material nonpublic information that could affect the value of an investment must not act or cause others to act on the information.
What does 'material' information mean?
This means the information would be considered relevant to an investor who is considering investing in this stock, or to a current shareholder wishing to sell. If a stock reflects all public information, does adding this new information significantly alter the perception of that stock? The source of the information also impacts its materiality. Overhearing a CEO on the train (material) versus your dentist sharing their opinion (non-material).
What are some example of material information?
Material information would include the following:
•Dividend increase, decrease or omission
•Quarterly earnings or sales significantly different from consensus
•Gain or loss of a major customer
•Changes in management
•Major development specific to that industry
•Government reports of economic trends (housing starts, employment etc.)
•Major acquisition or divestiture
•Offer is made to tender shares (acquisition)
What are the types of exam questions you can expect regarding Standard II-A?
Exam questions covering this Standard are likely to test whether a CFA candidate can understand and identify violations of the Standard and understand and identify actions (e.g. the mosaic theory, firewalls) that help prevent a violation of the Standard.
We'll present each of these categories of questions separately.
•Understand/Identify Violations - Hundreds of real-life situations can touch on a possible violation of the insider trading laws, and frequently it is not obvious whether a person has acted inappropriately. As a rule, if you obtain information that is not public and it is considered material, contains a tender offer, was misappropriated, or would violate a breach of confidence you should not trade the security. If the material is already public, (or if the material is not public but contains immaterial information), you are generally free and clear of a violation.
•Conflicts to Fiduciary Duty - Questions on the exam are likely to address a CFA member's fiduciary duty to, for example, act in the best interests of pension fund holders, and whether the member is really doing his or her duty if he or she doesn't trade on insider information. Indeed, some earlier Standards require placing client interests ahead of personal interests (e.g. with personal transactions or participation in IPOs). However, the guiding principle is that a CFA member's duty to the investing public (by not acting on inside information) is greater than other duties.
•Mosaic Theory - A securities analyst will be motivated to identify mispriced stocks and will be gathering information to such an extent that exposure to nonpublic information is a possibility. However, the work of an analyst depends on the free flow of information. As a defense to a charge that nonpublic information is being used to trade on a stock, the mosaic theory suggests that the analysis of a company form a mosaic; that is, by assembling small bits of nonpublic information together, large and meaningful conclusions can be drawn. The idea behind the mosaic theory is that each individual piece of information is nonmaterial by itself: an individual piece of information would not move the price of the security if disseminated in a public press release. Taken together, however, the bits of information can form a meaningful mosaic. This practice is perfectly legitimate, and it is encouraged.
Think of the mosaic theory as a way for analysts to do their jobs and use nonpublic information without feeling like they are at risk for liability under insider trading law. On the exam, hypothetical examples will carry identifying words - i.e. "material" or "nonmaterial" - to guide you to the right answer (material: trading restricted, non-material: no trading restrictions).
How can you comply with Standard II-A?
A compliance program is incomplete if all it does is create awareness of the definition of insider trading and the fines and jail sentences to which the employee could be liable. The real work of the compliance program should be to reduce and eliminate the possibility of a violation. In the real world, there will always be temptation to either profit from (or avoid loss through) knowledge of material nonpublic information.
The most sensible approach is control: prevent the information from being disseminated widely, thus removing the issue of temptation for all but a few.
Firewalls - "Firewall" is a common term applied to the barriers created to prevent sensitive information from being disseminated between departments of a firm. As applied to insider trading, the assumption is that certain departments (e.g. corporate underwriting) may have access to material nonpublic information that would be useful to those in other departments (e.g. investment management and research). The guiding principle is that only certain individuals need to know certain things, and thus no one else should have any access.
Some other procedures that may be adopted as part of a compliance program:
•Communicate Receipt of Information - Companies come into contact with material nonpublic information in a variety of ways. When such a situation occurs, the recipient must be obligated to inform his or her supervisor or compliance officer and not disclose any additional information to coworkers.
•Make Reasonable Efforts to Make Nonpublic Information Public - If material nonpublic information was received, particularly in breach of a duty or as a result of a misappropriation, it is possible that this information was eventually going to be made public. While Standard II-A prevents acting on that information while it is not public, the duty to client requires that investment action (should it be required) be made in light of the new information. For example, if new, nonpublic information makes it clear that a firm will be in violation of a bond covenant and its fixed-income securities will be downgraded to junk status, that security may no longer meet the investment objectives of the client. However, the bond cannot be sold until the information is made public. In such an instance, reasonable measures may involve a written request between the firm's compliance department and a legal representative of the firm that issued the bond.
•Keep Record of Research and a Rationale for Each Investment Decision - This procedure, most applicable to Standard V-A, Reasonable Basis, can help protect an analyst who has employed the mosaic theory and used several items of nonmaterial, nonpublic information to form an investment opinion.
•Watch List - Depending on the size of an organization, the placement of a company on a restricted list can have the unintended side effect of communicating to a wide audience that something is going on at that company. In this case, the firewall may be unintentionally broken, and while employees might be restricted from trading, the leak can find its way outside in a number of ways (it only takes one person to provide an insider tip). In situations where placing a firm on a restricted list is too public, a firm can adopt the use of a watch list, which means the compliance department will monitor activity on the companies on that list, perhaps making inquiries based on an individual's activities, but maintaining the confidentiality needed for a particular circumstance.
•Training/Continuing Education - Some employees will be more knowledgeable about insider trading laws (and the need to have them) than others. A comprehensive agenda needs to outline all issues related to insider trading, identify both individual and firm liability under these regulations and summarize procedures for compliance, such as the reporting of personal transactions.
What are the minimum elements of a corporate firewall in this compliance context?
•Segregation of Personnel - Someone involved with investment banking should not be doing research and trading, and vice versa.
•Confinement of Material Nonpublic Information - Employees have access only on a need-to-know basis.
•Control of Interdepartmental Communications - The compliance or legal functions of a firm might serve as a clearing house through which all interdepartmental memoranda are sent.
•Monitoring of Employee Trading - Those with particularly sensitive jobs might be required to pre-clear, that is, to receive permission in advance.
•Restricted List - The creation and maintenance of a restricted list can help limit employee trading as needed.
•Heightened Restrictions under Certain Conditions - For example, additional restrictions might be placed when material nonpublic information is received in the course of underwriting a new preferred stock placement.
What is Standard II-B?
Members and Candidates must not engage in practices that distort prices or artificially inflate trading volume with the intent to mislead market participants.
What are the two types of activities that Standard II-B covers?
2) Disseminating False Information
1. Transaction-Based Manipulation - This Standard is intended to prohibit activities designed to distort - for example, if an institutional investor with more than one account were to trade a micro-cap stock between two accounts with the sole intention of creating artificial volume and drawing attention to the stock. The capital markets have established a number of price-setting mechanisms that can be artificially distorted to create a perception that there is strength or weakness in a particular security, or a certain level of trading volume.
This Standard also covers those market participants who attempt to secure a "dominant" market position in a security and artificially inflate the price in an effort to benefit from a related (derivative) instrument.
2. Disseminating False Information - Some examples of this behavior include spreading false rumors that prompt others to buy or sell, or "pumping up" a price by issuing overly positive or optimistic projections, then "dumping" the stock once it has rallied. Another example would be if companies hired to promote a recently issued small-cap stock were to issue "independent research" that only served to promote that company. This scheme is also referred to as a "pump and dump" strategy.
How can you complay with II-B?
Establish a compliance program that sets out rules of conduct for those engaged in market transactions, as well as a set of rules governing any activities that involve the distribution or promotion of information on a publicly-traded company.
What is Standard III?
Duties to Clients and Prospective Clients
What are the subsections of Standard III: Duties to Clients and Prospective Clients?
III-A: Loyalty, Prudence, and Care
III-B: Fair Dealing
III-D: Performance Presentation
III-E: Preservation of Confidentiality
What is Standard III-A?
"Loyalty, Prudence and Care"
-Manage portfolio like it was your own money
Members and Candidates have a duty of loyalty to their clients and must act with reasonable care and exercise prudent judgment. Members and Candidates must act for the benefit of their clients and place their clients' interests before their employer's or their own interests. In relationships with clients, Members and Candidates must determine applicable fiduciary duty and must comply with such duty to persons and interests to whom it is owed.
What are some examples of exam scenarios to test Standard III-A?
(1) Identifying the Client - The portfolio manager of a global financial services mutual fund runs into a friend at an industry event. His friend mentions that her new client is invested in the portfolio manager's fund and therefore the two of them now share responsibility for her new client. Under standard III(A), this is incorrect. The portfolio manager's duty is to uphold the investment guidelines for his mutual fund with objectivity and independence, while his friend's duty is to be loyal to her new client.
(2) Brokerage Arrangements - A small, independent investment advisor manages the pension funds of several companies. One of her brokers is about to win several new client accounts. The advisor expects to manage and trade these accounts exclusively through that broker. To induce the broker to send more new accounts her way, the investment advisor directs trades for all her current clients to that broker, without their knowledge. The advisor violated standard III(A) by not seeking best practice and best execution on all trades. Additionally, the standard was violated because the advisor did not disclose how trades were directed.
(3) Excessive Trading - A CFA charterholder manages money for several high-net-worth families. A major part of his compensation comes in the form of fees based on trading volume. He trades excessively for his accounts, but all the trades made are appropriate and suitable assets for the clients. The manager has violated standard III(A) because he is using the assets of his clients to benefit himself.
Ethics problems on the CFA exam are usually case-study oriented. Keep in mind that many cases involve violations of more than one standard. A good way to determine whether standard III(A) was breached is to ask yourself the following questions:
1. Is this person acting in the best interests of clients?
2. Is this person placing clients' interests before his or her own?
How can you comply with III-A?
To ensure compliance with Standard III-A and to avoid a violation, CFA members and Candidates should start by thoroughly knowing and understanding the content of all governing documents to which they are bound in their relationships with clients. Given the duty to loyalty required by this Standard, are there any particular restrictions or unique characteristics that are not fully understood? Legal advice should be sought for unclear guidelines.
When in custodial control of client assets, the following procedures are suggested (per the Standards of Practice Handbook):
•Audit the firm at least once a year.
•Produce a quarterly statement for each client, indicating funds and securities in that account and itemized transactions during the period.
•Make full disclosure as to where the assets are maintained, and where and when they are moved.
•Separate assets so that each client's holdings can be distinguished.
To comply with soft-dollar standards, a fiduciary needs to ask three questions to determine whether soft dollars can be used and what percentage of the cost can be allocated:
1. Does this product provide investment research?
2. Will the information it provides contribute to the research process of this organization?
3. Will any portion of this product go for uses not directly involved in the investment research process?
For investment managers, an internal policies and procedures guide should observe the following rules:
•All applicable laws, rules and regulations must be followed.
•Potential conflict of interest arrangements (additional compensation, outside directorships) are required disclosures.
•Investment objectives for each client must be initially established and reviewed at least annually and as circumstances warrant.
•Asset diversification should be practiced as a risk reduction tool, except in cases where specific guidelines and objectives preclude it.
•Fairness and objectivity should be practiced with all clients, with no explicit favoritism toward one client or group.
•A process for vote proxies should be established with clients' best interests in mind; individual responsibilities for voting should be determined; and records should be maintained.
•Best execution on trades should be practiced. In other words, under the particular circumstances in place (i.e. what is reasonably available), what is the broker that provides the lowest total cost to the client? "Cost" refers not only to trading commissions but also to costs related to poorly executed trades (buying at prices that are higher and selling at prices that are lower than what was available from competitors).
•Duty of loyalty to clients, as a company policy, is top priority.
What is Standard III-B?
Members and Candidates must deal fairly and objectively with all clients when providing investment analysis, making investment recommendations, taking investment action, or engaging in other professional activities.
What is a likely scenario for an exam question on III-B?
1) Research Report Preview
2) No Time to Prepare a Report
3) Preparing for the Eventual Demand
4) Allocation of IPO
5) Notification via email
Case studies that test this Standard tend to place analysts in a situation where they are tempted to show favoritism toward one group over another. In determining the proper course of action, ask whether the individual's actions in any way discriminate against any subset of the firm's client base. Some of the more common situations to anticipate in a CFA exam question testing this Standard are described below.
1. Previewing Contents of a Yet-to-Be Published Research Report - An industry analyst is excited about an under-recognized company in her sector, and she is in the process of preparing a report to buy the stock. Currently the report is being fact-checked and is nonpublic information, but it will be sent to all clients following the fact-checking process. An important client calls and asks the analyst what she is currently researching. In this case, if she answers honestly, it is a violation of Standard III-B, given that the firm has a fair and defined process in place for distributing the new buy recommendation. She would simply need to tell the client that a new research report is awaiting publication and will be distributed shortly, and that she will be happy to discuss it once the client receives it.
2. No Time to Prepare a Report - Another industry analyst has a buy rating on a specialty medical-devices company, and he is considered a leading Wall Street expert on the industry in general and this company in particular. His initial study was rigorously detailed, about 50 pages in length and the product of two months of preparation. Each month, his firm publishes a recommended list (where this stock has been listed for the past year), followed by company commentaries. A couple of days before the list is published, he learns that one of the major products in the pipeline awaiting FDA approval will be indefinitely delayed, prompting the analyst to question his fundamental case. He switches to a hold recommendation but concludes he doesn't have enough time to prepare a report that conforms to his rigorous research standards, so he declines additional comment and requests that his summary be excluded from the publication. In a conference call with a mutual fund manager that is the largest owner of the stock, he indicates that he was no longer recommending it due to a change in fundamentals, but that he would need some time to put the report together. The fund manager immediately sells her entire position.
Is this action a violation? The analyst is in violation of Standard III-B, fair dealing. According to the Standard, he needed to recognize that his opinion counts as material information, and that if he made a change, he needed to include at least a summary outlining the reasons in the firm's monthly publication. He could follow up later with the rigor he deems necessary. As for the mutual fund manager, she is in violation of Standard V-A, Reasonable Basis, as she is trading out of the stock without knowing the detailed reasons. To avoid a violation, she would need to wait for the report to be disseminated.
3. Preparing for the Eventual Demand - Take a case where a brokerage is about to publish a brand new buy recommendation. The head trader for this brokerage learns of the news and buys a large block of the shares on the open market one week prior to publication, anticipating that there will be great demand for shares of this company among the clients of the firm. The company to be recommended is a small-cap stock that is thinly traded, so there might be liquidity issues if the trader does not act. Following firm policy, the portfolio administrators will faithfully allocate shares pro rata and give everyone the exact same price. However, this case is a clear violation of Standard III-B. Moreover, it's an example of the sort of tricks that show up on the CFA exam; there's an indication in the example that pro rata allocation was used so that a test taker sees a fair allocation procedure being implemented, which might obscure the fact that the trade itself was unethical. In fact, the brokerage must adhere to strict policies on disseminating its new recommendation, and it would never bepermitted to trade ahead of a research report. Such a trade is not only a violation of the CFA Institute's Standard; the fact that it happened when it happened is likely to capture the attention of the SEC.
4. Allocation of IPO - A portfolio manager occasionally will receive limited access to his firm's IPO underwriting activities. The number of shares varies depending on the outside demand for the issue, but these IPO allocations are typically insignificant compared to the accounts under management. It's never enough shares to make an across-the-board pro rata allocation worthwhile, as it would end up as an insignificant position in all portfolios. As a result, this manager simply disposes of these shares whenever she receives them by allocating them to her largest clients. Unfortunately, by allocating in this manner she is violating Standard III-B, as she systematically favors the largest portfolios (i.e. the smaller accounts never get a chance). Given that a pro rata procedure process is not always practical, the best way to comply with the Standard would be to select IPO participants at random from the entire client list and to establish a cycle where everyone must participate once before being chosen again.
On the exam, be prepared for questions looking at cases in which an IPO is oversubscribed. This means that more shares have been requested than the broker has available. If this situation comes up, know the term "pro rata". This term is a Latin phrase meaning "in proportion". With an oversubscribed IPO, a broker would allocate shares pro rata based on a fair allocation system. It's also very important to remember that the CFA member is obligated to forego shares for personal use (or the use of immediate family) in order to uphold a standard to place client interests first.
5. Notification via Email - A manager and CFA charterholder wishes to treat his clients fairly and also comply with the Standards of Professional Conduct. He prepares a bulk email notification of a new buy recommendation being published by his full service brokerage firm. Two days following the email, he places a block trade for discretionary accounts and for those nondiscretionary accounts that notified him of interest. Does this process violate the fairness doctrine required by Standard III-B? While it would be nice to communicate fully with everyone via email, and be confident that everyone reads his or her email, the reality is that some people do not have email access. As a result, disseminating a recommendation in this manner discriminates against non-email clients and violates the Standard on fair dealing. To comply, the manager will first need to 'snail mail' the recommendation to the full client list.
How can you comply with III-B?
Any particular compliance program is going to be a function of the unique factors present in that firm, such as its size and the scope of the activities in which it is involved. However, all procedures are going to share the common doctrine of fairness and develop processes that avoid systematic discrimination of one group of clients in favor of another.
The Handbook makes numerous worthwhile suggestions for developing a compliance program that adheres to the intent of this Standard:
•Disseminate Nonpublic Information as Quickly as Possible - Violations result from the fact that an analyst is required to keep a new idea secret for such a period of time that leaks develop.
•For Lengthy and Detailed Reports, Offer a Flash Summary - No one can be expected to rewrite a 50-page report in two days. However, changing a recommendation creates material nonpublic information. It's not necessary for such information to be held for weeks while the necessary labor is done to write up the report right. A brief flash summary that includes the essence and the conclusion, plus an indication that the laborious, detailed report is in progress, is sufficient to comply with the ethic of full disclosure.
•Guidelines for Pre-Dissemination Must Be Established - This is to insure that people who have access to this information are aware of the standards.
•Inform Everyone as Simultaneously as Possible - For example, a large brokerage can ensure that all branches receive the new research on the same day.
•Restrict Trading - Do not trade until all clients have a fair chance to receive the new recommendation. For example, place no trades for two to three business days following a mailing.
•Develop a Fair Process for Trade Allocation - Some common elements might include:
•All orders must be date and time-stamped.
•Have a process on a first in/first out basis, based on the time stamped.
•Block trades receive the same execution price and commission.
•Partially executed blocks should be allocated pro rata.
•For Hot IPO Issues, Obtain Indications of Interest in Advance - Allocation procedure should be systematic (e.g. pro rata, random draw) and not based on favoritism.
•Do Not Withhold Shares - Refrain from holding shares in hot issues for personal accounts, leaving out any interested clients, and make a bona fide effortto publicly distribute.
•Disclose - Discloseall trade allocation procedures to clients.
•Review Accounts Systematically - A supervisor or compliance officer can develop a process that indicates whether some accounts are being given preferential treatment - for example, whether trade executions in certain accounts appear to be better than average, or certain accounts seem to receive more shares in a hot IPO than what would be expected.
•Disclose the Presence of Tiers of Service - Many organizations offer both discretionary and nondiscretionary advisory service, but because of the differences in those accounts, they might find it necessary for practical reasons to take action in the discretionary accounts first, before they take the same action within the nondiscretionary accounts. Such procedure is not discriminatory since discretionary accounts are paying a premium; however, clients must be fully aware of this practice.
What is Standard III-C?
1.When Members and Candidates are in an advisory relationship with a client, they must:
a) make a reasonable inquiry into a client's or prospective client's investment experience, risk and return objectives, and financial constraints prior to making any investment recommendation or taking investment action and must reassess and update this information regularly.
b) determine that an investment is suitable to the client's financial situation and consistent with the client's written objectives, mandates and constraints before making an investment recommendation or taking investment action.
c) judge the suitability of investments in the context of the client's total portfolio.
2.When Members and Candidates are responsible for managing a portfolio according to a specific mandate, strategy or style, they must only make investment recommendations or take investment actions that are consistent with the stated objectives and constraints of the portfolio
What are some typical exam questions to expect related to III-C?
Fulfilling the purpose of this Standard requires that the actual investments chosen and strategy employed are consistent with the information gathered.
This suitability consideration applies to the total portfolio, not to the individual securities. For example, selling call options is a potentially risky strategy if the underlying stock rallies. However, a covered call strategy, where the underlying stock is already owned when writing calls, mitigates this risk and can serve to enhance income in a stagnant market. An exam question might test whether puts and calls are suitable for a conservative investor - some people will guess "no", but the actual answer is that they may be, depending on the total portfolio
The client/advisor relationship is an ongoing two-way exchange of information. Case studies that apply this Standard will likely examine whether pertinent information was properly exchanged or discussed (full disclosure).
Client to Advisor: Factors in applying suitability include the following:
•Age/Time to Retirement - Generally speaking, an investment strategy should become gradually less aggressive as a client gets older, but time to retirement is also a factor - someone retiring at age 50 would be treated differently than someone who is motivated to work until age 75. Moreover, with life expectancies increasing, clients can live 30-40 years after retiring. Some of their assets must assume a long-term orientation.
•Income Needs - Clients who are drawing meaningful monthly income from an account would probably not want all of it invested in aggressive equity funds. At the same time, an individual with a $1-million account, requiring $50,000 a year, wouldn't necessarily need an average 5% income from the portfolio. It's entirely appropriate to satisfy the withdrawal needs with a combination of current income yield and capital gains.
•Tolerance for Risk - Discussions about previous bad investment experiences and how an investment loss affects a client are absolutely essential.
•Total Net Worth - In cases where a new account is only a 5% to 10% slice of a client's larger financial picture, the approach taken by the advisor can be much different. Given the total picture, what does the client expect from this account? Current income? Aggressive speculation? On the other hand, if the account represents a substantial portion of the client's total savings, an investment plan may need to account for both short-term income and long-term growth, all within the same account.
•Other Unique Factors - For example, given the onerous effect that taxes can have on investment performance, is the degree of tax efficiency a primary consideration to this client? If tax efficiency isn't important (or a complete non-factor for tax-exempt portfolios), the resulting investment approach might change.
Advisor to Client: Appropriate disclosures include the following:
•General Overview of Process - There's no specific formula on what must be covered, as clients have varying degrees of sophistication when it comes to investing, as well as varying ideas of what specifically matters to them. Even for those who care little to discuss the details, some discussion on how investment strategy is developed and the return/risk expectations of a policy is required.
•Major Changes in Process - For example, a change might be necessitated by the growth of the organization. An advisor of small-cap accounts may see growth to the point where market liquidity (ability to move into and out of stocks) is affecting the ability to carry out a previously conceived investment process that favored micro caps (and marketed this process to clients and potential clients). If restricting investments to companies with a market capitalization of $250 million or less is now too narrow and the advisor must expand the range of investments in order to handle the increased asset base, this change in policy would be material. Perhaps the inclusion of companies with a market cap of between $250 million and $500 million is appropriate, or the inclusion of foreign-based stocks is deemed necessary. Whatever is decided, any material change in investment approach could potentially impact a client's decision to retain that manager and must be disseminated prior to implementation.
•Loss of Key Personnel - While the performance record of an investment strategy is the property of the firm, it's also a product of the work of the individual manager who led the development of the process, directed the research, made the investment decisions and so forth. A change in investment personnel can affect the client's decision to affiliate with that firm in the first place, or it can be a nonissue. Either way, the firm is obligated to provide adequate disclosure of key personnel changes. In addition, if the switch in personnel prompts a change in investment approach - for example, from an active strategy to a passive one - the manager may need to modify advisory fees accordingly. A client might be paying a premium fee for a manager's reputation or for the rigor of the research process and should not be required to pay the same premium if he or she is now going to be invested in a mix of passive index funds.
Some examples of the application of standard III(C) follow:
An independent investment advisory was previously an account manager with a hedge fund, with which he still maintains personal and business connections. To attract new clients, the advisor offers below market management fees and provides his new clients with direct access to the hedge fund. The investment advisor puts as many of his new clients in the hedge fund as possible. Standard III(C) has been violated because the risk profile of the hedge fund may not be suitable for every client. Additionally, standard V(A) - Diligence and Reasonable Basis may also have been violated.
Investment Policy Requirements
The chief investment officer (CIO) of a large financial subsidiary wants to improve the diversification and returns of its investment portfolio. The investment policy statement for the subsidiary authorizes highly liquid investments, such as highly rated corporate or government bonds, with a five-year maturity or less. The CIO has discovered an exciting new investment in a private equity fund, which includes a three-year lock-up period but an exit option in stages after that. The CIO invests 4% in the fund, leaving the portfolio well within guidelines for overall equity exposure. The CIO violated both standard III (A) - Loyalty, Prudence and Care, as well as standard III(C).
The fund does not fit the requirements for highly rated, liquid investments. Additionally, the lockup period and laddered exit structure of the fund suggests the investment could last beyond the required maturity limits of no more than five years.
Read more: http://www.investopedia.com/exam-guide/cfa-level-1/ethics-standards/standard-suitability.asp#ixzz1oMtwn2uw
How can you comply with III-C?
•Draft Investment Policy Statement - This is drawn from information contained on a written survey and in the client/advisor interview. The resulting policy statement should include the following ingredients:
-Client Identification - who they are, their age and time horizon, beneficiaries, previous investment experience
-Client Objectives - return expectations, needs for income and growth, tolerance for risk, need to limit downside risk potential and to preserve the initial invested capital
-Portfolio Constraints - current and future expected liquidity needs, regular contributions into account, regular withdrawals out of the account, tax considerations, time horizon, regulatory or legal circumstances, individual preferences and restrictions (no tobacco or gambling stocks, for example), guidance on proxy voting.
•Periodic Review Process - Think of the investment policy statement as the foundation of a relationship that should be ongoing and is expected to evolve over time. An annual review will help establish the benefits of ongoing communication, help identify changing circumstances and facilitate a re-examination of the specific guidelines contained in the investment policy statement. In addition, logging all history of client contact, phone calls and emails initiated and received, issues discussed and changes made as a result will help improve the understanding of the client's unique financial circumstances.
•Suitability Tests - Regulators increasingly are requiring that firms establish suitability tests. Test procedures should be established to include an analysis of the how different investments will impact portfolio diversification, a comparison of investment risks to client risk tolerance, and a test to ensure the investment fits the investment strategy.
What is Standard III-D?
When communicating investment performance information, Members or Candidates must make reasonable efforts to ensure the information is fair, accurate and complete
What should you know about PPS and GIPS?
PPS - Performance Presentation Standards
GIPS - Global Investment Performance Standards
CFA developed these common standard to help achieve goals of III-D. These are voluntary and on the exam, only GIPS will be tested.
How can you comply with III-D?
•Adopt the GIPS Guidelines - Or, more accurately, encourage your firm to adopt them. Doing so would be the best procedure to avoid any violations. However, full compliance with the GIPS is not absolutely required, and in the absence of full compliance, adopting certain aspects of the GIPS is likely to be beneficial.
•Add appropriate disclosures - This can help clarify and explain what a prospective client sees (e.g. what do "simulated" and "portable from a previous manager" mean?)
•Consider the Knowledge of the Audience - Some presentations will necessitate additional explanation.
•Present performance of Similar Portfolios - This avoids presenting a single portfolio as representative of likely results.
•Maintain records - These will clarify how performance was determined. It's wise to anticipate that full adoption of the GIPS may be the direction in which the industry is headed, and the records will help any needed conversion.
What is Standard III-E?
"Preservation of Confidentiality"
Members and Candidates must keep information about current, former and prospective clients confidential unless:
•the information concerns illegal activities on the part of the client or prospective client,
•disclosure is required by law, or
•the client or prospective client permits disclosure of this information.
What are typical situations related to III-E to expect on the exam?
Keeping client information confidential is essential to building and developing a relationship of trust. On the CFA exam, cases involving this Standard are likely to test the exceptions that will require disclosures to be made.
Here are some examples of situations that may require disclosure of confidential information:
•Settlement Agreements - In a case where a manager and client have entered into a settlement agreement, the agreement cannot be written so as to prohibit co-operation with the CFA Institute's Professional Conduct Program (PCP) in the investigation of a CFA member (i.e. investigating whether that member violated the Code and Standards). So-called confidentiality clauses must explicitly allow both the member and the client to respond to requests for information, without restriction. Failing to provide information in a PCP investigation, even if based on a confidentiality clause, subjects the member to a summary suspension under CFA Institute bylaws, and his or her right to use the CFA charter may be revoked.
•Charitable Donation - A portfolio manager meets with a corporate client that can reduce its taxes by giving away money to charity and that has set aside $100,000 for this purpose. Would the portfolio manager violate Standard III-E by divulging to a local charity that the company has $100,000 to give away? In such a case, it would depend on whether the corporate client gave permission to the manager to reveal this information. If not, the manager would need to keep the information private and protect confidentiality.
•Illegal Activities - A portfolio manager suspects a client of illegal activity, but has no tangible evidence to support these suspicions. The portfolio manager understands her obligation to keep sensitive information confidential, but does not wish to support anything illegal. If such a case arises, doing nothing is not an option. She is best served by seeking legal counsel and informing her supervisor.
How can you comply with III-E?
•Protect client information when received by not disclosing any gathered information to outside parties.
•Limit the number of employees with access to sensitive information regarding a client's financial or other activities.
•Seek legal counsel promptly if illegal activity is suspected.
•Seek legal counsel if asked to disclose confidential information as a result of an investigation, either by the CFA Institute's Professional Conduct Program or by legal authorities. Disclosure in these instances may ultimately be required but one is entitled to legal advice to determine how best to reveal this information.
What is Standard IV?
Duties to Employers
What are the subsections of Standard IV?
There are three subsections:
IV-B: Additional Compensation Arrangements
IV-C: Responsibilities of Supervisors
What is IV-A?
In matters related to their employment, Members and Candidates must act for the benefit of their employer and not deprive their employer of the advantage of their skills and abilities, divulge confidential information, or otherwise cause harm to their employer.
What is the definition of "Practice" as it applies to Standard IV-A?
Any service currently available (for remuneration) at the individual's firm. Thus, if a CFA member is employed at an investment advisor and is hired to write the ethics section of a CFA Level I study guide, he or she would not be violating Standard IV-A, since his or her employer does not publish CFA study guides
What is the definition of "Undertaking Independent Practice" as it applies to Standard IV-A?
"Actually engaged in competitive business" should be distinguished from "making preparations" to begin independent practice. An individual is free to prepare for a new independent venture, as long as the preparations do not involve any of the activities listed above (and, in particular, don't actively solicit clients). As noted previously, each circumstance is unique - actions must remain consistent with the duty to be loyal to one's employer.
How can one comply with IV-A?
How to Comply
1. Provide a written statement describing the relationship, the type of service, the expected duration and the expected compensation.
2.Do not render services until written consent from employer is received.
3.Disclose to clients the identity of one's employer, clarify that it is an independent arrangement and state the fees that would apply under a similar contract with the employer.
4.Do not render services until client reads and understands these disclosures and provides written consent.
What is standard IV-B?
"Additional Compensation Arrangements"
Members and Candidates must not accept gifts, benefits, compensation or consideration that competes with, or might reasonably be expected to create a conflict of interest with, their employer's interest unless they obtain written consent from all parties involved
What is the definition of "compensation" as it applies to Standard IV-B?
Compensation applies to direct cash payments or bonuses by the clients, as well as indirect compensation provided by third parties. It applies to non-monetary gifts, which includes complementary vacations, memberships to country clubs or health clubs, reimbursement of expenses - anything that is provided to the employee by the client and could create even the appearance of a conflict of interest.
What is the definition of "in writing" as it applies to Standard IV-B?
"In writing" means any form of communication that can be documented. Computer email is regarded as an acceptable format for disclosure, assuming that the direct supervisor has access to and uses email.
How can you comply with IV-B?
1. CFA members must report all arrangements for additional monetary compensation to their immediate supervisor, preferably prior to the acceptance of the gift, but immediately thereafter otherwise.
2. Written reports should include the specific terms, including the duration of the agreement, specific amounts that could be potentially earned and the nature of non-monetary benefits.
3. Review all existing internal compliance procedures relating to compensation from clients and business associates and the potential for conflicts. For example, outside business partners have traditionally paid for travel and other expenses in order to entice an employee to visit, but in recent years many firms have acted to strictly limit this practice. Discuss these issues with the compliance officer and understand what is and is not acceptable for that firm.
4. Follow all instructions made as a result of the disclosure. An employer may decide that a compensation arrangement is not appropriate, and if so, an employee is bound to follow that decision.
What is standard IV-C?
Members and Candidates must make reasonable efforts to detect and prevent violations of applicable laws, rules, regulations, and the Code and Standards by anyone subject to their supervision or authority.
How can you comply with IV-C?
Questions regarding procedure on the exam may test Standard IV-C. If it comes up, remember two simple questions that will help in designing an effective compliance program:
1.Which violations in particular are most likely to occur?
2.What rules will best uncover and prevent these violations?
Designating a compliance officer, as well as making a compliance manual available to the organization are effective methods in ensuring the organization has a system of checks and balances. There should be an educational program in place, which continually updates personnel on compliance procedures.
What is Standard V?
Investment Analysis, Recommendations, and Action
What are the subsections of Standard V?
There are three subsections:
V-A: Diligence and Reasonable Basis
V-B: Communication with Clients and Prospective Clients
V-C: Record Retention
What is Standard V-A?
"Diligence and Reasonable Basis"
Members and Candidates must:
1. Exercise diligence, independence and thoroughness in analyzing investments, making investment recommendations and taking investment actions.
2. Have a reasonable and adequate basis, supported by appropriate research and investigation, for any investment analysis, recommendation or action.
How can you comply with V-A?
•The Security - Each research process is likely to be unique, but whatever the particular basis for a specific recommendation might be, it should generally be consistently applied to the company's history of recommendations. Many research shops employ a general template of information that is always to be included with a recommendation (e.g. a summary of specific business factors, important financial statistics and ratios) to help guide compliance and ensure that the analyst employs a consistently diligent effort.
•The Portfolio - Is this security (and its expected level of risk) appropriate for all portfolios, or is it too risky for some, or perhaps not aggressive enough for others? CFA charterholders and candidates are obligated to examine the needs and circumstances of the clients on an ongoing basis, not just when the account opens. Portfolio theory emphasizes the need to diversify as a tool for reducing risk; thus any approach that concentrates a portfolio in just a couple of investments may not be in compliance.
•The Records - The importance of maintaining a complete track record of reasons for investment decisions is reinforced by the need to make this requirement a separate Standard in the revised list that becomes effective in 2006 (please refer to Standard V-C). Files can establish a paper trail and help protect the manager from accusations that a certain security (should it turn out badly) was not bought with an adequate basis and rationale.
What is Standard V-B?
"Communication with Client and Prospective Clients"
Members and Candidates must:
Standard V-B: Communication with Clients and Prospective Clients
Members and Candidates must:
1. Disclose to clients and prospective clients the basic format and general principles of the investment processes used to analyze investments, select securities and construct portfolios, and must promptly disclose any changes that might materially affect those processes.
2. Use reasonable judgment in identifying which factors are important to their investment analyses, recommendations or actions, and include those factors in communications with clients and prospective clients.
3. Distinguish between fact and opinion in the presentation of investment analysis and recommendations.
What is a "research report" as it applies to V-B?
The term "research report", as it applies to this Standard, is very broad and covers much more than the traditional research reports as defined above.
For example, any form of communication can potentially apply, including (but not limited to):
•speech or panel discussion
•internet webcast or blog
What are some questions to consider when addressing a hypotethical situation on the exam relating to V-B?
Are opinions and projections separated from factual information?
In the gathering of information on a company, has this information been reviewed for accuracy by a representative of that company?
Has a newsletter or watch list omitted too much relevant information?
Has a research report adequately outlined the risk factors, or failed to analyze less optimistic scenarios?
Does a research report omit the analyst's real reason for making a specific recommendation?
How can you comply with V-B?
Each subsection of this Standard relates to a specific goal that needs to be addressed when preparing research reports for public distribution:
•Using Reasonable Judgment on Factors to Include/Exclude - This procedure is in many ways the most subjective requirement within this Standard, as it is largely a function of an analyst's experience in preparing research reports and understanding what factors are of greatest importance to readers and users of the research. A specific checklist is not relevant to a standard of conduct where each case needs to be individually evaluated. As with the other Standards guiding the investment process, one would start by archiving all records relating to the report, so that conclusions can be explained and additional information can be supplied upon request.
•Distinguishing between Facts and Opinions - This goal avoids the most obvious violations of the Standard, but given that most reports use facts as the basis for investment opinions (i.e. all reports will have both), it's important to make such distinctions in as clear a manner as possible. Moreover, any data presented as fact must be properly scrutinized for reliability and accuracy. Financial databases that cover hundreds of data points for thousands of companies may produce misleading data - for example, they may show a negative price-to-earnings (P/E) ratio on a cyclical company, which then draws down the average P/E of a portfolio. In such a case, an analyst must ensure that the data presented is processed in a manner that provides for such situations.
•Indicate Basic Characteristics - This goal in particular provides some indication of the degree of risk that an investor will assume. A star system (1 through 5 stars, with 5 being safest) or a letter grade ("A" being the safest) will accomplish the task in the least amount of space. Other summary reports specify low, medium, high or very high risk. These labels are often an invaluable guide to determine whether the research should be used.
What is Standard VI?
Conflicts of Interest
What is Standard VII?
Responsibilities as a CFA Institute Member or CFA Candidate