Mock Exam - Afternoon Session Question 5

CFA Level I Ethics
#1

Tonya Tucker, CFA, is a financial analyst at Bowron Consolidated. Bowron has numerous subsidiaries and is actively involved in mergers and acquisitions to expand its businesses. Tucker analyzes a number of companies, including Hanchin Corporation. When Tucker speaks with the CEO of Bowron, she indicates many of the companies she has looked at would be attractive acquisition targets for Bowron. After her discussion with the CEO, Tucker purchases 100,000 shares of Hanchin Corporation at $200 per share. Bowron does not have any pre-clearance procedures, so the next time she meets with the CEO, Tucker mentions she owns shares of Hanchin. The CEO thanks her for this information but does not ask for any details. Two weeks later, Tucker sees a company-wide email from the CEO announcing Bowron’s acquisition of Hanchin for $250 a share. In regard to her purchase of Hanchin stock, Tucker least likely violated the CFA Institute Standards of Professional Conduct concerning:

A. Loyalty. B. Priority of Transactions. C. Material Nonpublic Information.

Answer = C C is correct because there is no indication the analyst had access to material nonpublic information and was in violation of Standard II (A) Material Nonpublic Information. Specifically, Tucker did not have information concerning any decision by Bowron to acquire Hanchin stock because she is not a part of the decision-making team at Bowron, which determines the companies it plans to take over. The analyst had indicated numerous companies were viable options for take over, and she did not single out any one company in particular.

First, the fact that the company was on a list of companies considered for acquistion by Bowron is undisputably non-public information that may or may not be considered material. I would personally consider it material because it increases the liklihood that it will be the target of an acquisition.

More importantly, the question is worded as “least likely violated” implying that Tucker “more likely” violated either loyalty or priority of transactions. As far as priority of transactions, clients were not involved in this case. I suppose she should have given the company the right to “buy shares” (in this case acquire) before she did but as the answer to the question states, she did not know they were going to try to acquire the company.

Loyalty was my choice, as I see no loyalty issue with her purchasing shares of a company she is analyzing, unless the volume of her purchase was significant enough to affect prices. Although, even in that case I don’t see how there was a violation with regard to loyalty. I don’t see how answer A is wrong.

Am I missing something? I got to say, there are a few questions in the mock exam that I disagree with. Taking the time to post them all seems unfruitful but I really hope that the actual exam takes more care to prevent these sort of ambiguities.

#2

Let me just provide one more example of what I think is a bogus question. Three questions later on the afternoon session, question 8:

Sanjay Gupta, CFA, is interviewed by the First Faithful Church to manage the church’s voluntary retirement plan’s equity portfolio based upon his superior return history. Each church staff member chooses whether to opt in or out of the retirement plan according to his or her own investment objectives. The plan trustees tell Gupta that stocks of companies involved in the sale of alcohol, tobacco, gambling, or firearms are not acceptable investments given the objectives and constraints of the portfolio. Gupta tells the trustees he cannot reasonably execute his strategy with these restrictions and that all his other accounts hold shares of companies involved in these businesses because he believes they have the highest alpha. By agreeing to manage the account according to the Trustees’ wishes, does Gupta violate the CFA Institute Standards of Professional Conduct? A. No B. Yes, because the manager was hired based upon his previous investment strategy C. Yes, because the restrictions provided by the Trustees are not in the best interest of the members Answer = A

A is correct. According to Standard III (A) Loyalty, Prudence, and Care, Gupta’s duty of loyalty, prudence, and care is owed to the participants and beneficiaries (members) of the pension plan. As a church plan, the restrictions are appropriate given the objectives and constraints of the portfolio.

The loyalty, prudence, and care is owed to the beneficiaries, not the trustees. Gupta’s strategy is significantly affected by the restrictions, according to the question, and the policy beneficiaries may not even be notified of the restriction. I stand by answer C.

#3

I’m sorry - last one from the same set. Question 18,

Chris Rodriguez, CFA, is a portfolio manager at Nisqually Asset Management, which specializes in trading highly illiquid shares. Rodriguez has been using Hon Securities Brokers almost exclusively when making transactions for Nisqually clients, as well as for his own relatively small account. Hon always executes Rodriguez’s personal trades at a more preferential price than for Rodriguez’s clients’ accounts. This occurs regardless of whether or not Rodriguez personally trades before or after clients. Rodriguez should least likely do which of the following in order to comply with the CFA Institute Code of Ethics and Standards of Professional Conduct? A. Eliminate the exclusive trading arrangement. B. Trade client accounts before his own account. C. Average trade prices across all trading accounts. Answer = C

C is correct because Rodriguez is in violation of Standard IV (A) Loyalty, which requires that, in matters related to their employment, members and candidates must act for the benefit of their employer and not deprive their employer of the advantage of their skills and abilities, divulge confidential information, or otherwise cause harm to their employer. Rodriguez should not accept the special treatment from Hon, and he should seek such favors for the clients of Nisqually, specifically the lower costs Rodriguez has been getting for his transactions. Rodriguez should not average transaction costs because his clients should be given the lower preferential prices according to Standard III (A) Loyalty, Prudence, and Care.

This one may not be AS BAD as the previous two but… the question clearly states that Rodriguez gets preferential treatment regardless of whether he trades his account before or after his clients. How is answer B incorrect? This would be the LEAST effective way to resolve the bias. I concur that eliminating the arrangement would be one solution but averaging trade prices (his own lower prices as well as his clients prices) would ensure that there is no biased. His account is admittedly a small account so his trade volume would not be expected to effect the price.

#4

Q5: Tonya analyzed a ’ num​ber’ of companies and suggested that ’ many’ of the them would be suitable. There is no specific mention that she suggests Hanchin should be acquired nor was she privy to those discussions, thus she could not know that Hanchin would be acquired vs. any of the other companies she recommended. Her analysis that Hanchin would be a good acquisition was based on public information. She violated loyalty by putting her interests ahead of her employer when she purchased the stock.

Q8: Good point, I can see a lot of protests should this question appear on the exam (CFAI may accept multiple answers of the question is ambiguous). I feel that as the terms of the pension are laid out and employees have the option to opt out by joining they are agreeing to the constraints set out. I feel that A is the more appropriate answer given those circumstances

Q18: I would celect C mainly by process of elimination. “A” is wrong becasue he is obligated to seek best execution. “B” is wrong because he must put his clients ahead of himself (to your argument on price fluctuation the question states “highly illiquid” shares which implies small trades will influence price). As for C you need a fair process for allocating trades, they can be allocated based on a FIFO basis instead of averaging all accounts and still comply with the standard.

Best of luck tomorrow.

#5

I think question 8 is confusing because it doesn’t say what the invetment mangers actions ended up being. He tells them he can’t beat alpha if he doens’t invest in those portfolios but doens’t say he won’t adher to their investment contraints…

#6

Thanks for commenting. I guess my frustration with alot of these questions is that I DO understand the material but I find the information in the questions incomplete in many cases. I’m not sure what to take away from the questions I answer incorrectly to help me down the line. For example,

Fair point that she did not specifically mention Hanchin should be acquired nor did she KNOW that it was going to be acquired. I would even concede that there was not a violation of the code in her purchase of the shares. However, given the option of the three how could we possibly choose C? I guess I’m just not seeing how her purchase of shares of Hanchin violated her loyalty by putting her interests ahead of her employer? If she didn’t have any material information about the company’s intent to acquire Hanchin then how was the purchase a loyalty breach? How did she violate the priority of transactions for that matter? If, as the argument goes, she merely provided a report and did not have knowledge of the company’s intent to buy Hanchin, why is the purchase of their shares a violation of priority of transactions?

I can understand A being the correct answer ex post. But a priori, I can’t tell if this question is meant to test whether I know that my fiduciary responsibility is to the beneficiary and not the trustee or whether I am obligated to establish an investment policy that is consistent with specific guidelines. In a real life situation, if a full disclosure was made and the opt-out option was provided I would not see a violation. If no disclosure was made to the beneficiaries, which was not part of the question, adhering to the trustees constraints would be unethical.

Good catch on the illiquidity issue and this is the one I object to the least. Agreed A must be eliminated. So the choice is between B and C. In this case of this particular broker/dealer, the order of the trade does not matter so B does not solve the bias (best execution) problem.

There are other questions on the mock, some of which I answered correctly (according to the answer key) but could have made strong arguments for another answer. Not all are in the ethics section either. I almost wish the questions were essay!

Thanks winkster. I appreciate all your insights. Hopefully tomorrow goes well.

#7

Great point! I didn’t even think about it from that angle. Technically it isn’t a violation of the code to turn down a client for any reason. So if he had turned them down because he did not thnk he was the best manager for their fund given their desired constraints, that would have been fine.

#8

Be prepared, you’re not going to see straight forward scenerio’s on the exam they will be confusing and you’ll be expected to pick up on key words - my strategy for the exam (particularly ethics) is to try to eliminate wrong answers as opposed to choosing the correct one. Keep in mind a lot of thought and resources have been put into the questions and the incorrect options are well designed to make you think they are correct.

Q5: there is a clear violation here, as an analyst reccomending a company you have a duty of loyalty to ensure that you are permitted to purchase a stock your company is considering. Sanjay mentioned he owned the stock but not that he purchased it after an analysis he conducted for his company. At a minimum he should have gotten clearence to purchase a stock he reccommended.

The priority of transactions was violated because she suggested the company as a suitable target but did not give them an opportunity to act on it before purchasing the shares. Keep in mind priority is clients, firm, you.

Q8: Having ethical constraints do not automatically conflict with the benficiaries interests it simply reduces the breadth of the investment universe. All funds have constraints; how is this one different from saying that you can only invest in domestic securities or may not purchase speculative instruments? Limiting the investment scope vs. acting contrary to the beneficiaries interests’ are two seperate things, there is no evidence of the latter.

Q18: It’s all about putting clients ahead of yourself. If you place a trade for yourself before your clients who would also like to purchase the security you have violated the ethical standards, this is about as clear as you can expect it to be on the exam.

Key for tomorrow is to pick up on key words the questions are designed to make sure you know the material well.

If the questions were easy the CFA designation would hold little value and you may not have considered doing it…

#9

The question asks “what Chris Rodriguez should not do”