CFA Level 3 - Ethical and Standards Session 2 - Reading 4

CFA Level 3 – Ethical and Standards, Session 2 – Reading 4

(Notes, Practice Questions, Sample Questions)

1. All of the following would be effective components of a formal compliance system EXCEPT:

A) the investor’s objectives and constraints should be maintained and reviewed periodically to reflect any changes in the client’s circumstances.(Explanation — According to Standard III(A) – Loyalty, Prudence, and Care, “members shall use particular care in determining applicable fiduciary duty.” Under ERISA, a fiduciary has the duty to diversify the plan’s investments in order to protect it from the risk of substantial loss.

The firm must follow pension plan instructions and restrictions unless they conflict with ERISA or other applicable laws and regulations. Having concentrated portfolios does not constitute effective diversification. An appropriate policy statement would be: “ The firm will follow pension plan documents only to the extent that they are consistent with applicable laws and regulations. The firm will diversify plan assets to minimize the risk of loss.

”)

B)as a fiduciary under ERISA, the firm will strictly follow pension plan instructions and restrictions, which may include concentrating portfolios in a few securities or industries.

C)the firm prohibits analysts and portfolio managers from using material nonpublic information in making investment recommendations or taking investment action

2. Klaus Gerber, CFA, is a regular contributor to the Internet site WizeGuy. This past week Gerber has been incorrectly quoted as recommending that investors buy shares in Bradford, Inc. He is unaware that this message has been placed on the site as the quote was placed as a prank by an unknown source.

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This is the third time this has happened over the past month and each time the stock being mentioned moved in price according to the buy or sell recommendation.Fritz Fox, CFA, maintains and updates the WizeGuy site and has learned how to determine if the quotes being attributed to Gerber are actually valid. Several days later, he observes an investment recommendation, posted on the site, to buy Gresham, Inc. The investment recommendation is purported to be from Gerber, but Fox actually knows it to be bogus. He immediately sells 1,000 Gresham short and e-mails Gerber to inform him of the bogus recommendation. Gerber immediately issues a rebuttal, and Gresham falls by 14%. Fox’s action is:

A)a violation of the Standard concerning use of material nonpublic information. (Explanation — Even though the information is false, this fact is known only to Fox and is thus nonpublic information. Since such recommendations have in the past had a significant affect on the price of the security in question, the information is clearly material. Fox is in violation of Standard II(A) Material Nonpublic Information)

B)a violation of the Standard concerning fiduciary duties.

C)not in violation of the Code and Standards

3. Mark Vernley, CFA, is the owner of an engineering consulting firm called Energetics, Inc., which consults on asset and project valuations in energy-related industries. The firm currently employs 10 professional engineers. Vernley wants to develop and implement adequate compliance procedures for his firm to avoid potential conflicts of interest. Which of the following statements is least likely to represent an appropriate compliance procedure dealing with conflicts of interest. Employees at Energetics are required to:

A)deal fairly and objectively with all clients and prospects when providing consultation on asset and project valuations. (Explanation — Standard III(B) – Fair Dealing requires members to deal fairly and objectively with all clients and prospects. Of the statements presented, dealing fairly and objectively with clients is least likely to be a compliance procedure dealing with conflicts of interests. The other statements involve compliance procedures dealing with conflicts of interests)

B)certify annually that they have maintained familiarity with the compliance procedures and agree to abide by them.

C)report, in writing, on a quarterly basis all securities transactions for their personal portfolios and those in which they have a beneficial interest

4. All of the following would be effective components of a formal compliance system EXCEPT:

A)all managers must obtain client information to prepare an investment policy statement for each client.

B)investment managers may use soft dollars for the payment of research services, travel, meals, and lodging. (Explanation — The Securities and Exchange Act of 1934, Section 28(e), contains a “safe harbor” provisions allowing investment managers to use soft dollars for research purposes only. Thus, soft dollars represent dollars paid for investment research and cannot be used for items such as travel, meals, and lodging)

C)the firm has a duty to vote all proxy statements in the best interests of plan participants and beneficiaries

5. Marc Feldman, a CFA Institute member, is treasurer of zippy.com, and is also Larry Goldman’s boss. Feldman is informed of “accounting irregularities of an unknown origin” during an audit by zippy’s external accounting firm. There are 3 individuals, including Goldman, handling the accounting function. According to the Code and Standards, Feldman should do all of the following EXCEPT:

A)terminate the accounting staff immediately and issue a press release describing the situation. (Explanation — Standard IV(C) spells out responsibilities of supervisors in the Standards of Practice Handbook. Since the investigation is ongoing, it would clearly be inappropriate to terminate the entire accounting staff until their complicity in the wrongdoing is established)

B)conduct a thorough investigation of activities.

C)leave the staff in their current jobs and increase supervision while the external auditors complete their work

6. Williams and Fudd is a major London-based brokerage and investment banking firm. Heritage Group, a money management firm, is the first, second, or third largest holder of each of the securities listed on Williams & Fudd’s “PrimeShare #10” equity security list.

Williams and Fudd faxed a preliminary copy of a research update bulletin on Yeshe Corp to Heritage at 7 a.m. on Wednesday the 23rd. The report, a change from a “hold” to a “strong buy”, was released to the public at 11 a.m. Between 11:00 and 11:20 a.m., Heritage executed a series of trades with which they bought 1.25 percent of Yeshe’s publicly traded stock. This action is:

A)a violation of the Standard concerning priority of transactions, but would conform if Heritage had waited at least 48 hours after the report was issued.

B)a violation of the Standard concerning fair dealing. (Explanation — This action, by giving preferential treatment in the dissemination of investment recommendations and material changes to a favored client, is a violation of Standard III(B) concerning fair dealing)

C)in accordance with the CFA Institute Code and Standards

7. Pamela Gee is a portfolio manager. She is planning to establish her own money management firm. She has already informed her employer, Branford, Inc., about her plans. In her remaining time at Branford, she can:

A)start the registration of her new company. (Explanation — The only action that will not breach Standard IV(A) Loyalty to Employer, is to start the registration of her new company)

B)solicit Branford colleagues but not Branford clients.

C)inform her current clients about her resignation and let them know how to reach her, in case any problems arise in the future

8. Noah Johnson, CFA, is a broker with a money management company, Factor, Inc. In a conversation with Tom Williams, Johnson describes the activities of Factor and discusses the characteristics of portfolio construction. Which of the following statements would NOT, on its face, be considered a misrepresentation?

A)The portfolio securities were carefully selected by Factor to minimize Williams’ risk. (Explanation — Standard I(C), Misrepresentation, prohibits CFA charterholders from misrepresenting characteristics of the portfolio or the services that the company can provide. The only statement that can be accepted as plausible is that the securities were selected to minimize the risk)

B)Factor guarantees the portfolio will achieve its goal return.

C)If Williams is not satisfied with the current target return, Johnson can always improve it by increasing his T-bills share

9. Which of the following is NOT considered plagiarism under CFA Institute Standards?

A) Using factual information from a recognized financial information agency without acknowledging the source of the information. (Explanation — Factual information that is already public and is obtained from a recognized information agency can be used without acknowledgment and is not considered plagiarism. All other options are considered plagiarism)

B) Improving an existing report and using it inside the company under a new title without acknowledging the source of the original report.

C) Adjusting an already published model and announcing it as a new model without acknowledging the source of the original model

10. Milton Baker, CFA, prepares a research report on the dynamics of a stock price. In his study, he uses a considerable number of information sources, both outside sources and his company’s own research papers, prepared for both internal and public use. The report will first be distributed at the monthly department meeting and then later will be published on the company’s Internet site. He thinks that he may have neglected to mention some of his sources in his reference list but decides that he needs to be concerned about full disclosure of his sources only for the public version of the report, so he will wait to revise his work until after the monthly meeting but before it is published on the internet site. Which Standards does Baker NOT comply with?

A) Standard I(C), Misrepresentation, I(B), Independence and Objectivity, and I(A), Knowledge of the Law.

B) Standard I(C), Misrepresentation, only.

C) Standard I(C), Misrepresentation, and I(A), Knowledge of the Law (Explanation — Baker has some doubts but does not initiate any action presuming they only apply to the publicly disclosed report. The lack of action is a violation of Standard I(A), Knowledge of the Law. He also violates Standard I(C), Misrepresentation, by failing to properly disclose the sources of his information, where necessary)

11. Amanda Brad, CFA, is a security analyst at UpTrend, Inc. During a routine visit to a beauty salon, she learns that a major cosmetic company, Lorean, is expected to present a revolutionary formula for facial cream. Brad buys Lorean stock for her portfolio and prepares a special report on the company. Brad also makes a call to Hillary Lang, another security analyst at UpTrend, to inform her about the news. Lang starts trading on her clients’ portfolios. Brad’s report states that given the on-going research activity at Lorean within the last months, investors can expect some successful new products and a sharp increase in the price of the stock. Lang’s actions:

A) violate the Standard of Objectivity and Independence.

B) violate the Standard of Fair Dealing. (Explanation — Lang violates Standard III(B), Fair Dealing, which imposes the requirement to start trading on the clients’ portfolios only after the information is disseminated to all clients)

C) violate the Standards because she trades on inside information

12. Marc Feldman, CFA, is manager of corporate investor relations for a high-tech startup, zippy.com, in Boise, Idaho. Feldman learns that Larry Smith, controller, is altering the accounting records. Feldman advises some of his personal friends to sell short zippy.com. This action:

A) constitutes a violation of the Standard concerning prohibition against misrepresentation.

B) constitutes the use of material nonpublic information and is a violation of the Code and Standards. (Explanation — The information is apparently nonpublic, and is clearly material since the valuation of securities in the market place is predicated upon financial data and other relevant information. Trading or inducing others to trade is a clear violation of Standard II(A))

C) constitutes professional misconduct but not the use of nonpublic information and is a violation of the Code and Standards

13. Perley & Sons is an investment advisor company that just signed a contract with full discretionary power for the management of assets for Bright Future, a charitable fund. Without consultation, portfolio manager Martin Brown, CFA, decides to trade the funds’ assets through a brokerage firm that provides, as an additional benefit, research reports for companies in the microchip industry. These companies represent the main investment interest for most of the Perley & Sons clients. The Bright Future portfolio does not hold any equities in the microchip industry, and, because of its risk profile, is unlikely to ever do so. Which of the following activities represents a possible breach with the CFA Institute standards?

A)Exercising a selection principle that does not comply with the idea of best trade price and execution. (Explanation — The problem refers to the fiduciary duties of the analyst and brokerage contracts involving soft money. Trades placed with a broker that provides the firm with research are implicitly paying for the research. In a competitive marketplace, it is probable that the trades could have been as effectively placed with a broker that was able to provide research that would apply to the holdings of Bright Future. According to Standard III(A) Loyalty, Prudence, and Care, it is permissible to direct trades of the client portfolio through a broker who provides research that does not directly benefit the client portfolio, but the client should be informed about the situation)

B)Accepting research reports from the brokerage firm that do not benefit client portfolios.

C)Lack of action in consulting with the client before choosing the brokerage firm

14. In order to comply with the CFA Institute Standards, an analyst should:

A)use only his own research in making investment recommendations, because anything else would violate Standard I(B), Independence and Objectivity.

B)use only his company’s research when making investment recommendations and use outside research for reports and analysis on stocks.

C)use outside research only after verifying its accuracy (Explanation — Standard I(B), Independence and Objectivity: the analyst is allowed to use outside research only after an insightful review. There are no restrictions regarding the exclusive use of outside information or in-house information)

15. Using as his universe all companies in the steel industry, Reynold Anderson analyses the performance of stock prices for the industry. He succeeds in developing a regression model with excellent statistical control measures. The extrapolation from the model shows low risk variance of the securities in this industry. Without the inclusion of non-steel stocks in the portfolio, Anderson concludes that, based on these results, every portfolio can use the steel industry securities to diversify and lower its risk. He persuades his clients to change their current portfolios. Anderson states that, as the model’s results show, some particular industries, such as car manufacturers, have underpriced stocks, and investors should take advantage of it. Anderson has violated the Standards because he:

A)does not consider the suitability of the investment.

B)is not clear enough about the model results.

C)does not distinguish the opinion, based on his model, from the fact (Explanation — While any of the answers can be shown to violate CFA Institute Standards, this cannot be determined conclusively from the information given. However, the scenario clearly indicates that Anderson does not distinguish between opinion and fact in communicating to his clients. Therefore, he violates the Standards on this basis)

16. Mary Hiller, CFA, is a senior analyst at a mutual fund. She is also a member of the Board of the Directors of her daughter’s Skating Club. She is often asked for advice about the management of the club budget and about possible short-term investments, but she is not paid for this advice. She does not undertake any research to answer these questions, providing information based only on the general practices of the mutual fund at that moment. The only benefit she receives is a free monthly membership for her daughter that would usually cost $182. What should she do before making any recommendations, in order to comply with the CFA Institute requirements?

A)Obtain prior permission from her employer. (Explanation — According to Standard IV(A) Loyalty to Employer, it is the employee’s duty to inform the employer about any type of outside consulting service, including duration and any compensation. Only after receiving permission from her employer, can she proceed)

B)Inform her current clients about her outside consulting.

C)Consult only on her free time and do not accept any benefit greater than $100

17. Benson & Company (BC) is a brokerage and investment advisory firm that specializes in venture capital. BC researches start-up companies for their clients and helps qualified startups raise money. BC often acts as a conduit for investors and firms needing start-up capital. Over the past ten years, of the venture capital opportunities for which BC has raised money, the proportion of successes is significantly higher than the average for BC’s peers. This fact appears in writing in most of BC’s promotional material. When approaching investors with venture capital deals, BC representatives have been instructed to say “we offer opportunities with a higher expected return than stocks without the extra risk.”Ron Thornton, CFA, has just been promoted to the role of supervisor of research, with a specific charge to reorganize his division. Thornton begins with a review of the files. He decides to throw out all files pertaining to companies that had applied to BC for financing, but had been refused by BC. He also decides to throw out files on those firms that have been researched, but were not being recommended by BC.

Thornton asks Sue Fosler, a level III CFA candidate, to look at Spanish Garden, which is a new concept family-restaurant chain that is seeking venture capital from BC. He gives her a coupon for a complementary meal that had been sent to BC by the owners of Spanish Garden. Fosler goes to a local branch of the restaurant for the meal. While she is there, she sees Fred Benson enjoying a meal at the restaurant. Fred Benson is one of the Benson and Company partners. Later, she asks him about the restaurant, and he says “I like the food.” He added jokingly that “the American public will benefit from the growth of Spanish Garden.” Fosler also learns that Fred Benson is on the board of directors of Spanish Garden and owns two-percent of the company. Fosler continues gathering data and, based on the data and her opinion regarding her dining experience at the restaurant, concludes that a “buy” recommendation is appropriate. After writing up her report, she gives it to Thornton who will be responsible for disseminating the report. The next day Fosler discovers that the Center for Disease Control (CDC) has ordered Spanish Garden to change some of its food handling procedures. She calls the CDC, and a CDC spokesman informs her that the restaurant could be closed down unless it complies with these requests immediately. Fosler calls the head quarters of Spanish Garden and is told “no comment” by a restaurant representative. Fosler relays this information to Thornton before he disseminates Fosler’s recommendation. He disseminates the recommendation without any changes. Upon learning this, Fosler made arrangements to speak with BC’s legal counsel. With regard to the written statement concerning the success of BC’s prior venture-capital investment offerings, and the verbal slogan concerning risk and return that BC’s representatives have been instructed to say to investors, which (if any) is a violation of the Code and Standards?

A)The written statement only.

B)Both statements are a violation.

C)The verbal statement only (Explanation — According to Standard I(C), Misrepresentation, the firm and its representatives cannot make oral or written statements that misrepresent the firm’s record or what it can expect to achieve. It is not reasonable to believe that BC is capable of repealing the laws of risk and return. Therefore the verbal statement is in violation of the Standard. On the other hand, assuming that its record of success is correct as indicated, then it can publish that fact. However, some caution is warranted here as well, and, despite what BC has accomplished, past performance is not necessarily an indicator of future results. This statement should accompany the performance data)

18. In preparing her report on Spanish Garden, Fosler violated the code and standards by:

A)accepting the meal coupon but not by eating at the restaurant before writing her report.

B)eating at the restaurant before writing her report but not by accepting the coupon.

C)no violation has occurred (Explanation — The gift is not a violation of Standard I(B), Independence and Objectivity. Token gifts are not a violation. Eating at the restaurant would be part of the research process and congruent with Standard V(A), Diligence and Reasonable Basis)

19. Of the two categories of files that Thornton has decided to throw away, for which will the discarding of the files be a violation of the Code and Standards?

A)Both categories of files.

B)The files on applicants for venture capital that were refused.

C)Neither category of files (Explanation — According to Standard V(C), Record Retention, a firm must keep adequate records supporting actions taken and recommendations made. The Code and Standards do not require records for actions not taken and recommendations not made)

20. Fred Benson’s comments concerning Spanish Garden would be considered:

A)material public information and Fosler would not be in violation of the Code and Standards by not including it in her report on Spanish Garden.

B)nonmaterial nonpublic information and Fosler would not be in violation of the Code and Standards by not including it in her report on Spanish Garden. (Explanation — Fred Benson saying he likes the food is merely a personal opinion, and such an opinion would not be unexpected, given his relationship with Spanish Garden. His second comment says nothing about the quality of the restaurant as an investment. No reasonable investor would take such comments as a reason to purchase the company. Under Standard V(B), Communication with Clients and Prospective Clients, “members shall use reasonable judgment regarding the inclusion or exclusion of relevant factors in research reports.” Clearly, the comment was just an opinion, and it should not be included in the report)

C)nonmaterial nonpublic information and Fosler would be in violation of the Code and Standards by not including it in her report on Spanish Garden

21. When issuing the report on Spanish Garden, Fosler must disclose:

A)neither Fred Benson’s ownership interest nor the directorship.

B)Fred Bensons’ ownership and the directorship. (Explanation — Both the ownership interest and the directorship must be disclosed to be in compliance with Standard VI(A), Disclosure of Conflicts. The disclosure of such information will allow those acting on the basis of the research to judge for themselves whether, and to what degree, such a conflict of interest may bias the opinion contained in the report)

C)Fred Benson’s directorship, but not the ownership

22. With respect to Fosler’s report on Spanish Garden, the CDC order, and the subsequent actions taken by Fosler and Thornton:

A)Thornton is in violation of the Code and Standards, but Fosler is not. (Explanation — Fosler composed the report using appropriate information and judgment. She told her supervisor about the CDC order. When Thornton disseminated the report without the new information, he was in violation of Standard V(B), Communication with Clients and Prospective Clients because he did not use reasonable judgment regarding the inclusion or exclusion of relevant factors in the research report. Fosler acted correctly by seeking BC’s legal counsel after the dissemination)

B)neither Fosler nor Thornton are in violation of the Code and Standards.

C)both Fosler and Thornton are in violation of the Code and Standards