Ethical and Professional Standards 【Reading 3】Sample principles, investment, concerning, one

JonnyKay

An investment advisor with fiduciary responsibilities over client assets is guided by some basic duties and principles concerning “soft dollars.” Which of the following is NOT one of these duties or principles?

A) All commissions paid to a broker are the property of the broker.

B) The quality of the transaction comes first.

C) To act in the clients' best interest.

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All (client) commissions paid to a broker are the property of the client.

JonnyKay

David Sanders is the Chief Investment Officer at a money management company that claims it is in compliance with CFA Institute Soft Dollar Standards. Last year he purchased a Bloomberg system for the portfolio managers to get information concerning investment decisions. He used soft dollars from brokers to pay for the system. Because the system has come up for renewal, he has an assistant audit the use of the terminal for a week. The assistant reports that the system is only used about 20 percent of the time for investment decision-making activities and 80 percent for other uses. Sanders:

A) can use soft dollars to pay for 20 percent of the system for the next year and must reimburse clients for 80 percent of the cost of last year's system.

B) cannot use soft dollars to pay for any part of the system for the next year, but need not take any action concerning last year's soft dollars.

C) can use soft dollars to pay for 20 percent of the system for the next year and need not take any action concerning last year's soft dollars.

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Sanders must make a good faith estimate for the proportion of the system that is used for investment decision-making and use that proportion to determine the amount of money that can be used for soft dollar purchases. He need not take any action with respect to last year's expenditures.

JonnyKay

A brokerage firm has just purchased a new computer system that will facilitate trades for its customers and supply research to the brokers directly aiding in their investment recommendations. Which of the following statements regarding the application of the CFA Institute Soft Dollar Standards is CORRECT?

A) Only the portion of the costs that will be attributed to research can be paid for with Client Brokerage.

B) The full cost of the computer system can be paid for with Client Brokerage.

C) Only the software applications and not the hardware can be paid for with Client Brokerage.

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Soft Dollar Standards set forth a three-level analysis to assist the Investment Manager in determining whether or not a product or service is Research. In nearly all cases, if the criteria of all three levels are satisfied, the Investment Manager can use Client Brokerage to pay for the Research. The final step in the analysis is to determine what portion of the Research will be used in the Investment-Decision-Making Process and pay only for that portion with Client Brokerage.

JonnyKay

Centurion Rivals (CR), an investment advisory firm, receives the following services in return for directing client brokerage to another firm:

• Research reports supporting trades surrounding IPOs, mergers, and bankruptcy proceedings.
• Access to an online database to track current, former, and prospective clients for marketing purposes.

Which of the following standards has CR most likely violated?

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

B) CFA Institute Soft-dollar Standards.

C) Both CFA Institute Soft-dollar Standards and Standard V(A) Diligence and Reasonable Basis.

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The marketing database is a violation of CFA Insititute soft dollar standards because it does not directly assist the investment manager in the investment management process. Rather, it is a benefit to the firm which should not be paid with client brokerage.

JonnyKay

Centurion Rivals (CR), an investment advisory firm, receives the following services in return for directing client brokerage to another firm:

• Research reports supporting trades surrounding IPOs, mergers, and bankruptcy proceedings.
• Access to an online database to track current, former, and prospective clients for marketing purposes.

CR wants to advertise that it is in compliance with CFA Institute’s soft dollar standards. CR should:

A) advertise compliance until notified by CFA Institute of a violation.

B) determine whether its policies are in compliance using CFA Institute’s 3-tiered analysis.

C) advertise partial compliance based on the differing treatment between the research reports and the online marketing database.

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CR should determine whether its policies are in compliance using CFA Institute’s 3-tiered analysis. CR will learn from this analysis that the online marketing database is a violation. No description of partial compliance is permissible.

JonnyKay

William Nagle, CFA has his own money management firm. He has a wide range of clients. Some of his clients are entirely invested in the money market while others like to actively trade stocks including hot new issues and options.
Over the years Nagle has developed a good relationship with Presley Brothers Brokerage who executes his trades. One of the reasons Nagle initially chose and continues to use Presley Brothers is that Presley Brothers provides to Nagle a free high-speed Internet service plus the services of a top-rated research firm over the Internet. That service provides up-to-the minute recommendations. Although the fees Presley Brothers charges Nagle’s clients per trade are slightly higher than competing firms, Nagle feels their speed of execution is worth the cost. Nagle has found the recommendations from the Internet research firm have been useful for some of his more active clients.
Presley Brothers also underwrites stocks and gives Nagle the opportunity to buy shares in initial public offerings for his clients. The amount of IPO stock offered to Nagle is proportional to the amount of commissions that Nagle has generated. As a rule, Nagle allocates the IPO shares to the clients who generated the most commissions in the previous year. He discloses this practice to all his clients, and since Nagle started dealing with Presley Brothers Brokerage, all of the IPOs Presley Brothers has underwritten have made a profit for Nagle’s clients. Therefore, Nagle has a standing order with Presley Brothers to purchase as much of each IPO that Presley Brothers can give him. Once Nagle gets the IPO issue, he divides it into three allocations and begins calling his clients one at a time, beginning with the top commission-generating client, and offers to sell an allocation to each client until all three allocations are sold.
Presley Brothers also offers Nagle another perk for doing business with the firm. If Nagle generates a certain minimum in commissions, then Presley Brothers provides Nagle with the opportunity to offer discount commissions on option trades. In addition to that, exceeding the commission quota earns Nagle an all-paid weekend trip to a resort where Presley Brothers gives seminars to managers like Nagle who have exceeded the commission quota. The trip does include seminars that provide valuable information on the products like mutual funds that Presley Brothers offers and financial markets in general, but it also takes place at a posh resort with many free amenities. In recent years, Nagle has exceeded the commission quota and has been able to take the trip. His main focus on the trips has been to learn something at the seminars that he can offer to his larger clients who generate the most business. The trips have given Nagle sufficient information on Presley Brothers’ products so that Nagle has decided to satisfy all of his clients’ needs with Presley Brothers products. By choosing to use Presley Brothers Brokerage for the indicated reason, has Nagle broken the standard concerning soft dollars?

A) No, because although his clients pay higher fees, the services are worth it.

B) Yes, because his clients pay higher fees and he gets free Internet service and the services of a research firm.

C) Yes, because his clients pay higher fees and he gets free Internet service only.

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Nagle is receiving free Internet service, and does not pass the savings on to his clients. The research benefits some of the clients; therefore, there must be some clients paying a higher fee and not getting anything from Nagle or Presley Brothers for the extra expense. (Study Session 1, LOS 3.b)

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The method that Nagle uses to allocate the IPO issues to his clients is:

A) a violation of the standards on fair dealing.

B) not a violation of the standards because Nagle discloses the practice to his clients.

C) a violation of the standard on soft dollars.

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Nagle needs to give all of his clients an opportunity to participate in profitable deals. In Nagle’s current system, it is possible for long-time clients who generate a consistent level of business per year to never be able to participate in a profitable IPO. (Study Session 2, LOS 8.a)

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Nagle’s standing order to purchase as much as much as possible of each Presley Brothers’ IPOs is a violation of the standard because:

A) Nagle should get advanced notice of his clients’ interest in the IPO.

B) Nagle is, in effect, distributing soft dollars.

C) of no reason, it is actually an acceptable practice because all the IPOs have been profitable.

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The standard on Trade Allocation: Fair Dealing and Disclosure requires that Nagle get an advanced indication of client interest. (Study Session 2, LOS 8.a)

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Nagle has violated the standards on research objectivity by:

A) his standing order for IPOs but not by his using only Presley Brothers investment products.

B) his standing order for IPOs and his using only Presley Brothers investment products.

C) his only using Presley Brothers investment products but not by his standing order for IPOs.

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Nagle is not doing any research on the IPOs before taking the allocations. Apparently, taking the trips has led to Nagle limiting his choices of possible products for his clients. Nagle needs to be more thorough in researching the needs of his clients. (Study Session 1, LOS 4.a)

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With respect to the trip that Nagle has been taking each year Nagle:

A) should disclose it to his clients because it provides him with information about stock market activities other than those of Presley Brothers.

B) should disclose it to his clients because it could represent a conflict of interest and hinder his objectivity.

C) does not need to disclose it to his clients because it provides him with valuable information.

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Nagle’s objectivity has clearly been compromised since he has started only using Presley Brothers’ products. The clients need to be aware that a significant portion of Nagle’s information is coming from the one firm that executes his trades and provides all of his clients’ products. (Study Session 1, LOS 2.a,b)

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Being able to offer his clients discount commissions on option trades after generating a certain amount of commissions is:

A) a violation because it benefits those clients who are inclined to do option trading.

B) not a violation because it is a benefit that all clients can share in if they so choose.

C) a violation because commissions on option trades are the quintessential soft dollars.

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Clearly some of Nagle’s clients will benefit from this arrangement more than others. (Study Session 1, LOS 2.a,b)

JonnyKay

Which of the following is one of the four requirements for meeting fiduciary obligations with regard to soft dollar arrangements? Commissions:

A) paid must be reasonable in relation to the research and execution services provided.

B) paid must be held in escrow for the benefit of the client.

C) paid must be minimized.

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Commissions paid must be reasonable in relation to the research and execution services provided. This does not imply that trades are always directed to the lowest cost broker.

JonnyKay

Which of the following is one of the four requirements for meeting fiduciary obligations with regard to soft dollar arrangements? Items purchased with soft dollars must:

A) provide a benefit to the firm.

B) provide a benefit to the client.

C) provide at least 50% of their benefits to the client.

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Items purchased with soft dollars must provide a benefit to the client.

JonnyKay

Which of the following is one of the four requirements for meeting fiduciary obligations with regard to soft dollar arrangements? Investment managers must:

A) avoid agency relationships.

B) seek the best price and execution.

C) minimize transactions costs.

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Investment managers must seek the best price and execution.

JonnyKay

Carl Johnson, a large equity client of Madison Investment Advisors, directs Madison to pass along old copies of any research purchased with soft dollars generated by trades in his account to his friend Jacob Wisnewski. Madison receives about ten such reports per year, and, after these have been reviewed in the context of their relevance to Johnson’s account, they are forwarded on to Wisnewski. With regard to this procedure, which of the following statements is CORRECT? The research:

A) provides a benefit to Johnson and may be released to Wisnewski with the permission of the source.

B) does provide a benefit to Johnson but may not be released to Wisnewski with or without the permission of the source.

C) does not provide a benefit to Johnson but may be released to Wisnewski with the permission of the source.

Since the research received is relevant to and is used for the benefit of Johnson, there is nothing inherently wrong with passing the reports to Wisnewski unless precluded from doing so by the provider of the research.