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CFA2: Ethics

Code of Ethics

  1. Act with integrity, competence, diligence, respect, and in an ethical manner with the public, clients, prospective clients, employers, employees, colleagues in the investment profession, and other participants in the global capital markets.
  2. Place the integrity of the investment profession and the interests of clients above their own personal interests.
  3. Use reasonable care and exercise independent professional judgment when conducting investment analysis, making investment recommendations, taking investment actions, and engaging in other professional activities.
  4. Practice and encourage others to practice in a professional and ethical manner that will reflect credit on themselves and the profession.
  5. Promote the integrity of, and uphold the rules governing, capital markets.
  6. Maintain and improve their professional competence and strive to maintain and improve the competence of other investment professionals.

Standards of Professional Conduct

I. Professionalism

A) Knowledge of the Law

  • Members must understand and comply with laws, rules, regulations, and Code and Standards of any authority governing their activities. In the event of a conflict, follow the more strict law, rule, or regulation. Do not knowingly participate or assist in violations, and disassociate from any known violation.
  • Members must know the laws and regulations relating to their professional activities in all countries in which they conduct business. Members must comply with applicable laws and regulations relating to their professional activity. Do not violate Code or Standards even if the activity is otherwise legal. Always adhere to the most strict rules and requirements (law or CFA Institute Standards) that apply.
  • Members should disassociate, or separate themselves, from any ongoing client or employee activity that is illegal or unethical, even if it involves leaving an employer (an extreme case). While a member may confront the involved individual first, he must approach his supervisor or compliance department. Inaction with continued association may be construed as knowing participation.

B) Independence and Objectivity

  • Use reasonable care to exercise independence and objectivity in professional activities. Members and Candidates are not to offer, solicit, or accept any gift, benefit, compensation, or consideration that would compromise either their own or someone else’s independence and objectivity.
  • Do not let the investment process be influenced by any external sources. Modest gifts are permitted. Allocation of shares in oversubscribed IPOs to personal accounts is NOT permitted. Distinguish between gifts from clients and gifts from entities seeking influence to the detriment of the client. Gifts must be disclosed to the member’s employer in any case.
  • Do not be pressured by sell-side firms to issue favorable research on current or prospective investment-banking clients. It is appropriate to have analysts work with investment bankers in "road shows" only when the conflicts are adequately and effectively managed and disclosed. Be sure there are effective "firewalls" between research/ investment management and investment banking activities.
  • Analysts should not be pressured to issue favorable research by the companies they follow. Do not confine research to discussions with company management, but rather use a variety of sources, including suppliers, customers, and competitors.
  • Buy-side clients may try to pressure sell-side analysts. Portfolio managers may have large positions in a particular security, and a rating downgrade may have an effect on the portfolio performance. As a portfolio manager, there is a responsibility to respect and foster intellectual honesty of sell-side research.
  • Remember that this type of issuer-paid research is fraught with potential conflicts. Analysts’ compensation for preparing such research should be limited, and the preference is for a flat fee, without regard to conclusions or the report’s recommendations.

C) Misrepresentation

  • Do not misrepresent facts regarding investment analysis, recommendations, actions, or other professional activities.
  • Trust is a foundation in the investment profession. Do not make any misrepresentations or give false impressions. This includes oral and electronic communications. Misrepresentations include guaranteeing investment performance and plagiarism. Plagiarism encompasses using someone else’s work (reports, forecasts, charts, graphs, and spreadsheet models) without giving them credit.

D) Misconduct

  • Do not engage in any professional conduct which involves dishonesty, fraud, or deceit. Do not do anything that reflects poorly on one’s integrity, good reputation, trustworthiness, or professional competence.
  • CFA Institute discourages unethical behavior in all aspects of members’ and candidates’ lives. Do not abuse CFA Institute’s Professional Conduct Program by seeking enforcement of this Standard to settle personal, political, or other disputes that are not related to professional ethics.

II. Integrity of Capital Markets

A) Material Nonpublic Information

  • Members and Candidates in possession of nonpublic information that could affect an investment’s value must not act or induce someone else to act on the information.
  • Information is "material" if its disclosure would impact the price of a security or if reasonable investors would want the information before making an investment decision. Ambiguous information, as far as its likely effect on price, may not be considered material. Information is "non-public" until it has been made available to the marketplace. An analyst conference call is not public disclosure. Selectively disclosing information by corporations creates the potential for insider-trading violations.
  • Mosaic theory: There is no violation when a perceptive analyst reaches an investment conclusion about a corporate action or event through an analysis of public information together with items of non-material non-public information.

B) Market Manipulation

  • Do not engage in any practices intended to mislead market participants through distorted prices or artificially inflated trading volume.
  • This Standard applies to transactions that deceive the market by distorting the price-setting mechanism of financial instruments or by securing a controlling position to manipulate the price of a related derivative and/or the asset itself. Spreading false rumors is also prohibited.

III. Duties To Clients

A) Loyalty, Prudence, and Care

  • Members must always act for the benefit of clients and place clients’ interests before their employer’s or their own interests. Members must be loyal to clients, use reasonable care, exercise prudent judgment, and determine and comply with their applicable fiduciary duty to clients.
  • Client interests always come first.
    • Exercise the prudence, care, skill, and diligence under the circumstances that a person acting in a like capacity and familiar with such matters would use.
    • Manage pools of client assets in accordance with the terms of the governing documents, such as trust documents or investment management agreements.
    • Make investment decisions in the context of the total portfolio.
    • Vote proxies in an informed and responsible manner. Due to cost benefit considerations, it may not be necessary to vote all proxies.
    • Client brokerage, or "soft dollars" or "soft commissions" must be used to benefit the client.

B) Fair Dealing

  • Members must deal fairly and objectively with all clients and prospects when providing investment analysis, making investment recommendations, taking investment action, or in other professional activities.
  • Do not discriminate against any clients when disseminating recommendations or taking investment action. Fairly does not mean equally. In the normal course of business, there will be differences in the time emails, faxes, etc. are received by different clients. Different service levels are okay, but they must not negatively affect or disadvantage any clients. Disclose the different service levels to all clients and prospects, and make premium levels of service available to all who wish to pay for them.
  • Give all clients a fair opportunity to act upon every recommendation. Clients who are unaware of a change in a recommendation should be advised before the order is accepted.
  • Treat clients fairly in light of their investment objectives and circumstances. Treat both individual and institutional clients in a fair and impartial manner. Members and Candidates should not take advantage of their position in the industry to disadvantage clients.

C) Suitability

  • When in an advisory relationship with client or prospect, Members and Candidates must:
      • Make reasonable inquiry into clients’ investment experience, risk and return objectives, and constraints prior to making any recommendations or taking investment action. Reassess information and update regularly.
      • Be sure investments are suitable to a client’s financial situation and consistent with client objectives before making recommendation or taking investment action.
      • Make sure investments are suitable in the context of a client’s total portfolio.
    1. When managing a portfolio, investment recommendations and actions must be consistent with stated portfolio objectives and constraints.
  • In advisory relationships, be sure to gather client information at the beginning of the relationship, in the form of an investment policy statement (IPS). Consider client’s needs and circumstances and thus the risk tolerance. Consider whether or not the use of leverage is suitable for the client.
  • If a member is responsible for managing a fund to an index or other stated mandate, be sure investments are consistent with the stated mandate.

D) Performance Presentation

  • Presentations of investment performance information must be fair, accurate, and complete.
  • Members must avoid misstating performance or misleading clients/prospects about investment performance of themselves or their firms, should not misrepresent past performance or reasonably expected performance, and should not state or imply the ability to achieve a rate of return similar to that achieved in the past.

E) Preservation of Confidentiality.

  • All information about current and former clients and prospects must be kept confidential unless it pertains to illegal activities, disclosure is required by law, or the client or prospect gives permission for the information to be disclosed.
  • If illegal activities by a client are involved, members may have an obligation to report the activities to authorities. The confidentiality Standard extends to former clients as well.
  • The requirements of this Standard are not intended to prevent Members and Candidates from cooperating with a CFA Institute Professional Conduct Program (PCP) investigation.

IV. Duties to Employers

A) Loyalty

  • In matters related to their employment, Members and Candidates must act for the benefit of their employer and not deprive their employer of the advantage of their skills and abilities, divulge confidential information, or otherwise cause harm to their employer.
  • Members must not engage in any activities which would injure the firm, deprive it of profit, or deprive it of the advantage of employees’ skills and abilities. Always place client interests above interests of employer. There is no requirement that the employee put employer interests ahead of family and other personal obligations; it is expected that employers and employees will discuss such matters and balance these obligations with work obligations.
  • Independent PracticeIndependent practice for compensation is allowed if a notification is provided to the employer fully describing all aspects of the services, including compensation, duration, and the nature of the activities and if the employer consents to all terms of the proposed independent practice before it begins.
  • Leaving an EmployerMembers must continue to act in their employer’s best interests until resignation is effective. Activities which may constitute a violation include:
  • Misappropriation of trade secrets.
  • Misuse of confidential information.
  • Soliciting employer’s clients prior to leaving.
  • Self-dealing.
  • Misappropriation of client lists.
Once an employee has left a firm, simple knowledge of names and existence of former clients is generally not confidential. Also there is no prohibition on the use of experience or knowledge gained while with a former employer.
  • Whistleblowing There may be isolated cases where a duty to one’s employer may be violated in order to protect clients or the integrity of the market, and not for personal gain.
  • Nature of Employment The applicability of this Standard is based on the nature of the employment—employee versus independent contractor. If Members and Candidates are independent contractors, they still have a duty to abide by the terms of the agreement.

B) Additional Compensation Arrangements

  • No gifts, benefits, compensation, or consideration are to be accepted which may create a conflict of interest with the employer’s interest unless written consent is received from all parties.
  • Compensation includes direct and indirect compensation from a client and other benefits received from third parties. Written consent from a member’s employer includes email communication.

C) Responsibilities of Supervisors.

  • All Members and Candidates must make reasonable efforts to detect and prevent violations of laws, rules, regulations, and the Code and Standards by any person under their supervision or authority.
  • Members must take steps to prevent employees from violating laws, rules, regulations, or the Code and Standards and make reasonable efforts to detect violations.
  • Understand that an adequate compliance system must meet industry standards, regulatory requirements, and the requirements of the Code and Standards. Members with supervisory responsibilities have an obligation to bring an inadequate compliance system to the attention of firm’s management and recommend corrective action. While investigating a possible breach of compliance procedures, it is appropriate to limit the suspected employee’s activities.

V. Investment Analysis, Recommendations, and Actions

A) Diligence and Reasonable Basis

  1. When analyzing investments, making recommendations, and taking investment actions use diligence, independence, and thoroughness.
  2. Investment analysis, recommendations, and actions should have a reasonable and adequate basis, supported by research and investigation.
  • The application of this Standard depends on the investment philosophy adhered to, members’ and candidates’ roles in the investment decision-making process, and the resources and support provided by employers. These factors dictate the degree of diligence, thoroughness of research, and the proper level of investigation required.
  • Using Secondary or Third-Party Research See that the research is sound. Examples of criteria to use to evaluate:
    • Review assumptions used.
    • How rigorous was the analysis?
    • How timely is the research?
    • Evaluate objectivity and independence of the recommendations.
  • Group Research and Decision Making Even if a member does not agree with the independent and objective view of the group, he does not necessarily have to decline to be identified with the report, as long as there is a reasonable and adequate basis.

B) Communication with Clients and Prospective Clients

  1. Disclose to clients and prospects basic format and general principles of investment processes used to analyze and select securities and construct portfolios. Promptly disclose any process changes.
  2. Use reasonable judgment in identifying relevant factors important to investment analyses, recommendations, or actions, and include factors when communicating with clients and prospects.
  3. Investment analyses and recommendations should clearly differentiate facts from opinions.
  • Proper communication with clients is critical to provide quality financial services. Members must distinguish between opinions and facts and always include the basic characteristics of the security being analyzed in a research report.
  • Members must illustrate to clients and prospects the investment decision-making process utilized. The suitability of each investment is important in the context of the entire portfolio.
  • All means of communication are included here, not just research reports.

C) Record Retention.

  • Maintain all records supporting analysis, recommendations, actions, and all other investment-related communications with clients and prospects.
  • Members must maintain research records that support the reasons for the analyst’s conclusions and any investment actions taken. Such records are the property of the firm. If no other regulatory standards are in place, CFA Institute recommends at least a seven-year holding period.

VI. Conflicts of Interest

A) Disclosure of Conflicts

  • Members and Candidates must make full and fair disclosure of all matters which may impair their independence or objectivity or interfere with their duties to employer, clients and prospects. Disclosures must be prominent, in plain language, and effectively communicate the information.
  • Members must fully disclose to clients, prospects, and their employers all actual and potential conflicts of interest in order to protect investors and employers. These disclosures must be clearly stated.
  • The requirement that all potential areas of conflict be disclosed allows clients and prospects to judge motives and potential biases for themselves. Disclosure of broker/dealer market-making activities would be included here. Board service is another area of potential conflict.
  • The most common conflict which requires disclosure is actual ownership of stock in companies that the member recommends or that clients hold.
  • Members must give the employer enough information to judge the impact of the conflict. Take reasonable steps to avoid conflicts, and report them promptly if they occur.

B) Priority of Transactions

  • Investment transactions for clients and employers must have priority over those in which a Member or Candidate is the beneficial owner.
  • Client transactions take priority over personal transactions and over transactions made on behalf of the member’s firm. Personal transactions include situations where the member is a "beneficial owner." Personal transactions may be undertaken only after clients and the member’s employer have had an adequate opportunity to act on a recommendation. *Note that family-member accounts that are client accounts should be treated just like any client account; they should not be disadvantaged.

C) Referral Fees.

  • Members and Candidates must disclose to their employers, clients, and prospects any compensation consideration or benefit received by, or paid to, others for recommendations of products and services.
  • Members must inform employers, clients, and prospects of any benefit received for referrals of customers and clients, allowing them to evaluate the full cost of the service as well as any potential impartiality. All types of consideration must be disclosed.

VII. Responsibilities as a CFA Institute member or CFA Candidate

A) Conduct as Members and Candidates in the CFA Program

  • Members and Candidates must not engage in any conduct that compromises the reputation or integrity of CFA Institute or the CFA designation or the integrity, validity, or security of the CFA exams.
  • This Standard applies to conduct which includes:
    • Cheating on the CFA exam or any exam.
    • Not following rules and policies of the CFA program.
    • Giving confidential information on the CFA program to Candidates or the public.
    • Improperly using the designation to further personal and professional goals.
    • Misrepresenting information on the Professional Conduct Statement (PCS) or the CFA Institute Professional Development Program.
  • Members and candidates are not precluded from expressing their opinions regarding the exam program or CFA Institute.

B) Reference to CFA Institute, the CFA designation, and the CFA Program

  • Members and Candidates must not misrepresent or exaggerate the meaning or implications of membership in CFA Institute, holding the CFA designation, or candidacy in the program.
  • Members must not make promotional promises or guarantees tied to the CFA designation. Do not:
    • Over-promise individual competence.
    • Over-promise investment results in the future (i.e., higher performance, less risk, etc.).
  • CFA Institute Membership Members must satisfy these requirements to maintain membership:
    • Sign PCS annually.
    • Pay CFA Institute membership dues annually.
    • If they fail to do this, they are no longer active members.
  • Using the CFA Designation
    • Do not misrepresent or exaggerate the meaning of the designation.
  • Referencing Candidacy in the CFA Program
    • There is no partial designation. It is acceptable to state that a Candidate successfully completed the program in three years, if in fact they did, but claiming superior ability because of this is not permitted.

  • Proper Usage of the CFA MarksThe Chartered Financial Analyst and CFA marks must always be used either after a charterholder’s name or as adjectives, but not as nouns, in written and oral communications.

Soft Dollar Standards

Research and other benefits provided to the client or the client’s investment manager by the broker for directing the trade to the broker

  • Principles
    • Brokerage is the property of the client.
    • Investment managers have a duty to obtain best execution, minimize transactions costs, and use client brokerage to benefit clients.
  • Intended to ensure:
    • Complete disclosure of the investment manager’s use of soft dollars and client brokerage.
    • Consistent presentation of data so all parties can clearly understand the brokerage practices.
    • Uniform disclosure and record keeping so the client clearly understands how the investment manager is using the client brokerage.
    • Consistently high ethical standards in the industry.

I. General

  • Soft dollar practices must benefit the client and must place the clients’ interests above the investment manager’s interests.
  • Allocation of client brokerage should not be based on the amount of client referrals the manager receives from a broker.
  • Regarding mutual funds, the investment manager’s client is the fund. The fund’s board sets policies regarding broker selection.

II. Relationships With Clients

  • Required: Disclose to the client that the manager may participate in soft dollar arrangements involving the client’s account prior to participating in such arrangements.


  • It is permissible to use client brokerage from agency trades to obtain research which may not directly benefit the client. Over time, however, the client should receive a benefit from the research.
  • As long as no fiduciary regulations apply, it is permissible to use client brokerage obtained from principal trades to benefit other client accounts, as long as this is disclosed to the client and prior consent is received.

III. Selection of Brokers

  • Proper broker selection is a key area where the investment manager can add value to the client. Failure to obtain best execution will hurt performance.


  • Consider capabilities when selecting brokers.


  • When evaluating best execution, consider the broker’s financial responsibility, responsiveness, rate or spread involved, and range of services provided.

IV. Evaluation of Research

To be able to use client brokerage to pay for research, these criteria must be followed:
  • Research must meet the definition. Research is defined as services and products provided by a broker whose primary use directly assists the investment manager in the investment decision making process, and not in the management of the firm.
  • Research must benefit the client.
  • The basis must be documented.
  • In the case of principal trades not subject to other fiduciary regulations, the research may benefit other client accounts, as long as disclosure is made to the client and prior permission is received.
  • If the criteria regarding client brokerage associated with principal trades is not met, the investment manager must pay for the research.
  • In the case of mixed-use research, make a reasonable allocation of the cost of the research based on its expected usage. *Only portions that are used by the investment manager in the investment decision making process can be paid with client brokerage. Mixed-use research allocation must be re-evaluated annually.

V. Client-Directed Brokerage

Brokerage is an asset of the client, so this practice does not violate the investment manager’s duty.


  • Do not use brokerage from another client to pay for products and services purchased under any client-directed brokerage agreement.


  • The investment manager should disclose the duty to continue to seek best execution.
  • Disclose to the client that the arrangement may adversely affect the manager’s ability to obtain best execution and receive adequate research for the client.
  • The investment manager should structure the arrangements so that they do not require the commitment of a certain portion of client brokerage to a single broker. The arrangement should ensure that commissions are negotiated and that there is an emphasis on best execution.

VI. Disclosure 

  • Investment managers must disclose in plain language their soft dollar policies. Principal trades must be addressed.
  • Investment managers must disclose the types of research received through proprietary or third-party research, the extent of its use, and whether an affiliated broker is involved.
  • To claim compliance with Soft Dollar Standards, the client must receive a statement that soft dollar practices conform to these Standards, and the statement must be provided at least annually.
  • Investment managers must disclose in writing that more information concerning soft dollar arrangements is available on request.
  • Additional information provided upon request may include a description of what the firm obtained through its soft dollar arrangements, the brokers who provided services, and total commissions generated for the client’s account.


  • As requested by the client, provide a description of the product or service obtained through client brokerage generated by the client’s account.
  • Provide the total amount of brokerage paid from all accounts over which the investment manager has discretion.

VII. Record Keeping

The investment manager must maintain records that:
  • Meet legal and regulatory requirements.
  • Are needed to supply timely information to clients consistent with the disclosure requirements.
  • Document any arrangements that obligate the investment manager to generate a specific amount of brokerage.
  • Document arrangements with clients regarding soft dollar or client-directed brokerage.
  • Document any broker arrangements.
  • Document the basis for allocations when using client brokerage for mixed-use services and products.
  • Show how services and products obtained via soft dollars assist the investment manager in the investment decision-making process.
  • Show compliance with the CFA Institute Soft Dollar Standards, and identify the personnel responsible.
  • Include copies of client disclosures and authorizations.

  • Three-level analysis to assist the investment manager in the determination of whether a product or service is "research."
  1. Level 1 – Define the Product/Service: Define it in detail, including multiple components. For example, a computer workstation may be classified as a qualifying product, but the electricity to run the equipment would not.
  2. Level 2 – Determine Usage: Determine the primary use of the product or service. For example, does the Bloomberg service received directly assist in the investment decision-making process, or is it there just to provide an "overall benefit to the firm"?
  3. Level 3 – Mixed-Use Analysis: This step only must be completed if the product or service is classified as "research" based on the Level 1 and Level 2 analysis above. This Level 3 analysis is the investment manager’s allocation of the portion of the product or service which directly assists in the investment decision-making process. For example, if the Bloomberg service is used 50% of the time to "determine market and industry trends as part of the investment manager’s investment decision-making process," then half of the expense can be paid from client brokerage.

Research Objectivity Standards


  • Prepare research, make recommendations, take investment actions, develop policies, procedures, and disclosures that put client interests before employees’ and the firm’s interests.
  • Facilitate full, fair, meaningful, and specific disclosures to clients and prospects of possible and actual conflicts of interest of the firm and its employees.
  • Promote the use of effective policies and procedures that minimize possible conflicts that may adversely affect independence and objectivity of research.
  • Support self-regulation by adhering to specific, measurable standards to promote objective and independent research.
  • Provide a work environment conducive to ethical behavior and adherence to the Code and Standards.

Recommended Compliance Procedures

  1. Research Objectivity Policy
    • Identify and describe covered employees—those conducting and writing research and making recommendations, including anyone who would benefit from his ability to influence the recommendations.
    • Specify whether covered employees are subject to a code of ethics and standards of professional conduct. Fully disclose any conflicts of interest.
    • Any policy should clearly identify the factors on which research analysts’ compensation is based.
    • Policy should also include terms regarding how research reports may be purchased.
  2. Public Appearances
    • Be sure that the audience can make informed judgments and that they consider the investment in the context of their entire portfolio.
    • Covered employees making public appearances should always be prepared to disclose all conflicts.
    • Firms should require these employees to disclose any investment banking relationships or whether the analyst has participated in marketing activities for the subject company.
    • Any supporting research reports should be provided at a reasonable cost.
  3. Reasonable and Adequate Basis
    • Firms must provide guidance on what constitutes reasonable and adequate basis for a specific recommendation.
    • Offer to provide supporting data to clients, and disclose the current market price of the security.
  4. Investment Banking
    • Firms must prohibit any communication between research and investment banking or corporate finance prior to the publication of a research report.
    • Investment banking/corporate finance personnel may review reports only to verify factual information or to identify possible conflicts.
    • Firms should have quiet periods for IPOs and secondary offerings of sufficient length to ensure that research reports and recommendations are not based on inside information obtained by the analyst through investment banking/corporate finance sources.
    • It is recommended that analysts not be allowed to participate in marketing "road shows."
  5. Research Analyst Compensation
    • Compensation systems should be based on measurable criteria consistently applied to all research analysts.
    • Ideally there should be no link between analyst compensation and investment banking and corporate finance activities, but firms should disclose to what extent analyst compensation depends upon investment banking revenues.
  6. Relationships With Subject Companies
    • Firms should have policies and procedures governing analysts’ relationship with subject companies, specifically relating to material gifts, company-sponsored trips, etc.
    • There should be efforts made to check facts contained in the research report before publication.
    • The compliance and legal departments should receive a report draft before it is shared with the subject company. Any subsequent changes should be carefully documented.
  7. Personal Investments and Trading
    • Always place interests of clients ahead of personal and firm interests.
    • Obtain approval from the compliance and legal departments in advance of trading on any securities of subject companies in the industries assigned to the analyst.
    • Firms should have procedures in place to prevent employees from trading ahead of investing client trades. Restricted periods should be in place at least 30 calendar days before and 5 calendar days after recommendations are made via research reports.
    • It may be acceptable for an analyst to sell contrary to their recommendation in the case of extreme financial hardship.
    • Firms should require covered employees to provide the compliance and legal departments with a complete list of personal holdings, including securities in which they have a beneficial interest.
  8. Timeliness of Research Reports and Recommendations
    • Firms should require regular updates to research and recommendations. Quarterly updates are preferred.
    • If coverage of a company is discontinued, the analyst should issue a "final" research report.
  9. Compliance and Enforcement
    • Firms should distribute to clients a list of activities which are violations and include disciplinary sanctions for such violations.
  10. Disclosure
    • Disclosures should be complete, prominent, and easy to understand.
    • Investment banking/corporate finance relationships should be disclosed.
    • All conflicts of interest must be disclosed, including whether the firm makes a market in the subject company’s security, whether it has managed a recent IPO or secondary offering, and whether any ownership position or covered employee’s family is affiliated in any way with the subject company. Any material gifts from the subject company should also be disclosed.
    • Disclose any statistical or quantitative basis for recommendations and ratings.
    • Disclose valuation methods used to determine specific price targets and include any risk factors.
  11. Rating System
    • Firms should avoid one-dimensional rating systems since they do not give investors enough information to make informed decisions.
    • Rating systems should include the recommendation and rating categories, time horizon categories, and risk categories.
    • Absolute (buy, hold, sell, etc.) or relative (market outperform, underperform, etc.) recommendation categories are permitted.
    • A complete description of the firm’s rating system should be provided to clients upon request.

Case Studies

The Glenarm Company

  • Loyalty Members and Candidates must always act for benefit of the employer. By taking confidential information, and soliciting clients and prospects to benefit Glenarm, Sherman has harmed his old employer, Pearl, and is in violation of his duty of loyalty. Sherman must act in the "old" employer’s best interest while still employed there.
    • Sherman should not solicit Pearl’s clients or prospects until he leaves Pearl’s employment.
    • Sherman should not have taken Pearl property.
  • Compensation arrangement It is acceptable for Sherman to contact prospects that Pearl decided not to pursue, because of a particular size or investment objective, while he is still employed at Pearl.
    • Sherman should disclose his consulting arrangements to Glenarm.
  • Disclosure of conflicts Unless the employer consents, departing employees may not misappropriate property. All of the items Sherman took are the property of Pearl, and there is a violation.
    • Sherman must disclose all details about outside compensation to Glenarm and obtain written permission from Glenarm in advance of entering into any such arrangements.

Preston Partners

  • SuitabilitySmithson should have considered clients’ individual risk tolerances, needs, circumstances, and goals; he should have also better matched clients with investments. Utah BioChemical is too volatile for many clients’ accounts.
    • Be sure that Smithson’s clients have written investment objectives and policy statements.
    • For accounts which contain unsuitable investments, the shares should be sold, and Preston Partners should reimburse any loss.
  • Fair DealingThe firm had no clear procedures for allocating block trades to client accounts. Large accounts were favored, disadvantaging smaller accounts.
    • Detailed guidelines covering block trades must be prepared, emphasizing fairness to clients, timely executions, and accuracy.
  • Responsibilities of SupervisorsThe senior management at Preston Partners should have made reasonable efforts to identify and prevent violations of applicable laws, rules, and regulations. A compliance program should have been in place. Supervisors and managers have the responsibility of training, distributing a policies and procedures manual, and providing refresher courses.
    • Preston must have proper procedures established that would have prevented violations such as those that occurred.
    • A compliance officer should be designated.

Super Selection

  • Responsibilities of Supervisors The presumption is that Cuff is the "supervisor" and thus must comply with this standard. Cuff has the responsibility to take steps to prevent violations, and as compliance officer she should see that the firm’s compliance procedures are adhered to by employees. Any violations must be addressed.
    • Cuff must take prompt action to correct violations by reporting the violations to senior management.
    • Cuff is a compliance officer and must monitor Trader’s personal trades and impose sanctions when necessary.
    • If the senior management does not back up Cuff, other options include disclosing the incident to the Board, to the regulators, and even resigning from the firm.
  • Disclosure of Conflicts Trader failed to disclose ownership of AMD stock options and also the compensation she received as a director of AMD.
    • As a supervisor, Cuff must take action by limiting behavior and imposing sanctions.
  • Diligence and Reasonable Basis Trader determined AMD was not a suitable security for her clients. Trader was pressured by James and reversed positions; thus the AMD stock was purchased.
    • Trader should have conducted due diligence and thorough research before making an investment decision for clients’ accounts. Any change in opinion must have a reasonable basis. Trader must also inform clients of any AMD conflicts such as directorship and stock options.
    • The compliance officer, Cuff, should review investment actions taken for clients at least annually.
  • Loyalty, Prudence and Care The fiduciary duty to clients was violated. Remember that client interests always come first.
    • Trader should have taken any investment action for the sole benefit of her clients. Cuff must completely investigate Trader’s activities to determine other fiduciary breaches. Following any fiduciary breaches, wrongdoers must have their activities limited.
  • Suitability AMD stock was purchased for clients without considering client needs and circumstances.
    • Trader should have considered clients’ needs and circumstances instead of taking actions that benefited her personally.
    • The compliance officer should establish at least an annual review to compare suitability of investment actions with investment policy statements.
  • Priority of Transactions Trader violated this Standard by trading personally prior to client trades.
    • By not reporting trades and brokerage accounts, Trader failed to follow her firm’s procedures. The compliance officer needs to fully investigate Trader’s transactions and recommend proper sanctions.

Trade Allocation: Fair Dealing and Disclosure

The allocation of client trades on an ad hoc basis lends itself to two fundamental fairness problems — that the allocation of trades may be based on compensation arrangements or client relationships.

  • Compensation arrangements In addition to violating Standard III(B) – Duties to Clients: Fair Dealing, this is a clear violation of Standard III(A) – Duties to Clients: Loyalty, Prudence, and Care since this has the effect of increasing fees paid to the investment adviser at the expense of asset-based fee accounts.
  • Client relationships In addition to violating the fair dealing standard, this is a clear violation of Standard III(A) – Duties to Clients: Loyalty, Prudence, and Care, which states that members owe a duty of loyalty to clients and requires them to put clients’ interests above their own. Conflicts of interest should be avoided. Giving certain clients special access to attractive IPOs with the intent to receive future investment banking business or more fees creates a conflict and breaches the duty to clients.
  • Appropriate actions to be taken:
    • Get advanced indication of client interest regarding any new issues.
    • Distribute new issues by client, not by portfolio manager.
    • Have in place a fair and objective method for trade allocation, such as pro rata or a similar system.
    • Be fair to clients regarding both execution of trades and price.
    • Execute orders in a timely and efficient manner.
    • Keep records and periodically review them to ensure that all clients are being treated equitably.

Disclosure of investment objectives and basic policies

  • In the case of pooled client funds such as mutual funds, it is particularly important that the portfolio manager’s recommendations and investment actions be consistent with the stated objectives and constraints of the fund (typically described in the fund’s prospectus). These processes are the key elements upon which the determination of appropriateness and suitability may be determined. A material deviation from these processes, in the absence of approval from clients, constitutes a violation of CFA Institute Standard III(C) – Duties to Clients: Suitability.
  • CFA standards
    • Determine the client’s financial situation, investment objectives, and level of investing expertise.
    • Adequately disclose the basic security selection and portfolio construction processes.
    • Conduct regular internal checks for compliance with these processes.
    • Stick to the stated investment strategy if managing to a specific mandate or strategy.
    • Notify investors and potential investors of any potential change in the security selection and portfolio construction processes and secure documentation of authorization for proposed changes.

New Prudent Investor Rule

  1. Diversification is expected of portfolio managers as a method of reducing risk.
  2. Trustees must base an investment’s appropriateness on its risk/return profile: how it contributes to the overall risk of the portfolio.
  3. Excessive trading (churning) as well as excessive fees and other transactions costs that are not warranted by the portfolio risk/return objectives should be avoided.
  4. Current income for the trust must be balanced against the need for growth.
  5. Trustees are allowed to delegate investment authority. In fact, this is a duty if the trustee does not have the required level of expertise.

Key changes to the traditional prudent investor rules

  1. Use of total return. The new Rule measures reasonable portfolio return as total return (income plus capital growth). It also emphasizes that the trustee’s duty is to not only preserve the purchasing power of the trust but in certain cases to realize principal growth in excess of inflation.
  2. Risk management. Under the new Rule the trustee has the obligation to assess the risk and return objectives of the trust beneficiaries and manage the trust in a prudent manner consistent with those objectives, rather than to avoid all risk.
  3. Evaluation in a portfolio context. While the new Rule calls for the avoidance of undue speculation and risk, it also encourages trustees to view risk in a portfolio context. For example, stock options are risky when held in isolation but can actually reduce portfolio risk when held as part of a properly structured portfolio. Protective put options are an example of this type of strategy.
  4. Security restrictions. No securities are "off-limits" because of their riskiness when held in isolation. For example, under the old Rule options were not allowed, but under the new Rule they are, as long as the manager takes the portfolio perspective to analyzing risk.
  5. Delegation of duty. The old Rule did not permit trustees to delegate investment authority. In fact, investing in mutual funds or even index funds was deemed improper. The new Rule goes so far as to say that it may be the duty of a trustee (this is stronger language than just authority) to delegate, just as a prudent investor would.

Fiduciary standards for trustee

  • Care means the trustees must do their homework by gathering pertinent information to use in their investment decisions. This could include seeking advice.
  • Skill means that if the trustee does not have the relevant investment knowledge, he or she has a duty to seek out such advice.
  • Caution must be used to balance the need for current income with the need to guard against inflation. In addition, a total return approach to money management should be employed. Principal growth (not just maintaining purchasing power) could indeed be a goal in certain circumstances.
  • Loyalty requires the trustee to avoid conflicts of interest by always acting exclusively in the best interest of beneficiaries.
  • Impartiality requires that the trustee act "in a fair and reasonable manner" when handling the conflicting interests of beneficiaries.

Key factors for asset investment and management

  • Economic conditions.
  • Effects of inflation and deflation.
  • Impact of investment decisions on the beneficiary’s tax liability.
  • How each individual investment contributes to the risk and return of the overall portfolio.
  • Expected total return from capital appreciation and income.
  • Other resources of the beneficiary.
  • The beneficiary’s liquidity, income, and capital preservation requirements.
  • Whether any assets have a special relationship to the requirements of the beneficiary or the trust.