Book Chapter 2 - Ethics and Investment Professionalism PDF

## Chapter 2 - Ethics and Investment Professionalism ### Section 2.1 - Ethical and Compliance-Driven Behaviour #### 2.1.1 - Ethics Versus Regulations * Describe the need for ethics in the investment industry Definitions of ethics vary, but generally ethics is viewed as a set of basic principles...

## Chapter 2 - Ethics and Investment Professionalism ### Section 2.1 - Ethical and Compliance-Driven Behaviour #### 2.1.1 - Ethics Versus Regulations * Describe the need for ethics in the investment industry Definitions of ethics vary, but generally ethics is viewed as a set of basic principles that ensure people behave for the benefit of all. Implementing regulations addresses some areas of unethical behaviour, but grey areas can remain where behaviour, even if it is not prohibited by regulation, does not seem to benefit a client. For example, the case study at the end of this section, on a major US investment bank, shows that the behaviour of investment professionals can be considered unacceptable and not in clients' best interests by many, but still not prohibited by regulations. It is difficult for regulators to keep pace with the investment industry. New products, technologies, and practices are often developed and used before regulations to govern them are written. Furthermore, if regulations are ambiguous or out of date, there is the risk that they will be exploited by unscrupulous participants in the financial services industry. Regulations are also difficult to enforce given the complexity of transactions, instruments, and the requirement to prove that rules have been broken. Ethical behaviour is therefore important for a number of reasons, such as: * Building public trust in financial markets, which encourages wider participation in them. * Promoting trust in investment professionals, encouraging the public to use professionals to manage and advise on their investments. * Instilling trust in other stakeholders, including providers of capital to the industry such as shareholders or providers of finance for transactions. * Earning the trust of regulators, allowing greater scope for self-regulation and less restrictive regulation of the participants in capital markets. #### 2.1.2 - Behavioural Indicators * Identify positive and negative behavioural indicators **Corporate and personal ethics** There are two schools of thought regarding unethical behaviour: 1. Unethical behaviour is the result of the environment or the situation a person is in, so a good person in a bad environment may still end up behaving unethically. 2. Unethical behaviour is the result of the attitude or personality of an individual, and the environment is less important. Most academic evidence suggests that environment is the more important factor. In the context of the investment industry, this suggests corporate ethics are critical in determining the behaviour of employees. Additionally, a person in a senior role can have a strong influence on junior staff behaviour. It is important that a strong ethical culture is led by the behaviour of management. Good corporate ethics can be enhanced by many factors typically found in companies with good corporate governance. These include independent directors, strong internal procedures, and fair remuneration packages that do not overly encourage risk-taking. It is also helpful to encourage employees to take some degree of personal responsibility for their actions - not to follow instructions unquestioningly nor respond to peer pressure that condones unethical activities. **Motivations for unethical behaviour** At a personal level, there are many factors that can lead to unethical behaviour: * Undue pressure or incentives to perform. If not structured carefully, bonuses and performance could increase risk-taking and reward short-term performance; * Ability to blame others, e.g. "I was just following instructions". Acting as a member of a team also diffuses responsibility rather than forcing an individual to accept personal responsibility for their actions; * Ability to rationalise unethical behaviour, e.g. the other party is being unethical too; * Conflicts of interest skewing judgment; * Lack of rigour due to overcapacity, e.g. unwillingness to conduct proper research into a product; * Disregard for clients, which is perhaps more likely to occur when an investment professional is distanced from clients; and * Failure to act, i.e. being unethical by omission. This is sometimes easier to justify than actively participating in unethical activities. **Cultural Issues** Interpretation of ethical behaviour varies between countries. Moral standards and value judgments partly depend on culture and will also vary over time. For example, giving a business contact a gift could be seen either as normal hospitality or as a bribe. This is one of the challenges of building a global code of ethics. Research by Meir Statman published in the Financial Analysts' Journal looked at how the balance between self-interest and fairness varies in different countries. Professionals and students in a number of countries were asked whether behaviour in a fictitious insider trading case was fair. The percentage who judged it completely fair or acceptable ranged from 5% to 76% depending on the country and whether they were professionals or students. The responses were examined against stock market participation levels in the respective countries, and there appeared to be a relationship between perception of fairness, levels of trust and the willingness of the public to participate in their stock market. #### 2.1.3 - Ethical Obligations * Identify the ethical obligations to clients, prospective clients, employers, and co-workers The CFA Code of Ethics identifies a number of ethical obligations on the part of those working in the investment industry. These are covered in more detail later in this chapter and are summarised here. A firm has a number of ethical obligations to its clients (and prospective clients) that can be summed up as its fiduciary duty. This means it must put the client's interests above its own and requires a firm (and its employees) to: 1. Act with loyalty to their clients and act with reasonable care and exercise prudent judgment; 2. Deal fairly and objectively with all clients when providing investment analysis, making investment recommendations, taking investment action, or engaging in other professional activities; 3. Provide suitable recommendations when in an advisory relationship; 4. Provide fair, accurate, and complete information when communicating investment performance information; and 5. Preserve confidentiality of client information unless the information concerns illegal activities, disclosure is required by regulation or is permitted by the client. #### 2.1.4 - Implications of Unethical Behaviour * Critically evaluate the outcomes which may result from behaving unethically - for the industry, individual advisers, the firm, and consumers #### 2.1.5 - Critically evaluate the outcomes which may result from limiting behaviour to compliance within the rules The terms ethics and compliance are often used interchangeably, so drawing a distinction between the two concepts may seem difficult. There is, however, a clear difference. Compliance involves abiding by the law or regulations, while ethics involves doing what is right, regardless of what the law or regulation states. Most of the time compliance with the law will be consistent with ethical behaviour. However, there are many examples of firms or their employees complying with the law, but still behaving unethically in order to win business or to increase commission. The selling of payment protection insurance (PPI) that was ineffective to some of the people it was sold to may not have been illegal, but it was clearly unethical, and eventually led to the banks involved in the mis-selling having to pay large amounts of compensation. Another example of a firm that acted in an unethical way that was nevertheless largely compliant with regulations was that of Goldman Sachs in 2010 - this is covered in the Case Study later in this section. **Industry** When practitioners in an industry behave unethically and put their own interests ahead of those of their clients (and in some cases ahead of the taxpayers’ interests), the industry becomes vulnerable to government intervention. This could result in: * New or higher taxes on the industry; * Increased regulation; * The breaking up of participants' businesses; * Restrictions on activities; or * Requirements for greater disclosure. Central regulation by government tends to replace self-regulation by practitioners. Not only does this risk stifle future activity in the industry, but it also creates uncertainty that slows investment and innovation. A loss of trust in capital markets and the investment industry can lead to reluctance among investors to participate in the markets and to use investment professionals. When investment firms are perceived to be operating for the benefit of their owners and not their clients, investors will look for alternative ways to manage their money. **Firm** A firm with a poor ethical stance faces the possibility of prosecution, which could lead to fines, loss of licence or compensation payments to clients. For individual firms, one of the main risks of unethical behaviour is reputational risk. Reputation is an asset of a firm because a good reputation should enhance future cash flows. Damage to reputation could lead to a loss of value, loss of independence, or potentially to the collapse of the organisation. It affects the firm’s ability to attract new business and may cause the loss of existing clients. Furthermore, time may need to be spent responding to client complaints, questions from regulators or rewriting inadequate internal procedures. Unethical behaviours can also detrimentally impact the "G" rating of a firm, and downgraded ESG ratings can impact the investibility of firms for investors, amongst other issues. Strong, consistent, internal procedures should be set in place with the objective of preventing employees from breaking regulations and acting unethically. Procedures need to specifically identify and address areas where there could be a conflict of interest, as well as detail the individual activities and processes of the firm. Statements on ethical standards should be written clearly and should stand out from the detailed instructions on compliance procedures. They need to be communicated clearly to employees and any violations should be investigated and reported to senior management. While breaching regulations can lead to investigation and possibly criminal proceedings, unethical conduct has its own potential penalties, such as: * Disciplinary action from a professional body; * Disapproval from clients, colleagues, and the industry peer group; * Negative publicity; and * The loss of an individual’s job. **Investment advisers and consumers** Investment practitioners have a fiduciary duty to their clients, so any investment decisions should be made for the benefit of the client. Negligent investment advice can result in returns that are lower than expected, and even financial loss. These negative outcomes could be due to: * Taking on too much risk; * Purchasing inappropriate investments; * Lack of diversification; * Excessive trading that incurs unjustified transaction costs; or * Purchasing products that charge fees not commensurate with performance. Needless to say, financial loss can cause extreme stress, particularly where clients may depend on their savings and investments to provide income. Investment advisers should be particularly careful when dealing with vulnerable clients and insistent clients. Consumers in vulnerable circumstances are less likely to be able to represent their own interests, and more likely to suffer harm, than the average consumer. Advisers need to have procedures to determine whether a client could be classed as vulnerable before offering advice, in order to avoid acting in an unethical manner. Insistent clients who do not wish to follow an adviser’s recommendation but instead wish to take a risky transaction, can put the adviser in a difficult position. In these circumstances, an adviser should follow the Financial Conduct Authority (FCA) guidance to avoid acting unethically. * Vulnerable clients are covered in more detail in Chapter 5, Section 5.1, and insistent clients are discussed in Chapter 3, Section 3.5. **Case Study of Goldman Sachs Abacus - Illustration of Unethical Behaviour** An example of an investment bank accused of behaving unethically was Goldman Sachs in 2010. The US Securities and Exchange Commission (SEC) filed a complaint against Goldman Sachs in 2010 for misleading statements and omissions in connection with the marketing of ABACUS 2007-AC1. ABACUS was a collateralised debt obligation (CDO) structured and tied to the perform ance of sub-prime residential, mortgage-backed securities specifically selected by a hedge fund, Paulson and Co, which stood to benefit if and when these securities defaulted. According to the SEC, Paulson and Co paid Goldman Sachs to structure these transactions. This deal was completely unknown to those buying the securities that Goldman Sachs was selling. The SEC’s main accusation was that while Goldman Sachs provided firms with a detailed list of the assets contained in ABACUS, that it built and sold in 2007, it concealed the role of John Paulson, a hedge fund manager who worked with Goldman Sachs to pick what went into the security. Paulson then placed bets that the security would lose value. In essence, the buyers bet that housing prices would go up, while Paulson bet that prices would fall. At a Senate hearing in April 2010 into the role of Goldman Sachs in the global financial crisis, a central line of inquiry was whether it was ethical for Goldman to go short on housing in its own trading positions, while at the same time continuing to market securities on which customers would be on the long side of the market. Goldman’s defence was that it shorted the CDOs to manage its own risk exposures. Goldman Sachs eventually admitted fault and reached a settlement with the SEC, paying US$550 million. The reputation of Goldman Sachs is likely to have been damaged as its behaviour was widely viewed as unethical. ### Section 2.2 - CFA Code of Ethics and Standards of Professional Conduct #### 2.2.1 - Code of Ethics * Identify the elements of the CFA Code of Ethics and Standards of Professional Conduct The Code of Ethics sets out the ethical standards that all CFA Institute Members (Members) and CFA Candidates who are registered to take CFA exams (Candidates) must follow. There are six elements in the Code of Ethics. Members and Candidates must: 1. Act with integrity, competence, diligence, respect, and in an ethical manner with the public, clients, prospective clients, employers, employees, colleagues in the investment profession, and other participants in the global capital markets. 2. Place the integrity of the investment profession and the interests of clients above their own personal interests. 3. Use reasonable care and exercise independent professional judgment when conducting investment analysis, making investment recommendations, taking investment actions, and engaging in other professional activities. 4. Practice, and encourage others to practice, in a professional and ethical manner that will reflect creditably on themselves and the profession. 5. Promote the integrity and viability of the global capital markets for the ultimate benefit of society. 6. Maintain and improve their professional competence and strive to maintain and improve the competence of other investment professionals. The Code of Ethics is the underlying philosophy of the Standards of Professional Conduct. The Standards promote fair and ethical behaviour, and are organised into seven broad categories: 1. Professionalism 2. Integrity of capital markets 3. Duties to clients 4. Duties to employers 5. Investment analysis, recommendations, and actions 6. Conflicts of interest 7. Responsibilities as a CFA Institute Member or CFA Candidate #### 2.2.2 - Standards of Professional Conduct * Explain the professional principles and values on which the CFA Code of Ethics and Standards of Professional Conduct is based #### 2.2.3 - Apply the CFA Code of Ethics and Standards of Professional Conduct to a range of ethical dilemmas This section looks at each of the Standards followed by some practical situations where the Standards provide guidance on the appropriate behaviour of investment professionals practicing in the UK. **Standard | Professionalism** **A. Knowledge of the law** Members and Candidates must understand and comply with all applicable laws, rules, and regulations (including the CFA Institute Code of Ethics and Standards of Professional Conduct) of any government, regulatory organisation, licensing agency, or professional association governing their professional activities. In the event of conflict, Members and Candidates must comply with the strictest law, rule, or regulation. Members and Candidates must not knowingly participate or assist in, and must dissociate from, any violation of such laws, rules, or regulations. Investment professionals practicing across many countries must adhere to all applicable regulatory requirements, whether these are the laws, rules, and regulations of their own country, or those of foreign countries. When there is a conflict between applicable regulatory requirements and the Code and Standards, they must follow whichever is the strictest. Investment professionals should ensure that they have appropriate knowledge of all relevant regulatory requirements and should ensure that they are up to date with changes in laws, rules and regulations. If in doubt, they should seek advice from compliance personnel. **Example** * **Situation:** Marilyn is part of the marketing team, and her responsibility is to attract new clients for her employer, a private client investment management firm. She is provided with performance data to use in presentations which she knows have been manipulated to give the impression that the firm is generating high returns for its clients. * **Analysis:** Marilyn has been asked to use misleading performance data, and misrepresenting performance violates the Code and Standards. She must bring the situation to the attention of her supervisor or the compliance department and request that the performance data is calculated correctly. She must refrain from using the misleading information and disassociate herself from the activity. If an investment professional suspects that a Standard or regulatory requirement has been violated, they should report it to their supervisor or compliance department (unless they are automatically required to inform the government or any regulatory organisations). If the situation is not remedied, they should disassociate themselves from the illegal or unethical activity and, if necessary, resign from their position. **B. Independence and objectivity** Members and Candidates must use reasonable care and judgment to achieve and maintain independence and objectivity in their professional activities. Members and Candidates must not offer, solicit, or accept any gift, benefit, compensation, or consideration that reasonably could be expected to compromise their own or another’s independence and objectivity. Investment professionals may come under pressure from their employers or be offered free trips or gifts by companies that may influence their recommendations or research. Gifts from clients are allowed as long as they are disclosed to the employer to avoid the appearance of favouring one client over another. Investment professionals should avoid those situations that would cause, or be perceived as causing, a conflict of interest. **Example** * **Situation:** Christopher is a junior fund manager working in London and is invited to visit a listed company based in Edinburgh by one of the brokers who is recommending the company’s shares. The broker pays for Christopher’s first-class travel, a night in a hotel, and for golf the next day. * **Analysis:** Christopher would be advised to pay (or for his employer to pay) for his own travel costs and golf. Accepting the trip and hospitality from the broker will lead to the accusation that he has compromised his independence by making himself indebted to the broker. **C. *Misrepresentation* ** Members and Candidates must not knowingly make any misrepresentations relating to investment analysis, recommendations, actions, or other professional activities. A misrepresentation is any untrue statement, or any other statement that is false or misleading. It may also be omission of a fact or a failure to correct a known misunderstanding. The Standard is relevant to misrepresentations in any form, including oral communication, advertisements, emails, or written materials. Investment professionals should not misrepresent any aspect of their practice, including: * Their qualifications or those of their firm; * Services provided by their firm; * Their performance record or that of their firm; and * Guaranteeing returns on a risky investment or risky investment product (unless the product is specifically structured with a built-in guarantee). **Example** * **Situation:** Bill is an investment adviser who tells his clients that equities are guaranteed to recover by at least 10% this year based on his view of the UK economic outlook. * **Analysis:** Bill is misleading his clients; equities, by their nature, have uncertain returns. The Standard of professionalism also covers plagiarism. Investment professionals shall not copy or use, in substantially the same form as the original, material prepared by another, without acknowledging and identifying the name of the author, publisher, and/or source of such material. **Example** * **Situation:** Janet is an investment adviser, and has decided that a company is attractive. She is anxious to recommend her clients to buy shares as soon as possible. She finds that a brokerage house has recently written a positive report on the company. Janet changes headings and a few words in the report and sends it out to her clients to support her recommendation. * **Analysis:** Janet should not use another broker’s report without acknowledging the source, and must not represent herself as the author of the report. Examples of plagiarism include: * Basing a report on another analyst’s report; * Using excerpts from an article; and * Using charts, graphs, or proprietary spreadsheets without referring to the original source or without the required permission. This Standard not only covers plagiarism in written materials, but also in oral communications, such as in client meetings or presentations. When preparing research reports, analysts should keep copies of sources of information used, acknowledge quotations and cite sources of statistics. * See Chapter 3, Section 3.5 for the FCA rules on investment research. **D. Misconduct** Members and Candidates must not engage in any professional conduct involving dishonesty, fraud, or deceit, or commit any act that reflects adversely on their professional reputation, integrity, or competence. The professionalism Standard addresses compliance with regulations and the upholding of professional integrity. Dishonest personal behaviour reflects badly on the profession. For example, excessive drinking in business hours and the manipulation of expense accounts, suggest poor judgment. This Standard addresses professional conduct rather than personal behaviour outside of work. **Standard II: Integrity of Capital Markets** **A. Material non-public information** Members and Candidates who possess material non-public information, that could affect the value of an investment, must not act or cause others to act on the information. 'Material' means that disclosure is likely to have an impact on the price of a security, or that reasonable investors would want to know the information before making an investment decision. The reliability of the source of the information is also a factor in determining whether it is material. The less reliable the source is, then the less likely it is to be material. 'Non-public' means that the information has not been disseminated in the market, and investors have not had a chance to react to it. In the situation that a group of analysts is given information by a company, it is still non-public information until it has been disseminated to other investors in the market. **Example** * **Situation:** James is a portfolio manager. He was at his son’s school party when he overheard another parent saying that she looked at a file in her husband’s briefcase and found out that Beckford Corporation is planning to make a bid to purchase a competitor, Easeby Inc, saying, "The company will pay up to two times the current market price for Easeby Inc stock!". James went into the office the next day, and immediately purchased Easeby Inc shares for his clients. * **Analysis:** James has taken an investment action based on material non-public information, which is a violation of Standard II(A). However, it is acceptable to analyse public information, and non-material non-public information to predict events, which would lead to the same conclusion as receiving material non-public information. This is called 'mosaic theory'. Most investment banking firms with combined brokerage services will set up an information barrier, a firewall, to prevent communication of non-public information from one department of a firm to another. For example, the corporate finance department should be separated from the sales and research departments. * See Chapter 3, Section 3.7 for a discussion of the law relating to insider dealing. **B. Market manipulation** Members and Candidates must not engage in practices that distort prices, or artificially inflate trading volume with the intent to mislead market participants. Market manipulation is often related to: * Transactions that artificially distort prices or volumes of securities traded; * Taking a dominant position in a security in order to manipulate the price of a related derivative; and * The dissemination of false or misleading information in order to artificially inflate or decrease a security price. * See Chapter 3, Section 3.7 for more information about market abuse. **Standard III: Duties to Clients** **A. *Loyalty, prudence and care*** Members and Candidates have a duty of loyalty to their clients, must act with reasonable care and exercise prudent judgment. Members and Candidates must act for the benefit of their clients, and place their clients' interests before their employer’s or their own interests. This Standard confirms that clients' interests must always come first and that investment professionals have a duty of loyalty, prudence, and care to clients. **Example** * An example of the importance of loyalty to clients is in regard to proxy voting. Unless the client instructs otherwise, the investment manager must always vote on a proxy Issue - it cannot be ignored. Proxies have economic value to a client, and Members and Candidates must ensure that they properly safeguard and maximise this value. An Investment manager who fails to vote, casts a vote without considering the impact of the question or votes blindly with management on non-routine governance Issues (e.g. a change in company capitalisation) may violate this Standard. **B. Fair dealing** Members and Candidates must deal fairly and objectively with all clients when providing investment analysis, making investment recommendations, taking investment action, or engaging in other professional activities. 'Fair dealing' means that the investment professional does not favour one client above any other when disseminating recommendations or taking investment action. Material changes must be announced, as far as it is practical, to all clients at the same time. **Example** * **Situation:** Monica works in the investment management department of a private client firm. She learns that the research department has just issued a 'buy' recommendation for ABC Housing Ltd. She promptly buys a large quantity of ABC Housing shares and allocates it to the collectives that are managed internally, since these accounts are particularly performance sensitive. Monica then reviews the firm’s other clients and purchases additional shares where appropriate. * **Analysis:** Monica’s activities clearly violate Standard III(B) by giving preferential treatment to the collectives over other clients. Discretionary and non-discretionary clients must be treated equally. New issues should be offered to all clients for whom the issue is an appropriate investment. If an issue is over-subscribed, or is a block trade, it should be distributed on a pro rata basis. * See Chapter 3, Section 3.5 for FCA rules on client order handling. **C. Suitability** 1. When Members and Candidates are in an advisory relationship with a client, they must: * Make a reasonable inquiry into a client’s or prospective client’s investment experience, risk and return objectives, and financial constraints prior to making any investment recommendation or taking investment action and must reassess and update this information regularly. * Determine that an investment is suitable to the client’s financial situation and consistent with the client’s written objectives, mandates and constraints before making an investment recommendation or taking investment action. * Judge the suitability of investments in the context of the client’s total portfolio. 2. When Members and Candidates are responsible for managing a portfolio to a specific mandate, strategy or style, they must make only investment recommendations or take only investment actions that are consistent with the stated objectives and constraints of the portfolio. This list of requirements means that advisers must know their clients before giving them advice. To comply with the Standard, an investment professional should undertake a fact-find for each client. The fact-find should establish: * The type and nature of the client and their attitude to risk; * Investment objectives in terms of risk and return; * Investment constraints, such as liquidity, legal requirements, time horizon, tax position, and unique circumstances; and * Performance measurement benchmarks. **Example** * **Situation:** David, an investment adviser, has been advising Delia, a risk-averse client, on the use of *covered call options* in her equity portfolio. The purpose is to generate income in the portfolio. David explains to Delia the risks, and tax implications involved. * **Analysis:** When determining the suitability of particular investments, the primary consideration is the characteristics of the client’s entire portfolio, i.e. not looking at it on an issue-by-issue basis. Although writing options is potentially very risky, in this case David appears to have properly considered the investment in the context of the entire portfolio and has thoroughly explained the investment to the client, making him compliant with Standard III(C). * See Chapter 5 on determining client objectives. **D. Performance presentation** When communicating investment performance information, Members and Candidates must make reasonable efforts to ensure that it is fair, accurate, and complete. The CFA Institute has developed the Global Investment Performance Standards (GIPS) as a common, accepted set of standards for the investment management industry. Although compliance is voluntary, investment professionals and their firms are encouraged to adopt the standards, and they are becoming more widely used. All performance statements must be fair, accurate, and complete. **Example** * **Situation:** Terry is preparing marketing material for his firm’s portfolio management services and decides to use the performance of a model portfolio to illustrate his firm’s performance record. * **Analysis:** Terry should make it clear in his marketing materials that these are the results of a model portfolio and not actual results achieved for clients. * See Chapter 3, Section 3.5 for FCA rules on the presentation of performance information in financial promotions. **E. Preservation of confidentiality** Members and Candidates must keep information about current, former, and prospective clients confidential unless: 1. The information concerns illegal activities on the part of the client or prospective client; 2. Disclosure is required by law; or 3. The client or prospective client permits disclosure of the information. In general, investment professionals should avoid disclosing any information about a client except to authorised fellow employees who are working for the benefit of the client. However, an investment professional may want to disclose information of a non-confidential nature, in this case they should check if the information is relevant to the work being performed for the client and whether disclosure enables the investment professional to provide a better service to the client. **Example** * **Situation:** Roger is a portfolio manager, and manages an endowment plan of a university. The university has given Roger a confidential review of the future plans for expansion, so he can better understand the fund’s objectives. Roger’s friend owns a local construction firm, and is interested in making a contribution to the endowment plan, with the understanding that his company would be favourably considered when bidding for construction work at the university. He asks Roger for information about the expansion plans. * **Analysis:** Roger owes confidentiality to the endowment fund and its trustees, and therefore should refuse to divulge any information to his friend without the client’s agreement. **Standard IV: Duties to Employers** **A. Loyalty** 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. The employer’s interests must come above the employee’s own interest in matters relating to employment. This covers issues such as independent practice: investment professionals should not enter into independent practice if it is in conflict with their employer’s interests. However, independent practice is not explicitly prohibited, but investment professionals need to obtain prior permission from their employer and any other party. Investment professionals can make preparations to undertake independent practice before leaving their employer, but care must be taken to ensure that the employer’s interests are maintained. When investment professionals plan to leave their current employers, there is scope for conflicts to arise, but they still have a professional duty to act in their employer’s best interests until their resignation becomes effective. For example, the investment professional must be careful not to misappropriate trade secrets, misuse confidential information, solicit the employer’s clients, or misappropriate client lists. **Example** * **Situation:** Joanna is an independent investment adviser, and runs her own advisory business advising five high-net-worth clients. A local stockbroker asks Joanne to join his firm as a portfolio manager. She accepts the offer but keeps her five clients. * **Analysis:** Joanna must seek written consent from her new employer to comply with Standard IV(A). **B. Additional compensation arrangements** Members and Candidates must not accept gifts, benefits, compensation, or consideration that competes with, or might reasonably be expected to create a conflict of interest with, their employer’s interest unless they obtain written consent from all parties involved. Employers have a right to know if their employees are subject to any conflict of loyalties. Additional compensation includes payments from clients, or from third parties. **Example** * **Situation:** Tony is a manager in a regional stockbroker. He also sits on the board of a publicly listed resort chain. In addition to receiving an annual payment as a non-executive director, he is given membership privileges for his family at all the resort facilities. Although Tony discloses the payment, he does not disclose receiving the membership privileges, because he believes that he is only obliged to report monetary compensation. * **Analysis:** Tony violated Standard IV(B) by failing to disclose the total compensation as a member of the board of directors. When dealing with the securities of the resort chain, he may be obligated to disclose this arrangement to clients and prospective clients under Standard VI(A). **C. Responsibilities of supervisors** Members and Candidates must make reasonable efforts to ensure that anyone subject to their supervision or authority complies with applicable laws, rules, regulations, and the Code and Standards. Supervisors are responsible for their subordinates’ ethical behaviour, even if the subordinate is not a CFA Institute Member. Supervisors can rely on reasonable compliance procedures designed to avoid, and detect any wrongdoing. Moreover, if a compliance system is not in place, then the investment professionals should not accept the supervisory responsibility until reasonable procedures are in place. Ideally, compliance procedures should: * Be contained in a clearly written and accessible manual that is easy to understand. * Outline permissible conduct; * Outline the scope of the procedures; * Implement a system of checks and balances; * Designate a compliance officer and specify their authority; * Outline procedures for reporting violations and sanctions; * Outline procedures to document and test compliance procedures; and * Describe the hierarchy of supervision and assign duties to supervisors. Compliance rules should be communicated to all employees and updated periodically. If a violation occurs, then a supervisor must respond promptly, conduct a thorough investigation, and put limits on the relevant employees’ activities until the investigation is complete. **Standard V: Investment Analysis, Recommendations and Actions** **A. Diligence and reasonable basis** Members and Candidates must: 1. Exercise diligence, independence, and thoroughness in analysing investments, making investment recommendations, and taking investment actions. 2. Have a reasonable and adequate basis, supported by appropriate research and investigation, for any investment analysis, recommendation, or action. This applies to primary research, secondary research (research conducted by someone else in the same firm) or third-party research. Investment professionals must make reasonable and diligent efforts to ensure that the research is sound. If any information is suspected of being inaccurate, then it cannot be used. * See Chapter 3, Section 3.5 for FCA rules relating to investment research. **Example** * **Situation:** Leah follows Widget Ltd as a research analyst. All the information she has accumulated suggests that the outlook for the company’s existing products is poor and the launch of new products has been delayed. Leah overhears a financial analyst during lunch say that Widget’s new products will be superior to those of its competitors. Upon returning to her office, Leah changes her recommendation from ‘sell’ to ‘buy’. * **Analysis:** Leah violated Standard V(A), as she should have conducted her own thorough research as an adequate and reasonable basis for her recommendation. **B. Communication with clients and prospective clients** Members and Candidates must: 1. Disclose to clients and investment clients the basic format and general principles of the investment processes they use to analyse investments, select securities and construct portfolios, and must promptly disclose any changes that might materially affect those processes. 2. Disclose to clients and prospective clients any significant limitations and risks associated with the investment process. 3. Use reasonable judgment in identifying which factors are important to their investment analyses, recommendations or actions and include those factors in communications with clients and prospective clients. 4. Distinguish between fact and opinion in the presentation of investment analysis and recommendations. This is a very important standard. It establishes the importance of clients understanding the information sent to them (via any means of communication), allowing them to make informed decisions. Analysts must provide information on the basic characteristics of an investment, which are the key factors supporting a recommendation, and differentiate between opinion (often on the investment’s future prospects) and fact. **Example** * **Situation:** Judy is a mining analyst and has written a research report on NB Minerals. Included in her report is her own assessment of the extent of mineral reserves likely to be found on the company’s land Based on preliminary core sample results from the company’s latest drilling and her own calculations, Judy writes, ‘Based on the fact that the company has in excess of 200,000 ounces of gold, we rate NB Minerals a "buy". She omitted to state that a potentially serious environmental litigation case has just been filed by local residents living adjacent to the mining sites. * **Analysis:** Judy violated Standard V*(B*, as her calculation of the total reserves is an opinion, not a fact, and her omission of the relevant legal case is not reasonable . **C. Record retention** Members and Candidates must develop and maintain appropriate records to support their investment analysis, recommendations, actions and other investment-related communications with clients and prospective clients. Investment professionals should maintain files to support their work, including sources of information and methodology by which recommendations or conclusions were made. Generally, these remain the property of the firm, not the employee. Records can be maintained in either hard copy or electronically. The Standard does not stipulate a minimum holding period, but local regulatory requirements must be followed. * See Chapter 3, Section 3.5 for FCA rules on record-keeping. **Standard VI: Conflicts of Interest** **A. Disclosure of conflicts** Members and Candidates must make full and fair disclosure of all matters that could reasonably be expected to impair their independence and objectivity, or interfere with respective duties to their clients, prospective clients, and employer. Members and Candidates must ensure that such disclosures are prominent are delivered in plain language and communicate the relevant information effectively. This Standard considers potential conflicts between investment professionals, their employer, clients and prospective clients. The emphasis is on full disclosure of conflicts, so that all the parties can evaluate the objectivity of advice or investment actions being taken. The investment professional cannot decide for themselves whether an actual or potential conflict exists - only clients and employers can make this decision. Investment advice to clients could be biased for a number of reasons, including where the investment professional has beneficial ownership (a direct or indirect personal interest) of a security. Other issues causing a conflict of interest include: an investment professional, or their