by Jules A. Huot, CFA
Jules A. Huot, CFA (Canada).
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LEARNING OUTCOMES |
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Mastery |
The
candidate should be able to: |
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a.
evaluate the practices and policies presented; b.
explain the appropriate action to take in response to conduct that violates the CFA Institute Code of Ethics
and Standards of Professional Conduct. |
CASE
FACTS
Sheldon Preston,
CFA, the senior
partner in Preston
Partners, is sitting
in his office and
pondering the actions he should take in light of the activities of one of his
portfolio managers, Gerald Smithson, CFA.
Preston Partners
is a medium-sized investment management firm that specializes in managing large-capitalization portfolios of US equities for pension funds and personal
accounts. As president, Preston has made it a habit to review each day all the Preston
Partner trades and the major price changes in the portfolios. Yesterday, he discovered some deeply disturbing information. Several weeks previously, when Preston was on a two-week vacation,
Smithson had added to all his clients’
portfolios the stock of Utah BioChemical Company, a client of Preston Partners,
and of Norgood PLC, a large northern European
manufacturer and distributor of drugs and laboratory equipment
headquartered in the United Kingdom.
Preston had known of a strong, long-standing relationship between Smithson and the president
of Utah BioChemical. Indeed,
among Smithson’s clients were the personal portfolio
of Arne Okapuu, president and CEO of Utah BioChemical, and the Utah BioChemical pension fund. Yesterday
came the announcement that Utah BioChemical intended
to merge with Norgood PLC, and with that news, the share prices of both companies increased
more than 40 percent. Preston Partners had adopted the CFA
Institute Code of Ethics and Standards of Professional Conduct as part of the firm’s own policy and procedures manual. Preston had written the manual himself but, because he had been pressed for time, had stuck to the key elements
rather than addressing all policies in detail. He made sure that every
employee received a copy of the manual
when he or she joined
the firm. Preston
© 2011 CFA Institute. All rights reserved.
thought
surely Smithson knew the local securities laws and the Code and Standards even if he hadn’t read the manual.
Extremely upset, Preston called Smithson into his office for an explanation.
While on vacation in Britain, Smithson
narrated, he had seen Okapuu in a restaurant dining with someone
he recognized as the chairman
of Norgood. Their
conversation appeared to be intense but very upbeat. Smithson
did not attempt to greet Okapuu. Later, Smithson
called on an old analyst
friend in London,
Andrew Jones, and asked him for some information on Norgood, the stock of which was trading
as American Depositary Receipts (ADRs) on the New York Stock Exchange. Jones sent Smithson
his firm’s latest research report,
which was recommending a “hold” on the Norgood stock.
Smithson was already somewhat
familiar with the biochemical industry
because his large accounts
owned other stocks in the industry. Nevertheless, when he returned to the United States, he gathered together
several trade journals for background, obtained
copies of the two companies’ annual reports, and carried out his own due diligence
on Utah BioChemical and Norgood.
After
thoroughly analyzing both companies’ financial
history, product lines, and market
positions, Smithson concluded that each company’s stock was selling at an attractive price based on his valuation. The
earnings outlook for Norgood was quite positive, primarily because of the
company’s presence in the European Union and its strong supplier relationships. Norgood’s stock price had shown little
volatility but had risen consistently in the past, and the
company currently had a strong balance sheet. Utah BioChemical, a leader in the biochemical industry,
at one time had been a
high-growth stock but had been in a slump in recent years. Based on his
analysis of the new products in
Utah’s pipeline, however, and their market potential, Smithson projected
strong sales and cash flow for Utah BioChemical in the future.
Through his research, Smithson
also recognized that Utah BioChemical and Norgood were in complementary businesses. Reflecting on what he had seen on his trip to London,
Smithson began to wonder if Okapuu was negotiating a merger with or takeover
of Norgood. Convinced of the positive
prospects for Utah BioChemical and
Norgood, Smithson put in a block trade for 50,000
shares of each company. The purchase orders were executed
during the next two weeks.
Smithson
had not personally executed a block trade for some time; he usually left execution
up to an assistant. Because
this trade was so large, however, he decided to handle it himself. He glanced at the
section on block trades in Preston Partners’
policy and procedures manual, but the discussion was not clear on methods
for allocating shares. So, he
decided to allocate the shares by beginning with his largest client accounts and working down to the
small accounts. Smithson’s clients ranged from very conservative personal
trust accounts to pension funds with aggressive objectives and guidelines.
At
the time of Smithson’s decision to make the share purchases, Utah BioChemical was
trading at $10 a share and the Norgood ADRs were
trading at $12 a share. During the
next two weeks, the price for each company’s shares rose
several dollars, but no merger or takeover announcement was made—until yesterday.
Several
activities in this case are or could be violations of the CFA Institute Code and Standards. Identify possible
violations, state what actions Preston and/or Smithson
should take to correct the potential violations, and make a short policy statement a firm could use to prevent the violations.
Gerald
Smithson’s story describes some perfectly legitimate actions but also some actions in clear violation of the CFA
Institute Code and Standards. In researching and making the decision
to purchase shares
of Utah BioChemical and Norgood for his client accounts,
Smithson complied with Standard V(A)—Diligence and Reasonable Basis. He observed a meeting between the
heads of two public companies in related businesses, which sparked his interest in researching the companies further.
He already had some knowledge of the biochemical
industry through some clients’ investments and
through his relationship with Arne Okapuu, and he
carried out his own due dili- gence on the companies. Smithson had a
reasonable basis, supported by appropriate research and investigation, for his investment decision, and he exercised diligence
and thoroughness in taking investment action.
Smithson
neither possessed nor acted on insider information. He did not actually overhear a conversation; rather, after his
research was complete, he “put two and two together” and speculated that the executives might have been discussing a merger or takeover. Viewing the two company
leaders together was only one piece of his “mosaic”
and was only a small factor in his investment decision-making process. If Smithson had based his decisions solely on
his chance viewing of the dinner meeting, the
investment decisions would have been inappropriate. Smithson failed to comply, however, with aspects of the Standards
related to the suitability of the investments for his clients and the allocation of trades. In addition, Sheldon
Preston failed to exercise his supervisory responsibilities.
Responsibilities to Clients and Interactions with Clients
Smithson purchased
shares in Utah BioChemical Company and Norgood PLC for all of his client
portfolios without first determining the suitability or appropriateness of the shares for each account. The case
states that the investment objectives and guidelines
for Smithson’s accounts ranged from conservative, for his personal trust accounts, to aggressive, for his pension
fund clients. Norgood, with its stable stock price, financial strength, and positive
earnings outlook, appears to be a conservative
stock that would fit within the guidelines of Smithson’s more
conservative accounts. It may or may
not fit the more aggressive guidelines established for some of Smithson’s pension fund clients.
Utah
BioChemical, however, is probably too volatile to be
included in a conser- vative account and thus may not have
been appropriate or suitable for some of the
firm’s personal trust clients. Therefore, Smithson may have violated
Standard III(C)— Suitability, in regard to the appropriateness and suitability of the investment actions he took. Under Standard
III(C), an investment manager must consider
the client’s tolerance for risk, needs,
circumstances, goals, and preferences, in matching a client with an investment.
Actions Required
The
case does not make clear whether Smithson’s clients have written investment objectives and guideline policy
statements. If they do not, Preston should direct Smithson to prepare such written guidelines for all accounts.
Smithson should review the guidelines
for every account for which he bought shares of Utah BioChemical
and Norgood and assess the characteristics of those investments in light of the objectives
of the clients and their portfolios. In those accounts for which either
investment is unsuitable and
inappropriate, he should sell those shares, and Preston Partners should reimburse
the accounts for any losses sustained by them.
“For each client of the firm,
portfolio managers, in consultation with the client,
shall prepare a written investment policy statement setting out the
objectives, the constraints, and the
asset-mix policy that meets the needs and circumstances of the client. Managers shall insert this analysis
in each client’s file. Portfolio managers shall review and confirm the investment policy statements at least
annually and whenever the client’s
business or personal circumstances create a need to review them. In their client relationships, portfolio managers
should be alert to any changes in the clients’
circumstances that would require a policy review. When taking investment
action, portfolio managers shall
consider the appropriateness and suitability of an investment to the needs and circumstances of the
client. Managers must satisfy themselves that
the basic characteristics of the investment meet the written guidelines
for the client’s account.”
Allocation of Trades
Standard
III(B)—Fair Dealing, states that members shall deal fairly
with clients when taking investment actions. In this case, the firm did not have detailed written
guidelines for allocating block trades to client accounts. So, Smithson simply
allocated trades to his largest
accounts first, at more favorable
prices, which discriminated against the smaller
accounts. Certain small clients were disadvantaged financially because of Smithson’s block-trade allocation method.
Standard
III(B) arises out of the investment manager’s duty of
loyalty to clients embodied in the
CFA Institute Code and Standards. Without loyalty, the client cannot trust or rely on the investment manager.
Whenever
an investment manager has two or more clients, he or she faces the possibility of showing one client
preference over the other. The Code and Standards require that the investment advisor treat each client fairly but
do not specify the allocation method
to be used. Moreover, treating all clients fairly does not mean that all clients must be treated equally. Equal
treatment, given clients’ different needs, objectives, and constraints, would be impossible.
Action Required
Because
Preston Partners has only vague policies for portfolio managers on allocating block trades, Preston
needs to formulate some detailed guidelines. The trade allocation procedures should be based on guiding principles that ensure 1)
fairness to clients, both in priority of execution of orders and in the allocation of the price
obtained in the execution of block trades, 2) timeliness
and efficiency in the execution of trades, and
3) accuracy in the investment manager’s records for trade orders and
maintenance of client account
positions. In advance of each trade, portfolio managers should be required to write down the account for
which the trade is being made and the number
of shares being traded.
Block
trades are often executed throughout a day or week, which results in many small trades at different prices. To
assure that all accounts receive the same average price for each segment of the trade, trades should be allocated
to the appropriate accounts just prior to or immediately following each segment
of the block trade on a
pro rata basis. For example, if 5,000 shares of Norgood
and 5,000 shares of Utah BioChemical traded on Day 1, Smithson would have immediately allocated each set of
shares to each appropriate account according to the relative size of the
account. Each account would thus pay
the same average price. If 10,000 more shares traded later that day, or the next day, or so on, Smithson would follow
the same procedure. Procedures for trade allocation should be disclosed
to clients in writing at the outset
of the
client’s relationship with the firm. Obtaining full disclosure and the client’s consent
does not, however,
relieve the manager
of the responsibility to deal fairly with clients under the Code and Standards.
Policy
Statement for a Firm
“All
client accounts participating in a block trade shall receive the same execution price and be charged the same commission,
if any. All trade allocations to client accounts shall be made on a pro rata basis prior to or immediately following part or all of a block trade.”
Responsibilities of Supervisors
Preston Partners
did not have in place
supervisory procedures that would have pre- vented
Smithson’s allocation approach. Preston’s failure to adopt adequate
procedures violated Standard IV(C)—Responsibilities
of Supervisors. Preston Partners had adopted
the Code and Standards; thus,
anyone in the firm with supervisory responsibility should have been
thoroughly familiar with the obligation of supervisors under the Code and Standards to make reasonable efforts to
detect and prevent violations of applicable laws, rules, and regulations. Supervisors and managers should
understand what constitutes an
adequate compliance program and must establish proper compliance procedures, preferably designed to prevent
rather than simply uncover violations.
The
case notes that certain sections of the policy and procedures manual were unclear.
Supervisors have a responsibility to ensure that compliance policies
are clear and well developed. Supervisors
and managers must document the procedures and
disseminate them to staff. In addition to distributing the policy and
procedures manual, they have a
responsibility to ensure adequate training of each new employee concerning the key policies and procedures
of the firm. Periodic refresher training sessions for all staff are also recommended.
Ultimately,
supervisors must take the necessary steps to monitor the actions of all investment professionals and enforce the established policies and procedures.
Actions Required
Preston
should assure that proper procedures are established that would have prevented the violation committed by Smithson.
Preston should assume the responsibility or appoint
someone within the firm to become the designated compliance officer whose responsibility is to assure that all
policies, procedures, laws, and regulations are being followed by employees.
Policy
Statement for a Firm
“Employees
in a supervisory role are responsible for the actions of those under their supervision with regard to compliance with the firm’s
policies and procedures and any securities laws and regulations that govern employee activities.”
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