Case study:

Raphael, an investment adviser for Enright Financial Solutions (EFS), enters into an understanding with a friend who is a lawyer regarding the referral of clients. Raphael will refer EFS clients needing legal services to the lawyer in return for the lawyer recommending clients needing financial advisory services to Raphael and EFS. This arrangement is:

A.  Acceptable because there are no payments involved.

B.  Acceptable as long as the lawyer discloses the arrangement to the clients he refers to Raphael.

C.  Acceptable as long as EFS is aware of Raphael’s agreement with the lawyer.

D.  Unacceptable.

Analysis:

This case deals with a mutually beneficial referral arrangement whereby service professionals refer clients to one another. Although such an agreement is not necessarily unethical and may ultimately be beneficial for the clients, there is a potential for a conflict of interest that must be disclosed. CFA Institute Standard VI(C): Referral Fees requires members to disclose to their employer, clients, and prospective clients “any compensation, consideration, or benefit received from or paid to others for the recommendation for products of services.” This disclosure allows both clients and the employer to evaluate any partiality shown in the recommendation of services and the full cost of those services.

Although there is no money changing hands between Raphael and his friend, there is mutual consideration and benefit. The fact that no money is exchanged would not preclude disclosure (Choice A).

Choice B addresses the disclosure issue but places the onus of disclosure on the lawyer and not on Raphael. Standard VI(C) requires Raphael to disclose the referral arrangement to any clients he refers to the lawyer and any potential clients referred to him by his friend.

Choice C also addresses the disclosure issue by correctly stating that Raphael must disclose the arrangement to his employer. But this does not go far enough because Standard VI(C) requires disclosure to be made to clients, prospective clients, AND the employer. Does Raphael disclose any information about the arrangement to this clients or EFS? The facts of the case do not mention that he made the appropriate disclosure.

The CFA Institute Ethical Decision-Making Framework calls for you to identify all relevant facts before making a decision. Assuming Raphael made no disclosure to his clients or employer, this arrangement would be unacceptable (Choice D).

Case study:

Miriam works as an investment adviser for JVC Wealth Managers. JVC provides wealth management services to high-net-worth clients through discretionary, diversified, risk-adjusted investment management accounts that hold positions in both mutual funds and hedge funds. On average, Miriam has invested 74% of her clients’ mutual fund assets and 63% of her clients’ hedge fund assets in JVC proprietary funds, earning JVC and its affiliates additional fees. Miriam’s actions are:

A.  Acceptable because clients hiring JVC as an investment manager should expect that the firm will prefer investing in its own funds.

B.  Acceptable if Miriam indicates her preference for investing client assets in JVC proprietary funds.

C.  Unacceptable if there are non-proprietary mutual funds and hedge funds that meet the clients’ investment needs.

D.  Unacceptable because the additional fees earned by JVC violate the duty of loyalty, prudence, and care that Miriam owes to her clients.

Analysis:

This case involves a potential conflict of interest for Miriam between providing cost efficient investment vehicles for her clients and selling her employer’s investment products. CFA Institute Standard VI(A): Disclosure of Conflicts states that CFA Institute members “must make full and fair disclosure of all matters that could reasonably be expected to impair their independence and objectivity” or interfere with their duties to their clients.

Best practice is to avoid conflicts of interest if possible, otherwise mitigate the conflict of interest through the disclosure called for in Standard VI(A). Although the additional fees earned by JVC from selling proprietary funds present a potential conflict, the fees do not automatically violate Miriam’s fiduciary duty to her clients (Answer D).

It is possible that those proprietary funds are the best and most appropriate investment vehicles for Miriam’s clients even with the additional fees. But because there is a potential conflict of interest, Miriam must clearly disclose those fees “such that the disclosures are prominent, are delivered in plain language, and communicate the relevant information effectively” according to Standard VI(A). And although Answer C is based on the existence of alternative non-proprietary mutual funds, that response does not say that those funds are superior to JVC funds or have lower costs. Assuming that the clients understand that Miriam, who works for JVC, will sell JVC products at every opportunity, is not sufficient (Answer A).

The best answer in this case is Answer B, which calls for Miriam to disclose the conflict. This disclosure should be made at the outset of the relationship and address what investment vehicles will be used by JVC along with their costs.

Case Study:

Foss is an institutional money manager specializing in a quantitative investment strategy. He developed his own quantitative model that he uses exclusively as the investment decision-making tool for client accounts. Foss heavily markets his “comprehensive and exclusive” model to clients and prospective clients as being an effective tool to manage risk. After using the model for several years, Foss discovers an error that inadvertently eliminated one of the key components for managing risk, leading to underperformance as a result of industry overexposure. During that time, several clients raised questions about their portfolio performance, but Foss attributed it to market volatility. Foss revises the model to address the error and begins to promote his “new and improved exclusive and comprehensive quantitative model.”

Foss’s conduct is:

A.  Unacceptable because the original model resulted in underperformance.

B.  Acceptable because factors in quantitative models are proprietary and do not need to be disclosed.

C.  Unacceptable because he failed to disclose the error in the model and its impact on client performance.

D.  Acceptable because Foss corrected the error and uses the new model.

Analysis:

This case involves CFA Institute Standard I(C): Misrepresentation, which states that CFA Institute members and candidates must not knowingly make any misrepresentation relating to investment analysis, recommendations, or actions. A misrepresentation is any untrue statement or omission of fact that is otherwise false or misleading. Although investment professionals are not required to divulge the proprietary elements of their investment decision-making model, they are prohibited from making statements about the model that are not true.

In this case, Foss claimed that his “comprehensive model” would effectively manage risk while at the same time, because of an error, the
model omitted a key factor for managing risk. Foss also made misrepresentations to clients by failing to disclose the error and its impact on performance and attributing the model’s underperformance to market volatility rather than the error. Correcting the error and using a new model does not address the misrepresentations.

Underperforming the market or benchmark is not necessarily of indicative unethical behavior. But the fact that the original model did not effectively manage risk and led to underperformance also may lead to a violation of the CFA Institute Standard V(A): Diligence and Reasonable Basis, which requires CFA members to exercise diligence and thoroughness in analysing investments and taking investment action. Choice C is the best response.

Case Study:

Yang is a research analyst at BAMCO, a registered broker/dealer and investment adviser. While employed with BAMCO, Yang established Prestige Trade Investments Limited and acts as that firm’s investment adviser. Yang is responsible for formulating Prestige’s investment strategy and directs all trades on behalf of Prestige. Over the course of several days, Yang purchases 50,000 shares of Zhongpin stock and 1,978 Zhongpin call options for his personal account at BAMCO. Shortly thereafter, Yang uses $29.8 million of Prestige’s funds to purchase more than 3 million shares of Zhongpin stock.

Yang’s actions are:

A.  Acceptable because Yang’s personal investments are not in conflict with the investment advice being given to his clients at Prestige.

B.  Acceptable as long as BAMCO is aware of and consents to Yang establishing and working for Prestige as a separate entity.

C.  Acceptable as long as Prestige clients are not negatively affected by Yang’s prior purchase of Zhongpin securities through his account at BAMCO.

D.  Unacceptable.

Analysis:

This case involves an investment adviser “front-running” client trades. Front-running involves trading for one’s personal account before trading for client accounts. In this case, Yang purchased Zhongpin stock and call options in his personal account at BAMCO before directing the Zhongpin trades of clients at Prestige. Standard VI(B): Priority of Transactions states that “investment transactions for clients…must have priority over investment transactions in which a [CFA Institute] member…is the beneficial owner.”

Yang’s personal investments are tracking with his client investments, so there is no conflict between his personal trading and the investment actions/advice for clients. But the timing of the trades is what is at issue in this case, making Answer A incorrect. Also, the fact that Prestige clients are not harmed by Yang’s earlier trades for his personnel accounts does not make his actions acceptable.

The issue is Yang’s personal benefit derived from trading before his clients, which makes Answer C incorrect. Disclosure is not a cure for front-running. So, even if Yang had told Prestige clients that he would be making personal trades prior to taking investment action on their behalf that would benefit him, the trading in his personal account would not be acceptable. Yang would have to get permission from BAMCO to create and work for Prestige, according to CFA Institute Standard IV(A): Loyalty, but such permission does not allow Yang to engage in unethical activity while at Prestige, making Answer B incorrect.

That leaves Answer D as the best answer.