Reading 2-III: Standards of Professional Conduct & Guid

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CFA Institute Area 1-2: Ethical and Professional Standards
Session 1: Code of Ethics and Professional Standards
Reading 2-III: Standards of Professional Conduct & Guidance: Duties to Clients and Prospective Clients
LOS C.: Suitability.

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

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

B) with the help of the special performance presentation standards.

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

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

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Answer and Explanation

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

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Stephen Rangen, a broker, has three accounts consisting of unsophisticated, inexperienced individual investors with limited means. One of these accounts is an elderly couple. The clients want to invest in safe, income-producing investments. They rely heavily on Rangens advice and expect him to initiate most transactions in their respective accounts. In managing their accounts, Rangen pursues the following strategies: (1) buys U.S. treasury strips and non-dividend paying over-the-counter (OTC) stocks, (2) uses margin accounts, and (3) concentrates the equity portion of their portfolio in one or two stocks. Rangens approach leads to extremely high turnover rates in all three accounts.

Which of the following statements about Rangen is FALSE?

A) Rangen has a fiduciary duty to each client.

B) Rangen's conduct violates Standard III(C), Suitability.

C) Rangen places his own interests above those of his clients by excessively trading in the accounts.

D) Rangen's conduct violates Standard IV(B), Additional Compensation Arrangements.

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Answer and Explanation

No information in the case suggests that Rangens conduct violates Standard IV(B), Disclosure of Additional Compensation Arrangements.

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Which of the following statements about Rangen's conduct is TRUE? Rangen's conduct:

A) meets the requirements of the Code and Standards because his clients are aware of the risks that he is taking in managing their accounts.

B) meets the requirements of the Code and Standards because he does not have complete control over his clients' accounts.

C) meets the requirements of the Code and Standards because his firm's research department recommended the U.S. Treasury strips and non-dividend paying stocks.

D) does not meet the requirements of the Code and Standards because his investment strategy is inconsistent with his clients' objectives.

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Answer and Explanation

Rangen's actions are inconsistent with Standard III(C), Suitability, because his investment actions are neither appropriate nor suitable for each client. Even if his clients were aware of the risks, the portfolios that he constructed are inconsistent with their financial needs. Because he is in a position to control the volume and frequency of transactions in their accounts, he has control over the accounts. Although Rangen relies upon recommendations from his firms research department, he cannot shift blame to his employer because he must follow recommendations that are in the best interests of his clients.

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The Securities and Exchange Commission (SEC) sanctioned Stephen Rangen, a former broker, for unsuitable recommendations and excessive trading in several accounts. His clients were unsophisticated, inexperienced individual investors with limited means. As such, they relied heavily on Rangens advice and expected him to initiate any transactions in their respective accounts. The SEC found that Rangens trading methods were contrary to his clients goals. For example, he used margin accounts and concentrated their equity holdings in particular securities. Rangen claimed that his actions were justified because his clients were aware of the risks.

Which of the following statements best describes why Rangens argument, that his clients were aware of the risks, did NOT meet the requirements of the Code and Standards? Rangen failed to:

A) make recommendations that were consistent with his clients' financial needs.

B) deal fairly and objectively with his clients when taking investment action.

C) consider the effect of excessive trading on the returns of his clients' portfolios.

D) disclose to his clients all matters that reasonably could be expected to impair his ability to make unbiased and objective recommendations.

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Answer and Explanation

Rangen did not fulfill the obligation he assumed when he agreed to counsel these clients. That is, he did not make recommendations that were consistent with their financial needs. According to Standard III(C), Suitability, Rangen must consider the appropriateness and suitability of investment recommendations or actions for each portfolio or client. This is true even if his clients wanted to speculate and were aware of the risks.

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Rangen bought U.S. Treasury strips and over-the-counter stocks that did not produce income as sought by his clients. Rangen claimed that his actions were justified because his firms research department recommended the purchase of the Treasury strips. Also, he claimed the stocks that he bought were all in the top-rated categories of his firms research division. Which of the following statements best describes why Rangens arguments, in which he attempted to shift the blame to his employer, did NOT meet the requirements of the Code and Standards?

A) Rangen misrepresented the basic characteristics of the investments that he bought for his clients' accounts.

B) Rangen did not use reasonable care and judgment to achieve and maintain independence and objectivity in taking investment actions.

C) Rangen used material nonpublic information from his firm's research department as the basis for selecting the securities that he bought for his clients' accounts.

D) Rangen's duty was to make only recommendations that were in the best interests of his clients.

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Answer and Explanation

Rangen cannot shift the blame to his employer. He had an obligation to consider not only his firm's recommendations, but also his clients' investment objectives and financial situations. He failed to consider relevant factors relating to his clients. Rangen violated Standard III(C) because he initiated investment actions without properly considering whether these actions were suitable to his clients' financial situations and investment objectives.

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

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

C) develop an investment policy statement for each client.

D) educate clients with respect to the selection of appropriate asset allocations and strategies.

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Answer and Explanation

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) reviewing investment policy statements regularly.

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

C) obtaining proper portfolio diversification where appropriate.

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

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Answer and Explanation

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.

D) When making investment recommendations or taking investment actions, managers should focus primarily on a client's tax considerations and after-tax returns. Managers should attempt to develop tax-efficient investment strategies and portfolios. Managers should typically avoid high-yielding securities in favor of those expected to result in capital gains. Managers are required to review changes in applicable tax laws and regulations to ensure that the best interests of clients are being met from a tax perspective. Managers should review portfolios at least annually.

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Answer and Explanation

Standard III(C) requires that members shall make a reasonable inquiry into a clients 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, minimizing risk, or focusing on tax considerations. All of these statements may be inconsistent with the needs and circumstances of each individual client.

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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) Best interests of the investment professional.

B) Basic characteristics of the total portfolio.

C) Basic characteristics of the investment involved.

D) Needs and circumstances of the portfolio or client.

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Answer and Explanation

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.

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The ODouls (husband and wife) have decided to work with Jane Mack, CFA, to have her recommend an investment portfolio for them. The ODouls are novice investors and Mack has determined their asset allocation model falls into the conservative category. After researching various investment options for the ODouls, Mack has made a recommendation that they divide their account on a 25%/75% basis between shares of a computer peripherals manufacturing company her brokerage firm is underwriting and investment grade corporate bonds. The ODouls are not aware that Macks firm is underwriting an offering of the company in question. Which CFA Institute Standard(s) has Mack violated given her actions?

A) Standard III(B), Fair Dealing, and III(A), Loyalty, Prudence, and Care.

B) Standard V(A), Diligence and Reasonable Basis, and I(D), Misconduct.

C) Standard III(D), Performance Presentation, and III(B), Fair Dealing.

D) Standard VI(A), Disclosure of Conflicts, and III(C), Suitability.

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Answer and Explanation

Mack is obliged to disclose the conflict of interest regarding her companys IPO and to consider both the appropriateness and the suitability of the investment for her client. She has apparently failed in both respects.

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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.

In this situation, all of the following would be components of an effective compliance process EXCEPT:

A) using margin accounts.

B) diversifying portfolios where appropriate.

C) educating clients in the basics of investment characteristics.

D) preparing an investment policy statement based on information obtained from each client.

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Answer and Explanation

Using margin accounts would be inappropriate in this situation because it would increase the risk of loss and require clients to pay interest on the margin loan, adding to the cost to maintain the account. Trading on margin is inappropriate for unsophisticated, inexperienced individual investors with limited means.

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In this situation, which of the following would NOT be a component of an effective compliance process?

A) Use concentrated portfolios consisting of only a few assets because this approach reduces trading costs.

B) Examine risk tolerance carefully because risk tolerance is an important element in determining an appropriate investment policy statement.

C) Update client information regularly, because client circumstances may change.

D) Educate clients on how to select investments because this can help clients accomplish their investment policy statement goals.

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Answer and Explanation

In this case, the broker increased the risk of loss for the clients beyond that consistent with the client objectives by concentrating much of their equity in particular securities. A component of an effective compliance process would be to develop diversified portfolios to reduce portfolio risk.

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Bob Hatfield, CFA, has his own money management firm with two clients. The accounts of the two clients are equal in value. One of the clients gets married and the assets of the new spouse and the client are combined. With the larger portfolio of the now married client, Hatfield determines that they can assume a higher level of risk and begins a change in the policy concerning that portfolio. Which of the following would violate Standard III(C), Suitability?

A) Implement a similar policy for the other client who did not just get married.

B) Assess the time horizon of the newly married client and his spouse.

C) Assess the return objectives of the newly married client and his spouse.

D) Notify the client of the change in policy and why he is enacting it.

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Answer and Explanation

According to Standard III(C), Suitability, the analyst must assess the time horizon, return objectives, tax considerations, and liquidity needs of a client before changing an investment policy. The analyst must notify the client of the new policy. Implementing the policy for the other client may be a violation of the Standard unless that clients needs are totally reassessed and determined to be identical to the needs of the newly married client.

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According to CFA Institute Standards of Professional Conduct, when a client asks her portfolio manager to change the current investment strategy of the clients portfolio, the manager should:

A) obey the client's request without question.

B) examine whether the strategy is appropriate for the client and explain the implications of the new strategy before implementing the strategy.

C) examine whether the strategy is appropriate and inform the SEC if it is not.

D) explain the implications of the new strategy after the member manager implements the strategy.

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Answer and Explanation

According to Standard III(C), Suitability, the member manager must determine that an investment is suitable given the clients objectives/constraints and within the context of the clients total portfolio. . In this case, the member manager must examine the new strategy to see if it is appropriate for the client, even if the client asked for the change. The member should also explain the implications of the strategy to avoid any misrepresentations that may result from omitting details.