Application of the Code and Standards

READING 43

APPLICATION OF THE CODE AND STANDARDS: LEVEL II

EXAM FOCUS

The cases discussed here introduce you to the obligations CFA Institute members and CFA® charterholders and candidates have under the Code of Ethics and Standards of Professional Conduct. These cases will give you a sense of the types of scenarios you are likely to encounter on the Level II exam. The particulars of any case are not important in terms of test questions. However, understanding how to analyse a case and having the ability to recommend procedures to bring an illustrative firm into compliance are crucial to your success on the ethics portion of the exam. There are three additional problem sets (for this reading) covered by the curriculum which provide excellent practice in identifying violations of Code and Standards. Candidates should use those as well in preparing for the Level II exam.

For clarity, the Code of Ethics expresses the ideals of members and candidates and describes the principles of ethical behaviour expected of investment professionals. The Standards of Professional Conduct translate those principles into specific professional responsibilities. In these case studies you will practise applying the Standards to fact patterns, identifying potential violations, and recommending corrective or preventive actions.

When analysing cases, follow a consistent method: identify the relevant facts, state which Standard(s) apply, explain why the facts do or do not satisfy the Standard(s), and recommend specific, practical remediation or compliance actions. This method is the approach examiners expect and it ensures comprehensive, logical answers.

MODULE 43.1: ETHICS CASE STUDIES

LOS 43.a: Evaluate practices, policies, and conduct relative to the CFA Institute Code of Ethics and Standards of Professional Conduct.

Video covering this content is available online.

LOS 43.b: Explain how the practices, policies, and conduct do or do not violate the CFA Institute Code of Ethics and Standards of Professional Conduct.

The case studies below illustrate typical ethical issues: conflicts of interest, suitability, fair dealing, disclosure, diligence, and employer-related duties. Read each case fact pattern carefully; many violations involve timing (for example, failing to disclose a conflict before acting) or procedural omissions (for example, lack of documentation or inconsistent allocation procedures).

1. SYYARK CASE OUTLINE

The main facts of the Syyark case are as follows:

Syyark, CFA, a private client adviser for Gueoe Bank, manages a globally diversified portfolio for client accounts. Syyark also advises clients on their outside holdings, thereby developing strong relationships with them.

Syyark starts research into cryptocurrencies and realises that competitive pressures make mining established digital currencies very difficult. Syyark settles on Meerine, a newer cryptocurrency. To limit his risk of being wrong, he recommends Meerine to a few of his smallest clients with an initial recommended allocation of 1% of portfolio.

After attending several conferences, Syyark starts mining Meerine using his home computer without informing his employer.

Syyark realises that the trading volume is low and volatility high for Meerine but is confident about its prospects. Meerine price appreciates since his 1% recommendation. Syyark then recommended a 3% portfolio allocation to Meerine to all clients.

In subsequent client review meetings, Syyark shares the performance of Meerine, its low correlation with stocks and bonds, and discloses his mining activity. Syyark offers to sell Meerine out of his own account to the firm's larger clients.

The facts above present multiple intersections of Standards: personal trading and holdings, disclosures to clients and employer, suitability of blanket recommendations, allocation and fair dealing when offering to sell from a personal account, diligence and research documentation, and potential employer conflicts arising from mining a cryptocurrency that competes with bank services.

CASE RESULTS

Standard III(B) Duties to Clients: Fair Dealing

Standard summary: Members and candidates must deal fairly and objectively with all clients when providing investment recommendations, taking investment action, and distributing investment opportunities. Unequal treatment is permissible only when it is disclosed and does not disadvantage a client group.

Original case observation: All clients should be treated fairly when taking investment actions and offering advice. Offering different levels of service is not a violation as long as it does not disadvantage a client group and is disclosed.

Violations of Standard III(B) in the facts:

• It is not acceptable for Syyark to fill orders of larger clients from his personal account.

Explanation and rationale: Selling from a personal account to selected clients can create preferential treatment and conflicts - larger clients receive access that smaller clients do not; pricing and allocation can be manipulated, and insider advantage may arise. Even if intentions are benign, the practice creates the appearance of unfair advantage and is inconsistent with fair dealing obligations.

Actions required to prevent these violations:

• Collect orders from all clients and fill the orders pro rata when appropriate, or refrain from offering to sell to any clients from his personal account.
• If a manager wishes to sell personal holdings, use transparent, documented processes approved by compliance, such as an established personal trading policy and pre-trade notifications to avoid preferential access.

Standard III(C) Duties to Clients: Suitability

Standard summary: Any investment action taken for a client or investment advice provided must be suitable to the client's financial situation, objectives, and constraints. Suitability requires both reasonable inquiry into client circumstances and reasonable basis for the recommendation.

Original case observation: Investment actions on behalf of the client and investment advice provided to a client must be consistent with client's goals and constraints.

Violations of Standard III(C) in the facts:

• Even though Syyark has evaluated the risk-reduction benefit of Meerine, a blanket 3% allocation may not be suitable for every client.
• The initial 1% allocation recommendation to the smallest client was driven by using those clients as "guinea pigs" (if things don't work out, Syyark's and the bank's reputations would be less tarnished) and not based on suitability for those clients.

Explanation and rationale: Suitability is client-specific. A recommendation based on testing a product on the most expendable clients rather than a genuine suitability assessment violates the duty to act in clients' best interests.

Actions required to prevent these violations:

• Properly assess each client's circumstances (including objectives, risk tolerance, liquidity needs, time horizon, tax situation, legal constraints) to determine whether an investment in Meerine is appropriate and, if so, what an appropriate level of investment should be for that individual client.
• Document the client suitability analysis and have it periodically reviewed by compliance or a supervisor.

Standard IV(B) Duties to Employer: Additional Compensation Arrangements

Standard summary: Members and candidates must not accept gifts, benefits, compensation, or consideration that creates a conflict of interest with their employer without written consent from the employer.

Original case observation: Cryptocurrencies compete with banks for transaction completion services. Syyark's mining of Meerine (even on his own computer) might conflict with Gueoe Bank's interest.

Violations of Standard IV(B) in the facts:

• Failing to inform the employer before engaging in mining activities.

Explanation and rationale: Personal ventures that compete with or distract from an employer's business can create divided loyalties or impair performance. The employer must be made aware and should evaluate whether the activity is permissible and under what terms.

Actions required to prevent these violations:

• Syyark should disclose to a supervisor or compliance officer his intent to mine Meerine, estimate potential earnings from this activity, and obtain written permission before commencing mining.
• Establish a written pre-clearance process for outside business activities and additional compensation arrangements, with periodic monitoring and recordkeeping.

Standard V(A) Investment Analysis, Recommendations, and Actions: Diligence and Reasonable Basis

Standard summary: Investment recommendations and actions must be based on adequate research and a reasonable basis supported by investigation and analysis.

Original case observation: Even though Syyark has researched Meerine, this initial recommendation to the smallest clients is not grounded in reasonable basis.

Violations of Standard V(A) in the facts:

• Syyark's evaluation of cryptocurrencies and Meerine in particular was not thorough.

Explanation and rationale: Reasonable basis requires appropriate research, analysis of factors that drive value, and clear documentation. Recommending an asset without sufficient investigation, or basing recommendations on informal or incomplete analysis, fails this Standard.

Actions required to prevent these violations:

• Syyark should document his research into Meerine, including the drivers of value, sources used, assumptions, risk factors (liquidity, volatility, regulatory risk), and identify the types of clients for which Meerine would be suitable.
• Maintain research files, date sources, and retain copies of relevant analysis and meeting notes so recommendations can be audited and defended.

Standard VI(A) Conflicts of Interest: Disclosure of Conflicts

Standard summary: Members and candidates must fully disclose all matters that could reasonably be expected to impair their independence and objectivity, including personal holdings and outside business activities that relate to their professional duties.

Original case observation: Syyark must disclose all conflicts of interest that could reasonably be expected to impair his independence and objectivity.

Violations of Standard VI(A) in the facts:

• Syyark recommending an investment with limited liquidity which he holds in his personal account would reasonably be construed as a conflict of interest. Not disclosing this conflict would be a violation of Standard VI(A).
• Syyark only reveals his mining activities in client meetings after his 3% recommendation is made to all clients.

Explanation and rationale: Timing of disclosure matters. Disclosing a conflict only after clients have adopted a recommendation does not allow clients to evaluate recommendations in light of the conflict. Full, timely disclosure empowers clients and the employer to assess impact and to require mitigation.

Actions required to prevent these violations:

• Syyark should disclose the conflict created by his recommendation of Meerine to his clients and to his employer: that he is mining Meerine and currently holds it in his personal portfolio.
• Preferably, the disclosure should be made before making recommendations, and a documented mitigation plan should be put in place (for example, restrictions on selling to certain clients, pre-clearance of personal trades, or refraining from recommending assets held personally).

2. AGARWAY CASE OUTLINE

The main facts of the Agarway case are as follows:

Agarway, CFA, recently joined CrowdWisdom as VP of due diligence. CrowdWisdom is a young, online crowdfunding company that matches venture capital investors with startups seeking capital. Fee-paying applicants that satisfy CrowdWisdom's due diligence would be listed on their platform and made available to all the investors that are members of the platform.

The founders of CrowdWisdom want to grow rapidly and want to recruit the customers of startups as potential member investors on their platform. Additionally, they created an investment club comprising those members that

were very active investors on the platform. Members of the investment club received a market intelligence report in addition to generally available applicant information.

Agarway's due diligence process includes several screens that he has successfully tested at his previous job, where he personally invested in several startups. These screens include size of the startup's potential market, accounting policies, interviews with company executives, etc.

One of the most promising companies that passed Agarway's screen is Deko, an IT startup with impressive founders, attractive prospects, and a unique product. Deko's target customer base is pre-teens and teenagers. The company's strategy calls for soliciting investment from customers via emails. Emails specify that the investors have to be adults over the age of 18.

Over time, Agarway's stack of applications to be reviewed grows over 300 and the founders are pressuring to have a 10% acceptance rate. Agarway explains that there are time constraints in reviewing applications. Founders also recommend that two specific applicants that they met at a conference be accepted.

The fact pattern raises issues about legal compliance when startups solicit underage customers, conflicts created by preferential access, potential insider behaviour, and pressures between commercial targets set by founders and the rigour of due diligence.

CASE RESULTS

Standard I(A) Professionalism: Knowledge of the Law

Standard summary: Members and candidates must understand and comply with all applicable laws, rules, and regulations of any jurisdiction in which they conduct business. When the law and the Code/Standards differ, members must comply with the law; when the law is silent, members must comply with the Code and Standards.

Original case observation: Members and candidates should understand and comply with all applicable laws and regulations.

Violations of Standard I(A) in the facts:

• It may not be legal in many jurisdictions to solicit investments from teenagers even if the solicitations specify that it is for adults only.
• Additionally, it may be illegal in many jurisdictions to collect information about minors without the permission of their parents. Sharing of information is further governed by various privacy laws that need to be carefully evaluated.

Explanation and rationale: The legal and regulatory framework for securities solicitation, consumer protection, and data privacy differs by jurisdiction. Companies targeting underage demographics must carefully ensure compliance with age restrictions, advertising standards, and parental consent requirements for data collection. Failure to ensure legal compliance can expose the platform and its officers to regulatory sanctions and reputational damage.

Actions required to prevent these violations:

• Agarway needs to ensure that Deko is in compliance with all applicable laws and regulations. This includes verifying that solicitation methods are legally permissible, that age-verification procedures are adequate, and that data collection and marketing practices comply with applicable privacy and consumer-protection laws.
• CrowdWisdom should adopt a legal compliance checklist for applicants whose target markets include minors, and require documentation of compliance as part of the listing process.

Standard VI(A) Conflicts of Interest: Disclosure

Standard summary: Members and candidates must disclose all actual and potential conflicts of interest to clients, employers, and prospective clients where such conflicts could reasonably be expected to impair independence and objectivity.

Original case observation: Members and candidates are required to disclose all conflicts of interest that could reasonably be expected to impair their independence and objectivity.

Violations of Standard VI(A) in the facts:

• Preferential access of market intelligence to members of the investment club may disadvantage other investors.
• Agarway's personal investments may be competing with potential startup applicants creating a conflict of interest.

Explanation and rationale: Preferential access to non-public or enhanced information for a select group of investors undermines fair treatment and creates informational asymmetry. Personal investments in competing startups create a conflict that must be disclosed so that investors can judge the objectivity of the due diligence process.

Actions required to prevent these violations:

• Agarway's personal investments that compete with prospective applicants must be disclosed to CrowdWisdom and to the platform's investor community where relevant.
• Preferential access to market intelligence should either be discontinued, made available to all investors, or clearly disclosed along with procedures to mitigate unfair advantage (for example, information barriers, time-stamped public releases of reports).
• CrowdWisdom should formalise and disclose its policies on access to additional reports, conflicts of interest, and the listing process, and keep records of disclosures and approvals.

Topic Quiz: Ethical and Professional Standards

You have now finished the Ethical and Professional Standards topic section. Please log into your Schweser online dashboard and take the Topic Quiz on this section. The Topic Quiz provides immediate feedback on how effective your study has been for this material. Questions are more exam-like than typical Module Quiz or QBank questions; a score of less than 70% indicates that your study likely needs improvement. These tests are best taken timed; allow three minutes per question.

Study guidance and best practices:

• When you take the Topic Quiz, apply the case-analysis method: identify facts, state relevant Standard(s), explain applicability, and recommend remediation.
• Focus practice on timing and the sequencing of events: many violations hinge on whether disclosure or actions occurred before or after recommendations were made.
• Review the Standards' definitions and illustrative examples so you can quickly match fact patterns to Standards during timed practice.
• Use the quiz feedback to identify weak Standards and revisit case studies where your analysis differed from the model answer; practise explaining why the model answer applies.

Additional preparatory tips:

• Keep a concise reference sheet of each Standard's key elements (what creates a violation, required disclosures, mitigation techniques) and test yourself on those elements.
• Study multiple case studies and problem sets to build pattern recognition-recognising recurring fact patterns (personal trading, outside business activities, preferential access, inadequate diligence) speeds analysis during the exam.
• Document practice answers clearly and concisely, using the same structure recommended above, so you develop the discipline to write complete ethical analyses under exam time constraints.