1215

An analyst thinks that a major change in the tax law will benefit holders of utility company stocks. She immediately begins calling all her clients and telling them of the upside potential of investing in such assets now. Based upon this information, this is most likely:

A) a violation of Standard V(A), Diligence and Reasonable Basis.

B) congruent with Standard V(A), Diligence and Reasonable Basis.

C) a violation of Standard III(C), Suitability.

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According to Standard III(C), the analyst needs to determine the suitability of an investment for each client. It is doubtful that all her clients are identical in their needs. According to the information, the analyst mentions the upside potential but does not mention the downside risk. Although the information says that she thinks that the change in the tax law will benefit holders of utility company stocks and says nothing of how she arrived at this conclusion, we do not know if she has or has not made her decision on a reasonable basis.

1215

Bob Hatfield, CFA, has his own money management firm with two clients. The accounts of the two clients are equal in value. Hatfield has been trading on the clients’ behalf with a single brokerage firm for several years. Because of his many years of business, the brokerage firm occasionally gives Hatfield shares in an initial public offering (IPO) to sell to his clients. Hatfield has a policy of allocating the IPO shares equally between the portfolios of the two clients. This policy is:

A) congruent with Standard III(C), Suitability.

B) a violation of Standard III(B), Fair Dealing.

C) a violation of Standard III(C), Suitability.

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According to Standard III(C), the analyst must consider the appropriateness and suitability of an investment recommendation for each portfolio or client. Having a fixed policy of adding investments to portfolios without evaluating their suitability is a violation of Standard III(C). The action does not violate Standard III(B)

1215

Kim Lee manages a variety of accounts at Superior Investments. Some are permitted to invest in tax-exempt issues only; others may not invest in a stock unless it pays dividends. Lee is researching a biotech firm specializing in the analysis of "mad cow" disease. While touring company facilities and meeting with management, she learns that they believe they may have found a way to reverse the disease. Moreover, one manager conjectured, "Suppose that we reversed the disease in someone who didn't even have it? We might then be able to boost that individual's IQ into the stratosphere!" Lee returns to her office and buys shares for all accounts under her supervision. This action is:

A) appropriate given the obvious potential of the therapy.

B) a violation of the Standard concerning appropriateness and suitability of investment actions.

C) a violation of the Standard concerning fiduciary duties.

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Given the variety of accounts under her supervision, it is not likely the shares of a speculative biotech firm would be suitable for all accounts. Placing such shares in all accounts indicates that she has failed to consider the appropriateness and suitability of the investment for each account, and this places her in violation of Standard III(C).

1215

Procedures for compliance with Standard III(C), Suitability, include determining all of the following with respect to a client EXCEPT:

A) liquidity needs.

B) social habits and interests.

C) return objectives.

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The procedures for compliance with Standard III(C) include determining all of the aspects of a client’s investment objectives and constraints mentioned above, but do not include gathering information about the client’s social habits and interests.

1215

A portfolio manager must determine the client’s constraints, which may include all of the following EXCEPT the client’s:

A) tax considerations.

B) mortgage payment.

C) liquidity needs.

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The mortgage payment per se is of interest to the portfolio manager only insofar as it affects the bigger picture issues such as liquidity needs, cash flow, etc.

1215

Stephen Rangen, a former broker, had three accounts consisting of unsophisticated, inexperienced individual investors with limited means. One of these accounts was an elderly couple. The clients wanted to invest in safe, income-producing investments. They relied heavily on Rangen’s advice and expected him to initiate most transactions in their respective accounts. In managing their accounts, Rangen pursued the following strategies: (1) bought U.S. treasury strips and non-dividend paying over-the-counter stocks, (2) used margin accounts, and (3) concentrated the equity portion of their portfolios in one or two stocks. Rangen’s approach led to extremely high turnover rates in all three accounts. The Securities and Exchange Commission sanctioned Rangen for unsuitable recommendations and excessive trading in several accounts.

For this specific situation, which of the following is least likely to be an appropriate compliance procedure involving Standard III(C), Suitability? The broker should:

A) develop an investment policy statement for each client.

B) avoid using material nonpublic information received in confidence to benefit clients.

C) assess and document each client's risk tolerance.

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The prohibition against use of material nonpublic information refers to Standard II(A), not Standard III(C), Suitability.

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For this specific situation, all of the following are appropriate compliance procedures involving Standard III(C), Suitability, EXCEPT:

A) complying with any prohibitions on activities imposed by their employer if a conflict of interest exists.

B) reviewing investment policy statements regularly.

C) educating clients about selecting appropriate asset allocations and strategies.

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Standard VI(A), Disclosure of Conflicts, refers to complying with any prohibitions on activities imposed by their employer if a conflict of interest exists and, therefore, is unrelated to Standard III(C).

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For this specific situation, which of the following policy statements should be adopted to ensure that future violations of this kind do not occur?

A) Before advising individual clients, managers should review the recommendations provided by the firm's research department. From this set of recommendations, they should select those securities that provide the expected highest return on investment. Managers should review the investor's portfolio at least monthly to see if existing securities should be replaced with those more recently recommended. Managers should turnover portfolios frequently and concentrate holdings within portfolios in order to achieve the highest possible returns for clients.

B) Before making any recommendations or taking any investment actions, managers should formulate an investment policy for a client. They should consider the type and nature of the client and should obtain and analyze necessary information on the client's objectives (risk and return) and constraints. Managers should maintain and review regularly the investor's objectives and constraints to reflect any changes in the client's circumstances. Where appropriate, managers should properly diversify portfolios.

C) When making recommendations or taking investment actions, managers should seek to minimize the client's portfolio risk. Managers should review the recommendations of the firm's research department to identify securities with low volatility. In making asset allocation recommendations or decisions for discretionary accounts, managers should weight the portfolios towards dividend-paying stocks and other income-producing assets such as bonds and mortgage REITS. Managers should review portfolios at least semi-annually.

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Standard III(C) requires that members shall “make a reasonable inquiry into a client’s financial situation, investment experience, and investment objectives prior to making any investment recommendations and shall update this information regularly to allow the members to adjust their investment recommendations to reflect changed circumstances.” The other policy statements focus on maximizing returns or minimizing risk. These statements may be inconsistent with the needs and circumstances of each individual client.

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1215

The best way to determine the suitability of an investment is:

A) to consider the financial situation, investment experience, and investment objectives of the client.

B) based on portfolio performance results, presented as a weighted average, from the biggest financial companies.

C) by administration of a specially designed survey of the client's opinions.

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Although broad in scope, the best way to determine suitability is to consider the financial situation, investment experience and investment objectives of the client. Both of the other choices deviate from these essential issues.

1215

A broker was sanctioned for unsuitable recommendations and excessive trading involving three accounts under his care. These clients were unsophisticated, inexperienced individual investors with limited means. According to CFA Institute Standard III(C), Suitability, which of the following is least likely to be considered a relevant factor in determining the appropriateness and suitability of investment recommendations or actions for each portfolio or client?

A) Basic characteristics of the total portfolio.

B) Best interests of the investment professional.

C) Needs and circumstances of the portfolio or client.

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Determining appropriateness and suitability focuses on the portfolio or client, not on the investment professional. Investment professionals should take particular care to ensure that their goals in selling products or executing security transactions do not conflict with the best interests of the client.

1215

Lance Tuipulotu, CFA, manages investments for 400 individuals and families and often finds his resources stretched. When his largest investors petition him to include a 5% to 7% allocation of non-investment-grade bonds in their portfolios, he decides he needs additional help to meet the request. He considers various independent advisors to use as submanagers, but determines that the most qualified advisors would be too expensive. Reasoning that a lower-cost provider would enable him to pass the savings along to his clients, he chooses that provider to invest the new bond allocation. Tuipulotu has violated:

A) Standard III(C) "Suitability" by failing to consider the appropriateness of the non-investment-grade bonds.

B) Both Standard III(C) "Suitability" and Standard V(A) "Diligence and Reasonable Basis."

C) Standard V(A) "Diligence and Reasonable Basis" by letting fee structure determine the selection of the submanager.

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Both Standard III(C) "Suitability" and Standard V(A) "Diligence and Reasonable Basis" were violated. Tuipulotu must perform a full IPS review to determine the appropriateness of the new portfolio allocations. Submanagers should not be selected by cost structure alone, as the quality and appropriateness of the submanager is Tuipulotu’s responsibility.

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