Reading 2-V: Standards of Professional Conduct & Guidance technology, Investment, companies, 2011, class

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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.

 

 

LMS Securities is a boutique broker-dealer specializing in private placements for technology companies. The firm also provides aftermarket support for the companies that go public after private rounds of financing. This support includes market making and research coverage.

Susan Jones, CFA, is an analyst at LMS Securities. She is responsible for a subset of the companies for which LMS offers research coverage. She recently received her annual CFA Institute Professional Conduct statement, but has not yet filled it out and turned it in. Steve Brown is an analyst who directs the due diligence process for LMS Securities’ private placements. Brown passed the Level II exam five years ago, and has registered for the Level III exam every year since then, but has never taken it. He is registered for the Level III CFA exam next June, but nobody at the office believes he will actually take the test.

Sunrise Technologies is a longtime client of LMS Securities. LMS arranged four levels of private financing, for Sunrise, providing in-depth business consulting as well as handling all of the private placements. Sunrise went public 90 days ago and is currently trading at $14 per share.

Kenneth Karloff, CEO of LMS Securities, instructed Jones to write a favorable research report on Sunrise Technologies right before the company went public, setting a price target of at least $30 per share. Jones has developed a number of alternative cash flow projections for Sunrise Technologies. She picks an optimistic scenario to justify a $30 price target and issues a positive report using those projections.

After Sunrise Technologies has gone public, Karloff decides to help Jones to write a more-detailed research report on the company. Karloff provides Jones with information about the product pipeline and sensitive patent litigation that was given to him in confidence by Sunrise executives while the company was private. Given the product pipeline and legal outlook, Jones revises her cash flow models to reflect greater growth, then writes a positive report and advises LMS’s clients to buy the stock.

LMS Securities has an arrangement with Clampett Securities, an investment adviser, under which the investment manager uses its client brokerage to obtain LMS’s research. Clampett manages accounts for wealthy individual investors. About half of Clampett’s clients have a growth objective, while the rest seek income.

 

In order to remain an active member of CFA Institute, Jones must annually:

A) submit her completed Professional Conduct Statement, pay applicable membership dues, and complete forty hours of continuing education.

B) pay applicable membership dues and complete forty hours of continuing education.

C) submit her completed Professional Conduct Statement and pay applicable membership dues.

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To remain an active member, Jones must agree to abide by the Code and Standards and the Professional Conduct Program. This is accomplished by completing the Professional Conduct Statement on an annual basis. In addition, Jones must pay annual membership dues. Continuing education is encouraged but not required to remain an active member. (Study Session 1, LOS 2.a,b)

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Which of the following statements regarding the research report on Sunrise Technologies after the company went public is CORRECT?

A) Jones has violated the Standard on research reports because she failed to distinguish between fact and opinion; Karloff is in compliance with the supervisory-responsibilities Standard because he is keeping up with Jones’ actions and ensuring her report is accurate.

B) Jones is in compliance with the objectivity Standard because she made her recommendation based facts, not conjecture; Karloff has violated the Standard regarding the use of material nonpublic information.

C) Jones has violated the misrepresentation Standard with her aggressive growth prediction for Sunrise Technologies; Karloff has violated the plagiarism Standard by disseminating information he received in confidence.

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Jones’ second research report made reference to hard facts, and her analysis and revision of the cash flow projections seems thorough and reasonable. This time, Karloff did not press her to express a certain opinion, and she found the information about the company compelling. She projected higher growth in cash flow for Sunrise, but nowhere is it said that she guaranteed a hard target. Jones is in compliance with the misrepresentation, objectivity, reasonable-basis, and research-report Standards. Karloff violated the insider-trading Standard because the information was given to him in confidence. He may also have violated his fiduciary duty to Sunrise, which probably kept the information private for a reason. (Study Session 1, LOS 4.a)

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According to CFA Institute Standards concerning fair dealing, Jones is required to do which of the following?

A) Ensure that accounts belonging to her immediate family purchase securities only after other clients have had the chance to buy.

B) Disseminate new investment recommendations to all clients at the same time.

C) Disclose to all clients whether different levels of service are offered.

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Jones must disclose different levels of service to all clients. Jones must inform clients about new buy recommendations and advise them not to sell, but she cannot disregard the order if the client still wishes to sell. Family-owned accounts should be handled in the same way as other accounts, and cannot be made to wait until everyone else has acted. The Standard allows for the fact that it is impossible to notify everyone at the same time. (Study Session 1, LOS 2.a,b)

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Which of the following statements could Brown put on his resume without violating Standard VII(B): Reference to CFA Institute, the CFA Designation, and the CFA Program?

A) I am a Level III CFA and should become a chartered financial analyst next year.

B) I am a Level III CFA candidate eligible to receive my charter in November 2005.

C) If I pass the Level III test, I may be eligible for my CFA charter late next year.

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This statement is quite literally correct, and complies with the Standards. “Level III CFA” is not an acceptable use of the CFA mark. Candidates should not offer a prediction about the time they will earn their charter. While Brown is not likely to take the test, as long as he is registered, he may refer to himself as a candidate. (Study Session 1, LOS 2.a,b)

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In order for Clampett Securities to claim compliance with CFA Institute Soft Dollar Standards, the company must:

A) re-evaluate mixed-use research at least once a year.

B) comply with all recommended provisions of the Soft Dollar Standards.

C) send all purchased research to the client whose brokerage was used to pay for it.

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Mixed-use research must be evaluated at least annually. Companies that claim soft-dollar compliance must follow the mandatory provisions, but can forgo some of the recommended provisions. If research only benefits some clients, it is acceptable to use just their brokerage to pay for it. The Standards do not require sending research to clients. (Study Session 1, LOS 3.b)

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When Jones produced the research report on Sunrise Technologies before it went public, she violated:

A) Standard V(B): Communication with Clients and Prospective Clients by leaving relevant facts out of the report, but not Standard III(A): Loyalty, Prudence, and Care because the CEO cannot pass his fiduciary duty on to her.

B) Standard V(A): Diligence and Reasonable Basis because her research was not thorough, and Standard I(B): Independence and Objectivity because of her obedience to her CEO.

C) Standard I(B): Independence and Objectivity because of her obedience to her CEO, and Standard II(A): Material Nonpublic Information because of Karloff’s involvement.

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Jones’ research was not thorough, and her report did leave out salient facts. Thus, she violated Standards V(A) and V(B). Her objectivity was certainly in question, so she violated Standard I(B). She also has a fiduciary duty to the clients regardless of what the boss says, so she violated Standard III(A). No nonpublic information was used in this report, so Standard II(A) was not violated. (Study Session 1, LOS 2.a,b)

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Susan Tigra, CFA, is a portfolio co-manager for the Sandia Energy pension fund. Sandra Bulow, a research analyst under Tigra’s supervision, creates a new trading model and immediately begins to trade. Susan stops Bulow from trading, but notes that the firm has no guidelines for testing new models. Tigra should most likely:

A) encourage her firm to develop detailed, written guidance that establishes minimum levels of testing for all computer-based models as required by Standard III(C) "Suitability."

B) report Bulow to the firm’s compliance department for violation of Standard V(A) "Diligence and Reasonable Basis."

C) encourage her firm to develop detailed, written guidance that establishes minimum levels of testing for all computer-based models as recommended by Standard V(A) "Diligence and Reasonable Basis."

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Tigra should encourage her firm to develop detailed, written guidance that establishes minimum levels of testing for all computer-based models as recommended by Standard V(A) "Diligence and Reasonable Basis." Reporting Bulow to the Compliance Department would be of limited usefulness as she has already established that the firm does not have rules discouraging this behavior.

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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) do both of these.

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

C) support a recommendation with appropriate research and investigation.

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

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Regarding the high-tech stock model, which of the following actions is least likely to help Sandro avoid violating the standards regarding plagiarism and research reports?

A) Acknowledging Standard & Poor’s as the original data source and Moody’s Investors Service as the new data source.

B) Acknowledging Wright’s development of the initial model.

C) Providing basic information about technology stocks in the research report.

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To comply with Standard I(C): Misrepresentation, Sandro should have gotten permission from Wright to copy the spreadsheets. The Standard also requires that Sandro identify Wright as the source of the initial model despite the fact that she made major changes to it. The plagiarism standard permits publishing factual information from Moody’s and S& without acknowledgment, but the use of different data sources could affect the performance of the model, and should be disclosed to satisfy Standard V(B): Communication with Clients and Prospective Clients. Because the report is going to an individual client, Sandro need not provide basic information about technology stocks, according to Standard V(B): Communication with Clients and Prospective Clients.

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The production of the advertising represented a violation of:

A) Standard VII(B): Reference to CFA Institute, the CFA Designation, and the CFA Program, and Standard I(C): Misrepresentation.

B) Standard IV(C):Responsibilities of Supervisors, but not Standard VII(B): Reference to CFA Institute, the CFA Designation, and the CFA Program.

C) Standard IV(A): Loyalty to Employer and Standard I(C): Misrepresentation.

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Sandro’s description of her CFA standing is truthful in this case because she is still technically a CFA candidate. Sandro is not allowed to imply that she can continue to produce superior returns, and as such violated the misrepresentation standard. Ferrazzo, in her supervisory role, should have prevented the violation but did not. Standard IV(A): Loyalty to Employer refers to independent practice, and is not relevant to this situation.

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Ferrazzo may use which of the following brokers?

A) Blue only.

B) Blue and Green only.

C) White and Blue only.

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The CFA Institute Soft Dollar Standards dictate members must always seek best price and execution. Soft-dollar arrangements must provide a benefit to clients, be disclosed, and be reasonable in relation to the research and execution services provided. Because both White and Blue provide best price and execution, it is within Ferrazzo’s discretion to pay more for White’s services as long as the research benefit is reasonable. Both White and Blue may be used.

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Which of the following statements regarding Alpha Co. is least accurate?

A) Sandro has breached a fiduciary duty to her client.

B) Both Wilson and Sandro have a reasonable basis for their recommendations.

C) The fair-dealing standard has not been violated.

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The use of a comprehensive research report is reasonable basis for a buy or sell recommendation. The fair-dealing standard has not been violated, as neither client was put at a disadvantage by the advice, even though the analysts’ advice was contradictory. The fair-dealing standard requires the notification of clients who trade in opposition to the firm’s official recommendation, so the trade should not be executed until the client is told about the firm’s buy rating. While Sandro’s advice differs from that of her colleague and is based on a competitor’s research, she did not necessarily breach a fiduciary duty, if the investment made sense for the client. There are numerous investments that are appropriate for certain types of clients and inappropriate for others.

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Which of the following statements regarding Sandro's biography is least accurate?

A) Sandro must disclose her stake in a thinly traded, family-owned construction company.

B) Sandro can begin using the CFA designation as soon as she receives her exam results.

C) Sandro need not deliver a copy of the Code and Standards to Ferrazzo.

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Just because Sandro receives her results from CFA Institute, she still must satisfy all of the requirements before she can use the designation. The standard governing use of the CFA mark states that there is no acceptable term for a partial designation. According the Standards of Practice Handbook, 9th Edition, delivering a copy of the Code and Standards is no longer required. Standard VI(A): Disclosure of Conflicts, requires the disclosure of all security ownership that might interfere with a member’s duties. While the stock is thinly traded, it still might be of interest to Seamark clients, and Sandro must disclose her ownership. In addition, if she holds a position in the company or on the board that could take up some of her time, Standard IV(A): Loyalty to Employer, also comes into play.

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Several years ago, Hilton and Ross, a full service investment firm, managed the initial public offering of eCom, Inc. Now, eCom wants Hilton and Ross to underwrite its secondary public offering. A senior manager at Hilton and Ross asks Brent Whitman, CFA, one of its equity analysts, to write a favorable research report on eCom to help make the underwriting a success. Whitman conducts a thorough analysis of eCom and concludes that the company has serious problems that do not suggest a favorable financial outlook. Nevertheless, Whitman writes a favorable report because he is fearful of losing his job. Hilton and Ross publicly distribute a report that only contains a buy recommendation and a brief description of the basic characteristics of eCom. Whitman has violated:

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

B) Standard I(B) Independence and Objectivity, only.

C) Both Standard I(B) Independence and Objectivity and Standard V(A) Diligence and Reasonable Basis.

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Whitman violated Standard V(A) Diligence and Reasonable Basis because he did not have a reasonable and adequate basis for issuing a favorable recommendation. Whitman violated Standard I(B) Independence and Objectivity because he did not act independently in issuing his recommendation but instead was influenced by senior management at Hilton and Ross.

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An analyst writes a report and includes the forecasts of an econometric model developed by the firm’s research department. The analyst identifies the source of the forecast and includes all the relevant statistics concerning the model and his opinion of the model’s accuracy. With respect to Standard V(A), Diligence and Reasonable Basis, the analyst has:

A) violated the Standard by including quantitative details in a report.

B) violated the Standard by not testing the model himself.

C) complied with the Standard.

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Including quantitative details in a report is not a violation of the Standard. The analyst has more of an obligation to give an opinion on the accuracy of the model than withhold such an opinion. Although the analyst should use reasonable care to verify information included in a report, retesting models developed by the research department of a firm is not explicitly required.

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An analyst notices that for most years that a given class of assets has an abnormally high rate of return, the asset class often has an abnormally low rate of return the next year. Based upon this information, according to Standard V(A), Diligence and Reasonable Basis, the analyst can recommend:

A) short selling assets that have had a good previous year to all clients.

B) an increased allocation of Treasury bills (T-bills) for all portfolios of assets that have increased dramatically in the previous year.

C) neither of these choices.

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An analyst should not make a recommendation based only upon a statistical anomaly. Furthermore, none of the other choices would be appropriate. Clients with low risk tolerance should not short sell assets. The analyst cannot make a recommendation to all clients because each client has different characteristics and portfolios. The one answer that may have some merit is to increase the allocation of T-bills in portfolios that have had recent, dramatic increases. This would be for the purposes of maintaining a balanced portfolio. But the decision to rebalance must be made on a case-by-case basis and not for all portfolios.

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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) none of the Standards listed here.

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

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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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Susan Plumb is the supervisor of her firm’s research department. Her firm has been seeking the mandate to underwrite Wings Industries’ proposed secondary stock offering. Without mentioning that the firm is seeking the mandate, she asks Jack Dawson to analyze Wings common stock and prepare a research report. After reasonable effort, Dawson produces a favorable report on Wings stock. Plumb then adds a footnote describing the underwriting relationship with Wings and disseminates the report to the firm’s clients. According to CFA Institute Standards of Professional Conduct, these actions are:

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

B) not a violation of any Standard.

C) a violation of Standard VI(A), Disclosure of Conflicts.

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The fact that the firm is seeking the mandate does not preclude the research department from performing analytical work on the security. As long as the final recommendation is based upon reasonable facts, not the desire to obtain the mandate, there is no violation.

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An analyst receives a research report from a colleague. The colleague’s report has an elaborate table with performance data on publicly traded stocks. The colleague says the data in the table consists of measures provided by Standard & Poor’s. The analyst finds the table a useful reference for a report she is writing. She uses several pieces of data from the table. The analyst is potentially in violation of:

A) Standard V(A), Diligence and Reasonable Basis, if she does not first verify the data in the table is accurate.

B) Standard I(C), Misrepresentation, concerning the use of the work of others.

C) no particular standard because this is appropriate activity.

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Since the data in the table supposedly comes from Standard & Poor’s, a recognized data source, the analyst does not have to cite the source of the data. However, the analyst needs to use reasonable care and verify that the data is accurate by going back to the source. Had the analyst printed the table prepared by her colleague without acknowledgement, the analyst would have violated Standard I(C), Misrepresentation.