Ethics - Standard I - Professionalism

Start - 11:30 AM

Moving on today to Reading 2 of the CFAI materials - Sara and I cut off early last night to go roam around Rome and have a few drinks so I stopped after about 2.5 hours yesterday, meaning I should aim to hit about 5 hours today.  Learning goals:

The candidate should be able to:

a. demonstrate and explain the application of the Code of Ethics and Standards of Professional Conduct to situations involving issues of professional integrity;

b. distinguish between conduct that conforms to the Code and Standards and conduct that violates the Code and Standards;

c. recommend practices and procedures designed to prevent violations of the Code of Ethics and Standards of Professional Conduct.

 (Institute 19)

Institute, CFA. Level I 2012 Volume 1 Ethical and Professional Standards and Quantitative Methods, 7th Edition. Pearson Learning Solutions. <vbk:9781256112754#page(19)>.

This basically seems to be the meat of the Ethics portion.  This will walk through each of the Seven Standards in detail including detail under each subsection, including very detailed and numerous examples of the application of the rules.  Maybe it'll make sense to make a separate post for each of the Seven Standards, I'll see after we do the first one.

Standard I - Professionalism (LIMM - Law, Independence, Misrepresentation, Misconduct)

I(A) Knowledge of the Law
Remember: Members must understand and comply with all applicable laws, rules, and regs including CFA Code and Standards, and in event of conflict conform with stricter law (how do we interpret this?) and must not knowing participate/assist in any violation and must dissociate from it.  Dissociation at the extreme is resignation.

Does not, however, require one to become an expert in compliance or know ALL laws

• Relation b/w Code/Standards and Applicable Law - apply more strict law
• 'More strict' means law/regulation that imposes greater restrictions on the member OR calls for member to exert greater action to protect investors' interests
• Ex, local laws might not require disclosure of referral fees, but CFAI do
• Member/Candidates (MC's) are responsible for violations in which they knowingly participate
• If candidate has reasonable grounds to think imminent or ongoing activity of client or employer is illegal, must dissociate
• First step - notify a supervisor or compliance.  If unsuccessful, attempt to dissociate - can be various things, ex. be reassigned, remove your name from reports, etc.
• CFAI recommends reporting to authorities, but not doing so is not necessarily unethical.  Consult legal/compliance.  Can also report violations by CFAs to CFAI.
• Investment products - must know where they originate and where they will end up
• Supervisors must know in and out, MC's must make reasonable effort to make sure peer firms also abide by applicable rules
• MC's must do necessary diligence in cross-border deals to understand multiple laws

Exercise: There are three types of countries - MS (more strict than Code/Standards), LS (less strict) and NS (no standards).

Ex 1) Member resides in LS country, does business in MS country; MS law applies.  Answer: Must adhere to law of MS country.

Ex 2) Member resides in LS, does business in NS country; LS law applies, but states that law of locality where business is conducted governs.  Answer: Must apply code, because otherwise NS would apply.

Ex 3) Member resides in MS, does business in LS with client who is citizen of LS; MS applies, but states that law of client's home country governs.  Answer: Must apply Code, bc otherwise LS would apply.

I can see how these would get tricky if you aren't solid on the rules - but you just have to think stricter.

CFAI recommends MCs stay informed, review their procedures, and maintain current files.  Firms should adopt codes of ethics, provide info on applicable laws, and establish procedures for reporting violations.

I(B) Independence and Objectivity (IO)

MCs must use reasonable care to achieve and maintain independence and objectivity.  MCs must not offer, solicit or accept any consideration that could be reasonably expected to compromise their OR another's independence/objectivity.

• Gifts
• No allocations of oversubscribed IPOs (not available to clients).
• Modest gifts are acceptable
• Gifts from clients can be considered supplementary compensation - MC should disclose these to their employers prior to accepting if possible or soon thereafter - then employer can decide if IO is compromised
• Pressure from firm/other orgs
• Issue favorable research - need to manage pressures to do this
• Using softer/more toned down language is not a solution - investors expect 'reasonably straightforward and transparent' analysis
• Recos must be true opinions, free of bias, and in clear and unambiguous language
• CFAI functions (luncheons etc) - MC should always consider whether it compromises IO and whether a client might reasonably construe it as a compromise
• Buyside clients
• Portfolio managers might implicitly or explicitly support sell-side ratings inflation
• PMs must respect and foster intellectual honesty of research
• Even a perception that a PM reprisal is possible (angry PM) may compromise IO
• Fund manager relations
• MC's who hire outside managers can't accept consideration that would affect IO
• Investment banking relations
• Having research analysts work with investment bankers is appropriate only when conflicts are adequately and effectively managed and disclosed
• MC's must follow best practices - firewalls may prohibit all communication bw groups
• Disclosures should be prominent and specific
• Public cos
• Companies want favorable ratings but don't always deserve them
• Again, perception that a company may retaliate against negative analysts (withhold information, sue, etc) is a reasonable fear for analysts and may compromise IO
• Credit rating agencies
• MCs at rating agencies should abide by agency rules
• Similar pressures to the IB issues
• MCs may need to independently verify the ratings granted
• Issuer paid research
• Companies hire in analysts to increase coverage
• Fraught with potential conflicts
• At a minimum this analysis should include thorough analysis of public financials, benchmarking within a peer group, and industry analysis
• Must distinguish between fact and opinion clearly
• Compensation must be strictly limited - best practice is flat fee not based on conclusion or recommendation
• Travel funding
• Benefits go beyond travel expenses - ex. might have chance to talk w mgmt in person, maybe in a private jet
• Best practice is MCs use commercial transportation rather than arranged travel
• If commercial transport not available, MCs may accept 'modestly arranged' travel to participate in 'appropriate' information gathering events (e.g. a property tour)

Notes from examples

• In general, when allowing companies to pay for travel, MCs must use their judgment
• You can promise to give full research coverage to a company, but cannot promise a rating
• If a banking relationship is forthcoming, it is best to put a company on restricted list to avoid awkward situations
• If asked by a manager to come up with a buy reco, two options - say you cannot cover it because your IO is compromised, or take coverage and come up with own IO analysis and if they conflict it is up to the manager whether to issue
• If you get a gift from a client and disclose it, not a violation - up to your manager to decide if it is excessive
• You should always run the analysis you think is right, even if your manager says otherwise - don't let your manager (even if he thinks he's being reasonable) skew your analysis

I(C) Misrepresentation

MCs must not knowingly make any misrepresentations relating to investment analysis/recos/actions or other professional activities.

• A misrepresentation is any untrue statement OR omission of a fact OR any statement that is otherwise false or misleading (e.g. giving a false impression)
• 'Knowingly' means MC knows or should have known the misrepresentation was being made or that omitted information could alter the process
• Written and electronic communications includes just about everything
• Websites should be regularly updated
• Analyses should cover a wide range of scenarios, from very positive to extremely negative - omission of the negative may misrepresent the economic value of an investment
• Prohibits guaranteeing any specific return on volatile investments - but you can of course state if a product is actually structurally guaranteed

Plagiarism

• 'Copying or using in substantially the same form' materials prepared by others without acknowledging the source of the material or author or publisher (MUST DISCLOSE ALL)
• Other violations:
• Using excerpts or material from others verbatim or only with slight changes and not attributing
• Attributing quotes to 'leading analysts' without naming specific refs
• Presenting statistics and citing but not including relevant caveats
• Using charts and graphs without sources
• Copying spreadsheets without seeking cooperation/authorization of authors (but what if seek and do not receive???)
• One may distribute 3rd party research so long as not representing self as author
• Also applies to oral communication
• Although there is no monopoly on ideas, MCs must give credit where clearly due 
• Sources must be revealed to bring responsibility back to the author

Work completed for employer

• In some situations MC may use research/models from others in the firm without it being a violation - ex. when original analyst(s) is(are) not with firm
• Research and models developed while employed are property of the firm - firm retains right to use information after an analyst has left - may issue further reports without citing analyst
• MC cannot however reissue a previously released report solely under his name

To prevent, Firms can:

• Assign guidance to employees, limit who can speak on behalf of firm
• Be specific about qualifications and experience
• Verify outside information diligently
• Maintain webpages
• Plagiarism - maintain copies of everything relied on, attribute quotes, attribute summaries of other analysts

Notes from examples

• Don't say 'we can provide everything you'll need'
• Typos are not violations because you do not knowingly make them - but once found you must take steps to correct (seems strange...should one reasonably be expected to find a typo?)
• When using another's model, you can take credit for the final recommendation but must acknowledge the author
• If you are steered to a report through media, you can just cite the report and not the media assuming the media added no value for you (interpretation etc.).  It is best to examine and cite original source because media may misintepret.
• Code and Standards stress protecting reputation of firm and sustainability and integrity of capital markets - if you are aware a third party is doing ill, you need to pursue corrections
• Don't pitch products you can't fully understand

I(D) Misconduct

MCs must not engage in any professional conduct involving dishonesty, fraud, or deceit, or commit any act that reflects adversely on their professional reputation, integrity or competence.

I have to note here that anyone who has been to an M&A closing dinner has probably witnessed several instances of professionals compromising their reputation.

• Whereas I(C) is restricted to professional activities/workplace, this standard applies to ALL conduct that reflects poorly
• Being drunk or declaring bankruptcy might not be illegal but may reflect poorly
• In some cases absence of appropriate conduct or lack of sufficient effort may be a violation
• E.g., you don't just rely on someone else's diligence - you need to do it yourself
• Some might abuse CFA PCP for their personal gain instead of professional ethics

To avoid, firms can adopt a code of ethics, provide a list of violations and do background checks.

Notes from examples:

• Don't get drunk at lunch (particularly an issue in London)
• Generally this standard isn't meant to cover legal transgressions resulting from acts of civil disobedience in support of personal beliefs - you can chain yourself to trees and get arrested, and it is not a violation
• If you see what is clearly a reporting issue and are told to keep hush, gather evidence and file a report, and if that doesn't work go to the authorities (see whistleblowing policy in IV(A) too)

End of Standard I - Professionalism

Finish - 2:30 PM, total of 3 hours