CFA 2018 level 3 schweser practice exam CFA 2018 level 3 question bank CFA 2018 CFA 2018 r03 applications of code and standards IFT notes

Summary The two major points of this case are: • While the protagonist in this case, Mark Vernley, isn’t directly involved in the investment industry, he is however a charterholder and

Applications of Code and Standards

1 Introduction 2

2 The Consultant 2

3 Pearl Investment Management (A) 5

4 Pearl Investment Management (B) 6

5 Pearl Investment Management (C) 7

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1 Introduction

This reading provides several cases to demonstrate how the CFA Institute Code of Ethics and Standards

of Professional Conduct should be applied, how to recognize violations and what corrective actions are

required to correct the violations

Exhibit 1 provides a framework to help with the ethical decision-making process

A framework for ethical decision making

• Identify the Important Facts and Issues

• Identify Others to Whom Duties are Owed

• Identify Potential Conflicts of Interest

• Identify Applicable Ethical Principles

• Consider Seeking Additional Guidance

• Consider Circumstances That Could Be Affecting Judgment

• Consider Alternative Actions

• Act and Review the Outcome

We will look at the application of this framework in the first case ‘The Consultant’ In the remaining

three cases we will focus on what violations occurred and what corrective action is required and what

polices need to be adopted to prevent future violations

2 The Consultant

Case facts

Mark Vernley’s background:

This case focuses on Mark Vernley Mark started his career several years ago as a petroleum engineer

and then he moved on to become a securities analyst focused on the energy sector Eventually Mark

started his own consulting firm called ‘Energetics’ While he was working as a securities analyst, Mark

also became a CFA charterholder

During his career Mark has built a substantial portfolio and most of his portfolio is in energy stocks This

makes sense because he understands this sector well His largest holding is in ‘Deepwell Explorations’,

where he worked for several years, he got options and those options were ultimately exercised

The consulting contract:

Mark and his team at Energetics have been hired by ‘Highridge Oil Pipeline’ to address a significant

issue The issue is that Highridge Oil Pipeline has a very difficult relationship with its customers There

are contentious arguments about what the correct price should be Mark and his team have suggested a

profit sharing solution that would work well for both Highridge and its customers

However, Plains Pipeline Systems which is a competitor of Highridge Systems claims that the plan

presented by Mark and his team is flawed, because Mart has a conflict of interest According to Plains

Pipeline, Mark has personal holdings in several companies which will benefit from Mark’s proposed

plan This issue has been presented to the regulator and the regulator has decided that there is no

evidence of wrongdoing So the ruling is in Mark's favor However Mark is still concerned about this

perceived conflict of interest and how this will impact his firm in the future

Evaluation of the case using the ethical decision making framework

Identify the Important Facts and Issues: The main point in this case is that Mark Vernley who is a

professional engineer and a CFA charterholder, has been charged with having a conflict of interest This

conflict of interest has prevented him and his company from offering objective advice to his clients, and

from presenting objective advice to the regulatory agency Even though this claim has been rejected,

Mark is still concerned about the perceived conflict of interest, and the potential impact on him and his

company

Identify Others to Whom Duties are owed: Mark Vernley clearly has a duty to Highridge, because

Highridge is the client Mark might also have a duty to the regulatory agency Mark does not have any

duty to Plains, which is a competitor of Highridge

Identify Potential Conflicts of Interest: Mark may have a conflict of interest with Highridge because: 1)

Mark has personal holdings in oil companies serviced by Highridge and 2) the plan presented by Mark

benefits those companies There could be a conflict of interest between Highridge and the regulator

There is also a conflict of interest between Highridge and competitors such as Plains

Identify Applicable Ethical Principles: From the Code and Standards we know that Mark is expected to

place client’s interest above his own Other ethical principles addressed in the Code and Standard are

more specific to the investment profession and global capital markets

Consider Seeking Additional Guidance: Clearly this is what Mark should do He is thinking about what is

the appropriate course of action

Consider Circumstances That Could Be Affecting Judgment: Mark’s holdings in oil companies might be

impacting his judgment

Consider Alternative Actions: Broadly speaking Mark could use the following two strategies or a

combination of these two strategies: (1) avoidance and (2) disclosure

(1) Avoidance

• Extreme case: An extreme form of avoidance would be to avoid investments in energy-related

companies This is considered extreme, because it is not very realistic We can’t just expect

someone to completely liquidate and sell all his interests in the sector While it will clearly

avoid any conflict of interest this is a somewhat extreme step

• Blind trust: In this option, Mark’s energy-related investments will move into what is called a

blind trust This trust will be managed by another fund manager, and the fund manager then

reports to Mark on a quarterly basis as required by the law The advantage here is that Mark

only finds out about the investment decisions after they have been made and this helps reduce

the conflict of interest However, the slight issue with this arrangement is that as long as there

are energy securities is in the trust there is still a possible perceived conflict of interest So Mark

would have to disclose these holdings or disclose the fact that he has a blind trust which

possibly includes energy companies to clients and prospective clients

• Mutual fund: A third possible solution under the avoidance category, is to invest in a mutual

fund which specializes in energy-related issues This mutual fund will be managed by a third

party, and as with any mutual fund, the exposure to any one stock would be relatively low So

from the avoidance perspective this appears to be the most logical route to take

(2) Disclosure

• Let's say, however, that Mark really wants to keep his stake in the various companies Then the

next best thing to do is to disclose as much as possible In fact at a very minimum Mark must

disclose to clients of Energetics, the existence and nature of any conflict of interest surrounding

a consulting assignment Vernley must ensure that such disclosures are prominent and are

delivered in plain language and communicate the relevant information effectively

A Plan for Energetics

The case leads us to believe that Mark himself is ethical and has high integrity Also, the people who

work in his organization belong to professional organizations and act ethically However, the

shortcoming is that there is no formal compliance program in the company So the perception of

potential conflicts of interest can harm the company Therefore, the plan of action for Energetics should

be to create some sort of a formal compliance system The main areas of focus are:

Culture and leadership: Ethical values start at the top and the organization needs to develop a culture of

honesty, integrity and high ethics To some extent that is already happening because of the informal

communications that Mark has with his team However, Mark should develop this further

Communication: A formal system of ethics needs to be developed Perhaps the CFA Institute Code and

Standards could be used Relevant parts of the engineer’s code of conduct can also be used Then the

code for Energetics needs to be formalized and communicated with the team

Education: The communication can happen through formal education There should be training sessions

and workshops where all employees of energetics properly understand the compliance procedures

Procedures for compliance

Companies should have written documents that spell out their compliance procedures A company can

document several measures that are aids in managing its compliance program effectively, including:

• annual certification by employees that they have maintained familiarity with the standards and

agree to abide by them;

• for the purpose of detecting conflicts of interest or insider trading, required reporting by

employees, at least quarterly, of all securities transactions for their own personal accounts or

those in which they have a beneficial interest;

• disclosing to management the existence and nature of any possible or actual compensation

from sources other than the employer;

• certification by employees that they have not entered into an independent business activity in

competition with their employer The purpose of this measure is to protect the firm from, for

example, misappropriation of trade secrets, misuse of confidential information, solicitation of

customers prior to cessation of employment, or self-dealing; and

• employee memberships in organizations that maintain standards required for the practice of

their professions—for example, continued affiliation by Energetics’ engineers with the

association of professional engineers

Summary

The two major points of this case are:

• While the protagonist in this case, Mark Vernley, isn’t directly involved in the investment

industry, he is however a charterholder and he does projects that involve valuation, so the CFA

Institute Code and Standards apply to him Also he is a supervisor and he therefore needs to

ensure that those working under him also follow the Codes and Standards and act ethically

• The other point is that clearly Mark Vernley is a man of high integrity, and yet that alone is not

enough Those who follow the Code and Standards also need to formally put in place practices

and procedures to ensure that that a high level of ethics is maintained To whatever extent

possible even a perception of misconduct should be avoided

3 Pearl Investment Management (A)

Case Facts

The protagonist in this case is Peter Sherman who obtained an MBA and then started work as an

account manager with Pearl investment management Pearl investment management is an investment

consulting firm, specializing in equity portfolio management for institutions as well as high net worth

individuals Sherman begins work in the firm’s back office handling administrative tasks for his assigned

accounts, settling transactions, balancing the accounts to bank records and ensuring that client

guidelines are followed

Pearl is a large firm with a number of different departments Pearl also has its own research staff Many

of the portfolio managers and analysts at Pearl are CFA charterholders and as a result the firm has

adopted the CFA Institute Code and Standards as part of its policy for internal compliance

All employees must read and sign a statement when they join the firm that they have read Pearl’s

policies They must repeat this procedure at the beginning of each subsequent year as a reminder of

their compliance responsibilities

On Sherman’s first day on the job, his department head gives him the policy manual as part of his

orientation program, requests that he read it during the day before signing the compliance statement,

and advises him that the firm’s compliance department will answer any questions he may have

Sherman reads through the manual quickly and then signs the company’s personnel policies statement

After a few months Sherman settles in his role He sees the close access to investment information and

strategies as an opportunity to invest his savings with greater insight He reads books about investment,

as well as the company summaries prepared by the firm’s research department He shares this

knowledge with family and friends He decides to purchase few stocks that are Pearl’s largest equity

positions

Violations

Sherman read the manual quickly and then signed the company’s policy statement Two violations

occurred here The supervisor simply instructed Sherman to read the manual but he did not help ensure

that Sherman understood the document So this is a violation of ‘Responsibilities of Supervisors’ Also,

by skimming the document, Sherman probably did not understand the laws So this is a violation of

‘Knowledge of the Law’

By using the firm’s proprietary information and client information for his personal investments, Sherman

has violated ‘Duties to Employer’ as well as ‘Loyalty, Prudence and Care’ The fact that Sherman’s

supervisor is not aware of this situation and has not put in polices in place to prevent this, means that

‘Responsibilities of Supervisors’ is also violated If Sherman trades securities before trading for clients

then, ‘Priority of Transactions’ and ‘Fair Dealing’ are also violated

Recommended Policy Statement for the firm

To prevent potential violations, the policies that the firm can put in place are:

Knowledge of the Law: “Supervisors shall exercise reasonable supervision over those employees subject

to their control and shall monitor all actions of employees in their charge to determine that the firm’s

policies are being followed and to prevent any violation by such persons of applicable statutes,

regulations, or provisions of the Code of Ethics and Standards of Professional Conduct Supervisors shall

review the contents of the compliance manual with all direct charges when they are hired and answer

any questions or concerns the employees may have.”

Responsibilities of Supervisors: “Employees shall submit personal trades to the compliance department

for approval in advance of any personal investment action in order to clear the trades against client

transactions In the event that an employee wishes to transact in securities that are being traded for

clients, the employee will be allowed to trade only after all client transactions have been processed, the

compliance department has approved the request, and a 24-hour moratorium has expired On a

monthly basis, all personal trades (as shown on brokerage statements of account) must be submitted to

the compliance department for review.”

Managing confidential client information: “Proprietary information shall not be communicated outside

the firm ‘Proprietary’ includes information about client portfolios, investment strategies, and portfolio

actions and recommendations Furthermore, employees should be mindful of the special relationship

with Pearl’s clients and ensure that the highest degree of care is preserved when investment action is

taken on their behalf.”

4 Pearl Investment Management (B)

Case facts

One year later, Sherman prepares for and passes the Level I examination He is assigned the task of

clearing up problems related to allocation of an IPO among certain large client accounts Since this is

rush project, Sherman does not have time to consult the client’s investment policy statements He

assumes that portfolio managers would have seen them and directed only those trades which were

suitable to the clients He also believes that trading desk would have acted as a second review for client

investment guidelines Sherman makes some adjustments, reverses a few transactions and reallocates

shares at the IPO price He believes that in doing this, all clients have been treated fairly

Violations

Since allocation of trades is taking place only amongst large clients, it implies that smaller clients have

been overlooked So there is a potential violation of ‘Fair Dealing’

By not going through the client’s investment policy statements, Sherman has violated ‘Loyalty, Prudence

and Care’ He cannot assume that someone else (portfolio manager or trading desk) will take care of

this

Since the misallocation was the firm’s error, the firm should bear all losses and they should not be

passed on to clients Simply reversing the transactions is not enough If client money was used during

this period of time, then appropriate interest should also be credited to the client accounts

A point to note is that since Sherman has now started participating in the CFA Program, he is should

follow the Codes and Standards In Case A he was bound only as an employee of the firm Now he is

bound both as an employee of the firm and as a candidate in the CFA Program

Recommended Policy Statement for the Firm

To prevent violations, the policies that the firm can adopt are:

Dealing with clients: “Employees owe a duty of loyalty, prudence, and care to clients, and in all

instances, the interests of clients shall come first Action contrary to this policy is expressly prohibited

Allocation of trades shall be on a fair and equitable basis for all portfolios with similar investment

objectives and constraints.”

Bearing the financial risk of errors in client accounts: “The firm will take all steps necessary to ensure the

integrity of its client accounts When errors do occur, the clients’ portfolios will be restored with no loss

of value to the client To the extent that such losses occur, Pearl will indemnify its clients and make the

appropriate restitution.”

5 Pearl Investment Management (C)

Case facts

Sherman has now passed Level II and gets a position in the research department He reports to Champa

who has a lot of experience in the international markets Champa wants the firm to start research

efforts in international equities and in particular wants to start with developing countries He tells his

team to come up with research recommendations in emerging equities quickly

Sherman starts his research on Central and South American companies Champa refers Sherman to one

of his old banking contacts, Gonzalo Alves, who is well connected in Mexico and on the board of

directors of a number of important Mexican corporations Alves tells Sherman about the strategic

direction of each company, some potential acquisition targets, and how changes in the Mexican

economy will affect each company directly Sherman now feels comfortable using this information in

writing his research reports

Champa asks Sherman to produce a research report on several Mexican telecommunications and cable

companies He gives Sherman a very tight deadline Due to shortage of time, Sherman plans to prepare

reports quickly by using brokerage firm reports and his conversation with Alves and other sources He

does not cite these sources because he believes they are well known

A junior analyst asks Sherman about why his report did not include specific details about the Mexican

economy or the historical exchange rate fluctuations between the Mexican peso and the US dollar She

questions the comparability of Mexican securities with US securities and notes that the diversification

available from investing in global markets is achieved only if the correlation between the specific non-US

market and the US market is low Sherman and Champa respond that “our clients are sophisticated

investors; they know these things already.”

Violations:

In his discussion with Alves, Sherman gained access to material non-public information If he uses this

information in his research, this will be a clear violation of ‘Material Non-Public Information’

By not giving sufficient time to conduct research, ‘Diligence and Reasonable Basis’ is violated

By not citing all sources used, ‘Misrepresentation’ is violated

By not communicating important details about the exchange rates and correlations, ‘Communication

with Clients and Potential Clients’ is violated Also the approach used by Sherman to prepare his

research report needs to be disclosed The report should clearly distinguish between facts and opinions

If the company is positing itself as an expert in emerging markets that is clearly a misrepresentation The

appropriate action would be to disclose to clients that they are beginning to research and invest in

emerging market companies

Recommended Policy Statement for the firm

To prevent violations, the policies that the firm can adopt are:

Proper care and independent judgement: “Analysts shall use proper care and exercise independent

professional judgment in the preparation of research reports to ensure that reports are thorough,

accurate, and include all relevant factors.”

Use of insider information: “Analysts and portfolio managers are prohibited from using material

non-public information in any form in making investment recommendations or taking investment action Any

employees who have come into possession of material non-public information (or who believe they

have) shall contact the compliance department or compliance officer for guidance If the information is

determined to be material non-public information, the employee must refrain from acting on it and

should take steps to disseminate the information publicly.”

Using Research of others: “Analysts are prohibited from using the work of others without reference and

are prohibited from plagiarizing the work of others by not giving due credit to the author, whether or

not the author is employed by the firm.”

Reasonable basis for a research opinion: “All relevant factors, including the basic characteristics involved

in the investment, are to be included in a research report, with a corresponding discussion of the

potential risks involved.”

Relevant factors and fact versus opinion in research reports: “Employees shall make only those

statements, either verbally or in writing, about the firm and its qualifications that represent the firm

properly and with the integrity it has tried to achieve The firm shall not solicit clients, new or existing,

for a new investment style without full disclosure of the firm’s qualifications and expectations for both

risk and potential return Performance results for a new investment style will be in compliance with

Standard III(D)—Performance Presentation, as discussed in the CFA Institute Standards of Practice

Handbook.”