Reading 2-V: Standards of Professional Conduct & Guidance technology, Investment, companies, 2011, class

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Session 1: Ethical and Professional Standards
Reading 2-V: Standards of Professional Conduct & Guidance: Investment Analysis, Recommendations, and Actions

LOS A.: Diligence and Reasonable Basis.

 

 

LMS Securities is a boutique broker-dealer specializing in private placements for technology companies. The firm also provides aftermarket support for the companies that go public after private rounds of financing. This support includes market making and research coverage.

Susan Jones, CFA, is an analyst at LMS Securities. She is responsible for a subset of the companies for which LMS offers research coverage. She recently received her annual CFA Institute Professional Conduct statement, but has not yet filled it out and turned it in. Steve Brown is an analyst who directs the due diligence process for LMS Securities’ private placements. Brown passed the Level II exam five years ago, and has registered for the Level III exam every year since then, but has never taken it. He is registered for the Level III CFA exam next June, but nobody at the office believes he will actually take the test.

Sunrise Technologies is a longtime client of LMS Securities. LMS arranged four levels of private financing, for Sunrise, providing in-depth business consulting as well as handling all of the private placements. Sunrise went public 90 days ago and is currently trading at $14 per share.

Kenneth Karloff, CEO of LMS Securities, instructed Jones to write a favorable research report on Sunrise Technologies right before the company went public, setting a price target of at least $30 per share. Jones has developed a number of alternative cash flow projections for Sunrise Technologies. She picks an optimistic scenario to justify a $30 price target and issues a positive report using those projections.

After Sunrise Technologies has gone public, Karloff decides to help Jones to write a more-detailed research report on the company. Karloff provides Jones with information about the product pipeline and sensitive patent litigation that was given to him in confidence by Sunrise executives while the company was private. Given the product pipeline and legal outlook, Jones revises her cash flow models to reflect greater growth, then writes a positive report and advises LMS’s clients to buy the stock.

LMS Securities has an arrangement with Clampett Securities, an investment adviser, under which the investment manager uses its client brokerage to obtain LMS’s research. Clampett manages accounts for wealthy individual investors. About half of Clampett’s clients have a growth objective, while the rest seek income.

 

In order to remain an active member of CFA Institute, Jones must annually:

A) submit her completed Professional Conduct Statement, pay applicable membership dues, and complete forty hours of continuing education.

B) pay applicable membership dues and complete forty hours of continuing education.

C) submit her completed Professional Conduct Statement and pay applicable membership dues.

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To remain an active member, Jones must agree to abide by the Code and Standards and the Professional Conduct Program. This is accomplished by completing the Professional Conduct Statement on an annual basis. In addition, Jones must pay annual membership dues. Continuing education is encouraged but not required to remain an active member. (Study Session 1, LOS 2.a,b)

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Which of the following statements regarding the research report on Sunrise Technologies after the company went public is CORRECT?

A) Jones has violated the Standard on research reports because she failed to distinguish between fact and opinion; Karloff is in compliance with the supervisory-responsibilities Standard because he is keeping up with Jones’ actions and ensuring her report is accurate.

B) Jones is in compliance with the objectivity Standard because she made her recommendation based facts, not conjecture; Karloff has violated the Standard regarding the use of material nonpublic information.

C) Jones has violated the misrepresentation Standard with her aggressive growth prediction for Sunrise Technologies; Karloff has violated the plagiarism Standard by disseminating information he received in confidence.

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Jones’ second research report made reference to hard facts, and her analysis and revision of the cash flow projections seems thorough and reasonable. This time, Karloff did not press her to express a certain opinion, and she found the information about the company compelling. She projected higher growth in cash flow for Sunrise, but nowhere is it said that she guaranteed a hard target. Jones is in compliance with the misrepresentation, objectivity, reasonable-basis, and research-report Standards. Karloff violated the insider-trading Standard because the information was given to him in confidence. He may also have violated his fiduciary duty to Sunrise, which probably kept the information private for a reason. (Study Session 1, LOS 4.a)

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According to CFA Institute Standards concerning fair dealing, Jones is required to do which of the following?

A) Ensure that accounts belonging to her immediate family purchase securities only after other clients have had the chance to buy.

B) Disseminate new investment recommendations to all clients at the same time.

C) Disclose to all clients whether different levels of service are offered.

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Jones must disclose different levels of service to all clients. Jones must inform clients about new buy recommendations and advise them not to sell, but she cannot disregard the order if the client still wishes to sell. Family-owned accounts should be handled in the same way as other accounts, and cannot be made to wait until everyone else has acted. The Standard allows for the fact that it is impossible to notify everyone at the same time. (Study Session 1, LOS 2.a,b)

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Which of the following statements could Brown put on his resume without violating Standard VII(B): Reference to CFA Institute, the CFA Designation, and the CFA Program?

A) I am a Level III CFA and should become a chartered financial analyst next year.

B) I am a Level III CFA candidate eligible to receive my charter in November 2005.

C) If I pass the Level III test, I may be eligible for my CFA charter late next year.

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This statement is quite literally correct, and complies with the Standards. “Level III CFA” is not an acceptable use of the CFA mark. Candidates should not offer a prediction about the time they will earn their charter. While Brown is not likely to take the test, as long as he is registered, he may refer to himself as a candidate. (Study Session 1, LOS 2.a,b)

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In order for Clampett Securities to claim compliance with CFA Institute Soft Dollar Standards, the company must:

A) re-evaluate mixed-use research at least once a year.

B) comply with all recommended provisions of the Soft Dollar Standards.

C) send all purchased research to the client whose brokerage was used to pay for it.

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Mixed-use research must be evaluated at least annually. Companies that claim soft-dollar compliance must follow the mandatory provisions, but can forgo some of the recommended provisions. If research only benefits some clients, it is acceptable to use just their brokerage to pay for it. The Standards do not require sending research to clients. (Study Session 1, LOS 3.b)

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When Jones produced the research report on Sunrise Technologies before it went public, she violated:

A) Standard V(B): Communication with Clients and Prospective Clients by leaving relevant facts out of the report, but not Standard III(A): Loyalty, Prudence, and Care because the CEO cannot pass his fiduciary duty on to her.

B) Standard V(A): Diligence and Reasonable Basis because her research was not thorough, and Standard I(B): Independence and Objectivity because of her obedience to her CEO.

C) Standard I(B): Independence and Objectivity because of her obedience to her CEO, and Standard II(A): Material Nonpublic Information because of Karloff’s involvement.

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Jones’ research was not thorough, and her report did leave out salient facts. Thus, she violated Standards V(A) and V(B). Her objectivity was certainly in question, so she violated Standard I(B). She also has a fiduciary duty to the clients regardless of what the boss says, so she violated Standard III(A). No nonpublic information was used in this report, so Standard II(A) was not violated. (Study Session 1, LOS 2.a,b)

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A client calls his money manager and asks the manager to liquidate a large portion of his assets under management for an emergency. The manager warns the client of the risk of selling many assets quickly but says that he will try to get the client the best possible price. This is a violation of:

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

B) Standard III(C), Suitability.

C) none of the Standards listed here.

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The money manager has done his duty. He has warned the client of the risk and made no explicit promises concerning what he can and cannot do.

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An analyst has found an investment with what appears to be a great return-to-risk ratio. The analyst double-checks the data for accuracy, keeps careful records, and is careful to not make any misrepresentations as he simultaneously sends an e-mail to all his clients with a “buy” recommendation. According to Standard V(A), Diligence and Reasonable Basis, the analyst has:

A) fulfilled all obligations.

B) violated the Standard if he does not verify whether the investment is appropriate for all the clients.

C) violated the Standard by communicating the recommendation via e-mail.

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If the analyst had been an investment manager, it would have been inappropriate for him to make a blanket recommendation for all of his clients without considering the unique needs of each. However, the analyst is merely stating that given the qualities of the investment, it is an attractive buy. He has kept adequate records, and made fair disclosure of his rating decision.

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Peggy Green, CFA, is a research analyst following Brown Co. All the information she has gathered suggests the stock should be rated a weak "hold." During a recent lunch, Green overheard another analyst say that the stock should be rated a "buy." Green returns to her office and issues a "buy" recommendation. Green:

A) has violated CFA Institute Standards of Professional Conduct because she did not have a reasonable and adequate basis for making this recommendation.

B) violated CFA Institute Standards of Professional Conduct because she did not seek approval of the change from her firm's compliance director.

C) has violated CFA Institute Standards of Professional Conduct because she failed to distinguish between fact and opinion.

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Analysts are required to have a reasonable and adequate basis, supported by appropriate research and investigation, for their recommendations.

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Wes Smith, CFA, works for Advisors, Inc. In order to remain in compliance with Standard V(A), Diligence and Reasonable Basis, Smith may recommend a security in which of the following situations?

A) Smith reads a favorable review of the security in a widely read periodical.

B) For either of the reasons listed here.

C) Advisors' research department recommends a stock.

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Smith will be in violation if he acts solely on the basis of what he read in the periodical. Use of information within the firm can be relied upon unless the Smith has reason to believe the source lacks a sound basis.

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The following scenarios refer to recommendations made by two analysts.

• Jean King, CFA, is a quantitative analyst at Quantlogic, Inc. King uses computer-generated screens to differentiate value and growth stocks based on accounting numbers such as sales, cash flow, earnings, and book value. Based on her analysis of all domestically traded stocks in the U.S. over the past year, King concludes that value stocks as a class have underperformed growth stocks over that period. Using only this analysis, she recommends that account executives at Quantlogic sell all value stocks from the portfolios for which they have discretionary authority to trade and replace these stocks with growth stocks.
• James Capelli, CFA, is a fundamental analyst at Wheaton Capital Management, which focuses on regional stocks. His analysis of Branson Wireless includes the investment's basic characteristics such as information about historical earnings, ownership of assets, outstanding contracts, and other business factors. In addition to conducting both a general industry analysis and a company financial analysis, Capelli interviews key executives at Branson. Based on his analysis, he concludes that the company's future prospects are strong and issues a "buy" recommendation.

According to CFA Institute Standards of Professional Conduct, did King and Capelli have a reasonable and adequate basis for making their recommendations?

A) Capelli has a reasonable basis for his recommendation, but King does not.

B) Both King and Capelli have a reasonable basis for their recommendations.

C) King has a reasonable basis for his recommendation, but Capelli does not.

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Capelli appears to have exercised diligence and thoroughness in making his recommendation. King's recommendation is not based on thorough quantitative work because the period used in her study is only one year. Also, her recommendation does not consider the client's specific needs and circumstances.

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A financial analyst and CFA Institute member sends a preliminary research report on a company to his supervisor. The supervisor approves the report, but then the analyst receives news that causes him to revise downward the earnings estimate of the company. The analyst resubmits the report to the supervisor with the new earnings estimate. The analyst soon finds out that the supervisor plans to release the first version of the report with the first earnings estimate without a reasonable and adequate basis. In response to this the analyst must:

A) both insist that a follow up report be issued and take up the issue with regulatory authorities.

B) only insist that the first report be followed up by a revision.

C) insist that the supervisor change the earnings forecast or remove his (the analyst's) name from the report.

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According to Standard V(A), Diligence and Reasonable Basis, the analyst must exercise diligence, independence, and thoroughness when performing investment analysis, making a recommendation, or taking investment action. The analyst should document the difference in opinion including any request to remove his or her name from the report.

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An analyst notices that for most years that a given class of assets has an abnormally high rate of return, the asset class often has an abnormally low rate of return the next year. Based upon this information, according to Standard V(A), Diligence and Reasonable Basis, the analyst can recommend:

A) short selling assets that have had a good previous year to all clients.

B) an increased allocation of Treasury bills (T-bills) for all portfolios of assets that have increased dramatically in the previous year.

C) neither of these choices.

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An analyst should not make a recommendation based only upon a statistical anomaly. Furthermore, none of the other choices would be appropriate. Clients with low risk tolerance should not short sell assets. The analyst cannot make a recommendation to all clients because each client has different characteristics and portfolios. The one answer that may have some merit is to increase the allocation of T-bills in portfolios that have had recent, dramatic increases. This would be for the purposes of maintaining a balanced portfolio. But the decision to rebalance must be made on a case-by-case basis and not for all portfolios.

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An analyst receives a report from his research department that summarizes and interprets a recent speech from the chairman of the U.S. Federal Reserve. The summary says that the chairman thinks inflation is under control. Based upon this summary, the analyst says in his next newsletter that inflation is under control. This is a violation of:

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

B) none of the Standards listed here.

C) Standard V(A), Diligence and Reasonable Basis, and Standard V(B), Communication with Clients and Prospective Clients.

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The analyst should verify that the research department has interpreted the chairman’s speech correctly. The analyst must make it clear that the statement concerning inflation is only an opinion. No one knows if that is true or not at any point in time. Based upon the given information, we cannot say that the analyst is violating only one standard. The analyst may also be violating plagiarism in accordance with Standard I(C), Misrepresentation. Hence, the answer citing the two standards and not limiting violations to just those two standards is the best answer.

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Susan Plumb is the supervisor of her firm’s research department. Her firm has been seeking the mandate to underwrite Wings Industries’ proposed secondary stock offering. Without mentioning that the firm is seeking the mandate, she asks Jack Dawson to analyze Wings common stock and prepare a research report. After reasonable effort, Dawson produces a favorable report on Wings stock. Plumb then adds a footnote describing the underwriting relationship with Wings and disseminates the report to the firm’s clients. According to CFA Institute Standards of Professional Conduct, these actions are:

A) a violation of Standard V(A), Diligence and Reasonable Basis.

B) not a violation of any Standard.

C) a violation of Standard VI(A), Disclosure of Conflicts.

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The fact that the firm is seeking the mandate does not preclude the research department from performing analytical work on the security. As long as the final recommendation is based upon reasonable facts, not the desire to obtain the mandate, there is no violation.