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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An analyst belongs to a nationally recognized charitable organization, which requires dues for membership. The analyst has worked out a deal that he provides money management advice in lieu of paying dues. For this arrangement to comply with the standards, the analyst needs consent from:

A) both his supervisor in the organization and his regular place of work.

B) his supervisor in the organization only.

C) his supervisor in his regular place of work only.

D) no one since it is a volunteer organization.

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Answer and Explanation

An employee/employer relationship does not necessarily mean monetary compensation for services. If the analyst is performing services for the organization, then the analyst must treat the position as if he were an employee and obtain consent from both his supervisor in the organization and in his regular place of work.

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Roger Halpert, CFA, prepares a company research report in which he recommends a strong "buy." He has been careful to ensure that his report complies with the CFA Institute Standard on research reports. According to CFA Institute Standards of Professional Conduct, which of the following statements about how Halpert can communicate the report is most correct?

A) Halpert can transmit his report by computer on the Internet.

B) Halpert can make his report in person, by telephone, or by computer on the Internet.

C) Halpert can make his report by telephone.

D) Halpert can make his report in person.

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Answer and Explanation

A report can be made via any means of communication, including in-person recommendation, telephone conversation, media broadcast, and transmission by computer such as on the Internet.

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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.

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Joni Black, CFA, works for a portfolio management firm. Black is a partner of the firm and is primarily responsible for managing several large pension plans. Black has just finished a research report in which she recommends Zeta Corporation as a Strong Buy. Her rating is based on solid management in a growing and expanding industry. She just handed the report to the marketing department of the firm for immediate dissemination. Upon returning to her desk she notices a news flash by CNN reporting that management for Zeta Corporation is retiring. Black wishes she did not recommend Zeta Corporation as a Strong Buy, but believes the corporation is still a good investment regardless of the management. What course of action for Black is best? Black:

A) is not obligated to revise the recommendation regarding material changes in the corporation because the information was public and not private information.

B) should report the new information to her immediate supervisor so that they can determine whether or not the marketing department should send out the report as written.

C) may send out the report as written as long as a follow up is disseminated within a reasonable amount of time reflecting the changes in management.

D) should revise the recommendation based on this new information.

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Answer and Explanation

This question is related to Standard V(B) which states that CFA Institute members should use reasonable judgment regarding the inclusion or exclusion of relevant factors in research reports. The change in management was a relevant factor and must be disclosed before dissemination.

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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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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 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.