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CFA Institute Code of Ethics and Standards of Professional Conduct – part III

DUTIES TO CLIENTS: STANDARD, GUIDANCE AND RECOMMENDED PROCEDURES FOR COMPLIANCE

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Standard III – Duties to Clients

 III A. Loyalty, Prudence, and Care  III B. Fair Dealing   III C. Suitability III D. Performance Presentation  III E. Preservation of Confidentiality 3

III A. Loyalty, Prudence, and Care

Members and Candidates have a duty of loyalty to their clients and must act with

reasonable care

and exercise

prudent

judgment. Members and Candidates must act for the benefit of their clients and place their

clients’ interests before their employer’s or

their own interests.

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III A. Guidance

 Identifying the Actual Investment Client  Developing the Client’s Portfolio  Soft Commission Policies / best price and best execution rule  Proxy Voting Policies 5

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III A. Recommended procedures for compliance

Regular Account Information Client Approval Firm Policies:          follow all applicable rules and laws establish the investment objectives of the client diversify deal fairly with all clients with respect to investment actions disclose conflicts of interest disclose compensation arrangements vote proxies in the best interest of the clients maintain confidentiality place client interests first 6

III B. Fair Dealing

Members and Candidates must deal fairly and objectively with all clients when providing investment analysis, making investment recommendations, taking investment action, or engaging in other professional activities.

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III B. Guidance

 Investment recommendations  Investment action 8

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III B. Recommended procedures for compliance

limit the number of people involved shorten the time frame between decision and dissemination publish guidelines for pre-dissemination behavior simultaneous dissemination maintain a list of clients and their holdings develop and document trade allocation procedures disclose trade allocation procedures establish systematic account review disclose levels of service 9

III C. Suitability (I)

1.

When Members and Candidates are in an advisory relationship with a client, they must: a.

Make a reasonable inquiry into a client or prospective client’s investment experience, risk and return objectives, and financial constraints prior to making any investment recommendation or taking investment action and must reassess and update this information regularly.

b. Determine that an investment is suitable to the client’s financial situation and consistent with the client’s written objectives, mandates, and constraints before making an investment recommendation or taking investment action.

c. Judge the suitability of investments in the context of the client’s total portfolio.

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III C. Suitability (II)

2. When Members and Candidates are responsible for managing a portfolio to a specific mandate, strategy, or style, they must only make investment recommendations or take investment actions that are consistent with the

stated objectives and constraints of

the portfolio.

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III C. Guidance

 Developing an investment policy  Understanding the client’s risk profile  Updating an investment policy  The need for diversification  Managing to an index or mandate 12

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III C. Recommended procedures for compliance

Investment policy statement:     client identification investor objectives investor constrains performance measurement benchmarks Regular updates Suitability test policies:    an analysis on the impact on the portfolio’s diversification a comparison of the investment risks with the clients assessed risk tolerance the fit of the investment with the required investment strategy 13

III D. Performance Presentation

When communicating investment performance information, Members and Candidates must make reasonable efforts to make sure that it is fair, accurate, and complete.

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III D. Guidance

Full disclosure of investment performance data to clients Avoiding:  misstating performance or misleading clients   misrepresenting past performance or reasonably expected performance stating the ability to achieve a rate of return similar to that achieved in the past For brief presentations – indicating that presentation was limited and making detailed information available on request 15

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III D. Recommended procedures for compliance

Applying GIPS standards or:      considering the knowledge and sophistication of the audience to whom a performance presentation is addressed, presenting the performance of the weighted composite of similar portfolios rather than using a single representative account, including terminated accounts as part of performance history, including disclosures that would fully explain the performance results being reported maintaining the data and records used to calculate the performance being presented.

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III E. Preservation of Confidentiality

Members and Candidates must keep

information about current, former, and

prospective clients confidential unless: 1.

The information concerns activities on the part of the client; 2.

Disclosure is required by law; or

illegal

3.

The

client

or prospective permits disclosure of the information.

client 17

III E. Guidance

 Status of client  Compliance with laws  Electronic information and security  Professional Conduct Investigations by CFA Institute 18

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III E. Recommended procedures for compliance

Questions to be asked before information disclosure:  In what context was the information disclosed? If disclosed in a discussion of work being performed for the client, is the information relevant to the work?

 Is the information background material that, if disclosed, will enable the member or candidate to improve service to the client?

Understanding and following the firms’ electronic information storage procedures Encouraging the firms to develop such procedures 19

DUTIES TO CLIENTS: APPLICATION EXAMPLES

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Example I

First Country Bank serves as trustee for the Miller Company’s pension plan. Miller is the target of a hostile takeover attempt by Newton, Inc. In attempting to ward off Newton, Miller’s managers persuade Julian Wiley, an investment manager at First Country Bank, to purchase Miller common stock in the open market for the employee pension plan. Miller’s officials indicate that such action would be favorably received and would probably result in other accounts being placed with the bank. Although Wiley believes the stock to be overvalued and would not ordinarily buy it, he purchases the stock to support Miller’s managers, to maintain the company’s good favor, and to realize additional new business. The heavy stock purchases cause Miller’s market price to rise to such a level that Newton retracts its takeover bid.

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Example II

JNI, a successful investment counseling firm, serves as investment manager for the pension plans of several large, regionally based companies. Its trading activities generate a significant amount of commission-related business. JNI uses the brokerage and research services of many firms, but most of its trading activity is handled through a large brokerage company, Thompson, Inc., principally because of close personal relationships between the executives of the two firms. Thompson’s commission structure is high in comparison with charges for similar brokerage services from other firms.

JNI considers Thompson’s research services and execution capabilities average. In exchange for JNI directing its brokerage to Thompson, Thompson absorbs a number of JNI overhead expenses, including those for rent.

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Example III

Charlotte Everett, a struggling independent investment advisor, serves as investment manager for the pension plans of several companies. One of her brokers, Scott Company, is close to consummating management agreements with prospective new clients whereby Everett would manage the new client accounts and trade the accounts exclusively through Scott. One of Everett’s existing clients, Crayton Corporation, has directed Everett to place securities transactions for Crayton’s account exclusively through Scott. But to induce Scott to exert efforts to land more new accounts for her, Everett also directs transactions to Scott from other clients without their knowledge.

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Example IV

Emilie Rome is a trust officer for Paget Trust Company. Rome’s supervisor is responsible for reviewing Rome’s trust account transactions and her monthly reports of personal stock transactions. Rome has been using Nathan Gray, a broker, almost exclusively for trust account brokerage transactions.

Where Gray makes a market in stocks, he has been giving Rome a lower price for personal purchases and a higher price for sales than he gives to Rome’s trust accounts and other investors.

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Example V

Lauren Parker, an analyst with Provo Advisors, covers South American equities for the firm. She likes to travel to the markets for which she is responsible and decides to go on a briefing trip to Chile, Argentina, and Brazil. The trip is sponsored by SouthAM, Inc., a research firm with a small broker/ dealer affiliate that uses the clearing facilities of a larger New York brokerage house. SouthAM specializes in arranging South American trips for analysts during which they can meet with central bank officials, government ministers, local economists, and senior executives of corporations.

SouthAM accepts commission dollars at a ratio of 2 to 1 against the hard dollar cost of the research fee for the trip. Parker is not sure that SouthAM’s execution is competitive but, without informing her supervisor, directs the trading desk at Provo to start giving commission business to SouthAM so she can take the trip. SouthAM has conveniently timed the briefing trip to coincide with the beginning of Carnival season, so Parker also decides to spend five days of vacation in Rio de Janeiro at the end of the trip. Parker used commission dollars to pay for the five days of hotel expenses.

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Example VI

Vida Knauss manages the portfolios of a number of high net-worth individuals. A major part of her investment management fee is based on trading commissions.

Knauss engages in extensive trading for each of her clients to ensure that she attains the minimum commission level set by her firm. While the securities purchased and sold for the clients are appropriate and fall within the acceptable asset classes for the clients, the amount of trading for each account exceeds what is necessary objectives.

to accomplish the client’s investment 26

Example VII

Bradley Ames, a well-known and respected analyst, follows the computer industry. In the course of his research, he finds that a small, relatively unknown company whose shares are traded over the counter has just signed significant contracts with some of the companies he follows. After a considerable amount of investigation, Ames decides to write a research report on the company and recommend purchase. While the report is being reviewed by the company for factual accuracy, Ames schedules a luncheon with several of his best clients to discuss the company. At the luncheon, he mentions the purchase recommendation scheduled to be sent early the following week to all the firm’s clients.

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Example VIII

Dominic Morris works for a small regional securities firm. His work consists of corporate finance activities and investing for institutional clients. Arena, Ltd., is planning to go public. The partners have secured rights to buy a arena football league franchise and are planning to use the funds from the issue to complete the purchase. Because arena football is the current rage, Morris believes he has a hot issue on his hands. He has quietly negotiated some options for himself for helping convince Arena to do the financing. When he seeks expressions of interest, the institutional buyers oversubscribe the issue. Morris, assuming that the institutions have the financial clout to drive the stock up, then fills all orders (including his own) and cuts back the institutional blocks.

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Example IX

Eleanor Preston, the chief investment officer of Porter Williams Investments (PWI), a medium-sized money management firm, has been trying to retain a difficult client, Colby Company.

Management at the disgruntled client, which accounts for almost half of PWI’s revenues, recently told Preston that if the performance of its account did not improve, it would find a new money manager. Shortly after this threat, Preston purchases mortgage-backed securities (MBS) for several accounts, including Colby’s. Preston is busy with a number of transactions that day, so she fails to allocate the trades immediately or write up the trade tickets. A few days later, when Preston is allocating trades, she notes that some of the MBS have significantly increased in price and some have dropped. Preston decides to allocate the profitable trades to Colby and spread the losing trades among several other PWI accounts.

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Example X

Jenpin Weng uses e-mail to issues a new recommendation to all his clients. He then calls his three biggest institutional clients to discuss the recommendation in detail.

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Example XI

Caleb Smith, an investment advisor, has two clients: Larry Robertson, 60 years old, and Gabriel Lanai, 40 years old. Both clients earn roughly the same salary, but Robertson has a much higher risk tolerance because he has a large asset base.

Robertson is willing to invest part of his assets very aggressively; Lanai wants only to achieve a steady rate of return with low volatility to pay for his children’s education. Smith recommends investing 20 percent of both portfolios in zero yield small-cap high-technology issues.

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Example XII

Jessica Walters, an investment advisor, suggests to Brian Crosby, a risk-averse client, that covered call options be used in his equity portfolio. The purpose would be to enhance Crosby’s income and partially offset any untimely depreciation in value should the stock market or other circumstances affect his holdings unfavorably.

Walters educates Crosby about all possible outcomes, including the risk of incurring an added tax liability if a stock rises in price and is called away and, conversely, the risk of his holdings losing protection on the downside if prices drop sharply.

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Example XIII

In a regular meeting with Seth Jones, the portfolio managers at Blue Chip Investment Advisors are careful to allow some time to review his current needs and circumstances.

In doing so, they learn that some significant changes have recently taken place. A wealthy uncle left Jones an inheritance that increased his net worth fourfold, to $1,000,000.

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Example XIV

Louis Perkowski manages a high-income mutual fund. He purchases zero-dividend stock in a financial services company because he believes the stock is undervalued and is in a potential growth industry, making it an attractive investment.

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Example XV

Max Gubler, CIO of a property/casualty insurance subsidiary of a large financial conglomerate, wants to better diversify the company’s investment portfolio and increase its returns. The company’s investment policy statement (IPS) provides for highly liquid investments, such as large caps, governments, and supra-nationals, as well as corporate bonds with a minimum credit rating of AA– and maturity of no more than five years. In a recent presentation, a venture capital group offered very attractive prospective returns on some of their private equity funds providing seed capital. An exit strategy is already contemplated but investors will first have to observe a minimum three-year lock-up period, with a subsequent laddered exit option for a maximum of one third of shares per year.

Gubler does not want to miss this opportunity and after an extensive analysis and optimization of this asset class with the company’s current portfolio, he invests 4 percent in this seed fund, leaving the portfolio’s total equity exposure still well below its upper limit.

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Example XVI

Kyle Taylor of Taylor Trust Company, noting the performance of Taylor’s common trust fund for the past two years, states in a brochure sent to his potential clients that “You can expect steady 25 percent annual compound growth of the value of your investments over the year.” Taylor Trust’s common trust fund did increase at the rate of 25 percent per annum for the past year which mirrored the increase of the entire market. The fund, however, never averaged that growth for more than one year, and the average rate of growth of all of its trust accounts for five years was 5 percent per annum.

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Example XVII

Aaron McCoy is vice president and managing partner of the equity investment group of Mastermind Financial Advisors, a new business. Mastermind recruited McCoy because he had a proven six-year track record with G&P Financial. In developing Mastermind’s advertising and marketing campaign, McCoy prepared an advertisement that included the equity investment performance he achieved at G&P Financial. The advertisement for Mastermind did not identify the equity performance as being earned while at G&P. The advertisement was distributed to existing clients and prospective clients of Mastermind.

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Example XVIII

Jed Davis developed a mutual fund selection product based on historical information from the 1990–95 period.

Davis tested his methodology by applying it retroactively to data from the 1996–2003 period, thus producing simulated performance results for those years. In January 2004, Davis’s employer decided to offer the product and Davis began promoting it through trade journal advertisements and direct dissemination to clients. The advertisements included the performance results for the 1996–2003 period but did not indicate that the results were simulated.

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Example XIX

In a presentation prepared for prospective clients, William Kilmer shows the rates of return realized over a five-year period by a “composite” of his firm’s discretionary accounts with a balanced objective. This “composite,” however, consisted of only a few of the accounts that met the balanced criteria set by the firm, excluded accounts under a certain asset level without disclosing the fact of their exclusion, and included nonbalanced accounts that would boost investment results. In addition, to achieve better results, Kilmer manipulated the narrow range of accounts included in the composite by changing the accounts that made up the composite over time.

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Example XX

Sarah Connor, a financial analyst employed by Johnson Investment Counselors, Inc., provides investment advice to the trustees of City Medical Center. The trustees have given her a number of internal reports concerning City Medical’s needs for physical plant renovation and expansion. They have asked Connor to recommend investments that would generate capital appreciation in endowment funds to meet projected capital expenditures. Connor is approached by a local businessman, Thomas Kasey, who is considering a substantial contribution either to City Medical Center or to another local hospital. Kasey wants to find out the building plans of both institutions before making a decision, but he does not want to speak to the trustees.

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Example XXI

Lynn Moody is an investment officer at the Lester Trust Company. She has an advisory customer who has talked to her about giving approximately $50,000 to charity to reduce her income taxes.

Moody is also treasurer of the Home for Indigent Widows (HIW), which is planning its annual giving campaign. HIW hopes to expand its list of prospects, particularly those capable of substantial gifts. Moody recommends that HIW’s vice president for corporate gifts call on her customer and ask for a donation in the $50,000 range.

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Example XXII

Government officials approach Casey Samuel, the portfolio manager for Garcia Company’s pension plan, to examine pension fund records. They tell her that Garcia’s corporate tax returns are being audited and the pension fund reviewed. Two days earlier Samuel learned in a regular investment review meeting with Garcia officers that potentially excessive and improper charges are being made to the pension plan by Garcia.

Samuel consults her employer’s general counsel and is advised that Garcia has probably violated tax and fiduciary regulations and laws.

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Bibliography

Ethical and Professional Standards and Quantitative Methods. CFA Program Curriculum. Volume 1. Level I 2011, CFA Institute, Pearson Custom Publishing, p. 1-250 Materials on ethical and professional standards from CFA Institute webpage: www.cfainstitute.org

, including: http://www.cfapubs.org/doi/pdf/10.2469/ccb.v2005.n3.4000

Schwesernotes 2011, CFA Level I Book 1: Ethical and Professional Standards and Quantitative Methods, Kaplan Schweser, USA, p. 12-96 43