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A company has a defined benefit plan that is currently under-funded. The plan sponsor has instructed the portfolio manager of the plan to invest more aggressively to bring the funding level up to an adequate amount. Which of the following statements best describes the course of action the portfolio manager should take? The portfolio manager should:

A) not invest more aggressively because this is not the method used to increase the funding level of a plan.

B) not invest more aggressively since this may expose the plan to too much risk and may not be in the best interest of the plan's beneficiaries.

C) invest more aggressively because this will increase the plan's assets faster as the stock market increases allowing the plan to become fully funded.

D) invest more aggressively because his fiduciary duties lie with the plan sponsor.

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Answer and Explanation

Standard III(A), Loyalty, Prudence, and Care, applies in this situation. According to this Standard, investment actions should be carried out for the sole benefit of the client and in a manner the manager believes to be in the best interest of the client. Here, the client is the plan beneficiaries, not the manager or the entity that hired the manager.

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Scott Andrews, CFA, is a stockbroker selling an oversubscribed stock issue. Which of the following best describes Andrews' actions regarding this sale? Andrews:

A) can offer this security on a prorated basis to all clients for which the security is appropriate.

B) can offer this security to all clients on a first come first serve basis.

C) can only offer this security to clients for which it is appropriate on a first come first serve basis.

D) cannot offer an oversubscribed issue of stock to any clients.

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Answer and Explanation

Standard III(B), Fair Dealing, applies. When new issues or secondary offerings are available or are being offered by the firm or if the firm is part of a selling syndicate, all clients for whom the security is appropriate are to be offered a chance to take part in the issue. If the issue is oversubscribed, then the issue is to be prorated to all subscribers.

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Which of the following actions is least likely to prevent the misuse of insider information?

A) Controlling relevant interdepartmental information.

B) Placing securities on a restricted list when the firm is in possession of material nonpublic information.

C) Monitoring the trading of the firm and personal trading of the employees.

D) Monitoring all the phone calls made by the brokers.

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Answer and Explanation

Standard II(A), Material Nonpublic Information, applies in this situation. Standard II(A) suggests the use of "fire walls" to protect the firm and to conform to the Standards. A fire wall is an information barrier designed to prevent the communication of material nonpublic information between departments of a firm. Although the fire wall system should provide a means to review transactions, it is not feasible to monitor all communications into/out of departments. Placing sensitive securities/firms on "watch, "restricted," or "rumor" lists helps management target monitoring of transactions.

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Rajiv Singh, a CFA charterholder, works as an equity analyst with Horizon Investments, a large broker/dealer. After ski-resort developer HighLife misses a quarterly earnings target, Singh changes his recommendation on HighLife from buy to hold. Singh has been following HighLife for years. In several previous research reports on HighLife, Singh told clients that, based on his detailed analysis of the financial statements and market position, he believed HighLife had stopped picking up market share. He had mentioned concerns about HighLife several times in his reports and said in the most recent report that he would downgrade the stock if it missed quarterly earnings.

Singh had produced his monthly report on HighLife just a week before the earnings announcement, and because he had just written about his intention to downgrade the stock, he felt he did not need to inform clients of his recommendation change until the next monthly report.

On the same day that the HighLife report was released, Singh initiated coverage on another company, the convenience-store operator QuickStop, with a Buy rating. His research report is distributed that afternoon. A client sends Singh a sell order for QuickStop via e-mail the same day the new recommendation is being disseminated to all Singhs clients and prospects.

John Womack, a Level II CFA candidate, is a trader at Horizon. Womack, walking past the conference room during an investment meeting, learns of the initiation of the buy rating on QuickStop. Prior to the dissemination of the buy rating to Horizons clients, he buys up a large block of QuickStop shares for Horizons account in anticipation of clients interest in the stock. When the rating is released to the firms customers, he fills the incoming customer orders out of Horizons inventory, generating a modest profit for the company.

Horizon is drafting trade-allocation guidelines for companywide use. Five regulations the company is considering are listed below:

• Regular orders are processed and executed on a pro-rata basis.
• Shares in initial public offerings will be allocated on a pro-rata basis to the firms portfolio managers according to advance indications of interest from the managers.
• When the full amount of a block order is not executed, partially executed orders are allocated on a first-in, first-out basis.
• Orders must be recorded in writing and stamped with the time of the order and the execution.
• All clients participating in block trades are give the same execution price, and all clients are charged the same commission.

When Singh receives the sell order for QuickStop, he should:

A) tell the client about the buy rating and advise him not to sell the stock.

B) ask the client to delay the order until he sees the new research report.

C) process the sell order immediately to fulfill his fiduciary duty to the client.

D) delay answering the e-mail until the client has received the new research report.

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Answer and Explanation

Standard III(B): Fair Dealing requires analysts to inform clients of rank changes before accepting the order. Delaying the order or asking a client to wait without explanation could violate the fair dealing Standard as well as the Standard relating to fiduciary duties.

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Womacks trading actions are a violation of:

A) Standard III(E): Preservation of Confidentiality and Standard VI(B): Priority of Transactions.

B) Standard IV(A): Loyalty to Employer and Standard III(B): Fair Dealing.

C) Standard III(A): Loyalty, Prudence, and Care and Standard VI(B): Priority of Transactions.

D) Standard III(A): Loyalty, Prudence, and Care and Standard IV(A): Loyalty to Employer.

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Answer and Explanation

Womacks actions violate the Standards related to fair dealing, priority of transactions, and fiduciary duties.

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With regards to his coverage of HighLife stock, Singh:

A) violated the research reports Standard because he failed to differentiate between facts and opinions.

B) violated the insider-trading Standard by using nonmaterial, nonpublic information in forming his opinion of HighLife.

C) did not violate the Standards for reasonable basis or research reports.

D) violated the reasonable-basis Standard by downgrading a stock just because it missed one quarterly earnings estimate.

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Answer and Explanation

Singh reported a series of facts that led him to draw a conclusion, and identified the conclusion as his own. No nonpublic information was used in the HighLife analysis. And while Singh did say that missing an earnings target would spur a downgrade, he made it clear that he had broader concerns about the firms market share. Missing an earnings target would simply be confirmation of his concerns, and thus be the catalyst to his change of opinion.

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After Singh changed his investment recommendation for HighLife from a buy to a hold, he violated:

A) Standard III(B): Fair Dealing by not telling clients about the downgrade of HighLife in the wake of his promise to downgrade the stock if it missed estimates.

B) Standard V(A): Loyalty, Prudence, and Care by not exercising reasonable care and prudent judgment in his research.

C) Standard I(C): Misrepresentation by not exercising diligence and thoroughness in his research.

D) Standard III(C): Suitability because he did not consider the needs of individual clients.

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Answer and Explanation

A change in stock rating is always material, and must always be disclosed to clients. Thus, Singh violated Standard III(B). Singh did not violate a fiduciary duty to his clients because he did not put anyones interest above theirs. As an analyst, Singhs job is to assess the appeal of an investment, not make investment decisions for individual accounts. As such, he did not violate Standard III(C). Standard I(C) relates to misrepresenting qualifications or guaranteeing investment returns, and is not relevant to this situation.

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Horizons proposed IPO-allocation procedures are:

A) a violation of Standard: Loyalty, Prudence, and Care and Standard VI(B): Priority of Transactions.

B) not a violation of Standard I(B): Independence and Objectivity.

C) not a violation of Standard III(B): Fair Dealing if they are disclosed to all clients and prospects.

D) a violation of Standard III(C): Suitability, but not of Standard ) III(A): Loyalty, Prudence, and Care.

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Answer and Explanation

Independence and objectivity has not been violated. According to Standard III(B), allocation of new issues according to advance indications of interest should be done on a pro-rata basis by client, rather than by portfolio manager. Therefore Horizons policy is not fair and equitable. Disclosure of this inequitable allocation method does not relieve Horizon of its obligation that the allocation method be fair and equitable. While the policy may violate fiduciary duty as required by Standard III(A), it does not violate either Standard III(C), which addresses investment suitability, or Standard VI(B), which relates to the priority of transactions.

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Which of the following trade allocation procedures being considered for Horizons trade allocation policy would NOT be consistent with Standard III(B), Fair Dealing?

A) When the full amount of a block order is not executed, partially executed orders are allocated on a first-in, first-out basis.

B) All clients participating in block trades are give the same execution price, and all clients are charged the same commission.

C) Regular orders are processed and executed on a pro-rata basis.

D) Orders must be recorded in writing and stamped with the time of the order and the execution.

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Answer and Explanation

All orders should be allocated on a pro-rata basis based on order size, not on a first-in, first-out basis. The other regulations satisfy the fair-dealing Standard.

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Mary Montpier, CFA, is an equity analyst located in the Malaysia office of World Class Advisers. The firm provides investment advice and financial-planning services globally to institutional and retail clients. The Malaysia office was opened last year to provide additional international investment opportunities for U.S. clients. Montpier covers small-cap stocks in the region. Montpiers supervisor, Rick Reynolds, CFA, works in New York.

Jim Taylor is an analyst in New York who works at World Class Broker-Dealer, a sister company of World Class Advisers. Taylor covers health-care and biotech stocks for the firm. Taylor recently completed Level I of the CFA examination and is registered for the Level II examination next year. Taylor works for John James, CFA.

Through her interaction with other analysts in Malaysia, Montpier learns that the use of material, nonpublic information is common practice in analyst research reports and recommendations, and is not prohibited by law in Malaysia. Montpier has acquired material, nonpublic information on the research pipeline of Circuit Secrets, a Malaysian semiconductor company. The nonpublic information makes the company seem like a fine investment. After extensive research through traditional means, Circuit Secrets appeared to be fully valued relative to its growth potential until Montpier found the nonpublic information.

In preparation for a client meeting, James asks Taylor to prepare a research report on attractive companies in the health-care industry. Since Taylor is busy preparing for company conference calls, James tells him to throw something together. To meet James request, Taylor obtains reports on Immune Health Care and Remedy Corp., two companies that he likes, but has not researched in depth. Taylor takes the original reports, which were prepared by a small brokerage firm in the Netherlands, adds some general industry information, incorporates World Classs proprietary earnings-growth model, and submits strong buy recommendations to James for the stocks. Although written procedures require James to review all analyst reports prior to release, time constraints consistently prevent him from reviewing the reports prior to distribution.

Montpier is proud of her CFA charter. In fact, she often boasts that she is one of the elite members of the CFA Institute that passed all three exams consecutively without failing. Taylor is also proud of the CFA program. He told his friends and family the CFA designation is globally recognized in the field of investment management and research. Furthermore, Taylor states that he believes the program will enhance his portfolio management skills and further his career development.

In her free time, Montpier has begun consultation for members of a local investment cluB.The club is in the process of developing an appropriate compensation package for her services, which to date have included financial-planning activities and investment research. Montpier informs the investment club that she has a full-time job at World Class Advisers, which offers similar services. The investment club gave Montpier written permission to consult for them despite her full-time work.

To gain insight on biotech stocks, Taylor registers for an upcoming asthma study conducted by Breakthrough Corp., through which he and others will be the subject of testing for the efficacy of several new drugs. On his application, longtime asthma sufferer Taylor indicates that he has the appropriate medical condition for the study and signs a confidentiality agreement. During the study, a researcher shows Taylor a spreadsheet detailing the progress of Breakthroughs research pipeline. Two of the new drugs on which Breakthrough is awaiting regulatory approval have serious negative side effects in patient testing. This information confirms suspicions Taylor had developed after extensive research and conversations with company executives regarding nonmaterial, nonpublic information, though he was not certain about the names of the drugs until he saw the spreadsheet. At the conclusion of the study, Taylor releases a report detailing the drugs side effects and recommends that clients sell Breakthrough Corp.

Over the next two weeks, Breakthrough releases information that the drugs in question have been held up by a regulatory agency pending additional investigation. The stock plunges more than 30 percent on the news.

Which of the following is a violation of the Code and Standards?

A) Reynolds approves Montpiers report on Circuit Secrets immediately, but tells his traders to wait a week before buying the stock themselves.

B) James has dinner with Taylor and promises to provide Taylor with three weeks off in May to study for the CFA exam and offer some test-taking tips.

C) Taylor sends out a resume referring to himself as a Level II CFA candidate and indicating his intention to take the Level II test in June.

D) An intern at World Class takes a side job as a bartender on weekends to supplement her income.

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Answer and Explanation

An immediate approval of Montpiers report implies that Reynolds did not check the facts or talk to Montpier about the recommendation, which was dependent on the use of insider information. Reynolds violated the Standard relating to supervisory responsibilities. Side work that is not in competition with the interns firm is not a violation unless the side job interferes with her work for World Class. The statement on Taylors resume is appropriate, and James plans to help Taylor are well within the requirements of the Standards.

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Which of the following statements about Montpiers analysis of Circuit Secrets is TRUE?

A) Montpier could satisfy the requirements of Standard II(A): Material Nonpublic Information by producing a research report on Circuit Secrets for Malaysian clients, but not making it available to U.S. clients.

B) If Montpier fails to use the nonpublic information, and as such is unable to recommend the company, she has violated Standard III(A): Loyalty, Prudence, and Care by failing to act in the best interest of her clients.

C) If Montpier prepares a research report for all World Class clients recommending Circuit Secrets as a Buy, but does not reveal the nonpublic information, she has still violated Standard II(A): Material Nonpublic Information.

D) Montpiers best course of action is to initiate coverage of Circuit Secrets as a hold, and attempt to get the company to disclose the nonpublic information.

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Answer and Explanation

Standard II(A) prohibits not only the revelation of nonpublic information, but also trading on the basis of that information. The buy rating itself is a product of the nonpublic information, and as such is a violation. Montpier must comply with the Code and Standards regardless of the laxness of regulations in her country. If Montpier believes the stock is a buy, initiating it as a hold would be inappropriate. Analysts cannot be expected to have a recommendation on every stock, so failing to recommend a potentially good stock is not a breach of fiduciary duty.

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With regard to Standard VII(B): Reference to CFA Institute, the CFA Designation, and the CFA Program:

A) neither Montpier nor Taylor is in compliance.

B) Montpier is in compliance, and Taylor is in compliance.

C) Montpier is not in compliance, and Taylor is in compliance.

D) Montpier is in compliance, and Taylor is not in compliance.

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Answer and Explanation

Both Montpier, as a CFA charterholder, and Taylor, as a CFA candidate, are subject to the Standards. Montpier violated Standard VII(B) by exaggerating the implications of passing the exam in three years. Taylors comments comply with the standard.

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Which of the following actions could Taylor take to ensure he is not in violation of Standard I(C): Misrepresentation?

A) Initiate coverage of Immune Health Care and Remedy Corp. as holds, not strong buys, until he has time to do further research.

B) Base his report on information from Value Line and Standard & Poors reports rather than research from rival analysts.

C) Nothing, as the reports he used came from an international source, and are not protected under U.S. law.

D) Just use excerpts from the original reports, rather than copying the whole reports.

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Answer and Explanation

Value Line and Standard & Poors are recognized financial or statistical reporting services, and, as such, can be used as the basis for reports without acknowledgment. Caveat: Those publications are copyrighted, and copying directly from them may be illegal in some circumstances, even if it does not technically violate the plagiarism Standard. Using excerpts is still plagiarism and changing the stock recommendation will not change that fact. It is unlikely that a Dutch research report would not be protected under U.S. copyright, and even if it were not, using the material without attribution still violates the Standard.

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Which of the following statements regarding Standard IV(A): Loyalty to Employer is TRUE?

A) By accepting compensation for his role in the medical study, Taylor is violating the Standard.

B) Despite getting written permission from her client to consult, Montpier is not in compliance with the Standard.

C) Taylors use of rival analysts reports in his own research violates the Standard.

D) Neither Taylor nor Montpier is in violation of the Standard.

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Answer and Explanation

Montpier needs to get permission from both the client and her employer before she can begin to consult. Thus, Montpier is not in compliance, as she has not received permission from World Class. Neither Taylors use of rivals research nor his participation in a medical study violate the Standard. Standard IV(A) addresses outside income, not research methods. And while the medical-study payment is certainly income, it is not in competition with his firm, and as such does not violate the Standard.

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Taylors actions regarding Breakthrough Corp.:

A) violate Standard II(A): Material Nonpublic Information because the information was not in the public domain.

B) do not violate Standard II(A): Material Nonpublic Information because he was only confirming what he already suspected.

C) did not violate Standard I(D): Misconduct because he did not misappropriate the information.

D) violate Standard IV(A): Loyalty to Employer because he is being compensated for the work.

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Answer and Explanation

Taylors use of the material nonpublic information provided to him in confidence by a researcher is a clear violation of Standard II(A). The professional-misconduct Standard prohibits actions that reflect negative on professional reputation, integrity, or competence. Since Taylor has signed a confidentiality agreement, his violation of the agreement definitely says something about his honesty. Thus, he is in violation of Standard I(D). Standard IV(A) only applies to work in competition with the employer.

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Jim Crockett is a portfolio manager for Miami Advisors and reports to Vicki Tubbs, the Chief Investment Officer. Miami has developed a proprietary model that has been thoroughly researched and is known throughout the industry as the Miami model. The model is purely quantitative and takes a given set of client characteristics and universe of potential securities and forms a portfolio for the investor. Individual portfolio managers are responsible for selecting securities to fit into the model based on recommendations from the firm's research department and the managers' own judgment. Because of the specific nature of the inputs to the model, each manager is responsible for applying the model on his or her own computer. The basic philosophy of the process is thoroughly explained to clients. Crockett does not understand the basics of the model, but feels that since it provides pure quantitative output, he does not need to understand it. However, he misapplies the model for several of his clients. In reviewing some of Crockett's portfolios, Tubbs finds the errors and points them out to Crockett. Which of the following statements regarding Tubbs and Crockett are TRUE?

A) Crockett has violated the Standards by not distinguishing between facts and opinion in presenting an investment recommendation.

B) Crockett has violated the Standards by not considering the appropriateness and suitability of the investment for his clients.

C) Tubbs has violated the Standards by failing to supervise adequately.

D) Crockett has violated the Standards by not exercising diligence and thoroughness in making investment recommendations.

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Answer and Explanation

Crockett had a responsibility to know the model well enough to detect the mistakes that could occur from misapplication, so he violated the Standard of diligence and reasonable basis.

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Janine Walker is an individual investment advisor with 200 individual clients. When she first obtains a client, Walker solicits personal data that helps her formulate an investment recommendation, including tax status, income, expenditure needs, and risk tolerance. The Standards:

A) require Walker to update the data regularly.

B) only require to update a client's data when a material change is being made to the clients' portfolio.

C) require Walker to update the data at least once every three years.

D) require updating a client's data only when a material change occurs to the personal data.

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Answer and Explanation

According to Standard III(C), Suitability, Members and Candidates must reassess client information and update regularly.

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Betsy Fox is an investment advisor who has a client, Don Gordon, who is an employment lawyer. At lunch, Fox noticed Gordon and the Chief Financial Officer of Blue Star Company at the next table. She overhears them talking and ascertains that Blue Star is about to announce higher than expected earnings. Before the earnings release, Gordon contacts Fox and asks her to purchase 3,000 shares for his portfolio. Fox:

A) can only purchase shares for her personal account after informing all of her clients about the potential of the increase in earnings.

B) can purchase shares for Gordon, but cannot ever purchase shares for her personal account.

C) must refuse to purchase shares for Gordon.

D) must wait until after she purchases the 3,000 shares for Gordon to purchase shares for her personal account, and then must keep the information quiet.

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Answer and Explanation

According to Standard II(A), Material Nonpublic Information, Fox cannot act or cause others to act on material nonpublic information until the information is made public. The information overheard at lunch was material and nonpublic; therefore, Fox must wait until the information is made public before accepting Gordons order.

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Ned Brenan manages two dozen pension accounts, one of which earned over 25 percent during the past two years. Brenan tells prospective clients that based on past experience they can expect a 25 percent return on their funds. Which of the following statements is TRUE?

A) Brenan has violated both Standard of Professional Conduct III(D), Performance Presentation, and Standard I(C), Misrepresentation.

B) Brenan has violated Standard of Professional Conduct III(D), Performance Presentation, but Brenan has not violated Standard I(C), Misrepresentation.

C) Brenan has not violated Standard of Professional Conduct III(D), Performance Presentation, but Brenan has violated Standard I(C), Misrepresentation.

D) Brenan has not violated either Standard of Professional Conduct III(D), Performance Presentation, or Standard I(C), Misrepresentation.

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Answer and Explanation

Brenan violated Standard of Professional Conduct III(D) by using only one portfolios results to create a false impression of all the portfolios, and Brenan violated Standard of Professional Conduct I(C) by creating the impression that a certain return was assured (he should have used the words might or could instead of can).

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Kim Lee is a research analyst at Superior Investments and 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!" After returning to her office, Lee issues a research report describing the compound as an "IQ booster with huge potential." This statement:

A) is reasonable given the information she was provided by the company.

B) lacks a reasonable and adequate basis in fact.

C) is allowable but only if quoted verbatim from her conversations with management.

D) violates the Standard concerning plagiarism.

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Answer and Explanation

Standard V(A) requires that a member have a "reasonable and adequate basis" before making an investment recommendation. Extrapolating on the basis of the conjecture of one member of the management team, without independent corroboration, is clearly in violation of this Standard. She is also in violation of Standard V(B) concerning the use of reasonable judgment regarding what is included or excluded in a communication with a client or prospective client.