Table of Contents
CFA Level 3 – Ethical and Standards, Session 2 – Reading 6
(Notes, Practice Questions, Sample Questions)
1. Which of the following is NOT part of the ethical responsibilities related to the Asset Manager Code of Professional Conduct?
A) Act in an objective manner.
B) Communicate with clients in an accurate manner.
C) Do not engage in market manipulation of security prices
[Explanation: C — The ethical responsibilities related to the Code are:
Always act ethically and professionally;
Act in the best interest of the client;
Act in an objective and independent manner;
Perform actions using skill, competence, and diligence;
Communicate accurately with clients on a regular basis; and
Comply with all legal and regulatory requirements.
Not engaging in market manipulation of security prices is part of the Investment Process and Actions section of the Code and is not considered one of the ethical responsibilities]
127 our experts are availableright now
2. Which of the following is part of the ethical responsibilities related to the Asset Manager Code?
A)Employing qualified staff.
B)Appointing a compliance officer.
C)Communicating with clients on a regular basis
[Explanation: C — The ethical responsibilities related to the Asset Manager Code are:
Always act ethically and professionally;
Act in the best interest of the client;
Act in an objective and independent manner;
Perform actions using skill, competence, and diligence;
Communicate accurately with clients on a regular basis; and
Comply with all legal and regulatory requirements.
The other answer choices listed relate to the specific section of the Code dealing with Compliance and Support]
3. All of the following are NOT part of the ethical responsibilities related to the Code EXCEPT:
A)communicating with clients in an accurate manner.
B)seeking best execution.
C)disclosing conflicts of interest
[Explanation: A — The ethical responsibilities related to the Code are:
Always act ethically and professionally;
Act in the best interest of the client;
Act in an objective and independent manner;
Communicate accurately with clients on a regular basis; and
Comply with all legal and regulatory requirements.
The other answer choices deal with specific sections of the Code and are not considered ethical responsibilities]
4. Which of the following is NOT part of the ethical responsibilities related to the Asset Manager Code of Professional Conduct?
A)Trading regarding insider information, priority of transactions, soft dollars, and best execution.
B)Communicating with clients on a regular basis.
C)Acting in an independent manner
[Explanation: A — The ethical responsibilities related to the Code are:
Always act ethically and professionally;
Act in the best interest of the client;
Act in an objective and independent manner;
Perform actions using skill, competence, and diligence;
Communicate accurately with clients on a regular basis; and
Comply with all legal and regulatory requirements.
Trading is not specifically mentioned in the ethical responsibilities section of the Asset Manager Code and is instead one of the six components of the Asset Manager Code specifically regarding trading which deals with insider information, fair dealing, soft dollars, best execution, and the allocation of shares]
5. Which of the following is NOT part of the ethical responsibilities related to the Asset Manager Code of Professional Conduct?
A)Maintain the confidentiality of client information.
B)Maintain your independence.
C)Always act in a professional manner
[Explanation: A — The ethical responsibilities related to the Code are:
Always act ethically and professionally;
Act in the best interest of the client;
Act in an objective and independent manner;
Perform actions using skill, competence, and diligence;
Communicate accurately with clients on a regular basis; and
Comply with all legal and regulatory requirements.
Maintaining the confidentiality of client information is part of the section of the Code dealing with Loyalty and is not considered one of the ethical responsibilities]
6. Kendall Kratz is consulting for Westmoreland Financial Services. Kratz was brought in by William J. Westmoreland IV, grandson of the company’s founder, to address concerns about ethics.
Westmoreland Financial does not have a centralized ethics code, but rather a series of rules of conduct, most of which were instituted more than 20 years ago. William Westmoreland is worried that the firm’s policies have not changed with the times, so he has hired Kratz to review all of the rules and bring the firm into compliance with the Asset Manager Code of Professional Conduct.
As soon as he arrives at Westmoreland Financial, Kratz receives a copy of all the rules of conduct for his review. Every client receives a copy of these rules. Kratz settles down in a vacant office to read and writes down the following.
IPO’s are distributed to about 60 percent of client accounts in proportion to account size, but the remaining 40 percent do not receive any allocation.
All investment policy statements are reviewed on an annual basis.
Portfolio managers may accept any gift valued up to $200 provided that they notify their supervisors in writing, but must receive written consent from the compliance officer in advance before accepting anything more expensive.
Most stock research is done in-house. About 30 percent of Westmoreland Financial clients do not own bonds, but substantially all of client brokerage pays for bond research.
Westmoreland Financial employees must receive preauthorization before buying stocks in the company’s portfolio model, and are not to buy stocks in advance of recommending them for addition to the portfolio model.
In a later discussion with William Westmoreland, he learns that all of the firm’s trades are conducted through Babel Brokerage, a business owned by William Westmoreland’s nephew. Babel provides best pricing and execution.
After making some recommendations regarding rules changes, Kratz is given two files to consider. William Westmoreland believes the firm has not acted correctly, and wants Kratz’s opinion.
The first file relates to the matter of Justin Yeats, a wealthy and flamboyant movie actor with more than $15 million under management at Westmoreland Financial. Veronica Jung, who manages the Yeats account, wrote this account of what happened:
“Yeats called me at 8 a.m. Eastern time, an hour before the market opened. He wanted me to purchase stock in Flimflam Films. He told me that the CEO of Flimflam spoke at a large fund-raiser the night before and provided some enticing sales figures for the firm’s latest movie.
“Yeats, who is a bit of a stock junkie, also told me to purchase shares of Blanton Resorts. He said he recently stayed in a Blanton Resort and found it offered amenities not found elsewhere. He then did some research, talking to the resort manager to assess his qualifications and entrepreurial business approach, and reviewing the company’s mission statement and financials. After all that, he concluded that Blanton was hiring the right people to grow the business.
“After Yeats hung up, I looked up Flimflam and discovered that the shares looked cheap. I then checked news reports, but found only one story about the fund-raiser on the society page. The CEO’s comments were not discussed. I also did some research on Blanton and learned that the stock’s volume was low, and only one analyst covered it. The stock appeared very cheap relative to earnings and book value. I immediately recommended Blanton for addition to the portfolio model and submitted a purchase order for Blanton for all of my accounts before the market opened, knowing it would not be executed until after the stock was approved by the investment director in the afternoon.
“I bought shares of Flimflam for Yeats, and then picked up a few shares for myself, but I did not buy Blanton for Yeats until the larger order was submitted, because I did not want to give Yeats preferential treatment.
“Later that day, Agent Cornelius Fillmore of the Internal Revenue Service (IRS) called to request Yeats’ trading records for a tax audit. In accordance with company policy, I refused, citing privacy concerns. Fillmore did not take the news well and said the agency’s attorneys would be in touch. After the legal threat, I reconsidered and sent him the files.”
The second file contains Westmoreland’s disclosure policy:
All returns disclosure will be presented net of fees.
All returns will be calculated on a quarterly basis, with monthly results available upon request.
Any legal action taken against the analyst who manages the client account will be disclosed.
All clients will receive a summary of our investment strategy and information about the risks of the investments in their portfolios.
Reports will contain information about our use of soft dollars, referral fees, sales incentives, brokerage arrangements, and a breakdown of our employees’ holdings of stocks’ in the client’s portfolio.
After reading the disclosure policy, Kratz recommends that the company add four items to the disclosure policy:
Allocation procedures.
Qualifications of account managers.
Asset-valuation methods.
Proxy-voting policies.
Which of Kratz’s four suggested additions to the disclosure policy goes beyond the recommendations set down by the Code?
A)Recommendation 2.
B)Recommendation 3.
C)Recommendation 1
[Explanation: A — The suggested disclosures include allocation procedures, valuations methods, and proxy policies, but not qualifications of employees]
7. With regard to the Flimflam stock, the Code was:
A)broken when Jung purchased Flimflam shares for herself, but not when she purchased the shares for Yeats or when Yeats tipped her off about Flimflam.
B)not broken.
C)broken when Jung purchased Flimflam for herself, and when she purchased Flimflam for Yeats, but not when Yeats tipped her off about Flimflam
[Explanation: B — A speech at a fund-raiser is most likely a public event. When a reporter is there, the issue of disclosure is moot, regardless of whether the reporter thought to write about the business news. Yeats’ tip is legitimate, and barring any rules about preauthorization, of which we have no knowledge, Jung’s purchase of Flimflam shares for Yeats, then afterward for herself, seems ethically sound]
8. With regard to Babel Brokerage, Westmoreland Financial:
A)is in compliance with the Code.
B)can comply with the Code only if it receives permission from clients.
C)can comply with the Code only if it switches a different brokerage
[Explanation: A — While the use of Babel Brokerage may not look good, the holy grail of brokerage is best pricing and execution. If clients are receiving the best service possible, the fact that William Westmoreland’s nephew owns the company does not put Westmoreland Financial in violation of the Code. However, the firm would be wise to either switch brokerages or disclose the relationship to clients and receive permission]
10. How many items on Westmoreland’s disclosure policy are insufficient to satisfy the Code?
A)1 item.
B)3 items.
C)2 items
[Explanation: A — Standard 4.A.14 says that firms must disclose all significant events that would help a prospective client interpret the compliant presentation thus legal disclosure should include information about action taken against the firm not just the investment advisor. Firms are required to present either gross or net of fees as long as it is properly labeled so this is not a violation of the GIPS. It is a recommendatin that returns should be presented gross of fees. The other three statements satisfy the Code]
11. With regard to the Yeats account, Jung broke the Code:
A)when she recommended Blanton shares for purchase, and when she failed to purchase Blanton shares for Yeats in the morning.
B)only when she sent the trading records to the IRS.
C)when she failed to purchase Blanton shares for Yeats in the morning, but not when she recommended Blanton shares for purchase
[Explanation: A — Jung violated the investment-process rules when she recommended Blanton stock for purchase based on nothing more than a recommendation from a client and a few minutes of analysis. She received a phone call an hour before the market opened, yet managed to talk to her client and research two stocks before the hour was up. She did not meet the standard, “Thoroughly investigate and research different investment options to have a reasonable basis for a recommendation.” As for Yeats’ shares, while she did not have enough information to recommend Blanton, she did have Yeats’ instructions to purchase the stock for himself. There appear to be no insider-trading issues, as the only nonpublic information he cited was an informal conversation with the manager, which is not likely to be material. So Jung should have purchased the shares for Yeats immediately, but not recommended them for anyone else until she had researched the company thoroughly. Based on her reasoning for not buying Flimflam, Jung was apparently allowed to purchase specific stocks at the request of investors without submitting them for approval by the investment director, so no matter what she thought about Blanton, there was no reason to wait on buying shares for Yeats. Regarding the IRS, confidentiality rules do not necessarily apply to official legal investigations]
12. Which of the rules Kratz wrote down is most likely in violation of the Code?
A) Most stock research is done in-house. About 30 percent of Westmoreland Financial clients do not own bonds, but substantially all of client brokerage pays for bond research.
B) IPO’s are distributed to about 60 percent of client accounts in proportion to account size, but the remaining 40 percent do not receive any allocation.
C) Portfolio managers may accept any gift valued up to $200 provided that they notify their supervisors in writing, but must receive written consent from the compliance officer in advance before accepting anything more expensive
[Explanation: C — The Code prohibits the acceptance of gifts other than of a modest value. There is no dollar amount stipulated in the standards although most likely $200 could be considered excessive. The other requirements in the gift policy appear to conform. The IPO allocation looks bad from the start, but the Code says investments must be fairly distributed among the accounts for which they are suitable. IPO’s are not for everyone, and it is certainly plausible that 40 percent of client accounts are too conservative for such securities. An annual review of investment policy statements is sufficient. Regarding soft dollars, the Code and Standards acknowledges that not every client will benefit from the all research. Such mismatches are unavoidable from a practical standpoint, and as long as brokerage is allocated toward research alone, the firm should be covered]
13. Stately Research is a firm specializing in providing investment research relating to individual stocks. They have not implemented the Asset Manager Code of Professional Conduct and have recently been cited by regulatory authorities for deficiencies in their research. Specifically, they have been cited for unclear language regarding price target valuation methods and their associated risks, the percentage of securities that were rated a “buy,” “hold,” or “sell,” and failure to adequately disclose “analyst industry view” ratings which ranked their analyst’s recommendations against a benchmark return such as the S&P 500. Which of the following is least likely to be responsible for causing the security violations?
A)Lack of funding or adequate staffing to conduct appropriate research.
B)Inadequate technological resources to adequately research investments.
C)The staff acting in an unethical manner
[Explanation: C — Stately’s lack of compliance with security laws can most likely be traced back to a lack of upper level management supporting a high level of ethical behavior. Ethical leadership starts from the support of upper management which leads to adequate funding and staffing to provide the right resources in hiring enough qualified staff and employing the technology to adequately research and report their stock findings]
14. Which of the following procedures relates specifically to maintaining the confidentiality of information under the Loyalty part of the Code?
A)Maintaining records for an appropriate amount of time.
B)Creating and implementing an anti-money laundering policy.
C)Using reasonable care and prudent judgment when managing client accounts
[Explanation: B — Where appropriate, firms should implement an anti-money laundering policy which falls under the Loyalty to Clients section specifically related to preserving the confidentiality of client information. Developing a business continuity plan and maintaining records falls under the Compliance and Support section of the Code. Using reasonable care and prudence falls under the section of the Code dealing with Investment Process and Actions]
15. Establishing information barriers between departments would fall under which section of the Code?
A)Investment Process and Actions.
B)Trading.
C)Compliance and Support
[Explanation: B — Establishing information barriers falls under the Trading section of the Code and is meant to restrict the flow of material nonpublic information so as to limit the potential misuse of this information for insider trading]
16. Georgette Litman, CFA, is an employee of Cooper and Grey Financial Consultants. She has had the responsibility for several client portfolios over several years. Litman was recently promoted to a senior management position with the idea of establishing guidelines to help ensure compliance with the Chartered Financial Analyst Institute Code and Standards and also the CFAI Asset Manager Code of Professional Conduct in the firm’s portfolio management business. To help in this task of compliance, Cooper and Grey Financial Consultants has hired Jack Book to help institute a set of procedures that will help Cooper and Grey Financial Consultants achieve their goal. Book has a legal background and is a new employee at Cooper and Grey Financial Consultants. Litman hopes that Book can help by providing a new and outside perspective to the process. Although Book is not a member of CFAI and has no immediate plans for joining CFAI and taking the Level I exam, Book brings a wealth of knowledge and experience. Understandably, Book must take some time to understand many details, e.g., the reasons for a separate conduct code for asset managers that is in addition to the CFAI Code of Professional Conduct.
Litman wants to know what the clients of Cooper and Grey Financial Consultants are thinking and get their perspective on how the firm is doing. She knows that many of the employees of Cooper and Grey Financial Consultants have close relationships with the clients and that gifts have been exchanged on occasion. She asks Book to look into this activity. She tells Book that it is acceptable for “token” gifts of any kind (except illegal substances) to be exchanged as long as the employees inform her of the gift. She sits down with Book to compose a list of all the recent gifts that Cooper and Grey Financial Consultants employees have told her they have received. She says that it is a good step to finally get them written down. After they compose this list, Book is to find out if there have been gifts that Litman was not informed as being given or received.
Litman is also concerned that money-laundering may be occurring through the accounts at Cooper and Grey Financial Consultants. Book has a background in detecting money-laundering activities, and this was one of the reasons Litman suggested that Cooper and Grey Financial Consultants hire Book. Litman asks Book to create an anti-money-laundering policy to detect and help prevent Cooper and Grey from being used for that purpose and other illegal activities. Litman cautions Book that the CFAI Asset Manager Code of Professional Conduct prevents Cooper and Grey Financial Consultants from providing client information to legal authorities, so Book will have to be careful in the design of the policies. Litman tells Book that, if all goes well in this area, she will see to it that Book becomes the compliance office of Cooper and Grey. In this position, Litman says that Book will report directly to her, and she will then use this information to report directly to the CEO and board of directors.Litman asks Book to help her draft procedures for monitoring performance and evaluating managers. She and Book compile a list of procedures that they plan to employ. Litman recommends abiding by the Global Investment Performance Standards, or GIPS, and using fair-market values when determining portfolio asset values. Book insists that Cooper and Grey Financial Consultants should use a third party for valuing asset accounts.
In addition to suggesting that an independent third party evaluate the performance of managers, Book recommends that the information disseminated to clients be reviewed by an independent third party for accuracy and completeness. Furthermore, in addition to maintaining adequate records, Book insists that Cooper and Grey Financial Consultants develop a plan for dealing with a natural disaster or some other event that could potentially destroy the records.With respect to establishing compliance with the CFAI Asset Manager Code of Professional Conduct, the fact that Book is not a member of CFAI is:
A)not directly important.
B)important and must be immediately remedied by his enrolling for the Level I exam.
C)important and must be immediately remedied by his joining CFAI, but he does not have to enroll for the Level I exam
[Explanation: A — It is not required that a CFAI member establish compliance]
17. Litman’s past and future policy concerning the monitoring and control of the exchange of gifts has:
A) only one problem: she apparently was not informed in writing.
B) only one problem: she apparently has not prohibited cash gifts.
C) at least two problems: she apparently was not informed in writing and she has not prohibited cash gifts
[Explanation: C — Recommend practices and procedures designed to prevent violations of the Asset Manager Code addresses loyalty to clients. Loyalty to clients deal with always putting the client’s interests before your own, maintaining the confidentiality of client information, and not engaging in any business relationship or accepting gifts from others that could affect your judgment and objectivity. The code requires a determination of what constitutes a token gift and allowing only token gifts from outside business. This is to limit the influence of these individuals over the asset manager. Cash should never be accepted, employees should always notify their supervisor in writing when they accept any gifts. Litman made no reference to prohibiting cash, and the conversation implies that Litman had not been getting reports of gifts in writing]
18. Litman’s plan for making Book the compliance officer at Cooper and Grey is:
A) not appropriate because Book is not a member of CFAI.
B) not appropriate because in that position, Book should be the one reporting to the CEO and the board of directors.
C) not appropriate because Book is new to the firm.
[Explanation: B — Recommend practices and procedures designed to prevent violations of the Asset Manager Code addresses compliance and support. Under compliance and support, the procedures specify that a compliance officer should be designated who reports directly to the CEO or board of directors and who is responsible for making sure compliance procedures are in place and followed. There are not strict and specific qualifications such being a member of CFAI (or not), nor how long the officer has been with the firm]
19. In drafting procedures for monitoring performance and evaluating managers, the:
A)suggestions by both Litman and Book are generally accepted and recommended to comply with the CFAI Asset Manager Code of Professional Conduct.
B)suggestions by both Litman and Book are not generally accepted nor recommended by the CFAI Asset Manager Code of Professional Conduct.
C)suggestion by Litman is generally accepted but that of Book is a violation of the CFAI Asset Manager Code of Professional Conduct
[Explanation: A — Recommend practices and procedures designed to prevent violations of the Asset Manager Code address performance and valuation. Performance and valuation deal with reporting investment results in an accurate manner without misrepresentation and using fair-market values when determining portfolio asset values. A good guideline to follow would be the Global Investment Performance Standards (GIPS®), which incorporates a high level of quality in reporting requirements. Because manager compensation is sometimes based on performance results, managers may be tempted to manipulate performance results in an attempt to increase their compensation. To avoid this conflict of interest, procedures for valuing asset accounts should include transferring the responsibility of valuing asset accounts to an independent third party]
20. In response to Book’s suggestions concerning the hiring of a third party to review information disseminated to clients and for the plan for dealing with a natural disaster, according to the CFAI Asset Manager Code of Professional Conduct, Litman should:
A) ignore them both.
B) adopt the plan for dealing with a natural disaster only.
C) adopt them both
[Explanation: C — Recommend practices and procedures designed to prevent violations of the Asset Manager Code addresses compliance and support. Compliance and support deal with: ensuring compliance with the Code and legal and regulatory requirements and appointing a compliance officer, ensuring that portfolio information disseminated to clients is accurate and complete and reviewed by an independent third party, appropriately maintaining records, employing qualified staff along with adequate resources, and instituting a contingency plan in the event of a natural disaster]
21. Which of the following procedures is NOT part of the Performance and Valuation section of the Code?
A)Having an independent third party value client accounts.
B)Implementing the Global Investment Performance Standards (GIPS®).
C)Performing stress testing on complex derivative products
[Explanation: C — The Performance and Valuation section of the Code deals with reporting the client’s and manager’s results in an accurate manner without misrepresentation. Stress testing falls under the section of the Code dealing with Investment Process and Actions]
