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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In light of Singhs comments during his telephone call to Patel prior to his uncles death, which of the following actions that Patel can take comply with CFA Institute Standards of Professional Conduct?

A) Patel may change the current portfolio strategy and begin trading based upon Singhs expectations because he advised her to do so.

B) Patel must adhere, in principle, to the existing strategy but may begin altering the accounts composition based upon Singhs expectations.

C) Patel must adhere to the existing portfolio strategy until she meets with Singh to develop a new portfolio strategy based upon updated financial information but may place trades which are consistent with the existing strategy.

D) Patel must not place any trades in the account until she meets with Singh to develop a new portfolio strategy based on the updated information.

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Answer and Explanation

According to Standard III(C) Suitability, Patel must observe the written investment objectives now in effect as determined in cooperation with the client and may trade only on that basis. Because the anticipated change in Singhs financial condition was subject to an event of indeterminable timing, she should continue to honor the existing written investment objectives until a change (1) is warranted by an actual increase in the clients total financial assets and (2) has been agreed upon with her client.

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According to CFA Institute Standards of Professional Conduct, may Patel reallocate Singhs portfolio toward technology stocks after his Uncle dies but before the meeting with Singh?

A) No, because Patel and Singh must meet and revise the investment policy statement and portfolio strategy before reallocating.

B) No, because Patel must wait until the next annual meeting to reallocate.

C) Yes, because the funds have actually been transferred and the timing is no longer uncertain.

D) Yes, because the total value of the municipal bonds received into the account will be too large relative to the other assets in the portfolio.

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Answer and Explanation

According to Standard III(C) Suitability, investment recommendations and actions must be consistent with a clients written objectives and constraints (usually in the form of an investment policy statement (IPS)). Because Singhs written IPS would not allow the large allocation to technology stocks prior to receiving the inheritance, the IPS must be updated by Singh and Patel prior to taking any actions that deviate from the original IPS. Patel will violate Standard III(C) by reallocating the portfolio before meeting with Singh.

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Did Patel violate any CFA Institute Standards of Professional Conduct when she purchased the NetWin stock for Singhs portfolio or for the other clients portfolios?

Net income

Depreciation expense

A) No No

B) Yes Yes

C) Yes No

D) No Yes

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Answer and Explanation

According to Standard III(C) Suitability, Patel must analyze the appropriateness and suitability of NetWin.com stock on a case-by-case basis before buying it. This will necessarily consider the basic characteristics of the security and how these will affect overall portfolio characteristics relative to the existing investment strategy for each portfolio. Patel has not analyzed the effect that the stock will have on any of the individual portfolios in question and has thus violated the Standard. Patel cannot look at aggregate measures to determine the appropriate weight that the security should represent in the individual portfolios because the portfolios are being managed individually, not in aggregate.

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Which of the following is least accurate regarding the promotional announcement of Patel passing the Level 3 exam?

A) The fact that a promotional announcement was made violates the restrictions on misrepresenting the meaning of the CFA designation.

B) The promotional announcement uses the letters CFA as a noun and hence is an improper use of the designation.

C) The announcement is likely a violation because passing the level 3 exam does not entitle Patel to use the CFA designation.

D) The announcement violates the Code of Ethics because it implies that obtaining a CFA charter leads to superior performance.

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Answer and Explanation

An announcement that a member of a firm has received the right to use the CFA® designation is not a violation of the Code or Standards. However, Standard VII(B) requires that any reference to the Charter must not misrepresent or exaggerate the meaning or implications of the CFA designation. A Charterholder cannot claim that holding a Charter leads to superior performance results. The letters CFA can only be used as an adjective (never a noun, as in he is a CFA). Finally, passing all three exams does not give one the right to use the designation. All criteria must be met (e.g., experience requirements) before Patel can use the designation.

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With respect to the choice of broker, did Patel violate any CFA Institute Standards of Professional Conduct?

A) Yes, since Patel is obligated to seek the best possible price and execution for all clients.

B) Yes, since Patel has inappropriately directed trades to a personal friend at a high-priced brokerage firm.

C) Yes, since Patel failed to properly notify Singh that using TradeRight would lead to higher commissions and opportunity costs.

D) No.

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Answer and Explanation

Since Singh directed Patel to use TradeRight, this should be considered client-directed brokerage. While Patel should inform Singh of the implications of that choice, Patel has no option but to follow the clients direction according to Standard III(A) Loyalty, Prudence, and Care. Singh was fully aware of the fees charged by TradeRight relative to other brokerage firms and elected to use TradeRight anyway. Investment managers are obligated to seek the best price and execution in the absence of client direction.

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Kim Lee manages a variety of accounts at Superior Investments. Some are permitted to invest in tax-exempt issues only; others may not invest in a stock unless it pays dividends. Lee is researching a biotech firm specializing in the analysis of "mad cow" disease. While touring company facilities and meeting with management, she learns that they believe they may have found a way to reverse the disease. Moreover, one manager conjectured, "Suppose that we reversed the disease in someone who didn't even have it? We might then be able to boost that individual's IQ into the stratosphere!" Lee returns to her office and buys shares for all accounts under her supervision. This action is:

A) appropriate given the obvious potential of the therapy.

B) only permissible if the account holders are contacted first before the shares are purchased.

C) a violation of the Standard concerning appropriateness and suitability of investment actions.

D) a violation of the Standard concerning fiduciary duties.

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Answer and Explanation

Given the variety of accounts under her supervision, it is not likely the shares of a speculative biotech firm would be suitable for all accounts. Placing such shares in all accounts indicates that she has failed to consider the appropriateness and suitability of the investment for each account, and this places her in violation of Standard III(C).

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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. Hatfield has been trading on the clients behalf with a single brokerage firm for several years. Because of his many years of business, the brokerage firm occasionally gives Hatfield shares in an initial public offering (IPO) to sell to his clients. Hatfield has a policy of allocating the IPO shares equally between the portfolios of the two clients. This policy is:

A) congruent with Standard III(C), Suitability.

B) a violation of Standard III(B), Fair Dealing.

C) a violation of Standard III(A), Loyalty, Prudence, and Care.

D) a violation of Standard III(C), Suitability.

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Answer and Explanation

According to Standard III(C), the analyst must consider the appropriateness and suitability of an investment recommendation for each portfolio or client. Having a fixed policy of adding investments to portfolios without evaluating their suitability is a violation of Standard III(C). The action does not violate either of the other standards listed.

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An analyst thinks that a major change in the tax law will benefit holders of utility company stocks. She immediately begins calling all her clients and telling them of the upside potential of investing in such assets now. Based upon this information, this is most likely:

A) congruent with Standard III(C), Suitability.

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

C) a violation of Standard III(C), Suitability.

D) congruent with Standard V(A), Diligence and Reasonable Basis.

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Answer and Explanation

According to Standard III(C), the analyst needs to determine the suitability of an investment for each client. It is doubtful that all her clients are identical in their needs. According to the information, the analyst mentions the upside potential but does not mention the downside risk. Although the information says that she thinks that the change in the tax law will benefit holders of utility company stocks and says nothing of how she arrived at this conclusion, we do not know if she has or has not made her decision on a reasonable basis.

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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.

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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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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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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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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.