Sonic the Hedgehog, CFA, is the fixed-income analyst and portfolio manager at SEGA Financial Corporation, a small investment firm. On April 1st, a friend (Tails) who works for a bond-rating agency mentions to Sonic that a bond the agency is analyzing will experience a rating change. That bond also happens to be in SEGA Financial’s portfolios. Not wanting to trade ahead of the rating change announcement, Sonic decides to wait for distribution of the information through Tails’ scheduled interview on a business television program the afternoon of 3 April. On the morning of 3 April, the information is released on a worldwide financial news service. Sonic immediately changes his mind about waiting for the interview and trades the bonds in SEGA Financial’s portfolios. 1. Does Sonic violate CFA Institute Standards of Professional Conduct by trading on the news of the bond rating change? A. No. B. Yes, only because he possessed material nonpublic information. C. Yes, only because he should have waited to trade until after Tails’ television interview took place D. Yes, both because he possessed material nonpublic information and because he should have waited to trade until after Tails’ television interview took place. On 3 April, Sonic also trades a second bond to rebalance one of SEGA Financial’s portfolios. Sonic knows before executing his transaction that the bond is thinly traded. Although Sonic’s trade will materially affect the bond’s market price, it is not his intention to create price movement. Robotnic witnesses the trade and large bond price change and says, “What a market overreaction; the bond price appears to be distorted now!” Robotnic also points out to Sonic that SEGA Financial’s policy on market manipulation states: “SEGA Financial employees must refrain from making transactions that distort security prices or volume with the intent to mislead market participants.” 2. Are Sonic’s 3 April trade of the second bond and SEGA Financial’s policy on market manipulation, respectively, consistent with CFA Institute Standards on market manipulation? A. Both Sonic’s 3 April trade of the second bond and SEGA Financial’s policy on market manipulation are consistent with CFA Institute Standards. B. Sonic’s 3 April trade of the second bond is inconsistent and SEGA Financial’s policy on market manipulation is consistent with CFA Institute Standards. C. Sonic’s 3 April trade of the second bond is consistent and SEGA Financial’s policy on market manipulation is inconsistent with CFA Institute Standards. D. Both Sonic’s 3 April trade of the second bond and SEGA Financial’s policy on market manipulation are inconsistent with CFA Institute Standards. In conducting fixed-income research, Sonic believes that insight into prospective corporate bond returns can be derived from information that is also relevant to a company’s stock. He spends several hours a week in equity investment chat rooms on the Internet, and he pays particular attention to the research reports posted by Knuckles, CFA, a self-employed analyst, on www. Knuckles the Independent Analyst.com. Prior to writing each report, Knuckles is paid a flat fee by the companies whose stocks he researches, but he does not reveal this fact to readers of his reports. He produces reports only for those companies whose stocks he can legitimately give “buy” recommendations after conducting a thorough analysis. Otherwise, he returns the flat fee. Investors have come to recognize all his “buy” ratings as having a sound and reasonable basis. 3. Does Knuckles violate CFA Institute Standards in preparing and disseminating his equity reports? A. No. B. Yes, only by misrepresenting his recommendations as independent. C. Yes, only by accepting payment from the companies on which he produces reports. D. Yes, both by misrepresenting his recommendations as independent and by accepting payment from the companies he covers. Sonic considers Knuckles’s summaries and forecasts to be very well-crafted. Knuckles has given Sonic written permission to use his summaries and forecasts, word for word and without attribution, in his own bond analysis reports. On occasion, Sonic has done so. In Knuckles’s othis Internet postings, he reports the results of relevant academic finance studies. Once Sonic learns of a study by reading Knuckles’s postings, he often reads the original study and mentions the results in his own reports. Sonic always cites the original study only and does not reveal that he learned of the study through Knuckles. 4. In preparing investment reports, does Sonic violate CFA Institute Standards with respect to his: Use of Knuckles’s summaries and forecasts? ----- Citation of studies found in Knuckles’s Internet postings? A. No No B. No Yes C. Yes No D. Yes Yes SEGA Financial occasionally sponsors seminars on ethics. In the most recent seminar, the main speaker made statements about the relationship between ethics and the law, and also about potential sources of conflict of interest for research analysts. The seminar speaker’s statements were: Statement 1: An illegal action is unethical, and actions that are legal are ethically sound. Statement 2: For analysts, a major source of conflict of interest is potential profit resulting from a weak barrier between the employer’s research department and investment banking department. 5. Are the seminar speaker’s statements #1 and #2, respectively, correct? Statement #1 ---- Statement #2 A. No No B. No Yes C. Yes No D. Yes Yes Statement 3: For situations in which conflicts of interest cannot be avoided, SEGA Financial’s written compliance policy should include the following component: “For unavoidable conflicts of interest that the employee judges to be material, employees must disclose the conflicts of interest to clients prominently, and in plain language.” Statement 4: On the matter of gifts that might impair employees’ objectivity, SEGA Financial’s written compliance policy should also include the following component: “Employees must disclose to SEGA Financial all client gifts regardless of value.” 6. Are the seminar speaker’s statements #3 and #4, respectively, sufficient to meet the requirements of related CFA Institute Standards? Statement #3 ---- Statement #4 A. No No B. No Yes C. Yes No D. Yes Yes
- A 2) A 3) B 4) C 5) B 6) C
1.A 2.A 3.D 4.C 5.B 6.D
- A 2. A 3. I’m not a fan of any of the answers. Shouldn’t he have to reveal his compensation structure? Also, isn’t returning the fee and not issuing a report on non-buy companies a violation? 4. A 5. B 6. C
1)A 2)A 3)B 4)D 5)B 6)D
My mistake, #3 should be B
1)A 2)A 3)C 4)C 5)B 6)B
- A 2) A 3) B 4) C 5) B 6) D
- A 2) A 3) B 4) C 5) B 6) C
I am shooting in the dark as I did not read ethics since last year: B A B B D D
Please Dwight, what is the actual answer?
Here were my guesses: 1. A 2. A 3. C 4. C 5. B 6. A
- A is correct. Sonic did not act on the material nonpublic information he possessed, and according to the Standards of Practice Handbook, “It is not necessary…to wait for the slowest methods of delivery.” 2. A is correct. Sonic’s transaction is a legitimate market order in a thinly-traded security, and SEGA Financial’s policy statement is consistent with CFA Institute Standards relating to the Integrity of Capital Markets. 3. B is correct. It is not a violation to accept compensation from an issuer in exchange for research but such arrangements must be disclosed prominently and in plain language. 4. C is correct. Receiving Knuckles’ written permission does not absolve Sonic of his responsibility to provide attribution. Because Sonic uses the results of the research studies and does not use Knuckles’s interpretation of the studies, it is appropriate to cite the original authors only. 5. B is correct. The first statement is incorrect and the second statement is correct. What is legal is not necessarily ethical, and a weak barrier between the employer’s research department and investment banking department is a potential source of conflicts. 6. B is correct. Statement 3 is incorrect. The disclosure of a conflict should be made—prominently and in plain language—regardless of whether the member views the conflict as material, so the client can determine the materiality of the conflict. Gifts (the $100 threshold is no longer applicable) from clients should be disclosed to the employer, which is responsible for determining whether the gift could affect the employee’s independence and objectivity. The SEGA Financial requirement exceeds, and therefore meets, CFA Institute Standards.