Reading 2-V: Standards of Professional Conduct & Guidan Investment

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CFA Institute Area 1-2: Ethical and Professional Standards
Session 1: Code of Ethics and Professional Standards
Reading 2-V: Standards of Professional Conduct & Guidance: Investment Analysis, Recommendations, and Action
LOS B.: Communication with Clients and Prospective Clients.

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In the preparation of a research report, a CFA Institute member may emphasize certain matters, touch briefly on others, and omit some altogether:

A) provided that the analyst has a reasonable basis for his or her actions.

B) provided that matters are not constrained by the Mosaic theory.

C) provided that the analyst both has a reasonable basis and is unconstrained by the Mosaic theory.

D) under no circumstances.

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Answer and Explanation

According to Standard V(B), the analyst must use reasonable judgment in identifying relevant factors when communicating with clients and prospects . The Mosaic theory does not apply here.

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Nicole Wise, CFA, is an analyst at Chicago Securities. She attends a meeting with management of one of the companies that she covers. During the meeting, management expresses great optimism about the companys recent acquisition of a new business. Wise is excited about these prospects and issues a research report that states that the company is about to achieve significant success with the new acquisition. Wise has:

A) violated CFA Institute Standards of Professional Conduct because she is not allowed to meet with management privately.

B) violated CFA Institute Standards of Professional Conduct because she did not check the accuracy of the statements that management made.

C) not violated CFA Institute Standards of Professional Conduct because she had reasonable reason to believe that the statements in her report were true.

D) violated CFA Institute Standards of Professional Conduct because she misrepresented the optimism by turning it to certainty.

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Answer and Explanation

Standard V(B), Communication with Clients and Prospective Clients. Members must distinguish between fact and opinion in the presentation of a research report or investment recommendation. Wise violated the standard because she misrepresented managements enthusiasm by turning it into certainty.

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An analyst finds a stock with historical returns that are not correlated with interest rate changes. The analyst writes a report for his clients that have large allocations in fixed-income instruments and emphasizes the observed lack of correlation. The clients with allocations of fixed income instruments are the only clients to see the report. According to Standard V(B), Communication with Clients and Prospective Clients, the analyst has:

A) violated the Standard concerning fair dealings with all clients.

B) violated the Standard by emphasizing the information concerning the correlation.

C) not violated the Standard.

D) violated the article in the Standard concerning facts and opinions.

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Answer and Explanation

Recommending a stock whose return is uncorrelated with interest rate changes is appropriate for the clients described in the problem. Emphasizing the lack of correlation is appropriate as long as the analyst makes no guarantees concerning the relationship in the future. Reporting historical correlation is a presentation of fact, and is not in violation. The analyst is free to show the report only to investors for whom the investment is appropriate.

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An analyst who routinely purges the files that support his research and recommendations:

A) is acting in accordance to Standard III(E), Preservation of Confidentiality.

B) is acting in accordance to Standard IV(A), Loyalty to Employer.

C) may be violating Standard II(A), Material Nonpublic Information.

D) may be violating Standard V(C), Record Retention.

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Answer and Explanation

According to Standard V(C), a member shall maintain appropriate records to support recommendations. None of the other choices would apply to this action.

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An analyst finds a stock that has had a low beta given its historical return, but its total risk has been commensurate with its return. When writing a research report about the stock for clients with well-diversified portfolios, according to Standard V(B), Communication with Clients and Prospective Clients, the analyst needs to mention:

A) the relationship of the historical total risk to return only.

B) both the historical beta and total risk and return.

C) the relationship of the historical beta and return only.

D) how the beta compares to total risk.

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Answer and Explanation

Using reasonable judgment, an analyst may exclude certain factors from research reports. Since the report will be delivered to clients with well-diversified portfolios, total risk is not as important as beta. Given that the total risk has been only commensurate with historical return, furthermore, then the analyst is not negligent by not mentioning it.

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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. It is Hatfields opinion that interest rates will fall in the near future. Based upon this, Hatfield begins increasing the bond allocation of each portfolio. In order to comply with Standard V(B), Communication with Clients and Prospective Clients, the analyst needs to:

A) inform the clients of the change and tell them it is based upon an opinion and not a fact.

B) make sure that the change is identical for both clients.

C) file a report with the SEC of the new portfolio allocation.

D) perform all of these functions.

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Answer and Explanation

According to Standard V(B), the analyst must inform the clients of the change and tell them it is based upon an opinion and not a fact. The SEC is not involved. Making an identical change in two portfolios may be a violation of this standard if the needs of the clients are not identical.

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An analyst has several groups of clients who are categorized according to their specific needs. Compared to research reports distributed to all of the clients, reports for a specific group:

A) will definitely include more basic facts.

B) will not be allowed because it violates the Standard V(A), Diligence and Reasonable Basis.

C) may generally exclude more basic facts.

D) will not be allowed because it violates the Standard III(B), Fair Dealing.

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Answer and Explanation

According to Standard V(B), an analyst can use reasonable judgment regarding the exclusion of some facts and should include more basic facts for reports to wider audiences. The key issue is that analysts should tailor their reports to the intended audience.

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Robert Hamilton, a CFA candidate, is preparing a research report on Pets-R-Us for public distribution. Hamilton's preliminary report contains unfavorable earnings forecasts for the next four quarters. As part of his analysis, Hamilton met with Linda Brisson, the president of Pets-R-Us, and asked her to review the preliminary report for factual inaccuracies. Brisson revised Hamilton's earnings forecasts so that the quarterly earnings showed an upward trend and resulted in positive earnings by the fourth quarter. Hamilton included the revised earnings figures in his report without further review. Although the final report included the basic characteristics of Pets-R-Us, it emphasized certain areas such as projected quarterly earnings but only briefly touched on others. According to CFA Institute Standards of Professional Conduct on research reports, Hamilton:

A) did not violate the Standard.

B) violated the Standard because he asked Brisson to review the report for factual inaccuracies.

C) violated the Standard because the report did not give similar attention to all areas but instead emphasized quarterly earnings at the expense of other areas.

D) violated the Standard because he did not thoroughly review and analyze any information provided by Brisson.

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Answer and Explanation

Standard V(B) permits Hamilton to ask company management to review his report for factual inaccuracies, but Hamilton should have taken care to thoroughly review and analyze any information provided by the company. The research report should have remained the product of Hamilton's own independent and objective analysis. Hamilton is not required to give equal emphasis to all areas but can emphasize certain areas, touch briefly on others, and omit certain aspects deemed unimportant.

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Janet Coleman, a CFA Institute member, is an analyst at a regional brokerage firm. She is preparing a research report on Standard Power and Light. Due to deregulation, utility companies face increased competition. During the past year, three of the five utility companies in her region have cut their dividends by 50 percent, on average, to provide more internal funds for investment purposes. In a discussion with Standard's chief executive officer, Coleman learned that Standard expects to have a record amount of capital expenditures during the next year. Although Standard subsequently issued a press release about its capital expenditure plans, it did not make any public statements about a change in dividend policy. Coleman reasons that the management of Standard will be under pressure to cut its dividends within the next year to remain competitive. Coleman issues a research report in which she states:

"We expect Standard Power and Light will experience an initial decrease of $3 a share in its stock price when it cuts its dividend from $2 to $1 a share by the second quarter. We expect that Standard will strengthen its competitive position by using more internally generated funds to finance its investment opportunities. If investors buy the stock now at around $50 a share, their total return should be at least 20 percent on the stock."

Based on CFA Institute Standards of Professional Conduct, which of the following statements about Coleman's actions is TRUE?

A) Coleman violated the Standards because she failed to separate opinion from fact in her research report.

B) Coleman did not violate the Standards.

C) Coleman violated the Standards because she used material inside information.

D) Coleman violated the Standards because she failed to use reasonable care and judgment to achieve and maintain independence and objectivity in making investment recommendations.

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Answer and Explanation

Coleman's statement that Standard will cut its dividend from $2 to $1 a share is an opinion, not a fact. She should distinguish between facts and opinions in research reports.