Walex

Preston Partners is an investment management firm that adopted the Code and Standards as part of its policy manual. Gerald Smithson, CFA, has recently added the stock of Utah Biochemical Company and Norgood PLC to all his client's investment portfolios. Shortly afterwards Utah Biochemical and Norgood announced a merger that increased the share price of both companies. Smithson contends he saw the president of Utah Biochemical dining with the chairman of Norgood, but did not overhear their conversation. Smithson researched both companies extensively and determined that each company was a good investment. He put in a block trade for shares in each company. Preston's policies were not clear in this area as he allocated the shares by starting with his largest client accounts and working down to the small accounts. Some of Smithson's clients were very conservative personal trust accounts, others were pension funds who had aggressive investment objectives. Which standard was NOT broken?

A) Standard IV(C)--Responsibilities of Supervisors.

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

C) Standard III(C)-- Suitability.

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Standard V(A)—Diligence and Reasonable Basis was not broken because Smithson conducted thorough and diligent research. Standard III(C)-- Suitability, Smithson failed to consider the needs of his conservative and aggressive clients. Standard IV(C)--Responsibilities of Supervisors, Preston Partners didn't have policies explaining how to allocate shares among clients.

Walex

Maggie McCarthy is an individual investment advisor who uses mutual funds for her clients. She typically chooses from a list of 40 funds that she has thoroughly researched. The Figgs, a married couple that are a client, asked her to consider the Boilermaker fund for their portfolio. McCarthy had not previously considered the fund because when she first conducted her research three years ago, Boilermaker was too small to be considered. However, the fund has now grown in value, and after doing thorough research on Boilermaker, she found the fund was by far the most outstanding large company value fund in her list of funds. She puts the fund in the Figgs' portfolio, and in all new clients portfolios, but not in any of her other clients' portfolios. Her reasoning is that her existing clients were comfortable with their current holdings, and she did not want to risk disturbing their comfort. Has McCarthy violated any Standards? McCarthy has:

A) violated the Standards by not having a reasonable and adequate basis for making the recommendation.

B) not violated the Standards.

C) violated the Standards by not dealing fairly with clients.

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The fund should have been considered for the existing clients' portfolios. There may have been reasons not to add the fund to their portfolios, such as tax consequences or a lack of suitability, but disturbing their comfort is not sufficient.

Walex

Lynne Jennings is a chemical industry research analyst for a large brokerage company. That industry is currently seeing an increase in mergers and acquisitions. While flying through Chicago, Jennings sees several senior officers who she knows are from the largest and fourth largest chemical companies walk into a conference room. She concludes that negotiations for an acquisition might be taking place. Jennings:

A) may use this information to support an investment recommendation.

B) may not act or cause others to act on this information.

C) should inform her compliance officer that she has material nonpublic information on firms she covers.

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The fact that the company officers met is not material nonpublic information. As long as she bases her investment recommendation on her own independent research, Jennings will not violate any Standards if she uses this additional information to support it.

Walex

Sharon Pope has been asked by the Chief Investment Officer to develop a firm-wide policy for proxy voting. Which of the following would NOT be acceptable to include in the policy statement?

A) Voting proxies may not be necessary in all instances.

B) The value of proxy voting must be maximized.

C) Portfolio managers of active funds must vote in all proxies; portfolio managers of index funds should vote only when they have a definitive opinion.

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Proxies for stocks in passively managed funds must also be voted. A cost-benefit analysis may show that voting all proxies may not benefit all clients.

Walex

Bella Brown is an experienced generalist securities analyst employed by Lang & Co., a major U.S. brokerage firm whose clients have a high regard for her research and stock selection abilities. She was visited recently by a Lang managing director who said, "Please take a look at SpecChem Inc., the specialty chemical producer. They are going to need an investment banker soon and, because we make a market in their stock, we will be one of the firms considered for this business. I had lunch with SpecChem's Treasurer today, who told me that their European problems are being resolved and that earnings results are definitely looking good. He likes us and is expecting you to call him for details." The managing director then left Brown's office, saying, "It would be great if you could rate the stock a 'Buy'."
In a subsequent hour-long telephone discussion with the Treasurer, Brown obtained some useful information concerning recent company trends and developments as well as SpecChem's overall view of the outlook for sales and earnings during the next several quarters. Brown began thinking quite positively about the company and its prospects. She then reviewed some general source material on the chemical industry and read the Standard & Poor's Stock Guide on SpecChem Inc. That afternoon, she wrote a report recommending purchase of the stock, shown below as Exhibit B. In accordance with Lang's routine procedures for pre-dissemination review of Research Department recommendations, the report has been sent to the firm's Director of Research, who is aware of the circumstances under which it was prepared.
Exhibit B
LANG & COMPANY Company Report
Industrial: Specialty Chemicals Equity Research
Rating: Buy
SpecChem Inc. (NYSE: SCM)

• 
  We are initiating coverage of SpecChem Inc. with this report.
• 
  Earnings, up to 51% in the first quarter, are expected to be up again in the quarter ending June 30. Higher sales, better margins, an improved geographic sales mix, and savings from reduced pension expense are all contributing to this year's gains.
• 
  Although European production is up only modestly year-over-year, successful cost reduction efforts are limiting the adverse effects of weak volume and pricing. A possible plant closure in September could improve plant utilization by 10%, accompanied by potentially dramatic margin improvement. However, a $30 million after-tax special charge could be taken at the time of the closure.
• 
  We expect a moderate increase in second half 1994 sales. Although management looks for European demand to remain slow, it feels that U.S. sales could be above expectations if auto-related demand strengthens. Management is also optimistic about receiving a sizable U.S. government contract in the next few months.
• 
  Based on the factors noted above, our confidence level concerning earnings levels over the balance of the year is high.
• 
  We think SpecChem stock is undervalued and believe it can easily reach the low 100s on the strength of continuing earnings momentum. The downside is estimated to be in the mid-80s. There is plenty of room for upside earnings surprises if volume and prices improve, which would take the stock up strongly. Purchase is recommended.

Analyst: Bella Brown
Research Department
This report is based upon information which we consider reliable, but we do not represent that it is accurate, and it should not be relied upon as such. We, or persons involved in the preparation or issuance of this material, may, from time to time, have long or short positions in the securities of the company mentioned herein.Under the CFA Institute Code and Standards, it is the responsibility of the Director of Research, a CFA Institute member to:

A) not knowingly participate or assist in any violation of laws, rules, or regulations.

B) exercise reasonable supervision over those subject to their supervision or authority to prevent any violation of applicable statues, regulations or provisions of the Code and Standards.

C) both of these.

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The Director of Research, as a CFA Institute member, is bound by the Standards of Professional Conduct. Accordingly, "members shall not knowingly participate or assist in any violation of such laws, rules or regulations" (Standard I(A): Knowledge of the Law). This responsibility is applicable under the circumstances. As a supervisor, the director of research has a responsibility to exercise reasonable supervision over subordinates to prevent violations of laws, regulations, and the provisions of CFA Institute Standards of Professional Conduct (Standard IV(C): Responsibilities of Supervisors).

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Under the current circumstances, the Director of Research should:

A) require the report to be redone with a neutral or hold rating pending the outcome of the awarding of the investment banking business.

B) require the report to be redone to ensure compliance with CFA Institute Standards.

C) allow the report to be distributed, as is.

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Based on the current circumstances, the supervisor (Director of Research) must not allow the report to be distributed. In this situation the overriding responsibility is to ensure that diligence, thoroughness, and independence be exercised in forming the investment judgment and in preparing the research report.

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The research report, as shown, has several aspects which violate CFA Institute Standards of Professional Conduct. Which of the following is NOT an apparent violation of CFA Institute Standards?

A) The report does not adequately discuss the factors important to analysis, recommendations, or action.

B) The report violates guidelines on investment performance presentation.

C) The report does not distinguish between fact and opinion.

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There is no attempt in the report to present data on the firm's performance as an investment manager. Violations relating to the report itself include the following:

• Though SpecChem's current and prospective earnings are mentioned, no real basis of SpecChem's earnings power is discussed, nor are such factors as cash flow, operating strength or financial condition. Brown has violated Standard V(B): Communication with Clients and Prospective Clients.
• The report fails to disclose Lang's market-making activities with SpecChem. This omission violates Standard VI(A): Disclosure of Conflicts.
• Brown is not separating fact from opinion in her comment, "There is plenty of room for upside earnings surprises if volume and prices improve further, which would take the stock up strongly." This is a violation of Standard V(B): Communication with Clients and Prospective Clients. The above-noted comment could also be considered a violation of Standard I(C): Misrepresentation.

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As to the process by which Brown's report in Exhibit B came into being, which of the following is NOT a procedural error in violation of CFA Institute Standards of Professional Conduct?

A) Brown has violated the Standard relating to independence and objectivity.

B) Brown has violated the Standard relating to the prohibition against plagiarism.

C) Brown has violated the Standard relating to disclosure of basic characteristics.

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There is nothing to indicate that a violation of the Standard on Prohibition against plagiarism has occurred. The word "process" violations include:

• Brown's report and investment conclusions were influenced by a senior member of her firm. In addition, near total reliance was put on the information supplied by SpecChem's management. She has violated Standard I(B): Independence and Objectivity.
• Brown showed a lack of diligence and thoroughness in forming her investment decision and preparing the report. Her analysis was cursory at best; the report was not objective nor was it based on adequate understanding of company fundamentals. Standard V(A): Diligence and Reasonable Basis was violated by Brown.
• A violation of Standard V(B): Communication with Clients and Prospective Clients has also occurred. Brown failed to investigate SpecChem's basic investment characteristics properly and did not communicate the company's investment characteristics through the research report.

Walex

Brian Williams is a portfolio manager with Santo Capital and works on the Banks Company's account. Santo has a policy against accepting gifts over $500 from clients. The Banks' portfolio has a fantastic year, and in appreciation, a Banks manager sends Williams a rare bottle of wine that he estimates is worth $300. Williams must:

A) return the bottle to the client.

B) report the pension fund manager to the CFA Institute Professional Conduct Program.

C) inform his supervisor in writing that he received additional compensation in the form of the wine.

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The Standards require that he inform his supervisor in writing about the gift.

Walex

After a very successful quarter of high investment returns, Judy O’Berry, CFA, receives several gifts from grateful clients. O’Berry considers the gifts to be of novelty or sentimental value only, but she hears rumors that several junior employees are jealous of the attention she received for the group’s efforts. She decides to consult the company’s compliance rules on gifts and is surprised to learn her firm has no established rules. She consults the Standards of Practice Handbook, and then submits proposed rules on gifts to her company’s compliance department. These rules should contain all of the following EXCEPT:

A) a formal value limit based on local customs.

B) a requirement to disclose the gift.

C) restrictions on all types business entertainment.

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The rules should contain a formal value limit based on local customs. Not all types of business entertainment are forbidden. Only business entertainment which is intended to influence or reward members and candidates should be avoided.

Walex

Susan Nielsen, CFA, works for a rating agency which competes directly with S&P and Moody’s. Her friend, Lance Parker, works for the same company but in a different department which is involved in advisory services for structured products. Nielsen frequently receives pressure from Parker to "put a positive face" on client ratings to help him sell advisory services. She is reluctant to discuss client ratings with Parker and tries to avoid the topic. She consults her company’s compliance department and learns that there are no policies or procedures to discourage Nielsen and Parker from sharing information and is encouraged to consider his advice on company ratings. Nielsen should most likely:

A) advise her firm to develop firewalls and protections to allow the different departments to function independently and avoid talking with Parker about client ratings.

B) continue to consult with Parker on company ratings as the compliance department’s position is that there is no conflict.

C) advise regulators of the potential conflict of interest and seek legal counsel.

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Nielsen should advise her firm to develop firewalls and protections to allow the different departments to function independently. If Nielsen and Parker are going to remain friends, they should stop talking about client ratings.

Walex

Nancy Westfall is an individual investment advisor who uses mutual funds for her clients. She typically chooses funds from a list of 40 funds that she has thoroughly researched. The Craigs, a married couple that is a client, asked her to consider the Eligis fund for their portfolio. Westfall had not previously considered the fund because when she first conducted her research three years ago, Eligis was too small to be considered. However, the fund has now grown in value, and after doing thorough research on the fund, she finds the fund has suitable characteristics to be included in her acceptable list of funds. She puts the fund in the Craigs' portfolio but not in any of her other clients' portfolios. The fund ends up being the poorest performing fund in the Craigs' portfolio. Has Westfall violated any Standards? Westfall has:

A) violated the Standards by not dealing fairly with clients.

B) violated the Standards by not having a reasonable and adequate basis for making the recommendation.

C) not violated the Standards.

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Because Westfall performed the same degree of research as she did for the other funds on her list, she provided a reasonable and adequate basis for her recommendation. There is not enough information given about the Eligis fund and how it fits in with the other funds on Westfall's list to determine whether or not the standard on Fair Dealing was broken. It was the Craigs who wanted the Eligis fund and Westfall found it to be acceptable for them and thus added it to her list of acceptable funds. If the Eligis fund was found to possess unique characteristics that were not found in any of the other funds on Westfall's list and the Eligis fund was suitable for some of Westfall's other clients and Westfall hadn't added it to their portfolios after their periodic review then a violation of fair dealing would have occurred.

Walex

Mike Johnson, who is sitting for Level III of the CFA exam this year, is a junior consultant at a small investment advisory firm. Julie Gowan, CFA, is Johnson’s supervisor and in the last three months had been letting Johnson develop a clientele. Johnson had met Mrs. Campbell two months earlier as a referral from an existing client: Mrs. Smith. Following his recent second visit with Mrs. Campbell, Johnson gave Campbell a personal data form to complete and return. The purpose of the form was to gather information about Campbell’s financial situation, investment experience, and investment objectives. Upon receiving the completed form in the mail, Johnson had his assistant, who is a CFA Level I candidate, type up the information. Johnson then reviewed the information and determined that he needed to call Campbell to clarify several items and to request more information.When Campbell answered the phone and Johnson identified himself, Campbell immediately asked if Johnson was still confident in the firm’s recommendation to buy shares of Brown Company, which Smith had purchased upon the firm’s recommendation three months earlier. The rapid rise of the stock of Brown Company after the recommendation, Campbell added, was the reason Campbell wanted to meet with a representative of Johnson’s firm. Johnson quickly did a search on his computer and found the buy recommendation on Brown Company that had been sent to Smith and other clients. Johnson then remembered that some of the clients, who were his friends, had been very happy with the stock’s performance. Johnson responded to Campbell by saying that purchasing the stock was a good idea.
Johnson then asked for a few details concerning Campbell’s situation, and Campbell answered some questions over the phone. Some of the information was not at her fingertips, so she promised to mail it to Johnson.During the phone conversation, Campbell stated that it is extremely important that the information she is providing to Johnson be considered confidential for several reasons. First, as a result of a lawsuit from a former neighbor, Campbell needs to hide some assets to avoid paying a judgment. Therefore, she wants to open up two separate accounts; a small one in her name, and a second account in the name of the company that Campbell owns. Second, Campbell told Johnson that she is about to file for divorce from her husband and does not want her husband to know about the accounts. After collecting all the information he needed, Johnson visited with Gowan to ask advice about opening the account in the name of Campbell’s company. Gowan told Johnson that Campbell should open the account in the name of a fictitious company instead of using the name of Campbell’s company. This would make it more difficult for the courts to find the assets. However, the supervisor stated, "You realize that opening an account in the name of a fictitious firm is illegal so I cannot suggest that you do it. I am only saying that, if you did this, it would help Campbell accomplish her objective."
Later that day, Johnson went to a restaurant and met his old college roommate, William Black, who is now a divorce attorney. Johnson told Black all about Campbell’s situation and suggested that, if Black needs a new client, he should contact Campbell who is about to divorce her husband. Black said he could not act on the information because Campbell’s husband had seen him already about a possible divorce. Johnson assured Black that, as they had agreed, he did not tell Campbell about the possibility of Johnson passing her name on to Black. Black thanked Johnson for the lead and said that, thanks to Johnson’s referrals, he currently had more clients than he could handle anyway. Despite that, Black paid for the dinner as he usually did when Johnson gave him a good lead. Did Johnson violate the Code and Standards by telling Black about Campbell’s impending divorce?

A) No, because Black is not going to act on the information.

B) No, because the impending divorce had nothing to do with Campbell’s financial situation.

C) Yes, he violated client-member confidentiality.

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Johnson violated Standard III(E), which states that all information about current and former clients and prospects must be kept confidential. The fact that Black does not act on the information, and that Black already knew that Campbell and her husband were having marital problems is irrelevant. Although the impending divorce had nothing to do with Campbell's financial situation, this information was clearly communicated to Johnson "within the scope of the client-member relationship." (Study Session 1, LOS 2.a,b)

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Did Johnson violate the Code and Standards by the way he gathered information from Campbell using the personal data form?

A) No, he did not violate the Code and Standards by the way he gathered information.

B) Yes, because he failed to collect the information during face-to-face contact.

C) Yes, because he permitted his assistant who does not hold the CFA designation to see this confidential information.

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There is no provision that would prohibit Johnson from gathering information through the mail,nor is there a provision prohibiting employees of an investing management firm from working with confidential client information. (Study Session 1, LOS 2.a,b)

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In his recommendation of Campbell buying the shares of Brown company, Johnson violates the Code and Standards concerning:

A) Standard III(C) Suitability but not Standard V(A) Diligence and Reasonable Basis.

B) both Standard III(C) Suitability as well as Standard V(A) Diligence and Reasonable Basis.

C) Standard V(A) Diligence and Reasonable Basis but not Standard III(C) Suitability.

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Although Johnson’s firm had made the recommendation three months earlier, he obviously had not been directly involved in the recommendation, nor did he check to see if any new information had been gathered on Brown Company. This is a violation of Standard V(A). Since the client profile was still incomplete at the time of the recommendation, Johnson did not know if Brown Company was suitable for Campbell. The stock had obviously gone up in value since the last recommendation and thus it may not have much capital gain potential left. This is a violation of Standard III(C). (Study Session 1, LOS 2.a,b)

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Did Johnson's supervisor violate the Code and Standards when she told Johnson about a more effective way to hide assets?

A) Yes, because the supervisor assisted in an apparent violation of law.

B) No, because the supervisor specifically stated that, "I cannot suggest" that you open an account in the name of a fictitious firm.

C) No, because the supervisor did not take specific action that violated the law.

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Johnson's supervisor violated the Code and Standards when she told Johnson about a more effective way to hide assets. Standard I(A), Knowledge of the Law, states that "members shall not knowingly participate or assist in any violation of such laws..."Giving information about which illegal act will most benefit Campbell falls into this category. Stating that "I cannot suggest doing this," does not avert blame from the supervisor. She has assisted in the violation of the law by suggesting how best to break the law. Also, there is no confidentiality relationship between investment professionals and their supervisor. (Study Session 1, LOS 2.a,b)

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

A) Johnson having the assistant type up Campbell’s information.

B) Black paying for the dinner with Johnson.

C) Johnson gathering information over the phone.

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Apparently Johnson has been referring many clients to Black, a practice Johnson hides from the clients, and the dinners Black has paid in return would qualify as a benefit received by the member or delivered to others for the recommendation. This violates Standard VI(C) Referral Fees and Standard III(E) Preservation of Confidentiality. None of the other circumstances listed violate the Code and Standards. (Study Session 1, LOS 2.a,b)

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Is Johnson in violation of the Code and Standards if he informs the legal authorities that Campbell is attempting to hide assets from the courts?

A) No, because Campbell has done something illegal.

B) Yes, because he would be violating client-member confidentiality.

C) Yes, because Johnson has only hearsay information about illegal activity and he would need written documentation to justify notifying the legal authorities.

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Johnson is not in violation of the Code and Standards if he informs the legal authorities that Campbell is attempting to hide assets from the courts, because Campbell has done something illegal. According to Standard III(E), the rules of confidentiality do not apply when a member receives information concerning illegal activities. (Study Session 1, LOS 2.a,b)