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BOOK 1- ETHICAL AND PROFESSIONAL
STANDARDS AND QUANTITATIVE
METHODS
Reading Assignments and Learning Outcome Statements. 9
Study Session 1-Ethical and Professional Standards 15
Self-Test- Ethical and Professional Standards. 95
Study Session 2 - Quantitative Methods: Basic Concepts 102
Study Session 3- Quantitative Methods: Application 251
Self-Test- Quantitative Methods 369
Formulas. 374
Appendices 378
Index 386
SCHWESERNOTES™ 2015 CFA LEVEL I BOOK 1: ETHICAL AND
PROFESSIONAL STANDARDS AND QUANTITATIVE METHODS
©2014 Kaplan, Inc. All rights reserved.
Published in 2014 by Kaplan, Inc.
Printed in the United States of America.
ISBN: 978-1-4754-2756-1 / 1-4754-2756-5
PPN: 3200-5522
If this book does not have the hologram with the Kaplan Schweser logo on the back cover, it was
distributed without permission of Kaplan Schweser, a Division of Kaplan, Inc., and is in direct violation
of global copyright laws. Your assistance in pursuing potential violators of this law is greatly appreciated.
Required CFA Institute disclaimer: “CFA Institute does not endorse, promote, or warrant the accuracy
or quality of the products or services offered by Kaplan Schweser. CFA® and Chartered Financial
Analyst® are trademarks owned by CFA Institute.”
Certain materials contained within this text are the copyrighted property of CFA Institute. The
following is the copyright disclosure for these materials: “Copyright, 2014, CFA Institute. Reproduced
and republished from 2015 Learning Outcome Statements, Level I, II, and III questions from CFA®
Program Materials, CFA Institute Standards of Professional Conduct, and CFA Institute’s Global
Investment Performance Standards with permission from CFA Institute. All Rights Reserved.”
These materials may not be copied without written permission from the author. The unauthorized
duplication of these notes is a violation of global copyright laws and the CFA Institute Code of Ethics.
Your assistance in pursuing potential violators of this law is greatly appreciated.
Disclaimer: The Schweser Notes should be used in conjunction with the original readings as set forth
by CFA Institute in their 2015 CFA Level I Study Guide. The information contained in these Notes
covers topics contained in the readings referenced by CFA Institute and is believed to be accurate.
However, their accuracy cannot be guaranteed nor is any warranty conveyed as to your ultimate exam
success. The authors of the referenced readings have not endorsed or sponsored these Notes.
WELCOME TO THE 2015
SCHWESERNOTES™
Thank you for trusting Kaplan Schweser to help you reach your goals. We are all very
pleased to be able to help you prepare for the Level I CFA Exam. In this introduction,
I want to explain the resources included with the SchweserNotes, suggest how you
can best use Schweser materials to prepare for the exam, and direct you toward other
educational resources you will find helpful as you study for the exam.
Besides the SchweserNotes themselves, there are many educational resources available at
Schweser.com. Just log in using the individual username and password that you received
when you purchased the SchweserNotes. Most candidates find our Online Resource
Library video “How to Pass the Level I CFA Exam” very helpful in both planning and
executing a successful study strategy.
SchweserNotes™
These consist of five volumes that include complete coverage of all 18 Study Sessions
and all Learning Outcome Statements (LOS) with examples, Concept Checkers
(multiple-choice questions for every topic review), and Challenge Problems for many
topic reviews to help you master the material and check your progress. At the end of
each major topic area, we include a Self-test. Self-test questions are created to be exam¬
like in format and difficulty in order for you to evaluate how well your study of each
topic has prepared you for the actual exam.
Practice Questions
To retain what you learn, it is important that you quiz yourself often. We offer online
and offline versions of the SchweserPro QBank, which contains thousands of Level I
practice questions and explanations. Quizzes are available for each LOS, topic, or Study
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Practice Exams
Schweser offers six full 6-hour practice exams. Practice Exams Volume 1 and Volume 2
each contain three full 240-question exams. These are important tools for gaining the
speed and skills you will need to pass the exam. Each book contains answers with full
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you can use our Performance Tracker to find out how you have performed compared to
other Schweser Level I candidates.
Schweser Library
We have created reference videos, some of which are available to all SchweserNotes
purchasers. Schweser Library volumes are typically between 20 and 60 minutes in length
and cover such topics as: “CFA Level I Exam Overview,” “Calculator Basics,” “Code and
Standards Overview,” and “Time Value of Money.” The full Schweser Library is included
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Online Schweser Study Calendar
Use your Online Access to tell us when you will start and what days of the week you
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Welcome to the 2015 SchweserNotes™
breaking each study session into daily and weekly tasks to keep you on track and help
you monitor your progress through the curriculum.
The Level I CFA exam is a formidable challenge (63 topic reviews and more than 500
Learning Outcome Statements), and you must devote considerable time and effort
to be properly prepared. There is no shortcut! You must learn the material, know the
terminology and techniques, understand the concepts, and be able to answer 240
questions quickly and (at least 70%) correctly. Fifteen to 20 hours per week for 20 weeks
is a good estimate of the study time required on average, but some candidates will need
more or less time, depending on their individual backgrounds and experience.
To help you master this material and be well prepared for the CFA Exam, we offer
several other educational resources, including:
Live Weekly Classroom Programs
We offer weekly classroom programs around the world. Please check Schweser.com for
locations, dates, and availability.
Online Class
Our Online Classes are available at New York time (6:30-9:30 pm) or London time
(6:00—9:00 pm) beginning in January and July. The approximate schedule for the Level I
Online Classes (3-hour sessions) is as follows:
Class # Class #
1 Exam Intro/Quantitative Methods SS2 9 Financial Reporting & Analysis SS10
2 Quantitative Methods SS3 10 Corporate Finance SS11
3 Economics SS4, 5 11 Equity Investments SS13, 14
4 Economics SS5, 6 12 Fixed Income SSI5
5 Financial Reporting & Analysis SS7 13 Fixed Income SS16
6 Financial Reporting & Analysis SS8 14 Derivatives SSI 7
15 Portfolio Management & Alternative
7 Financial Reporting & Analysis SS8, 9 Investments SSI2, 18
8 Financial Reporting & Analysis SS9
Archived classes are available for viewing at any time throughout the season. Candidates
enrolled in the Online Classes also have full access to supplemental on-demand video
instruction in the Schweser Library and an e-mail address to use to send questions to the
instructor at any time.
Late Season Review
Whether you use self-study or in-class, online, or video instruction to learn the CFA
curriculum, a late-season review and exam practice can make all the difference. Our
most complete late-season review course is our residence program in Windsor, Ontario
(WindsorWeek) where we cover the entire curriculum over seven days (May 2-8, 2015)
at all three levels. We offer 3-Day Live Exam Review Workshops in many cities (and
online) that combine curriculum review with an equal component of hands-on practice
with hundreds of questions and problem-solving techniques. We also offer Exam Review
Workshops in a 5-day format in Dallas/Fort Worth and New York. Please visit us at
Welcome to the 2015 SchweserNotes™
Schweser.com for complete listings and course descriptions for all our late-season review
offerings.
Mock Exam and Multimedia Tutorial
The Schweser Mock Exam will be offered live in over 100 locations around the world in
late May and late November, and as an online exam as well. The included Exam Tutorial
provides extended explanations and topic tutorials to get you exam-ready in topic areas
where you miss questions on the Mock Exam. Please visit Schweser.com for a listing of
cities and locations.
Topic Weighting
In preparing for the exam, you must pay attention to the weights assigned to each topic
within the curriculum. The Level I topic weights are as follows:
Topic Exam Weight
Ethical and Professional Standards 15%
Quantitative Methods 12%
Economics 10%
Financial Reporting and Analysis 20%
Corporate Finance 7%
Portfolio Management 7%
Equity Investments 10%
Fixed Income 10%
Derivatives 5%
Alternative Investments 4%
Total 100%
EIow to Succeed
There are no shortcuts; depend on the fact that CFA Institute will test you in a way
that will reveal how well you know the Level I curriculum. You should begin early and
stick to your study plan. You should first read the SchweserNotes and complete the
Concept Checkers and Challenge Problems for each topic review. You should prepare
for and attend a live class, an online class, or a study group each week. You should take
quizzes often using SchweserPro Qbank and go back to review previous topics and Study
Sessions as well. At the end of each topic area, you should take the Self-test to check
your progress. You should finish the overall curriculum at least four weeks (preferably
longer) before the Level I exam so that you have sufficient time for Practice Exams and
for further review of those topics that you have not yet mastered.
I would like to thank Craig Prochaska, CFA, Content Specialist, for his contributions to
producing the Level I SchweserNotes for the CFA Exam.
Best regards,
“Dotty 'Uatt Sato*
Dr. Douglas Van Eaton, CFA
SVP of CFA Education and Level I Manager
READING ASSIGNMENTS AND
LEARNING OUTCOME STATEMENTS
Thefollowing material is a review ofthe Ethical and ProfessionalStandards and
Quantitative Methodsprinciples designed to address the learning outcome statements setforth
by CFA Institute.
STUDY SESSION l
Reading Assignments
Ethicaland ProfessionalStandards and Quantitative Methods, CFA Program Level I 2015
Curriculum, Volume 1 (CFA Institute, 2014)
1. Code of Ethics and Standards of Professional Conduct
2. Guidance for Standards I-VII
3. Introduction to the Global Investment Performance Standards (GIPS®) page 85
page 87
page 15
page 15
4. The GIPS Standards
STUDY SESSION 2
Reading Assignments
Ethicaland ProfessionalStandards and Quantitative Methods, CFA Program Level I 2015
Curriculum, Volume 1 (CFA Institute, 2014)
5. The Time Value of Money
6. Discounted Cash Flow Applications
7. Statistical Concepts and Market Returns
8. Probability Concepts
page 102
page 143
page 168
page 207
STUDY SESSION 3
Reading Assignments
Ethicaland ProfessionalStandards and Quantitative Methods, CFA Program Level 12015
Curriculum, Volume 1 (CFA Institute, 2014)
9. Common Probability Distributions
10. Sampling and Estimation
11. Hypothesis Testing
12. Technical Analysis
page 251
page 287
page 310
page 350
1-Ethical and Professional Standards and Quantitative Methods
Assignments and Learning Outcome Statements
LEARNING OUTCOME STATEMENTS (LOS)
STUDY SESSION l
The topical coverage corresponds with thefollowing CFA Institute assigned reading:
1. Code of Ethics and Standards of Professional Conduct
The candidate should be able to:
a. describe the structure of the CFA Institute Professional Conduct Program and
the process for the enforcement of the Code and Standards, (page 15)
b. state the six components of the Code of Ethics and the seven Standards of
Professional Conduct, (page 16)
c. explain the ethical responsibilities required by the Code and Standards,
including the sub-sections of each Standard, (page 17)
2. Guidance for Standards I-VII
The candidate should be able to:
a. demonstrate the application of the Code of Ethics and Standards of Professional
Conduct to situations involving issues of professional integrity, (page 20)
b. distinguish between conduct that conforms to the Code and Standards and
conduct that violates the Code and Standards, (page 20)
c. recommend practices and procedures designed to prevent violations of the Code
of Ethics and Standards of Professional Conduct, (page 20)
3. Introduction to the Global Investment Performance Standards (GIPS®)
The candidate should be able to:
a. explain why the GIPS standards were created, what parties the GIPS standards
apply to, and who is served by the standards, (page 85)
b. explain the construction and purpose of composites in performance reporting.
(page 86)
c. explain the requirements for verification, (page 86)
4. The GIPS Standards
The candidate should be able to:
a. describe the key features of the GIPS standards and the fundamentals of
compliance, (page 87)
b. describe the scope of the GIPS standards with respect to an investment firm’s
definition and historical performance record, (page 89)
c. explain how the GIPS standards are implemented in countries with existing
standards for performance reporting and describe the appropriate response when
the GIPS standards and local regulations conflict, (page 89)
d. describe the nine major sections of the GIPS standards, (page 89)
STUDY SESSION 2
5. The Time Value of Money
The candidate should be able to:
a. interpret interest rates as required rates of return, discount rates, or opportunity
costs, (page 104)
b. explain an interest rate as the sum of a real risk-free rate, and premiums that
compensate investors for bearing distinct types of risk, (page 105)
c. calculate and interpret the effective annual rate, given the stated annual interest
rate and the frequency of compounding, (page 105)
Book 1-Ethical and Professional Standards and Quantitative Methods
Reading Assignments and Learning Outcome Statements
d. solve time value of money problems for different frequencies of compounding.
(page 107)
e. calculate and interpret the future value (FV) and present value (PV) of a single
sum of money, an ordinary annuity, an annuity due, a perpetuity (PV only), and
a series of unequal cash flows, (page 108)
f. demonstrate the use of a time line in modeling and solving time value of money
problems, (page 123)
6. Discounted Cash Flow Applications
The candidate should be able to:
a. calculate and interpret the net present value (NPV) and the internal rate of
return (IRR) of an investment, (page 143)
b. contrast the NPV rule to the IRR rule, and identify problems associated with
the IRR rule, (page 146)
c. calculate and interpret a holding period return (total return), (page 148)
d. calculate and compare the money-weighted and time-weighted rates of return of
a portfolio and evaluate the performance of portfolios based on these measures.
(page 148)
e. calculate and interpret the bank discount yield, holding period yield, effective
annual yield, and money market yield for US Treasury bills and other money
market instruments, (page 152)
f. convert among holding period yields, money market yields, effective annual
yields, and bond equivalent yields, (page 155)
7. Statistical Concepts and Market Returns
The candidate should be able to:
a. distinguish between descriptive statistics and inferential statistics, between
a population and a sample, and among the types of measurement scales.
(page 168)
b. define a parameter, a sample statistic, and a frequency distribution, (page 169)
c. calculate and interpret relative frequencies and cumulative relative frequencies,
given a frequency distribution, (page 171)
d. describe the properties of a data set presented as a histogram or a frequency
polygon, (page 174)
e. calculate and interpret measures of central tendency, including the population
mean, sample mean, arithmetic mean, weighted average or mean, geometric
mean, harmonic mean, median, and mode, (page 175)
f. calculate and interpret quartiles, quintiles, deciles, and percentiles, (page 180)
g. calculate and interpret 1) a range and a mean absolute deviation and 2) the
variance and standard deviation of a population and of a sample, (page 181)
h. calculate and interpret the proportion of observations falling within a specified
number of standard deviations of the mean using Chebyshev’s inequality.
(page 185)
i. calculate and interpret the coefficient of variation and the Sharpe ratio.
(page 186)
j. explain skewness and the meaning of a positively or negatively skewed return
distribution, (page 188)
k. describe the relative locations of the mean, median, and mode for a unimodal,
nonsymmetrical distribution, (page 189)
1. explain measures of sample skewness and kurtosis. (page 190)
m. compare the use of arithmetic and geometric means when analyzing investment
returns, (page 192)
1-Ethical and Professional Standards and Quantitative Methods
Assignments and Learning Outcome Statements
8. Probability Concepts
The candidate should be able to:
a. define a random variable, an outcome, an event, mutually exclusive events, and
exhaustive events, (page 207)
b. state the two defining properties of probability and distinguish among empirical,
subjective, and a priori probabilities, (page 207)
c. state the probability of an event in terms of odds for and against the event.
(page 208)
d. distinguish between unconditional and conditional probabilities, (page 209)
e. explain the multiplication, addition, and total probability rules, (page 209)
f. calculate and interpret 1) the joint probability of two events, 2) the probability
that at least one of two events will occur, given the probability of each and the
joint probability of the two events, and 3) a joint probability of any number of
independent events, (page 210)
g. distinguish between dependent and independent events, (page 213)
h. calculate and interpret an unconditional probability using the total probability
rule, (page 214)
i. explain the use of conditional expectation in investment applications, (page 218)
j. explain the use of a tree diagram to represent an investment problem, (page 218)
k. calculate and interpret covariance and correlation, (page 219)
1. calculate and interpret the expected value, variance, and standard deviation of a
random variable and of returns on a portfolio, (page 223)
m. calculate and interpret covariance given a joint probability function, (page 224)
n. calculate and interpret an updated probability using Bayes’ formula, (page 228)
o. identify the most appropriate method to solve a particular counting problem,
and solve counting problems using factorial, combination, and permutation
concepts, (page 230)
STUDY SESSION 3
9. Common Probability Distributions
The candidate should be able to:
a. define a probability distribution and distinguish between discrete and
continuous random variables and their probability functions, (page 251)
b. describe the set of possible outcomes of a specified discrete random variable.
(page 251)
c. interpret a cumulative distribution function, (page 253)
d. calculate and interpret probabilities for a random variable, given its cumulative
distribution function, (page 253)
e. define a discrete uniform random variable, a Bernoulli random variable, and a
binomial random variable, (page 254)
f. calculate and interpret probabilities given the discrete uniform and the binomial
distribution functions, (page 254)
g. construct a binomial tree to describe stock price movement, (page 257)
h. calculate and interpret tracking error, (page 259)
i. define the continuous uniform distribution and calculate and interpret
probabilities, given a continuous uniform distribution, (page 259)
j. explain the key properties of the normal distribution, (page 261)
k. distinguish between a univariate and a multivariate distribution, and explain the
role of correlation in the multivariate normal distribution, (page 261)
Book 1-Ethical and Professional Standards and Quantitative Methods
Reading Assignments and Learning Outcome Statements
1. determine the probability that a normally distributed random variable lies inside
a given interval, (page 262)
m. define the standard normal distribution, explain how to standardize a random
variable, and calculate and interpret probabilities using the standard normal
distribution, (page 264)
n. define shortfall risk, calculate the safety-first ratio, and select an optimal
portfolio using Roy’s safety-first criterion, (page 267)
o. explain the relationship between normal and lognormal distributions and why
the lognormal distribution is used to model asset prices, (page 269)
p. distinguish between discretely and continuously compounded rates of return,
and calculate and interpret a continuously compounded rate of return, given a
specific holding period return, (page 270)
q. explain Monte Carlo simulation and describe its applications and limitations.
(page 272)
r. compare Monte Carlo simulation and historical simulation, (page 273)
10. Sampling and Estimation
The candidate should be able to:
a. define simple random sampling and a sampling distribution, (page 287)
b. explain sampling error, (page 287)
c. distinguish between simple random and stratified random sampling, (page 288)
d. distinguish between time-series and cross-sectional data, (page 289)
e. explain the central limit theorem and its importance, (page 289)
f. calculate and interpret the standard error of the sample mean, (page 290)
g. identify and describe desirable properties of an estimator, (page 292)
h. distinguish between a point estimate and a confidence interval estimate of a
population parameter, (page 292)
i. describe properties of Student’s t-distribution and calculate and interpret its
degrees of freedom, (page 292)
j. calculate and interpret a confidence interval for a population mean, given a
normal distribution with 1) a known population variance, 2) an unknown
population variance, or 3) an unknown variance and a large sample size.
(page 294)
k. describe the issues regarding selection of the appropriate sample size, datamining
bias, sample selection bias, survivorship bias, look-ahead bias, and timeperiod
bias, (page 299)
11. Hypothesis Testing
The candidate should be able to:
a. define a hypothesis, describe the steps of hypothesis testing, and describe and
interpret the choice of the null and alternative hypotheses, (page 310)
b. distinguish between one-tailed and two-tailed tests of hypotheses, (page 311)
c. explain a test statistic, Type I and Type II errors, a significance level, and how
significance levels are used in hypothesis testing, (page 315)
d. explain a decision rule, the power of a test, and the relation between confidence
intervals and hypothesis tests, (page 317)
e. distinguish between a statistical result and an economically meaningful result.
(page 319)
f. explain and interpret the /)-value as it relates to hypothesis testing, (page 320)
g. identify the appropriate test statistic and interpret the results for a hypothesis
test concerning the population mean of both large and small samples when
the population is normally or approximately distributed and the variance is
1) known or 2) unknown, (page 321)
1-Ethical and Professional Standards and Quantitative Methods
Assignments and Learning Outcome Statements
h. identify the appropriate test statistic and interpret the results for a hypothesis
test concerning the equality of the population means of two at least
approximately normally distributed populations, based on independent random
samples with 1) equal or 2) unequal assumed variances, (page 324)
i. identify the appropriate test statistic and interpret the results for a hypothesis
test concerning the mean difference of two normally distributed populations.
(page 328)
j. identify the appropriate test statistic and interpret the results for a hypothesis
test concerning 1) the variance of a normally distributed population, and 2) the
equality of the variances of two normally distributed populations based on two
independent random samples, (page 332)
k. distinguish between parametric and nonparametric tests and describe situations
in which the use of nonparametric tests may be appropriate, (page 339)
12. Technical Analysis
The candidate should be able to:
a. explain principles of technical analysis, its applications, and its underlying
assumptions, (page 350)
b. describe the construction of different types of technical analysis charts and
interpret them, (page 351)
c. explain uses of trend, support, resistance lines, and change in polarity.
(page 354)
d. describe common chart patterns, (page 355)
e. describe common technical analysis indicators (price-based, momentum
oscillators, sentiment, and flow of funds), (page 357)
f. explain how technical analysts use cycles, (page 362)
g. describe the key tenets of Elliott Wave Theory and the importance of Fibonacci
numbers, (page 362)
h. describe intermarket analysis as it relates to technical analysis and asset
allocation, (page 363)
The following is a review of the Ethical and Professional Standards principles designed to address the
learning outcome statements set forth by CFA Institute. This topic is also covered in:
CFA INSTITUTE CODE OF ETHICS AND
STANDARDS OF PROFESSIONAL CONDUCT
GUIDANCE FOR STANDARDS I-VII
Study Session 1
EXAM FOCUS
In addition to reading this review of the ethics material, we strongly recommend that
all candidates for the CFA® examination read the Standards ofPractice Handbook 11th
Edition (2014) multiple times. As a Level I CFA candidate, it is your responsibility to
comply with the Code and Standards. The complete Code and Standards are reprinted in
Volume 1 of the CFA Program Curriculum.
LOS l.a: Describe the structure of the CFA Institute Professional Conduct
Program and the process for the enforcement of the Code and Standards.
CFA® Program Curriculum, Volume 1, page 9
The CFA Institute Professional Conduct Program is covered by the CFA Institute
Bylaws and the Rules of Procedure for Proceedings Related to Professional Conduct. The
Program is based on the principles of fairness of the process to members and candidates
and maintaining the confidentiality of the proceedings. The Disciplinary Review
Committee of the CFA Institute Board of Governors has overall responsibility for the
Professional Conduct Program and enforcement of the Code and Standards.
The CFA Institute Professional Conduct staff conducts inquiries related to professional
conduct. Several circumstances can prompt such an inquiry:
1. Self-disclosure by members or candidates on their annual Professional Conduct
Statements of involvement in civil litigation or a criminal investigation, or that the
member or candidate is the subject of a written complaint.
2. Written complaints about a member or candidate’s professional conduct that are
received by the Professional Conduct staff.
3. Evidence of misconduct by a member or candidate that the Professional Conduct
staff received through public sources, such as a media article or broadcast.
4. A report by a CFA exam proctor of a possible violation during the examination.
5. Analysis of exam materials and monitoring of social media by CFA Institute.
Session 1
Reference to CFA Institute Assigned Readings #1 & 2-Standards of Practice Handbook
Once an inquiry has begun, the Professional Conduct staff may request (in writing) an
explanation from the subject member or candidate and may: (1) interview the subject
member or candidate, (2) interview the complainant or other third parties, and/or
(3) collect documents and records relevant to the investigation.
The Professional Conduct staff may decide: (1) that no disciplinary sanctions are
appropriate, (2) to issue a cautionary letter, or (3) to discipline the member or
candidate. In a case where the Professional Conduct staff finds a violation has occurred
and proposes a disciplinary sanction, the member or candidate may accept or reject the
sanction. If the member or candidate chooses to reject the sanction, the matter will be
referred to a disciplinary review panel of CFA Institute members for a hearing. Sanctions
imposed may include condemnation by the member’s peers or suspension of candidate’s
continued participation in the CFA Program.
LOS l.b: State the six components of the Code of Ethics and the seven
Standards of Professional Conduct.
CFA® Program Curriculum, Volume 1, page 15
CODE OF ETHICS
Members of CFA Institute [including Chartered Financial Analyst® (CFA®)
charterholders] and candidates for the CFA designation (“Members and Candidates”)
must:1
• Act with integrity, competence, diligence, respect, and in an ethical manner with
the public, clients, prospective clients, employers, employees, colleagues in the
investment profession, and other participants in the global capital markets.
• Place the integrity of the investment profession and the interests of clients above
their own personal interests.
• Use reasonable care and exercise independent professional judgment when
conducting investment analysis, making investment recommendations, taking
investment actions, and engaging in other professional activities.
• Practice and encourage others to practice in a professional and ethical manner that
will reflect credit on themselves and the profession.
• Promote the integrity and viability of the global capital markets for the ultimate
benefit of society.
• Maintain and improve their professional competence and strive to maintain and
improve the competence of other investment professionals.
THE STANDARDS OF PROFESSIONAL CONDUCT
Professionalism
Integrity of Capital Markets
Duties to Clients
Duties to Employers
Investment Analysis, Recommendations, and Actions
Conflicts of Interest
Responsibilities as a CFA Institute Member or CFA Candidate
I
II
III
IV
V
VI
VII
1. Copyright 2014, CFA Institute. Reproduced and republished from “The Code of Ethics,”
from Standards ofPractice Handbook, 11th Ed., 2014, with permission from CFA Institute.
Study Session 1
Cross-Reference to CFA Institute Assigned Readings #1 & 2-Standards of Practice Handbook
LOS l.c: Explain the ethical responsibilities required by the Code and
Standards, including the sub-sections of each Standard.
CFA® Program Curriculum, Volume 1, page 15
STANDARDS OF PROFESSIONAL CONDUCT2
I. PROFESSIONALISM
A. Knowledge of the Law. Members and Candidates must understand and
comply with all applicable laws, rules, and regulations (including the CFA
Institute Code ofEthics and Standards ofProfessional Conduct) of any
government, regulatory organization, licensing agency, or professional
association governing their professional activities. In the event of conflict,
Members and Candidates must comply with the more strict law, rule, or
regulation. Members and Candidates must not knowingly participate or assist
in any violation of laws, rules, or regulations and must disassociate themselves
from any such violation.
B. Independence and Objectivity. Members and Candidates must use reasonable
care and judgment to achieve and maintain independence and objectivity in
their professional activities. Members and Candidates must not offer, solicit, or
accept any gift, benefit, compensation, or consideration that reasonably could
be expected to compromise their own or another’s independence and
objectivity.
C. Misrepresentation. Members and Candidates must not knowingly make any
misrepresentations relating to investment analysis, recommendations, actions,
or other professional activities.
D. Misconduct. Members and Candidates must not engage in any professional
conduct involving dishonesty, fraud, or deceit or commit any act that reflects
adversely on their professional reputation, integrity, or competence.
II. INTEGRITY OF CAPITAL MARKETS
A. Material Nonpublic Information. Members and Candidates who possess
material nonpublic information that could affect the value of an investment
must not act or cause others to act on the information.
B. Market Manipulation. Members and Candidates must not engage in practices
that distort prices or artificially inflate trading volume with the intent to
mislead market participants.
III. DUTIES TO CLIENTS
A. Loyalty, Prudence, and Care. Members and Candidates have a duty of loyalty
to their clients and must act with reasonable care and exercise prudent
judgment. Members and Candidates must act for the benefit of their clients
and place their clients’ interests before their employer’s or their own interests.
2. Ibid.
Session 1
Reference to CFA Institute Assigned Readings #1 & 2-Standards of Practice Handbook B. Fair Dealing. Members and Candidates must deal fairly and objectively with
all clients when providing investment analysis, making investment
recommendations, taking investment action, or engaging in other professional
activities.
C. Suitability.
1. When Members and Candidates are in an advisory relationship with a
client, they must:
a. Make a reasonable inquiry into a client’s or prospective clients’
investment experience, risk and return objectives, and financial
constraints prior to making any investment recommendation or taking
investment action and must reassess and update this information
regularly.
b. Determine that an investment is suitable to the client’s financial
situation and consistent with the client’s written objectives, mandates,
and constraints before making an investment recommendation or
taking investment action.
c. Judge the suitability of investments in the context of the client’s total
portfolio.
2. When Members and Candidates are responsible for managing a portfolio to
a specific mandate, strategy, or style, they must make only investment
recommendations or take investment actions that are consistent with the
stated objectives and constraints of the portfolio.
D. Performance Presentation. When communicating investment performance
information, Members or Candidates must make reasonable efforts to ensure
that it is fair, accurate, and complete.
E. Preservation of Confidentiality. Members and Candidates must keep
information about current, former, and prospective clients confidential unless:
1. The information concerns illegal activities on the part of the client or
prospective client,
2. Disclosure is required by law, or
3. The client or prospective client permits disclosure of the information.
IV. DUTIES TO EMPLOYERS
A. Loyalty. In matters related to their employment, Members and Candidates
must act for the benefit of their employer and not deprive their employer of the
advantage of their skills and abilities, divulge confidential information, or
otherwise cause harm to their employer.
B. Additional Compensation Arrangements. Members and Candidates must not
accept gifts, benefits, compensation, or consideration that competes with, or
Study Session 1
Cross-Reference to CFA Institute Assigned Readings #1 & 2-Standards of Practice Handbook
might reasonably be expected to create a conflict of interest with, their
employer’s interest unless they obtain written consent from all parties involved.
C. Responsibilities of Supervisors. Members and Candidates must make
reasonable efforts to ensure that anyone subject to their supervision or
authority complies with applicable laws, rules, regulations, and the Code and
Standards.
V. INVESTMENT ANALYSIS, RECOMMENDATIONS, AND ACTIONS
A. Diligence and Reasonable Basis. Members and Candidates must:
1. Exercise diligence, independence, and thoroughness in analyzing
investments, making investment recommendations, and taking investment
actions.
2. Have a reasonable and adequate basis, supported by appropriate research
and investigation, for any investment analysis, recommendation, or action.
B. Communication with Clients and Prospective Clients. Members and
Candidates must:
1. Disclose to clients and prospective clients the basic format and general
principles of the investment processes used to analyze investments, select
securities, and construct portfolios and must promptly disclose any changes
that might materially affect those processes.
2. Disclose to clients and prospective clients significant limitations and risks
associated with the investment process.
3. Use reasonable judgment in identifying which factors are important to their
investment analyses, recommendations, or actions and include those factors
in communications with clients and prospective clients.
4. Distinguish between fact and opinion in the presentation of investment
analysis and recommendations.
C. Record Retention. Members and Candidates must develop and maintain
appropriate records to support their investment analysis, recommendations,
actions, and other investment-related communications with clients and
prospective clients.
VI. CONFLICTS OF INTEREST
A. Disclosure of Conflicts. Members and Candidates must make full and fair
disclosure of all matters that could reasonably be expected to impair their
independence and objectivity or interfere with respective duties to their clients,
prospective clients, and employer. Members and Candidates must ensure that
such disclosures are prominent, are delivered in plain language, and
communicate the relevant information effectively.
Session 1
Reference to CFA Institute Assigned Readings #1 & 2-Standards of Practice Handbook
B. Priority of Transactions. Investment transactions for clients and employers
must have priority over investment transactions in which a Member or
Candidate is the beneficial owner.
C. Referral Fees. Members and Candidates must disclose to their employer,
clients, and prospective clients, as appropriate, any compensation,
consideration, or benefit received from, or paid to, others for the
recommendation of products or services.
VII. RESPONSIBILITIES AS A CFA INSTITUTE MEMBER OR CFA
CANDIDATE
A. Conduct as Participants in CFA Institute Programs. Members and Candidates
must not engage in any conduct that compromises the reputation or integrity
of CFA Institute or the CFA designation or the integrity, validity, or security of
CFA Institute programs.
B. Reference to CFA Institute, the CFA Designation, and the CFA Program.
When referring to CFA Institute, CFA Institute membership, the CFA
designation, or candidacy in the CFA Program, Members and Candidates must
not misrepresent or exaggerate the meaning or implications of membership in
CFA Institute, holding the CFA designation, or candidacy in the CFA
Program.
LOS 2.a: Demonstrate the application of the Code of Ethics and Standards of
Professional Conduct to situations involving issues of professional integrity.
LOS 2.b: Distinguish between conduct that conforms to the Code and
Standards and conduct that violates the Code and Standards.
LOS 2.c: Recommend practices and procedures designed to prevent violations
of the Code of Ethics and Standards of Professional Conduct.
CFA® Program Curriculum, Volume 1, page 21
Professionalism
Knowledge of the Law. Members and Candidates must understand and
comply with all applicable laws, rules, and regulations (including the CFA Institute
Code of Ethics and Standards of Professional Conduct) of any government, regulatory
organization, licensing agency, or professional association governing their professional
activities. In the event of conflict, Members and Candidates must comply with the
more strict law, rule, or regulation. Members and Candidates must not knowingly
participate or assist in and must dissociate from any violation of such laws, rules, or
regulations.
I
1(A)
Professor’s Note: While we use the term “members” in thefollowing, note that all
ofthe Standards apply to candidates as well.
Study Session 1
Cross-Reference to CFA Institute Assigned Readings #1 & 2-Standards of Practice Handbook
Guidance—Code and Standards vs. Local Law
Members must know the laws and regulations relating to their professional activities in
all countries in which they conduct business. Members must comply with applicable
laws and regulations relating to their professional activity. Do not violate Code or
Standards even if the activity is otherwise legal. Always adhere to the most strict rules
and requirements (law or CFA Institute Standards) that apply.
Guidance—Participation or Association With Violations by Others
Members should dissociate, or separate themselves, from any ongoing client or employee
activity that is illegal or unethical, even if it involves leaving an employer (an extreme
case). While a member may confront the involved individual first, he must approach
his supervisor or compliance department. Inaction with continued association may be
construed as knowing participation.
Recommended Proceduresfor Compliance—Members
• Members should have procedures to keep up with changes in applicable laws, rules,
and regulations.
• Compliance procedures should be reviewed on an ongoing basis to assure that they
address current law, CFAI Standards, and regulations.
• Members should maintain current reference materials for employees to access in
order to keep up to date on laws, rules, and regulations.
• Members should seek advice of counsel or their compliance department when in
doubt.
• Members should document any violations when they disassociate themselves from
prohibited activity and encourage their employers to bring an end to such activity.
• There is no requirement under the Standards to report violations to governmental
authorities, but this may be advisable in some circumstances and required by law in
others.
• Members are strongly encouraged to report other members’ violations of the Code
and Standards.
Recommended Proceduresfor Compliance—Firms
Members should encourage their firms to:
• Develop and/or adopt a code of ethics.
• Make available to employees information that highlights applicable laws and
regulations.
• Establish written procedures for reporting suspected violation of laws, regulations, or
company policies.
Members who supervise the creation and maintenance of investment services and
products should be aware of and comply with the regulations and laws regarding such
services and products both in their country of origin and the countries where they will
be sold.
Session 1
Reference to CFA Institute Assigned Readings #1 & 2-Standards of Practice Handbook
Application ofStandard1(A) Knowledge of the Laur’
Example 1:
Michael Allen works for a brokerage firm and is responsible for an underwriting of
securities. A company official gives Allen information indicating that the financial
statements Allen filed with the regulator overstate the issuer’s earnings. Allen seeks the
advice of the brokerage firm’s general counsel, who states that it would be difficult for
the regulator to prove that Allen has been involved in any wrongdoing.
Comment:
Although it is recommended that members and candidates seek the advice of legal
counsel, the reliance on such advice does not absolve a member or candidate from the
requirement to comply with the law or regulation. Allen should report this situation to
his supervisor, seek an independent legal opinion, and determine whether the regulator
should be notified of the error.
Example 2:
Kamisha Washington’s firm advertises its past performance record by showing the 10-
year return of a composite of its client accounts. However, Washington discovers that the
composite omits the performance of accounts that have left the firm during the 10-year
period and that this omission has led to an inflated performance figure. Washington
is asked to use promotional material that includes the erroneous performance number
when soliciting business for the firm.
Comment:
Misrepresenting performance is a violation of the Code and Standards. Although she did
not calculate the performance herself, Washington would be assisting in violating this
standard if she were to use the inflated performance number when soliciting clients. She
must dissociate herself from the activity. She can bring the misleading number to the
attention of the person responsible for calculating performance, her supervisor, or the
compliance department at her firm. If her firm is unwilling to recalculate performance,
she must refrain from using the misleading promotional material and should notify
the firm of her reasons. If the firm insists that she use the material, she should consider
whether her obligation to dissociate from the activity would require her to seek other
employment.
Example 3:
An employee of an investment bank is working on an underwriting and finds out the
issuer has altered their financial statements to hide operating losses in one division.
These misstated data are included in a preliminary prospectus that has already been
released.
Comment:
The employee should report the problem to his supervisors. If the firm doesn’t get the
misstatement fixed, the employee should dissociate from the underwriting and, further,
seek legal advice about whether he should undertake additional reporting or other
actions.
3. Ibid.
Study Session 1
Cross-Reference to CFA Institute Assigned Readings #1 & 2-Standards of Practice Handbook
Example 4:
Laura Jameson, a U.S. citizen, works for an investment advisor based in the United
States and works in a country where investment managers are prohibited from
participating in IPOs for their own accounts.
Comment:
Jameson must comply with the strictest requirements among U.S. law (where her firm
is based), the CFA Institute Code and Standards, and the laws of the country where she
is doing business. In this case that means she must not participate in any IPOs for her
personal account.
Example 5:
A junior portfolio manager suspects that a broker responsible for new business from
a foreign country is being allocated a portion of the firm’s payments for third-party
research and suspects that no research is being provided. He believes that the research
payments may be inappropriate and unethical.
Comment:
He should follow his firm’s procedures for reporting possible unethical behavior and try
to get better disclosure of the nature of these payments and any research that is being
provided.
1(B) Independence and Objectivity. Members and Candidates must use reasonable
care and judgment to achieve and maintain independence and objectivity in their
professional activities. Members and Candidates must not offer, solicit, or accept any
gift, benefit, compensation, or consideration that reasonably could be expected to
compromise their own or another’s independence and objectivity.
Guidance
Do not let the investment process be influenced by any external sources. Modest gifts
are permitted. Allocation of shares in oversubscribed IPOs to personal accounts is
NOT permitted. Distinguish between gifts from clients and gifts from entities seeking
influence to the detriment of the client. Gifts must be disclosed to the member’s
employer in any case, either prior to acceptance if possible, or subsequently.
Guidance—Investment Banking Relationships
Do not be pressured by sell-side firms to issue favorable research on current or
prospective investment-banking clients. It is appropriate to have analysts work with
investment bankers in “road shows” only when the conflicts are adequately and
elfectively managed and disclosed. Be sure there are effective “firewalls” between
research/investment management and investment banking activities.
Session 1
Reference to CFA Institute Assigned Readings #1 & 2-Standards of Practice Handbook
Guidance—Public Companies
Analysts should not be pressured to issue favorable research by the companies they
follow. Do not confine research to discussions with company management, but rather
use a variety of sources, including suppliers, customers, and competitors.
Guidance—Buy-Side Clients
Buy-side clients may try to pressure sell-side analysts. Portfolio managers may have large
positions in a particular security, and a rating downgrade may have an effect on the
portfolio performance. As a portfolio manager, there is a responsibility to respect and
foster intellectual honesty of sell-side research.
Guidance—FundManager and Custodial Relationships
Members responsible for selecting outside managers should not accept gifts,
entertainment, or travel that might be perceived as impairing their objectivity.
Guidance—Performance Measurement andAttribution
Performance analysts may experience pressure from investment managers who have
produced poor results or acted outside their mandate. Members and candidates who
analyze performance must not let such influences affect their analysis.
Guidance—Manager Selection
Members and candidates must exercise independence and objectivity when they select
investment managers. They should not accept gifts or other compensation that could
be seen as influencing their hiring decisions, nor should they offer compensation
when seeking to be hired as investment managers. The responsibility to maintain
independence and objectivity applies to all a member or candidate’s hiring and firing
decisions, not just those that involve investment management.
Guidance—Credit Rating Agencies
Members employed by credit rating firms should make sure that procedures prevent
undue influence by the firm issuing the securities. Members who use credit ratings
should be aware of this potential conflict of interest and consider whether independent
analysis is warranted.
Guidance—Issuer-Paid Research
Remember that this type of research is fraught with potential conflicts. Analysts’
compensation for preparing such research should be limited, and the preference is for a
flat fee, without regard to conclusions or the report’s recommendations.
Guidance—Travel
Best practice is for analysts to pay for their own commercial travel when attending
information events or tours sponsored by the firm being analyzed.
Study Session 1
Cross-Reference to CFA Institute Assigned Readings #1 & 2-Standards of Practice Handbook
Recommended Proceduresfor Compliance
• Protect the integrity of opinions—make sure they are unbiased.
• Create a restricted list and distribute only factual information about companies on
the list.
• Restrict special cost arrangements—pay for one’s own commercial transportation
and hotel; limit use of corporate aircraft to cases in which commercial transportation
is not available.
• Limit gifts—token items only. Customary, business-related entertainment is okay
as long as its purpose is not to influence a member’s professional independence or
objectivity Firms should impose clear value limits on gifts.
• Restrict employee investments in equity IPOs and private placements. Require pre¬
approval of IPO purchases.
• Review procedures—have effective supervisory and review procedures.
• Firms should have formal written policies on independence and objectivity of
research.
• Firms should appoint a compliance officer and provide clear procedures for
employee reporting of unethical behavior and violations of applicable regulations.
Application ofStandard1(B) Independence and Objectivity
Example 1:
Steven Taylor, a mining analyst with Bronson Brokers, is invited by Precision Metals to
join a group of his peers in a tour of mining facilities in several western U.S. states. The
company arranges for chartered group flights from site to site and for accommodations
in Spartan Motels, the only chain with accommodations near the mines, for three nights.
Taylor allows Precision Metals to pick up his tab, as do the other analysts, with one
exception—John Adams, an employee of a large trust company who insists on following
his company’s policy and paying for his hotel room himself.
Comment:
The policy of the company where Adams works complies closely with Standard 1(B) by
avoiding even the appearance of a conflict of interest, but Taylor and the other analysts
were not necessarily violating Standard 1(B). In general, when allowing companies to pay
for travel and/or accommodations under these circumstances, members and candidates
must use their judgment, keeping in mind that such arrangements must not impinge
on a member or candidate’s independence and objectivity In this example, the trip was
strictly for business and Taylor was not accepting irrelevant or lavish hospitality. The
itinerary required chartered flights, for which analysts were not expected to pay. The
accommodations were modest. These arrangements are not unusual and did not violate
Standard 1(B) so long as Taylor’s independence and objectivity were not compromised.
In the final analysis, members and candidates should consider both whether they can
remain objective and whether their integrity might be perceived by their clients to have
been compromised.
Example 2:
Walter Fritz is an equity analyst with Hilton Brokerage who covers the mining industry.
He has concluded that the stock of Metals & Mining is overpriced at its current level,
but he is concerned that a negative research report will hurt the good relationship
between Metals & Mining and the investment-banking division of his firm. In fact, a
senior manager of Hilton Brokerage has just sent him a copy of a proposal his firm has
Session 1
Reference to CFA Institute Assigned Readings #1 & 2-Standards of Practice Handbook
made to Metals & Mining to underwrite a debt offering. Fritz needs to produce a report
right away and is concerned about issuing a less-than-favorable rating.
Comment:
Fritz’s analysis of Metals & Mining must be objective and based solely on consideration
of company fundamentals. Any pressure from other divisions of his firm is inappropriate.
This conflict could have been eliminated if, in anticipation of the offering, Hilton
Brokerage had placed Metals & Mining on a restricted list for its sales force.
Example 3:
Tom Wayne is the investment manager of the Franklin City Employees Pension Plan.
He recently completed a successful search for firms to manage the foreign equity
allocation of the plan’s diversified portfolio. He followed the plan’s standard procedure
of seeking presentations from a number of qualified firms and recommended that his
board select Penguin Advisors because of its experience, well-defined investment strategy,
and performance record, which was compiled and verified in accordance with the
CFA Institute Global Investment Performance Standards. Following the plan selection
of Penguin, a reporter from the Franklin City Record called to ask if there was any
connection between the action and the fact that Penguin was one of the sponsors of an
“investment fact-finding trip to Asia” that Wayne made earlier in the year. The trip was
one of several conducted by the Pension Investment Academy, which had arranged the
itinerary of meetings with economic, government, and corporate officials in major cities
in several Asian countries. The Pension Investment Academy obtains support for the cost
of these trips from a number of investment managers, including Penguin Advisors; the
Academy then pays the travel expenses of the various pension plan managers on the trip
and provides all meals and accommodations. The president of Penguin Advisors was one
of the travelers on the trip.
Comment:
Although Wayne can probably put to good use the knowledge he gained from the trip
in selecting portfolio managers and in other areas of managing the pension plan, his
recommendation of Penguin Advisors may be tainted by the possible conflict incurred
when he participated in a trip paid for partly by Penguin Advisors and when he was in
the daily company of the president of Penguin Advisors. To avoid violating Standard
1(B), Wayne’s basic expenses for travel and accommodations should have been paid
by his employer or the pension plan; contact with the president of Penguin Advisors
should have been limited to informational or educational events only; and the trip, the
organizer, and the sponsor should have been made a matter of public record. Even if his
actions were not in violation of Standard 1(B), Wayne should have been sensitive to the
public perception of the trip when reported in the newspaper and the extent to which
the subjective elements of his decision might have been affected by the familiarity that
the daily contact of such a trip would encourage. This advantage would probably not be
shared by competing firms.
Example 4:
An analyst in the corporate finance department promises a client that her firm will
provide full research coverage of the issuing company after the offering.
Comment:
This is not a violation, but she cannot promise favorable research coverage. Research
must be objective and independent.
Study Session 1
Cross-Reference to CFA Institute Assigned Readings #1 & 2-Standards of Practice Handbook
Example 5:
An employee’s boss tells him to assume coverage of a stock and maintain a buy rating.
Comment:
Research opinions and recommendations must be objective and arrived at independently.
Following the boss’s instructions would be a violation if the analyst determined a buy
rating is inappropriate.
Example 6:
A money manager receives a gift of significant value from a client as a reward for good
performance over the prior period and informs her employer of the gift.
Comment:
No violation here because the gift is from a client and is not based on performance going
forward, but the gift must be disclosed to her employer. If the gift were contingent on
future performance, the money manager would have to obtain permission from her
employer. The reason for both the disclosure and permission requirements is that the
employer must ensure that the money manager does not give advantage to the client
giving or offering additional compensation, to the detriment of other clients.
Example 7:
An analyst enters into a contract to write a research report on a company, paid for
by that company, for a flat fee plus a bonus based on attracting new investors to the
security.
Comment:
This is a violation because the compensation structure makes total compensation depend
on the conclusions of the report (a favorable report will attract investors and increase
compensation). Accepting the job for a flat fee that does not depend on the report’s
conclusions or its impact on share price is permitted, with proper disclosure of the fact
that the report is funded by the subject company.
Example 8:
A trust manager at a bank selects mutual funds for client accounts based on the profits
from “service fees” paid to the bank by the mutual fund sponsor.
Comment:
This is a violation because the trust manager has allowed the fees to affect his objectivity.
Example 9:
An analyst performing sensitivity analysis for a security does not use only scenarios
consistent with recent trends and historical norms.
Comment:
This is a good thing and is not a violation.
Example 10
A member whose firm is seeking to become an investment manager for a labor union
contributes a large sum to the union leader’s re-election campaign. After the union
Session 1
Reference to CFA Institute Assigned Readings #1 & 2-Standards of Practice Handbook
hires the member’s firm, the member continues to spend significant amounts on
entertainment for the union leader and his family.
Comment:
Offering gifts or other compensation to influence a decision to hire an investment
manager is a violation of Standard 1(B).
Example 11
A member who is a performance analyst notices that one of her firm’s top investment
managers has changed his composite construction, removing a poorly performing large
account and placing it in a different composite. Knowing that the investment manager
is important to the firm and a close friend of the firm’s CEO, the member does not
disclose this change in her performance report.
Comment:
The member violated Standard 1(B) by failing to exercise independence and objectivity
in her analysis. Altering composites to conceal poor performance also violates Standard
III(D) Performance Presentation and may violate Standard 1(C) Misrepresentation.
1(C) Misrepresentation. Members and Candidates must not knowingly make any
misrepresentations relating to investment analysis, recommendations, actions, or other
professional activities.
Guidance
Trust is a foundation in the investment profession. Do not make any misrepresentations
or give false impressions. This includes oral, electronic, and social media
communications. Misrepresentations include guaranteeing investment performance
and plagiarism. Plagiarism encompasses using someone else’s work (reports, forecasts,
models, ideas, charts, graphs, and spreadsheet models) without giving them credit.
Knowingly omitting information that could affect an investment decision or
performance evaluation is considered misrepresentation.
Models and analysis developed by others at a member’s firm are the property of the firm
and can be used without attribution. A report written by another analyst employed by
the firm cannot be released as another analyst’s work.
Recommended Proceduresfor Compliance
A good way to avoid misrepresentation is for firms to provide employees who deal with
clients or prospects a written list of the firm’s available services and a description of the
firm’s qualifications. Employee qualifications should be accurately presented as well.
To avoid plagiarism, maintain records of all materials used to generate reports or other
firm products and properly cite sources (quotes and summaries) in work products.
Information from recognized financial and statistical reporting services need not be
cited.
Members should encourage their firms to establish procedures for verifying marketing
claims of third parties whose information the firm provides to clients.
Study Session 1
Cross-Reference to CFA Institute Assigned Readings #1 & 2-Standards of Practice Handbook
Application ofStandard I(C) Misrepresentation
Example 1:
Anthony McGuire is an issuer-paid analyst hired by publicly traded companies to
electronically promote their stocks. McGuire creates a website that promotes his
research efforts as a seemingly independent analyst. McGuire posts a profile and a strong
buy recommendation for each company on the website, indicating that the stock is
expected to increase in value. He does not disclose the contractual relationships with the
companies he covers on his website, in the research reports he issues, or in the statements
he makes about the companies in Internet chat rooms.
Comment:
McGuire has violated Standard 1(C) because the Internet site and e-mails are misleading
to potential investors. Even if the recommendations are valid and supported with
thorough research, his omissions regarding the true relationship between himself and the
companies he covers constitute a misrepresentation. McGuire has also violated Standard
VI(A) Disclosure of Conflicts by not disclosing the existence of an arrangement with the
companies through which he receives compensation in exchange for his services.
Example 2:
Claude Browning, a quantitative analyst for Double Alpha, Inc., returns in great
excitement from a seminar. In that seminar, Jack Jorrely, a well-publicized quantitative
analyst at a national brokerage firm, discussed one of his new models in great detail,
and Browning is intrigued by the new concepts. He proceeds to test this model, making
some minor mechanical changes but retaining the concept, until he produces some
very positive results. Browning quickly announces to his supervisors at Double Alpha
that he has discovered a new model and that clients and prospective clients alike should
be informed of this positive finding as ongoing proof of Double Alpha’s continuing
innovation and ability to add value.
Comment:
Although Browning tested Jorrely’s model on his own and even slightly modified it, he
must still acknowledge the original source of the idea. Browning can certainly take credit
for the final, practical results; he can also support his conclusions with his own test. The
credit for the innovative thinking, however, must be awarded to Jorrely.
Example 3:
Paul Ostrowski runs a 2-person investment management firm. Ostrowski’s firm
subscribes to a service from a large investment research firm that provides research
reports that can be repackaged by smaller firms for those firms’ clients. Ostrowski’s firm
distributes these reports to clients as its own work.
Comment:
Ostrowski can rely on third-party research that has a reasonable and adequate basis,
but he cannot imply that he is the author of the report. Otherwise, Ostrowski would
misrepresent the extent of his work in a way that would mislead the firm’s clients or
prospective clients.
Session 1
Reference to CFA Institute Assigned Readings #1 & 2-Standards of Practice Handbook Example 4:
A member makes an error in preparing marketing materials and misstates the amount of
assets his firm has under management.
Comment:
The member must attempt to stop distribution of the erroneous material as soon as
the error is known. Simply making the error unintentionally is not a violation, but
continuing to distribute material known to contain a significant misstatement of fact
would be.
Example 5:
The marketing department states in sales literature that an analyst has received an MBA
degree, but he has not. The analyst and other members of the firm have distributed this
document for years.
Comment:
The analyst has violated the Standards, as he should have known of this
misrepresentation after having distributed and used the materials over a period of years.
Example 6:
A member describes an interest-only collateralized mortgage obligation as guaranteed by
the U.S. government because it is a claim against the cash flows of a pool of guaranteed
mortgages, although the payment stream and the market value of the security are not
guaranteed.
Comment:
This is a violation because of the misrepresentation.
Example 7:
A member describes a bank CD as “guaranteed.”
Comment:
This is not a violation as long as the limits of the guarantee provided by the Federal
Deposit Insurance Corporation are not exceeded and the nature of the guarantee is
clearly explained to clients.
Example 8:
A member uses definitions he found online for such terms as variance and coefficient of
variation in preparing marketing material.
Comment:
Even though these are standard terms, using the work of others word-for-word is
plagiarism.
Example 9:
A candidate reads about a research paper in a financial publication and includes the
information in a research report, citing the original research report but not the financial
publication.
Study Session 1
Cross-Reference to CFA Institute Assigned Readings #1 & 2-Standards of Practice Handbook
Comment:
To the extent that the candidate used information and interpretation from the financial
publication without citing it, the candidate is in violation of the Standard. The
candidate should either obtain the report and reference it directly or, if he relies solely
on the financial publication, should cite both sources.
Misconduct. Members and Candidates must not engage in any professional
conduct involving dishonesty, fraud, or deceit or commit any act that reflects
adversely on their professional reputation, integrity, or competence.
1(D)
Guidance
CFA Institute discourages unethical behavior in all aspects of members’ and candidates’
lives. Do not abuse CFA Institute’s Professional Conduct Program by seeking
enforcement of this Standard to settle personal, political, or other disputes that are not
related to professional ethics.
Recommended Proceduresfor Compliance
Firms are encouraged to adopt these policies and procedures:
• Develop and adopt a code of ethics and make clear that unethical behavior will not
be tolerated.
• Give employees a list of potential violations and sanctions, including dismissal.
• Check references of potential employees.
Application ofStandard1(D) Misconduct
Example 1:
Simon Sasserman is a trust investment officer at a bank in a small affluent town. He
enjoys lunching every day with friends at the country club, where his clients have
observed him having numerous drinks. Back at work after lunch, he clearly is intoxicated
while making investment decisions. His colleagues make a point of handling any
business with Sasserman in the morning because they distrust his judgment after lunch.
Comment:
Sasserman’s excessive drinking at lunch and subsequent intoxication at work constitute
a violation of Standard 1(D) because this conduct has raised questions about his
professionalism and competence. His behavior thus reflects poorly on him, his employer,
and the investment industry.
Example 2:
Carmen Garcia manages a mutual fund dedicated to socially responsible investing. She is
also an environmental activist. As the result of her participation at nonviolent protests,
Garcia has been arrested on numerous occasions for trespassing on the property of a
large petrochemical plant that is accused of damaging the environment.
Session 1
Reference to CFA Institute Assigned Readings #1 & 2-Standards of Practice Handbook
Comment:
Generally, Standard 1(D) is not meant to cover legal transgressions resulting from acts
of civil disobedience in support of personal beliefs because such conduct does not reflect
poorly on the member or candidate’s professional reputation, integrity, or competence.
Example 3:
A member intentionally includes a receipt that is not in his expenses for a company trip.
Comment:
Because this act involves deceit and fraud and reflects on the member’s integrity and
honesty, it is a violation.
Example 4:
A member tells a client that he can get her a good deal on a car through his fatherin-
law, but instead gets her a poor deal and accepts part of the commission on the car
purchase.
Comment:
The member has been dishonest and misrepresented the facts of the situation and has,
therefore, violated the Standard.
II Integrity of Capital Markets
11(A) Material Nonpublic Information. Members and Candidates who possess
material nonpublic information that could affect the value of an investment must not
act or cause others to act on the information.
Guidance
Information is “material” if its disclosure would impact the price of a security or if
reasonable investors would want the information before making an investment decision.
Ambiguous information, as far as its likely effect on price, may not be considered
material. Information is “nonpublic” until it has been made available to the marketplace.
An analyst conference call is not public disclosure. Selectively disclosing information by
corporations creates the potential for insider-trading violations. The prohibition against
acting on material nonpublic information extends to mutual funds containing the
subject securities as well as related swaps and options contracts.
Some members and candidates may be involved in transactions during which they
receive material nonpublic information provided by firms (e.g., investment banking
transactions). Members and candidates may use the provided nonpublic information for
its intended purpose, but must not use the information for any other purpose unless it
becomes public information.
Study Session 1
Cross-Reference to CFA Institute Assigned Readings #1 & 2-Standards of Practice Handbook
Guidance—Mosaic Theory
There is no violation when a perceptive analyst reaches an investment conclusion about
a corporate action or event through an analysis of public information together with
items of nonmaterial nonpublic information.
Guidance—SocialMedia
When gathering information from internet or social media sources, members and
candidates need to be aware that not all of it is considered public information. Members
and candidates should confirm that any material information they receive from these
sources is also available from public sources, such as company press releases or regulatory
filings.
Guidance—Industry Experts
Members and candidates may seek insight from individuals who have specialized
expertise in an industry. However, they may not act or cause others to act on any
material nonpublic information obtained from these experts until that information has
been publicly disseminated.
Recommended Proceduresfor Compliance
Make reasonable efforts to achieve public dissemination of the information. Encourage
firms to adopt procedures to prevent misuse of material nonpublic information. Use a
“firewall” within the firm, with elements including:
• Substantial control of relevant interdepartmental communications, through a
clearance area such as the compliance or legal department.
• Review employee trades—maintain “watch,” “restricted,” and “rumor” lists.
• Monitor and restrict proprietary trading while a firm is in possession of material
nonpublic information.
Prohibition of all proprietary trading while a firm is in possession of material nonpublic
information may be inappropriate because it may send a signal to the market. In these
cases, firms should take the contra side of only unsolicited customer trades.
Application ofStandard11(A) Material Nonpublic Information
Example 1:
Samuel Peter, an analyst with Scotland and Pierce, Inc., is assisting his firm with a
secondary offering for Bright Ideas Lamp Company. Peter participates, via telephone
conference call, in a meeting with Scotland and Pierce investment-banking employees
and Bright Ideas’ CEO. Peter is advised that the company’s earnings projections for
the next year have significantly dropped. Throughout the telephone conference call,
several Scotland and Pierce salespeople and portfolio managers walk in and out of
Peter’s office, where the telephone call is taking place. As a result, they are aware of the
drop in projected earnings for Bright Ideas. Before the conference call is concluded,
the salespeople trade the stock of the company on behalf of the firm’s clients, and other
firm personnel trade the stock in a firm proprietary account and in employee personal
accounts.
Session 1
Reference to CFA Institute Assigned Readings #1 & 2-Standards of Practice Handbook
Comment:
Peter violated Standard 11(A) because he failed to prevent the transfer and misuse of
material nonpublic information to others in his firm. Peter’s firm should have adopted
information barriers to prevent the communication of nonpublic information between
departments of the firm. The salespeople and portfolio managers who traded on the
information have also violated Standard 11(A) by trading on inside information.
Example 2:
Elizabeth Levenson is based in Taipei and covers the Taiwanese market for her
firm, which is based in Singapore. She is invited to meet the finance director of a
manufacturing company, along with the other ten largest shareholders of the company.
During the meeting, the finance director states that the company expects its workforce
to strike next Friday, which will cripple productivity and distribution. Can Levenson use
this information as a basis to change her rating on the company from “buy” to “sell”?
Comment:
Levenson must first determine whether the material information is public. If the
company has not made this information public (a small-group forum does not qualify
as a method of public dissemination), she cannot use the information according to
Standard 11(A).
Example 3:
Jagdish Teja is a buy-side analyst covering the furniture industry. Looking for an
attractive company to recommend as a buy, he analyzed several furniture makers by
studying their financial reports and visiting their operations. He also talked to some
designers and retailers to find out which furniture styles are trendy and popular.
Although none of the companies that he analyzed turned out to be a clear buy, he
discovered that one of them, Swan Furniture Company (SFC), might be in trouble.
Swan’s extravagant new designs were introduced at substantial costs. Even though
these designs initially attracted attention, in the long run, the public is buying more
conservative furniture from other makers. Based on that and on P&L analysis, Teja
believes that Swan’s next-quarter earnings will drop substantially. He then issues a sell
recommendation for SFC. Immediately after receiving that recommendation, investment
managers start reducing the stock in their portfolios.
Comment:
Information on quarterly earnings figures is material and nonpublic. However, Teja
arrived at his conclusion about the earnings drop based on public information and
on pieces of nonmaterial nonpublic information (such as opinions of designers and
retailers). Therefore, trading based on Teja’s correct conclusion is not prohibited by
Standard 11(A).
Example 4:
A member’s dentist, who is an active investor, tells the member that based on his
research he believes that Acme, Inc., will be bought out in the near future by a larger
firm in the industry. The member investigates and purchases shares of Acme.
Comment:
There is no violation here because the dentist had no inside information but has
reached the conclusion on his own. The information here is not material because there
Study Session 1
Cross-Reference to CFA Institute Assigned Readings #1 & 2-Standards of Practice Handbook
is no reason to suspect that an investor would wish to know what the members dentist
thought before investing in shares of Acme.
Example 5:
A member received an advance copy of a stock recommendation that will appear in a
widely read national newspaper column the next day and purchases the stock.
Comment:
A recommendation in a widely read newspaper column will likely cause the stock
price to rise, so this is material nonpublic information. The member has violated the
Standard.
Example 6:
A member trades based on information he gets by seeing an advance copy of an article
that will be published in an influential magazine next week.
Comment:
This is a violation as this is nonpublic information until the article has been published.
11(B) Market Manipulation. Members and Candidates must not engage in practices
that distort prices or artificially inflate trading volume with the intent to mislead
market participants.
Guidance
This Standard applies to transactions that deceive the market by distorting the price¬
setting mechanism of financial instruments or by securing a controlling position to
manipulate the price of a related derivative and/or the asset itself. Spreading false rumors
is also prohibited.
Application ofStandard11(B) Market Manipulation
Example 1:
Matthew Murphy is an analyst at Divisadero Securities & Co., which has a significant
number of hedge funds among its most important brokerage clients. Two trading days
before the publication of the quarter-end report, Murphy alerts his sales force that he
is about to issue a research report on Wirewolf Semiconductor, which will include his
opinion that:
• Quarterly revenues are likely to fall short of management’s guidance.
• Earnings will be as much as 5 cents per share (or more than 10%) below consensus.
• Wirewolf’s highly respected chief financial officer may be about to join another
company.
Knowing that Wirewolf had already entered its declared quarter-end “quiet period”
before reporting earnings (and thus would be reluctant to respond to rumors, etc.),
Murphy times the release of his research report specifically to sensationalize the negative
aspects of the message to create significant downward pressure on Wirewolf’s stock to
the distinct advantage of Divisadero’s hedge fund clients. The report’s conclusions are
Session 1
Reference to CFA Institute Assigned Readings #1 & 2-Standards of Practice Handbook
based on speculation, not on fact. The next day, the research report is broadcast to all of
Divisadero’s clients and to the usual newswire services.
Before Wirewolf s investor relations department can assess its damage on the final
trading day of the quarter and refute Murphys report, its stock opens trading sharply
lower, allowing Divisadero’s clients to cover their short positions at substantial gains.
Comment:
Murphy violated Standard 11(B) by trying to create artificial price volatility designed to
have material impact on the price of an issuer’s stock. Moreover, by lacking an adequate
basis for the recommendation, Murphy also violated Standard V(A).
Example 2:
ACME Futures Exchange is launching a new bond futures contract. To convince
investors, traders, arbitragers, hedgers, and so on, to use its contract, the exchange
attempts to demonstrate that it has the best liquidity. To do so, it enters into agreements
with members so that they commit to a substantial minimum trading volume on the
new contract over a specific period in exchange for substantial reductions on their
regular commissions.
Comment:
The formal liquidity of a market is determined by the obligations set on market makers,
but the actual liquidity of a market is better estimated by the actual trading volume
and bid-ask spreads. Attempts to mislead participants on the actual liquidity of the
market constitute a violation of Standard 11(B). In this example, investors have been
intentionally misled to believe they chose the most liquid instrument for some specific
purpose and could eventually see the actual liquidity of the contract dry up suddenly
after the term of the agreement if the “pump-priming” strategy fails. If ACME fully
discloses its agreement with members to boost transactions over some initial launch
period, it does not violate Standard 11(B). ACME’s intent is not to harm investors but on
the contrary to give them a better service. For that purpose, it may engage in a liquidity¬
pumping strategy, but it must be disclosed.
Example 3:
A member is seeking to sell a large position in a fairly illiquid stock from a fund he
manages. He buys and sells shares of the stock between that fund and another he also
manages to create an appearance of activity and stock price appreciation, so that the sale
of the whole position will have less market impact and he will realize a better return for
the fund’s shareholders.
Comment:
The trading activity is meant to mislead market participants and is, therefore, a violation
of the Standard. The fact that his fund shareholders gain by this action does not change
the fact that it is a violation.
Study Session 1
Cross-Reference to CFA Institute Assigned Readings #1 & 2-Standards of Practice Handbook
Example 4:
A member posts false information about a firm on internet bulletin boards and stock
chat facilities in an attempt to cause the firm’s stock to increase in price.
Comment:
This is a violation of the Standard.
III Duties to Clients
III(A) Loyalty, Prudence, and Care. Members and Candidates have a duty of loyalty
to their clients and must act with reasonable care and exercise prudent judgment.
Members and Candidates must act for the benefit of their clients and place their
clients’ interests before their employer’s or their own interests.
Guidance
Client interests always come first. Although this Standard does not impose a fiduciary
duty on members or candidates where one did not already exist, it does require members
and candidates to act in their clients’ best interest and recommend products that are
suitable given their clients’ investment objectives and risk tolerances.
• Exercise the prudence, care, skill, and diligence under the circumstances that a
person acting in a like capacity and familiar with such matters would use.
• Manage pools of client assets in accordance with the terms of the governing
documents, such as trust documents or investment management agreements.
• Make investment decisions in the context of the total portfolio.
• Inform clients of any limitations in an advisory relationship (e.g., an advisor who
may only recommend her own firm’s products).
• Vote proxies in an informed and responsible manner. Due to cost benefit
considerations, it may not be necessary to vote all proxies.
• Client brokerage, or “soft dollars” or “soft commissions” must be used to benefit the
client.
• The “client” may be the investing public as a whole rather than a specific entity or
person.
Recommended Procedures of Compliance
Submit to clients, at least quarterly, itemized statements showing all securities in custody
and all debits, credits, and transactions.
Encourage firms to address these topics when drafting policies and procedures regarding
fiduciary duty:
• Follow applicable rules and laws.
• Establish investment objectives of client. Consider suitability of portfolio relative to
client’s needs and circumstances, the investment’s basic characteristics, or the basic
characteristics of the total portfolio.
• Diversify.
• Deal fairly with all clients in regards to investment actions.
• Disclose conflicts.
• Disclose compensation arrangements.
Session 1
Reference to CFA Institute Assigned Readings #1 & 2-Standards of Practice Handbook
• Vote proxies in the best interest of clients and ultimate beneficiaries.
• Maintain confidentiality.
• Seek best execution.
• Place client interests first.
Application ofStandard111(A) Loyalty, Prudence, and Care
Example 1:
First Country Bank serves as trustee for the Miller Company’s pension plan. Miller
is the target of a hostile takeover attempt by Newton, Inc. In attempting to ward off
Newton, Miller’s managers persuade Julian Wiley, an investment manager at First
Country Bank, to purchase Miller common stock in the open market for the employee
pension plan. Miller’s officials indicate that such action would be favorably received and
would probably result in other accounts being placed with the bank. Although Wiley
believes the stock to be overvalued and would not ordinarily buy it, he purchases the
stock to support Miller’s managers, to maintain the company’s good favor, and to realize
additional new business. The heavy stock purchases cause Miller’s market price to rise to
such a level that Newton retracts its takeover bid.
Comment:
Standard 111(A) requires that a member or candidate, in evaluating a takeover bid, act
prudently and solely in the interests of plan participants and beneficiaries. To meet this
requirement, a member or candidate must carefully evaluate the long-term prospects of
the company against the short-term prospects presented by the takeover offer and by
the ability to invest elsewhere. In this instance, Wiley, acting on behalf of his employer,
the trustee, clearly violated Standard 111(A) by using the pension plan to perpetuate
existing management, perhaps to the detriment of plan participants and the company’s
shareholders, and to benefit himself. Wiley’s responsibilities to the plan participants
and beneficiaries should take precedence over any ties to corporate managers and selfinterest.
A duty exists to examine such a takeover offer on its own merits and to make
an independent decision. The guiding principle is the appropriateness of the investment
decision to the pension plan, not whether the decision benefits Wiley or the company
that hired him.
Example 2:
Emilie Rome is a trust officer for Paget Trust Company. Rome’s supervisor is responsible
for reviewing Rome’s trust account transactions and her monthly reports of personal
stock transactions. Rome has been using Nathan Gray, a broker, almost exclusively for
trust account brokerage transactions. Where Gray makes a market in stocks, he has been
giving Rome a lower price for personal purchases and a higher price for sales than he
gives to Rome’s trust accounts and other investors.
Comment:
Rome is violating her duty of loyalty to the bank’s trust accounts by using Gray for
brokerage transactions simply because Gray trades Rome’s personal account on favorable
terms.
Study Session 1
Cross-Reference to CFA Institute Assigned Readings #1 & 2-Standards of Practice Handbook
Example 3:
A member uses a broker for client-account trades that has relatively high prices and
average research and execution. In return, the broker pays for the rent and other
overhead expenses for the member’s firm.
Comment:
This is a violation of the Standard because the member used client brokerage for services
that do not benefit clients and failed to get the best price and execution for his clients.
Example 4:
In return for receiving account management business from Broker X, a member directs
trades to Broker X on the accounts referred to her by Broker X, as well as on other
accounts as an incentive to Broker X to send her more account business.
Comment:
This is a violation if Broker X does not offer the best price and execution or if the
practice of directing trades to Broker X is not disclosed to clients. The obligation to seek
best price and execution is always required unless clients provide a written statement that
the member is not to seek best price and execution and that they are aware of the impact
of this decision on their accounts.
Example 5:
A member does more trades in client accounts than are necessary to accomplish client
goals because she desires to increase her commission income.
Comment:
The member is using client assets (brokerage fees) to benefit herself and has violated the
Standard.
III(B) Fair Dealing. Members and Candidates must deal fairly and objectively with
all clients when providing investment analysis, making investment recommendations,
taking investment action, or engaging in other professional activities.
Guidance
Do not discriminate against any clients when disseminating recommendations or taking
investment action. Fairly does not mean equally. In the normal course of business,
there will be differences in the time e-mails, faxes, etc., are received by different clients.
Different service levels are okay, but they must not negatively affect or disadvantage
any clients. Disclose the different service levels to all clients and prospects, and make
premium levels of service available to all who wish to pay for them.
Guidance—Investment Recommendations
Give all clients a fair opportunity to act upon every recommendation. Clients who
are unaware of a change in a recommendation should be advised before the order is
accepted.
Session 1
Reference to CFA Institute Assigned Readings #1 & 2-Standards of Practice Handbook
Guidance—Investment Actions
Treat clients fairly in light of their investment objectives and circumstances. Treat
both individual and institutional clients in a fair and impartial manner. Members and
candidates should not take advantage of their position in the industry to disadvantage
clients (e.g., in the context of IPOs). Recommended Proceduresfor Compliance
Encourage firms to establish compliance procedures requiring proper dissemination of
investment recommendations and fair treatment of all customers and clients. Consider
these points when establishing fair dealing compliance procedures:
• Limit the number of people who are aware that a change in recommendation will be
made.
• Shorten the time frame between decision and dissemination.
• Publish personnel guidelines for pre-dissemination—have in place guidelines
prohibiting personnel who have prior knowledge of a recommendation from
discussing it or taking action on the pending recommendation.
• Simultaneous dissemination of new or changed recommendations to all clients who
have expressed an interest or for whom an investment is suitable.
• Maintain list of clients and holdings—use to ensure that all holders are treated fairly.
• Develop written trade allocation procedures—ensure fairness to clients, timely and
efficient order execution, and accuracy of client positions.
• Disclose trade allocation procedures.
• Establish systematic account review—ensure that no client is given preferred
treatment and that investment actions are consistent with the account’s objectives.
• Disclose available levels of service.
Application ofStandard III(B) Fair Dealing
Example 1:
Bradley Ames, a well-known and respected analyst, follows the computer industry. In
the course of his research, he finds that a small, relatively unknown company whose
shares are traded over the counter has just signed significant contracts with some of the
companies he follows. After a considerable amount of investigation, Ames decides to
write a research report on the company and recommend purchase. While the report is
being reviewed by the company for factual accuracy, Ames schedules a luncheon with
several of his best clients to discuss the company. At the luncheon, he mentions the
purchase recommendation scheduled to be sent early the following week to all the firm’s
clients.
Comment:
Ames violated Standard III(B) by disseminating the purchase recommendation to the
clients with whom he had lunch a week before the recommendation was sent to all
clients.
Example 2:
Spencer Rivers, president of XYZ Corporation, moves his company’s growth-oriented
pension fund to a particular bank primarily because of the excellent investment
performance achieved by the bank’s commingled fund for the prior 5-year period. A
Study Session 1
Cross-Reference to CFA Institute Assigned Readings #1 & 2-Standards of Practice Handbook
few years later, Rivers compares the results of his pension fund with those of the bank’s
commingled fund. He is startled to learn that, even though the two accounts have the
same investment objectives and similar portfolios, his company’s pension fund has
significantly underperformed the bank’s commingled fund. Questioning this result at
his next meeting with the pension fund’s manager, Rivers is told that, as a matter of
policy, when a new security is placed on the recommended list, Morgan Jackson, the
pension fund manager, first purchases the security for the commingled account and then
purchases it on a pro rata basis for all other pension fund accounts. Similarly, when a
sale is recommended, the security is sold first from the commingled account and then
sold on a pro rata basis from all other accounts. Rivers also learns that if the bank cannot
get enough shares (especially the hot issues) to be meaningful to all the accounts, its
policy is to place the new issues only in the commingled account.
Seeing that Rivers is neither satisfied nor pleased by the explanation, Jackson quickly
adds that nondiscretionary pension accounts and personal trust accounts have a lower
priority on purchase and sale recommendations than discretionary pension fund
accounts. Furthermore, Jackson states, the company’s pension fund had the opportunity
to invest up to 5% in the commingled fund.
Comment:
The bank’s policy did not treat all customers fairly, and Jackson violated her duty to
her clients by giving priority to the growth-oriented commingled fund over all other
funds and to discretionary accounts over nondiscretionary accounts. Jackson must
execute orders on a systematic basis that is fair to all clients. In addition, trade allocation
procedures should be disclosed to all clients from the beginning. Of course, in this case,
disclosure of the bank’s policy would not change the fact that the policy is unfair.
Example 3:
A member gets options for his part in an IPO from the subject firm. The IPO is
oversubscribed and the member fills his own and other individuals’ orders but has to
reduce allocations to his institutional clients.
Comment:
The member has violated the Standard. He must disclose to his employer and to his
clients that he has accepted options for putting together the IPO. He should not take
any shares of a hot IPO for himself and should have distributed his allocated shares of
the IPO to all clients in proportion to their original order amounts.
Example 4:
A member is delayed in allocating some trades to client accounts. When she allocates the
trades, she puts some positions that have appreciated in a preferred client’s account and
puts trades that have not done as well in other client accounts.
Comment:
This is a violation of the Standard. The member should have allocated the trades to
specific accounts prior to the trades or should have allocated the trades proportionally to
suitable accounts in a timely fashion.
Session 1
Reference to CFA Institute Assigned Readings #1 & 2-Standards of Practice Handbook
Example 5:
Because of minimum lot size restrictions, a portfolio manager allocates the bonds she
receives from an oversubscribed bond offering to her clients in a way that is not strictly
proportional to their purchase requests.
Comment:
Since she has a reason (minimum lot size) to deviate from a strict pro rata allocation to
her clients, there is no violation of Fair Dealing.
III(C) Suitability
1. When Members and Candidates are in an advisory relationship with a client, they
must:
Make a reasonable inquiry into a client’s or prospective clients’
investment experience, risk and return objectives, and financial
constraints prior to making any investment recommendation or taking
investment action and must reassess and update this information
regularly.
a.
