cfa level iii - cfa society of los angeles review … slides... · 1 university of southern...

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University of Southern California

CFA Society of Los Angeles

CFA Review Program

CFA LEVEL III

Ethical and Professional Standards

Study Session 2

March 18, 2017

Mark Harbour [email protected]

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Reading Assignments

1. “The Consultant,” Jules A. Huot, Ethics Cases (CFA

Institute, 1996; adapted 2005)

2. “Pearl Investment Management (A), (B), and (C),” Glen

A. Holden, Jr., Ethics Cases (CFA Institute, 1996;

adapted 2005)

3. Asset Manager Code of Professional Conduct, including

Appendix A (CFA Institute, Centre for Financial Market

Integrity, 2005)

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Part I – Reading 3

Application of the Code and Standards

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Learning Outcomes

You should be able to

a) Evaluate professional conduct and formulate an appropriate response to actions that violate the Code of Ethics and Standards of Professional Conduct

b) Formulate appropriate policy and procedural changes needed to assure compliance with the Code of Ethics and Standards of Professional Conduct

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Learning Outcomes

Framework for Ethical Decision Making

Identify facts and issues

Identify Others to whom duty is owed

Identify Potential Conflicts of Interest

Identify Applicable Ethical Principles

Consider Seeking Additional Guidance

Consider Circumstances that Could Be Affecting Judgment

Consider Alternative Actions

Act and Review the Outcome

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Ethics in Practice

Summary of Important Points

A. Ethics and the Investment Profession • What constitutes a profession (as opposed to a

business, a trade, or a craft)?

Two factors taken together - 1. An established body of knowledge 2. A commitment to a broader good than the practitioner’s self

interest

• A body of knowledge that continues to grow as new insights are published is foundation of investment analysis (for example, quantitative methods, economics, financial statement analysis, corporate finance, analysis of equity/debt/derivative/alternative investments, portfolio management, portfolio results presentation, industry specific ethics standards)

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Ethics in Practice


• The “broader good” standard is met by promoting fair and efficient capital markets and focus on the importance of putting clients first

• The Code and Standards are aimed at serving the broader good.

B. Professional Ethics and Law • Is it enough just to obey the law?

• Can ethical obligations exceed legal requirements?

• While it may be legally possible to overstate experience to win a client, is it ethical?

Being legally correct but ethically wrong can destroy a reputation and disadvantage others who merit honest and equitable treatment

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Ethics in Practice


C. Interpreting and Applying the CFA Institute

Code and Standards • Ethical reasoning is not mathematically precise even though

it is logical

• It is based on abstract concepts

• Terms like “integrity” and “respect” are not technical terms and cannot be reduced to clear cut definitions

• Interpreting them may take thoughtful effort

• Judgment is acquired with both education and experience – knowledge + experience judgment

“The whole theory of [right] conduct is bound to be an outline only and not an exact system” Aristotle.

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Ethics in Practice


Useful questions - Is the course of action consistent with the intent of Code and

Standards? Would the client agree that you are doing the right thing? How would it be read by the public in a press release? Is your decision in favor of a course of conduct “commendable” and

consistent with being a leader? Would you be setting a good example for others?

D. Preamble to Code – Key Points

Highest standards of ethics, education, and professional excellence For the ultimate benefit of society Who is bound (CFA Institute members and candidates) Sanctions for violations

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Ethics in Practice

Summary

Disciplinary sanctions may be imposed for violations of Code and Standards

Code of Ethics requires: 1. DERIC (Diligence, Ethics, Respect, Integrity,

Competence)

2. Integrity of profession and client’s interests first

3. Reasonable care and independent judgment

4. Ethical behavior (in self and helping others)

5. Promote integrity and uphold rules of capital markets

6. Competence (for self and in helping others)

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Ethics in Practice

Summary

Standards

Standard I Professionalism

Standard II Integrity

Standard III Duties to Clients and Prospective Clients

Standard IV Duties to Employers

Standard V Investment Analysis, Recommendations, and Actions

Standard VI Conflicts of Interest

Standard VII Responsibilities as a CFA Institute Member or CFA Candidate

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Case Studies

The Consultant

Pearl Investment Management A, B, and C

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The Consultant - Case Facts

Mark Vernley, CFA, is also a petroleum engineer with a

doctorate in engineering and 30 years of business experience

Vernley started Energetics, an energy consulting firm, after

spending 15 years with an oil company, Deepwell Explorations,

followed by 8 years at a major brokerage firm as a securities

analyst specializing in energy issues. He is known for his

professionalism, expertise and integrity

Vernley has a substantial personal energy company stock

portfolio with a large position in Deepwell Explorations and a

position in Highridge.

Energetics recently won a consulting contract from Highridge

Oil Pipeline to devise a plan to resolve conflicts with

Highridge’s clients

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The Consultant - Case Facts

Under a plan developed by Vernley, Highridge will now have an

incentive to operate its pipeline more economically than at

present. Oil companies using the pipeline, including Vernley’s

old employer, Deepwell Explorations, will share any increase in

earnings that results from reduced costs.

After lengthy hearings at a regulatory agency the plan is

approved.

Plains Pipeline Systems, a competitor to Highridge, has objected

to the regulatory agency because it alleges the plan is flawed

because Vernley has a conflict of interest due to his personal

energy stock positions.

At a subsequent hearing, the regulatory agency confirmed its

prior decision.

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The Consultant - Case Discussion

How could Vernley have avoided allegations of conflict of interest based on his ownership of energy company shares?

Conflicts of Interest in a Personal Portfolio

o Avoidance Options

- refrain from investing in energy stocks

- divest energy stocks

- establish blind trust

- invest only in energy related mutual funds

o Disclosure

- should have disclosed holdings thereby enabling the client to evaluate the materiality of Vernley’s holdings and whether the conflict of interest is significant enough to affect Vernley’s ability to give advice or make recommendations that are unbiased and objective

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The Consultant - Case Discussion

Communication – to employees of standards for conformance

Education – adopted standards workshops and training

Establish comprehensive formal compliance program -

• Annual certification by employees

• Quarterly reporting of employee security transactions

• Disclosure of compensation from other sources

• Certification of no independent business competitive activity

• Membership in organizations that maintain professional standards

Actively pursue an Ethical Culture

• Vernley should continue instilling an ethical culture in Energetics by developing a corporate credo and moral system based on professional standards, self interest, values and ideals

Plan for Energetics

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Pearl Investment Management

Pearl Investment Management (A)

– Case Facts

– Case Discussion

Pearl Investment Management (B)

– Case Facts

– Case Discussion

Pearl Investment Management (C)

– Case Facts

– Case Discussion

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Pearl Investment Management (A) -

Case Facts

Peter Sherman, who has an MBA, starts at Pearl

Investment Management working in the firm’s

back office

Pearl is a CFA shop; Sherman quickly reads and

signs Pearl’s personnel policies statement

Sherman enjoys being close to investment

information by working at Pearl

Sherman decides to put new found knowledge to

work in making personal trades

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Case Discussion

Standard I (A): Knowledge of the Law

– Using knowledge gleaned through employment at Pearl

could trigger violation of laws and regulations

Standard IV (C): Responsibilities of

Supervisors

– Sherman’s supervisors must monitor activities

regardless of the fact that Pearl has compliance policy

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Case Discussion

Standards III (B) and IV (B): Fair Dealing and

Priority of Transactions

– Sherman can’t make personal trades that conflict with

client interests

Standards IV (A) and III (A): Duty to Employers

and Loyalty, Prudence and Care

– Sherman can’t communicate information that would

breach special position of trust with employer

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Pearl Investment Management (B) -

Case Facts

Peter Sherman, an employee of Pearl Investment Management passes CFA Level I exam

Sherman works on resolving some trade allocation issues among certain large client accounts

This is a rush project; he doesn’t complete all due diligence

As a result of the project, some securities are shifted among accounts

Sherman believes all clients have now been treated fairly, but wonders why adjustments were necessary in the first place

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Pearl Investment Management (B) -

Case Discussion

Responsibility of Candidate to Comply with the Code and Standards

o Sherman, as a CFA candidate, is bound by Code and Standards but also must follow Pearl’s policies

Standards III (A) and III (B): Responsibility to Clients and Fair Dealing

o Rushing a project could lead to inappropriate short cuts and failure to ensure that client interests are placed first and clients are treated fairly

Bearing the Financial Risk of Errors in Client Accounts

o In this instance, the cost of errors and misallocations should be borne by Pearl

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Pearl Investment Management (C) -

Case Facts

Peter Sherman passes the CFA II exam

Sherman becomes a junior analyst

His supervisor, Thomas Champa, is well suited to being a

research director and wants analysts to quickly come up with

recommendations to please management and to lure clients to a

new endeavor for Pearl: the management of emerging markets

stocks.

Sherman reads several reports and browses through other

material

Champa refers Sherman to one of his contacts who is well

connected in Mexico and is on a number of boards of Mexican

companies

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Case Facts

Sherman spends several hours speaking with this contact

Because of time pressure, Sherman incorporates material

from brokerage firm reports without citing sources in

developing a research report on Mexican

telecommunications and cable companies

Another junior analyst at Pearl questions Sherman as to

why his report seems to be lacking important information

such as the relationship between the Mexican peso and the

U.S. dollar; Sherman responds by stating that Pearl clients

are sophisticated, they know these things already

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Case Discussion

Standard II (A) Material Non-Public Information

o Sherman must base recommendations on his research

alone without engaging in illegal or unethical actions

o Use of mosaic theory OK

Standard I (C): Misrepresentation

Sherman must cite sources of non-original material

contained in his research report

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Case Discussion

Standard V (A): Diligence and Reasonable Basis o Using recommendations of others suggests that he may

not have had a reasonable basis for making his recommendations; rushing a report is almost a per se violation

Standard V (B): Communication with Clients o Excluding important information from the report may be

a violation of this standard; a high level of client sophistication is irrelevant

Standard I (C): Misrepresentation o Pearl must not hold itself out as experienced in emerging

markets until it actually manages assets in this area

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Part 2 – Reading 4

Asset Manager Code of Professional Conduct

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Learning Outcomes

You should be able to a) Explain the purpose of the Asset Manager Code and

benefits that may accrue to a firm that adopts the code

b) Explain the ethical and professional responsibilities

required by the six General Principles of Conduct of the

Asset Manager Code

c) Determine whether an asset manager’s practices and

procedures are consistent with the Asset Manager Code

d) Recommend practices and procedures designed to

prevent violations of the Asset Manager Code

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Asset Manager Code of

Professional Conduct

• CFA Institute’s mission is to lead the investment profession globally by setting the highest standards of ethics, education, and professional excellence.

• Honesty and integrity are critical to maintaining trust and confidence of investors

• To foster a culture of ethics and professionalism, the CFA Institute offers this voluntary code of conduct

• Designed to be adopted on a firm-wide basis and is aimed at all asset managers including unregulated hedge fund managers who may not have a code in place

Introduction

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Professional Conduct Ethical leadership starts at highest level of organization;

therefore this code should be adopted by senior management, board of directors or similar oversight body

The Code is intended to cover all employees of the firm

Code sets forth minimum ethical standards for providing asset management services for clients

Code is meant to be general and allow flexibility for asset managers of various sizes and structures

Goal of code is to set forth a useful framework for all asset managers to provide services in a fair and professional manner and to fully disclose key elements of these services regardless of legal or regulatory requirements

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To be implemented properly, the code must be supported

by appropriate compliance procedures

While the Code is designed to provide universal set of

principles and standards relevant to all asset managers, it

may need to be supplemented with additional provisions to

meet applicable security regulation in markets around the

world

Code seeks to promote full and fair disclosure in order to

develop client trust and confidence from asset managers

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General Principles of Conduct

Managers have these responsibilities to their clients:

1. Act in a professional and ethical manner at all times

2. Act for the benefit of clients

3. Act with independence and objectivity

4. Act with skill, competence, and diligence

5. Communicate with clients in a timely and accurate

manner

6. Uphold the applicable rules governing capital markets

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1. Place client interests before their own

2. Preserve confidentiality of manager-client relationship

(except, for example, in case of illegal activity such as

money laundering)

3. Refuse any relationship or gift that could reasonably be

expected to affect their independence, objectivity, or

loyalty to clients

A. Loyalty to Clients

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Professional Conduct B. Investment Process and Actions

1. Reasonable care and prudent judgment (balance risk and the client’s portfolio; act with care skill, and diligence)

2. Do not attempt to distort prices or artificially inflate trading volume in order to mislead market participants (for example, do not spread false rumors to induce trading or trade illiquid stock at end of measurement period in order to drive up price to boost manager performance)

3. Deal fairly and objectively with clients with regard to investment information, recommendations, or actions (for example, managers must not give preferential treatment to favored clients to the detriment of other clients)

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Professional Conduct 4. Have a reasonable and adequate basis for investment

decisions (for example, a manager implementing a passive strategy will have a very different basis for investment actions than a manager employing an active strategy)

5. When managing a portfolio or pooled fund according to a

specific mandate, strategy, or style:

a. Take only investment actions consistent with stated objectives

and constraints (helps determine client suitability)

b. provide adequate disclosures regarding proposed changes in

investment style or strategy so clients can consider whether they

will meet their needs

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Professional Conduct 6. When managing separate accounts and before providing

investment advice or taking investment action

a. evaluate client’s investment objectives, risk tolerance, time horizon, liquidity needs, financial constraints, any other unique circumstances (ideally, each client will have their own investment policy statement that outlines risk tolerances, return objectives, time horizon, liquidity requirements, liabilities, tax considerations, etc)

b. determine that an investment is suitable to a client’s financial situation (remember, not all investments are suitable for every client)

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1. Do not act or cause others to act on material nonpublic information (does not prevent use of “mosaic theory”)

2. Give priority to client’s investments over personal investments (managers should develop policies and procedures to monitor and, where appropriate, limit the personal/trading of employees)

3. Use commission soft dollar credits to pay for only investment-related product or services that directly assist manager in investment decision making process and not in the management of the firm (if managers choose to use soft dollars, they should disclose practice to clients)

C. Trading

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4. Always seek “best execution” (best execution is more

than commission rates)

5. Establish policies to ensure fair and equitable trade

allocation among client accounts (should have specific

procedures in this area, particularly with regard to IPOs

and private placements)

C. Trading (cont’d)

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1. Develop and maintain policies and procedures to promote compliance with this code and all applicable laws and regulations (these policies and procedures should be tailored to suit the firm and be treated as a “living” document)

2. Appoint a compliance officer to administer policies and procedures and to investigate complaints (bigger, more complex firms may require “compliance department”)

3. Ensure portfolio information is accurate and complete and arrange for independent third-party confirmation or review (third-party verification is a good risk management tool)

D. Compliance and support

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4. Maintain records for an appropriate period of time in an easily accessible format (managers should keep records at least seven years)

5. Employ qualified staff and sufficient human and technological resources to thoroughly investigate, analyze, implement, and monitor investment decisions and actions (managers should ensure that adequate internal controls are in place to prevent fraudulent behavior)

6. Establish business-continuity plan for disaster recovery or periodic financial market disruptions

7. Establish a firmwide risk management process that identifies, measures, and manages the risk position (including sources, nature, and degree of risk)

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1. Present information that is fair, accurate, relevant, timely,

and complete. Managers must not misrepresent the

performance of individual portfolios or of their firm

2. Use fair-market prices to value client holdings and apply, in

good faith, methods to determine the fair value of any

securities for which no independent, third-party market

quotation is readily available (widely accepted valuation

methods and techniques should be used to appraise portfolio

holdings of securities and other investments and should be

applied on a consistent basis)

E. Performance and Valuation

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1. Communicate with clients on an on-going and timely basis (key to providing high-quality financial services)

2. Ensure disclosures are truthful, accurate, complete, and understandable and are presented in a format that communicates the information effectively (use plain language)

3. Include any material facts when making disclosures or providing information to clients regarding themselves, their personnel, investments, or the investment process (“material” information provides reasonable investors a basis to choose to use or continue to use a manager)

F. Disclosures

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a. Conflicts generated by relationships with brokers, other accounts, fee structures, or other matters (manager must decide whether conflict should be avoided or managed and disclosed ... examples of potential conflicts: soft dollars, referral fees, trading commissions, sales incentives, directed brokerage, allocations of IPOs, personal investing, use of affiliated brokers, etc)

b. Regulatory or disciplinary action taken against manager or its personnel related to professional conduct (disclose past professional conduct record because it is an important factor in an investor’s selection of a manager)

4. Disclose the following:

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Professional Conduct c. The investment process, including information regarding

lock-up periods, strategies, risk factors, and use of derivatives and leverage (managers should help clients thoroughly understand the nature of the investment product or service so clients may determine whether changes could affect their investment objectives)

d. Management fees and other investment costs charged to investors, including what costs are included in the fees and the methodologies for determining fees and costs (managers should provide plain language, specific disclosures regarding fees, costs and methodologies used to determine such fees and costs)

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Professional Conduct e. The amount of any soft or bundled commissions, the

goods and /or services received in return, and how those goods and/or services benefit the client (remember, commissions belong to the client and should be used in their best interest; clients deserve to know how commissions are spent, what is received in return, and what benefits them)

f. The performance of clients’ investments on a regular and timely basis (managers should report to clients at least quarterly, and when possible, such reporting should be provided within 30 days after the end of the quarter)

g. Valuation methods used to make investment decisions and value client holdings (clients should be provided specific disclosures regarding how holdings are valued – not “boilerplate” – so that they can understand results)

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Professional Conduct h. Shareholder voting policies (managers must adopt policies

and procedures regarding how they seek to vote shares in the best interest of clients; these policies should specify, among other things, guidelines for instituting regular reviews for new or controversial issues)

i. Trade allocation policies (by establishing and disclosing trade allocation policies that treat clients fairly, managers foster an atmosphere of openness and trust with their clients)

j. Results of the review or audit of the fund or account (managers must disclose annual review or audit results to clients; this enables clients to hold managers accountable and alerts them to any potential problems)

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Professional Conduct k. Significant personnel or organizational changes that have

occurred at the manager (such changes could include personnel turnover and merger and acquisition activities of the manager and should be disclosed in a timely manner)

l. Risk management processes

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