PASSMAX

2016 CFA® LEVEL I

HOMEWORK - LOS
STUDY SESSION 1:
ETHICS

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1.1 CODE OF ETHICS and STANDARDS OF
PROFESSIONAL CONDUCT
1.1.a. THE PROFESSIONAL CONDUCT PROGRAM AND THE
ENFORCEMENT OF THE CODE AND STANDARDS

The Code of Ethics (further referred to as the “Code”) is a set of principles that members
must incorporate into their conduct. From these codes, the CFA Institute devised a set of
specific rules referred to as the Standards of Professional Conduct (or just “Standards”).
The Code and Standards are intended to promote fair and ethical business practices.

The Professional Conduct Program (PCP) deals with the violation of the Code and
Standards by CFA Institute members and candidates (hereafter collectively referred to as
just members). The CFA Institute Board of Directors maintains its oversight of the PCP
through its Disciplinary Review subcommittee, and arm which enforces the Codes and
Standards.

An investigation into the member’s conduct may be prompted from any of the following
reasons:
i) A disclosure by the member in the annual Professional Conduct Statement
that a matter has been brought against them.
ii) A written complaint sent to the CFA Institute.
iii) The CFA Institute may itself become aware of a member’s violation through
the publication of regulatory actions or media reports.
iv) The exam proctor may submit a report of misconduct performed during the
examination by a candidate.

The PCP staff would then initiate an inquiry (much like the police). A Designated
Officer would then be appointed to have oversight of the inquiry (much like the district
attorney). After reviewing the evidence, the Designated Officer may do either of three
things:
i) Determine that no disciplinary action is required.
ii) Issue a caution to the member.
iii) Continue the proceedings toward a disciplinary action.

Any proceedings that do follow however, must:

i) Be fair to the member, and
ii) Preserve confidentiality.

During the proceedings, the Designated Officer may propose a sanction (much like a plea
bargain), which the member may either accept or reject. Sanctions may include the
revocation of:

i) Membership with the CFA Institute.

ii) Candidacy in the CFA Program.
iii) The right to use the CFA Designation.

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If the member does reject the sanction, the proceedings would then lead to a hearing by a
panel of CFA Institute members (much like a trial by jury).

1.1.b & c. THE SIX CODES and THE SEVEN STANDARDS

The Codes reflect the principles (i.e. broad values) which every member must adhere to.
Specifically, the Code mandates that members shall:

i) Act with Integrity, competence, and diligence.

ii) Place the interests of the profession and clients above their own.
iii) Use care and independent judgment when making investment
decisions.
iv) Practice in a professional and ethical manner, while encouraging
others to do the same.
v) Promote the integrity of the capital markets.
vi) Maintain and improve their competence as well that of other
investment professionals.

Using the Six Codes as a framework, a more specific set of Standards are developed in
order to address typical situations that a member is likely to encounter while in the
investment profession. In its simplest form, there are seven sets of Standards:

I. Professionalism
II. Integrity of Capital Markets
III. Duties to Clients
IV. Duties to Employers
V. Investment Analysis, Recommendations, and Action
VI. Conflict of Interest
VII. Responsibilities as CFA Institute Members or CFA Candidates

Each of these Standards, in turn, is comprised of a number of specific responsibilities.

Therefore, in its expanded form, the Standards of Professional Conduct are as follows:

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STANDARD I - PROFESSIONALISM
I(A)- Knowledge of the Law
I(B)- Independence and Objectivity
I(C)- Misrepresentation
I(D)- Misconduct

STANDARD II – INTEGRITY OF CAPITAL MARKETS

II(A)- Material Nonpublic Information
II(B)- Market Manipulation

STANDARD III – DUTIES TO CLIENTS

III(A)- Loyalty, Prudence, and Care
III(B)- Fair Dealings
III(C)- Suitability
III(D)- Performance Presentation
III(E)- Preservation of Confidentiality

STANDARD IV – DUTIES TO EMPLOYER

IV(A)- Loyalty
IV(B)- Additional Compensation Arrangements
IV(C)- Responsibilities of Supervisors

STANDARD V – INVESTMENT ANALYSIS, RECOMMENDATIONS, AND

ACTION
V(A)- Diligence and Reasonable Basis
V(B)- Communication with Clients and Prospective Clients
V(C)- Record Retention

STANDARD VI – CONFLICTS OF INTEREST

VI(A)- Disclosure of Conflicts
VI(B)- Priority of Transactions
VI(C)- Referral Fees

STANDARD VII – RESPONSIBILITIES AS A CFA INSTITUTE MEMBER OR

CFA CANDIDATE
VII(A)- Conduct as Members and Candidates in the CFA Program
VII(B)- Reference to CFA Institute, the CFA Designation, and the CFA Program

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While the Code and Standards apply to individuals, firms are encouraged to incorporate
the Code and Standards into their own set of Code of Ethics. Once the firm is able to
achieve this, they may make the following claim:

“Company Name is in compliance with the CFA Institute’s Codes and Standards. This
claim has not been verified by the CFA Institute.”

The company may make this claim even if none of its employees are members of the
CFA Institute. The objective of the CFA Institute is to foster an environment of ethical
behavior in the entire financial industry, not just amongst its members. Ethical behavior
on the part of investment professionals assures investors that their best interests are being
looked after, thus increasing the level of investor confidence.

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1.2 GUIDANCE FOR STANDARDS
The Handbook is a guide which shows how to properly apply the Code and the Standards
to unique situations. Consequently, for each specific standard, we will discuss:
i) Its purpose and scope (guidance),
ii) The procedures required in order to be in compliance with it (compliance), and
iii) How it should be applied (application).

In the discussion that follows, the term “member” will refer to all individuals who are
bound by the Code and Standards (that includes candidates).

STANDARD I - PROFESSIONALISM
I(A)- Knowledge of the Law
i) Guidance:

It is very important for members to become familiar with and to comply with all
applicable rules and regulations as set forth by not only the Code and Standards, but also
by any governing bodies that the member might be subject to (ex. Securities and
Exchange regulations). While members are not expected to become legal experts in this
matter, ignorance or “I didn’t know”, is not a defense either.

In the event that there is a conflict between the Code and Standards and the regulatory
rules which the member is subject to, then the stricter rule shall apply. The logic is that
by complying with the stricter rule, the less strict rule would most likely have been
indirectly complied with as well. For example, the Standards require that a client’s
investment policy be reviewed on an annual basis. However, if local regulations require
updates on a quarterly basis, then the member would have to comply with the local laws
instead. Therefore, in all cases, the Code and Standards would never be violated, as
detraction from the Code and Standards would simply mean that the member is
complying with an even stricter ethical rule (i.e. going beyond that which is required by
the Code and Standards).

On the other hand, there may be some activities that are deemed as legal, but which are
not allowed by the Code and Standards. A member must refrain from these activities.
For example, even if local laws were to allow the member to purchase shares from an
over-subscribed IPO issue at the same time as her clients, the member would be
prohibited from doing so since the Code and Standards clearly gives clients the priority
when it comes to executing trades.

Members must not knowingly participate in any act that may be a violation of the Code
and Standards or any other set of governing rules. Should a member come to learn of
activities within the firm that are clear violations of any of the rules, the member should
first bring the matter to the attention of his supervisor or compliance officer. If the act

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persists, the member must dissociate from such activities, which may involve any of the
following actions:

a) Removing name from reports.

b) Ask for a different assignment.
c) Refuse to accept any new clients or to service the existing ones.
d) Document the violation and urge the firm to persuade the perpetrator to cease such
activity.

Otherwise, inaction coupled with continued association with such activities may be
deemed as participation by the member. In unusual situations, when the activities are
grossly illegal or unethical and nothing is being done by the employer to stop them, then
the member’s best course of action may be to leave the employer. While the firm may be
complacent with such activities, the member must not be. However, the Code and
Standards would not require the member to report such activities to regulatory bodies,
unless it was mandated by law (note again how the stricter rule always applies).
Furthermore, while it is not mandatory, members are strongly encouraged to report
violations of fellow members to the Professional Conduct Program of the CFA Institute.

Therefore, to adhere to the requirements of this standard, the member must:

a) Comply with all applicable laws and industry rules,
b) Never violate the Code and Standards, even if the act is legal, and
c) When the laws, the rules, the jurisdictions, and the Code and Standard all present a
different set of guidelines to deal with a particular situation, the member must follow the
more strict guideline (i.e. the one placing the greater onus on the member)

ii) Compliance:

The best way to comply with this standard is by making an effort to keep current with all
applicable rules and regulations which the member may be subject to. With the onus on
the member, this Standard would clearly be violated if the member knew or should have
known that an activity was a violation.

Specific acts a member may undertake in order to keep her firm in compliance with this
standard include:
a) Keeping employees up to date with respect to changes in applicable rules and
regulations.
b) Ensuring that procedures reflect current laws.
c) Encouraging the employer to establish its own set of code of ethics.
d) Establishing procedures which would enable employees to report a violation. The
formality and complexity of the compliance procedures should be tailored based on
the nature and the size of the firm’s operation.

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iii) Application:

a) In all cases, the member must adhere to the more strict set of rules. For members who
deal within an international context, this would mean knowing the laws of the countries
in which an investment product is ‘developed’ and those in which the product is
‘distributed’.

b) If questionable activities continue, the member must disassociate from it. If unsure
about the legality or ethicality of an activity, the member should seek the advice of
compliance or legal counsel.

c) The member may have to consult with outside legal counsel if the employer’s efforts
to cease questionable activity is ineffective.

d) If a member splits the cost of purchasing copyrighted material, whereby he keeps the
original while his peer keeps the copy, then both would have violated this standard as
they both conspired to infringe copyrighted material.

I(B)- Independence and Objectivity

i) Guidance:

To maintain independence and objectivity, a member must not solicit, accept, or offer any
benefits or gifts to or from special interest (i.e. parties other than the member’s clients).
In other words, the member must maintain her objectivity while at the same time, not
jeopardize someone else’s. To be safe, the member should avoid situations that could
potentially lead to violations. For example, if a mining analyst at ABC Brokers were to
attend a weekend retreat hosted by XYZ Mining Co. (a firm on which the analyst issued
research reports on) then the analyst’s independence and objectivity might become
compromised. Therefore, the perception of a violation (i.e. attending this event) should be
avoided just as much as the violation itself (the analyst’s independence actually
becoming compromised).

A member must make a distinction between a party which is a client (which pays for the
member’s service) and parties which are special interests (which seeks to influence the
member’s decision). A client is expected to compensate the member; thus, gifts from
clients may simply be seen as supplementary forms of compensation. However, client
gifts may only be accepted by the member if the member’s employer consents to it (after
the member discloses the nature and amount of the gift). The employer has to consider
whether such a gift would impair the member’s partiality to the rest of the clients.

On the other hand, gifts (other than token items) which are bestowed by special interests
may be viewed as attempts to influence the member’s decisions. For example, issuers
and underwriters would benefit tremendously if the member were to issue a favorable
report. Consequently, accepting more-than-token gifts from these parties would be
deemed to have impaired the member’s independence and objectivity, and thus a violated
this standard.

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This standard is particularly applicable to analysts. Analysts issue investment
recommendations or ratings, which at times, could have a significant impact on the price
of the subject company’s securities. Consequently then, there are a number of outside
parties who would like to at least have some influence on the analyst’s recommendations.
Some of these special interests are as follows:

a) Investment Banking Relationships:

Large brokerage firms usually have two main divisions: retail and investment banking.
The retail division deals with the portfolios of individual clients, who generally buy and
sell stocks in accordance with what the analysts recommend. On the other hand, the
investment banking division deals with corporate clients, who often times, need to raise
capital (with the investment banking division acting as the underwriter). Naturally, these
corporate clients would like to issue shares at the highest price possible (as they would
get more capital for each share that’s issued). Consequently, corporate clients would
prefer to deal with brokers whose analysts have a favorable outlook for their securities.
(A favorable outlook leads to a higher price, which in turn leads to more capital being
raised). Realizing this, the investment banking division may unduly pressure the analysts
on the retail side of the firm to issue an overly optimistic assessment of the potential
corporate client’s securities (in the hopes of enticing the corporate issuer to utilize their
investment banking services).

However, the analyst’s duty is to the individual clients of the retail division, who rely on
the analyst to give them a fair assessment of the various securities that are available for
investing. Consequently, to preserve the analyst’s independence and objectivity:

i) There should be a firewall between the retail and investment banking

divisions in order to restrict inter-departmental communications.
ii) Under no circumstances should the investment baking division have the
authority to alter or reject reports produced by the analysts.
iii) The analyst’s compensation should in no way be tied to the business that’s
generated by the investment banking division. The existence of such an
arrangement may entice the analyst to only issue positive reports in the hopes
of attracting additional investment banking business, and thus earn a higher
bonus.

This conflict of interest between the two divisions is prevalent enough whereby the
analyst is required to disclose in her reports if the brokerage firm has an investment
banking relationship with the company on which the analyst’s report is based. This way,
a retail investor is made alert to the potential conflict.

b) Public Companies (the issuers):

The price of securities issued by public companies, are heavily influenced by the outlook
expressed by analysts. For example, the issuance of a buy recommendation by the
analyst can result in a significant appreciation of the subject company’s stock price.
During the due diligence phase of the research report, analysts often meet with the senior
managers of these public companies. Consequently, it is possible for these senior

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managers to shut out analysts which have an unfavorable view towards the issuer’s
securities. This may sway the analyst to lighten up her outlook in order to gain access to
information being granted to other analysts. While blocking out analysts is an
unfortunate business tactic that may be used by issuers, analysts must in no way
compromise their objectivity in order to gain access to such information.

c) Institutional Investors:

For example, a mutual fund may hold a large number of shares of Mega Co, a company
for which an analyst at ABC Broker provides coverage for. Consequently, if the analyst
were to issue an unfavorable report, the losses incurred in the mutual fund portfolio could
be quite substantial. As a result, the portfolio manager may threaten to take his trading
business to some other brokerage firm. The analyst must not allow such a threat to
influence her judgment and objectivity.

d) Issuer-paid Research:

In an effort to raise their awareness in the securities markets, some thinly traded public
companies may hire an independent analyst to issue a report on their securities.
However, this situation is fraught with conflict. For example, if the analyst’s
compensation was tied to the eventual price of the security, then the analyst would have a
powerful incentive to issue only a favorable report. Clearly, this would be a violation of
this standard. Irrespective of whether the analyst works for an independent broker or an
issuer, independence and objectivity must be maintained at all times. In particular, for all
reports, the analyst must distinguish between fact and opinion, and use reasonable and
adequate basis to arrive at any conclusions.

To minimize conflict, an analyst contracted to conduct and issuer-paid research should

require a flat fee before the report is produced. Hence, the analyst’s pay would not be
dependent on the conclusions reached. This will enable the member to produce an
objective report, supported by reasonable and adequate basis. It would then be up to the
issuer to determine whether to publicize such a report (remember, they bought the report;
so they can do whatever they want with it). With the analyst fully disclosing all sources
of conflicts, particularly with respect to the sponsor of the report and the means by which
the member is being compensated, the investor can then decide if such conflicts render
the report as biased.

e) Hiring outside Managers:

It is not uncommon for some investment management firms to hire outside managers in
order to manage some portion of the assets that are under their management. In order to
ensure that these managers are hired purely on merit, a member should not accept gifts,
entertainment, or free travel from these outside managers (as these perks may impair the
member’s objectivity in hiring these outside managers). Outside management firms often
do host educational events with the intention of marketing their services. In such cases,
the member must determine if he can attend such an event without losing any
impartiality.

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f) Credit Rating Agency Opinion:

Firms that publicly issue bonds often hire a rating agency in order to rate their bonds
(otherwise investors will not purchase a bond that is not rated). Consequently, a member
charged with rating a bond must not succumb to pressures from the company that is
issuing the bond (which is the same company is paying the rating agency). These
pressures may further be compounded by the fact that rating agencies often provide other
services to issuers. For instance, Mega Co. may hire ABC Rating Agency to not only
issue a rating for its bonds, but to also provide advice on how to develop structured
products. Naturally, issuers are inclined to direct their consulting business towards rating
agencies that issue a more favorable rating for their securities. Despite the lucrative fees
that ABC may collect from Mega for both its rating and consulting services, the analyst
must maintain her objectively when issuing a rating for Mega Co. To maintain this
objectivity, ABC Rating Agency should impose firewalls between its various business
units (i.e. the rating department and the consulting department).

ii) Compliance:

a) Ensure that the analyst’s compensation plan does not impair the objectivity of the
research reports. For example, the analyst’s pay should not be tied to the number of
investment banking clients that are drawn by the reports, or the eventual price of the
security for which the report is being issued (in the case of issuer-paid research).

b) Gifts from special interests (i.e. other than clients), should be limited to token items
only. Business related meals and entertainment are acceptable if it is clear that they are
not designed to impair the member’s objectivity.

c) Ensure that analyst’s reports are not subject to approvals or revisions from other
departments, particularly, the investment banking division.

d) Employee purchases of over-subscribed issues (such as IPO’s or private placements)

should be restricted. Firms should mandate that their employees obtain prior approval
before purchasing IPO shares, and prompt disclosures of any investment actions taken
after the IPO.

e) If the employer is unwilling to have unfavorable reports issued regarding one of its
investment banking clients, then that corporate client should be removed from analyst
coverage list and instead be put on a restricted list, thus allowing only factual information
to be released (i.e. with no recommendations).

f) If an analyst has to make a site visit to an issuer (as part of her research work), then the
analyst’s firm should pay for all commercial transportation and lodging. The analyst
should not accept any reimbursement from the issuer. In the case where the issuer’s
facilities are inaccessible by commercial means, an analyst may rely on the issuer’s
arranged form of transportation and lodging (for instance, touring mines at a remote
location). However, such accommodations must not be lavish. Lavish spending by an
issuer on an analyst can be deemed as attempts to influence the analyst’s decisions.
Furthermore, during these issuer sponsored trips, the analyst may get too much face time

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to the host company’s executives (be it in flight or at tours of the company’s sites). The
analyst must ensure that this one-on-one face time with the issuer’s executives will not
impair her objectivity when issuing research reports on the very same issuer.

g) If the meetings between the analyst and the issuer are quite frequent, then the issuer
should not always be the one that’s hosting. For instance, on some occasions, the senior
officers of an issuer should visit the analyst’s office.

iii) Application:

a) Members should avoid situations that merely give the appearance of a conflict of
interest. However, if such situations cannot be avoided, then they should at least be
disclosed. Best practice is for the analyst not to receive any benefits from the parties that
have a vested interest in the outcome of her recommendation. Analysts must be careful
not to become too friendly with issuers on whom they issue research reports on.

b) If an analyst is instructed to issue a report with a conclusion that is contrary to the one
that she arrived at objectively, then she should either decline to issue the report or to issue
the report with her own independent conclusion, and leave the publication decision up to
her superiors. The point is that the analyst can never compromise her objectivity.

c) While gifts from issuers are restricted to token amounts only (i.e. items with nominal
values of less than a $100), gifts from clients are treated differently. In the latter case,
gifts may be accepted so long as they are disclosed to the employer. It would then be up
to the employer to decide if such a gift would impair the member’s fiduciary duty to all
the other clients. This employer oversight provision is intended to avoid situations where
the member begins to give preferential treatment to the gift-giving clients at the expense
of the other clients.

d) Analysts are not the only individuals whose objectivity is constantly tested. For
example, portfolio managers must execute client trades through brokers. Consequently,
brokers may attempt to lure the portfolio manger’s business through many incentives.
For example, in what is referred to as a soft-dollar arrangement, a broker may promise to
pass some of the fees earned on trades directed by the portfolio manager back to the
portfolio manager’s firm in the form of benefits. Consequently, the manager may have
an incentive to choose a broker with the soft-dollar arrangement that’s most favorable for
him. In effect then, he would not be choosing a broker for his client’s account in an
objective manner.

e) If the research report is sponsored by the issuer, then this special relationship between
the analyst and the issuer must be disclosed in the research report. However, disclosure
alone simply points out the conflict of interest. To actually prevent the conflict and thus
maintain the objectivity of the report, the member’s compensation should not be tied to
the outcome of the report; instead it should be a flat fee payable before the report is
produced.

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f) While the investment banking division may assure its corporate clients that they will
receive analyst coverage, it should never promise the issuer that its analysts will produce
a favorable report.

I(C)- Misrepresentation

i) Guidance:

Misrepresentation is the act of making an untrue statement or omitting an important fact.

Consequently, a member must not knowingly misrepresent his analysis, recommendation,
or some characteristics of an investment. For example, indicating that the returns on a
particular investment are guaranteed when in fact they are not, would be clear violation
of this standard. Members are also barred from misrepresenting their qualifications,
credentials, and performance records.

This standard also prohibits plagiarism (the act of copying or using in substantially the
same form, material prepared by others without acknowledgment). Consequently, if a
member uses someone else’s idea or research, he must not mislead the reader into
thinking that it was his own. Instead, the member must disclose the source of the original
work. The rules on plagiarism apply to oral as well as written forms of communication.
The following examples then would constitute a direct violation of this standard:

a) Rewriting parts of a third party report without acknowledging the source.

b) Attributing some statements as having been made by leading experts without
specifically mentioning who these experts were.
c) Attributing statements to their original source but without mentioning the caveats
that were attached to those original statements.
d) Copying spreadsheets or models without first obtaining permission from the
original author.
e) Using charts and graphs without stating the source.

Sometimes, it may be more economical for a broker to outsource its research work
(perhaps because it has no expertise in the area of interest). While the broker may in turn
re-distribute these third party research reports to its clients, it may not hold itself out to be
the original author of the report. This provision ensures that members do not
misrepresent their capabilities, while allowing clients to know the source of the expertise
behind the reports.

ii) Compliance:

To avoid misrepresentation, a firm should:

a) Publish a listing of its qualifications and services, so as to avoid any confusion or

misunderstanding.
b) Designate a limited number of individuals who would be authorized to speak on
behalf of the company.
c) Update its website to ensure that it reflects the firm’s current capabilities.

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The following actions may help to prevent plagiarism:

a) Keep a copy of all the work that was used in the preparation of a report.
b) Attribute all works to their original source, even when summarizing them. The only
exception to this rule is if the source was a widely recognized statistical or financial
reporting agency (ex. Reuters).

iii) Application:

a) A member or his employer should limit a description of their services to only those
that are actually provided.

b) A member writing an issuer-paid research report must disclose the nature of her
relationship with the issuer.

c) If it comes to be known that incorrect information was distributed regarding the

credentials or qualification of the member or her firm, then the distribution of all such
material must cease and those who received the erroneous information must be notified.

d) A member may use portions or summaries of another’s report, so long as the original
source is identified. This rule also applies if the member modifies or retests a model
originally developed by someone else.

e) A member may indeed violate this standard unknowingly, if he should have known
that a particular act would lead to misrepresentation.

f) Avoid copying material verbatim (word for word), even if it’s a description of a
common concept (ex. a description of beta). Thus, a member should either cite the
source of the original description or describe the concept in his own words.

g) A member using information learned through a media outlet (ex. Newspaper), should
cite the original source of the information, rather than the media outlet itself. There is no
need to mention the media outlet from which the info was learned from, if the member
does not use that outlet’s interpretation of that info. The best course of action would be
for the member to get the complete work from the original source, and thus only
acknowledge that source.

h) A firm must not lead clients to believe that they were the authors of outsourced
research reports, even if they did pay for it. Members and their firms must not
misrepresent their capabilities.

i) A member must not knowingly make a statement of assurance or guarantee with

respect to expected investment performance.

j) When issuing an outlook, an analyst should incorporate a broad range of scenarios. Omitting
potentially large negative outcomes may misrepresent the true risk-return characteristic of the
investment.

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k) The member must not misrepresent credit ratings or third party research into her own reports.
Therefore, the member must exercise care and diligence when incorporating any third party
information.

l) A member may use models or research developed by others within the same firm without
making any attributions to the original authors, as these materials are essentially the property of
the firm. However, a member cannot re-issue a previously released report as his own.

m) When outsourcing work to third parties (i.e. sub-managing a portion of a portfolio), the
member has a responsibility to ensure that any marketing material provided by the third party is
accurate with respect to their capabilities and services. This is especially important if the two
firms jointly market their services. As well, the member should encourage her employer to
develop procedures in order to verify the accuracy of information that is provided by the third
party firms.

I(D)- Misconduct
i) Guidance:

A member must not engage in any activity that would reflect poorly on his integrity.
This includes acts of deceit, fraud, or dishonesty. Even if an act was not deemed as
illegal or was related to member’s personal life only, a violation of this standard would
nevertheless occur if the act could damage the profession’s reputation. While the Code
and Standards only apply to the member’s professional life, it is inevitable that unethical
behavior in one’s personal life will eventually spill over to his professional life. For
example, drug and alcohol abuse will eventually engulf the member’s professional life.

ii) Compliance:

To minimize misconduct, a firm should:

a) Adopt a code of ethics that all employees must adhere to.

b) Conduct background checks on prospective employees to ensure that bad behavior
isn’t brought into the firm.
c) Ensure that employees are aware of what acts that are deemed as misconduct and the
disciplinary actions that would apply to such acts.

iii) Application:

a) Even though acts of civil disobedience may be illegal (ex. forming a blockade to
prevent logging of a nearby forest), it does not necessarily constitute a violation of this
standard since such acts are meant to make a point. In other words, those acts are not
grounded in deceit or fraud, and thus do not necessarily reflect poorly on the member’s
professionalism or integrity.

b) A member must never circumvent the Code/Standards, local laws, or her firm’s rules.
For example, a member might have a pre-clearance from her firm’s compliance
department to purchase 3,000 shares of Stock A and short sell 5,000 shares of Stock B. If

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however, the member only ends up purchasing 3,800 shares of Stock A instead, then she
would be in violation for having purchased 800 more shares than what she was allowed
to. Note that by not going ahead with the short sell, a violation is not committed since a
pre-clearance only sets an upper bound for a trade.

c) The absence of appropriate conduct, along with a lack of effort to correct the situation, may be
viewed as a violation of the Code and Standards. If the firm refuses to take corrective action,
then the member should seriously consider reporting the unethical behavior to regulators (even
though the Code and Standards does not explicitly require this course of action).

d) A member is expected to conduct the necessary due diligence before undertaking an

investment recommendation or action. By omitting these steps and simply relying on other’s
assessment, the member may breach his duty towards his clients.

STANDARD II – INTEGRITY OF CAPITAL MARKETS

II(A)- Material Nonpublic Information
i) Guidance:

If a member comes to possess material nonpublic information, then he must not act or
cause others to act on it. Information is deemed material if its disclosure would impact
the price of the security or it would be something that an investor would consider before
making the investment. Whether the information is material or not, is dependent upon
the following characteristics:

a) How specific the information is: For example, if the information is regarding the sales
projection for a firm over the coming quarter, then the information could be deemed as
quite material. On the other hand, if the information is regarding the long term trend in
sales for a particular industry, then it may not be all that material, as the market impact of
such a disclosure would not be all that clear.

b) How reliable the information is: For example, disclosure by a small supplier that its
customer, Mega Co., is losing market share is not as reliable as a similar statement made
by a senior executive at Mega. Consequently, the less reliable the source, the less
material it is likely to be.

c) The extent to which the information differs from current public information. For
example, if the new information is simply in line with what is already publicly available,
then it is unlikely to be deemed as material.

d) Passage of time: the more dated the information, the less likely it is to have an impact
on market price upon its disclosure.

© 2016 PASSMAX. All Rights Reserved. SS1-16

For publicly traded companies, material non-public information may be in reference to:
• Tender offers (i.e. either it’s being taken over or it is taking over some other
company). Regulatory approvals.
• Change in management.
• Change in dividend policy.
• Change in auditors.
• Stock splits.
• Earnings figures.
• Change in credit rating.

Material non-public information may also refer to items that are not associated with
publicly traded companies. For example:

a) Pending orders for large trades (ex., knowing that a large buy order may drive
up the price of a stock, a trader with advance knowledge of this pending trade can
purchase the ahead of time).

b) Government reports of economic activity (ex., data that’s worst than expected
can possibly drive down market prices once it is disclosed)

c) A pending analyst’s recommendation (ex., a Buy recommendation may very

well cause the stock price to appreciate).

In each of these examples, there is the potential for a significant impact on market prices
once the information is disclosed. Consequently, such information must not be acted
upon until it is made available to the market at large. Disclosure to a select group of
analysts would not constitute a public disclosure. Instead, the information must be
disseminated to the market under the assumption that the market will receive the
information in a normal course of operation. It is not necessary to assume the slowest
method of transmission of the information. For instance, a day after disseminating the
information, it is reasonable to assume that the information is no longer considered as
materially non-public.

Sometimes, an astute analyst is able to piece together non-material non-public

information along with material public information to reach a conclusion that would have
been reached had the analyst possessed materially non-public information. For example,
an analyst may observe that Mega’s customers are placing larger orders with the firm (i.e.
the non-material non-public piece of the puzzle) while at the same time noting that one of
Mega’s competitor’s sales are dwindling (the material public component). Quickly
adding the competitor’s lost sales to Mega’s sales, the analyst computes an earnings
figure that comes in line with the eventual earnings figure that is released by Mega. This
process is referred to as the “Mosaic Theory” and it is perfectly legitimate. In fact, such
activity is the hallmark of an exceptional analyst.

© 2016 PASSMAX. All Rights Reserved. SS1-17

ii) Compliance:

If a member should come to possess material non-public information, he should

encourage the source to immediately disseminate the information to the public. For
example, if the member inadvertently overhears insiders at Mega Co. discussing their
soon to be released earnings figures, he should then immediately encourage Mega to
make those figures public. If that is not possible, then the member should only notify his
supervisor of the situation and ensure that no action is taken on this information.

To avoid coming in possession of such information, members must be careful not to

induce or trigger the release of this information privately while in contact with issuers.
Issuers, on the other hand, should make press releases before analyst meetings so that
they will not be viewed as making selective disclosures. Furthermore, during those
meetings with analysts, corporate managers should discuss only what is considered to be
public information up to that point.

A member should also encourage her employer to review all employee and proprietary
trading at the firm to ensure that no one is trading on material non-public information.
Furthermore, the employer should establish a firewall in order to monitor inter-
departmental communications and ensure that materially non-public information is not
being transmitted inappropriately from the investment banking division (who possess
inside information about their corporate clients) over to the retail division (who only have
access to publicly available information). A proper firewall would involve the following:
• A clearance area through which information is transmitted between departments.
• A review of employee trading of securities on watch or restricted lists.
• A documentation of the procedures used to limit the flow of information between
departments.
• A heightened scrutiny of trading when the company is in possession of materially
non-public information.

As well, there should be a physical separation of the investment banking division from
the retail division. The goals of the clients for each of these departments are in direct
conflict with each other. For instance, corporate clients of the investment banking
division would like to see their securities issued at the highest price possible while retail
clients would like to buy these same securities at the lowest price possible. Since both
departments must serve clients with conflicting interests, there should be no overlap of
personnel. Therefore, an employee may only work for one department at any given point
in time. For example, if an analyst is asked to share her industry expertise by working
with the investment banking division, then during that assignment, she would no longer
be able to issue research reports for the retail division. This would make sense since
during her time at the investment banking division, she would come to possess details
about corporate clients that aren’t public yet.

The following steps are designed to meet the compliance requirement of this standard:

a) There should only be a limited number of supervisors or compliance officers

designated in order to act as intermediaries between the two departments.

© 2016 PASSMAX. All Rights Reserved. SS1-18

b) The firm should keep written records of all communication flows between the
departments.

c) Implement a training program for all personnel so that they do not inadvertently trade
on material non-public information.

d) Monitor the trading activities of employees and their immediate family members. In
particular, when the firm is in possession of materially non-public information, all
affected securities should be placed on a watch list to ensure that its employees are not
trading on such information.

Note however, that this standard does not prohibit all proprietary trading activity when
the company is in possession of materially non-public information. Instead, the watch list
is simply used to detect unusual activities. For example, if a firm’s employees regularly
trade an average of 5,000 shares of Mega Co. then a red flag would arise if an abnormally
higher number of shares were traded at a time when the firm possessed material non-
public information on Mega Co.

ii) Application:

a) Taking investment action on material non-public information is a violation,

irrespective of how it was obtained. For example, even if the material non-public
information is inadvertently overheard, any resulting investment action before the
information becomes public is a violation. Trading on material non-public information
gives an unfair advantage over the investing public. This practice could cause investors
to lose confidence in the capital markets.

b) If the member is in a position whereby dealing with material non-public information is

part of her occupation (ex. Investment banker), then it is just as much a violation of this
standard if she fails in her duty to prevent the transfer or the misuse of such information.

c) Pending analyst recommendations, as well as pending large orders, may also be

deemed as materially non-public information (as their disclosures would impact the price
of the affected securities). Consequently, any investment action taken before such
information becomes public, would be a clear violation of this standard.

d) Measures taken to prevent employees of a brokerage firm from trading on material

non-public information include:
• Firewalls: which prevent communication between the investment banking
division (who possess material non-public information about their corporate
clients) and the retail division (whose analyst attempt to set a valuation for those
same corporations).
• Watch lists: so that supervisors can monitor employee trading on securities for
which the brokerage firm is currently in possession of material non-public
information.
• Restricted list: includes the names of issuers for which the brokerage firm is
currently doing investment banking business with. To prevent a conflict of

© 2016 PASSMAX. All Rights Reserved. SS1-19

 interest, analysts would only be allowed to issue factual reports on these issuers
(i.e. without any recommendations accompanying the report).

e) Material non-public information may not be used to trade either the security that is
directly affected or any other security whose value may be tied to that particular security.
For instance, if a member should come in the possession of unreleased positive earnings
news from Mega Co., then the member must not only not trade Mega shares, but he must
also refrain from trading any options on Mega shares as well. The point is not to profit in
any manner from the use of material non-public information.

f) Any trading based on material non-public information is a violation, even if that trade
should eventually result in a loss.

g) The firm should designate a single supervisor or compliance officer with the task of
determining if information is public enough in order to be used as the basis for
investment recommendation or action.

II(B)- Market Manipulation

i) Guidance:

Members are prohibited from engaging in practices which are intended to manipulate
security prices or their volume in an effort to mislead the public. While all trading
activity will have some impact on the security’s price and volume, for a violation to
occur, the intent to manipulate must be present. For example, placing a large order in the
final minutes of trading to show a higher closing price just so that other participants can
join in and drive up the stock price even higher, would be a violation. However, placing
the exact same order because the member believes that fundamentally, the stock is
undervalued, would be considered as legitimate activity, even if the trade induces other
participants to jump in and drive the stock price even higher. Once again, it is the motive
for the trade that determines whether this standard is violated, not its eventual impact on
market price.

Similarly, efforts to exploit market inefficiencies (ex. Long stocks and short stock
futures) or to execute tax loss strategies (ex. Sell in December and repurchase in January)
all have legitimate motives. In other words, these actions were not intended to
manipulate the markets, but to rather profit from market opportunities.

ii) Compliance:

The following examples would not be in compliance with this standard:

a) Acquiring a majority stake in a security just so its price and volume can be
manipulated.

b) Spreading false rumors in order to affect the security’s price.

© 2016 PASSMAX. All Rights Reserved. SS1-20

iii) Application:

a) Issuing inaccurate reports improperly identified as being objective analysis is a

violation.

b) Even if a member does not personally benefit from manipulative activity, the act itself
is the violation, not the resulting profit.

c) A stock exchange may attempt to inject some liquidity into some of its listed securities
by requiring its members to artificially boost their trading volume. Liquidity is one of the
necessary building blocks in forming an efficient market. However, unless the exchange
discloses such a practice, the action of its members will be deemed as a violation of this
standard.

d) Mutual fund units are only priced after the market closes. Consequently, only orders
received before the market close should receive that day’s closing price. Otherwise,
manipulation would be possible. For example, if at 4:05pm, some positive economic
report is released, then knowing that the markets will open higher the next day, a trader
may place a buy order for the mutual fund at 4:06pm, but force the mutual fund to
backtrack the time of the request so that the units are bought at the pre-economic news
price. Such a practice would be a clear violation of this standard.

e) Trades intended to exploit market inefficiencies are ‘not’ a violation of this standard.
For instance, suppose that two firms, Mega Co. and York Co. are exactly identical. If
Mega Co. is trading at $15 a share while York Co. is trading at $17 a share, then
purchasing Mega Co. shares and short selling York Co. shares should eventually result in
a profit of $2 to the trader. This trade would in no way violate the Code and Standards.

f) Any manipulative activity which may result in a loss of confidence in the market
would be deemed as a violation of this standard.

g) Manipulation may also be present if a scenario analysis is presented that excludes

certain adverse events. This output would no doubt underestimate the degree of risk that
is inherent in the underlying investment.

STANDARD III – DUTIES TO CLIENTS

III(A)- Loyalty, Prudence, and Care

i) Guidance:

A member must always place the interests of clients ahead of his own and that of his
employer. As well, he must act with care, skill, and diligence. Furthermore, the
member’s actions must always be bound by any applicable laws or regulations that may
exist. For example, a pension fund manager in the U.S. must not only act with care, skill

© 2016 PASSMAX. All Rights Reserved. SS1-21

and diligence, but her actions must also adhere to the guidelines as set out by ERISA
(Employee Retirement Income Security Act).

A member must also be clear in identifying who the ultimate client is, as it is that party to
which a duty of loyalty is owed to. For example, the pension fund manager would have a
fiduciary duty towards the beneficiaries (employees) of a pension fund, and not the
employer which hired the manager in the first place. Consequently, whatever investment
actions the manager takes, she must only consider the well being of the pensioners.

Portfolio managers are also in a position to vote the proxies related to the shares being
held in the portfolio. Firms that are publicly traded are required to mail out proxies to their
shareholders so that they may be able to vote on matters that are important to the firm (such as the
election of new members to the board of directors). Consequently, investment managers who
manage portfolios on their client’s behalf, would receive these proxies directly. Proxy voting is
very much a part of the investment management process, since the outcome of the vote
may very well shape the fortunes of the securities that are being held. Consequently, the
manager has a duty to vote the proxies on behalf of the clients for which their portfolio is
being managed. Furthermore, the manager should disclose to the client the process that
he uses in voting proxies. If the manager can justify his actions, then voting proxies on
routine issues may not be necessary all the time.

Portfolio managers may also be in a position to select the broker through which client
trades will be undertaken. Of course, brokers charge varying rates of commissions for
such trades, which in turn would be expensed to the client’s account. The issue of soft
dollars arises when trades for client accounts are executed through brokers who charge
full service commissions, but who also provide other services to the manager, for
instance, research. The manager can then argue that such high commission costs are
justified given the added value that the broker’s research brings in to the investment
decision making process. Consequently, the practice of paying soft dollars (i.e. using
commission to paying for services other than direct execution costs) is allowed so long as
all the following conditions are met:
• The services (ex. Research) obtained assists the manager in making better
investment decisions for her clients.
• The amounts paid are in line with the services received from the broker, and
• The soft dollar practice is disclosed to the client.

Therefore, if the manager were to use client brokerage to pay for services that did not
directly benefit the client, then this standard would have been violated. The exception to
this rule is if the client were to direct the manager to use a specific broker, even if that
broker charged a rate that was considered to be high in relation to the services being
rendered (it’s the client money, they can spend it however they see fit). However, the
manger should still disclose to the client any apprehensions he may have about using that
specific broker (i.e. the quality of the broker’s service not justifying the fees).

© 2016 PASSMAX. All Rights Reserved. SS1-22

ii) Compliance:

The following are just some of the things that a member and her employer can do in order
to comply with this standard:
a) Diversify client assets, unless this would be imprudent given the client’s objectives and
constraints.

b) Disclose all actual and potential conflicts of interest to the client.

c) Seek the best execution for client trades.

d) Maintain confidentiality.

e) Disclose all forms of portfolio management fees that are charged to the client (i.e. no
hidden fees).

f) Submit to clients an itemized statement of their holding at least on a quarterly basis.

g) If ever in doubt about a specific action, the matter should be disclosed in writing to the
client and their consent obtained.

h) Have a formal policy with respect to how to allocate block trades among various client
accounts and how to disseminate investment recommendations. This will ensure fair
dealing with all clients. For example, a portfolio manager managing 5 separate accounts
may only be able to purchase 10,000 shares of an over-subscribed stock issue. The
question then becomes how to allocate those 10,000 shares over the 5 accounts. This
standard would require a fair allocation procedure, with its details disclosed to the clients
in advance.

i) Make reasonable inquiry into the clients’ investment experience, risk and return
objectives, and investment constraints before taking any investment action on their
behalf.

j) The suitability of an investment should be determined by examining the client’s needs,

the investment’s basic characteristics, and the affect that the investment would have on
the client’s portfolio.

k) Conduct regular portfolio reviews to ensure that it is in line with its mandate.

l) Vote proxies such that it ultimately benefits the client.

m) Seek the party (i.e. broker) that provides the best trade execution for the client’s
portfolio, unless directed by the client to use some other entity.

© 2016 PASSMAX. All Rights Reserved. SS1-23

iii) Application:

a) A member must always act in the best interest of her clients. Therefore, on the matter
of proxies (whereby the investment manager controls the votes for all the shares that are
held on behalf of her investors) the member must vote in the interests of her investors,
and not necessarily side with the managers of those publicly traded companies. For
example, if Mega Co. becomes the target of a hostile takeover, naturally its senior
managers would attempt to persuade its shareholders to vote against the proposed
takeover. However, if the takeover price for Mega shares is attractive enough, then the
member must vote in favor of the acquisition.

b) If a situation should arise that poses an actual or perceived conflict of interest, the
matter should be disclosed to the client immediately. While a conflict does not mean that
the member must cease servicing the client, the client should be aware of factors that are
not necessarily conducive to serving their best interests.

c) A portfolio manager may direct client trades to brokers which routinely send business
to the manager (quid pro quo) so long as the clients are not being disadvantaged by this
arrangement. For example, the fees charged by these brokers (which are paid with client
money) would have to be reasonable, given the level and quality of service provided, and
the reciprocity arrangement with the broker would have to be disclosed to the client.

d) Accounts for non-immediate family members, who pay regular fees, would not be
subject to the same restrictions that would apply to the accounts for which a member has
a beneficial interest in. In other words, these family accounts should be treated the same
way as any other client account.

e) An investment manager who fails to vote proxies on important issues, casts votes without
initially conducting a proper due diligence, or votes blindly with the issuing firm’s managers on
non-routine issues, will be in violation of this standard.

f) In cases where an investment manager is managing a pool of assets (i.e. mutual funds), there
isn’t a particular beneficiary towards whom a duty of loyalty is owed towards. Instead, the
manager is simply required to adhere to the mandate of the fund. For example, the task of a small
cap equity fund manager would be to select the best small cap stocks for the portfolio. The task
of determining whether the fund is suitable for a particular investor would fall upon the advisor
(broker) who recommended the fund in the first place, not the manager of the fund itself.

g) If providing expert testimony, the member’s first priority is to provide testimony that is
independent and objective, irrespective of the impact that his testimony might have on the party
that hired the member as an expert witness.

h) If a family member has a regular fee paying account at the member’s firm, then this account is
owed the same degree of loyalty, prudence, and care that is owed to all the other arm’s length
accounts at the firm.

© 2016 PASSMAX. All Rights Reserved. SS1-24

III(B)- Fair Dealings

i) Guidance:

A member must not benefit one client at the expense of another. For example, a member
cannot allocate favorable trades to the larger clients at the expense of the smaller clients.
Instead, the member must deal fairly with all clients. However, fair does not necessarily
mean equal. For example, it would be perfectly acceptable for a firm to offer a higher
level of service to its premium paying clients, so long as this practice is disclosed, and the
premium service is made available to all clients who are willing to pay the higher price.
For example, if an analyst were to issue a new recommendation, this standard would
require that all clients be informed of this news at around the same time. However, after
the information has been disseminated to all the clients, the premium paying clients may
receive a call from the analyst elaborating on his already publicized reasons for issuing
the recommendation. The point is that no one group of clients received an unfair edge
over the other.

This standard is particularly applicable when it comes to two sets of activities:

a) Investment Recommendations:
These should be disseminated in a manner that would give all clients a fair opportunity to
act upon it. Disclosure to a selective group are prohibited. Whenever there is a change in
a recommendation, all clients who acted upon the original recommendation should be
notified of the change. Furthermore, if during the time of disseminating the change in
recommendation, an uninformed client places an order that is contrary to the new
recommendation, then the member would have a duty to inform the client of the change
in recommendation before accepting the order.

b) Investment Actions:
The shares acquired from a block trades should be distributed among the various client
accounts in a fair manner. If the clients had oversubscribed (i.e. collectively, the number
of shares ordered was more than what the manger was able to acquire in the market), then
the manager would have to pro-rate the distribution (i.e. each account would have to get
less than their original order). In other words, no one particular client is disadvantaged
by the allocation policy. However, since the member’s interest (which includes
immediate family) and that of her firm are secondary, they would have to forfeit any buy
orders that they may have placed for the over-subscribed issue, thus allowing the
maximum number of shares to become available for distribution to their clients.

ii) Compliance:

The following measures should be undertaken in order to comply with this standard:

a) Limit the number of access persons (employees who are privy to a pending investment
recommendation).

© 2016 PASSMAX. All Rights Reserved. SS1-25

b) Reduce the lag as much as possible between the time that an analyst concludes her
report and the time that it is disseminated to clients. Should a comprehensive report take
too long to publish, then an advanced summary report should be released in the interim.

c) Prohibit access persons from discussing what they know or taking investment action
based on their knowledge.

d) Maintain a list of clients who might be affected by any changes in recommendation.

e) Monitor the trading activities of employees to ensure that there is no front-running

ahead of pending orders (i.e. placing a trade to profit from the market impact that a larger
pending trade will have once it’s executed). The best practice would be to communicate
a recommendation both within the firm and to clients simultaneously. This will ensure
that employees of the firm do not get an edge over the firm’s clients.

f) Disseminate recommendations to all interested clients within approximately the same

period of time. For example, a member should not give preferred clients advanced
knowledge of recommendations if such an act would disadvantage other clients. Note
that a member need not notify clients for whom the investment may not be suitable for.

g) Ensure that shares from an oversubscribed block trade are distributed on a pro rata
basis and that each client is given the same price and charged the same transaction fee on
a per share basis. For example, if eventually 50,000 shares are acquired, with the first
25,000 purchased at $10 a share and the second at $12, then each client’s account should
be charged $11 (i.e. the average between $10 and $12) for every share that’s assigned to
them. Furthermore, if the total transaction fee in acquiring the 50,000 shares was
$12,500, then each client should be charged a fee of $0.25 ($12,500/50,000) for each
share that’s allocated to their account.

h) In a block trade, securities should be allocated on a client basis, not on a per manager
basis. For example, if a firm had two investment managers with the first one having 5
clients and the second one having 10 clients, block trades executed on a firm wide basis
should be divided into 15 pieces (client basis) rather than two equal pieces (manager
basis).

i) Disclose the firm’s trade allocation procedures in writing to its clients. However,
disclosure and subsequent client consent is not grounds for the firm to implement an
unfair allocation procedure. An unfair allocation procedure would be a violation even if
the client were to consent to it.

j) Conduct a systematic review of the accounts held at the firm to ensure that no one
client is given a preferential treatment at the expense of another.

k) Disclose to all clients the differing levels of service that are provided by the firm.

© 2016 PASSMAX. All Rights Reserved. SS1-26

iii) Application:

a) Access persons are those who are in possession of material non-public information (ex.
pending recommendations). To ensure fair play for everybody else, the trading activity
of access persons (and those of immediate family members) should be restricted until
clients have had an opportunity to react to the new recommendation.

b) A member should also disclose his firm’s trade allocation procedure at the beginning
of a client relationship. To ensure fair allocation, a member should allocate shares to
client accounts immediately following the block purchase. If allocation is postponed, and
the share price appreciates during that time, then the manager may have an incentive to
allocate a greater proportion of those shares to his preferred clients. Alternatively, if the
share price were to fall, the manager may have an incentive to direct those shares away
from his preferred clients’ accounts. Clearly, this would be an unfair practice, not to
mention a violation of this standard.

c) The member may also find herself being the intermediary between two of her clients.
For example, if Client A wanted to sell some Mega Co. shares while Client B wanted to
purchase some of those shares, then the price at which that transfer is made would have
to be fair and the details of this inter-client trade disclosed to both clients. The member
should obtain both clients’ consent before executing such a trade.

d) When clients’ collective order size exceeds the amount of shares that the firm is able to
acquire, the firm must allocate those shares among the various clients in a manner that is
practical and fair. For instance, suppose that of the firm’s 10 clients, 7 place an order size
of 20,000 shares and 3 place an order size of 80,000 shares, thus resulting in a collective
buy order of 380,000 shares [(7x20,000) + (3x80,000)]. Now suppose that for liquidity
purposes, the firm allocates shares in blocks of 10,000 (i.e. it’s easier to trade a stock in
blocks of 10,000 shares then it is to trade in partial blocks). Consequently, if the firm is
only able to acquire 160,000 shares, perhaps the fairest allocation would be as follows:

Shares Requested Shares Allocated

7 clients: 20,000 each 10,000 each (minimum block size)
3 clients: 80,000 each 30,000 each

In other words, after the first 7 clients are allotted 10,000 shares each, only 90,000 shares
would remain [(160,000 – (7x10,000)]. Consequently, when this remainder is allocated
among the 3 remaining clients, each would get 30,000 shares. Had this minimum lot size
restriction not been applicable, then each client that placed an order for 20,000 shares
would have been allocated 5.26% (20,000 ÷ The total order size of 380,000 shares) of
any acquired shares and all those who placed an order for 80,000 shares would have been
allocated 21% (80,000 ÷ 380,000).

© 2016 PASSMAX. All Rights Reserved. SS1-27

III(C)- Suitability

i) Guidance:

This standard is particularly applicable to investment advisers and portfolio managers,

since they would have to deal directly with individual investors (i.e. they are in an
advisory position). Consequently, when trying to determine the suitability of an
investment for a particular client, a member should:
• Inquire into the client’s investment objectives, constraints, and financial situation
prior to making any investment recommendations.
• Gauge the client’s level of investment knowledge and experience (i.e. less
experienced investors tend to have a higher aversion to volatility).
• Keep current on the client’s situation on a regular basis.
• Ensure that an investment is suitable for a particular client before it is
recommended.

Suitability of an investment should be determined from the perspective of the client’s

overall portfolio, not on a security by security basis. For example, commodities are a
very volatile asset group; however, since they have little correlation with stock and
bonds, a portfolio constructed with the inclusion of commodities might be less volatile
than one constructed using stocks and bonds alone. Consequently, commodities would
be viewed as a suitable investment, even for some of the more conservative clients.
Only actions which are consistent with the client’s portfolio objectives and constraints
should be undertaken.

ii) Compliance:

To best fulfill the requirements of this standard, the member should construct an
"Investment Policy Statement" (IPS) for each client at the onset of a new relationship.
The IPS is a written document which highlights the client’s:
• Personal information (age, occupation, financial situation).
• Objectives (in terms of both risk and return).
• Constraints (liquidity, tax, regulatory, time horizon).
Consequently, when these client parameters (as indicated on the IPS) are combined with
the manager’s expectations regarding the capital markets (i.e. the outlook for the various
investments), the manager will be able to develop a Strategic Asset Allocation (SAA) for
that client’s portfolio.

The IPS should also identify the roles and responsibilities of the various parties involved
in the portfolio management process as well as a schedule for periodic reviews. In
general though, an IPS should be updated annually to see if any changes are warranted in
the portfolio in order to better reflect the client’s current risk and return objectives. A
more immediate update may be warranted if there should be significant changes in the
client’s tolerance for risk, wealth, tax status, health, liquidity requirements, or the number
of dependents. For institutional clients, important changes (which may warrant a review
of the IPS) may include items such as a change in the funded status (if it’s a pension plan)
or a change in the distribution requirements (if it’s a foundation or an endowment plan).

© 2016 PASSMAX. All Rights Reserved. SS1-28

When determining the suitability of an investment for a client, the member should
consider the client’s overall portfolio, and not just the portion that is managed by the
member. After all, the client’s well being will be based on how her investments
collectively perform. For example, if a portion of the client’s overall portfolio is invested
in high risk assets with an on-line broker, then perhaps it would be more prudent if the
member looked at some more conservative assets for the portion of the client’s portfolio
that he is currently managing. In effect, the member is taking into account the client’s
overall risk exposure before taking any investment action. Therefore, suitability can best
be determined if the client were to disclose all her holdings, and not just the portion being
managed by the member’s firm.

The exception to this “big-picture” approach would occur if the member was simply
hired to manage a portfolio with a specific mandate. For example, an institutional
investor may hire the member to construct a sub-index fund designed to track a particular
sector of the economy. In that case, it would serve no purpose for the member to inquire
into the investor’s other holdings.

Unlike those who advise clients (i.e. brokers or investment advisors), analysts are not
required to determine the suitability of an investment recommendation for each of the
firm’s clients. Instead, the task of an analyst is to determine whether a particular security
is overvalued (in which case a SELL recommendation would be issued) or undervalued
(in which case a BUY recommendation would be issued). It would then be up to the
advisor or the portfolio manager to determine if the risks and return potential of that
security warrants its inclusion into the client’s portfolio.

iii) Application:

a) The IPS is a formal agreement between the client and the investment manager.
Consequently, the manager must abide by any of the objectives and restraints placed in
the IPS by the client. For example, if the mandate for the portfolio is to only to invest in
small cap stocks, then the manager may not drift the portfolio into including large cap
stocks as well.

b) A member cannot refuse a direct order to trade from a client. However, should the
client place an unsolicited order, which if executed would make the portfolio non-
compliant with the IPS, then the advisor should seek an affirmative statement from the
client indicating that this violation would be acceptable (i.e. the client would have to
explicitly state that suitability is not a consideration). Furthermore, the member should
make an effort to explain to the client why the unsolicited order would not be appropriate.
At the extreme, the member may decline to accept new clients if their orders are expected
to be out of line with their risk and return objectives.

c) Just because an investment might have a high return potential, it should not
automatically be considered for inclusion into every client’s portfolio. To determine
suitability, a member must examine not only the return potential of the investment, but
the effects that it would have on the risk profile of the portfolio as well.

© 2016 PASSMAX. All Rights Reserved. SS1-29

d) The suitability of a particular investment should be viewed within the context of how it
will impact the client’s portfolio as a whole. It would be prudent to diversify a portfolio
by including securities that are not highly correlated with the already existing securities
in the portfolio. Therefore, even a security that has a high degree of stand-alone risk may
be considered for inclusion in the portfolio if its volatility could partially offset the
volatility of the securities that are already included in the portfolio. In effect then, the
portfolio’s overall risk would be reduced.

e) When selecting sub-advisors to help manage a portfolio, the member is not obligated
to simply select the managers with the lowest fee. Of primary importance will be how
suitable the sub-manager’s skills are in helping to achieve the client’s overall risk and
return objectives.

f) The member should not be swayed by incentives offered by some investments which
do not directly benefit the client. For example, a mutual fund company may offer a free
trip for advisors who sell a certain amount of their funds. The advisor should only select
investments based on their suitability for the client’s portfolio.

III(D)- Performance Presentation

i) Guidance:

Investment performance must be presented in a way that is fair, accurate, and complete.
Care must be exercised in order to avoid any misrepresentation. The presentation should
never imply that historic rate of return will be repeated. If only a summary of the
investment performance is publicized, then the member should be willing to make
available, upon request, detailed information supporting his presentation.

ii) Compliance:

The CFA Institute itself has developed a set of performance standards which are referred
to as GIPS® (Global Investment Performance Standards). Since GIPS are meant to result
in a fair, accurate, and complete set of performance figures, its adoption is the best way to
comply with standard III(D). However, a firm does not necessarily need to adopt GIPS
in order to be in compliance with this standard. The only requirement is that the
performance presentations be fair, accurate, and complete (irrespective of whether they
were computed using GIPS or some other approach).

The following are some of the procedures that should be followed in order to be
compliant with this standard:

a) The performance for a particular investment category should be reported using

composites (a collection of accounts with similar objectives), rather than a representative
portfolio. For example, if the firm was managing 3 small cap funds of equal size, and
their returns equaled to 18%, 13%, and 6%, then the proper return that should be reported
for the firm’s small cap sector would be 12.33% [(18 + 13 + 6) / 3]. If instead, the firm
simply reported the return of a representative portfolio, then it would have an incentive to

© 2016 PASSMAX. All Rights Reserved. SS1-30

report the return of its best performing fund (i.e. the 18%). Clearly, the latter approach
would be a violation of this standard.

b) The historical returns of accounts that are no longer with the firm should not be
removed from the firm’s historical composite performance figures. Generally, accounts
are lost due to poor performance; thus leaving them out would bias the firm’s historical
performance upwards.

c) The firm should disclose the methodology that was used in computing the reported
performance figures.

d) The firm should maintain all the records that were used in computing the reported
performance figures.

iii) Application:

a) A firm should only claim that its performance presentation is fair, accurate, and
complete if this were true on a firm-wide basis. In other words, the spirit of this standard
would not be met if the firm was simply compliant in the presentation of the performance
of some of its composites and not the others.

b) When simulated results are combined with the performance of actual portfolios, the
two must be clearly identified and distinguished from each other.

c) In addition to her performance at the current firm, a manager may present the historic
performance she achieved while with a prior employer, so long as a disclosure is made
with respect to where those prior returns were achieved and the manager’s role in
achieving them.

d) Performance presentation figures which are not in accordance with GIPS, or are not
verified (audited by an independent party), are not necessarily a violation of this standard.
To be compliant with this standard, the performance presentation need only be fair,
accurate, and complete.

III(E)- Preservation of Confidentiality

i) Guidance:

A member must maintain the confidentiality of all information related to former, current,
and prospective clients unless:
a) The activities are illegal,
b) Disclosure is required by law, or
c) The client consents to the disclosure.

Information must be kept confidential if it was obtained during the course of the
member’s duties towards his client and, the nature of the relationship with the client
warrants confidentiality. For example, information regarding the client’s net worth

© 2016 PASSMAX. All Rights Reserved. SS1-31

would have clearly been obtained during the course of the business (and confidential)
relationship between the member and the client, and thus must remain confidential at all
times. Preservation of confidentiality must be maintained even after the client ends her
relationship with the firm, unless of course the client consents to the disclosure.

If a member suspects her client to be engaged in illegal activities, then she should inform
her compliance officer. Disclosure of such activities to regulators is largely dependent
upon the laws of the jurisdiction in which the member operates in. For example, if the
law required the reporting of such activities, then the member would have an obligation
to disclose. Otherwise, the Code and Standards would not require the reporting of such
activities to the authorities. Furthermore, if the law requires that confidentiality be
maintained at all times, even if illegal activities are being committed, then the member is
precluded from disclosing such activity.

When warranted, the Professional Conduct Program (PCP) of the CFA Institute may
conduct an investigation into a member’s actions. In the course of their investigation, the
PCP may request information about the member’s client(s) that would otherwise be
deemed as confidential. Where the law would permit such a disclosure (i.e. to self-
regulatory organizations), then the member shall consider the PCP as an extension of
themselves and thus forward the requested information to this body without violating this
standard.

ii) Compliance:

Best practice would be to simply not disclose any client information to parties other than
those who need the information in order to perform their duties. If the information is
obtained from the client outside the advisor-client relationship (i.e. over a beer after
work), before disclosing the information to someone else, the member should determine
if the information is relevant to the work performed and if its material. If so, then the
matter should not be disclosed.

iii) Application:

a) If the information is confidential and it is obtained within the scope of the advisor-
client relationship, then the matter may not be disclosed, even if it would benefit the
client. For example, if Client A was need of financing while Client B was in a position to
invest, the member would not be able to inform Client A of Client B’s position, without
first having obtained Client B’s consent.

b) If the member suspects that his client is engaged in illegal activities, then he should
consult with his compliance department and determine if the law requires that it be
reported.

c) When it comes to electronic information and security, the member is not expected to
be an expert. However, all efforts must be made to ensure that confidential information
is not inadvertently disclosed.

© 2016 PASSMAX. All Rights Reserved. SS1-32

STANDARD IV – DUTIES TO EMPLOYER
IV(A)- Loyalty
i) Guidance:

A member must act for the benefit of the employer and thus must not deprive the
employer of any opportunities or deny the employer the use of her skills. Furthermore, a
member must not cause any harm to the employer or divulge any confidential
information belonging to the employer. However, in the event that a conflict arises
between the interests of the employer and those of clients, then the member is obligated
to place the interests of the clients first.

ii) Compliance:

This standard is particularly relevant in the following situations:

a) Independent Practice:
A member is allowed to take on outside work (which would otherwise be deemed as
being in competition with her employer) so long as the employer consents to all the terms
of this outside activity. Specifically, the member must disclose the type of service being
provided, its duration, and the remuneration that’s expected. Written consent must be
provided by the employer before such independent practice may be engaged in.

b) Leaving an Employer:
A member is free to make preparations to go into a competing business while still
employed, so long as the duty of loyalty isn’t breached before the member’s effective
resignation date. Therefore, during this time, a member must not misappropriate his
employer’s trade secrets or client lists, misuse confidential information, solicit the
employer’s clients to follow the member once he leaves, or withhold an opportunity that
would have benefited the employer. Even company records stored in the member’s home
computer must be erased (since the content belongs to the company). These restrictions
may only be overturned with the employer’s consent. Once the termination is effective,
the member may use his knowledge of the whereabouts of former clients in order to
solicit their business, unless such an act is forbidden by an agreement with the former
employer or by law. Furthermore, the standards do not forbid a member from using skills
or knowledge that may have been gained while employed with a former employer.

c) Whistle blowing:
Where a member suspects that the employer’s activities might jeopardize the integrity of
the markets or the interests of clients, then the employer’s interests would become
secondary. In other words, in certain situations, the member may act contrary to the
employer’s interests, provided that her intention is to protect market integrity and client
interest, and not to achieve a personal gain. Many jurisdictions now require firms to have
procedures in place to enable employees to anonymously report illegal or unethical
practices within the firm.

© 2016 PASSMAX. All Rights Reserved. SS1-33

d) Nature of Employment:
A member must determine whether her current relationship is one of employer-employee
or a client-contractor relation. If the member is an employee, then all of the preceding
rules would apply. On the other hand, if the member is simply contracted to do the work,
then she would be bound by the terms of the agreement reached with the client. The
nature of the member’s relationship is primarily dependant upon the degree of control
that the employing entity exercises over the member. For instance, if the employing
entity dictates the hours, location, and guidelines for the work to be performed, then the
member may be regarded as an employee. On the other hand, if the member does work
for other clients as well and is not reimbursed for any of his expenditures, then he would
more likely be regarded as a contractor.

iii) Application:

a) A departing employee may not take employer property without the employer’s
consent. The fact that the material was prepared by the departing employee is irrelevant.
Since the material was produced during employment with the employer, it becomes the
property of the employer. On the other hand, if the employee was originally hired
because of some model that he had developed, then upon departure, the employee may
take the model with him (i.e. it was his from the beginning).

b) Collaboration by employees to buy out a segment of the employer’s business is not a

violation of this standard, since employer consent would be required to make the
transaction possible.

c) An unpaid intern (ex. Summer student) is just as much subject to this standard as a full
time paid employee. While the intern is not paid, his compensation is in the form of very
valuable experience. Therefore, the intern owes just as much loyalty to his employer as
the other employees.

d) Using a former employer’s data base, without permission, in order to contact former
clients for any reason, would be a violation of this standard. On the other hand, if the
clients’ contact information is commonly available, and the member is not bound by any
restrictions in its agreement with the former employer, then contacting these clients
would not be deemed as a violation.

e) A member is required to give his all in the course of his duty to his employer.
Consequently, before undertaking any extracurricular activities (ex. Sit on the Board of a
local charity) which may compete with the employer for the member’s time and energy,
the matter should be discussed with the employer, an a written consent obtained.

f) A member is not prohibited from beginning to make preparations to start her own
company, so long as these preparations are done on her own time, outside the employer’s
facilities, and the competing business won’t be operational until after her effective
termination from the employer.

g) While the member is encouraged to provide the employer with a copy of the CFA
Institute’s Code and Standards, the employer is not obligated to adhere to them.

© 2016 PASSMAX. All Rights Reserved. SS1-34

However, the member should ensure that the employer’s standards of conduct would not
force him to engage in any activity that would violate the CFA Institute’s Code and
Standards. In other words, while the member’s firm is not obligated to abide by the CFA
Institute’s Code and Standards, the member is. To mitigate this potential conflict, the
member’s firm should not devise an incentive system that might encourage unethical
behavior among its employees.

h) The firm should have a set of procedures in place to deal with the departure of
employees, in particular, how to notify clients and how to transfer the departing
employee’s responsibility on to the remaining employees.

i) Records accumulated at the firm are the property of the employer, irrespective of the
medium in which they are in (i.e. be it hard copy, portable storage devise, the member’s
home computer, etc.). Therefore, if an employee should leave his current employer, he
may only use publicly available information in order to contact former clients or to re-
establish any reports or models he may have developed while at his former employer.

IV(B)- Additional Compensation Arrangements

i) Guidance:

A member must not accept compensation, including gifts and benefits, which may create
a conflict with that of the employer’s interests. The exception to this rule is if the
member can obtain a written consent from the employer and the party to which these
services will be performed for.

ii) Compliance:

Before accepting any benefits from parties other than the employer, the member should
submit a written report to the employer specifying the nature of the compensation (i.e.
gift, benefit, monetary, etc.), the amount, and the duration over which it will be received.
Furthermore, employer consent would be required before any such benefits may be
accepted by the member.

iii) Application:

a) If a client wished to reward the manager for every year that she beats the index, the
member would have to disclose this incentive arrangement to her employer. It would
then up to the employer to determine if such an arrangement could possibly impair the
member’s ability to serve other client’s as well. Once again, employer consent would be
required before the member can accept such payments.

b) If the member were to also serve on the board of other companies, then the member
would have a duty to inform his employer of any monetary or non-monetary benefits
received from such positions. For example, if the directors of a restaurant chain were
allowed to eat for free at any of its locations, then a portfolio manager who was also a
director of this restaurant company might be inclined to continuously purchase the shares

© 2016 PASSMAX. All Rights Reserved. SS1-35

of that restaurant company for the portfolios that she manages. The point of the
disclosure then is to allow the employer to determine if all these outside incentives may
impair the member’s objectivity at work.

IV(C)- Responsibilities of Supervisors

i) Guidance:

A member, who is in a supervisory position, must make a reasonable effort to prevent

and detect violations of applicable rules and laws by anyone that is subject to her
supervision. To achieve this goal, the member must ensure that there are established
compliance procedures in place, and that it is communicated to all those under her
supervision. Compliance procedures should not simply be a broad set of rules. Instead,
they must be specific enough to address the unique circumstances of the firm or the
division over which the member has oversight. If the firm does not have an effective
compliance system in place or is slow to adopt one, then the member should decline, in
writing, to accept a supervisory role until such a system is put in place.

Upon learning of an infraction, the member must promptly initiate an investigation.

During the investigation, the member may have to place some restrictions on the
violator’s activities or monitor his activities more closely. The member is not
immediately held liable for her subordinate’s infractions if she had made reasonable
efforts to prevent such infractions from occurring. On the other hand, the supervisor may
be held accountable if she knew or should have known that procedures were not being
followed. While a supervisor may delegate some of her duties, she will nevertheless still
be held responsible for the overall effectiveness of the compliance system. In other
words, delegation does not relieve the supervisor of her obligations.

ii) Compliance:

The general task of a supervisor may be categorized as follows:

a) Ensure that an adequate compliance system exists. This system should be designed to
prevent and deal with infractions that are most likely to occur under the supervisor’s area
of responsibility. Furthermore, these policies must be clearly written, accessible,
unambiguously point out permissible and non-permissible conduct, and indicate how to
report violations.

b) Once an adequate compliance system is in place, the supervisor should ensure that it is
properly communicated to all those affected and that it is updated regularly. To ensure
compliance, subordinates’ professional conduct should be incorporated into their annual
employee evaluation.

iii) Application:

a) Firms must have a system of checks and balances to ensure that violations are quickly
detected. For example, watch lists (whereby the securities listed are only known to

© 2016 PASSMAX. All Rights Reserved. SS1-36

supervisors) allow supervisors to monitor their subordinates’ trading activities while the
company is in possession of material non-public information.

b) A supervisor’s investigation of a breach of the rules should involve more than just
taking the violator’s version of accounts. A more thorough investigation may be
required.

c) This standard does not require a supervisor to report employee violations to regulators,
unless local laws require such a disclosure. Recall, that whenever the Code/Standards
and local laws treat a matter differently, a member must abide with the more strict set of
rules.

d) A supervisor should enforce not only investment related policies, but non-investment
related policies as well. This uniform enforcement of rules will send the message that all
rules are important, thus fostering an environment of more ethical behavior.

e) Codes of ethics are supposed to express the fundamental principles of the firm.
Therefore, they should be in plain language and not become diluted with excessive
details. The specific details may instead be incorporated into the firm’s compliance
manuals.

STANDARD V – INVESTMENT ANALYSIS,

RECOMMENDATIONS, AND ACTION
V(A)- Diligence and Reasonable Basis
i) Guidance:

A member must be diligent in his research and must have a reasonable and adequate basis
before making an investment recommendation or taking an investment action. The
member may rely on secondary or 3rd party research if a reasonable effort is made to
ensure that the research is sound. (Secondary research refers to that which is provided by
members within the same firm while 3rd party research is that which is prepared by other
firms) In both cases, if the member suspects that the research does not have an adequate
basis, he should refrain from using it. To determine if the research is sound, the member
must examine the assumptions used in the report, the due diligence of the research, the
objectivity of the report, and its timeliness. The member may be relieved from reviewing
research prepared by others if his employer has a system to check the soundness of the
reports.

Some firms use investment committees in order to validate a recommendation or take an

investment action. If a member serves in such a committee and is satisfied with the
reasonableness and the adequate basis of a recommendation or a proposed action, then
even if she were to disagree with the committee’s recommendation or the proposed
action, she would not have to disassociate herself from the report. In other words, if the
process is sound, then the member does not have to dissociate from the eventual

© 2016 PASSMAX. All Rights Reserved. SS1-37

recommendation. However, the member may document her disagreement with the
group’s final decision.

ii) Compliance:

a) A firm should designate an individual or a group to review all research before it is

published or acted upon.

b) A check list should be made available to analysts to ensure that their research is
complete and diligent.

c) A set of criteria should be established to assess the quality of research reports.

iii) Application:

a) A member must never sacrifice diligence for the sake of expediting a report. A
member should accept work only to the extent that it won’t impede his current
responsibilities.

b) A firm may issue a report that is different from the one that was originally constructed
by its analysts, if there was a reasonable and adequate basis for the change.

c) A member must not be forced to issue a report that was contrary to his objective
conclusions. However, if the member was part of a committee, with which there was a
difference of opinion, then the member would not be required to disassociate himself
from the committee’s conclusions (so long as he is confident in the reasonableness of the
conclusion). In other words, the member may include his name in a committee report
that bears a recommendation which is in contrast with the member’s opinion.

d) A member may rely on research produced by other firms so long as he regularly audits
the soundness of these research reports.

e) A member should update a report if current circumstances make the original report
outdated.

f) Suppose that after performing the necessary due diligence for a particular stock and
then determining its suitability for a particular client, a member purchases that stock for
the client’s account. Subsequently, even if the price of the stock were to fall
dramatically, the member is deemed to have complied with the Code/Standards. In other
words, due diligence and suitability refers to the process, not the eventual outcome.

g) A member is not expected to be an expert in the use of quantitative models. However,

if the output of the model is used in the investment decision making process, then the
member needs to have a good understanding of the parameters and assumptions that were
used in the model. Furthermore, the member must examine the sample period that was
used in order to formulate the inputs that went into the model. If the sample period is too
short, then the input data may not fully incorporate some of the more adverse scenarios
that may take place. Consequently, the member may have to test the model using

© 2016 PASSMAX. All Rights Reserved. SS1-38

volatility estimates that were not present in the sample period that was used to construct
the model in the first place.

h) When firms outsource some of their portfolio management activities, they should
establish a set of criteria which may include an examination of the external parties’:
• Code of ethics.
• Compliance with internal control systems.
• Quality of their reported performance figures.
• Adherence to their stated investment strategies.

In an effort to assist in the selection of outside asset managers, the CFA Institute has
established the following documents:

• The Asset Manager Code of Professional Conduct.

• The Global Investment Performance Standards (GIPS).
• Model Request for Proposals.

i) A member is required to make a reasonable effort in order to support his

recommendation. Some of the factors that the member might have to consider before
making a recommendation include the following:
• The stage of the life cycle that the industry is currently in.
• The underlying firm’s operating and financial history.
• In the case of analyzing mutual funds, the fee structure and management history.
• In the case of analyzing structured products (such as mortgage backed securities),
the quality of the assets underlying the pool.
• In the case of quantitative models, any limitations that might be present.
• If comparisons are being made, the appropriateness of any peer group that is used.

V(B)- Communication with Clients and Prospective Clients

i) Guidance:

A member must disclose the process that is used when making investment
recommendations or taking investment actions. Subsequently, if any changes are made to
this process, the client would need to be notified immediately. Furthermore, any
recommendations made by a member must be accompanied by factors which were
deemed as important in reaching those recommendations (This allows the reader to
decide if the analyst’s recommendation are in line with the new facts). The member must
also be careful between distinguishing his opinions from the facts that are included in the
reports.

ii) Compliance:

Reports to clients should at least include the basic characteristics of the investment and
how the recommendation was reached. As well, the member must disclose any

© 2016 PASSMAX. All Rights Reserved. SS1-39

assumptions and limitations that the report might have. For example, if a BUY rating
was based on a best case scenario, then the reader would need to know this.

Furthermore, standards covering communications with clients are not just restricted to
written reports (i.e. the standard is just as much applicable to oral communications with
the clients). To be safe then, all briefings (be it written or oral) must be backed by
comprehensive reports that should be available to the client upon request.

iii) Application:

a) Reports sent to clients should include all the relevant factors that were relied upon in
reaching a recommendation, such as the underlying security’s risk and return
characteristics. While every detail need not be included, a client must have enough
information to follow the logic that was used in reaching a recommendation.

b) Clients must be promptly notified if there is a change in the process that is used in
reaching investment recommendations or taking investment action. For example, if the
manager that was hired to manage a small cap stock portfolio, eventually begins to
include mid-cap stocks in the portfolio, then he would have effectively changed the
overall composition of the client’s assets (i.e. reducing the client’s exposure to small cap
stocks). Consequently, the manager must notify the clients of this change in strategy so
that the clients will have the opportunity to change their portfolio before the manager
undertakes these new investment actions. Other important items that clients need to be
made aware of include:
• The extent to which derivatives or leverage may be used.
• The use of new valuation models.
• The inclusion of foreign securities in the portfolio.
• The recommendation process, whether it’s from an individual analyst or a
committee.
• The use of external managers and their areas of specialization.

All of these changes will eventually have an impact on the client’s portfolio, and thus,
they need to be made aware of these changes.

V(C)- Record Retention

i) Guidance:

Members must retain appropriate records to support their investment recommendations

and actions. These records may be maintained either in physical or electronic form.

ii) Compliance:

Records are the property of the firm. Therefore, a member may not re-create reports that
were originally produced while with a former employer, without first collecting the
documents and records that served as the foundation for the original report. In other

© 2016 PASSMAX. All Rights Reserved. SS1-40

words, there must be supporting documentation for anything that is published (i.e. the
member cannot just re-produce a record from memory). Record retention is the
responsibility of the firm rather than the individual. Unless local laws require a longer
retention period, the CFA Institute recommends maintaining records for at least seven
years.

iii) Application:

a) Members who deal directly with clients (i.e. investment advisors) should always
maintain an updated IPS (investment policy statement) for each client, and a record
indicating all the recommendations that were made to the client. Unless a situation
requires an immediate update to the IPS, an annual review should suffice.

b) A member should retain copies of all the documents that were used in the creation of a
report, including:
• Research either done by others at the firm (2nd parties) or by analysts at other
firms (3rd parties).
• Personal notes from meetings with executives of companies that are being
analyzed by the member (i.e. covered companies).
• Press releases or presentations issued by the covered companies.
• Model parameters and outputs.
• Analysis of how a security’s inclusion will affect the risk of the portfolio.
• Selection criteria used to hire external managers.
• Any notes that are used to update the IPS for a client.

STANDARD VI – CONFLICTS OF INTEREST

VI(A)- Disclosure of Conflicts
i) Guidance:

A member must first attempt to avoid all situations that put his interests in conflict with
those of his employer, clients, or prospective clients. However, if this conflict (be it
perceived or actual) cannot be avoided, he must make full and fair disclosure of all
matters that may impair his independence and objectivity. This disclosure should be
prominent and in plain language. The intent of disclosure is to allow the employer or the
client to weigh the member’s objectivity in light of the conflict. In other words, it should
be left up to the employer or the client to determine whether the conflicts are too great in
order to render the member’s recommendations as being objective.

a) Disclosure to Clients:

A conflict arises between the interests of the member (or her employer) and that of the
client when the member makes recommendations for securities in which she or her
employer have an interest in. A member or his firm is deemed to have an interest in a
security if:

© 2016 PASSMAX. All Rights Reserved. SS1-41

 i) The member owns the security.
ii) The member has a personal or a business relationship with the issuer.
iii) The firm has employees that serve as directors on the issuer’s board.
iv) The issuer is an investment banking client of the firm.
v) The firm provides consulting services to the issuer.
vi) The firm is a market maker for the issuer’s securities.
vii) The firm has a material ownership of the issuer’s securities.

Should a member serve as a director on an issuer’s (i.e. publicly traded company) board,
conflict may arise from three sources. First, the member must weigh the interests of the
issuer’s shareholders, which desire a maximum stock price, and those of his investment
clients, which rely on the member to recommend undervalued securities. Imagine the
reaction of shareholders if the member, serving as a board member, recommends to his
investment clients that the issuer’s shares be sold. Second, if the member’s compensation
(for serving as a director) is partly in the form of the issuer’s shares, then he may have an
incentive to never issue a negative outlook for that stock to his investment clients.
Finally, as a director, the member would be an insider and thus have access to material
non-public information. Consequently, to avoid any conflict or breaches of securities
laws (i.e. trading on insider information), a member who serves as a director for a
publicly traded company should be precluded from making investment recommendations
or taking investment action as it pertains to that issuer’s securities.

Sometimes, a firm may act as a market maker for a particular security (i.e. the firm will
buy and sell that security from its own inventory in order to provide liquidity). However,
if the firm were to act as the counterparty to a client trade, then a conflict would arise.
For example, in a buy trade, the client would like to pay the lowest price possible, while
the counterparty (the firm) would maximize their profit if they were to sell the security at
the highest price possible. Clearly then, the client must be notified whenever the firm
acts as a market maker for the security underlying the trade.

The client should also be notified if the firm has a special business relationship with the
issuers for whom it is issuing investment recommendations on. For example, a large
brokerage firm may have an investment banking division, which occasionally assists
Mega Co. in raising capital, and a retail division, whose analysts routinely issue
investment recommendations on Mega Co stock. It is possible then for analysts to be
pressured into provide a favorable review for Mega Co. just so the firm can get Mega
Co.’s investment banking business. Such an overly optimistic report may induce the
firm’s retail clients to purchase the security when they would otherwise have avoided it.
Consequently, the retail clients must be alerted to this potential conflict.

It’s also possible for a member to maximize her own gains if she were to recommend
securities for which she held a material position in. The recommendation would drive up
the price of the security, and thus in turn, the value of her own portfolio. In fact, she may
be motivated to never issue a sell recommendation so long as she is holding those shares.
This is clearly a conflict which compels the member to disclose her material ownership in
a security that’s subject to her recommendations. Note then that the member is not barred
from owning securities subject to her analysis, so long as she discloses her ownership
stake.

© 2016 PASSMAX. All Rights Reserved. SS1-42

b) Disclosure of Conflicts to Employers:

A member has a duty to report to his employer any situation which may interfere with his
ability to act in the best interest of his clients or employer. Note that any conflict which
qualifies for disclosure to a client, must therefore also be reported to the employer. For
instance, if a situation placed the member’s independence and objectivity into question, it
must be disclosed not only to the client, but to the employer as well. The logic is simple:
if the client is affected adversely, then it would reflect poorly on the firm. Consequently,
the employer must always be informed of any actual as well as potential conflicts.

ii) Compliance:

When in doubt, a member should err on the side of caution and disclose matters which
may be deemed as creating a conflict between his interests and that of his employer and
clients. For example, if the member’s bonus was tied to the portfolio’s short term
performance, then the matter should be disclosed to the client. The conflict arises
because the member’s interest would be to maximize short term performance while the
client’s focus might be to stabilize long term performance. If the firm does not permit its
employees to disclose compensation arrangements to clients, then the member should at
least document his request to disclose.

iii) Application:

a) Research reports should disclose any special relationship that may exists between the
issuer underlying the report, and the member or her firm. For example, if the issuer also
happens to be an investment banking client of the firm, then this must certainly be
disclosed in any research report regarding that particular issuer. Furthermore, if the firm
has an option to purchase shares of the issuer, then the quantity of these options and their
expiry dates should also be disclosed.

b) If a member has a significant ownership in a particular issue, then she may be

discouraged from issuing any negative reports with respect to that issue, thus impairing
her independence and objectivity. Consequently, the member should disclose to her
employer any material ownership which she may have and attempt to persuade the
employer to assign another analyst to provide coverage for the security. If this conflict
cannot be avoided, then the member must disclose her ownership stake in the securities
for which she is issuing the report for. Note that how the member came to possess the
securities in the first place is irrelevant in this matter. For instance, whether the member
purchased the securities in the market, received them as gifts, or were bestowed through
an inheritance, the conflict must still be disclosed.

c) Clients should also be notified if the member’s compensation arrangement with the
employer may lead to a conflict with the interest of the client.

d) Disclosure is also required if the member is getting additional compensation for

recommending a particular stock.

© 2016 PASSMAX. All Rights Reserved. SS1-43

e) Some matters need only be disclosed to the employer. For example, if the member
intends to engage in extra-curricular activities which may interfere with his duties at
work, then the matter would only be needed to be discussed with the employer.

f) If an issuer, Mega Co. were to hire John to issue a research report and Jane to conduct
the firm’s public relations affairs, and both were to receive shares of Mega Co. as part of
their compensation, then both John and Jane would have to disclose this share based
compensation in their dealings with the public. In both cases, the public needs to know
how strong the forces are that might be working against the member’s objectivity.

g) Prior personal bankruptcy does not necessarily reflect poorly on the member’s
integrity and thus its disclosure would not always be required. For example, if the
bankruptcy was the result of a large medical bill, then clearly, this would have no bearing
on the member’s independence, objectivity, or integrity, and thus would not have to be
disclosed.

h) The member must disclose to his employer if any personal relationship exists with any
of the 3rd parties that the member may be hiring. It would then be up to the employer to
determine if this personal relationship may be impairing the member’s objectivity.

VI(B)- Priority of Transactions

i) Guidance:

The order of transactions must be prioritized as follows: clients, the firm, the member.
For example, if a particular issue had an oversubscription of buy orders, then the member
must make sure that all the client buy orders are filled first. Following, if there are any
shares remaining, the firm’s order may be executed. Only after the order for these two
groups are filled, can the member execute trades for his (or immediate family) accounts.
There is nothing wrong with a member profiting from his trades, so long as the client is
not disadvantaged by them. We must be careful not to confuse the Priority of
Transaction standard with the Fair Dealing standard. The former standard relates to the
prioritization of investment action in the order of client, employer, and then member. The
Fair Dealing standard refers to the fair treatment among the client group (i.e. not to
benefit one client at the expense of another client).

ii) Compliance:

Clients should be informed of the firm’s policy with respect to its employees’ trading
activities. Furthermore, when there is a large pending trade order outstanding, there
should be a black out or restricted period during which employees with knowledge of the
trade cannot trade in those shares. Otherwise, employees may engage in front-running (a
practice of trading in anticipation of the effect the client trade will have on the security’s
price). Members should not be benefiting from the position or impact that their clients
may have on the marketplace.

© 2016 PASSMAX. All Rights Reserved. SS1-44

To ensure that clients are given a priority with respect to transactions, a firm should
require its employees to disclose holdings in accounts for which they have an interest in
and to forward duplicate confirmation of all their subsequent trades in those accounts to
their supervisors or compliance officers. This allows supervisors to determine if its
employees are allowing client trades to be executed before their own. Employees should
make available an update of their holdings at least annually. Furthermore, if in a position
of conflict, employees should be required to obtain a pre-clearance before they are able to
trade. For example, the analyst who covers Mega Co. stock should be required to get
pre-clearance before he buys or sells shares of Mega Co for any of the accounts in which
he has an interest in.

iii) Application:

a) When a member issues a recommendation, an opportunity must first be afforded to the

clients to trade in that security before the employer and then subsequently the member
can trade for the accounts for which they have an interest in. This order of priority
applies not only to the security subject to the recommendation, but to any derivative
securities which may benefit from the change in the price of the underlying security.

b) For transactions that may place the interests of the member in conflict with her clients
or the employer, a pre-clearance should be required. For example, an analyst who has a
buy rating on Mega Co. may actually need to sell some of his holdings of Mega Co. in
order to meet some personal expenses. By obtaining a pre-clearance for this trade, any
perceived conflict may be mitigated.

c) The member should allow clients and the employer to act on a recommendation before
he takes action for accounts for which he has an interest in. Such accounts would include
the member’s personal accounts, those of immediate family, and trust accounts for which
he may be a beneficiary. On the other hand, the accounts of extended family members
should be treated just like any other client account.

d) When there is an oversubscription to an IPO, the member should withhold her

purchases of the issue or obtain a clearance from the firm’s compliance department
before purchasing those shares for himself.

e) A member should not use his position to reward or provide incentives to selected
clients. For example, Jane is a broker with Kermit Securities. One of her personal clients
is John, who happens to be the CEO of Mega Co. Consequently, Jane should not promise
John a large piece of the allotment of an oversubscribed IPO if only he were to direct
Mega’s investment banking business over to Kermit Securities. Clearly, such an “arm-
twisting” tactic would be a violation of this standard.

© 2016 PASSMAX. All Rights Reserved. SS1-45

VI(C)- Referral Fees
i) Guidance:

A member must disclose to her employer, client, or prospective client any fees or benefits
received or paid for the referral of a product or a service. The objective is to allow the
client or the prospective client to determine the objectivity of the referral and the true cost
of the referral (since clients can expect the fees paid for referrals to be eventually priced
into the services provided).

ii) Compliance:

The disclosure regarding compensation exchanged for a referral must be made to the
client or prospect before they enter into a formal business relationship. The disclosure
must address the monetary value of the compensation and its characteristics, such as:
• Whether it’s a flat fee or a percentage of the contract value,
• Whether it’s a one time fee or an ongoing arrangement, and
• Whether it’s in the form of cash, soft dollars, or any form of quid pro quo.

iii) Application:

a) All compensation for referral arrangements must be disclosed to clients at the time the
referral is being made and before the start of a business relationship. This disclosure
should be in writing. Withholding referral fee information raises doubt with respect to
the member’s integrity and objectivity (i.e. if he’s keeping it a secret, then it might just be
affecting his judgment).

b) Referral fee arrangements with other departments within the firm should also be
disclosed. The point is that anytime a referral is made for a fee, the client must be made
aware it. The exception to these disclosure rules is when the employer provides bonuses
to member for bringing in new business. In this scenario, it should be apparent to
prospective clients that the member will benefit if business is directed to the member’s
own business unit.

c) Disclosure should also be made if a member receives additional compensation for

referring the firm’s proprietary products.

d) The member should provide to clients a list of approved referral fee programs. As well, the
member should at least on a quarterly basis, update her employer with respect to the amount and
nature of referral compensation received or paid out by the member during that period.

© 2016 PASSMAX. All Rights Reserved. SS1-46

STANDARD VII – RESPONSIBILITIES AS A CFA
INSTITUTE MEMBER OR CFA CANDIDATE
VII(A)- Conduct as Members and Candidates in the CFA Program
i) Guidance:

A member must not engage in any conduct that may reflect badly on the reputation of the
CFA Institute, the CFA designation, or the CFA examinations.

ii) Compliance:

A member must refrain from the following activities:

a) Cheat on the CFA exam or any other exam.

b) Release confidential information about the CFA Program.
c) Circumvent security measures around the CFA examinations.
d) Use the CFA designation improperly.
e) Misrepresent information on the Professional Conduct Statement.
f) Violate any of the policies during the CFA Exam (ex. using a calculator other than the
ones that are prescribed or not signing the Candidate Pledge).
g) Discuss specific details about questions, topics, or formulas appearing (or not
appearing) on the CFA Exam. The contents of the CFA Exam are deemed as confidential
until the CFA Institute releases them publicly.

Candidates may however express their opinion with respect to the level of difficulty of
the CFA Exam or how well they think that they did (without discussing the specifics of
any exam questions). Furthermore, this standard does not preclude members from voicing
any disagreements that they may have with the CFA Institute. Members are free to
express their opinion, so long they are professional about it.

iii) Applications:

The following acts would be a clear violation of this standard:

a) After completing the CFA exam in New York, a candidate informs a fellow candidate
in Hong Kong (where the exam is written hours later) of the questions which appeared on
the exam.

b) A candidate continues to work on the exam after being told to stop.

c) A member who was responsible for grading portions of the Level III exam (which has
a written component) discusses the questions that he was responsible for marking.

d) A member uses her volunteer position at the CFA Institute or one of its societies in
order to benefit herself or her clients. For example, Jane, a broker with Kermit
Securities, is also an executive with the Yorkland CFA Society. For the Society’s analyst

© 2016 PASSMAX. All Rights Reserved. SS1-47

events, whereby corporate issuers are invited to speak to the analysts in order to get
greater exposure, Jane only invites her corporate clients to address the audience.
Furthermore, she uses her access to these events in order to lure in more corporate clients
for Kermit Securities. Clearly, Jane would be in violation of this standard. Jane would
however, be free to disclose her volunteer position with the society.

e) A candidate cheats or attempts to cheat on the CFA exam, or any other exam for that
matter. For example, if the candidate sneaks in a formula sheet to the CFA exam, but
never ends up using it, then this standard would still be have been deemed to be violated
(as the candidate intended to cheat).

f) Discussing the level of difficulty of specific CFA Exam questions with other
candidates who wrote the exam, (even if the discussion takes place weeks after the exam
is written). It goes without saying then that candidates are prohibited from posting CFA
exam questions on internet chat rooms. However, prior to the exam, candidates are
allowed to openly discuss the contents of the CFA curriculum with other candidates in
preparation for the exam. Therefore, there is nothing wrong with forming a study group
in order to prepare for the CFA exam.

g) Members who are involved in the development, administering, or the grading of the
CFA Exams may not disclose:
• The questions that are under consideration for inclusion in the CFA Exam.
• The deliberations related to the examination process.
• The score required in order to pass the exam.

VII(B)- Reference to CFA Institute, the CFA Designation, and the CFA
Program
i) Guidance:

A member must not misrepresent or exaggerate the significance of being a member of the
CFA Institute, holding the CFA charter, or being a candidate in the CFA Program.
Therefore, communications (be it written, oral, or electronic) with clients or the public
must not tie the achievement of the CFA charter with future investment performance.
However, it is perfectly acceptable to discuss the merits of the CFA charter, the rigors
required in achieving it, and how all members are bound by the CFA Institute’s Codes of
Ethics and Standards of Professional Conduct.

ii) Compliance:

a) Reference as a member:
To maintain membership status (be it regular or affiliate) with the CFA Institute, a
member must on an annual basis, pay the required dues and submit the Professional
Conduct Statement (PCS). If a member fails to meet any of these two conditions, then he
is no longer deemed to be an active member, although he may still refer to the period

© 2016 PASSMAX. All Rights Reserved. SS1-48

over which he was a member. If after the suspension, the reinstatement conditions are
met, the affected individual may once again refer to himself as a member and have the
right to use the CFA designation.

b) Use of the Designation:

Charterholders are given the “right” to use any three of the CFA trademarks: CFA®,
Chartered Financial Analyst®, or the CFA logo. The “CFA” or “Chartered Financial
Analyst” may be used after a name or used as an adjective, but never as a noun. For
instance, one cannot say “I am a CFA” (using the CFA mark as a noun). Instead, the
proper expression would be “I am a CFA charterholder” or in written form:
John Smith, CFA.

The CFA logo itself may only be used to reference individual charterholders or a group
of charterholders. For instance, it may appear on the business card or letterhead of the
charterholder. It is not to be used in conjunction with a company logo. This may give
the false impression that somehow the firm is certified by the CFA Institute, which is
something that the CFA Institute does not do.

The designations CFA or Chartered Financial Analyst may be accompanied by an

accurate explanation of the requirements that had to be met in order to be eligible to use
the designation. As well, if the member chooses to state her other designations, there is
no specific requirement with respect to the order in which the designations should be
stated in. If a member were to pass all 3 levels of examination on a first attempt, then she
may state so but without implying that such an achievement is the hallmark of a superior
investment professional. Once the CFA charter is obtained, a member may update his
resume to indicate the year in which he received the designation and cite the CFA
Institute as the conferring body:

20XX, CFA, CFA Institute.

As an option, the member may also indicate on his resume where the CFA Institute is
domiciled: Charlottesville, Virginia, USA. The member should be careful not to give the
appearance that the CFA designation was bestowed by the local CFA Society.

c) Candidacy in the CFA Program:

Under no circumstances can a candidate infer that a partial CFA designation has been
achieved or state an expected date upon which the charter will be bestowed upon him.
An individual is deemed to be a CFA candidate only if either:
i) She is registered to sit in for an exam, or
ii) She has already written an exam but is currently awaiting the results.
For example, an individual who wrote the L2 exam in June would continue to be
regarded as a Level 2 candidate until the exam results are released a few months later.
Beyond the exam results release date, she would no longer be deemed as a candidate until
she registers to write the next scheduled exam. Should an individual, who is registered to
write the CFA exam, not show up to take the exam, then he would immediately cease to
be regarded as a candidate (until he registers for a subsequent exam date).

© 2016 PASSMAX. All Rights Reserved. SS1-49

iii) Application:

All of the following statements would constitute a violation of this standard:

a) John Brown, CFA-Level 1 (Can’t imply a partial designation).

b) Michael Green, CFA (Expected 2014). (Never imply an expected completion date for
achieving the CFA charter).

c) CFA charterholders are expected to achieve superior investment results. (Should never
associate the CFA designation with superior performance).

d) As a CFA charterholder, Sandy is the most qualified to manage investment portfolios.

(Should never associate the CFA designation with superior capabilities).

e) Zuleika is among the best of the CFA charterholders, she passed all her exams on a
first attempt. (Can’t imply successive passes to mean superiority).

f) Michael Jordon is a CFA. (Can’t use the designation as a noun).

g) Wayne Gretzky, C.F.A. (There shouldn’t be any periods in the designation, it should
just be CFA).

i) Jack Sittler, CFA-equivalent or Bobby Brown, CFA-England (No such designation

exists).

j) Tom Woods, CFA (Cannot bold or large text the CFA mark).

k) Arnold Chartered Financial Analysts Ltd. (Can’t incorporate the designation into a
company name).

l) CFA charterholders provide the best value in the investment management business.

m) The CFA Program ensures that one becomes better at valuing equity securities.
(While the CFA Program discusses in great detail how to value equity securities, that
does not translate into an assurance that a member will become better at it).

n) Mary Bell has a CFA degree (the CFA is a professional designation; it is not a degree).

o) Having just passed the 3rd level of the CFA Exam, Emma Pham is now a CFA finalist.
This statement is a violation because passing the Level 3 exam does not automatically
imply that the candidate is now considered as a charterholder. The candidate must also
meet 4 years of relevant work experience before the CFA Institute can consider
bestowing upon the candidate the right to use the charter. Until such time, a candidate
who has passed the Level 3 exam cannot use the CFA designation.

p) Upon receiving the CFA designation, Bill Saxton updates his resume as follows:
CFA, 2009, Toronto CFA Society.

© 2016 PASSMAX. All Rights Reserved. SS1-50

This statement is a violation because it gives the impression that the local CFA Society
was the conferring body of the CFA designation. Only the CFA Institute located in
Charlottesville Virginia may bestow the CFA designation to its members.

In contrast, the following statements would be acceptable:

a) Ranjiv passed all three levels of the CFA examinations on his first attempt.

b) The knowledge gained from the CFA Program is an excellent tool to have as an
investment professional. The CFA designation will be the key for my future career
development.

c) As a CFA charterholder, I am committed to the highest ethical standards in the

industry.

d) A CFA charter is recognized around the world as the highest standard for
professionalism in the investment industry.

e) I have passed all the examinations of the CFA Program and will be eligible for the
charter once I have completed the required work experience.

f) Bobby is a Level II candidate (i.e. he is either registered to write the L2 exam or is

currently awaiting the results of his L2 exam).

g) Larry Bird is a CFA charterholder.

h) Wayne Gretzky, CFA.

i) Mark Messier, Chartered Financial Analyst.

© 2016 PASSMAX. All Rights Reserved. SS1-51

1.3 INTRODUCTION TO THE GLOBAL INVESTMENT
PERFORMANCE STANDARDS (GIPS)

1.3.a(i). WHY GIPS WERE CREATED

Before a uniform set of performance presentation standards were available, it was quite
difficult to compare the performance between investment managers. Discrepancies arose
for many reasons. For instance, a manager may have only chosen her best accounts when
presenting historic performance, or the performance might have been subject to
survivorship bias, whereby only the performance of existing accounts were included in
the presentation. This latter practice would ignore accounts that were previously
managed but which were eventually transferred out by clients perhaps due to poor
performance. Furthermore, managers had an incentive to report only their best
performing periods.

Therefore, the CFA Institute created GIPS, a ‘voluntary’ set of best practices in
performance presentation that should facilitate a more fair and complete presentation of
the performance figures of managers domiciled anywhere in the world. The primary
objectives of GIPS are as follows:

i) Establish best practices for the computation and reporting of investment performance.
ii) Obtain world-wide acceptance of the notion of a single set of performance
presentation standards.
iii) Promote the use of accurate performance data.
iv) Encourage fair, global competition among investment firms without creating barriers
to entry (i.e. GIPS is not intended to make performance presentation more costly).
v) Foster the notion of industry self-regulation on a global basis.

Thus, by adhering to a global set of standards, firms in countries with a minimal set of
performance standards will be able to compete on an equal footing with firms operating
in jurisdictions with a more established set of standards. Clients will benefit as the
performance presentation among the firms will become more comparable, thus fostering
a greater degree of confidence among investors.

1.3.a(ii). PARTIES AFFECTED BY GIPS

GIPS may be used by any entity that routinely reports its investment performance
(examples include mutual funds, private wealth management firms, pension fund
managers, etc.). Other parties, such as pension sponsors or consultants, may endorse
GIPS, but since they are not directly involved in the investment management process,
cannot claim compliance with GIPS. While the choice to comply with GIPS is voluntary,
a firm may only claim compliance if it meets the conditions of GIPS on a firm-wide
basis, and not just for a few portfolios or composites (a compilation of similar portfolios).
If compliance is not on a firm-wide basis, then a claim of “partial” compliance cannot be
made.

© 2016 PASSMAX. All Rights Reserved. SS1-52

GIPS is meant to serve two groups. First of all, investment management firms should
benefit since GIPS compliant performance figures will be deemed as being of high
quality, thus enabling them to compete globally. And second, prospective investment
clients will benefit as GIPS compliant performance figures may be more comparable
between the various competing investment mangers. However, GIPS does not eliminate
the need to perform the due diligence required in selecting investment managers.

1.3.b. COMPOSITES

Composites are a compilation of portfolios which have a similar investment objective or

are managed the same way. For example, a domestic equity composite is a compilation
of all the portfolios (or parts of larger portfolios) managed at the firm that have a mandate
to invest in domestic stocks. Consequently, it is the performance of this composite which
is used to report how the firm did on its domestic equity strategy. In other words, the
firm’s reported performance of its domestic equity strategy should take into account the
performance of ALL its domestic equity portfolios.

For a portfolio to be included in a composite, the following conditions must be met:

i) The portfolio must be discretionary (i.e. the manager has the power to select the
investments for the portfolio). Since these composites are meant to measure the
performance of the manager, client-directed accounts (client makes the investment
decisions) are excluded.
ii) The portfolio must be real. Since GIPS only captures actual returns, simulated
portfolios may not be included in the composites.
iii) The portfolio must be fee paying. Therefore, non-fee paying portfolios are excluded
from the composites.

In other words then, composites reveal the return on all actual, fee-paying, discretionary
portfolios that were managed by the firm.

A composite’s historical performance is a matter of fact and thus should not be changed.
For instance, suppose that a composite generated a return of 5.2% in 2003. If in 2005,
one of the poorer performing portfolios from that composite was withdrawn from the
firm, the firm then would not be able to retroactively re-compute the composite’s return
for 2003 (this time excluding the withdrawn portfolio). This prohibition of retroactive
restatement of composite returns will ensure that the reported performance figures are
free from survivorship bias. Survivorship bias occurs when the weaker variables are
dropped from a group, thus causing the average for the group to look much better than
had the weaker variables been included.

It is largely up to the investment manger to determine how to allocate all the qualifying
portfolios to the various composites. Best practice would be for the firm to establish a
predetermined set of allocation criteria. The existence of these allocation rules would
ensure that portfolios are not allocated in such a way that would result in the
manipulation of composite returns. For example, if the portfolio manager was soliciting
a large equity based account, he may have an incentive to allocate all the best performing
equity portfolios in the equity composite, and place the inferior performing equity

© 2016 PASSMAX. All Rights Reserved. SS1-53

portfolios in some other composite. Consequently, the equity composite returns would be
made to look artificially high in the hopes of attracting that prospective equity client.

1.3.c. VERIFICATION

A firm is allowed to self-proclaim compliance with GIPS. However, prospective clients

would be more assured of this assertion if the firm were to hire an outside 3rd party to
independently verify the firm’s claim of compliance (much like how a publicly traded
company hires an independent auditor to verify that its financial statements are accurate
and fair). A firm cannot verify (i.e. audit) its own compliance with GIPS. Verification
may only be performed by an independent party.

GIPS compliance may only be verified if the following 2 conditions exist:

i) The firm has complied on a firm wide basis in constructing its composites (i.e.
all qualifying portfolios at the firm have been included in at least one composite).
ii) The calculations and the performance presentations are in compliance with
GIPS.

Therefore, verification can only be for the firm as a whole (i.e. verification is not possible
on a composite by composite basis). While verification is not mandated, it is strongly
recommended. Investment firms must realize that verification by an independent third
party adds credibility to their stated performance figures.

© 2016 PASSMAX. All Rights Reserved. SS1-54

1.4 GLOBAL INVESTMENT PERFORMANCE
STANDARDS (GIPS)
1.4.a(i). KEY CHARACTERISTICS OF GIPS

The key characteristics of GIPS are as follows:

1. Establish ethical standards to ensure that performance presentation is fair.

2. In addition to complying with all the requirements of GIPS, firms should also abide
with all its recommendations in order to achieve the best practices possible.

3. Firms are required to include all actual, fee-paying, discretionary portfolios in at least
one composite in order to prevent the exclusion of the less favorable performing
portfolios from the performance presentation figures.

4. In order to produce an accurate presentation of performance, GIPS sets forth

requirements with respect to the measurement of input data, calculation methodologies,
and necessary disclosures.

5. In order to claim compliance with GIPS, a firm must meet all of the requirements of
GIPS, including any updates that are periodically released.

1.4.a(ii) FUNDAMENTAL OF COMPLIANCE WITH THE GIPS

GIPS has a set of Requirements and Recommendations:

A. REQUIREMENTS:

1. The firm must comply with all the requirement of GIPS and any applicable laws or
regulations which may exist with respect to performance presentation.

3. The firm must not present performance information that is false or misleading.

4. GIPS standards must be applied on a firm-wide basis.

5. Firms must document the policies and procedures used in order to comply with GIPS.

6. The firm is prohibited from making a claim of partial compliance (or full compliance
“with the exception of” claim). GIPS compliance is an all-or-nothing proposition. For
example, even if the firm were to compute its composite returns using GIPS
methodology, but did not meet the other requirements of GIPS, then it would not be able
to claim that its returns were computed in accordance with GIPS. In other words, a firm
can’t just use parts of GIPS and then claim compliance on those parts alone. However, if
the firm was GIPS compliant, then it may report the performance of an individual
account to its holder as being GIPS compliant. In other words, if the firm was indeed
GIPS compliant on a firm wide basis, then it may report individual composite returns as

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being GIPS compliant as well. Otherwise, if GIPS did not hold on a firm-wide basis,
then the firm would be prohibited from presenting the return on a specific portfolio or
composite as being GIPS compliant.

7. A GIPS-compliant firm must make its performance figures available to all prospective
clients (i.e. the firm cannot selectively choose whom to release the performance figures
to). As well, all the firm’s existing clients should receive a performance presentation
report at least on an annual basis. Firms must also, upon client request, provide a listing
and description of all its composites (ex. Domestic Stock composite, Domestic Bond
composite, International Stock composite, etc.). This list must also include composites
which have been discontinued for less than 5 years.

8. Should a GIPS-compliant firm engage in joint marketing efforts with non-GIPS-

compliant firms, then its GIPS compliance must in no way be inferred to also blanket the
performance figures of the non-GIPS-compliant firms. In other words, the GIPS
complaint figures and the non-GIPS compliant figures cannot be combined into one and
be labeled as being compliant (i.e. it must be made clear which is the firm that is claiming
to be in compliance with GIPS).

9. The entity claiming to be GIPS compliant must clearly define itself as either being:
i) A stand alone investment firm.
ii) A subsidiary.
iii) A division that’s held out to the public as a distinct business unit.
The reader must know exactly who the compliant figures pertain to, especially if the
entity is a component of a much larger entity.

10. Once the firm defines its boundaries, it should disclose the value of all the assets
under its management, irrespective of whether the accounts are discretionary or not, or
whether they are fee or non-fee paying (however, only the assets that are included in fee
paying discretionary portfolios are included in the performance presentation).
Furthermore, the firm’s presentation figures must also incorporate the performance on
any of the accounts that were sub-contracted to outside managers (assuming that the firm
had discretion in selecting these outside managers). Finally, an organizational change at
the firm (i.e. change of managers) is not a reason to alter the historical performance of the
composites.

B. RECOMMENDATIONS:

1. The firm should comply with all the recommendations.

2. The firm should use a 3rd (independent) party in order to verify its claim of compliance
with GIPS. A firm cannot conduct its own verification. As well, verification may only be
conducted on the firm as a whole. For example, verification cannot be performed on just
some aspects of GIPS (or only for a limited number of the firm’s composites).

3. Reporting entities are encouraged to adopt the broadest definition of a firm. For
example, an entity should incorporate the assets managed at offices that operate under the

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same name but at different geographic locations when presenting GIPS-compliant
figures.

4. At least on an annual basis, firms should provide to each client the GIPS-compliant
performance of the composite in which her portfolio is a part of.

1.4.b THE SCOPE OF THE GIPS STANDARDS

1. The Definition of the Firm.

It is important to clearly identify the entity that’s claiming to be in compliance with

GIPS. For instance, an entity may be categorized into any of the following three
definitions of a firm:
i) A stand alone investment firm.
ii) A subsidiary.
iii) A division that’s held out to the public as a distinct business unit.
Recall that GIPS compliance must be on a firm-wide basis. Therefore, defining the
parameters of the firm will let the reader know exactly who it is that is claiming
compliance. For example, suppose that Mega Investment Councilors is a subsidiary of
Mega Parent Bank. If Mega Investment Councilors were to make a claim of compliance
without using the proper definition of firm, the reader might mistakenly interpret
compliance for Mega Parent as a whole. Consequently, in the context of GIPS
compliance, Mega Investment Councilors would have to define itself as a subsidiary unit.

2. Historical Performance Record.

When a firm initially adopts GIPS, it must present a GIPS compliant performance history
going back at least 5 years or since the time of the composite’s inception (if the
composite had been in existence less than 5 years). Companies are not prevented from
initially presenting more than 5 years of GIPS compliant performance record. For
subsequent years, the firm is required to add annually to its GIPS-compliant history until
it has accumulated a total of 10 years’ worth of historical data. For example, if Mega Co
(which was formed 3 years ago) were to adopt GIPS in the current year, it would first
have to report its 3 year historical record (retroactively computed using GIPS).
Subsequently, over the next 7 years, it would add annual performance figures to this
historical record. Once it achieves a 10 year GIPS compliant history, it may either roll
forward its 10 year history (i.e. drop the record for the performance achieved 10 years
ago in order to make room for the current year) or it may simply stretch its performance
history to over 10 years. In other words, there is no restriction as to how long a track
record the firm may present, so long as it is GIPS compliant. Therefore, 10 year track
record is simply the “minimum” required performance period that the firm must
eventually present.

A firm may link a period of non-compliant performance figures with GIPS compliant
figures so long as the noncompliant period was before January 1st, 2000. Of course, the
firm must clearly distinguish the non-compliant period from the GIPS compliant period
and disclose the reasons why those prior periods were non-compliant. Furthermore, the

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new version of GIPS became effective on January 1st, 2011. Results up to this date may
still be presented using the previous version of GIPS.

1.4.c. CONFLICT BETWEEN GIPS AND LOCAL LAWS

Where the requirements of GIPS are in conflict with local laws, those affected firms must
comply with the local laws. While they may still present their performance as being
GIPS compliant, they must disclose the sources of conflict. Recall that CFA Institute
rules and standards may not be used to contravene local laws. However, jurisdictions that
do not have a well-defined set of presentation standards, are encouraged to adopt GIPS as
their local standards. In particular, regulators within these jurisdictions are encouraged
to:

i) Recognize the benefits of compliance with a set of presentation standards that represent
the best practices around the world.

ii) Take enforcement action against firms that falsely claim to be in compliance with
GIPS.

iii) Encourage firms to have their performance presentation verified by an independent 3rd
party.

1.4.d. THE MAJOR SECTIONS OF GIPS

GIPS has 9 main sections, each having its own set of requirements and recommendations.
While the requirements must be met in order to claim compliance, firms as strongly
advised to adopt the recommendations as well.

1. Fundamentals of Compliance: outlines the core principles of GIPS, which includes:

• Defining the firm so that the assets under its management may be properly
measured.
• Defining what constitutes ‘discretion’ so that only portfolios over which the firm
has the ability to implement its investment strategies are included in the
computation of the firm’s performance figures. Therefore, the performance of
portfolios that the firm does not have discretion over (i.e. client directed accounts)
are not included in the computation of the firm’s performance figures.
• Providing a compliant performance presentation to all prospective clients.
• Adhering to all applicable laws.
• Ensuring that the information presented is neither false nor misleading.

2. Input Data: The integrity and accuracy of the input data (such as the fair value of
assets) sets the foundation for a full, fair, and comparable presentation. In other words,
the accuracy of the firm’s presentation is only as good as the accuracy of the data that
was used in order to compute those performance figures. As of January 1st, 2011,

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performance figures must be based on the fair value of the assets being held under
management.

3. Calculation Methodology: Sets a uniform set of rules so that performance data may be
comparable. Therefore, benchmarks and composites parameters should be defined before
the performance of the underlying portfolios become evident. In other words, the rules of
the game should be established before the game begins.

4. Composite Construction: A composite is a basket of portfolios that are similar either in

their mandate, objective, or strategy. Composite return then is simply the asset-weighted
average of its individual portfolio returns. Firms must include all actual, fee-paying, and
discretionary portfolios in at least one composite. This ensures that the firm does not
leave out the inferior performing portfolios from its performance presentations.

5. Disclosures: Allow the presenter to elaborate on the presented figures and to provide
the context within which the results may be interpreted. Some disclosures (such as assets
under management) are required for all firms, while others might only be applicable in
certain cases. However, firms are not required to make negative assurance disclosures.
For instance, if the firm does not use derivatives for a particular composite, then it would
not have to disclose this practice. On the other hand, if it did use derivatives, then it
would have to make a full disclose. As well, if the firm’s performance presentation is
fully compliant with GIPS, then it may disclose this fact (although the disclosure would
have to indicate if this claim of compliance has been verified by an independent verifier).

6. Presentation and Reporting: This stage may begin once the data is properly inputted,
portfolio returns have been computed, composites constructed, and disclosures have been
made. The firm must be aware however that the GIPS standards cannot possibly address
all the investment situations that may arise. Therefore, investment firms may have to
include information that is not necessarily addressed by GIPS.

7. Real Estate: Includes provisions related to land, buildings, or any improvements to

both. While this section supplements all the provisions set forth in Sections 1 -6, some of
those provisions may either not apply to Section 7 or are superseded by the provisions set
forth in Section 7.

8. Private Equity: Includes provisions for investments made in non-publicly traded

securities, including venture capital and limited partnerships. While this section
supplements all the provisions set forth in Sections 1 -6, some of those provisions may
either not apply to Section 8 or are superseded by the provisions set forth in Section 8.

9. Wrap Fee and/or Separately Managed Account (SMA) Portfolios: While this section
supplements all the provisions set forth in Sections 1 -6, some of those provisions may
either not apply to Section 9 or are superseded by the provisions set forth in Section 9.

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