Reading 3 - Guidance for Standards I-VII Flashcards
Learning Objects for Reading 3
The candidate should be able to:
(1) demonstrate the application of the Code of Ethics and Standards of Professional Conduct to situations involving issues of professional integrity;
(2) distinguish between conduct that conforms to the Code and Standards and conduct that violates the Code and Standards;
(3) recommend practices and procedures designed to prevent violations of the Code of Ethics and Standards of Professional Conduct.
Standard I – Professionalism
Standard I (A) Knowledge of the Law Standard I (B) Independence and Objectivity Standard I (C) Misrepresentation Standard I (D) Misconduct
Define Standard I(A) 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.
Some members or candidates may live, work, or provide investment services to clients living in a country that has no law or regulation governing a particular action or that has laws or regulations that differ from the requirements of the Code and Standards. When applicable law and the Code and Standards require different conduct, what is required?
Members and candidates must follow the more strict of the applicable law or the Code and Standards.
Define “Applicable Law”
“Applicable law” is the law that governs the member’s or candidate’s conduct. Which law applies will depend on the particular facts and circumstances of each case.
Define “more strict” law
The “more strict” law or regulation is the law or regulation that imposes greater restrictions on the action of the member or candidate or calls for the member or candidate to exert a greater degree of action that protects the interests of investors.
Members and candidates must adhere to the following principles in regards to applicable laws and Code of Standards.
1) Members and candidates must comply with applicable laws or regulations related to their professional activities.
2) Members and candidates must not engage in conduct that constitutes a violation of the Code and Standards, even though it may otherwise be legal.
3) In the absence of any applicable law or regulation or when the Code and Standards impose a higher degree of responsibility than applicable laws and regulations, members and candidates must adhere to the Code and Standards.
CFA Institute members are obligated to abide by the following documents:
CFA Institute Articles of Incorporation Bylaws Code of Ethics Standards of Professional Conduct Rules of Procedure Membership Agreement And other applicable rules promulgated by CFA Institute, all as amended periodically
CFA candidates who are not members must also abide the following documents:
All Member documents (except for the Membership Agreement) as well as rules and regulations related to the administration of the CFA examination, the Candidate Responsibility Statement, and the Candidate Pledge.
If a member or candidate has reasonable grounds to believe that imminent or ongoing client or employer activities are illegal or unethical, what must the member or candidate do?
The member or candidate must dissociate, or separate, from the activity. In extreme cases, dissociation may require a member or candidate to leave his or her employment.
Members and candidates involved in creating or maintaining investment services or investment products or packages of securities and/or derivatives should be:
Mindful of where these products or packages will be sold as well as their places of origination.
For Recommended Procedures for Compliance, under Standard I(A), suggested methods by which members and candidates can acquire and maintain understanding of applicable laws, rules, and regulations include the following:
(1) Stay informed
(2) Review procedures
(3) Maintain current files
For Recommended Procedures for Compliance, under Standard I (A), what is recommended for Distribution Area Laws?
Members and candidates should make reasonable efforts to understand the applicable laws—both country and regional—for the countries and regions where their investment products are developed and are most likely to be distributed to clients.
For Recommended Procedures for Compliance, under Standard I(A), what is recommended for Legal Counsel?
When in doubt about the appropriate action to undertake, it is recommended that a member or candidate seek the advice of compliance personnel or legal counsel concerning legal requirements. If a potential violation is being committed by a fellow employee, it may also be prudent for the member or candidate to seek the advice of the firm’s compliance department or legal counsel.
For Recommended Procedures for Compliance, under Standard I (A), what is recommended for Dissociation?
When dissociating from an activity that violates the Code and Standards, members and candidates should document the violation and urge their firms to attempt to persuade the perpetrator(s) to cease such conduct. To dissociate from the conduct, a member or candidate may have to resign his or her employment.
Standard I(A) Knowledge of the Law – Highlights
Relationship between the Code and Standards and Applicable Law
Participation in or Association with Violations by Others
Investment Products and Applicable Laws
Standard I(A) Knowledge of the Law – Recommended Procedures for Compliance
Members and Candidate Distribution Area Laws Legal Counsel Dissociation Firms
For Recommended Procedures for Compliance, under Standard I (A), what is recommended for Firms?
The formality and complexity of compliance procedures for firms depend on the nature and size of the organization and the nature of its investment operations. Members and candidates should encourage their firms to consider the following policies and procedures to support the principles of Standard I(A):
(1) Develop and/or adopt a code of ethics
(2) Provide information on applicable laws
(3) Establish procedures for reporting violations
Define Standard I(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.
Define Standard I(B) Independence and Objectivity – Highlights
Buy-Side Clients Fund Manager and Custodial Relationships Investment Banking Relationships Performance Measurement and Attribution Public Companies Credit Rating Agency Opinions Influence during the Manager Selection/Procurement Process Issuer-Paid Research Travel Funding
How is there a source of pressure, effecting the independence and objectivity, on sell-side analysts from buy-side clients?
1) Institutional clients are traditionally the primary users of sell-side research, either directly or with soft dollar brokerage. Portfolio managers may have significant positions in the security of a company under review.
2) A rating downgrade may adversely affect the portfolio’s performance, particularly in the short term, because the sensitivity of stock prices to ratings changes has increased in recent years. A downgrade may also affect the manager’s compensation, which is usually tied to portfolio performance.
3) Moreover, portfolio performance is subject to media and public scrutiny, which may affect the manager’s professional reputation. Consequently, some portfolio managers implicitly or explicitly support sell-side ratings inflation.
How is there a source of pressure, effecting the independence and objectivity, on Fund Manager and Custodial Relationships?
Members and candidates who are responsible for hiring and retaining outside managers and third-party custodians should not accepts gifts, entertainment, or travel funding that may be perceived as impairing their decisions. The use of secondary fund managers has evolved into a common practice to manage specific asset allocations. The use of third-party custodians is common practice for independent investment advisory firms and helps them with trading capabilities and reporting requirements. Primary and secondary fund managers, as well as third-party custodians, often arrange educational and marketing events to inform others about their business strategies, investment process, or custodial services. Members and candidates must review the merits of each offer individually in determining whether they may attend yet maintain their independence.
How is there a source of pressure, effecting the independence and objectivity, on Investment Banking Relationships?
Although collaboration between research analysts and investment banking colleagues may benefit the firm and enhance market efficiency (e.g., by allowing firms to assess risks more accurately and make better pricing assumptions), it requires firms to carefully balance the conflicts of interest inherent in the collaboration. Having analysts work with investment bankers is appropriate only when the conflicts are adequately and effectively managed and disclosed. Firm managers have a responsibility to provide an environment in which analysts are neither coerced nor enticed into issuing research that does not reflect their true opinions. Firms should require public disclosure of actual conflicts of interest to investors.
How is there a source of pressure, effecting the independence and objectivity, on Performance Measurement and Attribution?
As performance analysts, their analyses may reveal instances where managers may appear to have strayed from their mandate. Additionally, the performance analyst may receive requests to alter the construction of composite indices owing to negative results for a selected account or fund. The member or candidate must not allow internal or external influences to affect their independence and objectivity as they faithfully complete their performance calculation and analysis-related responsibilities.
How is there a source of pressure, effecting the independence and objectivity, on Public Companies?
Research analysts may justifiably fear that companies will limit their ability to conduct thorough research by denying analysts who have “negative” views direct access to company managers and/or barring them from conference calls and other communication venues. Retaliatory practices include companies bringing legal action against analysts personally and/or their firms to seek monetary damages for the economic effects of negative reports and recommendations. Although few companies engage in such behavior, the perception that a reprisal is possible is a reasonable concern for analysts. This concern may make it difficult for them to conduct the comprehensive research needed to make objective recommendations.
How is there a source of pressure, effecting the independence and objectivity, on Credit Rating Agency Opinions?
Credit rating agencies provide a service by grading the fixed-income products offered by companies. Analysts face challenges related to incentives and compensation schemes that may be tied to the final rating and successful placement of the product.
How is there a source of pressure, effecting the independence and objectivity, on Influence during the Manager Selection/Procurement Process?
When serving in a hiring capacity, members and candidates should not solicit gifts, contributions, or other compensation that may affect their independence and objectivity. Solicitations do not have to benefit members and candidates personally to conflict with Standard I(B). Requesting contributions to a favorite charity or political organization may also be perceived as an attempt to influence the decision-making process. Additionally, members and candidates serving in a hiring capacity should refuse gifts, donations, and other offered compensation that may be perceived to influence their decision-making process.
How is there a source of pressure, effecting the independence and objectivity, on Issuer-Paid Research?
Issuer-paid research conducted by independent analysts, however, is fraught with potential conflicts. Depending on how the research is written and distributed, investors may be misled into believing that the research is from an independent source when, in reality, it has been paid for by the subject company. Best practice is for independent analysts, prior to writing their reports, to negotiate only a flat fee for their work that is not linked to their conclusions or recommendations.
How is there a source of pressure, effecting the independence and objectivity, on Travel Funding?
Acceptance also comes with potential concerns; for example, members and candidates may be influenced by these discussions when flying on a corporate or chartered jet or attending sponsored conferences where many expenses, including airfare and lodging, are covered. To avoid the appearance of compromising their independence and objectivity, best practice dictates that members and candidates always use commercial transportation at their expense or at the expense of their firm rather than accept paid travel arrangements from an outside company.
For recommended procedures for compliance, Members and candidates should adhere to the following practices and should encourage their firms to establish procedures to avoid violations of Standard I(B), Independence and Objectivity:
(1) Protect the integrity of opinions
(2) Create a restricted list
(3) Restrict special cost arrangements
(4) Limit gifts
(5) Restrict investments
(6) Review procedures
(7) Independence policy
(8) Appointed officer
Define Standard I(C) Misrepresentation
Members and Candidates must not knowingly make any misrepresentations relating to investment analysis, recommendations, actions, or other professional activities.
Standard I(C) Misrepresentation – Highlights
Impact on Investment Practice Performance Reporting Social Media Omissions Plagiarism Work Completed for Employer
How does Standard I(C) relate to the Impact on Investment Practice?
Members and candidates must not misrepresent any aspect of their practice, including (but not limited to) their qualifications or credentials, the qualifications or services provided by their firm, their performance record and the record of their firm, and the characteristics of an investment. Any misrepresentation made by a member or candidate relating to the member’s or candidate’s professional activities is a breach of this standard.
How does Standard I(C) relate to Performance Reporting?
The performance benchmark selection process is another area where misrepresentations may occur. Members and candidates may misrepresent the success of their performance record through presenting benchmarks that are not comparable to their strategies. Further, clients can be misled if the benchmark’s results are not reported on a basis comparable to that of the fund’s or client’s results.
How does Standard I(C) relate to Social Media?
The advancement of online discussion forums and communication platforms, commonly referred to as “social media,” is placing additional responsibilities on members and candidates. When communicating through social media channels, members and candidates should provide only the same information they are allowed to distribute to clients and potential clients through other traditional forms of communication.
How does Standard I(C) relate to Omissions?
When inputs are knowingly omitted, the resulting outcomes may provide misleading information to those who rely on it for making investment decisions. Additionally, the outcomes from models shall not be presented as fact because they represent the expected results based on the inputs and analysis process incorporated.
How does Standard I(C) relate to Plagiarism?
Plagiarism is defined as copying or using in substantially the same form materials prepared by others without acknowledging the source of the material or identifying the author and publisher of such material. This can even include oral communications.
How does Standard I(C) relate to Work Completed for Employer?
Research and models developed while employed by a firm are the property of the firm. The firm retains the right to continue using the work completed after a member or candidate has left the organization. The firm may issue future reports without providing attribution to the prior analysts. A member or candidate cannot, however, reissue a previously released report solely under his or her name.
Standard I(C) – Recommended Procedures for Compliance
Factual Presentations Qualification Summary Verify Outside Information Maintain Webpages Plagiarism Policy
For Recommended Procedures for Compliance, under Standard I(C), what is recommended for Factual Presentations?
Firms can provide guidance for employees who make written or oral presentations to clients or potential clients by providing a written list of the firm’s available services and a description of the firm’s qualifications. This list should suggest ways of describing the firm’s services, qualifications, and compensation that are both accurate and suitable for client or customer presentations.
For Recommended Procedures for Compliance, under Standard I(C), what is recommended for Qualification Summary?
In addition, to ensure accurate presentations to clients, each member and candidate should prepare a summary of his or her own qualifications and experience and a list of the services the member or candidate is capable of performing.
For Recommended Procedures for Compliance, under Standard I(C), what is recommended to Verify Outside Information?
When providing information to clients from a third party, members and candidates share a responsibility for the accuracy of the marketing and distribution materials that pertain to the third party’s capabilities, services, and products. Misrepresentation by third parties can damage the member’s or candidate’s reputation, the reputation of the firm, and the integrity of the capital markets. Members and candidates should encourage their employers to develop procedures for verifying information of third-party firms.
For Recommended Procedures for Compliance, under Standard I(C), what is recommended for Maintaining Webpages?
Members and candidates who publish a webpage should regularly monitor materials posted on the site to ensure that the site contains current information. Members and candidates should also ensure that all reasonable precautions have been taken to protect the site’s integrity, confidentiality, and security and that the site does not misrepresent any information and provides full disclosure.
For Recommended Procedures for Compliance, under Standard I(C), what is recommended for Plagiarism Policy?
To avoid plagiarism in preparing research reports or conclusions of analysis, members and candidates should take the following steps:
Maintain copies: Keep copies of all research reports, articles containing research ideas, material with new statistical methodologies, and other materials that were relied on in preparing the research report.
Attribute quotations: Attribute to their sources any direct quotations, including projections, tables, statistics, model/product ideas, and new methodologies prepared by persons other than recognized financial and statistical reporting services or similar sources.
Attribute summaries: Attribute to their sources any paraphrases or summaries of material prepared by others. For example, to support his analysis of Brown Company’s competitive position, the author of a research report on Brown might summarize another analyst’s report on Brown’s chief competitor, but the author of the Brown report must acknowledge in his own report the reliance on the other analyst’s report.
Define Standard I (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.
What is the difference between Standard I (A) and Standard I (B)?
Whereas Standard I(A) addresses the obligation of members and candidates to comply with applicable law that governs their professional activities, Standard I(D) addresses all conduct that reflects poorly on the professional integrity, good reputation, or competence of members and candidates. Any act that involves lying, cheating, stealing, or other dishonest conduct is a violation of this standard if the offense reflects adversely on a member’s or candidate’s professional activities.
In addition to ensuring that their own behavior is consistent with Standard I(D), to prevent general misconduct, members and candidates should encourage their firms to adopt the following policies and procedures to support the principles of Standard I(D):
1) Code of ethics
2) List of violations
3) Employee References
Standard II – Integrity of Capital Markets
Standard II (A) Material Nonpublic Information Standard II (B) Market Manipulation
Define Standard II (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.
Standard II (A) Material Nonpublic Information – Highlights
What Is “Material” Information? What Constitutes “Nonpublic” Information? Mosaic Theory Social Media Using Industry Experts Investment Research Reports
What is “Material” Information?
Information is “material” if its disclosure would probably have an impact on the price of a security or if reasonable investors would want to know the information before making an investment decision. In other words, information is material if it would significantly alter the total mix of information currently available about a security in such a way that the price of the security would be affected.
What constitutes “Nonpublic” Information?
Information is “nonpublic” until it has been disseminated or is available to the marketplace in general (as opposed to a select group of investors). “Disseminated” can be defined as “made known.”
What is Mosaic Theory
A financial analyst gathers and interprets large quantities of information from many sources. The analyst may use significant conclusions derived from the analysis of public and nonmaterial nonpublic information as the basis for investment recommendations and decisions even if those conclusions would have been material inside information had they been communicated directly to the analyst by a company. Under the “mosaic theory,” financial analysts are free to act on this collection, or mosaic, of information without risking violation.
Standard II: Integrity of Capital Markets – Standard II(A) Material Nonpublic Information – Social Media
As long as the information reaches all clients or is open to the investing public, the use of these platforms would be comparable with other traditional forms of communications, such as e-mails and press releases. Members and candidates, as required by Standard I(A), should also complete all appropriate regulatory filings related to information distributed through social media platforms.
Standard II: Integrity of Capital Markets – Standard II(A) Material Nonpublic Information – Using Industry Experts
Members and candidates may provide compensation to individuals for their insights without violating this standard. However, members and candidates are ultimately responsible for ensuring that they are not requesting or acting on confidential information received from external experts, which is in violation of security regulations and laws or duties to others.
Standard II: Integrity of Capital Markets – Standard II(A) Material Nonpublic Information – Investment Research Reports
Presumably, the analyst created the report from information available to the public (mosaic theory) and by using his or her expertise to interpret the information. The analyst’s hard work, paid for by the client, generated the conclusions. Simply because the public in general would find the conclusions material does not require that the analyst make his or her work public. Investors who are not clients of the analyst can either do the work themselves or become clients of the analyst to gain access to the analyst’s expertise.
Standard II: Integrity of Capital Markets – Standard II(A) Material Nonpublic Information – Recommended Procedures for Compliance
Achieve Public Dissemination Adopt Compliance Procedures Adopt Disclosure Procedures Issue Press Releases Firewall Elements Appropriate Interdepartmental Communications Physical Separation of Departments Prevention of Personnel Overlap A Reporting System Personal Trading Limitations Record Maintenance Proprietary Trading Procedures Communication to all employees
Standard II(A) – Recommended Procedures for Compliance – Achieve Public Dissemination.
If a member or candidate determines that information is material, the member or candidate should make reasonable efforts to achieve public dissemination of the information. If public dissemination is not possible, the member or candidate must communicate the information only to the designated supervisory and compliance personnel within the member’s or candidate’s firm and must not take investment action or alter current investment recommendations on the basis of the information. Moreover, members and candidates must not knowingly engage in any conduct that may induce company insiders to privately disclose material nonpublic information.
Standard II(A) – Recommended Procedures for Compliance – Adopt Compliance Procedures.
Members and candidates should encourage their firms to adopt compliance procedures to prevent the misuse of material nonpublic information. Particularly important is improving compliance in such areas as the review of employee and proprietary trading, the review of investment recommendations, documentation of firm procedures, and the supervision of interdepartmental communications in multiservice firms. Compliance procedures should suit the particular characteristics of a firm, including its size and the nature of its business.
Standard II(A) – Recommended Procedures for Compliance – Adopt Disclosure Procedures.
Members and candidates should encourage their firms to develop and follow disclosure policies designed to ensure that information is disseminated to the marketplace in an equitable manner. For example, analysts from small firms should receive the same information and attention from a company as analysts from large firms receive. Similarly, companies should not provide certain information to buy-side analysts but not to sell-side analysts, or vice versa. Furthermore, a company should not discriminate among analysts in the provision of information or “blackball” particular analysts who have given negative reports on the company in the past.
Standard II(A) – Recommended Procedures for Compliance – Issue Press Releases.
Companies should consider issuing press releases prior to analyst meetings and conference calls and scripting those meetings and calls to decrease the chance that further information will be disclosed. If material nonpublic information is disclosed for the first time in an analyst meeting or call, the company should promptly issue a press release or otherwise make the information publicly available.
Standard II(A) – Recommended Procedures for Compliance – Firewall Elements.
An information barrier commonly referred to as a “firewall” is the most widely used approach for preventing the communication of material nonpublic information within firms. It restricts the flow of confidential information to those who need to know the information to perform their jobs effectively.
Standard II(A) – Recommended Procedures for Compliance – Appropriate Interdepartmental Communications.
Although documentation requirements must, for practical reasons, take into account the differences between the activities of small firms and those of large, multiservice firms, firms of all sizes and types benefit by improving the documentation of their internal enforcement of firewall procedures. Therefore, even at small firms, procedures concerning interdepartmental communication, the review of trading activity, and the investigation of possible violations should be compiled and formalized.
Standard II(A) – Recommended Procedures for Compliance – Physical Separation of Departments.
As a practical matter, to the greatest extent possible, firms should consider the physical separation of departments and files to prevent the communication of sensitive information that should not be shared. For example, the investment banking and corporate finance areas of a brokerage firm should be separated from the sales and research departments, and a bank’s commercial lending department should be segregated from its trust and research departments.
Standard II(A) – Recommended Procedures for Compliance – Prevention of Personnel Overlap.
There should be no overlap of personnel between the investment banking and corporate finance areas of a brokerage firm and the sales and research departments or between a bank’s commercial lending department and its trust and research departments. For a firewall to be effective in a multiservice firm, an employee should be on only one side of the firewall at any time.
Standard II(A) – Recommended Procedures for Compliance – A Reporting System.
A primary objective of an effective firewall procedure is to establish a reporting system in which authorized people review and approve communications between departments. If an employee behind a firewall believes that he or she needs to share confidential information with someone on the other side of the wall, the employee should consult a designated compliance officer to determine whether sharing the information is necessary and how much information should be shared.
Standard II(A) – Recommended Procedures for Compliance – Personal Trading Limitations.
Firms should consider restrictions or prohibitions on personal trading by employees and should carefully monitor both proprietary trading and personal trading by employees.
Standard II(A) – Recommended Procedures for Compliance – Record Maintenance.
Multiservice firms should maintain written records of the communications between various departments. Firms should place a high priority on training and should consider instituting comprehensive training programs, particularly for employees in sensitive areas.
Standard II(A) – Recommended Procedures for Compliance – Proprietary Trading Procedures.
Procedures concerning the restriction or review of a firm’s proprietary trading while the firm possesses material nonpublic information will necessarily depend on the types of proprietary trading in which the firm may engage. A prohibition on all types of proprietary activity when a firm comes into possession of material nonpublic information is not appropriate. For example, when a firm acts as a market maker, a prohibition on proprietary trading may be counterproductive to the goals of maintaining the confidentiality of information and market liquidity.
Standard II(A) – Recommended Procedures for Compliance – Communications to All Employees.
Members and candidates should encourage their employers to circulate written compliance policies and guidelines to all employees. Policies and guidelines should be used in conjunction with training programs aimed at enabling employees to recognize material nonpublic information. Such information is not always clearly identifiable.
Standard II (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.
Standard II (B) – Highlights
Information-Based Manipulation
Transaction-Based Manipulation
Market Manipulation includes:
(1) the dissemination of false or misleading information
(2) transactions that deceive or would be likely to mislead market participants by distorting the price-setting mechanism of financial instruments.
Standard II (B) – Market Manipulation – Information based manipulation
Information-based manipulation includes, but is not limited to, spreading false rumors to induce trading by others. For example, members and candidates must refrain from “pumping up” the price of an investment by issuing misleading positive information or overly optimistic projections of a security’s worth only to later “dump” the investment (i.e., sell it) once the price, fueled by the misleading information’s effect on other market participants, reaches an artificially high level.
Standard II (B) – Market Manipulation – Transaction-based manipulation
Transaction-based manipulation involves instances where a member or candidate knew or should have known that his or her actions could affect the pricing of a security. This type of manipulation includes, but is not limited to, the following:
1) transactions that artificially affect prices or volume to give the impression of activity or price movement in a financial instrument, which represent a diversion from the expectations of a fair and efficient market, and
2) securing a controlling, dominant position in a financial instrument to exploit and manipulate the price of a related derivative and/or the underlying asset.
Standard III (A) – Duties to Clients – 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.
Standard III (A) – Duties to Clients – Understanding the application of Loyalty, Prudence, and Care
There is a large variety of professional relationships that members and candidates have with their clients. Standard III(A) requires them to fulfill the obligations outlined explicitly or implicitly in the client agreements to the best of their abilities and with loyalty, prudence, and care. Whether a member or candidate is structuring a new securitization transaction, completing a credit rating analysis, or leading a public company, he or she must work with prudence and care in delivering the agreed-on services.
Standard III – Duties to Clients
Standard III (A) Loyalty, Prudence, and Care Standard III (B) Fair Dealing Standard III (C) Suitability Standard III (D) Performance Presentation Standard III (E) Preservation of Confidentiality
Standard III (A) – Duties to Clients – Identifying the Actual Investment Client
The first step for members and candidates in fulfilling their duty of loyalty to clients is to determine the identity of the “client” to whom the duty of loyalty is owed. In the context of an investment manager managing the personal assets of an individual, the client is easily identified. When the manager is responsible for the portfolios of pension plans or trusts, however, the client is not the person or entity who hires the manager but, rather, the beneficiaries of the plan or trust. The duty of loyalty is owed to the ultimate beneficiaries.
Standard III (A) – Highlights
Understanding the Application of Loyalty, Prudence, and Care Identifying the Actual Investment Client Developing the Client’s Portfolio Soft Commission Policies Proxy Voting Policies
Standard III (A) – Duties to Clients – Developing the Client’s Portfolio
The duty of loyalty, prudence, and care owed to the individual client is especially important because the professional investment manager typically possesses greater knowledge in the investment arena than the client does. This disparity places the individual client in a vulnerable position; the client must trust the manager. The manager in these situations should ensure that the client’s objectives and expectations for the performance of the account are realistic and suitable to the client’s circumstances and that the risks involved are appropriate. In most circumstances, recommended investment strategies should relate to the long-term objectives and circumstances of the client.
Standard III (A) – Duties to Clients – Soft Commission Policies
An investment manager often has discretion over the selection of brokers executing transactions. Conflicts may arise when an investment manager uses client brokerage to purchase research services, a practice commonly called “soft dollars” or “soft commissions.” A member or candidate who pays a higher brokerage commission than he or she would normally pay to allow for the purchase of goods or services, without corresponding benefit to the client, violates the duty of loyalty to the client.
Standard III (A) – Duties to Clients – Proxy Voting Policies
Part of a member’s or candidate’s duty of loyalty includes voting proxies in an informed and responsible manner. Proxies have economic value to a client, and members and candidates must ensure that they properly safeguard and maximize this value. An investment manager who fails to vote, casts a vote without considering the impact of the question, or votes blindly with management on nonroutine governance issues (e.g., a change in company capitalization) may violate this standard. Voting of proxies is an integral part of the management of investments.
Standard III (A) – Recommended Procedures for Compliance
Regular Account Information
Client Approval
Firm Policies
Standard III (A) – Recommended Procedures for Compliance – Regular Account Information
Members and candidates with control of client assets (1) should submit to each client, at least quarterly, an itemized statement showing the funds and securities in the custody or possession of the member or candidate plus all debits, credits, and transactions that occurred during the period, (2) should disclose to the client where the assets are to be maintained, as well as where or when they are moved, and (3) should separate the client’s assets from any other party’s assets, including the member’s or candidate’s own assets.
Standard III (A) – Recommended Procedures for Compliance – Client Approval
If a member or candidate is uncertain about the appropriate course of action with respect to a client, the member or candidate should consider what he or she would expect or demand if the member or candidate were the client. If in doubt, a member or candidate should disclose the questionable matter in writing to the client and obtain client approval.
Standard III (A) – Recommended Procedures for Compliance – Firm Policies
Members and candidates should address and encourage their firms to address the following topics when drafting the statements or manuals containing their policies and procedures regarding responsibilities to clients:
Follow all applicable rules and laws Establish the investment objectives of the client Consider all the information when taking actions Diversify Carry out regular reviews Deal fairly with all clients with respect to investment action Disclose conflicts of interest Disclose compensation arrangements Vote proxies Maintain confidentiality Seek best execution Place client interests first
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.
Standard III(B) covers conduct in two broadly defined categories—investment recommendations and investment action.
Standard III (B) – Fair Dealing – Investment Recommendations
The criterion is that the member’s or candidate’s primary responsibility is the preparation of recommendations to be acted on by others, including those in the member’s or candidate’s organization. Standard III(B) addresses the manner in which investment recommendations or changes in prior recommendations are disseminated to clients. Each member or candidate is obligated to ensure that information is disseminated in such a manner that all clients have a fair opportunity to act on every recommendation.
Standard III (B) – Fair Dealing – Investment Action
Investment action, like investment recommendations, can affect market value. Consequently, Standard III(B) requires that members or candidates treat all clients fairly in light of their investment objectives and circumstances. For example, when making investments in new offerings or in secondary financings, members and candidates should distribute the issues to all customers for whom the investments are appropriate in a manner consistent with the policies of the firm for allocating blocks of stock.
Standard III (B) – Recommended Procedures for Compliance – Develop Firm Polices
Members and candidates should consider the following points when establishing fair-dealing compliance procedures:
Limit the number of people involved
Shorten the time frame between decision and dissemination
Publish guidelines for pre-dissemination behavior
Simultaneous dissemination
Maintain a list of clients and their holdings
Develop a document trade allocation procedures
Standard III (B) – Recommended Procedures for Compliance – Develop Firm Policies – Limit the number of people involved
Limit the number of people involved: Members and candidates should make reasonable efforts to limit the number of people who are privy to the fact that a recommendation is going to be disseminated.
Standard III (B) – Recommended Procedures for Compliance – Develop Firm Policies – Shorten the time frame between decision and dissemination
Shorten the time frame between decision and dissemination: Members and candidates should make reasonable efforts to limit the amount of time that elapses between the decision to make an investment recommendation and the time the actual recommendation is disseminated.
Standard III (B) – Recommended Procedures for Compliance – Develop Firm Policies – Publish guidelines for pre-dissemination behavior
Publish guidelines for pre-dissemination behavior: Members and candidates should encourage firms to develop guidelines that prohibit personnel who have prior knowledge of an investment recommendation from discussing or taking any action on the pending recommendation.
Standard III (B) – Recommended Procedures for Compliance – Develop Firm Policies – Simultaneous dissemination
Simultaneous dissemination: Members and candidates should establish procedures for the timing of dissemination of investment recommendations so that all clients are treated fairly—that is, are informed at approximately the same time. For example, if a firm is going to announce a new recommendation, supervisory personnel should time the announcement to avoid placing any client or group of clients at an unfair advantage relative to other clients.
Standard III (B) – Recommended Procedures for Compliance – Develop Firm Policies – Maintain a list of clients and their holdings
Members and candidates should maintain a list of all clients and the securities or other investments each client holds in order to facilitate notification of customers or clients of a change in an investment recommendation. If a particular security or other investment is to be sold, such a list can be used to ensure that all holders are treated fairly in the liquidation of that particular investment.
Standard III (B) – Recommended Procedures for Compliance – Develop Firm Policies – Develop and document trade allocation procedures
Develop and document trade allocation procedures: When formulating procedures for allocating trades, members and candidates should develop a set of guiding principles that ensure
(1) fairness to advisory clients, both in priority of execution of orders and in the allocation of the price obtained in execution of block orders or trades,
(2) timeliness and efficiency in the execution of orders, and
(3) accuracy of the member’s or candidate’s records as to trade orders and client account positions.
Standard III (B) – Recommended Procedures for Compliance – Develop Firm Policies – Develop and document trade allocation procedures
With these principles in mind, members and candidates should develop or encourage their firm to develop written allocation procedures, with particular attention to procedures for block trades and new issues. Procedures to consider are as follows:
- requiring orders and modifications or cancellations of orders to be documented and time stamped;
- processing and executing orders on a first-in, first-out basis with consideration of bundling orders for efficiency as appropriate for the asset class or the security;
- developing a policy to address such issues as calculating execution prices and “partial fills” when trades are grouped, or in a block, for efficiency;
- giving all client accounts participating in a block trade the same execution price and charging the same commission;
- when the full amount of the block order is not executed, allocating partially executed orders among the participating client accounts pro rata on the basis of order size while not going below an established minimum lot size for some securities (e.g., bonds); and
- when allocating trades for new issues, obtaining advance indications of interest, allocating securities by client (rather than portfolio manager), and providing a method for calculating allocations.
Standard III (B) – Recommended Procedures for Compliance – Develop Firm Policies – Disclose Trade Allocation Procedures
Members and candidates should disclose to clients and prospective clients how they select accounts to participate in an order and how they determine the amount of securities each account will buy or sell. Trade allocation procedures must be fair and equitable, and disclosure of inequitable allocation methods does not relieve the member or candidate of this obligation.
