Ethical and Professional Standards 【Reading 3】 investment, including, recently, Investment, Jackson

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Sally Watson works as an equity portfolio manager for Brunswick Investment Advisers (BIA). Wally Jackson, President and Chief Investment Officer of the firm, is a CFA charterholder who supervises Watson and other investment professionals within the firm. Watson is a candidate in the CFA Program, and she has recently passed the Level II exam. BIA's clients include trusts, foundations, endowments, corporations, and high net worth individuals, including accounts for family and friends of its employees. Jackson and Watson manage client portfolios with a growth strategy and concentrate on holdings in the healthcare, technology, and communications sectors. About 10 percent of BIA accounts are actively managed.
Because BIA uses Accommodate Broker Dealer for executing transactions, Accommodate provides research to BIA regarding holdings in accounts that are actively managed. The fees Accommodate charges BIA are competitive, and BIA applies the same basic fee structure to all its clients. BIA’s clients do not know about BIA’s arrangement to get research information from Accommodate.
The clients do know that Accommodate routinely allocates shares in IPOs that it underwrites to BIA. Jackson is eagerly awaiting the IPO of a new technology company that he intends to allocate across all current portfolios, including the proprietary account and accounts of friends and family. Based upon his research, Jackson feels this IPO has good potential and has been working to get an unusually large number of shares of the IPO.
BIA has recently been awarded two new client accounts, totaling $100 million, which are in the process of completing transitions from other managers. Although an investment objective and guidelines have not been formalized for the accounts, Jackson allocates shares of the IPO across all client accounts on a pro rata basis, including an allocation for these new client accounts.
Watson serves on the board of directors for New Medical Developments, a biotech firm in which she maintains significant stock and options. BIA owns 4.5 percent of New Medical’s stock on behalf of its clients and in its proprietary account. At a special meeting of New Medical’s board, Watson learns that Remedy Inc. is preparing a confidential tender offer for all of New Medical’s shares outstanding. After the meeting, Watson sends an electronic mail message to Jackson detailing the offer.
Jackson immediately places New Medical Developments on BIA’s restricted list so representatives of BIA cannot recommend the stock. As rumors circulate in the investment community about the tender offer, some of Jackson’s clients call and ask him to look into the possibility of purchasing stock in New Medical Developments. Jackson is fearful of his situation and puts off such requests. As a result, one client, Craig Mills, files a complaint with CFA Institute that Jackson is not responding to his requests. Knowing the precarious situation he is in, Jackson decides to wait until the tender offer has been announced to address Mills’ complaint.
CFA Institute becomes suspicious of Mills, because he seems to have a history of trading stocks for which material information soon becomes public. As part of an investigation into possible insider trading activities, CFA Institute asks Jackson to furnish CFA Institute with Mills’ trading history.
Watson must notify BIA of all the following EXCEPT:

A) her ownership of the stock in New Medical Developments.

B) her plans for taking the next CFA exam.

C) any independent consulting work she performs for third parties.

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Watson does not have to inform BIA about her plans to take a CFA exam. She should be careful, of course, not to misinform BIA of her plans, i.e., say she will when she knows she cannot. All of the other notifications are required. Standard VI(A) requires her to inform BIA about potential conflicts of interest. Standard IV(A) requires her to inform BIA about any consulting work she performs. (Study Session 2, LOS 4.a,b)

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With respect to the arrangement that BIA has with Accommodate, based on the provided information:

A) no violation has occurred as long as BIA informs CFA Institute that the firm receives research information from the brokerage firm.

B) no violation has occurred since BIA charges the fee structure to all of its clients.

C) a violation has occurred because BIA charges the same fee structure to all of its clients.

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Watson has violated the Soft Dollar Standard. For directing the trades through a given brokerage firm, BIA is getting research that only benefits about 10 percent of the clients. The remaining clients are paying the same fees, but they are not getting the same benefit. If BIA were to inform all of its clients of the arrangement, it might not be a violation, but the vignette says that information has not been disclosed. (Study Session 2, LOS 6.c)

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With respect to how Jackson allocated the shares in the IPO of the technology company, has Jackson acted in accordance with the Code and Standards?

A) Yes, Jackson allocated the shares of the offering fairly on a pro rata basis to all client accounts.

B) No, Jackson has violated Standard III(C) Suitability.

C) No, Jackson has violated Standard VI(B) Priority of Transactions.

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Jackson violated Standard III(C) – Suitability by allocating shares of the public offering to the two new client accounts without establishing an investment objective or guidelines for the accounts. Standard III(C) requires a reasonable inquiry into the client’s financial situation, investment experience, and investment objectives prior to taking any investment actions. Such information must also be updated regularly. The Standard also requires that the appropriateness and suitability of investment recommendations or actions be considered for each client, including 1) client needs and circumstances; 2) basic characteristics of the investment involved; and 3) basic characteristics of the total portfolio. Although the shares were allocated pro rata across all client portfolios, no investment action should have been initiated for the new clients without appropriate consultation regarding investment objectives and guidelines. (Study Session 2, LOS 3.a)

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Given Brunswick’s current ownership in New Medical, the Code and Standards require Jackson to:

A) not initiate any investment action prior to the information being publicly disseminated.

B) trade the shares in client accounts before any accounts for himself, family or friends.

C) not take any investment action but communicate the information to other members of the proxy committee in preparation for consideration.

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Under the Code and Standards, Jackson should not initiate any investment action on the information provided by Watson in order to prevent a violation of Standard II(A) – Material Nonpublic Information. The information provided by Watson involved a proposed confidential tender offer for New Medical’s outstanding shares and, therefore, was material, nonpublic information. Information is “material” if its disclosure would have an impact on the stock value or if a reasonable investor would want to know the information prior to making an investment decision. Material is “nonpublic” until it has been generally disseminated to the marketplace and investors have had an opportunity to react to the information. Neither Jackson, nor Watson should take any investment action regarding New Medical. Upon receipt of the information, Jackson should inform his compliance officer of the information, but otherwise keep the information confidential. However, not responding to unsolicited requests from clients to purchase New Medical is a possible violation because it appears that he is not acting in the best interest of the clients. (Study Session 2, LOS 3.a)

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Given Watson’s actions, which of the following statements is most accurate?

A) Standard III(A) – Loyalty, Prudence, and Care was violated.

B) Standard III(E) – Preservation of Confidentiality was violated.

C) None of the Code and Standards were violated.

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Watson communicated the tender offer information to her supervisor which is not a violation of any standards because shares of the target firm, New Medical, are held in some of BIA's client's portfolios and in the firm's proprietary account thus trading in New Medical should be put on a restricted list. The information provided by Watson involved a proposed tender offer for New Medical’s outstanding shares and, therefore, was material, nonpublic information. Information is “material” if its disclosure would have an impact on the stock value or if a reasonable investor would want to know the information prior to making an investment decision. Material is “nonpublic” until it has been generally disseminated to the marketplace and investors have had an opportunity to react to the information. Neither Jackson, nor Watson should take any investment action regarding New Medical and it should be added to Brunswick’s restricted list to prevent a violation. Since Watson serves on the board of New Medical she has a duty to the firm but the communication of the tender offer (for New Medical) by Watson to Jackson is not a violation of Standard III(A) Loyalty, Prudence, and Care because neither New Medical nor the offering firm, Remedy, are clients of BIA the firm Watson works for. Standard III(E) – Preservation of Confidentiality does not appear to have been violated by Watson’s actions. She does not appear to communicate any confidential information provided by clients, prospects, or her employer concerning the scope of any client-member, prospect-member or employer-member relationship. (Study Session 2, LOS 3.a)

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With respect to the complaint Mills filed against Jackson, and the subsequent investigation of Mills by CFA Institute, which of the following statements is least accurate?

A) Jackson violated the Code and Standards by putting New Medical Developments on its restricted stock list.

B) Jackson violated the Code and Standards by not responding to Mills.

C) Jackson did not violate the Code and Standards if he provides Mills’ trading information to CFA Institute.

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Rules concerning the confidentiality of client information do not apply to investigations of CFA Institute, which will keep any information it receives confidential. Jackson does not violate a Standard by placing a stock on a restricted list when the firm is in possession of material nonpublic information, and this is a recommended move. However, unsolicited requests from clients deserve a response. Jackson is putting his self-interest above his own by trying to protect himself by not responding to client inquiries concerning New Medical. (Study Session 2, LOS 3.a)

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Harold Klein, CFA, is an expert on ethical conduct in the investment banking industry and has been asked by an association of investment bankers to give a presentation on interpreting codes of ethics and standards of practice such as the CFA Institute Code of Ethics and Standards of Professional Conduct. In his presentation, Klein makes two key points:

• Sound ethical judgment requires careful and thoughtful application of ethical standards which are precise and exacting in nature
• An ethical professional must begin the ethical decision making process by determining the applicable code and standards that govern the situation.

Determine whether Klein’s statements are correct or incorrect and state your conclusion.

Statement 1

Statement 2

A) Correct Correct

B) Incorrect Correct

C) Incorrect Incorrect

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Statement 1 is incorrect. Ethical standards and codes of conduct are not mathematically precise and exacting but are ambiguous and open to interpretation. This characteristic requires wisdom and a mature approach on the part of the professional. Statement 2 is correct. In deciding what course of action is ethically sound, a professional must first determine the applicable code and standards and assess their requirements in light of the circumstances.

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Which of the following statements concerning the interpretation and application of the CFA Institute Code of Ethics and Standards of Professional Conduct is least accurate?

A) Ethical reasoning is mathematically precise and the technical terms found in the Code of Standards and Standards of Professional Conduct are clear-cut and unambiguous.

B) The Code of Ethics is a concise set of general principles that can be used to address questions as they arise, but as a practical matter, ethical decision making is needed to apply the Code to complicated situations.

C) Once the relevant sections of the Code of Ethics and Standards of Professional Conduct have been identified, the investment professional must determine if the course of action is consistent with the intent, whether the client would agree the action is the best alternative, and whether the firm’s reputation would be enhanced or compromised.

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Ethical reasoning is not mathematically precise and the technical terms found in the Code and Standards are not necessarily unambiguous. All of the other statements are true.

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Tyler Hanson, CFA was recently hired as a portfolio manager at Newton Management Inc. Hanson is concerned about several ethically questionable situations that have presented themselves over the past few weeks, and has approached the firm’s compliance officer for counsel as to the best course of action to take in light of each situation. The compliance officer has offered several suggestions to assist Hanson in evaluating the situations that he detailed in their meeting. Which of the compliance officer’s following suggestions should Hanson NOT use in interpreting the Code and Standards to determine appropriate action?

A) Determine whether a fully informed client would likely view the chosen action favorably and if not, choose a different course of action.

B) Assess whether the general public would perceive the firm more favorably if the situation were to be objectively reported in the media and if not, choose a different course of action.

C) Assess whether the chosen action would provide an immediate positive economic benefit to the firm and if not, choose a different course of action.

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In order to interpret the CFA Institute Code of Ethics and Standards of Professional Conduct it is suggested that a particular course of action be assessed as to its conformance with the Code and Standards, whether a well informed client would view the action favorably, whether public knowledge of the situation enhances or damages the firm’s reputation, and whether the action is commendable and sets a good example for others. Determining that an action provides an immediate positive economic benefit to the firm does not necessarily promote ethical decision making as some actions that are deceptive or illegal would certainly provide a firm with an immediate economic benefit but would be unethical to pursue.

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Steve Copper has worked as an independent consultant for the past ten years advising companies on various ways to increase their internal efficiency and thereby increase the firm’s stock price as well. Copper recently accepted a job offer from an equity research firm as a senior stock analyst. One of the firms he will be responsible for researching, Johnson Machine Tools (JMT), is also one of his consulting clients. Copper currently has a contract with JMT to provide consulting services for another six months which he plans to honor even though there are no penalties in the contract for early termination on his part. According to CFA Institute Standards of Professional Conduct, which of the following is the most appropriate action for Copper to take? Copper should:

A) disclose the arrangement only if he plans to renew the contract in six months.

B) disclose the consulting arrangement to clients considering JMT as an investment.

C) terminate the contract with JMT prior to issuing any research on the company.

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Standard VI(A) – Disclosure of Conflicts requires members and candidates to inform clients, prospects, and their employers of any situation that may impair their independence and objectivity or interfere with duties owed to the same groups. The Standard notes that best practice is to avoid conflicts of interest when possible. This best practice recommendation is consistent with Standard I(B) – Independence and Objectivity, which requires that independence and objectivity be maintained. The consulting arrangement with JMT, a company about which Copper will write research reports, divides his loyalty between JMT and the clients purchasing Copper’s research on the same company. This is a clear conflict of interest which must be disclosed to clients, prospects, and Copper’s employer if the conflict cannot be avoided. However, there is no penalty for ending the consulting relationship and best practice would dictate that Copper terminate the contract with JMT.

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A firm recently hired Viola Sandoval, CFA, to be a managing supervisor in the firm. Sandoval knows that all of her subordinate supervisors are members of CFA Institute and the firm has a compliance system in place with respect to the Code and Standards. Under these conditions Sandoval needs to:

A) rely on the current compliance system since the subordinate supervisors are subject to the Code and Standards.

B) immediately implement a new compliance system.

C) review the compliance system for its adequacy.

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According to Standard IV(C), Responsibilities of Supervisors, Sandoval must make reasonable efforts to detect violations of the law, rules, regulations, and Code and Standards. This responsibility is not eliminated because Sandoval’s subordinates are CFA Institute members. Sandoval should review the compliance system and report any inadequacies to senior management.

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Steve Reese, CFA, an equity analyst for Bison Investments, has just completed his extensive research on the long-term prospects of ThetaCorp, a small technology firm that creates medical software for hospitals and other medical clinics. Reese has determined that the economic outlook for ThetaCorp warrants issuing a buy recommendation and has reflected this long-term view in his report which is being reviewed by Bison’s compliance department. The head of Bison’s investment banking department, Mark Hazel, CFA, learned of the report and called Reese to suggest that he increase his recommendation to a strong-buy in an effort to support Bison’s bid to be retained as the lead underwriter for an upcoming bond issue by ThetaCorp. Hazel explained that the level of risk that Reese has assigned to ThetaCorp is too high and that with a slight downward adjustment, a strong-buy recommendation would be justified. Reese agreed to the adjustment and updated his report which he then resubmitted to the compliance department which gave its official approval for distribution. According to CFA Institute Standards of Professional Conduct, which of the following is CORRECT? Reese has:

A) violated the Standards by failing to deal fairly with all of Bison Investments’ clients.

B) violated the Standards by failing to maintain his independence and objectivity.

C) not violated the Standards since he has reasonable basis to support a strong-buy recommendation.

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According to Standard I(B) – Independence and Objectivity, members and candidates must not allow other entities to compromise the independence and objectivity of their professional activities. Reese has allowed Hazel to materially influence his research report. Hazel is the head of Bison’s investment banking department which may have interests at odds with the equity research department. Ideally, the firm would build a firewall to prevent such communication between departments.

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CFA Institute members are required to do all of the following, EXCEPT:

A) inform their employer, clients, and potential clients of benefits received for recommending products or services.

B) disclose, in writing, all observed violations of security laws and regulations to the proper regulatory authorities.

C) receive permission from both their employer and outside clients to engage in investment consulting outside the firm.

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Members are not required to report violations of others to regulatory authorities, either verbally or in writing, but such reporting may be prudent.

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Jim Bennett, CFA, leases office space to his best friend, Steve Waters. Bennett is an independent investment advisor specializing in high net worth clients and Waters is a licensed life insurance underwriter. In lieu of paying rent, Waters refers his insurance clients to Bennett, but only with the clients’ permission. For clients referred by Waters, Bennett:

A) need not disclose the terms of the lease arrangement because Waters obtained the clients’ permission for the referral.

B) must disclose the terms of the lease arrangement.

C) need not disclose the referral fee if Waters discloses the lease arrangement to the clients first.

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Standard VI(C), Referral Fees, requires members to disclose to clients and prospects any consideration or benefit received by the member or delivered to others for the recommendation of any services to the client or prospect. Bennett has delivered a benefit (free rent) to Waters, which must be disclosed to the clients referred by Waters. Bennett must not rely on Waters to make the disclosure.

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Kevin Lowell, CFA, manages a pension plan for a national grocery retailer. All of the following are required as a part of Lowell’s fiduciary duties, EXCEPT:

A) act in a prudent and judicious manner.

B) support the sponsor's management during proxy fights.

C) place the client’s interest before the employer’s interest.

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Members are required to act in the interest of their clients. In voting proxies, the client’s interest must prevail over management’s interest.