CFA Level 3 - Ethical and Standards Session 2 - Reading 5

CFA Level 3 – Ethical and Standards, Session 2 – Reading 5

(Notes, Practice Questions, Sample Questions)

1. 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. Knowing the data is incorrect, Feldman releases Smith’s financial data to investors. This action:

A)constitutes a violation of the Standard concerning duty to employer.

B)constitutes a violation of his fundamental responsibilities under the Code and Standards.

C)constitutes a violation of Standard III(D) concerning performance presentation.

{Explanation} As a CFA Institute member, Feldman is bound, under Standard I(A), not to “knowingly participate or assist in any violation of such laws, rules, or regulations.” Since it should be clear that releasing bogus financial information is in contravention of laws, rules, and regulations, and since he knows that the data is purposely distorted, he must not release the data to the public. Doing so places him in violation of the Code and Standards

2. Kimberly Olson has recently become a CFA charterholder, and has just started a new job at Securities Online as a junior analyst. After preparing her first research report, Olson decides to consult with one of the senior analysts who make minor corrections to improve the content of the report. Olson makes changes to the report according to the senior analyst. Upon presentation of the report, Olson finds that statements made by the senior analyst contained incorrect information. Which of the following statements is CORRECT?

A)Olson did not need to check the additional comments.

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B)Olson should have checked the accuracy of the comments.

C)If Olson attributes those comments to the senior analyst, she cannot be held responsible for incorrect information

{Explanation} It is the responsibility of the analyst to confirm that information provided is accurate. The fact that the person editing the report is a senior analyst is irrelevant

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

A)seminars and conferences may be paid for using soft dollars only if the activity qualifies as research.

B)allocation of trades should first be to certain large client accounts with similar investment objectives and constraints and then to other suitable client accounts.

C)the firm should disclose any soft-dollar arrangements to clients

{Explanation} Standard III(B) – Fair Dealing requires that members treat all clients and prospects fairly when taking investment action. Giving priority to certain large accounts violates Standard III(B). An appropriate statement complying with the standard would be: “Allocation of trades shall be on a fair and equitable basis for all portfolios with similar investment objectives and constraints.”

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

A)managers and brokers should pay careful attention to risk tolerance in determining an appropriate investment policy statement for each client.

B)employees who receive material nonpublic information should communicate that information to the company’s compliance officer without discussing the information with co-workers.

C)members with supervisory responsibility can rely on the compliance manual and the compliance department to prevent and detect violations

{Explanation} Standard IV(C) – Responsibilities of Supervisors states that members with supervisory responsibility must make reasonable efforts to detect violations of laws, rules, regulations, and the Code and Standards. Once a compliance program is in place, supervisors should take such actions as reviewing the compliance material with employees personally, periodically updating procedures, reviewing the actions of employees to ensure compliance and identify violators, and take the necessary steps to enforce the procedures once a violation has occurred

5. Kenny Barrett, CFA, is working in the Australian office of American Investments Co. From an informal conversation, Barrett learns that the company’s most recent investment report was based on misappropriated information. No one at the Australian office expresses concern, however, because there has been no breach of Australian law. Barrett should:

A)do nothing because the branch is outside of U.S. jurisdiction.

B)seek advice from company counsel to determine appropriate action.

C)disassociate himself from the case with a written report to his supervisor

{Explanation} Kenny’s best choice is to seek the company counsel’s advice. If Kenny does nothing, he is breaching Standard I(A) Knowledge of the Law. Disassociation is not enough

6. While copying some of her research materials at work, Mary Jones comes across a few incomplete research notes written by one of her colleagues. As a result of reading the notes, and without further review, Jones immediately changes one of her stock recommendations from sell to buy. Which of the following CFA Institute Standards has Jones violated?

A)Standard V(A), Diligence and Reasonable Basis.

B)Standard III(A), Loyalty, Prudence, and Care.

C)Standard I(B), Independence and Objectivity

{Explanation} Jones has violated Standard V(A) by failing to exercise diligence and thoroughness

7. Futura Investments Co. decides to diversify its current portfolio with stocks from three companies in a new segment of the biotechnology industry. William Burgin, CFA, is an analyst at Futura and had previously bought shares of the same three companies for his own portfolio, well before his employer started researching them. Burgin has already disclosed the composition of his personal portfolio to Futura Investments, to be in compliance with the Code & the Standards. Which of the following actions should Burgin take?

A)Hire a full discretionary power or blind trust manager for his portfolio.

B)Diversify his personal portfolio so, in this way, these stocks will no longer represent a substantial portion of the portfolio.

C)Open an account that will be managed by someone else but will allow him to maintain his investment preferences

{Explanation} Burgin followed Standard VI(A) and informed his employer about the potential conflict of interest. He needs to follow the CFA Institute Standards in the best interest of his employer. To prevent any future problems with conflict of interest, his best option is to discontinue the active management of his personal portfolio and use a blind trust

8. 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.On Tuesday morning, August 22, Williams & Fudd released a research report recommending the purchase of Skelmerdale Industries to the public and to its clients. On Wednesday afternoon, August 23, Heritage Group bought 1.5 million shares of Skelmerdale. This action is:

A)a violation of the Standard concerning fair dealing.

B)a violation of the Standard concerning disclosure of conflicts.

C)in accordance with the CFA Institute Code and Standards

{Explanation} These actions are in accordance with both Standards III(B), Fair Dealing, and VI(B), Priority of Transactions. There is no violation

9. Marc Feldman, CFA, is manager of corporate investor relations for a high-tech startup, zippy.com, in Boise, Idaho. Feldman is well-known in the high tech community in Boise, and Dragon.com has asked if he will help them organize their investor relations function on a consulting basis. They offer him an all-expenses-paid two-week holiday for two on Australia’s Gold Coast in payment. Regarding this offer as a CFA Institute member Feldman is:

A)allowed to accept the offer only with written approval from zippy and from Dragon.

B)allowed to accept the offer only with written approval from zippy.

C)not allowed to accept such an offer since it effectively places him in competition with his employer

{Explanation} Under Standard IV(A) Loyalty to Employer, and Standard IV(B) Additional Compensation Arrangements, Feldman is allowed to accept the offer, but only with written permission from both zippy and Dragon

10. Adam Core, CFA, is a supervisor at a brokerage firm. Recently he discovered a complicated mechanism that brokers are using to obtain referrals of new clients in exchange for reduced commissions and other benefits to existing clients. The new clients are not aware of this practice. Core consults with compliance counsel and initiates an investigation. Which of the following actions violates CFA Institute Standards?

A)Core starts collecting information and records on the case, as well as interviewing all involved employees. He decides against immediate limitations on their work, to insure the work of the company will continue undisturbed.

B)Core makes sure that everybody in the company has a copy of the CFA Institute Code and Standards and a copy of the internal compliance system. He starts organizing special seminars on compliance with CFA Institute requirements.

C)Core’s first goal is to identify all violators

{Explanation} Given the possibility of a violation, Core must impose limitations on the normal activities of the suspected employees until the investigation is complete, as explained in Standard IV(C), Responsibilities of Supervisor

11. Calvin Moore, CFA, has been transferred from the brokerage house of the Browning Company to the portfolio management department. In portfolio management, Moore learns that clients are grouped into three divisions according to portfolio value, divided as follows:

Group 1 up to $10,000

Group 2 from $10,001 to $100,000

Group 3 more than $100,000

When recommendations are announced or trades are initiated, a particular sequence is followed in communicating to these groups. At the next monthly meeting, Moore suggests that the sequencing practice is a breach of CFA Institute Standards. One of Moore’s co-workers replies that the grouping approach helps the company in applying the Standard regarding portfolio recommendations. He further suggests that because Browning’s overall performance is more strongly affected by actions taken on the high value portfolios, that these portfolios should take priority over the small value portfolios. What should Moore do? Moore should:

A)do nothing since there is no breach with the Standards.

B)prepare a written report to the CEO describing the problem.

C)disassociate himself from the problem and seek legal advice

{Explanation} Taking a special approach in disseminating information in relation to initiating trades is a breach of Standard III(B), Fair Dealing. Given the fact that Moore works in the department and has already unsuccessfully tried to prevent the practice from continuing, he needs to disassociate himself and seek legal advice

12. While working on her report, Jean Paul, CFA, learns from her friend in the investment banking department that the company she is analyzing can expect a tender offer very soon. Concerning this conclusion, Paul can:

A)not trade on it because it is material nonpublic information.

B)trade on it, because it is public information.

C)trade on it, because she figured it out by herself

{Explanation} According to Standard II(A), Material Nonpublic Information, an analyst is prohibited from trading on information that is both material and nonpublic

13. Xenica Jones, CFA, is a portfolio manager and also follows the office equipment industry for Hynes-Gold and Co. In her June 30 discussions with the management of Zprint, she learns that an internal audit has detected irregularities in the firm’s Italian operations. This fact is disclosed on July 1 in both The Wall Street Journal and The Financial Times. On July 10 Zprint’s management announces that an investigation of the matter would not be completed until an external audit of all European operations was complete. This stock dropped 6 percent on the news release on the 10th. Jones places a series of sell transactions in Zprint stock on the 3rd. When she places the trades, she trades first for her clients and finishes with a trade selling short for her own account. These actions are:

A)in violation of the Standard concerning fair dealing.

B)not in violation of the Code and Standards.

C)in violation of the Standard concerning fiduciary duties since she is not allowed to sell short under the Standard

{Explanation} Her actions are not in violation of the Code and Standards. So long as her firm does not preclude her selling short, she is entitled to do so

14. 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. He decides that any ramifications from such activity is Smith’s problem and does not report this fact. According to the CFA Institute Code and Standards he should or is required to do all of the following EXCEPT:

A)determine legality, consulting counsel if necessary.

B)urge Smith to cease altering the accounting records.

C)report the activity to the FASB or other relevant regulatory body

{Explanation} As per the Standards of Practice Handbook “The Code and Standards do not require that members report legal violations to the appropriate governmental or regulatory organizations, but such disclosure may be prudent in certain circumstances.” In this instance, he would likely be better off discussing the matter with the firm’s legal counsel and Smith’s superiors

15. 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 Gresham, 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. This is the third time this has happened over the past month.

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%.

Gerhard Rau, CFA, is Fox’s supervisor at WizeGuy and has reviewed Fox’s trade in Gresham. Gerhard should:

A)initiate an investigation and place limits, as deemed necessary, on Fox’s behavior.

B)begin monitoring Fox’s activities surreptitiously over the upcoming months to see if the activity recurs.

C)confront Fox, warn him to cease, and require him to sign a statement that such activities will not happen again

{Explanation} Standard IV(C) spells out the responsibilities of supervisors. There are three main procedures for compliance once wrongdoing is suspected. Respond promptly, investigate thoroughly, and place limits upon the suspected wrongdoer. According to the Handbook, “Relying on an employee’s statements about the extent of the violation or assurances that wrongdoing will not recur is not enough. Reporting the misconduct up the chain of command and warning the employee to cease the activity are also not enough.”

16. Bonnie Tully, CFA, is a supervisor with Bonn Financial Advisors. Tully has been assigned by Bonn’s governing board to design procedures to minimize potential conflicts of interest that can arise during the course of the firm’s business. Specific areas of interest include when the firm’s representatives trade in the same securities as their clients, fair treatment of clients when disseminating recommendations, and ensuring that recommendations to clients are appropriate. All of Bonn’s representatives have a working knowledge of the Code and Standards, so the goal is for Tully to lay out the details for compliance.

Tully has generated a list of eight specific goals she feels are the most important.

1) Creating guidelines for representatives when they trade for their own account.

2)Defining material, nonpublic information.

3)Drafting a common investment policy statement that representatives must sign and apply to all clients.

4)Creating guidelines for the use of nonpublic information concerning a tender offer.

5)Developing an effective means for disclosure to clients information regarding relationships between Bonn and its representatives and corporations whose securities are being recommended by Bonn.

6)Drafting a written policy on soft dollars.

7)Creating guidelines on how to treat gifts and benefits from external sources to representatives.

8)Creating a restricted list of publicly traded companies.

The governing board of Bonn has asked Tully to examine and comment on two current situations. The first situation concerns Midland Investment Banking (MIB), a subsidiary of Bonn Financial. MIB has issued a prospectus for its open-end Midland Gold Fund. In the prospectus, the investment policy was disclosed as, “We will maintain an investment posture of 50 percent or more in gold stocks and/or bullion, depending upon market conditions.” This policy was adhered to until the price of gold fell by 20 percent, leaving the fund 40 percent invested in gold stocks and bullion. MIB Management has decided that since the allocation was effected by market conditions, no action—either to change the investment policy or to rebalance the portfolio—is required on their part.

The second situation concerns Toby Waller, CFA, who is an employee of Bonn Financial. Bonn is a major shareholder in Stepp Company. Stepp appears likely to be the target of a tender offer from Joshua Manufacturing. Stepp Shareholders have been asked to vote on whether to implement a “poison pill” that would effectively prevent any merger or buy-out. Prior to the vote, Waller receives a phone call from Joshua Manufacturing’s director of corporate communications, Danielle Jones. Jones offers to pay Waller’s airfare and hotel expenses so that he can attend a dinner meeting at Joshua’s headquarters in Philadelphia. At this meeting the firm’s CEO and General Counsel plan to explain their position on the offer and answer questions. In the meantime, Stepp’s management has announced that it will hold a half-day seminar for analysts and major shareholders, where its attorneys and industry experts will discuss management’s reasons for promoting the “poison pill.” Lunch will be provided to all attendees, and Waller’s office is close to Stepp’s headquarters so he can easily attend the meeting. Which of the following items from Tully’s list of eight goals will probably require the least amount of effort to complete?

A)#1.

B)#4.

C)#3

{Explanation} The guideline for compliance of #4, how to use inside information concerning a tender offer, would only require one sentence: You cannot use this information under any circumstances. The other items would require more detail concerning the specific actions that are and are not allowed

17. Which item on the list, if completed by Tully, would most likely be a violation of the Code and Standards?

A)#5.

B)#4.

C)#3

{Explanation} The drafting of a common investment statement for all clients would most likely be a violation of the Code and Standards. Each client should have an investment policy statement that reflects their own particular circumstances.

18. For goal #2, in defining “material nonpublic information,” the term “material” refers to information that is likely to significantly affect the market price of the issuing company’s securities or that is:

A)likely to preclude the financial analyst or analyst’s firm from rendering unbiased or objective advice.

B)acquired by the financial analyst from a special or confidential relationship with the issuing company.

C)likely to be considered important by reasonable investors in determining whether to trade a particular security

{Explanation} “Material” refers to information that is likely to significantly affect the market price of the issuing company’s securities or that would be considered useful information by reasonable investors in their determining whether to trade a particular security.

19. The following applies to goal #6. If some of the available brokers are offering soft dollars that are only of general benefit to Bonn, Tully should recommend that Bonn should choose the broker with which of the following characteristics:

A)good price and execution and low soft dollars.

B)good price and execution and good soft dollars.

C)best price and execution but no soft dollars

{Explanation} Standard III(A), Loyalty, Prudence, and Care, requires members to act for the benefit of their clients and to place client interests ahead of their own interests. Best price and execution is always in the client’s interest. Members who obtain best price and execution from a firm that allocates soft dollars may use that firm as long as the soft dollar research benefits clients and the practice is disclosed to clients

20. MIB Management has:

A)violated the Code and Standards by allowing the value of the Gold Fund to decline, but not by not rebalancing it.

B)not violated the Code and Standards by allowing the value of the Gold Fund to decline, nor by not rebalancing it.

C)not violated the Code and Standards by allowing the value of the Gold Fund to decline, but did violate the Code and Standards by not by rebalancing it.

{Explanation} As long as MIB was managing the Gold Fund in accordance to its prospectus, a decline in value does not mean that a violation has occurred. However, the prospectus does specify a certain allocation in gold. Standard V(B), Communication with Clients and Prospective Clients, requires members to disclose “general principles and investment processes” to clients and to “promptly disclose to clients and prospects any changes that might significantly affect those processes.” Under the Standard, Midland management is required either to:

rebalance the portfolio in a timely manner so as to maintain compliance with the investment policy, or

communicate an intended change in that policy well in advance of the actual change so as to afford investors time to act prior to the change in investment policy taking place.

Midland is in violation of the Standard by not rebalancing the portfolio

21. With respect to the invitations Waller has received from the management of Stepp and Joshua, to comply with the Code and Standards, Waller:

A)may attend the Joshua meeting and may not attend the Stepp meeting under any circumstances.

B)may attend the Stepp meeting and may not attend the Joshua meeting under any circumstances.

C)must not attend the Joshua Manufacturing meeting unless Waller pays his own expenses

{Explanation} Standard I(B), Independence and Objectivity, requires that “members shall use reasonable care and judgment to achieve and maintain independence and objectivity in making investment recommendations or taking investment action.” This Standard specifically addresses special cost arrangements, and precludes members from accepting payment for commercial transportation and hotel charges. Since the meeting is in Philadelphia, regular commercial air service is available, and Waller cannot accept payment for this expense. He is also prohibited from accepting payment for ordinary hotel charges. Hence, he may only attend the meeting with Joshua if his firm pays his expenses. Accepting the lunch provided by Stepp, because its value is token, would not be a violation of the Standard