Ethics

Question
Tyler McKinna hears on the radio that Nihon Corporation, a Japanese firm, has
delivered a tender offer to American Broadcasting that would result in acquiring 127
media properties, many of which are in markets where the company already owns
media firms. At a local restaurant, McKinna overhears the senator from his state
mention to his aid his intentions to introduce legislation that prevents foreign
companies from owning more than one media firm in each market. McKinna estimates
that the Nihon Corp. offer for American Broadcasting would be 20 percent over market
value if the duplicate media properties must be sold. Has McKinna violated CFA
Institute Standards of Professional Conduct related to material nonpublic information?
a. No.
b. Yes, based on information in the radio news story alone.

c. Yes, based on information he gained in overhearing the Senator and his aid.

Solution
Choice "a" is correct. Analysts are in the business of formulating insights that are not obvious
to the general investing public. Initiatives to discover and analyze information, and use the
results of such analysis, significantly enhance market efficiency to the benefit of all investors.
Perceptive analysts do not violate the prohibition against using material nonpublic
information when they develop a mosaic of nonmaterial nonpublic information and material
public information. The information provided by the senator in his comments to his aid
constitutes nonmaterial nonpublic information because they would not, in isolation, cause
someone to alter their evaluation of American Broadcasting. That information, however,
becomes important when combined with the material public information about the merger.
Choice "b" is incorrect. The radio news story is public information.
Choice "c" is incorrect. Perceptive analysts do not violate the prohibition against using
material nonpublic information when they develop a mosaic of nonmaterial nonpublic
information and material public information. The senator's conversation was one of many
pieces to the story and would not on its own cause someone to alter the evaluation of
American Broadcasting.

Question
An investment advisor deletes all her client files upon leaving one employer for
another and intends to recreate them while working for her new firm. On her last day
at the current firm, the advisor contacts her existing clients to tell them that she is
leaving, but is careful not to disclose the new firm. The advisor has violated the
Standards with regard to Duties to Employers by:
a. Deleting client files.
b. Notifying clients that she is leaving.
c. Deleting client files and notifying clients that she is leaving.

Solution
Choice "c" is correct. The client files belong to the employer. Deleting the employer's
files violates a covered person's obligation of loyalty to an employer. She should not be
informing clients that she is leaving prior to her employer having the opportunity to
make the announcement about the personnel changes to clients. She has a duty to her
employer not to take away clients while she is still employed with the firm. Her actions
could cause harm to the employer and therefore is a violation.

Question
Jeff Steiner, CFA, specializes in municipal bond investing while his colleague, Andrew
Rovinski, CFA, specializes in equity investments. They decide to recommend each
other's services exclusively to clients, but agree not to exchange fees for these
referrals so that they don't have to disclose the arrangement to their employers,
clients, and prospects.
According to the Standards, this arrangement is:
a. Acceptable.
b. Not acceptable even if there are no payments in cash for the referrals.
c. Not acceptable because bilateral referrals are specifically prohibited in the
Standards.

Solution
Choice "b" is correct. As a general rule, all referral arrangements must be disclosed to
employers, clients and prospective clients. Although no referral fees are exchanged,
the exchange of referrals constitutes a "benefit" covered under the standard
addressing referral fees.
Choice "a" is incorrect. The advisors receive benefits by giving referrals (they get
referrals in return). While the benefit may not be in cash, it is a benefit nevertheless.
Therefore, it should be disclosed to clients that come to them because of such
referrals.

Choice "c" is incorrect. The Standards do not prohibit referral fees, whether bilateral or
otherwise. The Standards require that all referral arrangements be disclosed in writing
to any client or prospective client.

Question
At dinner with the trader at his firm, an analyst indicates that he will likely change his
recommendation from hold to sell on a company he follows. As soon as the market
opens the next day, the trader closes out a personal long call position and buys puts in
the stock that the analyst discussed. The firm has internal controls in place to prevent
portfolio managers from closing out any client positions until a report is disseminated.
Later that day, the analyst sends out his report with the sell recommendation. The
trader has most likely violated the Code and Standards by failing to:
a. Have a reasonable basis for his recommendation only.

b. Disseminate information to clients before he trades on the information only.

c. Have a reasonable basis for his recommendation and to disseminate information to
clients before he trades on the information.

Solution
Choice "b" is correct. Reasonable basis relates to having a reasonable and adequate
basis for making recommendations or actions to others. Because the trader made
trades for himself, he did not violate Standard V(A) - Investment Analysis,
Recommendations and Actions. However, the trader must wait until clients have had
the opportunity to receive and act upon the recommendation before he can trade for
his personal account. Ideally, there would be a blackout period where insiders (firm
employees) could not trade personally for some period of time after such a statement
has been made by an analyst.

Question
As part of his research process, an analyst regularly obtains information from meeting
with the company's CFO, who also happens to be his former college roommate. The
CFO sends the analyst and his family substantial Christmas gifts each year. After
randomly learning of the relationship, the analysts supervisor instructs the analyst not
to issue his research recommendation on the company and reassigns coverage of the
company to another analyst. The analyst issues the update anyway. Based only on this
information, this analyst has most likely violated Standards related to:
a. Loyalty only.

b. Disclosure of Conflicts only.

c. Both Loyalty and Disclosure of Conflicts.

Solution
Choice "c" is correct. The analyst violated his duty of loyalty by not acting in the best
interest of his employer. The supervisor had every reason to be concerned about the
potential conflict of interest before the analyst issued another research report on that
firm. Furthermore, the analyst should disclose such relationships to his employer so
that his employer can better assess the situation. While it is not a conflict of interest to
cover a firm in which a friend happens to be the CFO, the substantial Christmas gifts to
the family may suggest a potential conflict.

Question
An investment advisor tells his prospective clients that he has achieved a 20 percent
annual return from January 1, 20X0 through the present reporting period. He does not
tell them that these results were unduly influenced by the results primarily from the
success of one client who pays him an additional bonus fee based on a percentage of
gain in excess of the markets performance. Furthermore, the advisor has not
discussed the special arrangement with his employer. The advisor violated CFA
Institute Standards relating to:
a. Performance Presentation only.

b. Additional Compensation Arrangements only.

c. Both Additional Compensation Arrangements and Performance Presentation.

Solution
Choice "c" is correct. The investment advisor must disclose his compensation
arrangement when presenting his performance. This will allow potential investors to
know that their accounts might not receive the same level of service and returns
unless they similarly follow the same compensation arrangement. Lastly, the advisor
must disclose the arrangement to his employer and receive written approval prior to
entering into additional compensation arrangements.

Question
Justin Owens, CFA, is an advisor at Bay Area Partners and services institutional clients,
high net-worth individual clients, and general individual clients. Owens's institutional
clientele provide over 50 percent of the firm's revenues. Owens recently completed a
research report strongly recommending a new company in the biotech sector. The
firm's investment committee determined that this biotech company is not suitable for
the needs of any of the general individual clients. Owens issues a research report first
to his institutional clients as part of the premium service he offers. Several days later,
he issues the same research report to his high net worth clients. Did Owens violate any
Standards regarding Fair Dealing?
a. No.
b. Yes, because Owens did not issue the report to general individual clients.

c. Yes, because Owens gave preferential treatment to his institutional clients.

Solution
Choice "c" is correct. This is the best answer because Owens did not provide fair
treatment to the high net worth individual clients. Fair treatment means that an
investment idea should be issued simultaneously to all suitable clients. General
individual clients need not be given the research report because the investment
committee deemed the recommendation unsuitable for them. However, note that if
the firm had indicated a premium service designed for certain clients, and had made
all clients aware of the premium service at inception of their relationship, there may
not have been a violation.
Choice "a" is incorrect. There is a violation because institutional clients received
preferential treatment.
Choice "b" is incorrect. This is not the best answer because the firm's investment
committee determined that the biotech company was not suitable for any general
individual clients.

Question
An airline industry analyst developed a compelling merger argument in a research
report, concluding: "XYZ Airlines will soon merge with another major airline." XYZ
Airlines has not announced merger intentions. Has the analyst violated the Standards
of Professional Conduct?
a. No.

b. Yes, by failing to distinguish between fact and opinion.

c. Yes, by not having a reasonable basis for his recommendation.

Solution
Choice "b" is correct. The Standard addressing communication with clients and
prospects requires analysts to distinguish fact from opinion. While research may
indicate a potential merger, the analyst failed to properly distinguish between fact and
opinion regarding an event that may or may not occur in the future.
Choices "a" and "c" are incorrect. The fact pattern indicates the analyst may have
determined merger potential based on analysis of business models, financials, etc.
There is nothing in the fact pattern to indicate this conclusion was based on
unreasonable or unreliable information.

Question
Kim Lin, Chairman of Warrensburg Advanced Futures Board (WAFB), has introduced a
new type of equity index-linked futures contract. In order to convince investors of its
liquidity, Lin encourages member firms to use the contract by offering specific
incentives for minimum trading volume commitments on the new contract. Lin
discloses these agreements in all marketing materials related to the security, in
addition to posting the information on the WAFB website. Lin has:
a. Violated the prohibition against market manipulation.
b. Violated the requirement of fair dealing.

c. Not violated any Standards.

Solution
Choice "c" is correct. By disclosing the agreement in all marketing materials and on
their website, has not violated any Standards. Lin is attempting to introduce a new
security that offers better service to investors. If Lin had failed to notify investors of
the "pump-priming" strategy of offering incentives to WAFB members, then he would
have been engaging in market manipulation. In such a case, investors could be misled
into believing that the security had liquidity without the help of any incentives during
the initial trading period.
Choice "a" is incorrect. Lin did not violate the prohibition against market manipulation
because he announced the terms of the incentive agreement, thus alerting investors
to the potential limits to the new instrument's liquidity.
Choice "b" is incorrect. There is no indication in the fact pattern that Lin did not deal
fairly with any constituent group.

Question
An investment advisor learns that a client wishes to make a charitable donation to
reduce her income tax liability. The advisor suggests to the symphony foundation
chairman that he contact the client without first determining whether the client would
consider making a tax-deductible contribution to the symphony. The advisor has:
a. Not violated the Standards.

b. Violated the Standards by disclosing confidential client information.

c. Violated the Standards by recommending a potentially unsuitable action.

Solution
Choice "b" is correct. Members must not reveal confidential information about current
or former clients or prospects unless:
1) the information concerns illegal client activity,
2) the law requires disclosure, or
3) the client permits disclosure.
In this case, the advisor should have recommended the foundation to her client as a
possible donation rather than suggesting her client to the foundation as a possible
donor. The advisor did not violate III (C) Suitability because that Standard refers to
investment recommendations rather than charitable gifts.

Question
Fay Armand, an investment advisor, informs his clients of his policy to purchase
recommended securities for the commingled accounts first, and then for the individual
pension fund accounts on a pro rata basis. Armand has most likely violated the
Standard relating to:
a. Fair dealing, only.

b. Misrepresentation, only.
c. Fair dealing and Misrepresentation.

Solution
Choice "a" is correct. Investment advisors must not discriminate against any clients
when disseminating investment recommendations or taking investment action.
Blatantly stating unfair allocation procedures does not eliminate the violation, even if
the client actively or passively consents to it. With regard to misrepresentation, there
is no violation since full disclosure of the unfair practice was given to his clients.
Choice "b" is incorrect. There is no misrepresentation and, in fact, there is full
disclosure of the unfair practice.
Choice "c" is incorrect. Investment advisors must not discriminate against any clients
when disseminating investment recommendations or taking action.