Reading 2-II: Standards of Professional Conduct & Guidanc center, material, div, following, class

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Session 1: Ethical and Professional Standards
Reading 2-II: Standards of Professional Conduct & Guidance: Integrity of Capital Markets

LOS A.: Material Nonpublic Information.

 

 

Which one of the following constitutes the illegal use of material nonpublic information?

A) Trading based on your analytical review of the firm's future prospects.

B) Trading immediately after attending the firm's annual shareholders’ meeting.

C) Trading on information your sister, the firm's attorney, told you over dinner.

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Members may not trade on material nonpublic information; therefore, the information conveyed by the firm’s attorney may not be used by a member for trading purposes.

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Hunter Harrison, CFA, is president and chief investment officer (CIO) of Ironclad Investments, an investment adviser and pension consultant for medium and large corporate pension clients. Ironclad recently hired a compliance officer to update its compliance manual, which follows the CFA Institute Code and Standards. Harrison serves as a director on several non-profit and corporate boards of directors, some of which have their pension assets managed by Ironclad. Harrison oversees Ironclad’s research analysts and portfolio managers, including Michelle Myers, who completed Level II of the CFA examination last year but has not registered for Level III. Myers is a portfolio manager who regularly meets with clients and prospects. Myers is also a partner in a software company that sells retirement and benefit administration services to institutional clients, some of which are also clients of Ironclad. During her correspondence with prospects and clients, Myers includes reference to her status as a “Level III CFA candidate” in her biographical background to increase her prominence in the industry.

Regarding Myers' references of her status as a candidate in the CFA program, what Standard governs these actions and is she in compliance?

A) Standard VII: Responsibilities as a CFA Member or CFA Candidate. Compliance: No.

B) Standard I: Professionalism. Compliance: No.

C) Standard III: Duties to Clients. Compliance: No.

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The actions of Myers are covered under Standard (VII)—Responsibilities as a CFA Member or CFA Candidate. Standard VII(B)—Reference to CFA Institute, the CFA designation, and the CFA Program requires that CFA candidates appropriately reference their participation in the CFA program, clearly stating their candidate status and not implying the achievement of any type of partial designation. Importantly, to be considered a candidate an individual must be registered to take the next scheduled exam. (Study Session 1, LOS 2.a,b)

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All of the following most likely apply to Myers’ participation as a partner in the software company EXCEPT:

A) Standard IV (B.4)—Priority of Transactions.

B) Standard IV (B.5)—Preservation of Confidentiality.

C) Standard III (C)—Disclosure of Conflicts to Employer.

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Standard VI(B)—Priority of Transactions most likely does not apply to Myers’ participation in the software company. Standard VI(B) covers priority over transactions in securities or other investments for clients and employers to prevent any instances of “front-running” for the benefit of the member. Myers’ software business is not transaction-oriented, and there is no information that describes any instances of the software company having priority in securities transactions over Ironclad or its clients. (Study Session 1, LOS 2.a,b)

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As part of Ironclad’s portfolio management activities on behalf of clients, Harrison and Myers maintain relationships with third party soft dollar providers and commission recapture brokers.

• Better Trading Brokerage (“Better Trading”), one of Ironclad’s top ten brokers and soft dollar providers, has offered Harrison two round-trip airline tickets anywhere in the U.S. in appreciation for their two-year relationship with Ironclad.
• One of Harrison’s clients, Worldwind Travel (“Worldwind”), who participates in commission recapture, has offered Harrison two round-trip airline tickets anywhere in the U.S. or Europe in appreciation for their two-year relationship with Ironclad.

Which of the following best describes Harrison’s actions under the Code and Standards? Harrison:

A) can accept the offer from both Better Trading and Worldwind.

B) can accept the offer from Worldwind, but cannot accept the offer from Better Trading.

C) cannot accept the offer from either Better Trading or Worldwind.

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Subject to additional disclosure, Harrison can accept the offer from Worldwind, but cannot accept the offer from Better Trading. Harrison’s actions are covered by Standard I(B)—Independence and Objectivity. Under Standard I(B), members shall use reasonable care and judgment to achieve and maintain independence and objectivity in their professional activities. As such, Harrison’s acceptance of the offer from Better Trading could be perceived to compromise his independence and objectivity on behalf of his clients, as the broker may be trying to influence Harrison to increase the amount of trading that Ironclad executes on behalf of clients. Since Better Trading is not a client of Ironclad, and its offer could negatively influence Harrison’s actions on behalf of Ironclad’s clients in violation of the Standard, the offer should be refused. The offer from Worldwind, who is one of Ironclad’s clients, if accepted, does not cause Harrison to violate Standard I(B). Gifts from clients are distinguishable from gifts from third parties seeking to influence the activities of an investment manager. Worldwind’s offer to Harrison may be accepted, provided it is disclosed to Ironclad in writing as additional compensation or benefits. Standard IV(B)—Additional Compensation Arrangements requires members to disclose in writing any additional compensation or other benefits received for their services in addition those provided by their employer. Harrison is obligated to disclose the offer and abide by any further requirements set forth by Ironclad prior to accepting the tickets. (Study Session 1, LOS 2.a,b)

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Myers has disclosed her partnership interest in the software company to Harrison, including the potential for additional compensation and the possible conflicts of interest.  

• One of Myers’ software clients, Breakthrough Pharmaceuticals (“Breakthrough”), is a publicly-traded corporation that is also held in portfolios of Ironclad’s clients. In the course of their business relationship, Breakthrough’s chief executive officer (CEO) informs Myers that the company has been experiencing problems making retirement benefit payments, and its pension plan has recently gone from “overfunded” to “significantly underfunded” as a result of market conditions.
• Breakthrough’s CEO indicates to Myers that he is attempting to source additional short-term financing to make retiree benefit payments and will disclose the significant “underfunded status” of the pension plan in the upcoming financial statements.  
• Myers, concerned about Ironclad clients holding stock of Breakthrough given the impact on earnings from the current pension troubles and short-term liquidity issues, informs Harrison of the impending disclosure. 
• Ironclad sells 1,800,000 shares of Breakthrough for clients, causing the price to drop $4 per share. 
• Upon disclosure of the pension troubles, Breakthrough’s stock dropped 18%. 

According to Standard II—Integrity of Capital Markets, Myers has:

A) violated the Standard by sharing material nonpublic information with Harrison.

B) not violated the Standard since the information shared with Harrison was used to fulfill Ironclad’s fiduciary duty to avoid significant losses.

C) not violated the Standard by sharing material nonpublic information with Harrison because the information did not involve a tender offer.

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Although the information shared by Myers may have helped Ironclad’s clients avoid losses in shares of Breakthrough, the information was material nonpublic information. In this example, Myers’ software company owes a duty of loyal and confidentiality to Breakthrough. Information is “material” if its disclosure would have an impact on the stock or if a reasonable investor would want to know the information prior to making an investment decision. Material is “nonpublic” until it has been generally disseminated to the marketplace and investors have had an opportunity to react to the information. The information about Breakthrough’s pension difficulties was both material and nonpublic, as the stock dropped significantly upon disclosure of the information in the market. Therefore, Myers had a duty to keep the information confidential and not to trade, or cause others to trade, on the information. (Study Session 1, LOS 2.a,b)

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Ironclad owns shares in several research and technology companies, including approximately 4% of the outstanding shares of Advanced DSL (“Advanced”), Internet Connections (“Internet”), and approximately 6% of the outstanding shares of Speedy Chip Technology (“Speedy Chip”) and Wavelength Digital (“Wavelength”).

• Harrison serves on the board of directors for Internet and Wavelength, while Myers provides consulting services for Speedy Chip. Harrison receives cash compensation and stock options for his services, while Myers receives restricted stock and stock options.
• The investment bank that led the public offering of Internet and Speedy Chip and seven of nine sell-side analysts covering the companies have “sell” ratings on the stocks. Ironclad’s analysts have also issued “sell” recommendations on the companies due to lack of earnings transparency and quality of earnings, among other issues.

• Harrison increases his position in both Internet and Wavelength citing “growth opportunities” and “consensus opinion.”

Which of the following Standards were least likely violated by Harrison and Myers?

A) Standard IV(B)—Additional Compensation Arrangements.

B) Standard III(A)—Loyalty, Prudence, and Care.

C) Standard II(A)—Material Nonpublic Information.

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Standard II(A)—Material Nonpublic Information is least likely to apply to both Harrison and Myers in this situation. Given Harrison’s role on the boards of directors for Internet and Wavelength, he is in the position to potentially receive material nonpublic information; however, there are no facts presented that would infer that he either received or used material nonpublic information about Internet or Wavelength. Myers, as a benefits consultant for Speedy Chip, also may be in a position receive to material nonpublic information, but there are no facts presented that would infer Myers’ receipt or use of material nonpublic information. (Study Session 1, LOS 2.a,b)

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Harrison, as CIO, is chairman of Ironclad’s proxy voting committee, while Myers is a voting member.  Ironclad, as a discretionary investment manager, votes proxies on behalf of clients.

• Ironclad is currently reviewing proxies for several companies covered in research, including technology companies Advanced DSL (“Advanced”), Internet Connections (“Internet”), Speedy Chip Technology (“Speedy Chip”) and Wavelength Digital (“Wavelength”), which have all presented the expensing of employee stock options for vote in their current proxies.
• Investment personnel of Ironclad recently participated in an industry forum in support of increased disclosure for company stock options, which Ironclad believes provides investors with a more accurate perspective of corporate earnings.
• Contrary to committee consensus, Harrison and Myers vote client proxies “against” the expensing of employee stock options for Internet, Wavelength and Speedy Chip.

All of the following describe Harrison's actions for compliance with the Code and Standards regarding proxy voting EXCEPT:

A) Harrison should maintain the confidentiality of voting information on behalf of Ironclad’s clients.

B) Harrison should vote in accordance with Ironclad’s policy and coordinate major proxy issues across all client accounts.

C) Harrison should discard all proxies on behalf of Ironclad’s clients when there is a conflict of interest.

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Proxy voting is a plan asset under ERISA and as such, is subject to the fiduciary duty obligations. Ironclad, as a discretionary investment manager, is responsible (unless otherwise stipulated in the client guidelines or agreement) for making informed and reasonable decisions regarding proxy voting on behalf of clients. Among other things, Ironclad should have a proxy voting policy and a process for identifying and reviewing major proxy issues for appropriate clients. Ironclad and Harrison also have an obligation to avoid conflicts of interest when voting proxies. Although Harrison has a conflict of interest in voting issues on behalf of Internet and Wavelength due to his role on their board of directors, proxies should not be discarded under any circumstances, as such action would constitute a breach of fiduciary duty. Harrison should abstain from voting on matters affecting Internet and Wavelength to avoid the appearance of a conflict of interest. Harrison should also ensure proper treatment of any confidential information received in his role on the respective boards of directors. Harrison should maintain confidentiality of voting information on behalf of clients and follow Ironclad’s proxy voting policy, coordinating major proxy voting issues across all client accounts. (Study Session 1, LOS 2.a,b)

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A stockbroker who is a CFA Institute member is called on the telephone by the CEO of a large company. The CEO asks to buy shares of the CEO’s company for the accounts of the CEO’s children. In the course of the conversation, the CEO says this will really pay off when the upcoming takeover goes through. The stockbroker checks her sources and finds no information about the takeover. In this case the broker should:

A) only execute the order in compliance with Standard III(A), Loyalty, Prudence, and Care. Since the client is buying the stock for the children, there is not a problem.

B) do neither of the actions listed here.

C) execute the order for all clients as required by Standard III(B), Fair Dealing.

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Doing any of these actions would be a violation of Standard II(A), Material Nonpublic Information. Members and Candidates must not act or induce others to act on material nonpublic information.

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Which one of the following least accurately describes the CFA Institute Standard about using material nonpublic information?

A) An analyst using material nonpublic information may be fined by CFA Institute.

B) An analyst may use nonmaterial nonpublic information as long as it has been developed under the Mosaic Theory.

C) An analyst may violate this Standard by passing information to others even when it has been obtained from outside the company.

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There is no provision for CFA Institute to issue fines to members. Members may not use material nonpublic information for trading purposes. Nonmaterial, nonpublic information may be used together with analysis of public information under the Mosaic Theory.

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Carl Weather, CFA, is the chief financial officer of Talbot Enterprises. Based on inside information about Talbot’s favorable prospects, Weather concludes that Talbot’s common stock price is substantially undervalued in the market. With the approval of Talbot’s Board of Directors, Weather announces a program for his firm to repurchase $100 million of its own stock in the market. Talbot’s stock price rises immediately after the announcement of the repurchase program.

Reese Winter, a CFA Institute member, is Weather’s assistant. While waiting in Weather’s office, Winter reads an internal memo marked “confidential” from Talbot’s chief accountant to Weather. The memo states that Talbot sustained an unexpected substantial profit during the past quarter, and its earnings projections show a substantial increase compared with previous estimates. Winter uses her cell phone to call her brother and discloses this information to him. Her brother immediately buys 1000 shares of Talbot’s stock.

Did the actions of Weather and Winter violate Standard II(A): Material Nonpublic Information?

Weather

Winter

A) Yes No

B) No Yes

C) Yes Yes

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Weather did not violate Standard II(A) because this prohibition applies to recipients who are not directly or indirectly associated with the firm the material nonpublic information is about. As a corporate insider, Weather can use insider information to benefit his firm’s shareholders. Winter violated Standard II(A) because the information is both material and nonpublic and she is required not to trade or cause others to trade on the information.

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Insider trading can be defined as information that is:

A) material and public.

B) nonmaterial and nonpublic.

C) material and nonpublic.

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Information is material if it would be important to the investor in their investment making decision. Information is nonpublic if it is not yet available to the public.

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A CFA Institute member is a U.S. citizen living and working in a foreign country. That country has no laws against insider trading. Based on this information, the CFA Institute member may:

A) trade using insider information.

B) not trade using insider information based upon the rules of the SEC.

C) not trade using insider information based upon the CFA Institute Standards.

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CFA Institute Standard II(A) prohibits trading using insider information. A member may not trade using such information regardless of the rules of the country where he/she lives.

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The term "material" in the phrase "material nonpublic information" refers to information that is likely to affect significantly the market price of the issuing company's securities or that:

A) is acquired by the financial analyst from a special or confidential relationship with the issuing company.

B) is likely to be considered important by reasonable investors in determining whether to trade a particular security.

C) is derived by the financial analyst from direct communication with an issuing company's management.

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An item of information is material if its disclosure would be likely to have an impact on the price of a security, or if reasonable investors would want to know the information before investing.