Reading 2-V: Standards of Professional Conduct & Guidance 2011, face, Investment, center, style

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Session 1: Ethical and Professional Standards
Reading 2-V: Standards of Professional Conduct & Guidance: Investment Analysis, Recommendations, and Actions

LOS A.: Diligence and Reasonable Basis.

 

 

Don Wilson and Nadine Chavis, both CFA charterholders, are investment advisors at Uptown Securities. Wilson recommends that one of his clients buy Alpha Company based on research conducted by Uptown. Chavis recommends that one of her clients sell Alpha Company based on research conducted by another brokerage firm for general distribution. Both recommendations are consistent with each client's investment objectives and within the context of their entire portfolios. Neither Wilson nor Chavis has reason to suspect that any information contained in the research reports from these two sources is inaccurate or inadequately supported. According to Standard V(A) Diligence and Reasonable Basis, do Wilson and Chavis have a reasonable basis for making their investment recommendations?

A) Both of these advisors have a reasonable basis for their recommendations.

B) Only one of these advisors has a reasonable basis for his or her recommendation.

C) Neither of these advisors has a reasonable basis for their recommendations.

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Wilson and Chavis have a reasonable and adequate basis if they recommend an investment transaction based on sound research prepared by their firm or an independent third party.

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A financial analyst and CFA Institute member sends a preliminary research report on a company to his supervisor. The supervisor approves the report, but then the analyst receives news that causes him to revise downward the earnings estimate of the company. The analyst resubmits the report to the supervisor with the new earnings estimate. The analyst soon finds out that the supervisor plans to release the first version of the report with the first earnings estimate without a reasonable and adequate basis. In response to this the analyst must:

A) insist that the supervisor change the earnings forecast or remove his (the analyst's) name from the report.

B) both insist that a follow up report be issued and take up the issue with regulatory authorities.

C) only insist that the first report be followed up by a revision.

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According to Standard V(A), Diligence and Reasonable Basis, the analyst must exercise diligence, independence, and thoroughness when performing investment analysis, making a recommendation, or taking investment action. The analyst should document the difference in opinion including any request to remove his or her name from the report.

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The following scenarios refer to recommendations made by two analysts.

• Jean King, CFA, is a quantitative analyst at Quantlogic, Inc. King uses computer-generated screens to differentiate value and growth stocks based on accounting numbers such as sales, cash flow, earnings, and book value. Based on her analysis of all domestically traded stocks in the U.S. over the past year, King concludes that value stocks as a class have underperformed growth stocks over that period. Using only this analysis, she recommends that account executives at Quantlogic sell all value stocks from the portfolios for which they have discretionary authority to trade and replace these stocks with growth stocks.
• James Capelli, CFA, is a fundamental analyst at Wheaton Capital Management, which focuses on regional stocks. His analysis of Branson Wireless includes the investment's basic characteristics such as information about historical earnings, ownership of assets, outstanding contracts, and other business factors. In addition to conducting both a general industry analysis and a company financial analysis, Capelli interviews key executives at Branson. Based on his analysis, he concludes that the company's future prospects are strong and issues a "buy" recommendation.

According to CFA Institute Standards of Professional Conduct, did King and Capelli have a reasonable and adequate basis for making their recommendations?

A) Capelli has a reasonable basis for his recommendation, but King does not.

B) Both King and Capelli have a reasonable basis for their recommendations.

C) King has a reasonable basis for his recommendation, but Capelli does not.

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Capelli appears to have exercised diligence and thoroughness in making his recommendation. King's recommendation is not based on thorough quantitative work because the period used in her study is only one year. Also, her recommendation does not consider the client's specific needs and circumstances.

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A client calls his money manager and asks the manager to liquidate a large portion of his assets under management for an emergency. The manager warns the client of the risk of selling many assets quickly but says that he will try to get the client the best possible price. This is a violation of:

A) Standard V(A), Diligence and Reasonable Basis.

B) Standard III(C), Suitability.

C) none of the Standards listed here.

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The money manager has done his duty. He has warned the client of the risk and made no explicit promises concerning what he can and cannot do.

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An analyst has found an investment with what appears to be a great return-to-risk ratio. The analyst double-checks the data for accuracy, keeps careful records, and is careful to not make any misrepresentations as he simultaneously sends an e-mail to all his clients with a “buy” recommendation. According to Standard V(A), Diligence and Reasonable Basis, the analyst has:

A) violated the Standard if he does not verify whether the investment is appropriate for all the clients.

B) fulfilled all obligations.

C) violated the Standard by communicating the recommendation via e-mail.

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If the analyst had been an investment manager, it would have been inappropriate for him to make a blanket recommendation for all of his clients without considering the unique needs of each. However, the analyst is merely stating that given the qualities of the investment, it is an attractive buy. He has kept adequate records, and made fair disclosure of his rating decision.

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An analyst receives a report from his research department that summarizes and interprets a recent speech from the chairman of the U.S. Federal Reserve. The summary says that the chairman thinks inflation is under control. Based upon this summary, the analyst says in his next newsletter that inflation is under control. This is a violation of:

A) Standard V(A), Diligence and Reasonable Basis, only.

B) Standard V(A), Diligence and Reasonable Basis, and Standard V(B), Communication with Clients and Prospective Clients.

C) none of the Standards listed here.

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The analyst should verify that the research department has interpreted the chairman’s speech correctly. The analyst must make it clear that the statement concerning inflation is only an opinion. No one knows if that is true or not at any point in time. Based upon the given information, we cannot say that the analyst is violating only one standard. The analyst may also be violating plagiarism in accordance with Standard I(C), Misrepresentation. Hence, the answer citing the two standards and not limiting violations to just those two standards is the best answer.

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Peggy Green, CFA, is a research analyst following Brown Co. All the information she has gathered suggests the stock should be rated a weak "hold." During a recent lunch, Green overheard another analyst say that the stock should be rated a "buy." Green returns to her office and issues a "buy" recommendation. Green:

A) has violated CFA Institute Standards of Professional Conduct because she did not have a reasonable and adequate basis for making this recommendation.

B) violated CFA Institute Standards of Professional Conduct because she did not seek approval of the change from her firm's compliance director.

C) has violated CFA Institute Standards of Professional Conduct because she failed to distinguish between fact and opinion.

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Analysts are required to have a reasonable and adequate basis, supported by appropriate research and investigation, for their recommendations.

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Bill Fox, CFA, has been preparing a research report on New London Wire and Cable, one of his major investment clients. He had completed much of his analysis and had planned on having his report typed and bound today. Unfortunately, his briefcase was stolen while he ate breakfast, and he lost all his notes and working papers. The lost materials included his notes from management interviews, conversations with suppliers and competitors, dates of company visits, and his computer diskette containing much of his quantitative analysis. Fox's client needs this report tomorrow. In a panic, Fox called New London's vice president of finance and was faxed a copy of the company's most recent financial projections. Fox remembered that his own analysis showed that management's estimates were too high. He did not remember the exact amount, so he revised New London's figures downward 10%. Fox also incorporated some charts and graphs on New London from a research report he had received last week from a small regional research firm and used some information from a Standard & Poor's reference work. With the help of his secretary, a Xerox machine, and some creative word processing, Fox got the report done in time for the evening Fedex pick up. On the way home from the office that night, Fox wondered if he had violated any CFA Institute Standards of Professional Conduct. Fox has:

A) violated the requirement to have a reasonable basis for a recommendation, the prohibition against plagiarism, and the requirement to maintain appropriate records.

B) violated none of the Standards.

C) violated the requirement to have a reasonable basis for a recommendation and the prohibition against plagiarism.

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New London's report is potentially self serving, so Fox did not exercise diligence or have an adequate basis for his recommendation. In addition, Fox did not acknowledge his source of the charts and graphs. Finally, he did not maintain adequate records.

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Todd Gable, CFA, was attending a noon luncheon when he overheard two software executives talking about a common vendor, Datagen, about how wonderful they thought the company was, and about a rumor that a major brokerage firm was preparing to issue a strong buy recommendation on the stock. Gable returned to the office, checked a couple of online sources, and then placed an order to purchase Datagen in all of his discretionary portfolios. The orders were filled within an hour. Three days later, a brokerage house issued a strong buy recommendation and Datagen’s share price went up 20%. Gable then proceeded to gather data on the stock and prepared a report that he dated the day before the stock purchase.

Gable has:

A) violated the Standards by using the recommendation of another brokerage firm in his report.

B) violated the Standards by not having a reasonable basis for making the purchase of Datagen.

C) violated the Standards by improper use of inside information.

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Standard V(A) requires members to have a reasonable and adequate basis for taking investment actions. Overhearing a conversation does not provide adequate basis. It is not improper to use overheard conversations that do not include inside information, nor is it improper to reference another firm's report to substantiate adequate basis, if the other report is justified.

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In the process of recommending an investment, in order to comply with Standard V(A), Diligence and Reasonable Basis, a CFA Institute member must:

A) have a reasonable and adequate basis for the recommendation.

B) do both of these.

C) support a recommendation with appropriate research and investigation.

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Both of these are explicitly required by Standard V(A).