Super Selection

Super Selection

by Zoe L. Van Schyndel, CFA

Zoe L. Van Schyndel, CFA, is at the Evergreen State College (USA).

 

LEARNING OUTCOMES
Mastery	The candidate should be able to:
	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

Patricia Cuff, chief financial officer and compliance officer for Super Selection Investment Advisors, has just finished reviewing the brokerage account statement for one of Super Selection’s portfolio managers, Karen Trader. When a disgruntled board member of Atlantis Medical Devices (AMD) informed her of Trader’s possible misconduct, Cuff decided to investigate Trader’s relationship with AMD, a company whose stocks Trader recently bought for all her portfolios. As a result, Cuff obtained and is now reviewing Trader’s brokerage statements, which were not previously submitted by Trader. Cuff is concerned about possible violations of the company’s standards of professional conduct and her responsibilities as a compliance officer and member of CFA Institute to act on those violations.

Super Selection is a medium-size, rapidly growing money manager registered with the US Securities and Exchange Commission to manage both separate accounts and mutual funds. Super Selection has subscribed to the CFA Institute Code of Ethics and Standards of Professional Conduct by incorporating the CFA Institute Code and Standards into the firm’s compliance manual.

Trader has been a portfolio manager for Super Selection for almost five years. She loves the job because of the people she meets and the money she is able to earn. She has been particularly pleased to keep up her friendship with Josey James, a former college classmate and now the president of AMD, a rapidly growing local biotech company. Over the past five years, James has provided Trader with information on attractive stocks in Trader’s field—biotechnology—on which Trader capitalized for her Super Selection portfolios and her personal portfolio. Because she was able to act more

 

© 2011 CFA Institute. All rights reserved.

 

 

quickly on her personal trades than her Super Selection trades, Trader has often pur- chased stocks of the companies recommended by James for her own account prior to purchasing them for her clients. As a result, the performance of her personal portfolio has been better than the performance of her other portfolios.

Three years ago, James asked Trader to serve as an outside director for AMD and, despite AMD’s uncertain prospects at the time, Trader eagerly accepted the offer. Because AMD was in shaky financial condition until recently, the company compensated its directors with stock options rather than cash payments. For the past several years, directors received options exercisable into 200,000 shares in AMD stock. AMD’s shares were not traded anywhere, however, so this compensation was essentially worthless, and Trader has not reported her relationship with AMD to Super Selection. This year, with AMD’s sales setting records and earnings up, directors started receiving quarterly director fees of $5,000.

Several months ago, the AMD board voted to issue shares of stock to the public to raise needed cash. The market for initial public offerings (IPOs) was very hot, with valuations of biotech companies at record levels; so, AMD top managers believed the moment was opportune to go public. A public market for AMD shares was very appealing to many board members. Trader, for example, was eager to exercise her stock options so that she could cash in on their value. She had just begun construc- tion of a new home, which was putting significant pressure on her cash flow. Trader voted, with the majority of the board, to go public as soon as possible—before the new-issue market soured.

Shortly before the public offering date, Trader received a frantic phone call from James asking for a favor. James indicated that the IPO market had reversed course in the preceding few days; valuations of biotech companies were falling rapidly. James was afraid that investor interest in AMD had slowed so much that the IPO would be threatened. James asked Trader to commit to purchasing a large amount of the AMD offering for her Super Selection accounts to provide enough support for the offering to proceed as planned.

Trader had previously decided that AMD was a questionable investment for her accounts. As an AMD director, however, she also wanted to see a successful IPO, so she offered to reevaluate that decision. In this reevaluation, AMD’s stock price seemed high to Trader. Moreover, if she wanted to achieve the desired volume, AMD stock would then represent a higher percentage of Trader’s Super Selection portfolios than most holdings. Nevertheless, Trader decided to purchase the shares as James suggested, and when the IPO was effective, she placed the order for the separate accounts and the mutual funds that she managed.

Explain what violations of the CFA Institute Code and Standards have occurred and the steps that Trader should have taken to avoid the violations. What responsibility does Cuff, as compliance officer, have? What actions should Cuff take now?

 

 

 

CASE DISCUSSION

Several violations of the Code and Standards have occurred as a result of Karen Trader’s involvement with an outside company.

Trader is neither a CFA charterholder nor a member of CFA Institute, but she is bound by the CFA Institute Code and Standards to the extent that they are incorporated in her firm’s compliance policies. Patricia Cuff’s responsibility to take action regarding violations of the Code and Standards arises from her duties as a CFA Institute member, as a compliance officer, and as a senior manager of Super Selection.

 

 

Responsibilities of Supervisors

Those with legal or compliance responsibilities, such as the designated compliance officer, do not become supervisors solely because they occupy such named positions. Generally, determining whether an individual has supervisory responsibilities depends on whether employees are subject to that individual’s control or influence. In other words, does the individual have the authority, for example, to hire, fire, reward, and punish an employee. In this case, even though Trader does not report directly to Cuff, we assume Cuff supervises the actions of all employees of the firm (and has the power to hire, fire, reward, and punish them) in her dual responsibilities as CFO and com- pliance officer. Therefore, she must comply with the Standard IV(C)—Responsibilities of Supervisors.

As a supervisor, Cuff has a responsibility to take appropriate steps to prevent any violation by those she oversees of applicable statutes, regulations, or CFA Institute Standards. As compliance officer, she must also ensure that the firm’s compliance policies are being followed and that violations of these policies are addressed.

Actions Required

As a supervisor, Cuff should take corrective action after discovering the violations by reporting them to senior management. Cuff and Super Selection’s senior managers should then take affirmative steps to ensure that the appropriate action is taken to address the misconduct.

As compliance officer, Cuff should direct or monitor a thorough investigation of Trader’s actions, recommend limitations on Trader’s activities (such as monitoring all trading done in her client accounts, prohibiting her from personal trading, and imposing sanctions on her, including fines), implement procedures designed to prevent and detect future misconduct, and ensure that her recommendations are carried out. The senior managers should also consult an attorney to determine whether Trader’s actions should be reported to local legal or regulatory bodies. If senior management fails to act, Cuff may need to take additional steps, such as disclosing the incident to Super Selection’s board of directors and to the appropriate regulatory authorities, and

may need to resign from the firm.

Policy Statement for the Firm

“Employees in a supervisory role are responsible for the actions of the employees they supervise regarding compliance with the firm’s policies and procedures and any securities laws and regulations that govern the employees’ activities. When supervisors become aware of a violation of securities laws or firm policies, they must notify the compliance officer and senior management and/or ensure that appropriate steps are taken to address the violation.”

 

Employees and the Employer/Supervisor

Trader has responsibilities under Standard VI(A)—Disclosure of Conflicts. Trader violated this standard by 1) failing to disclose the conflict of interest that she had as a result of her ownership of AMD stock options and 2) failing to disclose to her employer the compensation she received as a director of AMD. The stock options and the cash compensation both should have been disclosed.

 

 

Actions Required

To avoid the violation, Trader should have disclosed to her employer the compensation she was receiving as an AMD director, whether cash or any other benefit, and should have disclosed her ownership of the AMD stock options and her directorship. This disclosure would have provided her employer and clients the information necessary to evaluate the objectivity of her investment advice and actions.

Cuff, since discovering the violation, needs to ensure that proper disclosure is made to clients and a thorough review is made of Trader’s client accounts and her personal accounts to determine whether any conflicts have occurred in addition to the IPO violation. If conflicts are discovered, Cuff has a responsibility to take appropriate action—e.g., limit behavior, impose sanctions, and so on.

Policy Statement for the Firm

“All personnel are required to inform their supervisors of any outside activities, such as board directorships, in which they are engaged or into which they propose to enter and receive approval for these activities prior to engaging in them. Employees shall disclose all conflicts of interest to clients and Super Selection prior to engaging in any activity that could be influenced by such conflicts.”

 

Reasonable Basis

Trader had previously determined that AMD was not a suitable investment for her clients. Under pressure from James, Trader has reversed her stance on AMD and has thus violated Standard V(A)—Diligence and Reasonable Basis.

Actions Required

Trader should have diligently and thoroughly researched AMD again prior to making a decision on investing in this security for her clients’ accounts. Once having con- cluded that AMD was not appropriate, she should not change her opinion, without adequate foundation. Trader must also inform clients of any conflicts she has as an AMD director and as an owner of AMD stock options.

Cuff should periodically—at least annually—review investment actions taken for clients by Super Selection employees to determine whether those actions were taken on a reasonable and adequate basis.

Policy Statement for the Firm

“Portfolio managers must consider all applicable relevant factors for each investment recommendation. Recommendations should be made in view of client objectives and the basic characteristics of the investment to be bought or sold.”

 

Duties to Clients

By investing in and influencing the public offering of AMD in order to boost the price of this stock, Trader misused her professional position for personal benefits and breached her duty of loyalty to her clients by placing her interests before her clients’ interests, thus violating Standard III(A)—Loyalty, Prudence and Care.

Although Trader, as a director of AMD, has a duty to that companies’ sharehold- ers, she cannot void her obligation to her clients at Super Selection and in the case situation, should have acted in client interests first.

 

 

Actions Required

Trader should have taken investment actions that were for the sole benefit of her cli- ents. She should not have been swayed by her ownership of any company into taking an investment action for her clients that she might not have taken in the absence of that ownership. Cuff must thoroughly investigate Trader’s activities to see whether other breaches of Standard III(A) have occurred. Following this type of breach and any others, Cuff must limit the activities of the wrongdoers, ensure the implementation of procedures to prevent and detect future occurrences, and follow up to make sure that her recommendations are carried out.

Policy Statement for the Firm

“Employees have a responsibility to identify those persons and interests to which they owe duties of loyalty, prudence, and care. Employees must comply with any fiduciary duties imposed on them by law or regulation.”

 

Investment Recommendations and Actions

Trader violated Standard III(C.1)—Suitability, when she purchased AMD stock for her clients and did not take into consideration their needs and circumstances.

Actions Required

Trader should have considered clients’ needs and circumstances prior to taking investment actions and should not have taken these actions to benefit herself or her friends. Cuff should establish a periodic review—to occur at least annually—to com- pare the suitability of investment actions taken for client accounts with their written investment policy statements.

Policy Statement for the Firm

“The objectives and constraints of each client’s portfolio should be put into a written investment policy statement. In taking action or making investment recommendations for clients, employees should consider the needs and circumstances of the client and the basic characteristics of the investment and portfolio involved. No recommenda- tion should be made unless it has been reasonably determined to be suitable for the client’s financial situation, investment experience, and objectives.”

 

Priority of Transactions

Trader violated Standard VI(B)—Priority of Transactions, by trading prior to her clients’ trades and may have benefited from the impact of her clients’ trades on the stock price.

Actions Required

In this instance, Trader circumvented Super Selection’s procedures by not reporting trades and brokerage accounts. Nevertheless, Cuff should have made efforts to ensure that Super Selection’s policies were being followed. Cuff should review her firm’s policies and procedures to make sure they are adequate and determine whether any adjustments should be made to implement or improve them. If adjustments are necessary, she should carry them out. Cuff should also make sure that employees of Super Selection are periodically informed of the Code and Standards and its requirements so as to eliminate any uncertainty about which employees are covered and what responsibilities they have to comply with these standards. Cuff needs to investigate Trader’s personal transactions thoroughly and recommend appropriate sanctions for Trader’s behavior. Cuff must also ensure that her recommended sanctions are followed to completion.

 

 

Policy Statement for the Firm

“The interests of customers will always be given priority over the personal financial interests of the firm’s personnel—particularly when securities are being traded or investment actions are being taken. All personal trades by employees of the firm will be pre-cleared in accordance with the firm’s compliance policies. In addition, personal trades will be monitored for suspicious activity, such as conflicts of interest and trading on material nonpublic information. Any violator of these priority and pre-clearance policies will be subject to sanctions, including loss of employment.”