Standard III Flashcards
What is Standard III?
Duties to Clients and Prospective Clients
What are the subsections of Standard III: Duties to Clients and Prospective Clients?
III-A: Loyalty, Prudence, and Care III-B: Fair Dealing III-C: Sutability III-D: Performance Presentation III-E: Preservation of Confidentiality
What is Standard III-A?
“Loyalty, Prudence and Care”
-Manage portfolio like it was your own money
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. In relationships with clients, Members and Candidates must determine applicable fiduciary duty and must comply with such duty to persons and interests to whom it is owed.
What are some examples of exam scenarios to test Standard III-A?
(1) Identifying the Client
(2) Brokerage Arrangements
(3) Excessive Trading
Identifying the Client
The portfolio manager of a global financial services mutual fund runs into a friend at an industry event. His friend mentions that her new client is invested in the portfolio manager’s fund and therefore the two of them now share responsibility for her new client. Under standard III(A), this is incorrect. The portfolio manager’s duty is to uphold the investment guidelines for his mutual fund with objectivity and independence, while his friend’s duty is to be loyal to her new client.
Brokerage Arrangements
A small, independent investment advisor manages the pension funds of several companies. One of her brokers is about to win several new client accounts. The advisor expects to manage and trade these accounts exclusively through that broker. To induce the broker to send more new accounts her way, the investment advisor directs trades for all her current clients to that broker, without their knowledge. The advisor violated standard III(A) by not seeking best practice and best execution on all trades. Additionally, the standard was violated because the advisor did not disclose how trades were directed.
Excessive Trading
A CFA charterholder manages money for several high-net-worth families. A major part of his compensation comes in the form of fees based on trading volume. He trades excessively for his accounts, but all the trades made are appropriate and suitable assets for the clients. The manager has violated standard III(A) because he is using the assets of his clients to benefit himself.
Question Types Standard III - A
Ethics problems on the CFA exam are usually case-study oriented. Keep in mind that many cases involve violations of more than one standard. A good way to determine whether standard III(A) was breached is to ask yourself the following questions:
- Is this person acting in the best interests of clients?
- Is this person placing clients’ interests before his or her own?
How can you comply with III-A?
To ensure compliance with Standard III-A and to avoid a violation, CFA members and Candidates should start by thoroughly knowing and understanding the content of all governing documents to which they are bound in their relationships with clients.
Given the duty to loyalty required by this Standard, are there any particular restrictions or unique characteristics that are not fully understood?
Legal advice should be sought for unclear guidelines.
When in custodial control of client assets, what procedures are suggested (per the Standards of Practice Handbook):
- Audit the firm at least once a year.
- Produce a quarterly statement for each client, indicating funds and securities in that account and itemized transactions during the period.
- Make full disclosure as to where the assets are maintained, and where and when they are moved.
- Separate assets so that each client’s holdings can be distinguished.
To comply with soft-dollar standards, a fiduciary needs to ask which three questions to determine whether soft dollars can be used and what percentage of the cost can be allocated ?
- Does this product provide investment research?
- Will the information it provides contribute to the research process of this organization?
- Will any portion of this product go for uses not directly involved in the investment research process?
For investment managers, an internal policies and procedures guide should observe the following which rules ?
- All applicable laws, rules and regulations must be followed.
- Potential conflict of interest arrangements (additional compensation, outside directorships) are required disclosures.
- Investment objectives for each client must be initially established and reviewed at least annually and as circumstances warrant.
- Asset diversification should be practiced as a risk reduction tool, except in cases where specific guidelines and objectives preclude it.
- Fairness and objectivity should be practiced with all clients, with no explicit favoritism toward one client or group.
- A process for vote proxies should be established with clients’ best interests in mind; individual responsibilities for voting should be determined; and records should be maintained.
- Best execution on trades should be practiced. In other words, under the particular circumstances in place (i.e. what is reasonably available), what is the broker that provides the lowest total cost to the client? “Cost” refers not only to trading commissions but also to costs related to poorly executed trades (buying at prices that are higher and selling at prices that are lower than what was available from competitors).
- Duty of loyalty to clients, as a company policy, is top priority.
What is 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.
What is a likely scenario for an exam question on III-B?
1) Research Report Preview
2) No Time to Prepare a Report
3) Preparing for the Eventual Demand
4) Allocation of IPO
5) Notification via email
Case studies that test this Standard tend to place analysts in a situation where they are tempted to show favoritism toward one group over another. In determining the proper course of action, ask whether the individual’s actions in any way discriminate against any subset of the firm’s client base. Some of the more common situations to anticipate in a CFA exam question testing this Standard are described below.
Previewing Contents of a Yet-to-Be Published Research Report
An industry analyst is excited about an under-recognized company in her sector, and she is in the process of preparing a report to buy the stock. Currently the report is being fact-checked and is nonpublic information, but it will be sent to all clients following the fact-checking process. An important client calls and asks the analyst what she is currently researching. In this case, if she answers honestly, it is a violation of Standard III-B, given that the firm has a fair and defined process in place for distributing the new buy recommendation. She would simply need to tell the client that a new research report is awaiting publication and will be distributed shortly, and that she will be happy to discuss it once the client receives it.
- No Time to Prepare a Report
- Another industry analyst has a buy rating on a specialty medical-devices company, and he is considered a leading Wall Street expert on the industry in general and this company in particular. His initial study was rigorously detailed, about 50 pages in length and the product of two months of preparation. Each month, his firm publishes a recommended list (where this stock has been listed for the past year), followed by company commentaries. A couple of days before the list is published, he learns that one of the major products in the pipeline awaiting FDA approval will be indefinitely delayed, prompting the analyst to question his fundamental case. He switches to a hold recommendation but concludes he doesn’t have enough time to prepare a report that conforms to his rigorous research standards, so he declines additional comment and requests that his summary be excluded from the publication. In a conference call with a mutual fund manager that is the largest owner of the stock, he indicates that he was no longer recommending it due to a change in fundamentals, but that he would need some time to put the report together. The fund manager immediately sells her entire position.
Is this action a violation? The analyst is in violation of Standard III-B, fair dealing. According to the Standard, he needed to recognize that his opinion counts as material information, and that if he made a change, he needed to include at least a summary outlining the reasons in the firm’s monthly publication. He could follow up later with the rigor he deems necessary. As for the mutual fund manager, she is in violation of Standard V-A, Reasonable Basis, as she is trading out of the stock without knowing the detailed reasons. To avoid a violation, she would need to wait for the report to be disseminated.
- Preparing for the Eventual Demand
- Take a case where a brokerage is about to publish a brand new buy recommendation. The head trader for this brokerage learns of the news and buys a large block of the shares on the open market one week prior to publication, anticipating that there will be great demand for shares of this company among the clients of the firm. The company to be recommended is a small-cap stock that is thinly traded, so there might be liquidity issues if the trader does not act. Following firm policy, the portfolio administrators will faithfully allocate shares pro rata and give everyone the exact same price. However, this case is a clear violation of Standard III-B. Moreover, it’s an example of the sort of tricks that show up on the CFA exam; there’s an indication in the example that pro rata allocation was used so that a test taker sees a fair allocation procedure being implemented, which might obscure the fact that the trade itself was unethical. In fact, the brokerage must adhere to strict policies on disseminating its new recommendation, and it would never bepermitted to trade ahead of a research report. Such a trade is not only a violation of the CFA Institute’s Standard; the fact that it happened when it happened is likely to capture the attention of the SEC.
- Allocation of IPO
- A portfolio manager occasionally will receive limited access to his firm’s IPO underwriting activities. The number of shares varies depending on the outside demand for the issue, but these IPO allocations are typically insignificant compared to the accounts under management. It’s never enough shares to make an across-the-board pro rata allocation worthwhile, as it would end up as an insignificant position in all portfolios. As a result, this manager simply disposes of these shares whenever she receives them by allocating them to her largest clients. Unfortunately, by allocating in this manner she is violating Standard III-B, as she systematically favors the largest portfolios (i.e. the smaller accounts never get a chance). Given that a pro rata procedure process is not always practical, the best way to comply with the Standard would be to select IPO participants at random from the entire client list and to establish a cycle where everyone must participate once before being chosen again.
On the exam, be prepared for questions looking at cases in which an IPO is oversubscribed. This means that more shares have been requested than the broker has available. If this situation comes up, know the term “pro rata”. This term is a Latin phrase meaning “in proportion”. With an oversubscribed IPO, a broker would allocate shares pro rata based on a fair allocation system. It’s also very important to remember that the CFA member is obligated to forego shares for personal use (or the use of immediate family) in order to uphold a standard to place client interests first.
- Notification via Email
- A manager and CFA charterholder wishes to treat his clients fairly and also comply with the Standards of Professional Conduct. He prepares a bulk email notification of a new buy recommendation being published by his full service brokerage firm. Two days following the email, he places a block trade for discretionary accounts and for those nondiscretionary accounts that notified him of interest. Does this process violate the fairness doctrine required by Standard III-B? While it would be nice to communicate fully with everyone via email, and be confident that everyone reads his or her email, the reality is that some people do not have email access. As a result, disseminating a recommendation in this manner discriminates against non-email clients and violates the Standard on fair dealing. To comply, the manager will first need to ‘snail mail’ the recommendation to the full client list.
How can you comply with III-B?
Any particular compliance program is going to be a function of the unique factors present in that firm, such as its size and the scope of the activities in which it is involved. However, all procedures are going to share the common doctrine of fairness and develop processes that avoid systematic discrimination of one group of clients in favor of another.
The Handbook makes numerous worthwhile suggestions for developing a compliance program that adheres to the intent of this Standard:
- Disseminate Nonpublic Information as Quickly as Possible - Violations result from the fact that an analyst is required to keep a new idea secret for such a period of time that leaks develop.
- For Lengthy and Detailed Reports, Offer a Flash Summary - No one can be expected to rewrite a 50-page report in two days. However, changing a recommendation creates material nonpublic information. It’s not necessary for such information to be held for weeks while the necessary labor is done to write up the report right. A brief flash summary that includes the essence and the conclusion, plus an indication that the laborious, detailed report is in progress, is sufficient to comply with the ethic of full disclosure.
- Guidelines for Pre-Dissemination Must Be Established - This is to insure that people who have access to this information are aware of the standards.
- Inform Everyone as Simultaneously as Possible - For example, a large brokerage can ensure that all branches receive the new research on the same day.
- Restrict Trading - Do not trade until all clients have a fair chance to receive the new recommendation. For example, place no trades for two to three business days following a mailing.
- Develop a Fair Process for Trade Allocation - Some common elements might include:
- All orders must be date and time-stamped.
- Have a process on a first in/first out basis, based on the time stamped.
- Block trades receive the same execution price and commission.
- Partially executed blocks should be allocated pro rata.
- For Hot IPO Issues, Obtain Indications of Interest in Advance - Allocation procedure should be systematic (e.g. pro rata, random draw) and not based on favoritism.
- Do Not Withhold Shares - Refrain from holding shares in hot issues for personal accounts, leaving out any interested clients, and make a bona fide effortto publicly distribute.
- Disclose - Discloseall trade allocation procedures to clients.
- Review Accounts Systematically - A supervisor or compliance officer can develop a process that indicates whether some accounts are being given preferential treatment - for example, whether trade executions in certain accounts appear to be better than average, or certain accounts seem to receive more shares in a hot IPO than what would be expected.
- Disclose the Presence of Tiers of Service - Many organizations offer both discretionary and nondiscretionary advisory service, but because of the differences in those accounts, they might find it necessary for practical reasons to take action in the discretionary accounts first, before they take the same action within the nondiscretionary accounts. Such procedure is not discriminatory since discretionary accounts are paying a premium; however, clients must be fully aware of this practice.
•Disseminate Nonpublic Information as Quickly as Possible - .
Violations result from the fact that an analyst is required to keep a new idea secret for such a period of time that leaks develop
•For Lengthy and Detailed Reports, Offer a Flash Summary -
No one can be expected to rewrite a 50-page report in two days. However, changing a recommendation creates material nonpublic information. It’s not necessary for such information to be held for weeks while the necessary labor is done to write up the report right. A brief flash summary that includes the essence and the conclusion, plus an indication that the laborious, detailed report is in progress, is sufficient to comply with the ethic of full disclosure.
•Guidelines for Pre-Dissemination Must Be Established -
This is to insure that people who have access to this information are aware of the standards.
•Inform Everyone as Simultaneously as Possible
- For example, a large brokerage can ensure that all branches receive the new research on the same day.
