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Michael Smyth is Senior Vice President of equity investments at Systematic Investment Advisors, Inc. (SIA). He manages a team of analysts and portfolio managers and is responsible for maintaining and developing client relationships. SIA is located in a small European country and provides investment management services to high net worth individuals. Smyth is also a Level III Candidate for the CFA designation.

One of Smyth’s clients is the Muller-Durand family. He had a long relationship with Helmut Muller. Before Muller’s untimely death, he gave Smyth full discretion over his portfolio based on an investment policy statement that had been refined continuously over the years.

  • Muller was the president of a publicly traded manufacturing company, Comax, and 20% of his portfolio’s assets were invested in Comax equity. His contract with Comax prohibited his selling his Comax shares while he was employed.
  • Muller had little liquidity needs. His children were grown and his salary at Comax was sufficient to cover his annual expenditures as well as contribute to his investment portfolio.
  • A former Chartered Accountant, Muller had been extremely knowledgeable and comfortable with the investment decision-making process.
  • Smyth owns 10,000 shares of Comax and serves on Comax’s board.
  • Smyth played golf with Muller on a regular basis and, with Muller's help, developed many client relationships from these outings.

SIA has a soft dollar arrangement with a local brokerage firm, First Brokerage, owned by Smyth’s sister.

  • Muller had agreed in writing that all trades in his portfolio would be directed to First Brokerage.
  • Smyth purchased new carpets for his office with client brokerage. He believes that his managers make better investment decisions when their environment is pleasant and comfortable.
  • Smyth attended an industry conference in the Bahamas with soft dollars. The program is devoted to improving management of the investment advisory firm. He believes that a well-run firm makes better investment decisions.
  • Smyth consistently uses soft dollars to purchase research reports from an independent research firm that does in-depth analysis of a company’s financial reporting. Several of his managers have commented on the quality and usefulness of these reports to their analysis and decision-making.

Smyth has an appointment to meet with Muller’s widow, Wilhelmina Durand, who, as an artist, left management of their financial assets to her husband. She is meeting with Smyth to better understand her financial position.

Which of the following Standards is most relevant regarding Smyth’s meeting with Durand?

A)
Standard III(C), Suitability.
B)
Standard III(A), Loyalty, Prudence, and Care.
C)
Standard III(E), Preservation of Confidentiality.


Standard III(C), Suitability, is most relevant for Smyth's meeting with Wilhelmina Durand. This Standard requires Smyth to make a reasonable inquiry into Durand’s financial situation, investment experience, and investment objectives prior to making any recommendations about her portfolio. Smyth must also consider the appropriateness of the existing portfolio and investment policy statement for Durand. Standard III(A) also has some relevance since Smyth is in a position of trust with respect to Durand, and Smyth must ensure that his and SIA’s goals do not conflict with Durand’s. (Study Session 1, LOS 2.a,b)


Standard VI(A), Disclosures of Conflicts, requires Smyth to disclose all matters, including beneficial ownership of securities of other investments, that could be expected to impair the member’s ability to make unbiased and objective recommendations. Which of the following matters would least likely be disclosed to Durand?

A)
Smyth played golf with Muller on a regular basis and developed client relationships.
B)
Smyth owns shares in Comax.
C)
SIA has a soft dollar arrangement with a brokerage firm owned by Smyth’s sister.


Smyth playing golf with Muller is not a conflict with respect to his relationship with Durand and he need not disclose to her that he played golf with Muller. Muller was his client at the time and there was full disclosure that Smyth developed new client relationships. All the other matters must be disclosed. Smyth must get Durand’s approval to continue to direct brokerage from her portfolio to his sister’s firm. As a director and shareowner of Comax, he has a potential conflict of interest when making a recommendation regarding Durand’s Comax shares. (Study Session 1, LOS 2.a,b)


Which of the following best describes Smyth’s compliance with the CFA Institute Soft Dollar Standards in his use of client brokerage?

A)
Purchase of research reports and attending the conference are allowable uses of client brokerage.
B)
Purchase of research reports is an allowable use of client brokerage.
C)
Purchase of both research reports and carpeting are allowable uses of client brokerage.


The primary principles regarding use of client brokerage are (1) brokerage is the property of the client and (2) the investment manager has an ongoing responsibility to seek to obtain best execution, minimize transaction costs, and use client brokerage to benefit clients. Consequently, contingent on disclosure of the soft dollar arrangement to clients whose portfolios might be affected, the CFA Institute Soft Dollar Standards permit client brokerage only to be used to purchase research; that is, goods and services, the primary use of which directly assists the investment manager in the investment decision-making process and not in the management of the firm. Therefore, the only allowable use of soft dollars by Smyth is purchase of the research reports. The purchase of the carpeting to create a more pleasant environment would, at best, only contribute indirectly to the investment manager and use of client brokerage is not permitted. Conferences may sometimes be considered research if their programs are designed to improve the investment decision-making process. In Smyth’s case, the conference he attended only had sessions on the management of the investment management firm, not the investment decision-making process. (Study Session 1, LOS 3.b)


Smyth would like to continue to direct brokerage from Durand’s portfolio to his sister’s brokerage firm. In order to continue the arrangement and comply with the CFA Institute Soft Dollar Standards, which of the following disclosures are required?

A)
Smyth must clearly disclose that his duty as the investment manager is to continue to seek to obtain best execution.
B)
Smyth must clearly disclose, with specificity and in “plain language,” its policies with respect to all Soft Dollar Arrangements.
C)
Smyth must disclose that directed brokerage arrangements that require the investment manager to commit a certain percentage of brokerage might affect his ability to seek to obtain best execution.


Investment managers are required to clearly disclose, with specificity and in “plain language,” policies with respect to all Soft Dollar Arrangements. Because brokerage is an asset of the client, not the investment manager, the practice of client-directed brokerage does not violate the CFA Institute Soft Dollar Standards. However, directed brokerage arrangements have no required disclosures beyond those required for other soft dollar arrangements. Several disclosures are recommended. Because directed brokerage may impede the investment manager’s ability to seek to obtain best execution, which is one of the investment manager’s fundamental responsibilities, it is recommended that investment managers disclose his duty to seek to obtain best execution and that arrangements to commit a certain percentage of brokerage may affect his ability to do so. For all soft dollar arrangements, it is recommended, but not required, that, on request from the client, investment managers provide a description of the product or service obtained through brokerage generated from the client’s account. (Study Session 1, LOS 3.b)


After determining Durand’s risk and return objectives, liquidity needs, tax considerations, and unique circumstances, Smyth has decided that he must reduce Durand’s holdings of Comax shares. He has several other clients, whom he met through Muller, who also have significant holdings in Comax. Smyth has also decided to reduce his own holdings in Comax since his term as a director of Comax will be up in June. He does not plan to seek reappointment but as a member of the audit committee he is privy to information about a tender offer. Smyth realizes this is a complex situation.

Of the following Standards, determine which would least likely help Smyth decide what actions with respect to selling shares of Comax would be in compliance with the CFA Institute Standards of Practice.

A)
Standard III(B), Fair Dealing.
B)
Standard VI(A), Disclosure of Conflicts.
C)
Standard III(C), Suitability.


Standard III(C), Suitability, is the standard least likely to provide Smyth with guidance when he considers selling Durand’s holdings of Comax. This standard describes members’ responsibilities in developing appropriate recommendations and taking suitable actions. To reach the point where he has decided to sell Durand’s shares, Smyth would already have met these requirements. He has determined Durand’s and his other clients’ requirements and has recommended an appropriate and suitable investment action. His concern is how to implement his recommendation and be in compliance with the Standards of Professional Conduct.

Smyth has several problems with respect to selling shares of Comax from Durand’s portfolio and the portfolios of his other clients. First, he must comply with Standard III(B) and deal fairly and objectively with all clients and prospects when taking this investment action. Smyth must disclose his ownership of Comax to all affected clients according to Standard VI(A) and ensure that transactions for clients take precedence over transactions on his own behalf according to Standard VI(B). (Study Session 1, LOS 2.a,b)


Since Smyth is a director of Comax and a member of the audit committee, what additional Standard is specifically applicable to Smyth’s decision to sell his and his clients’ shares of Comax?

A)
Standard VII, Responsibilities as a CFA Institute Member or CFA Candidate.
B)
Standard II, Integrity of Capital Markets.
C)
Standard IV, Duties to Employers.


As a director and member of Comax’s audit committee, Smyth possesses material nonpublic information about a tender offer. Therefore, Smyth must be particularly concerned about complying with Standard II(A), Material Nonpublic Information. Under this standard, Smyth may not trade nor cause others until the information becomes public. (Study Session 1, LOS 2.a,b)


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Greg Allen is a security analyst and visits David Dawson, the Chief Financial Officer of Edmonds Company. Dawson reveals a great deal of nonmaterial financial data to Allen, data that Dawson routinely reveals to all security analysts who visit him. From this data and other industry information, Allen conjectures that Edmonds is likely to make a tender offer for another company in the industry, a fact that if true would be considered material to the value of the company. Allen:

A)
must not disseminate the information or use it for trading purposes until the tender offer is announced.
B)
can publish his conclusion in a research report.
C)
should send a copy of the report to Dawson for verification before disseminating the report to clients.


Releasing information to analysts does not constitute a public release of information. Dawson's information should be considered nonpublic until it is released to the public. Allen has used this information, along with other industry information, to come to his conclusion of a pending tender offer which he can use to trade upon based on the mosaic theory.

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Jim Taylor works as a portfolio manager for Rose Capital and also serves as president of the Little League board of directors in his town. He receives no money from Little League, however the local golf club provides him with a free membership for volunteering his time on the Little League board. Taylor's involvement with Little League is in his company biography, but the club membership has not been disclosed to Rose or his clients. Taylor has:

A)
not violated the Standards.
B)
violated the Standards by not disclosing the club membership to Rose, but not by failing to disclose it to clients.
C)
violated the Standards by not disclosing the club membership to Rose and failing to disclose it to clients.


He must disclose any compensation to his employer if it conflicts with his employers/clients interests. However, this relationship does not likely represent any conflict of interest.

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Brenda Simone is a money manager and the Blue Streets Pension Fund is one of her clients. The director of the pension fund calls Simone and asks her to use a particular broker so that the fund can obtain some research services with the soft dollars from that broker. Simone believes that the desired broker will provide the same price and execution as the normal broker that Simone uses. Simone does as the client wishes. Simone has:

A)
not violated the Standards as long as the research provided by the broker will benefit the plan beneficiaries.
B)
not violated the Standards as long as the research provided by the broker will benefit Blue Streets.
C)
violated the Standards.


Simone must ensure that the research benefits the parties to whom she owes fiduciary duty, which are the plan participants.

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

A)
Monitoring all the phone calls made by the brokers.
B)
Placing securities on a restricted list when the firm is in possession of material nonpublic information.
C)
Controlling relevant interdepartmental information.


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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Scott LaRue is a portfolio manager for Washington Advisors. Washington has developed a proprietary model that has been thoroughly researched and is known throughout the industry as the Washington model. The model is purely quantitative and screens stocks into buy, hold, and sell categories. The basic philosophy of the model is thoroughly explained to clients. The director of research frequently alters the model based on rigorous research—an aspect that is well explained to clients, although the specific alterations are not continually disclosed. Portfolio managers then make specific sector and security holding decisions, purchasing only securities that are indicated as "buys" by the model. La Rue feels the model would be improved by adding some factors but he has not fully tested this new version of the model. LaRue discloses his model to his own clients but not to his supervisor. LaRue is:

A)
violating the Standards by not having a reasonable and adequate basis for his investment recommendation.
B)
violating the Standards by not considering the appropriateness of the recommendations to clients.
C)
not violating the Standards.


The ad hoc model is not part of the formal research process and does not formulate an adequate basis for a recommendation.

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Brenda Clark is an investment advisor. Two years ago Clark decided to stop calculating a return composite because of the time required to make those calculations. A prospective client asks Clark what she thinks her performance would have been over the past two years. Clark:

A)
can answer the question orally but cannot state the numbers in writing.
B)
cannot answer the question because it would be misleading.
C)
cannot answer the question, nor can she discuss potential future market returns with the prospective client.


Any discussion of past performance would imply that Clark had made some calculations, which would be misleading. However, Clark need not calculate historical performance to be an advisor. She can also talk about her view on the future of capital markets.

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While having a conversation with a prospective client, John Henry states that his performance across all of his past clients over the past five years was over 20%, which was 200 basis points higher than his benchmark. He tells the client that while the benchmark may rise or fall over time, his excess performance will remain consistent. Henry violated the Standards of Professional Conduct because:

A)
he cannot discuss prospective future performance in any manner.
B)
the statement of excess performance is misleading with respect to its certainty.
C)
he cannot discuss performance without clearly stating that the composite does not conform to GIPS.


Guaranteeing performance on investments that are inherently volatile is misleading to clients.

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June Carter passed Level III of the CFA examination in June but will not complete her work experience requirement until August of next year. Carter can state on her resume that she:

A)
will be a CFA charterholder in August of next year as long as she is on track to complete her work experience.
B)
is a CFA in waiting.
C)
passed Levels I, II, and III of the CFA examination.


A candidate cannot use any form of the CFA designation until receiving her charter.

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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.


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.

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