Level 2 Ethical and Professional Standards 1 The Code and Standards Topical Studies Prudence in Perspective Study Session 1 Reading Assignments “Code of Ethics," p. 1, Standards of Practice Handbook, 8th LOS 1.1 edition (AIMR, 1999) “Standards of Professional Conduct," pp. 2-7, Standards of LOS 1.2 Practice Handbook, 8th edition (AIMR, 1999) Standards of Practice Handbook, 8th edition, "Preface" and pp. LOS 1,3.a -LOS 1.3.¢ 9-283 (AIMR, 1999) “Prudence in Perspective,” Ch. 2 including Appendixes 3 and 4, LOS 1.4.a- LOS 1.4.4 Investing and Managing Trusts under the New Prudent Investor Rule, John Train and Thomas A. Melfe (Harvard Business School Press, 1999)Level 2, Study Session 1 + Ethical and Professional Standards 1 Stalla Review for the CFA® Exam NOTES 12 (©2005 DevrysBacker Educabensl Development Crp. All nights reserve.Stalla Review for the CFA® Exam Level 2, Study Session 1 + Ethical and Professional Standards 1 Ethics is an extremely important topic. Candidates whose exam scores are “borderline” often pass the exam only if they pass the Ethics portion of the test. In May 2004, the Association for investment Management and Research (AIMR) changed its name to the CFA Institute. However, the current candidate reading has not yet been revised to reflect this change. Therefore, in this study session, we continue te refer to the AIMR Codes and Standards to more precisely track to the current assigned reading. The CFA Institute is in the process of revising the AIMR Standards of Practice Handbook, which will likely reflect the name change in 2005, THE GODE AND STANDARDS. INTRODUCTION REASONS PROFESSIONAL STANDARDS ARE NEEDED A Professional standards are needed in the field of financial analysis and investment management because 4 The public needs competent, objective, and trustworthy investment advice and financial management There are certain fundamental standards of conduct that can be commonly applied to all who are engaged in the profession of financial analysis and investment management A "Body of Knowledge” exists that persons engaged in the professional practice of financial analysis and investment management should know, understand, and apply. Consequently, the CFA institute (AIMR) 4 Has established educational standards, including the compilation of the "Body of Knowledge," for the field of investment management and research. Conducts examinations designed to measure a person's understanding of that Body of Knowledge and awards the CFA° designation to persons demonstrating competency in financial analysis and investment management. Promotes high ethical and professional standards for financial analysts and investment managers worldwide by establishing a Code of Ethies and Standards of Professional Conduct (the Code and Standards), which are published and explained in its Standards of Practice Handbook, Enforces its standards of conduct by requiring its members to abide by the Code of Ethies and Standards of Professional Conduct and establishing Rules of Procedure by ‘which members who do not live up to this obligation can be disciplined by the Association's Board of Govemors, acting through its Professional Standards and Policy ‘Committee Itis important that AIMR members (and prospective members} know and understand the ethical and professional standards contained in the Standards of Practice Handlook, eury/Becker Educational Development Cop, All nghts reserved 13Level 2, Study Session 1 + Ethical and Professional Standards 1 Stalla Review for the CFA® Exam a DEFINITIONS OF IMPORTANT TERMS Following are the definitions of key terms used in the Standards of Practice Handbook. 4. "Member" or "Covered Person" means any of the following: a. Regular and affiliate members of AIMR and its subsidiaries b. CFA Charterholders ¢. CFA Candidates 2. "CFA Candidate" means a person enrolled to take the next scheduled CFA exam. 3. "Employer" means an immediate supervisor. 4. "Employee" means a subordinate. 5. "Access Person” means someone who, because of their employment position or other association with an investment decision maker, has knowledge of an impending investment decision (a security recommendation, change in investment opinion, or investment action) in advance of that decision being implemented or communicated to slients or the public. 6. "In Writing" means any form of communication that can be retrieved and documented {including e-mails) 7. "Research Report" means all methods of communicating an investment recommendation 8. 'Misrepresentation" means making an improper or imperfect representation or giving a false or misleading impression 9. ‘Conflict of Interest" means any situation, fact, or circumstance that could interfere with @ member's ability to render unbiased investment advice, or cause the member not ta act ina client's or employer's best interest 40. "Supervisor" means someone who has employees subject to his or her contro! or influence. 41. "Social Investing" means having a policy that includes or excludes the securities of certain issuers from a managed portfolio based on moral or social, rather than economic or financial, considerations. 12. "Relationship Investing" means basing decisions regarding whether or not to hold a security in 4 portfolio {in part) upon the ability to enhance retums by taking an active role in the affairs of the security's issuer. 43. "Front Running" means buying or selling securities for one's own benefit (when in possession of information obtained as a result of one's employment or ather special “need-to-know’" position) before another (larger) trader will be buying or selling the same, or related, securities. The hope is ta profit from the change in the price of the securities when the larger trades take place ©: 2005 Devry/tecker Eatucatonal Development Corp. AS rights reservedStalla Review for the CFA® Exam Level 2, Study Session 1 + Ethical and Professional Standards 1 ll. THE GODE OF ETHICS* Los 1.4 State the four components of the Gods of Ethics. Los 1.2 Identity the ethical responsibilities required by the Code and Standards. A. ETHICAL RESPONSIBILITIES REQUIRED BY THE CODE The Code of Ethics imposes the following ethical responsibilities on its members: 4. Members must conduct themselves with integrity and dignity, and act in an ethical manner in their dealings with the public, clients, customers, employers, employees, and fellow professionals. 2. | Members must conduct themselves, and encourage fellow investment professionals to ‘conduct themselves, in a professional and ethical manner that will reflect credit on themselves and the profession as a whole. 3. Members must act competently and strive to improve their competence 4. Members must use proper care and exercise independent professional judgment. B. THE COMPONENTS OF THE CODE Memorize the following four components of the Code of Ethics 4. Act with integrity. 2. Bea credit to the profession. 3. Be competent, 4, Use Independent professional judgment. OVERVIEW OF THE STANDARDS OF PROFESSIONAL CONDUCT Los 1.2 Identity the ethical responsibiities required by the Standasds of Professional Gonduct. The basic ethical responsibilities required by the Standards of Professional Conduct are: 4 Know and comply with all "the rules." Do not knowingly aid and abet others to break "the rules." Use the CFA designation correctly. Be honest, even in your personal life. Inform your employer that you must abide by the Code and Standards 2 3 4 5. Donot plagiarize. 6. 7. Donot engage in "outside" work without your employer's written approval. 8. Disclose conflicts of interest to employers, clients, and prospects * Copyright, 1999 Edition (Eighth Edition) of the Standards of Practice Handbook, Reprinted and edited with permission from the Association for Investment Management and Research. All rights reserved esorced 15 ) 2005 Devry/Backer Educational Develcoment Cerp. All rightsLevel 2, Study Session 1 + Ethical and Professional Standards 1 Stalla Review for the CFA® Exam 9. Disclose all income from an “outside” job. 40. Supervisors must adequately supervise their subordinates 44, Back up recommendations with good reasons. 42, Do not make misrepresentations, 43. Keep good records. 44. Put all relevant facts in research reports. 45. Distinguish between facts and opinions. 16. Indicate the basic characteristics of investments. 47. Maintain independence and objectivity 48. Know and carry out your fiduciary duties. 49. Know what is suitable for your clients, 20, Tell the client your basic methodology. 21. Treat clients fairly. 22. Give transaction priority to the client and employer. 23. Keep client and employer information confidential 24. De not give guarantees. 25. Disclose referral fees. 26. Do not use material nonpublic information. 27. Present your investment performance fairly and accurately IV. THE STANDARDS OF PROFESSIONAL CONDUCT Los 13.8 Interpret the Code and Standards in the context of specific situations. Los 1.3.6 Explain the application of the Code and Standards in situations that prasent multiple issues of questionable professional conduct. Los 1.3.6 Identity violations of the Code and Standards, Note: While it Is necessary to know the conduct required or prohibited by the Standards of Professional Conduct, candidates are not required to know the Standards by number (for example, it is necessary to know that claiming to be a CFA charterholder at a time when one's charter is under suspension is an Improper use of the CFA designation and a misrepresentation; it Is not necessary to identify these as a violation of Standards I (A) and IV (B.6))..Stalla Review for the CFA® Exam Level 2, Study Session 1 + Ethical and Professional Standards 1 A. STANDARD I: FUNDAMENTAL RESPONSIBILITIES 4. (A): Know and Comply with all appticable Laws, Regulations, Ethical Codes, and Professional Standards a. Required Conduct (1) (2) Know and comply with all applicable laws and regulations (including the Code and Standards) of any government, regulatory organization, or professional association governing the member's professional activities. Members who work or trade with or within more than one country must comply with the laws and regulations of their home countries, the laws and regulations of the countries in which they work or trade, and the Code and Standards. When these laws, regulations, and the Code and Standards are different, the member must comply with the most strict laws, regulations, and Code and Standards to which he or she Is subject. b. Compliance Procedures (1) 2) (3) Maintain current files of applicable laws and regulations and distribute such information to employees, Establish procedures whereby employees are regularly informed about changes in these laws and regulations. Regularly review written compliance procedures of the firm to make sure they reflect current law and provide adequate guidance to employees. 2. KB): Do Not Knowingly Participate or Assist Others in any Violation of Applicable Regulations or Ethical Codes a, Required Conduct (i) (2) Members are responsible for legal and ethical violations in which they knowingly participate or assist Ignorance of the law or the Code and Standards does not excuse illegal or unethical acts. Members are responsible for their illegal or unethical acts, even if they did not know they were violating the law or the Code and Standards, when the illicit nature of those acts would be evident to someone who was familiar with the information contained in the Standards of Practice Handbook, their firm's compliance manual, and/or rules and regulations deemed to be common knowledge to a reasonably informed professional. b. Compliance Procedures a) (2) A professional should be familiar enough with the rules of conduct for his or her job, so as to be able to recognize when an act might be in violation of acceptable norms of conduct. At that point, outside advice of one's immediate supervisor and/or legal counsel should be sought before engaging in a questionable act When a member suspects that a client, fellow employee, or employer is doing something illegal or unethical, the following steps should be taken (2) Consult the immediate supervisor (ar legal counsel, if necessary) to determine the legality of the conduct, esorced 7Level 2, Study Session 1 + Ethical and Professional Standards 1 Stalla Review for the CFA® Exam 1B (3) (b) _ Disassociate oneself from the illegal or unethical activity and from those committing it. Urge the firm to persuade those engaged in the illegal or unethical activity to stop such actions. Inaction, combined with continued association with those involved in illegal or unethical conduct, may be construed as participation or assistance in the illegal or unethical conduct. (c) Under normal circumstances, the Code and Standards do not require that members report violations of the law to governmental or regulatory organizations, but such disclosures may be prudent in certain situations to prove disassociation, In some cases, reporting must be made if there are legal or regulatory requirements to report illegal activities. A supervisor or legal counsel can give advice as to whether or not such reporting is required. Although members are presumed to know the laws and regulations applicable to their position, a member might be confused as to whether or not acts committed by clients, fellow employees, or their employer are in violation of the law or the Code and Standards because they are not fully aware of all the facts of situation. In such cases, they should seek the advice of their supervisor and/or legal counsel. If such advice is sought and it turns out to be erroneous, the fact that a good faith effort was made not to violate the Code and Standards or the law may be used as a defense against charges that the member violated this Standard as long as: (a) The advice was sought from someone that was competent to render it. (o) All the relevant facts were told to the party whose advice was sought. (c) The advice was followed without material deviations. {d) The member had no reason to believe that the advice was erroneous. B. STANDARD II: RELATIONSHIPS WITH AND RESPONSIBILITIES TO THE PROFESSION 4. INA): Use of Professional Designation a, Required Conduct (i) (2) (3) (4) (5) Members may reference their membership in the CFA Institute onlyin a dignified and judicious manner. An accurate explanation of the requirements that have been met to obtain membership may be included in such references. Only those awarded CFA charters may use the initials "CFA" after their names. There is no special entitlement or partial designation to someone who has passed any or all levels of the CFA examinations, but who has not been awarded a charter. CFA charterholders must use "Chartered Financial Analyst," or the CFA mark in a dignified and judicious manner. They may also give an accurate explanation of requirements that have been met to obtain the designation. CFA candidates may reference their participation in the CFA program, as ong as it is made clear that they are only candidates. CFA candidates may state that they are a Level |, Il, or Ill candidate, but should not cite a date at which the CFA examination process will be completed or when they expect to receive the CFA charter. No claim of superior performance, ability, or knowledge by virtue of being a CFA charterholder or member of the CFA Institute should be given or implied.Stalla Review for the CFA® Exam Level 2, Study Session 1 + Ethical and Professional Standards 1 6) (7) GFA charterholders must file an annual professional conduct statement, pay the annual dues, and abide by the Professional Conduct Program. If these obligations are not satisfied, all rights to use the CFA designation are automatically suspended until the charterholder is reinstated "CFA" is a registered trademark of the CFA Institute (AIM) and, therefore, must be referenced in accordance with applicable provisions of trademark law. b. Compliance Procedures (a) (2) (3) 4) 6) On letterheads, business cards and in directory listings, only the CFA mark or the words “Chartered Financial Analyst" should appear after the charterholder's name. The CFA mark cannot appear in larger type than the charterholder's name. Any printed, electronic, or oral explanation of the CFA designation or membership in the CFA Institute should be limited to a concise description of the requirements needed to obtain it and/or a concise description of the organization Members should inform their firm's compliance, public relations, and marketing departments of this Standard, in writing, and provide a description of the CFA Institute and the requirements for obtaining and using the CFA designation Because the CFA mark is a registered trademark, it should never be used as a noun or in pluralized form. Someone who has the right to use the CFA designation is not a "CFA"; such a person is a CFA charterholder; a firm does not have 15 CFAs on its staff; the staff includes 15 CFA charterholders. 2. I1(B): Professional Misconduct (Do Not Engage in any Act that Adversely Reflects Upon Your Honesty, Trustworthiness, or Professional Competence) a. Required Conduct (1) Members should act in ways that exhibit high levels of personal integrity and behave in ways that reflect favorably on the financial profession beth in their professional and personal activities. Violations of this Standard that subject the member to disciplinary sanction include {a} Convictions for a felony or any crime punishable by more than one year in prison, even if not related to professional activities. (b) Convictions for a misdemeanor involving moral turpitude, such as lying, cheating, stealing, and other dishonest conduct. (c) Repeated convictions for misdemeanors, no matter how inconsequential, because a large number of such convictions represent a pattem of behavior suggesting the member has a general disrespect for lawful authority. (d) Any action suggesting that a member's level of ethical conduct is not up to the level expected of a financial professional, or which adversely affects the investment industry in general. Examples of such behavior include: + Excessive drinking or intoxication, especially while on the job * "Padding" the expense account. * Committing intentionally dishonest acts esorced 19 went Coep. al nightsLevel 2, Study Session 1 + Ethical and Professional Standards 1 3. INC): (2) 8) Stalla Review for the CFA® Exam Members should encourage their employers to adopt a clear policy indicating what kinds of personal behavior will not be tolerated of employees because they reflect poorly on the individual, the firm, or the investment industry. Members who are supervisors should conduct background checks on potential employees to ensure they are not ineligible to work in the investment industry because of past infractions of the law. Compliance Procedures (a) (2) Generally, it is a matter of the member's own character and integrity to ensure compliance. The personal history information of investment employees required by regulatory agencies and firms offers some guidance concerning the types of conduct that would be considered improper of a member. Prohibition against Plagiarism Required Conduct (1) Alll outside sources used in reports should be acknowledged, identifying the source, its author, and publisher. The only exception to this requirement is that the use of factual information published by recognized financial and statistical reporting services may be cited without reference. This Standard appliestto oral, written, audio/visual media, and electronic communications. Violations of this Standard include the following (2) Using parts of reports or articles prepared by others, either verbatim ‘or with only a slight change in wording, without acknowledging the source, {b) Attributing specific quotations to “leading analysts" or “investment experts," without specifically referring to them by name. (c) Presenting statistical estimates or forecasts made by others with the source identified, but without any of the caveats qualifying those estimates or forecasts that appeared in the source (4) Using a chart or graph prepared by others without stating the source {e) Copying proprietary spreadsheets or algorithms without the permission of their creators. Compliance Procedures (1) 2) (3) Maintain copies of any materials prepared by others that were relied on in preparing a report. Attribute the source of any direct quotation including tables, projections, and new methodologies (prepared by a source other than a recognized financial and statistical reporting service). Attribute the source when paraphrasing or summarizing material prepared by others.Stalla Review for the CFA® Exam Level 2, Study Session 1 + Ethical and Professional Standards 1 . STANDARD Ill: RELATIONSHIPS WITH AND RESPONSIBILITIES TO THE EMPLOYER An employee-employer relationship exists if there is a person (employer) with the power or Tight to control and direct an individual in their service (employee) in how work is to be performed. There can be an employer-employee relationship even in the absence of a written or implied contract or in the absence of actual monetary compensation. The level of control exercised by the employer is the primary factor in determining the existence of the relationship 4. IN(A): Obsigation to Inform Employer of Code and Standards a. Required Conduct (1) Members must inform their immediate supervisor, in writing, that they are required to conform te the Code and Standards, unless the employer has publicly stated, in writing, that it has adopted them as part of its policies (2) Members are obligated te deliver a copy of the Code and Standards to their supervisor, if he or she does not already have a copy. (3) Members who are supervisors should inform new employees about the high degree of ethical conduct expected of them b. Compliance Procedures (1) Members should notify their immediate supervisor, in writing, that they are required to abide by the Code and Standards. (2) Along with the copy of the Code and Standards delivered to the supervisor, make a written request that the Code and Standards be adopted and disseminated throughout the firm. Maintain a written record of this notification. 2, IN(B): Duty to Employer a. Required Conduct (1) Donot undertake independent practice in competition with your employer that might result in some compensation or other benefit, unless you have written consent from both your employer and the outside entity (client) to do so. (2) Act only in the best interests of the employer until the employment is terminated. In this regard, an employee must refrain from doing an thing that would injure the employer, deprive it of profit, or deprive it from using the employee's skills, b. Gompliance Procedures (1) _ Ifamember contemplates performing services for an entity other than his or her employer that could result in compensation by rendering a service currently available by the employer, a written statement to the employer must be made describing (@) The types of services to be offered (b) The expected duration of the service. (c) The proposed compensation esorced wld went Coep. al nightsLevel 2, Study Session 1 + Ethical and Professional Standards 1 Stalla Review for the CFA® Exam (2) In addition, a disclosure should be made to the praspective outside olient, in writing, that {2} _ Identifies the member's primary employer. (b) States the fees that the primary employer would charge for the same service (c) Clearly states that the member will be performing independently of his or her primary employer. No service on behalf of the outside client should be rendered until the member receives written permission from his or her primary employer to perform the proposed service(s) and obtains written acknowledgment from the proposed outside client Indicating he or she has read and understood the written disclosure made to them. It contemplating termination of one's employment, continue to give full and complete attention to your duties with the employer until termination occurs. Do not engage in the following activities: (2) Misappropriating the trade secrets of an employer. (b) Misusing an employer's confidential information (c) Engaging in a conspiracy to bring about mass resignation of other employees. (4) Coaxing customers to leave the employer prior to ceasing employment with the employer. {e) _ Self-dealing (appropriating for oneself a business opportunity or information that belongs to the employer} () Taking the employer's customer lists, records, or files without the written permission of employer. (9) Taking property of the employer or interfering with the employer's business. {h) Deviating from any understanding that has been reached and agreed upon between the member and the employer, or between the member and a client. 3. INC): Disclosure of Conflicts to Employer a. Required Conduct (1) (2) Members must disclose to employers any material fact or circumstance that could reasonably be expected to interfere with their duty to the employer or their ability to act in an unbiased and objective manner. Employers have a right to know if their employees have potential conflicts of interests that could interfere with their ability to perform their duties objectively so they can assess whether any conflicts of interests do, in fact, exist and how best to resolve them. Members must know and abide by employer guidelines (often found in compliance manuals) and comply with any prohibitions an activities if conflicts of interest existStalla Review for the CFA® Exam Level 2, Study Session 1 + Ethical and Professional Standards 1 b. Compliance Procedures (1) Disclose to employers: (a) Material ownership of securities (b) Participation in outside boards of directors or trusteeships. (©) Consulting relationships. (4) Any other financial or other pressures that may influence the ability to make objective and independent decisions or render advice required of the job (2) Abide by the employer's decision as to how to resolve the conflicts of interest 4, IIKD): Disclosure of Additlonal Compensation Arrangements a. Required Conduct (1) (2) Members must inform their employers, in writing, of any proposed compensation arrangements (monetary or otherwise) that have been offered to them from clients, vendors, brokers, or others that are in addition to the regular compensation paid to them by their employer for services rendered as part of their employment duties. The employer is entitled to have full knowledge of a member's compensation arrangements in order to assess the true cost of services, and their likely effects on the employee's loyalty and objectivity. For example, assume a client offers to pay a portfolio manager a bonus based on the performance of the client's portfolio. This arrangement could cause the portfolio manager to pay undue attention to that client's account, which may be detrimental to other clients, The employer has a right to decide whether or not such arrangement should be permitted The use of in-kind payments (of products and services) and expense reimbursements as a means of concealing compensation is not allowed. b, Compliance Procedures (1) Ifa member is contemplating entering into an agreement to obtain compensation from a client, vendor, broker, or other party that would be in addition to the regular compensation paid by his or her employer for performing the service, the member must file a written report with the primary employer (immediate supervisor) outlining: (a) The source of additional compensation (b) Adescription of the compensation. {c) The amount of compensation. (d) The duration of the agreement. esorced 113 went Coep. al nightsLevel 2, Study Session 1 + Ethical and Professional Standards 1 Stalla Review for the CFA® Exam 5. IKE): Responsibilities of Supervisors a. Required Conduct (1) (3) (4) 6) (6) Members with supervisory responsibilities should understand what constitutes an adequate compliance system for their firm or department. They should make reasonable efforts to ensure that appropriate procedures are established, documented, communicated to subordinates, monitored, and enforced to detect and prevent violations of laws, regulations, compliance procedures, and provisions of the Code and Standards Members with supervisory responsibilities must exercise their responsibility with respect to both persons who hold and do not hold the CFA designation Members with supervisory responsibility must make every effort to detect improper work conduct, fraudulent behavior, and misleading statements or practices on the part of subordinates. A member may not be in violation of this Standard if he or she is unable to detect violations that occur, provided reasonable procedures have been adopted and steps have been taken to insfitute an effective compliance program. If a supervisor discovers that an employee may have violated the law, the firrn's compliance procedures, or the Code and Standards, the supervisor must promptly initiate an investigation and place limits on the employee pending its outcome. It is not enough to rely on an employee's statement about the extent of wrongdoing, or an assurance by the employee that it will not occur again. The member must report the misconduct to his or her superior and take steps to ensure the violation will not be repeated. if a member Is in a supervisory position at a firm with an inadequate compliance system, he or she should recommend corrective action to senior management. If corrective steps are not welcomed and the member is unable to discharge supervisory responsibilities due to an inadequate compliance system, the member should refuse to accept supervisory responsibility, in writing, until reasonable procedures are adopted. Members with supervisory responsibility should advise new employees, in writing, that high ethical conduct is expected of them. Delegation of supervision does not relieve the member of ultimate responsibility. b. Compliance Procedures (1) Identify situations that are likely to result in violations of legal statutes, the firrn's compliance procedures, or the Code and Standards and establish and enforce procedures that should prevent such violations from occurring Adequate compliance procedures should (2) Be written in an accessible compliance manual in a manner that is easy for employees to understand, (b) Be tailor-made to meet the needs of the firm or department. {c) Outline permissible conduct and conduet that is not permissible. (4) Provide procedures for reporting violations. () _ Indicate the sanctions to be imposed for violating the compliance procedures,Stalla Review for the CFA® Exam (2) (3) 4) Level 2, Study Session 1 + Ethical and Professional Standards 1 ‘Once a compliance pragram is established, supervisors should (2) _ Disseminate the program to their employees and educate them about the procedures. (b) Periodically update the pracedures to make sure they are adequate and legal () _ Issue periodic reminders about what conduct is proper and improper. {d) Include a professional conduct evaluation of employees in normal performance reviews. (e) Review employee conduct to ensure compliance and to discover violations. (f) Enforce the procedures ifa violation is found. Ifa violation of the compliance procedures is discovered, the supervisor should (2) Respond promptly. (b) _ Investigate the situation to discover the scope of the wrongdoing, () Place appropriate limitations an the wrongdoer. Subordinates should be informed of the existence of the Code Standards, be given a copy of the Standards of Practice Handbook, and be advised to take the self-administered Standards of Practice Exam to show proof that they understand the Standards. D. STANDARD IV: RELATIONSHIPS WITH AND RESPONSIBILITIES TO CLIENTS AND PROSPECTS 1. IM(A.1): Reasonable Basis and Representations a. Required Conduct (1) (2) 8) 4) 6) 6) Members must be diligent and thorough in investigating securities before they undertake investment actions for others or make recommendations to others, Members must have a reasonable and adequate basis, supported by appropriate research, for the recommendations and investments they make to, and on behalf of, others. Members must avoid material misrepresentations in their research reports and investment recommendations, Members must maintain files and records that support the reasonableness of their recommendations and investment decisions. Members must make reasonable and diligent efforts to ensure research reports are accurate; they should not use any information from sources that are suspected to be inaccurate. When dealing with foreign securities: (a) Members must attempt to make comparable financial statements (and their associated financial ratios) that are prepared under different accounting rules. {b) Clients must be informed of any unusual risks that may exist in certain foreign securities. eury/Becker Educational Development Cop, All nghts reserved v5Level 2, Study Session 1 + Ethical and Professional Standards 1 (c) Members must know the laws, regulations, accounting standards, market liquidity, and other factors that affect investments of their home countries, and of thase of foreign cauntries where they trade, have clients, or whose securities they analyze. This information should be communicated to clients when advising them on foreign securities and markets. Compliance Procedures The compliance procedures associated with this Standard depend upon the job duties of the member. a) (2) Compliance Procedures for Brokers and Portfolio Managers Account executives (brokers) and portfolio managers are in compliance with this Standard if they recommend a security based on: (a) Their firm's research department reports and recommendations or another source(s) that can be relied upon as having done a diligent and thorough analysis (6) An understanding of the basic characteristics of the investment {c) _Ananalysis of the portfolio needs and circumstances of their client Account executives and portfolio manager(s), with the help of their client, should develop, in writing, a statement of investment objectives. Investment objectives should be reviewed with the olfent at feast annually, ar after a significant change in the olfent’s circumstances. Every recommendation made to olients and investment actions taken on behalf of clients should be considered with those objectives in mind (suitability). The member must also consider the effect of the investment on the client's overall portfolio. The focus of all recommendations or investment actions should be on characteristics of the total portfolio, with respect to clients' needs, rather than on a security-by-security basis (4) The member must also maintain files of the specific research report's quantitative systems, or other information that were used to make the investment decisions. A record should also be kept of specific recommendations and actions that were taken. These files should be Kept in paper or electronic form (if in electronic form, adequate backup should be maintained) Compliance Procedures for Security Analysts Members engaged as security analysts are in compliance if they (2) Make investment recommendations only after performing diligent and thorough analyses of the securities they analyze. (b) Comply with Standard IV (A.2), Research Reports. (c) Maintain records of: (1) The information (including interviews) used to perform the original research (2) Working papers showing calculations that were performed to determine estimates used to reach investment conclusions. (3) End work product, such as research reports. ©: 2005 Devry/tecker Eatucatonal Development Corp. AS rights reserved Stalla Review for the CFA® ExamStalla Review for the CFA® Exam (3) Level 2, Study Session 1 + Ethical and Professional Standards 1 Compliance Procedures for Corporate Finance Members engaged in Corporate Finance are in compliance if they: (2) Perform diligent and thorough investigations with regard to initial public offerings (IPOs), private placements, and secondary offerings. (b) Study the use of proceeds, capital structure, potential conflicts of interest, legal matters, and environmental considerations. (c) Maintain all records necessary to reconstruct the analyses performed that justify the conclusions that were reached. 2. IM(A2): Research Reports This Standard applies to all forms of communications used by security analysts to disseminate their investment opinions, including: Traditional research reports on the market, a class of investments, asset allocation, or a specific security in paper form. in-person or telephone recommendations. Media broadcasts. Computer transmissions, including the Internet. Required Gonduct a) (2) 3) 4) 6) 6) Research reports should contain all the relevant factors that support conclusions reached Distinguish between facts and opinions in research reports Indicate the basic characteristics of the investment for any research reports containing an investment recommendation Disclose the limitations of the analysis and conclusions contained in research reports Capsule recommendations (such as a "buy" or “sell” lists) must be supported by background reports or data that are available to interested parties. Clients should be informed that this adaitional information is available and how te obtain it A supervisory analyst should check research reports to assure compliance with these Standards. Compliance Procedures (4) (2) (3) For diligence and thoroughness to be exercised in writing a research report, basic investigative steps must be undertaken to determine the nature of a company's earnings power, cash flow, dividend potential, operating and financial strength, and viability. Members should follow research report guidelines issued by national securities exchanges, regulatory bodies, and their employers. ‘As long as the member has performed an adequate investigation, he or she can select the important elements ta emphasize in a research report, briefly discuss other factors, and omit factors considered unimportant Members must take reasonable steps to assure the reliability, accuracy, and appropriateness of the databases used in drafting a report. ‘Acknowledgment of the source(s) should be made when appropriate—see Standard II (C) esorced ul? went Coep. al nightsLevel 2, Study Session 1 + Ethical and Professional Standards 1 Stalla Review for the CFA® Exam 4) 5) 6) Violations of the requirement to distinguish facts from opinions in research reports are most likely to occur when reports fail to identify that the earnings estimates, dividend outlook, and/or future market outlook are opinions that may be subject to future changes in prevailing economic or financial market conditions. Regulatory agencies, self-regulatory organizations, exchanges, and most firm compliance manuals have specific requirements related to research reports that members should review and meet. Members are urged to encourage their firms to develop such procedures if they are not already in place 4. IM(A.3): Independence and Objectivity Los 1.3.4 Interpret the topical study "Personal investin 4d relates to the Code and Standards, a. Required Conduct (1) Every member should avoid situations that might cause, or be perceived to cause, a loss of independence and objectivity in recommending investments or taking investment action, Analysts and portfolio managers violate Standard IV (A.3) if they: (a) Take an allocation of shares in oversubscribed IPOs for their personal account. (b) Accept expensive gifts or entertainment from corporations (corporations that are not clients), {c) Allow their firm's business relationships with a company to affect a research report or investment decision (d) Allow compensation schedules to affect judgment b. Compliance Procedures (1) 2) (3) (4) Members and their firrns should establish policies to ensure independence and objectivity in making investment recommendations or taking investment action. The compensation system should be structured so that objectivity is not at risk Members must disclose: (a) The relationship if any employee or owner of the securities firm is a director of the company recommended. (b) Whether their firm underwrites the security or makes a market in the company being recommended (c) Ownership of a security being discussed in their personal holdings or in accounts where they have a beneficial interest. Ifthe firm is unwilling or unable to disseminate opinions about a particular company, that company should be put on a restricted list. Only disserninate factual information, no estimates or opinions, on companies that are on such a restricted list When attending corporate functions or meetings, the member should pay for his or her transportation and lodging. The only exception to this tule is when the meeting is located in a place that is relatively inaccessible and commercial travel and lodging is unavailable or too difficult to obtain,Stalla Review for the CFA® Exam 6) © @) Level 2, Study Session 1 + Ethical and Professional Standards 1 Gifts fram anyone having a business relationship with one’s firm whose value Is above a token amount should not be accepted; members should not accept lavish entertainment from corporations. Gifts in a client relationship are considered less likely to affect a member's objectivity and independence than gifts arising from other relationships. Consequently: (2) Under no circumstances may members accept gifts worth more than $100 U.S. from non-client organizations or persons (such as companies they analyze) (b) Members may accept gifts worth more than $100 U.S. from clients, as long as the member discloses the gift to his or her employer and the employer gives permission to accept it. In making such decisions, supervisors should be satisfied that such gifts are not excessive and that they do not result in the member giving too much attention to gift-giving clients (to the detriment of other clients). Members should refrain from purchasing IPOs and private placements for their own account and accounts in which they have a beneficial interest They should also encourage their firms to adopt policies that restrict employee purchases of equities, IPOs, and private placements. Members should implement, and encourage their firms to implement, effective supervisory and review procedures to ensure improprieties and conflicts of interest are minimized with respect to personal investments of analysts and portfolio managers 5. IM(B.1): Fiduciary Dutles Los 1.3, Interpret the topical study iciary Duties" as itralates to the Cede and Standards. a. Required Conduct of Fiduciaries in General a) (2) Members who have discretionary authority in managing client assets or who have other relationships of special trust must know, understand, and comply with their fiduciary duties. These duties are found in: (2) The legal statutes of their jurisdiction (b) Rules and regulations set down by governing agencies. {c) Employer compliance manuals. (d) The Code and Standards. When these duties are different, members are obliged to follow whatever is the highest set of standards imposed by these sources taken as a whole. While fiduciary duties may vary depending upon facts, circumstances, and jurisdiction, the general duties of fiduciaries are: (a) Loyalty Loyalty means to act only in ways that are in the best interests of clients. Fiduciaries should avoid conflicts of interest, always put their client's interests above their own self interest, and refrain from any formn of self-dealing (buying assets from, selling them to, borrowing from, or lending to clients) esorced 119Level 2, Study Session 1 + Ethical and Professional Standards 1 Stalla Review for the CFA® Exam 3) (b) Gare Care means to fully analyze Investment alternatives, using all the skills, knowledge, and insights customarily expected of a professional in the field (one who has more investment knowledge and skill than the ordinary person). (c) Prudence Prudence requires that the preservation of the value of the assets entrusted to one’s care should be the prime Investment objective of a fiduciary; earning a reasonable return on those assets should be a second concern. No more risk should be taken than is appropriate for the client's cireumstances (suitability) (a) Impartiality impartiality requires that all cllents must be treated fairly. This essentially means that all clients of equal circumstances should be treated equally. For example, if a block of stock is purchased for client accounts, all clients for whom the security is a suitable investment should have the right to receive their appropriate pro rata share of the block, at the same price per share. (2) Discretion Discretion means that alf Information about clfent affairs, wealth, transaetions, and so forth should be kept confidential, except on a “need-to-know” basis. Members with control over client assets should (a) Submit to an independent audit at least once a year. (b) Give each client an itemized statement showing the funds and securities in custody at least quarterly. {c) Disclose to the client where his or her assets are maintained. (d) Keep client assets separated from those of other parties. b. Required Conduct of Trustees (1) Most U.S. jurisdictions employ the Prudent Man Rule, or the Prudent investor Rule, to define the fiduciary duties of trustees. As usually applied under state laws, the Prudent Man Rule requires that every investment undertaken for a trust, standing alone, must be made “prudently,” with the “prime directive" of preserving the value of the corpus of the trust and, secondarily, providing a safe return on the capital invested, While, the Prudent Man Rule has been the traditional standard that legally defined the fiduciary duties of trustees under state law, more recently, states have moved toward a Prudent Investor Rule. The Prudent Investor Rule is similar to the Prudent Man Rule in that it imposes the same general standards of prudence, care, discretion, and loyalty upon trust fiduciaries. However, It differs from the traditional Prudent Man Rule in the following respects:Stalla Review for the CFA® Exam fa) {o) (e) (e) Level 2, Study Session 1 + Ethical and Professional Standards 1 Under the Prudent Man Rule, certain asset classes might be interpreted to be inherently imprudent (such as options), whereas no asset class is considered inherently imprudent under the Prudent Investor Rule. The riskiness of assets must be considered within a portfolio context, For example, buying a put option might be ‘considered imprudent under a Prudent Man Rule because, standing alone, it is an unduly risky asset. However, buying a put option as part of a portfolio insurance strategy would probably be considered prudent under the Prudent Investor Rule. Nevertheless, practices, such as buying on margin, investing in uncovered futures contracts, speculating with naked options, and so forth should be scrutinized very carefully because they may not meet the standard of prudence standard required by either the Prudent Man or the Prudent Investor Rules. Under the Prudent Man Rule, the standard of prudence is applied to each asset held in trust, standing alone. Under the Prudent investor Rule, the standard of prudence /s applied to the overall portfolio. The prime directive is to achieve a return/tisk objective that is reasonable, without exceeding a level of overall portfolio risk that an investment professional would deem suitable to the trust under the prevailing circumstances. This makes the trade-off between return and risk a primary concern to a trustee operating under a Prudent Investor standard. In any event, the potential to earn an extraordinarily high return is not a justification for taking undue risk under either the traditional Prudent Man or the modern Prudent 'sfivestor standards. On the other hand, employing overly conservative investment strategies may be subjected to less criticism under the traditional Prudent Man Rule (where the emphasis is on preserving the nominal value of the trust) than under the more modern Prudent Investor Rule, where overly conservative investment strategies may not be justified if they result in generating significantly inferior returns (especially if the real value of the trust is jeopardized). ‘The Prudent Investor Rule requires that trust investments be reasonably diversified because this is the meaning of prudence in the portfolio context, Under the Prudent Investor Rule the fiduciary duties of prudence and care have been extended. Trustees may delegate the authority to make investment decisions to qualified investment managers, as long as those managers are selected prudently. In addition, there is a requirement to select advisors and supervisors prudently, Under the traditional Prudent Man Rule, trustees were usually not permitted to delegate the authority to make investment decisions, although the seeking of advice was often required to meet the standard of prudence required by the Standard. ‘The modern Prudent Investor standards usually require trustees to ‘operate trusts in a cost-efficient manner. The costs of operating a trust should be reasonable and appropriate ta its needs. Paying excessive commissions can be a breach of fiduciary duty. However, paying above-average commissions for research or other services provided by a broker is permitted if the fiduciary comes to a ‘conclusion that the services rendered are worth the extra cost, and such services are exclusively used for the benefit of the trust. ment Carp. All rights ceserved. 121Level 2, Study Session 1 + Ethical and Professional Standards 1 Stalla Review for the CFA® Exam (f) Whereas the traditional Prudent Man Rule imposed an ordinary standard of prudence upon trustees (unless they held themselves out to be professionals), the modern Prudent investor standards generally impose a professional standard of care and prudence (this is sometimes called the Prudent Expert Standard). (9) Other fiduciary duties regarding the management of trust assets that must be followed under U.S. law are: (1) All of the beneficiaries of a trust should be treated equally. For example, a trustee should not invest all of the assets ofa trust so as to generate high current yield solely to benefit its income beneficiaries, which is contrary to the needs of the trust's remaindermen, who are interested in preserving the real value of the trust's assets, Rather, the trustee must seek an equitable compromise between these two competing interests, such as generating the maximum income that can safely be eared, while maintaining the real value of the principal at a constant level. (2) Best efforts must be applied to maximizing after-tax returns. Prudence and care generally require that the advice of tax experts should be obtained and employed in managing trust assets. (3) Legal requirements, such as the filing of periodic financial statements and tax returns required by law, must be known and satisfied. It is prudent to consult attorneys who are expert in trust law and the legal requirements that it imposes an trustees. Required Conduct for Managing Private Retirement Plans Governed by ERISA The controlling U.S. law governing all qualified private retirement and employee stock-option plans (except those of churches, governments, workers" compensation funds, unemployment funds, disability insurance funds, and retirement plans whose only participants are corporate officers) is the Employee Retirement Income Security Act (ERISA). This is a federal law that is based on the Common Law of Trusts and is administered by the U.S. Department of Labor. ERISA defines a fiduciary of a retirement plan as being any person who: * Exercises any discretionary authority or contro! with respect to the management of the plan or the disposition of its assets. © Iscompensated, directly or indirectly, for rendering investment advice to a plan. * Has discretionary authority or responsibility in the administration of a plan. © Isnamed, appointed, or identified as a fiduciary by, or under provisions of, the plan documents. Fiduciaries include officers and directors of the retirement plan, the company sponsoring the retirement plan, members of the investment committee, and persons responsible for the administration of the plan, including its funding investing, evaluation, and personnel functions:Stalla Review for the CFA® Exam Level 2, Study Session 1 + Ethical and Professional Standards 1 Under ERISA, fiduciaries of retirement plans have the following affirmative duties: a) (2) @) 4) 6) Loyalty Loyalty, under ERISA, requires fiduciaries to act solely in the interest of the plan participants and beneficiaries with the exclusive purpose of: {a) Providing pian benefits. {b) Detraying reasonable plan expenses. Even trustees of employee stock ownership plans (ESOPs) are subject to this duty of loyalty. Investments in the employer's stock and the voting of proxies for the shares must be done in ways that solely benefit the beneficiaries and not the employer as an independent entity. Care Gare requires fiduciaries to use aif of the skills of a professional in carrying out their responsibilities. Thus, ERISA applies a Prudent Expert Standard. Prudence Prudence requires fiduciaries to take no risks that are likely to endanger the ability of the plan to provide promised benefits and eam a reasonable return commensurate with the risk taken. To satisfy this requirement, ERISA requires retirement plans to: {a) Have written investment policies. (0) Be diversified, by asset class, industry, risk level, geography, and so forth, so as to reduce the risk of incurring large losses. Except for eligible individual account plans (profit sharing plans whose investments are controlled by the beneficiary, stock bonus plans, thrift or savings plans, employee stock ownership plans, and money purchase plans in existence on ERISA's effective date), a limit ‘of 10% is imposed on the amount that a pension fund may have invested in sponsor assets, unless the plan specifically provides for a higher limit, Employer-established IRA accounts and annuities are always prohibited from investing more than 10% of their net assets in securities or real property of the sponsoring company. (c) Monitor and evaluate the performance of the investment portfolio against plan needs and guidelines, using appropriate and customary actuarial methods, at reasonable intervals. Fiduciaries should know and carry out their responsibilities as defined by the plan's trust documents. ERISA prohibits fiduciaries from (a) Self-Dealing For example, buying from, selling to, borrowing from, or lending to the plan. However, a fiduciary may: (1) Receive normal benefits as a plan beneficiary: (2) Receive reasonable compensation for services rendered. (3) Bean officer, employee, or representative of a party in interest. esorced 1-23 went Coep. al nightsLevel 2, Study Session 1 + Ethical and Professional Standards 1 Stalla Review for the CFA® Exam (b) Permitting Conflicts of interest For example, engaging in transactions involving the plan on behalf of a party with interests that are adverse to the plan participants and beneficiaries, (c) Receiving "Kickbacks" For example, receiving compensation from a party who is involved with a transaction involving the plan (a) Dealing with Parties in Interest For example, dealing with anyone who is able to exercise influence ‘over some aspect of a plan or whose dealings with the plan could involve a conflict of interest (see self-dealing above), Specifically, ERISA contains detailed standards for the acquisition of the securities ‘or property of the sponsoring employer, Acquiring employer assets or securities to help finance the employer or to prevent a takeover does not meet these standards Legal Rights of Beneficiaries and Participants Under ERISA Under ERISA, plan participants and beneficiaries who believe that their retirement trust is not being operated solely for their best interests may bring civil action against the plan fiduciaries. If victorious, they have the right to recover both the losses the court decides they have suffered as a result of breaches of duty by the plan fiduciaries and their attorney(s) fees, The plan fiduciaries are personally liable for these damages. Generally, these duties and their commensurate liabilities cannot be shifted to others. However, there are two important exceptions to the concept that fiduciaries are separately and jointly liable for breaches of duty: (1) (2) (3) A fiduciary is permitted to delegate investment management responsibilities to a qualified investment manager who accepts the role as a fiduciary with respect to those investment responsibilities in writing, Thisis allowed if the investment manager is selected "prudently," the manager has been given “prudent” guidelines by which to operate, and the manager's performance is monitored in accordance with professionally established standards. Under ERISA, a qualified investment manager must be a registered investment adviser, a bank, or an insurance company that is qualified as a money manager under the laws of more than one state The plan documents permit plan participants and beneficiaries to control the investments in their own accounts (as is commonly done in profit sharing or defined contribution plans). In such cases, the plan fiduciaries are nat liable for losses resulting from decisions made by the plan participants and beneficiaries. Plan fiduciaries still have the responsibility of fulfling their other administrative duties with respect to the plan Fiduciaries can be jointly liable for actions committed by each other if: {a) One fiduciary knowingly participates in, or conceals, breaches of fiduciary duty by another fiduciary (b) A fiduciary fails to meet his or her administrative duty of being reasonably informed of how the plan is being operated (oversight function) (6) Afiduciary delegates tasks that he or she could reasonably be expected to perform (d) A fiduciary delegates tasks to persons imprudently. °Stalla Review for the CFA® Exam Level 2, Study Session 1 + Ethical and Professional Standards 1 4) To avoid legal problems, fiduciaries should: (a) Maintain records documenting that all investment actions were undertaken after completing a diligent research effort that appropriately weighed the expected returns against the probable risks, and that there was a judgment that the action was in the best interest of the plan beneficiaries. {b) Know the probable payout requirement of the plan, and make sure liquid funds are available to make payouts when due (c) Make sure to adhere to oversight responsibilities, including documenting and keeping a record of the steps that were taken to meet these responsibilities (a) Ifany misconduct or imprudent behavior is discovered during ‘oversight investigations, take prudent, corrective action immediately to correct the problems. e. Required Conduct for Fiduciaries Associated with Public Pension Plans a) 2) Public pension fund fiduciaries must know and abide by the law and guidelines adopted for their jurisdictions regarding the management of public pension funds. These laws and guidelines usually are similar to the ERISA requirements. Public pension fund fiduciaries are often permitted, and sometimes pressured, to invest in the local economy and local businesses to an extent that might be imprudent. Under the Code and Standards such practices may be imprudent. Since members must adhere to the strictest of the standards imposed upon them, in such cases, the Code and Standards may apply. Ifnecessary, members who are fiduciaries in public pension plans should obtain independent legal counsel to secure their right, as a matter of law, to do their duty in resisting pressures to follow standards in their jurisdiction that are less strict than those imposed by the Code and Standards. f. Required Conduct for Fiduciaries of Charitable Organizations and Endowments (i) Directors, officers, and investment managers of charitable and endowment fund assets, as fiduciaries, must know, understand, and abide by their fiduciary duties. In the U.S., these are primarily contained in the Uniform Management of Institutional Funds Act (UMIFA), which embodies most of the same standards as those found in the Prudent Man and Prudent Investor Standards. The duties of a fiduciary under UMIFA are closer to those of a director of a corporation than a trustee of a trust. This means that fiduciaries of institutional funds are held to a standard of ordinary business care and prudence under the circumstances prevailing at the time a decision is made (as does the Prudent Man Rule). However, like the Prudent Investor Rule, the UMIFA standard of prudence is applied on a total portfolio, rather than a security-by-security, basis. Under the Prudent Man Standards contained in UMIFA: (2) The fiduciary must only exercise ordinary and reasonable care, acting with honesty and in good faith. There is no requirement to act like a prudent person of intelligence. wnt Corp. Al nights eererved 125Level 2, Study Session 1 + Ethical and Professional Standards 1 Stalla Review for the CFA® Exam (b) Inthe absence of proof to the contrary, it is presumed that the fiduciary has acted in a correct manner. The burden of proof is an the accuser under the ordinary business care standard, unlike the Prudent Man Rule or Prudent Investor Rule, which place it on the accused, UMIFA does impose some unique affirmative duties on institutional fiduciaries. These are: (2) Fiduciaries must formulate policies for the investment program of the ‘organization's assets, Such policies should be based upon (1) The amount of funds needed, on a long- and short-term basis, to carry out the work of the institution (2) The current and probable future resources of the organization (3) The expected retum on its assets. (4) Probable future economic trends. Under UMIFA, the board of trustees of a charitable institution or endowment are permitted to delegate the investment management function to investment professionals. However, they cannot delegate the responsibility of setting overall policy, and they retain the responsibility of supervising the investment manager(s) and their investments, (b) To follow spending and investment policies adopted by the institution. g. Required Conduct for Money Managers (i) (2) In the U.S., money managers can look to the Investment Advisers Act of 1940 for some behavioral guidance. This act prohibits investment advisors from (a) _Defrauding or attempting to defraud a client or prospective client. (b) Acting as a principal or agent in a client's account without the client's, permission Some general principles that should guide a money manager are (2) Be honest and loyal to the client, acting always in the client's best interest (b) Use care and independent professional judgment in investment matters, (c) Havea reasonable and adequate basis for investment decisions. (d) Avoid conflicts of interest and make full disclosure of facts and circumstances that could be construed as a conflict of interest {e) Make sure advice given and investment actions undertaken are suitable for the client. () Obtain the best executions on trades for clients. Make sure that ‘commissions and other expenses are reasonable for the service rendered. (9) Avoid misrepresentations of all kinds, particularly with respect to performance. ©: 2005 Devry/tecker Eatucatonal Development Corp. AS rights reservedStalla Review for the CFA® Exam Level 2, Study Session 1 + Ethical and Professional Standards 1 h. — Required Conduct for Brokers and Dealers Although brokers and dealers do not invest funds for others and, therefore, do not have fiduciary duties, they are, nevertheless, held to a professional standard under the law, and the Code and Standards, because they market themselves as professionals. In particular, brokers and dealers: (1) Should not churn customer accounts, (2) Should not accept funds when their firms are insolvent (3) Should not engage in fraudulent, deceptive, or manipulative practices. (4) Should not exploit their customers’ trust or ignorance (5) Should deal fairly with their clients i, Required Conduct for Securities Analysts Research analysts must (1) Do the best job they can for their employers and their employers’ clients. (2) Use independent judgment. (3) Have an adequate basis for their recommendations. (4) Deal fairly with clients and fellow professionals. j. _ Required Conduct for Proxy Voting STUDY AID The CFA Institute has recommended proxy-voting guidelines for its members. These recommended guidelines are included later in this Study Session in the section titled TOPICAL STUDIES. Candidates should be aware of and understand the GFA Institute's recommendations The right to vote a proxy has economic value. Therefore, anyone exercising this right on behaif of a client, beneficiary, or participant incurs fiduciary responsibilities. The general duties of loyalty, care, prudence, impartiality and discretion apply in cases involving the voting of proxies on behalf of a client. The U.S. Department of Labor has set forth specific regulations for proxy voting of shares held by qualified retirement plans governed by ERISA. These regulations can serve as a set of guidelines for all fiduciaries faced with proxy vating issues. Some of the more important regulations are: (1) The investment manager has the fiduciary responsibility of voting proxies arising from the retirement plans under his or her control, unless the plan documents designate some other person(s) as the responsible party(s). (2) Fiduciaries must assure that the number of proxies received equals the number that the plan is entitled to vote. If they do not, discrepancies should be rectified (3) _Fiduciaries must formulate and periodically review written policies, guidelines, and procedures for voting proxies. (4) A fiduciary must cast an informed vote after carefully considering the issues involved and coming ta a decision as to what is in the best interests of the beneficiaries of the plan (care and loyalty) esorced 1-27 went Coep. al nightsLevel 2, Study Session 1 + Ethical and Professional Standards 1 Stalla Review for the CFA® Exam (8) _ Records must be kept documenting haw proxies were voted and the reasons that the votes were in the best interests of the beneficiaries. (6) Anyone whe votes a proxy on behalf of a fiduciary accepts the same fiduciary responsibilities and is subject to the same laws, regulations, rules, and standards as the fiduciary, kK. Required Conduct Pertaining to Soft Dollars STUDY AID The CFA Institute has recommended soft-dollar guidelines for its members. These recommended guidelines are included later in this Study Session in the section titled TOPICAL STUDIES. Candidates should be aware of and understand the CFA Institute's recommendations When an investment manager has a broker pay for goods or services that benefit the manager by channeling security transactions through specific brokers who are paid commissions for those transactions, the funds paid are called "soft dollars." When managers use their own funds to pay for goods and services, such payments are called "hard dollars." The primary rule is that brokerage befongs to the cilent. Fiduclaries must not use client funds for their own benefit. However, transactions involving soft dollars are permitted under the following circumstances: (1) The goods or services purchased help the manager make a better investment decision. (2) The manager has sought out the best price for the brokerage services, taking into account the quality of the services received, and has come toa conelusion that the commissions paid are reasonable in relation to the services obtained. (3) The soft dollar practice is disclosed to clients 1. Other Issues Regarding the Required Conduct of Fiduciaries (4) Social Investing Social investing is permitted under most fiduciary laws and guidelines only if (2) The portfolio's return and risk are not compromised. (b) Diversification is stil sufficient to avoid the risk of sustaining unusually large losses. {c) Excessive costs are not incurred (2) Relationship Investing Relationship investing is permitted under most fiduciary laws and guidelines. However, factors te consider before engaging in relationship investing are: (a) What are the expected benefits from this approach to the client? (b) How costly is this approach in terms of time and money? (c) Willthe approach reduce the ability to diversity, thereby increasing risk? 1-28 €22005 OWvry/tecker Eaucatonal Development Corp. Al rights reservedStalla Review for the CFA® Exam Level 2, Study Session 1 + Ethical and Professional Standards 1 (4) Willa conflict of interest exist if the fund fiduciary plays bath the role of corporate director, whose duty is to the shareholders of the issuer, and money manager, whose duty is to the beneficial owners of the fund? 6. — IV(B.2): Portfollo Investment Recommendations and Actions a. Required Conduct (a) (2) @) 4) 6) 6) Members acting as portfolio managers must know their clients’ financial situations, investment experiences, and investment objectives and constraints before any investment recommendations or actions are made This information should be updated at feast once a year. Before making a recommendation or taking investment action, the member must come to a conclusion that the proposed action is appropriate and suitable for the slient. Members must distinguish between facts and opinions in presenting investment recommendations. Members must disclose to clients and prospective clients the basic format and general principles by which they select securities and construct portfolios. Additionally, members must promptly disclose any changes that might significantly affect this process. Members must obtain written authorization fram their clients to make changes in their security selection or portfolio construction methodologies. Members need to address the basic characteristics of a particular investment being considered for investment action. Understanding the basic characteristies is important to judge the suitability of each investment on a stand-alone basis, and is particularly important in determining the impact each investment will have on the characteristics of client portfolios. With the growth of synthetic investment vehicles and derivative investment products, members need to pay careful attention fo the leverage in the vehicle or product. The degree of leverage has a direct bearing on the suitability and appropriateness of such products in a given portfolio. b. Compliance Procedures (1) 2) To fulfill the basic provisions of this Standard, a member should put the needs, circumstances, constraints, and investment objectives of each client into a written investment policy statement. Client policy statements should be reviewed periodically. In addition, investor objectives and constraints should be maintained and updated at reasonable intervals. An annual review is reasonable, unless there are reasons that dictate a more frequent review. 7. (MB.3); Fair Dealing a. Requi a) ired Gonduct Members are required to deal fairly with clients regarding: {@) Dissemination of recommendations. (b) Dissemination of changes in prior opinions (c) Taking investment actions. esorced 1-29Level 2, Study Session 1 + Ethical and Professional Standards 1 Stalla Review for the CFA® Exam Falr treatment does not mean equal treatment. While it may be physically impossible to reach all clients simultaneously, every effort should be made to communicate investment ideas to those clients for which the ideas are suitable and who have a known interest in them as simultaneously as possible within reasonable limits defined by communications technology. Members should make sure that procedures are developed that ensure the selection process by which clients receive information is based on suitability and known interest without preferential treatment given to any select group of clients. Compliance Procedures 0) (2) @) (4) 6) 6) @) 8) 9) (10) (11) Limit the number of access persons who have advanced knowledge of impending recommendations, changes of investment opinions, and/or investment actions to as small a group as possible. Keep the period as short as possible between the time when a decision to make a recommendation, a change in investment opinion, or make a portfolio change is made and when this information is disseminated or action is taken. For research reports involving a change of opinion, if a long time is required to get a full report published, a short summary report should be published first stating the essence of the recommendation, Firms should establish guidelines that prohibit their personnel from discussing or taking any action on pending recommendations, changes of opinions, or portfolio decisions before official dissemination of this information occurs. Establish procedures that reasonably assure the simultaneous disclosure of recommendations or opinion changes to appropriate clients, Establish procedures, such as minimum waiting periods and "blackout" periods, and monitor the trading action of firm personnel to ensure that “front running" does not occur. This guarantees that client transactions take precedence over transactions that benefit the firm, its officers, partners, or employees. Publish guidelines to determine whether a change in investment opinion is considered material, Maintain a list of clients who hold securities on the firm's research list to facilitate notification of a change in opinion Develop trade allocation procedures that ensure: (a) Advisory clients will have priority over the firm and its personnel with respect to the execution of orders in recommended securities. (b) Timeliness of execution. (c) Accurate records of trade orders and client account positions will be kept Require that orders, modifications, or order cancellation be in writing and time stamped. Process orders on a first-in, first-out basis, to give all accounts participating ina block trade the same execution price and pra rata share of the trading cost. When the full amount of a block order is not executed, allocate partially executed orders among the participating client accounts on a pro rata basis according to order size ©: 2005 Devry/tecker Eatucatonal Development Corp. AS rights reservedStalla Review for the CFA® Exam Level 2, Study Session 1 + Ethical and Professional Standards 1 (12) (13) (14) Disclose trade allocation procedures to clients and praspective clients. Review client accounts periodically to make sure no one is receiving preferential treatment, that some accounts are not bailing out others from bad investments, and that accounts are not being churned. Disclose to all clients any differences in levels of service offered and their fees, Care should be taken to treat different types of customers in an equitable manner, notwithstanding this disclosure. 8 IM(B.4): Priority of Transactions Los 1.3, Interpret the topical study "Personal investing a. Required Conduct (1) The priority in investment transactions must be given to clients and the firm employing a member over the accounts of access persons and accounts in which access persons have a beneficial ownership—access persons are prohibited from front running. While these persons may invest for their own benefit, they may not use their special knowledge about impending recommendations, changes in investment opinions, or investment actions that they obtain from their employment activities to enrich themselves, nor may they give this information to others. To do so is bath illegal (misappropriation of information belonging to one's firm) under U.S. law and a violation of this Standard Likewise, communicating information about an impending recommendation, a change in opinion regarding a security, or an impending investment action to preferred accounts before such information is generally given to firm clients is.@ misappropriation of employer information and could, therefore make one subject to criminal and/or civil legal action and sanction under this Standard Because front running is illegal (as well as unethical), this Standard applies to all access persons, whether or not they are covered persons. Members have the responsibility of enforcing this Standard with respect to all access persons in their employ, whether or not these access persons are members themselves. For the purposes of this Standard, a beneficial owner is a person with: (2) A direct or indirect monetary interest In an investment. (b) The power to vote or direct the voting of proxies, (c) The power to dispose of an investment. The foregoing notwithstanding, for the purpose of this Standard, the following accounts are also considered to be accounts in which an access person has a beneficial interest: (a) Accounts of the access person's Immediate family members (wife, children, and other relatives who live with the access person). {b) Any account in which the access person has a pecuniary Interest. esorced 131Level 2, Study Session 1 + Ethical and Professional Standards 1 (2) @) 4) 6) 6) @ Stalla Review for the CFA® Exam A beneficial interest is usually not assumed to exist for accounts of members of an access person's family who are not in the access person's immediate family (the access person's sisters, brothers, parents, in-laws, and 80 forth, who do not live with the access person). Such accounts can be treated as any other regular client account. it fs both illegal and unethical for an access person (such as a research analyst) to inform his or her firm's trading department of new recommendations or changes in opinion before the same information is made avallable to the client base. Interests of clients, the employer firm, and the integrity of the profession must be put ahead of the access person's or member's own personal interests. Care must be taken that personal investments do not create conflicts of interest or impair a member's ability to be objective and render independent professional judgment about securities All applicable laws, regulations, and compliance procedures with regard to the priority of transactions with respect to fiduciaries who are access persons or supervisors of access persons must be followed Members should not receive a personal benefit from investment actions taken on behalf of a client (except for the usual and customary compensation for the service rendered). Members shall not make (or refrain from making) an investment recommendation, change the rating (or refrain from changing the rating) on a security, or undertake (or refrain trom undertaking) an investment action because of personal financial reasons. For example, an analyst would violate this Standard if he or she fails to change a stock's rating from a "buy" to a "sell" when it is appropriate because the value of his or her personal portfolio would be adversely affected if clients and/or the public took such advice and sold the shares. Compliance Procedures a) (2) (3) 4) 6) Limit the number of access persons to reduce the chances of information "leaks" pertaining to impending recommendations, changes in opinions about secutities, or investment actions Implement appropriate physical and procedural barriers ("fire walls") to prevent the flow of information from one group (such as Corporate Finance) to another (such as Research, Trading, or Institutional and Retail Sales) within a firm Make sure employees understand the meaning of such terms as “personal transaction,” "beneficial interest,” *immediate family members,” “restricted transactions," "prohibited transactions," and so forth. Make it clear that if trading in, or ownership of, particular securities is, restricted or prohibited, all related securities are also covered by the restriction or prohibition. For example, if employees are prohibited from trading in a certain equity security, options on, or convertible securities of, the same issuer is also prohibited Restrictions should be placed on the ability of investment firm employees to invest in IPOs and private placements. When an investment professional makes a personal investment in such securities, there can be an appearance of impropriety. ©: 2005 Devry/tecker Eatucatonal Development Corp. AS rights reservedStalla Review for the CFA® Exam Level 2, Study Session 1 + Ethical and Professional Standards 1 6) @) 6) ) (10) (it) (12) Investment firms should establish "blackout" periods during which access persons are prohibited from trading in a security when the firm has a pending buy or sell order in the security. Such blackout periods should extend from the time a decision to trade is made until the trade is completed or cancelled, Investment firms should establish a minimum waiting period between the time a recommendation is made and when employees are permitted to trade in the securities for their own, or related, accounts. This waiting period normally will be three days for brokerage firms, but could be longer for investment counseling firms. Short-term trading by investment firm employees should be discouraged. This is defined as the buying and selling of the same security within a 60- day period. A review committee or a senior officer of the employer firm should be required to approve such transactions. Such a rule reduces the possibility of front running. Employees of investment firms should be required to disclose to the firm their investment holdings, the holdings of accounts in which they have a beneficial interest, and provide duplicate confirmations of trades. A record of all employee transactions should be maintained and reviewed at least quarterly Employees of investment firms should be required to obtain prior approval before any trade is made for their own account or far one in which they have a beneficial interest. Any conflicts of interest must be disclosed at that time. Approval of a supervisor, compliance officer, or review committee should be required before such trades occur Employees should be required to break any trade that is made in violation of the principles stated herein and should be required to pay back any profit on such transactions. Firms should allocate disgorged profits in a way that does not benefit the individual involved or the firm, Firms should initiate prompt internal investigations into any questionable activities that could involve a violation of this Standard. Disciplinary procedures should be established and enforced if violations are found to have occurred. 9. IM(B.5): Preservation of Confidentiality a. Required Conduct a) Preserve the confidentiality of client and firm information. The best approach Js never to disclose information received from a client or employer, except to authorized persons on a “need-to-know" basis. There are two exceptions to this general principle: {a) _ Inthe case of illegal activities, there may be an obligation to consult with a supervisor or legal counsel and report such activities to appropriate authorities, if counsel deems it necessary. {b) [tis not a violation to forward confidential information to the Professional Conduct Program (PCP) in cooperation with an investigation. Any information turned over to the PCP is kept in the strictest confidence esorced 133 went Coep. al nightsLevel 2, Study Session 1 + Ethical and Professional Standards 1 Stalla Review for the CFA® Exam Members are prohibited from executing settlement agreements that may prevent another party from providing information to the PCP in an investigation. Members who refuse to provide the PCP with requested Information on the basis of confidentiality clauses from settlement agreements are subject to suspension of membership. 10. 1V(B.6): Prohibition against Misrepresentation a. Required Conduct (a) 2) (3) Members may not misrepresent in written, oral, or electronic communications (whether for public dissemination or internal use) {@) The extent of their (or the employer firm's) services or investment performance. {b) Their qualifications or the qualifications of their firms. (©) Their academic and professional credentials. Only factual information about the terms of a security or the issuer's obligations under terms of an indenture or charter may be communicated, No guarantees or assurances should be given regarding the outcome or the probable (nominaf or relative) return on an investment. Itis a misrepresentation, as well as being a violation of Standard II (A), to claim that possessing 4 CFA charter, passing any number of CFA examinations, or being a member of the CFA Institute means that one has the ability to praduce superior investment results, or has any unique knowledge or expertise in investment matters. b. Compliance Procedures (4) 2) (3) Firms should provide a written list of the services that they perform anda description of their qualifications so that employees who make oral or written presentations to clients or potential clients can communicate this information accurately. Each member should prepare a list of his or her own qualifications and the services he or she is capable of performing. Members who use (or whose firms use) web pages shauld regularly monitor materials posted to the web site to ensure it maintains current information. Members should also ensure that all reasonable precautions have been taken to protect the site's integrity, confidentiality, and security and that the site does not misrepresent any information and provides full disclosure. 11. IV(B.7): Disclose Conflicts to Clients and Prospects a. Required Conduct (1) Members must disclose to clients and prospects any potential conflicts of interest that could reasonably impair their objectivity. This allows clients to judge for themselves the member's possible motives and biases regarding their investment recommendations, changes in opinions about securities, and investment actions.Stalla Review for the CFA® Exam Level 2, Study Session 1 + Ethical and Professional Standards 1 (2) Conflicts of interest that must be disclosed are: (2) Aspecial relationship between the member or the member's firm and an issuer, Such as: (1) The member, or someone who works for the member's firm, is a director of the company whose securities are being discussed (2) The member, or someone who works for the member's firm, or the member's firm itself, consults with the company whose securities are being discussed {b) Underwriting or financial relationships that exist between the member ‘or the member's firm and the company whese securities are being discussed. {c) Broker-dealer and market-making activities conducted by the member ‘or the member's firm and the company whose securities are being discussed. {d) The member, the member's immediate family, or the member's firm has a material beneficial ownership in the securily being discussed. (e) Special compensation arrangements members have that might conflict with client interests (such as short-term performance bonuses, incentive fees, or referral fees) b. Compliance Procedures (1) Firms should establish adequate procedures for reviewing and governing the personal investing of employees. (2) _ Inform all employees of the "special relationships" that must be disclosed (3) _ Require prior approval before investment personnel can serve as consultants to or directors of companies. Also require prior approval before investment personnel can purchase company securities. 12, IM(B.8): Disclosure of Referral Fees a. Required Gonduct (1) Members should disclose to prospective clients, in writing, any fees they have paid for referrals as soon as the prospective client is referred to them b. Compliance Procedures (1) Disclose, in writing, the existence and terms of referral fee agreements. (2) Inthe disclosure, describe the nature of the referral fees paid and their amounts. (3) _ Before engaging in a referral fee agreement, consult a supervisor and legal counsel regarding the legality or ethical nature of the terms of the proposed agreement (4) Follow the instructions of | and their disclosure. counsel with respect to referral agreements eury/Becker Educational Development Cop, All nghts reserved 135Level 2, Study Session 1 + Ethical and Professional Standards 1 Stalla Review for the CFA® Exam Los 1.3.4 E. STANDARD V: RELATIONSHIPS WITH AND RESPONSIBILITIES TO THE INVESTING PUBLIC 4. V(A): Prohibition against Use of Material Nonpublic Information Intespret the topical study sider Trading” as it relates to the Code and Standards, a. Definitions of Material Nonpublic Information In the absence of a statutory definition, the U.S. courts have developed theories of what inside information is under general antifraud and deceptive practices provisions of Section 10(b) of the Securities and Exchange Act (1934) and Rule 10b-5, adopted by the Securities and Exchange Commission (SEC). The law has developed in a way that persons are subject to criminal and civil liability for the act of securities fraud under either one of two theories: the traditional theory and the misappropriation theory. a) Traditional Theory According to the traditional theory, trading or recommending a trade in securities when in possession of inside information is an act of securities fraud only when the person taking the investment action has, or inherits, a fiduclary duty to the company whose securities are acted upon, and breaches that duty. The tests that determine whether or not the information possessed by an individual prevents that individual from taking any investment action in the related security under this theory are as follows: (a) The Information is Material Information is material if (1) It pertains to a tender offer. Legally, information pertaining to a tender offer is automatically material. It is an act of fraud for any person to base a trade on, or ‘communicate, nonpublic information about a tender offer, if it is known (or should be known) that the information was obtained, directly or indirectly, from parties involved in the tender. It is important to note that this rule does not require a breach of a fiduciary duty fora violation to occur. Mere possession of information regarding a tender offer that is not public knowledge prohibits a person or firm from trading, recommending, or communicating this inside information. Therefore, under no circumstance may a covered person take an investment action with respect to a security while in possession of nonpublic information about a tender offer involving the company that has issued the security, unless one ‘of two exceptions apply: (@) The action involves the purchase of securities on behalf of the entity that is making the tender offer (enabling the party who is going to make the tender offer to buy shares prior to the offer) (b) The action involves the sale of securities to the proposed tender offeror.Stalla Review for the CFA® Exam > 2005 Devry/acker Educaticnal Development Corp. Al nhs (b) {ey Level 2, Study Session 1 + Ethical and Professional Standards 1 (2) It would significantly change the total mix of information about a company, its affairs, or its securities. in other ‘words, information a reasonable investor would want to know before making an investment decision, or, if known, it would probably have an impact on the price of a security. (3) Its a specific fact, rather than an opinion. The Information is Nonpublic information becomes public as soon as the company discloses it in a way intended to make it available to the general investing public. Selective disclosure to a group of investors or analysts does not constitute @ public disclosure. Corporate officials who give selective disclosure of material information to certain investors or investment professionals can be guilty of being illegal tippers. Corporate disclosure made to a “room full of analysts" does not constitute public disclosure under the law. Persons who are in possession of material nonpublic information in advance of its being publicly disclosed cannot use the information for investment purposes immediately after its public disclosure. Rather, they have an affirmative duty to wait until an adequate time has elapsed for the information to be disseminated and assimilated by the investing public before using it for their own investment purposes. The Source is an Insider ‘An example of an insider is someone who knows the information because he or she is in a position to receive confidential information about a company's affairs and who has a fiduciary duty not to disclose it Tippees, such as analysts, who receive material nonpublic Information, may legally use it, unless they are brought into the fold of confidentiality, or they know (or should know) that the information was misappropriated or obtained illegally. They are brought into the fold of confidentiality when they are given the Information for a legitimate business purpose (consultants, lawyers, accountants, underwriters, and so forth), or when they know (or should know) that the tipper breached a fiduciary duty in giving the information. A tipper breaches his or her fiduciary duty to a firm when the reason for making the disclosure is not for a legitimate business purpose; rather, the disclosure was made so that the tipper could, directly or indirectly, derive some benefit from i. Such benefit may be: (1) Financial, as when the tipper is paid for the information (2) Reputational, as when giving out the information may improve the tipper's future income, job apportunities, or prestige (3) Away of establishing or cementing a relationship between the tipper and tippee that suggests some kind of quid pro quo arrangement (4) Away that the tipper can give a gift to the tippee. Note that a fiducfary duty exists as a matter of law; it cannot be imposed simply by telling someone to "keep this (information) confidential." esorced 137Level 2, Study Session 1 + Ethical and Professional Standards 1 Stalla Review for the CFA® Exam (2) Information that is received inadvertently (as when a conversation is accidentally overheard) does not constitute inside information, unless the tippee knows (or should know) that it was illegally obtained or misappropriated Investment professionals should be cautious when in possession of inside information; however, because the mere possession of such information could taint any trades or recommendations that they make in securities that are affected by such information The Misappropriation Theory Under the traditional theory, an individual can trade or recommend an investment action even when possessing material nonpublic information about the involved securities, if the person owes no fiduciary duty to the issuer of those securities. However, under the misappropriation theory, individuals commit securities fraud if they obtain materlal nonpublic information from another to whom they owe a duty of trust and confidence, and then communicate that information or use it as the basis of a trade or recommendation, even if they owe no fiduclary duty to the issuer of the involved securities. They also commit fraud if they obtain material nonpublic information illegally (as when stealing it, causing it to be stolen, ar receiving stolen information) Thus, the fraud provisions of Rule 10b-5 are extended to duties owed not only to issuers and their shareholders, but also to anyone to whom a duty not to disclose information obtained through a special relationship applies, as well as to information obtained illegally or by deception. The concept is that materfal nonpubilc information about a firm's activities Is “property of the firm." Anyone who has access to this type of Information because of a special relationship that he or she has with an employer (employees, consultants, accountants, legal experts, directors, underwriters, and so forth) is only entitled to use it within the scope of the employment function. Such insiders owe the employer a duty not fo use this “property” of the employer for their personal benefit. f they use it for their own personal benefit, or give it to others, they misappropriate company property. This is a form of theft, which is punishable by criminal and civil actions The law also extends these duties to any tippee who receives such misappropriated information from an inside tipper, if the tippee knows (or should know) that the tipper breached a duty in giving the information to him or her. However, these duties are imposed when one receives information from a person to whom a /ega/ duty is owed to keep information confidential; itis not imposed by simply being told to "keep this information confidential.”Stalla Review for the CFA® Exam Level 2, Study Session 1 + Ethical and Professional Standards 1 b. The Mosaic Theory Note that the test of materiality relates to the significance of specific acts, standing alone, al the time they are communicated. It does not include information that becomes material at some later date, or that becomes material only after it is evaluated by an analyst in conjunction with other facts that are publicly available or immaterial in themselves. Taking several immaterial andior publicly avaiable stand-alone facts from various sources and putting them together to form a complete and significant picture of a corporate situation Is called the mosaic theory. This is the analyst's job and is completely legal. Under the mosaic theory, if an analyst pieces together nonmaterial facts, whether or not these facts are public knowledge, to form a "mosaic" that leads to a particular investment decision, this conclusion can be used to trade securities or make investment recommendations. This is true even if the conclusions drawn from the analysis would have constituted material nonpublic information if it had been directly given to the analyst from a tipper. For their own protection, however, investment professionals should save and document their research so as to be able to document that their actions were based on the analysis of a series of facts rather than on illegally attained inside information c. Required Conduct (1) Members shall not take any investment action (trade a security or make a recommendation regarding a security), or communicate information about a security or company, when in the possession of material nonpublic information related to the value of the security, if such action would breach a duty owed to the company, the information was misappropriated, or if it relates to a tender offer. (2) _ If material nonpubiie information about a company or securities is received. an effort should be made to get the company about whom the information relates to make a public disclosure of the information. The only exception is if the information was received because of a special or confidential relationship with the company (as in the case of a "constructive" insider) and the information is to be Kept in confidence. (3) Broker-dealers and Investment advisors must establish, maintain, and enforce written policies and procedures designed to reasonably prevent iilegal insider trading by their employees. (4) Supervisors must design procedures for their area that will reasonably prevent the illegal use of material nonpublle Information by their subordinates, Supervisors must: (@) Understand what constitutes inside and misappropriated information {b) Understand the policies put into place by themselves and/or their firm designed to prevent illegal activities in this area from occurring (c) Inform their subordinates of what constitutes illegal or unethical activity in this area (4) _ Inform their subordinates of their department's and firm's policies and procedures designed to prevent illegal or unethical use of material nonpublic information. (e) Enforce department and firm policies and procedures in this area () Appropriately discipline subordinates who are found to engage in such activities, esorced 1:39 ) 2005 Devry/Backer Educational Develcoment Cerp. All rightsLevel 2, Study Session 1 + Ethical and Professional Standards 1 6) (6) Stalla Review for the CFA® Exam When acting as a consultant or any ather role in which the member becomes a “temporary insider," the member keeps information received confidential, and does not use it for Investment purposes or communicate it to others. It material nonpublic information is received on a select" basis, evaluate it from the point of view as to whether or not it is “inside" or misappropriated information. Seek help from supervisors, compliance officers, or legal counsel, if necessary. If the information is deemed to be inside or misappropriated information, encourage the affected company to disclose it. Refrain fram using or communicating such information until itis disseminated. Do not take any investment action until the information is disseminated and assimilated by the market, even if'such action is warranted on some other basis Compliance Procedures (i) (2) @) 4) 6) Do not seek out material nonpublic information. Be alert to the possibility that material nonpublic information has been received during meetings with company officials or if company officials provide guidance in the interpretation of drafts of reports, financial statements, ar public announcements Employers should devise procedures to help prevent the seeking out, or the use of, material nonpublic information by their employees. Written compliance manuals should be distributed to employees, explaining the law with regard to material nonpublic information and giving detailed instructions regarding the prohibitions against seeking, or using, such information, and what procedures employees are to follow if they come into possession of such information An investment professional in possession of inside information should consult a supervisor, compliance officer, or legal counsel before undertaking any investment action in the securities of the company about which the Information pertains. Analysts and portfolio managers should be separated from corporate finance functions, and the solicitation of inside information from outsiders or fellaw employees should be forbidden. A “fire wall" shauld be established to prevent the communication of material nonpublic information from one department within a firm to another. This requires the firm to: {@) Control relevant interdepartmental communication. There should be no overlap of personnel or close physical proximity between the investment banking and corporate finance departments and the brokerage, sales, and research departments. {b) Establish procedures that monitor firm and employee trading activity (c) Review and restrict employee trading in the securities of companies about which the firm possesses material nonpublic information. To facilitate this, firms should have “restricted” or ‘watch’ lists of securities on which the firm has, or may have, material nonpublic information. Securities that are placed on such lists should be known only to 4 limited number of firm personnel, but trading activity in securities on these lists should be scrutinized carefully.Stalla Review for the CFA® Exam Level 2, Study Session 1 + Ethical and Professional Standards 1 6) 1) (8) @) (d)__ Restrict or prohibit employees from engaging in proprietary trading when the firmis in possession of inside information about affected securities. |f a firm cannot stop trading ina security in which it has inside information, such as might occur ifit is a market maker in the security and to step making a market would be a tip off to the market that “something is in the wind," traders should be instructed to take a passive stance on the security—to only take the other side of unsolicited orders. Arbitrage should be suspended in securities in whieh a firm has inside information (e) Have written rules and guidelines, limiting the dissemination of material nonpublic information inside and outside the firm to only those individuals who need to know the information in order to carry out their legitimate business functions. (f) Assign a supervisor or compliance officer to be responsible for determining whether or not information received by the firm or its employees is material and is public. This supervisor or compliance officer should be required to approve communication of information to the research, brokerage, or sales departments and should not be a member of one of these departments. If investment banking or corporate finance must share inside information with a member of the research department, a compliance officer should be involved in the process to determine whether, and to what extent, the information needs to be shared. The analyst must not use the information for trading or recommendations, nor should the information be communicated to persons wha have no legitimate reason to know it. Employees who receive information that is known or reasonably believed to be material and nonpublic should communicate that information to a designated supervisor, compliance officer, or the firm's legal counsel, without discussing the information with fellow employees. Firms' written compliance procedures must require that employees refrain from trading on, or discussing, potential inside information, until the supervisor decides the information is either not material or has been made public. |f material inside information is received by a member via a breach of duty on the part of the tipper, the member should make reasonable efforts to achieve public dissemination of the information, This usually means encouraging the company, about whom the information applies, to make a public disclosure. Keep all research department records documenting reasons behind recommendations, methods of determining earnings estimates, and so forth. This may enable the firm to document that inside information was not the basis of an investment decision. Regularly review client accounts to: {@) _ Investigate patterns of heavy and unusual trading in a particular security. {b) Inquire about trading in securities not covered by the research department esorced 14 went Coep. al nightsLevel 2, Study Session 1 + Ethical and Professional Standards 1 2 (10) (11) (12) Stalla Review for the CFA® Exam Be aware of information being circulated about companies, and inquire about the sources and public availability of such information Require employees to report on trades made for family members. Corporations that issue securities should {@)__ Refrain from making selective disclosures of material information {b) Not engage in the practice of "blackballing" analysts (for example, refusing to give information to analysts who have written negative reports about the company), (c) _ Issue press releases, prior to analyst meetings, disclosing any new information that will be disclosed at the meetings (d) _ Issue press releases after any analyst or investor meeting disolosing any new, material, previously nonpublic information that was disclosed in the meeting. (e) Make a public disclosure of information that is brought to their attention that is material and selectively known within the investment ‘community. () Establish training and continuing education programs for employees to develop their ability to recognize material nonpublic information and leam the pracedures to follow when they have knowledge of material nonpublic information. (a) Appropriate disciplinary actions should be provided for and carried ‘out for violations of inside information rules and statutes Employers who comply with these procedures are nat legally responsible for violations committed by their employees; employers who fail to comply with them could be held liable for the illegal actions of their employees. ‘V(B): Performance Presentation Reasons Why Performance Presentation Standards are Necessary a Historically, investors have faced many difficulties in obtaining fair performance results that were comparable amnong various investment management firms. This is because: a) (2) (3) Managers often showed only the performance of selected "representative" accounts, rather than the performance of all accounts under management Survivor biases (managers only showed the performance of accounts currently under management or that were managed by current employees and not these of former clients or managed by former employees who left the firm). There was no consistency among investment managers in the way performance results were measured or how composites were constructed. Therefore, the Global Investment Performance Standards were developed in the hope that a set of globally accepted common standards will enable performance results among various investment firms to become truly comparable. ©: 2005 Devry/tecker Eatucatonal Development Corp. AS rights reservedStalla Review for the CFA® Exam Level 2, Study Session 1 + Ethical and Professional Standards 1 The main difference between the two Standards is that Performance Presentation Standards requires the presentation of 10 years of performance by asset class, while the Global Investment Performance Standards requires only a five-year performance history without the need to show results by asset class, On the important issues of how results are to be measured (time-weighted, geometrically computed rate of return), how composites are to be constructed, how performance history is to be compiled (on a firm basis), that a firm must be in total compliance with ali mandatory provisions of the Standards in order to claim compliance with the Standards, and so forth, the two sets of standards are in agreement These standards both require that firms adhere to the principle that every reasonable effort should be made to ensure that investment performance information is fair, accurate, and complete b. Required Conduct (1) Members may not misrepresent their investment performance record, either in terms of the presentation or the measurement of those results. (2) When communicating data about the performance history of individual accounts, composites (groups of accounts), an individual investment manager, or an entire firm, the member must give a fair and complete presentation. (3) _ Its unethical to misrepresent either the past investment performance or the investment performance that a client can reasonably expect to obtain in the future. ¢. Compliance Procedures (1) Compliance with the Global investment Performance Standards is the best way to comply with this Standard (2) Members should encourage their firs to voluntarily adhere to either of these, or comparable, standards. (3) Members should consider the knowledge and sophistication of clients and prospective clients when giving a performance presentation, (4) Give full disclosure to make sure that performance results are not misunderstood. For example, if simulated madel results are presented, it ‘should be made clear that the results are not the actual returns of real portfolios. {5) Maintain data and records that were used to calculate performance results 2005 OeUry/Backer Educational Development Carp. All ights reserved 143Level 2, Study Session 1 + Ethical and Professional Standards 1 Stalla Review for the CFA® Exam RULES OF PROGEDURE FOR PROCEEDINGS RELATED TO PROFESSIONAL CONDUCT The AIMR Rules of Procedure specify the steps that must be followed before a covered person can be sanctioned for misconduct, and the disciplinary sanctions that may be impased upon such a person ‘A. AUTHORITY OF THE PROFESSIONAL STANDARDS AND POLICY COMMITTEE The Professional Standards and Policy Committee (PSPC), a committee of the AIMR Board of Governors, has the primary authority to conduct disciplinary investigations of covered persons and to impose disciplinary sanctions in accordance with the AIMR Bylaws and these Rules of Procedure. To perform these functions, the PSPC has subcommittees that carry out specific tasks on its behall The PSPC has two primary subcommittees +. The Disci inary Review Subcommittee, which is responsible for: a. Enforcing the Code and Standards b. Reviewing and recommending changes to the Rules of Procedure. c. _ Reviewing and approving all stipulated disciplinary matters. 4. Reviewing and approving summary suspensions. ¢. Performing other tasks requested of it by the PSPC. 2. The Standards and Policy Subcommittee, which is responsible for a. _ Reviewing and revising the Code and Standards. b. Promoting the Code and Standards, ¢. Reviewing and revising the Standards of Practice Handbook. 4. Reviewing and revising the standards of practice examinations. e. Reviewing and revising the annual professional conduct statement. f. Assisting in professional condust investigations. g. Performing other tasks requested of it by the PSPC B, GROUNDS FOR DISCIPLINARY ACTION Covered persons may be subject to disciplinary sanction for any of the following reasons: 4. Violating AIMR's Articles of Incorporation, Bylaws, the Code and Standards, Rules of Procedure, Member's Agreements, or other applicable rules. 2. Agovernmental, judicial, or regulatory agency with jurisdiction aver investment- related matters has imposed a disciplinary sanction or injunction on the covered person. 3. Convietion of, or pleading guilty to, a felony (or a crime that Is punishable by more than one year in prison). 4. Being barred permanently or indefinitely trom registration under securities laws or from acting as an investment professional under laws regulating such matters.Stalla Review for the CFA® Exam Level 2, Study Session 1 + Ethical and Professional Standards 1 Failure to complete, sign, and return the annual professional conduct statement. Falsification of information provided on membership or CFA candidate applications, Any good cause, Including the fallure to cooperate with an official Investigation into the covered person's professional conduct. C. DISCIPLINARY SANCTIONS THAT MAY BE IMPOSED Covered persons who are found guilty, or who stipulate guilt, for any of the above violations: are subject to the following disciplinary sanctions: 4 Private censure, which means that the violation may be announced publicly in a CFA newsletter, or similar publication, without identifying the violator. This is the least severe sanction that can be imposed, Public censure, which means the name of the violator and the violation will be published in a CFA newsletter, or similar publication. Timed suspension of membership, which means the violator's membership in AIMR. or its affiliated organizations and member societies will be suspended for a specified period of time, Timed suspension of the right to use the GFA designation, which means the violator may not use the CFA designation for a specified period of time. Revocation of membership, which means the violator's membership in AIMR and its affiliate organizations and member societies is permanently revoked. Revocation of the right to use the GFA designation, which means that the violator’s right to use the CFA designation is permanently revoked Summary suspension, which automatically removes the violator from membership in AIMR, and its affiliate organizations and member societies, and revokes the violator’s right to use the GFA designation or to participate in the CFA Candidate Examination Program Suspension or revocation from further participation in the CFA professional designation study and examination program, which means the violator is automatically removed from participation in the CFA Candidate Examination Program, D. NORMAL DISCIPLINARY INVESTIGATION AND SANCTION PROCEDURE The normal process for undertaking a disciplinary investigation and sanctioning a covered person is as follows 4 A complaining party files a written complaint with AIMR concerning a covered person's professional conduct, explaining the facts and circumstances of the alleged misconduct. The statement may include documentation that supports the claim Upon receiving the complaint, a Designated Officer, appointed by the Disciplinary Review Subcommittee to handle inquiries related to professional conduct matters, sends the accused covered person: a. — ANotice of Inquiry stating the accusation b. Other information that could help the accused covered person answer the charges. c. Copies of the Rules of Procedure, the AIMR Articles of Incorporation, the AIMR: Bylaws, the Code and Standards, and a notice of the right to be represented by counsel in the matter, esorced 145Level 2, Study Session 1 + Ethical and Professional Standards 1 Stalla Review for the CFA® Exam ‘The accused covered persan must respond, in writing, to the Notice of inquiry within 30 days of its receipt. Failure to respond in the allotted time is grounds for a summary suspension for failure to cooperate with an AIMR investigation into one’s professional conduct. After the accused covered person responds to the Notice af Inquiry, and following an investigation of the facts and circumstances of the matter, the Designated Officer may determine that there is not enough evidence to warrant proceeding with the inquiry. In this case, the inquiry is terminated and the accused covered person is notified of such termination. Termination of an inquiry does not preclude the possibility that the inquiry may be reopened at a later date. Ifthe Designated Officer determines that the accused covered person has committed a minor violation of the Code and/or Standards, he ar she may propose a private censure. However, this sanction cannot be imposed until: a. ANotice of Private Censure has been sent to the accused covered person, and the covered person has had an opportunity to accept or reject it in writing b. Ifthe accused covered person accepts the private censure in writing, or fails to reject it within 30 days of its receipt, the private censure is imposed. There is no appeal if a covered person accepts, or fails to reject, a Notice of Private Censure within the allotted time Ifthe accused covered person rejects the private censure, in writing, within 30 days of receiving the Notice of Private Censure, the Designated Officer will continue the inquiry by referring the matter to a Hearing Panel. Ifthe Designated Officer believes the violation is more serious than a minor infraction, he or she may propose a Stipufation Agreement, in which the accused covered person stipulates that they did commit (a) certain named violation(s) and agrees to accept a specified disciplinary sanction that will be more severe than a private censure. In retum, the Designated Officer agrees to terminate the professional conduct inquiry. Ifthe accused covered person accepts the terms of the stipulation agreement, all rights toan appeal are waived. A signed stipulation agreement, containing the facts related ta the alleged misconduct and the recommended sanction, are forwarded to the Disciplinary Review Subcommittee for approval. The Disciplinary Review Subcommittee, after reviewing the Stipulation Agreement, may: + Impose the same or lesser sanction than that recommended by the Designated Officer in the Stipulation Agreement * Dismiss the matter without sanetion. * Refer the matter back to the Designated Officer or the Chair of the Disciplinary Review Subcommittee for further investigation and action Ifthe accused covered person rejects the terms of the Stipulation Agreement, in writing, within 30 days of receiving it, he or she may request a Hearing Panel Ifthe accused covered person does not respond, in writing, to the proposed Stipulation Agreement within 30 days of receiving it, the Chair of the PSPC shall designate a Hearing Panel to hear the matter. Ifa Hearing Panel is convened: a. The Designated Officer provides a Statement of Charges to the PSPC Chair. This is similar to an indictment in that it lists the charges levied at the accused covered person for which there appears to be reasonable basis for disciplinary action. ©: 2005 Devry/tecker Eatucatonal Development Corp. AS rights reservedStalla Review for the CFA® Exam Level 2, Study Session 1 + Ethical and Professional Standards 1 b. Upon receiving the Statement of Charges, the PSPC Chair appoints a Hearing Panel to hear the evidence, render a decision, and impose a sanction pertaining to the matter. ¢. Hearing Panels consist of 3-6 persons, at least one of which must be a member of the PSPC {but not the Chair of the PSPC). Other members of the Hearing Panel may be chosen from the AIMR Board of Governors or from members of the PSPC subcommittees. The PSPC Chair also appoints one of the members of the Hearing Panel to be the Hearing Panel Chair. No one with a conflict of interest, or who helped in the investigation of the matter, may serve on the Hearing Panel. d. The Hearing Panel shall convene within 120 days of the request for a Hearing The accused covered person has 30 days to agree upon a mutually acceptable date for the hearing, Otherwise, the Chair of the Hearing Panel shall set the date of the Hearing. & At least 30 days prior to the Hearing, a Hearing Notice shall be given te the accused covered person. This Hearing Notice must include: (1) The Statement of Charges (2) Information regarding the accused covered person's right to a defense. (3) _ Information about the accused covered person's right to be represented by counsel. (4) Information about the accused covered person's right to present evidence and witnesses at the Hearing (6) Information about the accused covered person's right to cross-examine witnesses at the Hearing. Ifthe accused covered person wishes to present evidence and/or witnesses at the Hearing, he or she must give eight (8) copies of any documented evidence expected to be used at the Hearing and a witness list (including the expected testimony of each witness) to the Designated Officer at least fourteen (14) days prior to the date of the Hearing. The Designated Officer must submit this information, together with any other material he or she will use in the Hearing to the Hearing Panel. Information submitted to the Hearing Panel by the Designated Officer must be given to the accused covered person at least seven (7) days prior to the Hearing f. At the Hearing, testimony from witnesses, including the accused covered person, shall be under cath g. The Hearing Panel is not bound by the rules of evidence applicable to a court of law, but the Hearing Panel Chair may exclude evidence that it deems to be irrelevant, h. Cross-examination and questioning of witnesses and evidence is permitted at the Hearing. i. After concluding the Hearing, the Hearing Panel shall deliberate and issue a report on its findings within 30 days. The report shall include a finding of whether or not the accused covered person is guilty or innocent of the charges brought before the Hearing Panel. Ifthe Hearing Panel finds the accused covered person guilty of one or more charges, it shall alo recommend a specific disciplinary sanction Ifthe Hearing Panel recommends a sanction, it shall be imposed unless the accused covered person requests a review by the PSPC, in writing, within 30, days of the Hearing Panel's decision. esorced 147 went Coep. al nightsLevel 2, Study Session 1 + Ethical and Professional Standards 1 Stalla Review for the CFA® Exam 10 Nore: Ifthe accused covered person requests such a review, the PSPC Chair will appoint a Review Panel. This Review Panel will consist of 3-5 members fromthe Board or the PSPC who have not previously been involved with the matter. The Review Panel's sole responsibility Is to determine whether or not the Hearing Panel's recommended sanction Is inequitable because of exceptional or unusual circumstances. ‘The accused covered person has 30 days after requesting a review to submit additional information to the Review Panel supporting why the recommended sanction would be inequitable because of exceptional or unusual circumstances. The Review Panel may alse request additional information from the covered person. Within 30 days of its review, the Review Panel shall notify the accused covered person of its decision. The Review Panel may impose the same, or a lesser sanction, than that recommended by the Hearing Panel. In any event, the decision of the Review Panel is final and conclusive. Ifa sanction is imposed on the convicted covered person, a Notice of Disciplinary Sanction is sent to him or her. This Notice shall contain: a. Asummary of the matter, the disciplinary proceedings, and the sanction imposed b. The applicable rules, Code, or Standards that were violated, ¢. Other information deemed appropriate by the PSPC. This information is announced publicly in a CFA newsletter, or similar publication, is given to the convicted covered member's regulators, and to any member society to which the covered member belongs, except that the identity of the covered person is withheld from these public announcements when the sanction is a private censure. After a Notice of Inquiry has been sent to a covered person, disciplinary proceedings may proceed and sanctions imposed even if the covered person resigns from AIMR, its affiliated organizations, and its member societies, or relinquishes the right to use of the CFA designation, or postpones his or her status in the CFA Candidate Examination Program E. SUMMARY SUSPENSION PROCEDURE Asurnmary suspension involves taking away, without a Hearing, a covered person's Membership in AIMR, its affiliated organizations, and member societies. Right to use the CFA designation Right to participate in the CFA Candidate Examination Program. Grounds for Summary Suspension The Designated Officer or the Disciplinary Review Subcommittee shall impose an automatic summary suspension upon a covered person who: a. Is convicted, pleads guilty, or consents toa felony (or any crime that Is punishable by more than one year in prison). b. _ is barred permanently or indefinitely by a competent authority from registration in, or working as a professional in the investment business, . Fails to cooperate with an official investigation into the covered person's professionaf conduct. d. — Faifs to complete, sign, and return the required annual professional conduct statement.Stalla Review for the CFA® Exam Level 2, Study Session 1 + Ethical and Professional Standards 1 z Summary Suspension Procedures Ifthe Designated Officer determines there is cause for an automatic summary suspension of a covered person, he or she will send a Notice of Summary Suspension to that covered person along with information regarding the right to petition to have the suspension reviewed by a Summary Suspension Review Panel. The accused covered person may petition for such a review, in writing, within 30 days of receiving the Notice of Summary Suspension. Ifthe covered person is being summarily suspended because of a failure to cooperate with an inquiry about his or her professional conduct, the covered person shall also have the right to object to the summary suspension by agreeing, within 30 days of receiving the Notice of Summary Suspension, to cooperate with the inquiry. If the covered person is being summarily suspended because of a failure to return the annual professional conduet statement, the covered person may object to the suspension within 30 days of receipt of the Notice of Summary Suspensian and comply with the requirement by submitting all outstanding professional conduct statements. Thereafter, the Designated Officer must review the matter. Upon review, the Designated Officer can lift the summary suspension. However, as a condition of lifting the summary suspension, the Designated Officer can require the covered person to demonstrate fitness to practice as a professional in the investment business, including the passing of a self-administered standards of practice examination. Ifthe Designated Officer does not lift the summary suspension, the covered person has the right to have the matter reviewed by a Summary Suspension Review Panel. Ifthe accused covered person does not petition for a review of the summary suspension within the allotted time, the summary suspension goes into effect and a new petition for review cannot be made for one (1) year. A summary suspension automatically becomes a revocation of membership in AIMR and its affiliated organizations and member societies and/or the right to use the CFA designation if the covered person does not petition for a review of the summary suspension within five (5) years of the date of the summary suspension Ita summary suspension has been issued because of a criminal conviction or because the covered person has been barred from acting as an investment professional, the summary suspension will be terminated immediately upon filing with the Designated Officer proof that the underlying criminal conviction or professional suspension has been reversed. However, a reversal of the legal matter does not preclude the PSPC from pursuing an inquiry into the matter. Ita summary suspension has been terminated, the covered person may request, in writing, that notice of the termination be publicly announced in the same manner as the summary suspension was announced, ‘The Summary Suspension Review Process Upon receiving a request for a review of a summary suspension, the PSPC Chair shall appoint 3-5 members to a Summary Suspension Review Panel. Members of this review panel shall be selected from members of the PSPC, the Disciplinary Review Subcommittee, and/or the Standards and Policy Subcommittee who have no conflicts of interest in, and no connection to, the matter. The PSPC Chair shall name one member of the Panel as the Summary Suspension Review Panel Chair. ‘The affected covered person has 30 days to determine a mutually acceptable date on which the review will be held. Ifno mutually acceptable date can be determined in that time, the Review Panel Chair shalll fx the review date. The review date must be within 90 days of the receipt of the petition for the review. esorced 149Level 2, Study Session 1 + Ethical and Professional Standards 1 Stalla Review for the CFA® Exam ‘The affected covered person shall be given a 30 day written notice of the date of the review together with The Statement of Charges. Information about the right to present a defense. a. b ¢. Information about the right to be represented by counsel. 4. Information about the right to present witnesses and evidence e. Information about the right to cross-examine witnesses. At least fourteen (14) days prior to the review hearing, the affected covered person * shall furnish the Summary Suspension Review Panel eight (8) copies of any written information or evidence to be used on his or her behalf; * must give the Designated Officer a list of witnesses that are expected to appear at the review hearing, including a description of their expected testimony. The Designated Officer may also submit information to the Review Panel. This submission, made no later than seven (7) days prior to the hearing, should be in conjunction with any material submitted by the covered person. The covered person shall be given a copy of the Designated Officer's submission at least seven (7) days prior to the review hearing, In the review hearing, the Designated Officer shall present the case for the summary suspension and the affected covered person may present a case against it, The rules of evidence applicable to a court of law do not apply to the review hearing, However, the Review Panel Chair shall not permit irrelevant information or testimony to be presented to the Review Panel Upon deliberation, the Summary Suspension Review Panel can terminate the summary suspension if it determines that a summary suspension is inequitable because of exceptional or unusual circumstances. Within 30 days of the review hearing, the Summary Suspension Review Panel shail issue a report of its decision and the reasons that support it. This report is to be delivered to the Chair of the PSPC and the affected covered person. The decision of the Summary Suspension Review Panel is final and conclusive. REINSTATEMENT AFTER A TIMED SUSPENSION When a timed suspension has elapsed, the covered person shall be reinstated, provided he or she files a professional conduct statement that indicates that he or she has net been the ‘subject of any additional disciplinary action(s) since the suspension became effective. REINSTATEMENT FOLLOWING A REVOCATION Ita person has had his or her membership and/or right to use the CFA designation revoked, that person may petition for reinstatement of these privileges if: 4. 2. At least five years have elapsed since the effective date of the revocation. ‘The person demonstrates to the PSPC that he or she is fit to practice as an investment professional and shows rehabilitation and a willingness to fully comply with all disciplinary orders. The person adheres to other reasonable canditions for reinstatement set down by the PSPC, including filing a professional conduct statement and passing a self- administered standards of practice examination.Stalla Review for the CFA® Exam Level 2, Study Session 1 + Ethical and Professional Standards 1 Upon receipt of a Petition for Reinstatement, the Designated Officer shall investigate the petitioner and issue a report to the PSPC. The PSPC may or may not reinstate the petitioner. Ifthe petition for reinstatement is denied by the PSPC, the petitioner may petition again for reinstatement ater two (2) years have elapsed from the date of the denial. CONFIDENTIALITY OF PROCEEDINGS Asa general rule, all disciplinary proceedings are kept confidential with the following exceptions: 4. The misconduct is a clear violation of the law or regulations, 2. The misconduet caused, or has the potential to cause, serious harm to the investment profession or the general public. 3. The violation was the result of a criminal conviction or the barring of a person from acting in a professional capacity in the investment business. 4. The covered person waived confidentiality. 5. Disclosure is required by a legal procedure (such as subpoena) The PSPC may provide the following documents to the covered person's regulators: 4. Stipulation agreements. 2. Notice of Disciplinary Action. 3. Decisions of the Hearing Panel and/or Review Panel 4. Information that is publicly available. 5, __ Information obtained prior to having received it from the covered person. 6. _ Information that the receiving regulator is legally permitted to keep confidential (an ‘example is information that is exempt from the Freedom of Information Act's disclosure requirements) RECORDS Records of all disciplinary proceedings are kept for six (6) years. eury/Becker Educational Development Cop, All nghts reserved 151Level 2, Study Session 1 + Ethical and Professional Standards 1 Stalla Review for the CFA® Exam TOPIGAL STUDIES 1 CORPORATE GOVERNANCE A. INTRODUCTION Corporate governance is the system by which corporations are directed and controlled The typical corporate governance structure involves a board of directors that acts as the overseeing body of the corporation, The board of directors is the direct representative of the shareholders. it has the responsibility of evaluating company performance and making the strategic changes necessary to enhance shareholder value. The board of directors has jegal and fiduciary responsibilities to the shareholders and not the firm's management. Common stock shareholders have the power to influence the management of a corporation through the voting rights that are attached to their common shares. Actively exercising these rights can be an effective way of enhancing portfolio value. The traditional "Wall Street Rule" has been to sell the shares of companies whase managements are not acting as good stewards of shareholder assets. This “rule” is less applicable in a world where indexing and other strategies require portfolios to hold companies simply because they are included in some appropriate grouping. In these situations, common shareholders may have to use their proxy voting rights in an attempt to force managements to operate their companies in ways that will maximize shareholder value. Therefore, the right to vote proxies is a valuable right. When proxies are not voted, or when they are voted without careful analysis of the issues involved, a valuable right is surrendered that can adversely affect the value of portfolios. B. _ FIDUCIARIES RESPONSIBLE FOR VOTING PROXIES The legal owners of the comman shares of a corporation are generally enlitled to vote proxies. In many cases, these legal owners are not the beneficial owners of the shares. in some cases, the legal shareowners designate some other party to be responsible for vating their proxies. Whenever a party other than the beneficial owner of common shares accepts the responsibility to vote proxies, that party becomes a fiduciary and is responsible for carrying out fiduciary duties with regard to the voting process: 4. For trusts, the trustee is the legal owner of shares and is responsible fer voting proxies ‘on behalf of the beneficiaries of the trust. 2. For retirement plans, the investment manager of the plan is deemed to be the responsible party by the Department of Labor (the administrator of ERISA), unless the retirement plan documents specify some other party as being responsible for voting proxies on behalf of the participants and beneficiaries of the plan 3. For managed portfolios, the investment manager often takes on the responsibility of voting proxies for the beneficial owners of the portfolio.Stalla Review for the CFA® Exam Level 2, Study Session 1 + Ethical and Professional Standards 1 G. PROXY VOTING STANDARDS FOR FIDUGIARIES Because the voting right has economic value, fiduciaries who vote proxies on behalf of others must take this duty seriously. To guard against being accused of breaching their fiduciary duties, such parties must adopt procedures to ensure that 4 2. They receive all of the proxies that they are entitled to vote ‘They exercise their voting rights on behalf of their clients (or permit the clients to vote for themselves). The failure fo vote proxies, effectively, surrenders something of value to beneficial shareholders and is a breach of fiduciary duty. They study the issues put before them in proxy statements and make a good-faith due diligence effort to determine how to vote in a way that will be in the best interest of the client, Voting proxies without careful study is a breach of fiduciary duty. tis also a breach of fiduciary duty to use any criterion other than what is in the best interest of the client as the basis for determining what vate to cast The person or group responsible for voting proxies is not influenced by factors other than what is in the best interest of the client. To vote a proxy In a way that benefits some entity other than the cllent or the beneficial ownors of the shares Is a breach of fiduciary responsibility. Records are kept to show that the appropriate proxies were received, that they were voted, that the issues were studied thoroughly, and why it was decided that the vote that was cast was in the best interest of the client. D. RECOMMENDED ELEMENTS IN A PROPER PROXY VOTING POLICY A proper proxy voting policy should contain the following elements: 4 © 2005 Devry/acker Educaticnal Development Corp. Al nhs Designate a competent individual or policy-making body as being responsible for implementing and monitoring @ proxy voting policy. This person or body should: a. Develop specific guidelines regarding the process that should be followed with regard to proxy voting and a regular review process to make sure that the guidelines are followed. b. Identify major proxy issues applicable to each account under management, The major proxy-related issues generally fall within five categories: (1) Corporate governanse issues. (2) Takeover defenses {3) Compensation plans. (4) Capital structure decisions (S) Social responsibility issues. ©. Carefully study the issues that are to be voted upon and determine what vote is in the best interest of the client, participants, or beneficiaries to whom a fiduciary duty is owed, esorced 153Level 2, Study Session 1 + Ethical and Professional Standards 1 Stalla Review for the CFA® Exam d. Affirm and verify that any decision about how to vote a proxy is in accordance with the best interests of the client, participants, or beneficiaries of an account. Sometimes, problems arise with respect to pooled accounts. For example, a retirement fund manager might find that some of the beneficiaries of a pension fund would benefit by casting a proxy vote one way, while others in the same plan ‘would benefit from the oppasite vote. in such cases, the manger must attempt to reconcile the proxy voting policies as much as possible. To the extent that reconciliation is not possible, the manager should consider voting the securities in proportion to the plan's respective interests in the pooled account. 2. Set up administrative procedures that: a. Define who is responsible for actually voting proxies. b. Monitor any delegation of proxy voting responsibility to others. s. Provide for a process to monitor performance of a custodian to ensure timely receipt of proxies. a Avoid or minimize conflicts of interest for those with voting authority. ° Educate and train staff members about proxy voting policies, issues, and the importance of these because of the fiduciary responsibilities that voting on behalf of clients imposes on the management firm. in this regard, each person related to voting proxies should have a copy of the policies and guidelines and an opportunity to discuss them with supervisory staff. Designate specific staff members to receive all proxies, reconcile receipt with holdings lists, trace missing proxies, and distribute proxies to those who vate them = Provide for detailed record keeping that: (1) Reconsiles proxies received with the stock held on the proxy record date, (2) Can quickly trace any missing proxies. (3) Documents how proxies were voted, the rationale of the vote, and the due diligence that was done to reach that rationale, h. Review these procedures, at least annually, to assure they are adequate. If they are not, make the necessary changes. LAWS AND REGULATIONS REGARDING THE VOTING OF PROXIES BY FIDUCIARIES Fiduciaries may come under pressure from supervisors or from corporate managements to vote proxies in ways that benefit their employer, a sponsoring corporation, or the management of a corporation whose proxies are being voted, rather than those to whom they owe a fiduciary duty. A fiduciary responsible fer voting proxies for others should know that there are laws, regulations, and ethical standards that provide support to the fiduciary in dealing with these pressures. Fiduciaries who are pressured to vote proxies in ways that may breach their fiduciary duties should inform those putting pressure on them that attempting to unduly or inappropriately influence a fiduciary inta voting proxies in a way that is not in the best interest of the fiduciary's clients or the beneficial owners may be subjecting themselves to lawsuits, fines, sanction, and/or imprisonment under the following laws, regulations, and ethical standards: 4. ERISA, which enables beneficiaries of, and participants in, qualified retirement plans to sue fiduciaries that breach their fiduciary duties, and to recover both damages and attorney fees. ©: 2005 Devry/tecker Eatucatonal Development Corp. AS rights reservedStalla Review for the CFA® Exam Level 2, Study Session 1 + Ethical and Professional Standards 1 The 1990 Budget Reconciliation Act, which permits the Department of Labor, under ERISA, ta levy penalties up to 20% of the court's judgment of damages in cases involving breaches of fiduciary responsibility The Federal Reserve, the Comptroller of the Currency, and the FDIC, which have regulations involving breaches of fiduciary duty that can be applied to financial institutions under their jurisdiction with regard to proxy voting Standard IV(B.1), which requires members to know, understand, and properly execute their fiduciary responsibilities with respect to proxy voting Anyone voting proxies on behailf of a fiduciary takes on the duties of that fiduciary. i. AIMR SOFT DOLLAR STANDARDS. A. INTRODUCTION 4. Defi Soft dollar arrangements occur when investment managers pay for products, research oF services from brokers with client brokerage (commissions) rather than with their own funds {hard dollars) General Rules Regarding Soft Dollar Arrangements ion of Soft Dollar Arrangements Asa general rule, soft dollar payments to brokers are permitted as long as the product, research, or service obtained by the investment manager helps the manager make Investment decisions that benefit his or her clients. Often, it is difficult to determine whether it is proper to use client brokerage to buy services for the investment manager. Therefore, there is a need for standards in this area AIMR Soft Dollar Standards AIMR has developed a set of voluntary soft dollar standards for investment managers to follow. To claim compliance with these Standards, there are mandatory practices and disclosures that must be followed and recommended practices and disclosures that should be followed, As with all AIMR standards, compliance does not supplant the responsibility to comply with applicable laws. Investment managers should comply with the relevant laws of the countries in which they do business. However, when the AIMR Soft Dollar Standards impose a higher degree of responsibility or disclosure than the local Jaw requires (assuming the Standards do not conflict with focal law), the mandatory provisions of the Standards should be followed if compliance Is being claimed. a. Applicable U.S. Law (1) Section 28(e) of the U.S. Securities Exchange Act of 1934 provides a "sate harbor" for investment managers from claims that they breached a fiduciary duty owed to a client by causing a client to pay higher commissions costs if: (a) _ Inetur for such brokerage, the manager receives research services that help the investment manager make better investment decisions that benefit the client. esorced 155Level 2, Study Session 1 + Ethical and Professional Standards 1 Stalla Review for the CFA® Exam (b) The informed consent of the client is obtained to use the client's brokerage after full disclosure has been given to the client regarding the amount and use of brokerage, providing the transaction does not involve investment funds that are commingled with those of other slients, or funds of a qualified retirement plan. (2) Regulations under the U.S. investment Advisers Act of 1940 require investment managers who are registered with the SEC to provide disclosure to clients regarding their allocation of client brokerage, including whether the receipt of research that helps the manager make investment decisions is a consideration in allocation of brokerage. (3) The USS. Investment Company Act of 1840 governs transactions that apply to investment company assets. It restricts affiliates of mutual funds from receiving compensation as an agent for the sale of the fund's property. (4) Provisions of ERISA apply to any transaction that involves the assets of a qualified retirement plan. These provisions state that a retirement plan is to be operated strictly to provide retirement benefits to beneficiaries and participants. b. Applicable Canadian Law (1) Onrequest, investment managers must disclose to the applicable party the names of the persons or companies who have provided any investment decision-making services to the manager and a summary of the nature of those services paid for by commissions (including principal trades) (2) Amanager may not direct brokerage transactions to a dealer as payment for goods or services provided to the manager, other than for order execution services or investment decision-making services. (3) The offering documents of mutual funds must disclose the actual use of commission dollars, including the names of the persons or companies who have provided any investment decision-making services with a summary of the nature of those services and a best estimate of the aggregate amount of any commissions on brokerage transactions that were directed to dealers since the date of the last offering documents Furthermore, mutual fund managers may not pay dealers for the distribution of shares of the fund by directing brokerage transactions to the dealer or their representative All brokerage must be directed through institutional representatives and not retail representatives. PURPOSE OF THE AIMR SOFT DOLLAR STANDARDS: The AIMR Soft Dollar Standards are intended to ensure: 4 Full and fair disclosure of an investment manager's use of brokerage on behalf of a client. Consistent presentation of information so that the client, broker, and related parties can clearly understand an investment manager's brokerage practices. Uniform disclosure and record keeping to enable an investment manager's client to have a clear understanding af how the investment manager is using the client's brokerage accounts. High standards of ethical practices within the investment industry with respect to the use of brokerage ©: 2005 Devry/tecker Eatucatonal Development Corp. AS rights reservedStalla Review for the CFA® Exam Level 2, Study Session 1 + Ethical and Professional Standards 1 G. PRINCIPLES TO BE FOLLOWED IN MAKING SOFT DOLLAR DECISIONS The AIMR Soft Dollar Standards are based on the following set of fundamental principles that an investment manager should consider when deciding whether or not to pay for services with soft dollars: 4 Brokerage belongs to the client. An investment manager is a fiduciary and, as such, must disclose all relevant aspects concerning any benefit received through a client's: brokerage account Proprietary research and third-party research are to be treated the same in evaluating soft dollar arrangements when the research that an investment manager receives from each is purchased with client brokerage. Research should be purchased with client brokerage only if the primary use of the research, whether a product or a service, directly assists the investment manager in the investment decision-making process (as opposed to the management of the investment firm) AIMIR sets forth a three-level test to help make the determination of whether a product or service can be considered research and, therefore, payable using client brokerage: a Level! Define the product or service that might be purchased with client brokerage. in some cases, the products and services consist of different components that are related only in the ability to assist in the decision-making process (such as a computer work station that runs research software). The investment manager must narrowly define the component parts that are necessary for the products or services to directly assist in the decision-making process. The computer workstation could be considered a closely related component of the product that constitutes the research. However, the electricity needed to run the computer is not closely related and would violate the ethical principles of the AIMR Soft Dollar Standards if paid with client brokerage b. Level ll Determine whether the primary use of the product or service (as defined in the Level / analysis) will directly assist the investment manager in the investment decision-making process. For example, suppose an investment manager subscribes to the Bloomberg service and uses it only to enable people visiting the office to look up the price of securities and analyze market trends. Under the Level | analysis, the manager defines the service as the market data received from Bloomberg, plus the terminal and dedicated line necessary to receive service. Under the Level I! analysis, the investment manager does not use the Bloomberg service to directly assist in the investment decision-making process. Rather, it is used to benefit the firm. Therefore, the Bloomberg service could not be paid for with client brokerage c. Level Ill Use “mixed-use analysis" for products and services that partially help the manager make investment decisions and partially serve other functions. esorced 157 went Coep. al nightsLevel 2, Study Session 1 + Ethical and Professional Standards 1 Stalla Review for the CFA® Exam Ifa product or service has "passed" the Level | and Level II tests, the third step is to determine whether it is used exclusively to help the manager make investment decisions, or if a portion of the product or service is used for other purposes. Ifa portion of the product or service is used directly to assist in the investment decision-making process and a portion is not, the investment manager must consider the product or service "mixed-use." With mixed-use products and services, only the portion used directly to assist in the decision-making process may be paid for with client brokerage. The rest must be paid with hard dollars 4. When in doubt, services should be paid for with investment manager assets (hard dollars), rather than with client brokerage (soft dollars). AIMR SOFT DOLLAR STANDARDS Remember, the AIMR Soft Dollar Standards are voluntary. Members have to comply with the mandatary requirements only if they claim compliance with the Standards. 4. General Principles The AIMR Soft Dollar Standards apply to all members’ proprietary and third-party research arrangements, They are based on two fundamental principles: * Brokerage is the property of the client ° The investment manager has an ongoing duty to ensure the quality of transactions affected on behalf of its clients, including: (1) Seeking to obtain the best execution for trades (2) Minimizing transaction costs. (3) _ Using client brokerage to benefit the client and not the manager. a. Required Practice (1) Aninvestment manager involved in soft dollar arrangements must always act for the benefit of his or her clients and place clients’ interests before his ‘or her own. (2) Aninvestment manager may not allocate a client's brokerage based on the amount of client referrals the manager receives from particular brokers (for mutual funds, the fund's board establishes the policies with respect to the use of certain brokers), 2 Relationships with Clients a. Required Practice The investment manager must disclose to clients that it may engage in soft dollar arrangements involving the client's account before engaging in such an arrangement. b. Recommended Practice The investment manager should ensure that, over time, all clients receive the benefits of research purchased with client brokerage. (1) _ tis permissible for the investment manager to use a client's brokerage derived from agency trades (trades involving a commission) to obtain research thal may not directly benefit that particular client al the time of the trade, However, the investment manager should try to ensure that, over a reasonable period of time, the client receives the benefit of research purchased with other clients’ brokerage. ©: 2005 Devry/tecker Eatucatonal Development Corp. AS rights reservedStalla Review for the CFA® Exam Level 2, Study Session 1 + Ethical and Professional Standards 1 (2) For principal trades (trades involving a discount or spread), the investment manager should determine if the particular principal trade is subject ta certain fiduciary requirements that require client brokerage that is derived to benefit the client account generating the brokerage. If such requirements do not apply, it is permissible to use client brokerage derived from principal trades to benefit client accounts other than the account generating the brokerage, as long as the investment manager discloses this practice and obtains prior consent from the clients who are affected. Certain fiduciary statutes may require the brokerage derived from a principal trade to directly benefit the client account generating the trade. In such situations, even consent by the client will not waive this legal requirement 3. Selection of Brokers Selecting brokers to execute clients’ securities transactions is a key component of the investment manager's ability to add value to its client portfalios. The failure to obtain best execution (for the value received) may result in impaired performance for the client a. Required Practice In selecting brokers, the investment manager must consider the capabilities of the broker to provide best execution (most favorable total cost for the service received at the time of a trade). b. Recommended Practice In evaluating a broker's capability to provide best execution, the investment manager should consider the broker's responsiveness to the investment manager, the commission rate or spread involved, and the range of services offered by the broker. 4. Evaluation of Research a. Required Practice (1) (2) In determining whether to use client brokerage to pay for research, the investment manager must use the following criteria: {a) The research should fall under the definition of research that helps the investment manager make investment decisions. (b) The research should benefit the manager's client(s) {c) The manager should be able to document the basis for the above determinations, (d) The research should directly benefit the client under certain fiduciary regulations regarding principal trades. If the principal trades are not subject to such regulations, the research may benefit client accounts other than those generating the trade if the investment manager has disclosed this and obtained prior client consent Ifit cannot be determined and documented that research meets the above criteria, then the investment manager cannot pay for such research with client brokerage; the manager must pay for the research with its own funds. esorced 1-59 went Coep. al nightsLevel 2, Study Session 1 + Ethical and Professional Standards 1 (3) Stalla Review for the CFA® Exam Sometimes, investment managers obtain mixed-use research (services andlor products that are used for both the investment decision-making process and other purposes). In this case, the manager should make an effort to determine what percentage should be paid with client brokerage and what percentage to pay with the manager's awn funds. Under these conditions, the investment manager must: (a) tb) te) Be able to make a reasonable, justifiable, and documentable allocation of the cost of the research according to its expected usage Pay with client brokerage only the portion of the research that is actually used by the investment manager in the investment decision- making process. Re-evaluate the mixed-use research allocation at least annually. Client-Directed Brokerage Because brokerage is the property of the client and not the investment manager, the practice of allowing the client to direct to whom brokerage is to be paid does not violate any fiduciary duties of the manager. Required Practice ina client-directed brokerage arrangement, the Investment manager must not use brokerage from another cifent account to pay for a product or service purchased under the client-directed brokerage arrangement. Recommended Practice The investment manager should disclose to the client: (1) (2) a) {o) The investment manager's duty to seek best execution on trades. Arrangements that require the investment manager to commit a certain percentage of brokerage in a particular manner that may affect the investment manager's ability to obtain best execution and/or to obtain adequate research, Structure the client-directed brokerage arrangement as follows: a) {b) (c) (a) fe) When directed by a fiduciary the investment manager should receive written assurance from the fiduciary that the client-directed brokerage arrangement will solely benefit the client's account Try to limit the percentage of the total brokerage that is paid to a single broker. Negotiate commissions and seek out best execution. Request from clients in any client-directed brokerage arrangement written instructions that: (1) Restate the investment manager's continuing responsibility for seeking to obtain best execution (2) List the eligible brokers. (3) Specify the approximate target percentage or dollar ammount of transactions to be directed. (4) State procedures for monitoring the arrangements. The investment manager should regularly communicate with the client for the purpose of jointly evaluating the client-directed brokerage arrangements °Stalla Review for the CFA® Exam Level 2, Study Session 1 + Ethical and Professional Standards 1 6. Additional Disclosure Terms a. Required Practice (1) (2) @) An investment manager must clearly disclose its policies with respect to all soft dollar arrangements to clients and potential clients. To claim compliance with the AIMR Soft Dollar Standards for a given client account, an investment manager must provide the client, at least annually, with a statement that any soft dollar arrangements with respect to the client's account are in compliance with the AIMR Soft Dollar Standards An investment manager must prominently disclose to its clients, in writing, that additional information concerning the investment manager's soft dollar arrangements is available on request. The additional information should include detailing the soft dollar arrangements: (a) Ona firmwide basis: A description of the products and services that were received from brokers (and identity of the brokers) due to soft dollar arrangements, regardless of whether the product or service was from proprietary or third-party research arrangements. (b) For a specific client account: The total amount of commissions generated from that client through a ‘soft dollar arrangement and the total amount of brokerage directed by that client through directed brokerage arrangements. (c) _ Forclient-directed brokerage: The aggregate percentage of the investment manager's brokerage derived from client-directed brokerage arrangements and the amount of the individual client's directed brokerage as a percentage of the aggregate. Note that the investment manager is not obligated to report client- directed brokerage that constitutes less than ten percent of the manager's client-directed brokerage aggregate. b. | Recommended Practices and Disclosures When requested by a client, an investment manager should (1) (2) Provide a description of the product or service obtained through brokerage generated from the client's account, Provide the aggregate dollar amount of brokerage paid from all accounts over which the manager has investment discretion 7. Record Keeping a. Required Practice The investment manager must maintain all records that: (4) 2) (3) Are required by applicable law. Are necessary to supply clients with the information required by the AIMR Soft Dollar Standards. Document arrangements, oral or written, obligating the investment manager to generate a specific ammount of brokerage. esorced 1-61 went Coep. al nightsLevel 2, Study Session 1 + Ethical and Professional Standards 1 Stalla Review for the CFA® Exam 4) 6) Document the basis of allocation in determining the use of client brokerage to pay for any portion of a mixed-use service or product. Show compliance with the AIMR Soft Dollar Standards and identify the personnel responsible for determining compliance, 8 ACase Example of How to Apply the AIMR Soft Dollar Standards a The Case Henry, an AIMR member and investment manager at Top Firm, seeks to comply with the AIMR Soft Dollar Standards. Henry manages a variety of accounts: (1) (2) (3) 4) Separate accounts, including accounts of employee benefit plans subject to ERISA, accounts of non-ERISA institutional investors, and accounts of wealthy individuals; Several collective investment vehicles, including a group trust for employee benefit plans subject to ERISA; A hedge fund for institutional and other “sophisticated” individual investors; and Three SEC-registered investment companies, including an equity fund, a fixed-income fund, and a money market fund. Henry executes trades for the firm's client accounts with several broker-dealers who conduct trades on both a principal and agency basis. Some of the broker- dealers have offered to provide Henry with the following products and/or services to be paid for with Henry's client brokerage from trading transactions (1) (2) (3) @) Desks and office equipment Trading room television sets that receive the Financial News Network and other financial news services supplied by cable and satellite service. Bloomberg service that includes a terminal. Software that will assist Henry in analyzing economic trends in the industries followed by the firm, plus widely available computer stations to install and operate the software. In addition, Henry has received the following requests from clients: 6) 6) @) (6) The trustees of a pension fund that is subject to ERISA and managed by Henry, has requested that a portion of the brokerage from its account be directed to a given broker to obtain research information that will be used, personally, by the plan trustees, for purposes that are unrelated to the pension fund. ‘A public pension plan has requested that Henry direct a portion of its brokerage to a given broker in return for cash credits to be paid to the plan. Anon-ERISA institutional investor in Henry's hedge fund has requested that Henry direct a portion of the hedge fund's brokerage to a given broker to compensate that broker for research services provided to the institutional investor, The SEC-registered investment companies have requested that Henry direct a portion of the equity fund's brokerage to a given broker in return for credits to be used to reduce or eliminate all of the registered investment companies’ custodian fees. ©: 2005 Devry/tecker Eatucatonal Development Corp. AS rights reservedStalla Review for the CFA® Exam Level 2, Study Session 1 + Ethical and Professional Standards 1 b. Analysis of the Proposed Transactions from the Point of View of the AIMR. Soft Dollar Standards (1) 2) 3) 4) 6) Henry should analyze the proposed transactions with respect to the standards that apply to all AIMR members (which includes analyzing the proposed transactions with respect to all applicable laws and regulations) and also with respect to the AIMR Soft Dollar Standards. Standard | of the AIMR Standards of Professional Conduct requires that a member be familiar and comply with all applicable laws governing their professional activities. Only those transactions that comply with local laws are eligible for subsequent analysis under the AIMRt Soft Dollar Standards. Assuming the proposed transactions comply with local laws and regulations, and they are allowable under AIMR’s Standards of Professional Conduct, they must still comply with the provisions of AIMR Soft Dollar Standards for Henry to act on them and claim compliance with the AIMR Soft Dollar Standards. In selecting a broker, the AIMR Soft Dollar Standards require that Henry consider the capabilities of the broker in providing best execution After determining a broker can provide best execution, Henry must evaluate the eligibility of any products and/or services for soft dollar payment. (a) Transaction 1: Using client brokerage to pay for desks and office equipment. Desks and office equipment do not qualify as research as defined by either the Soft Dollar Standards, the safe harbor provision of the Securities and Exchange Act of 1934, or Canadian law. Furthermore, ERISA requires fiduciaries to act solely in the interest of the plan's beneficiaries and for the exclusive purpose of providing benefits to the plan's beneficiaries, This is not likely to be the case in Transaction 1. Therefore, Henry could not engage in Transaction t and claim compliance with the AIMR Soft Dollar Standards. (b) Transaction 2: Using client brokerage to pay for trading room television sets. While a Jegal argument could be made that trading room television sets help Henry make better investment decisions (instant access to breaking news and analyses), the AIMR Soft Dollar Standards are more strict and, therefore, gover this transaction. Accordingly: (1) _ Ifthe primary use of the televisions directly aids Henry in his investment decision-making process, then Transaction 2 qualifies as research and could be paid for with client brokerage. (2) Ifthe television sets are not used offen, are used to watch the Jerry Springer Show, are for clients’ use, and so forth, then the service does not qualify as research and cannot be paid for with client brokerage (3) _ Ifthe televisions are used for both investment decision-making and other activities, Henry must make a good faith determination about what portion of the service is actually used in the investment decision-making process. Only this portion ‘can be paid for with client brokerage esorced 1-63Level 2, Study Session 1 + Ethical and Professional Standards 1 (c) (4) fe) (f) Stalla Review for the CFA® Exam Transaction 3: Using client brokerage to pay for Bloomberg service. While legally permissible because a case can be made that the Bloomberg service helps Henry in the decision-making process, the AIMR Soft Dollar Standards govern this situation because they are stricter. Accordingly: (1) fused primarily to make investment decisions, Transaction 3is allowable for soft dollars (2) IFthese services are used primarily for clients to access financial information (or other scenarios), Transaction 3 would not be eligible for soft dollar payment (3) _ Ifthe Bloomberg service is mixed-use, then a determination must be made about what portion is used to directly assist in the investment decision-making, and that portion is eligible for soft dollar payment Transaction 4: Using client brokerage to pay for software and computer stations. Depending on what the software is actually used for, Transaction 4 might be fully or pastially paid with soft doliars, or soft-dollar payment might not be permitted under the AIMR Soft Dollar Standards Transaction 5: Using fiduciary-directed brokerage to buy services that benefits the fiduciary. The AIMR Soft Dollar Standards require that Henry must not use brokerage from one client account to pay for a product or service purchased under another client's client-directed brokerage arrangement, A fiduciary must understand who is the client. Brokerage is the property of the beneficiaries and participants of a qualified retirement plan or trust and not the trustee or the fiduciary representing the beneficial owner(s). Therefore, even though the brokerage is “client. directed” in the sense that the trustee of the retirement plan requested the services be bought with soft dollars, the investment manager must look to whether or not these services benefit the ultimate client (the beneficiaries and participants of the retirement plan). Since, the services benefit the plan's trustee and not the beneficiaries or participants of the plan, these services cannot be purchased with soft dollars under the AIMR Soft Dollar Standards. This transaction would also violate ERISA provisions Canadian law would also prohibit this transaction because the services are for the trustees! personal benefit and not for the benefit of the beneficiaries or participants of the retirement plan Consequently, Transaction 5 is not permissible ‘Transaction 6: Directing of brokerage by a public pension plan to obtain cash credit for the plan. Transaction 6 is a permissible client-directed brokerage arrangement because the client brokerage would be used to generate cash credits that solely benefit the plan (hence its beneficiaries and participants)Stalla Review for the CFA® Exam Level 2, Study Session 1 + Ethical and Professional Standards 1 (6) (g) Transaction 7: Directing a hedge fund's brokerage to compensate a broker for research provided to one Investor In a commingled Investment fund. The hedge fund is a commingled poo! containing numerous investors. In this case, Henry's "client" is all of the investors in the pool, Henry cannot purchase a product or service for one cifent using the brokerage from another client. Since the research reports benefit ‘only the one institutional investor and not all of the investors in the hedge fund, Transaction 7 in not permissible. (h) Transaction 8: Three separate funds, each benefiting from directing a portion of one funa's brokerage. Each registered fund is a distinet client. Some clients cannot benefit from other clients’ client-directed brokerage and, therefore, Transaction 8 is not permitted under the AIMR Soft Dollar Standards. In addition, Transaction 8 is prohibited by sections of the Investment Company Act of 1940 that prohibit joint transactions among affiliated funds Since all of the funds benefit to some degree, this transaction might be allowable under Canadian law. However, if Henry isa member, the stricter AIMR Standards have to be applied and Transaction & would not be permitted. In addition to these considerations, Henry must also meet specific disclosure and record-keeping obligations set forth in the AIMR Soft Dollar Standards if he wants ta claim to be in compliance with the AIMR Standards of Practice. esorced 1-65 went Coep. al nightsLevel 2, Study Session 1 + Ethical and Professional Standards 1 Stalla Review for the CFA® Exam PRUDENGE IN PERSPECTIVE 1 INTRODUCTION The following section is a summary of “Prudence in Perspective” by John Train and Thomas A. Melfe. This article discusses the old Prudent Man Rule and the new Prudent Investor Rule. A, THE OLD PRUDENT MAN RULE The principle of the old Prudent Man Rule was first enunciated by Judge Putnam in the 1830 Massachusetts case of Harvard College v. Amory. The issue in the case was whether a trustee (Amory) should be obliged to replace losses in a trust that were incurred while the trust was managed by the trustee. In ruling in favor of the Trustee (Amory), the judge stated, in effect, that compliance with fiduciary duties should not be based on hindsight or the results obtained from investment decisions; investment losses do not (ipse facto) constitute praof that a trustee has incurred a legal liability Do what you will, the capital is at hazard. All that can be required of a trustee is that he shall conduct himself faithfully and exercise sound discretion. He is to observe how men of prudence, discretion, and intelligence manage their own affairs, not in regard to speculation, but in regard to the permanent disposition of their funds, considering the probable income, as well as the probable safely of the capital invested, For the following 160 years, this “rule of prudence" governed the behavior of trustees with respect to managing trust assets. Los 1.4, Explain the general fiduciary standards to which a trustee must adhe Over time, legal precedents and legislation defined the basic fiduciary duties of trustees. These basic duties require a trustee to act with: 4. Loyalty, which means a trustee should be free from conflicts of interest with respect to trust management and act solely in the interests of the beneficiaries of the trust. 2. Prudence, which requires trustees to handle trust matters with: a. Gare, which means a trustee should (1) Obtain relevant information on the circumstances and requirements of a trust and its beneficiaries. (2) Understand the content and resources of the trust. (3) Understand available investment choices. (4) Seek the advice of experts. b. Skill, which requires a trustee who possesses an expertise in the management of assets to apply that knowledge and understanding to the management of the trust's affairs. While a person of ordinary intelligence can be a trustee, ifa trustee does not have investment expertise, he or she should seek the advice of experts. ¢, Caution, which means that trust funds should be invested with the primary view of safety with regard to the principal and to eam a reasonable retum within the confines of the risk level that can be toleratedStalla Review for the CFA® Exam Level 2, Study Session 1 + Ethical and Professional Standards 1 There are two aspects of trust management, both of which must be carried out with care, skill, and caution: + Administrative prudence, which deals with such matters as: (1) The safekeeping of trust assets, (2) Distributing trust income and principal (3) Maintaining trust records (4) Providing timely information to beneficiaries (6) Treating trust beneficiaries impartially. + Investment prudence, which requires a trustee to: 1) Establish suitable trust investment objectives. 2) Select investments with care and diligence ( ¢ 3 ( ) Select an appropriate level of risk tolerance. (4) Select investments that are suitable for the trust. (5) _ Diversify trust holdings ) Hold assets that meet the trust's liquidity needs. ( (6 (7) Seek expert investment advice when needed. (8) _ Invest for the benefit of all trust beneficiaries. 3. Impartiality, which means a trustee must give equal consideration to the interests of a trust's income beneficiaries and remaindermen Often, there is an inherent conflict between these two classes of trust beneficiaries. ‘The income beneficiaries usually want high current income (which comes at the expense of sacrificing long-term capital growth), while the remaindermen want high long-term capital growth (which cores at the expense of sacrificing current income). The trustee must manage the trust in a way that reaches some fair compromise between these two positions. One way to de this is to distribute 4-5% of the three-year average value of the trust's capital every year to the income beneficiaries. The development of trust law under the Prudent Man Rule produeed many problems over time, Some important problems included + Certain investments (futures and options, non-dividend paying common stocks, and the use of margin) were deemed by the courts and the legislatures to be imprudent by their very nature. This limited trustees from pursuing certain strategies (such as portfolio insurance) + Trustees could ask for advice from experts, but they were not permitted to delegate investment decision-making responsibilities to those experts. This precluded trustees from investing trust assets in mutual funds because it left the investment decisions to someone other than the trustee « Every investment, standing alone, had to be prudent. This precluded trustees from investing in index funds because some securities in the index might be imprudent on a ‘stand-alone basis. Asa result of these problems, a new Prudent Investor Rule has gradually evolved that preserves many of the good features of the old Prudent Man Rule, but incorporates new features that are more in harmony with modern theories of portfolio management eury/Becker Educational Development Cop, All nghts reserved 1-67Level 2, Study Session 1 + Ethical and Professional Standards 1 Stalla Review for the CFA® Exam THE NEW PRUDENT INVESTOR RULE Los 1.4. State the five basic principles of the New Prudent Investor Rule. Anew Prudent Investor Rule is embodied in the Uniform Prudent Investor Act (also called the Model Act), This Act has been adopted, in whole or in part, by many states and jurisdictions inthe U.S., and appears to be the wave of the future with regard to the law of trusts. It gives more latitude to trustees than did the old Prudent Man Rule with respect to making investment decisions. The new Prudent Investor Rule contains five basic principles: 4 Diversification is fundamental to minimizing risk. Therefore, trust investments must be diversified unless there is a compelling reason nat to do so. The risk tolerance of a trust must be determined. This is because return and risk are interrelated. Trustees have a duty to determine how much risk a trust can tolerate, and manage the trust funds so as not to exceed that level of risk. Trustees have a duty to incur only those expenses that are reasonable and Justifiable. It is a violation of a trustee's fiduciary duty to subject a trust to unreasonably high and/or unjustifiable transaction costs, fees, and other expenses The fiduciary duty of Impartiality requires trustees to consciously reach a fair compromise between the confllcting objectives of current income for the Income beneficlarles and long-term capital growth for the remaindermen. Trustees have the authority and duty to delegate specific responsibilities to experts, when they lack the expertise themselves. Those aspects of the old Prudent Man Rule that have stood the test of time have been retained in the new Prudent Investor Rule, while thse aspects that praved to be detrimental and not worthwhile to effective trust management have been replaced. Los 14d Discuss the general fiduciary standards carried over from the old Prudent Man Rule to the new Prudent Investor Rule, The general fiduciary standards that have been carried over from the old Prudent Man Rule to the new Prudent Investor Rule include: 4 Trustees must adhere to the general fiduciary duties of a. Loyalty. b. Prudence (exercising care, skill, and caution with respect to administrative and investment activities). c. Impartiality. While the requirements of loyalty and impartiality are essentially the same under the new Prudent Investor Rule as under the old Prudent Man Rule, what exactly constitutes care, skill, and caution is interpreted differently under the new Prudent Investor Rule. In any event, a trustee who claims expertise in trust administration and/or investment has a duty to use that expertise in managing the trust. Compliance with these fiduciary duties is judged by the facts and circumstances ling at the time the decisions were made or the activities were carried out. Legal ies are not proven on the basis of hindsight, subsequent developments, or the outcome of a decision. The standard of prudence is relational; in other words, a professional trustee who claims special expertise in trust administrative or investment matters is held to a higher standard than an amateur trustee who makes no such claimStalla Review for the CFA® Exam Level 2, Study Session 1 + Ethical and Professional Standards 1 4. The terms of the trust dictates whether the Rules apply to investments. Trustees can make investments that are specifically authorized by the trust documents. The terms of the trust control the investment duties of trustees, even if they differ from the Rule, so long as they do not conflict with the law. 5. The trustee of a new trust, or an ald trust to which new assets are being added, or a successor trustee, should review the assets in the trust immediately and assess whether or not the assets in the trust are suitable for it. Those assets that are not suitable should be sold SUMMARY OF THE DIFFERENCES IN THE TWO RULES LOS t.4.e Differentiate between the old Prident Man Rule and the new Prudent Investor Rule from the perspectives of individual investments, total portfolio, and delegation of duty Even though there are some similarities between the old Prudent Man Rule and the new Prudent Investor Rule, there are also a substantial number of differences. The following table illustrates the important differences between the old and new Rules: Old Prudent Man Rule New Prudent Investor Rule Regarding individual Investments: Under “legal list” statutes, certain investments (such as speculative grade, derivative, and non-income producing securities) and certain investment strategies (such as buying on margin and strategies employing derivatives) are inherently imprudent and are unsuitable for trusts. The prime directive is to preserve the nominal principal of the trust, to avoid large losses, and to eam an income that is reasonable, within the confines of preserving the nominal principal. Regarding Individual Investments: No investment or investment strategy is inherently imprudent. Prudence depends more on the process that is used to arrive at an investment decision than on the decision itself. A trustee can invest in anything or use any strategy that is deemed to be appropriate to achieve the risk/retum objectives of the trust, as long as this determination is made by a process in which care, skill, and caution were exercised. Indeed, the trustee is required to develop an overall strategy designed to achieve the expected distributions to beneficiaries and to do so with a proper regard for the risk level that is suitable for the trust and the return that is reasonable for that level of risk tolerance The prime directive is to preserve the real value of the principal of the trust and pravide a reasonable return given the risk that the trust can tolerate. In this context, return is defined as a total return (income and capital appreciation). If the trust's risk objective is high, a reasonable return might be one that should produce an increasing real value of the Principal eury/Becker Educational Development Cop, All nghts reserved 1-69Level 2, Study Session 1 + Ethical and Professional Standards 1 Stalla Review for the CFA® Exam Old Prudent Man Rule New Prudent Investor Rule Every investment in the trust, standing alone, | The portfolio as 4 whole must be managed must meet the test of prudence. Atrustee is | prudently. Individual investments are nat legally liable for losses incurred ona single | prudent or imprudent in isolation; their imprudent investment within a trust, prudence is judged by the role that they play regardless of the overall performance of the —_| in enabling the portfolio to meet the risk/retumn trust portfolio, objectives of the trust Regarding Total Portfolios: Regarding Total Portfolios: The portfolio is simply a collection of individual | The portfolio as a whole must be managed assets, each of which must be prudent in its | prudently. The trustee must determine the ‘own right. The law looks to the individual riskireturn objective of the trust and manage assets, not to the overall porffalio, in judging | the portfolio so that its risk approximates its prudence. risk abjective and its return is reasonable for the level of risk. ‘Taking undue risk is to be avoided by not Risk cannot be avoided, but it can be investing in risky assets. managed. Careful attention should be given to determining a trust's risk tolerance (defined as the ability to accept return volatility) Trustees have the affirmative duty to assess the trust's risk tolerance and to actively manage the retum/tisk trade-off. While there is no general legal standard for setting the appropriate level of risk tolerance, trustees must make a reasonable effort to determine how mush risk should be tolerated based on the purpose of the trust. The types of investments that are suitable for the trust should be basedon its risk tolerance and the degree to which risk can be reduced by diversification Because of the central role it plays in optimizing the return/tisk trade-off diversification is elevated to a fiduciary duty. Diversification is required to manage a trust portfolio effectively, unless there is a compelling reason for not diversifying (such as a large block of very low-cost stock is held in the trust and the tax implications of selling it outweigh the benefits of diversification). A trustee can only incur costs that are appropriate and reasonable. There is an obligation to compare agent fees and brokerage commissions. However, the obligation is to contro! costs to obtain the best benefits per unit of cost incurred, not to obtain the lowest cost. Trustees, therefore, should perform a costibenefit analysis to determine which agents and brokers offer the best overall value to the trust. This rule applies to agents, brokers, vendors, and trustee fees themselves. 1-70 ©: 2005 Devry/tecker Eatucatonal Development Corp. AS rights reservedStalla Review for the CFA® Exam Level 2, Study Session 1 + Ethical and Professional Standards 1 Old Prudent Man Rule New Prudent Investor Rule Regarding Delegating Authority: Investment decisions may not be delegated; they must be made by the trustee, although the trustee may seek the advice of investment experts. eury/Becker Educational Development Cop, All nghts reserved Regarding Delegating Authority: in some instances, the trustee has a duty to delegate administrative andor investment authority to agents (an example is where the trustee does not have sufficient investment expertise and, therefore, employs an investment manager). However, the trustee has the duty to exercise appropriate care, skill, and prudence when * Selecting agents * Establishing the scape and terms of the delegation of authority to agents. * Periodically reviewing the agents’ actions. LT.Level 2, Study Session 1 + Ethical and Professional Standards 1 Stalla Review for the CFA® Exam NOTES 172 (© 2008 Devry/tecker Educatonal Development Corp. AN rights reserved.Stalla Review for the CFA® Exam Level 2, Study Session 1 + Ethical and Professional Standards 1 KEY POINTS The Code and Standards The four components of the Cade of Ethics are: 1) act with integrity; 2) be a credit to the profession; 3) strive to maintain or improve competency; and 4) use reasonable care and exercise independent professional judgment, ifthe applicable laws, rules and regulations of a jurisdiction are stricter than the requirements of the Code and Standards, you must adhere to the applicable laws, rules, or regulations of that jurisdiction; otherwise you must adhere to the Code and Standards. The Code and Standards serve as the minimum requirements in any investment jurisdiction ‘A member cannot imply a partial designation for passing Level I, Level !! or Level Ill of the CFA exam. For example, if you recently passed the Level ll CFA exam, you should not put on your resume that you are 4 "CFA ||", In addition to committing a felony, repeated convictions of minor offenses (misdemeanors) constitute a violation of the Professional Misconduct Standard member should acknowledge the saurce of outside material used in research reports, with the exception of information used from recognized financial and statistical reporting services (such as Standard and Poors and Moody's Investor Service) ‘A member must inform their direct supervisory in writing about his or her obligation to comply with the Code and Standards. The member should deliver a copy of the Code and Standards to their supervisor unless informed that the employer already has a copy of the Code and Standards. Amember may enter into independent practice while currently employed as long as the member has written consent from both their employer and the outside entity, While employed it is acceptable to make arrangements to go into another business that could result in compensation, as long as the member does not breach his or her duty of loyalty to their current employer. The member must disclose any potential conflict of interests to their employer including owning stocks that are analyzed or recommended, participation in autside boards, and any special relationships with the senior management of the company. Any directive by the employer regarding the actual or potential conflict of interest must be complied with by the member employee. A direct supervisor must establish and implement reasonable procedures to detect and prevent violations of the Cade and Standards. A member with supervisory responsibility must bring an inadequate compliance procedure to the attention of the firm’s senior management. {f no action is taken, the supervisor member should decline in writing to accept supervisory responsibility until adequate compliance procedures are established by the firm When a member provides an investment recommendation or takes investment action, the member must have a reasonable and adequate basis supported by appropriate documented research and investigation. For all or part of the background information, a member can depend on reliable sources both within and outside a member's firm. Always distinguish between fact and opinion in research reports. ‘A member should avoid situations that might cause or be perceived to cause a loss of independence or objectivity in recommending an investment or taking investment actions. Receiving modest gifts (less that $100 value) may be acceptable as lang as the member does not come under any pressure to act in a way that could hinder other clients, esorced L73 went Coep. al nightsLevel 2, Study Session 1 + Ethical and Professional Standards 1 Stalla Review for the CFA® Exam Investment actions need to be carried out for the sole benefit of the client, with the best interests of the client in mind considering the client's investment policy and investment experience. An investment manager's fiduciary responsibilities to a client include a duty of loyalty and a duty to exercise reasonable care in taking investment actions. * Members should not make an investment recommendation or take an investment action unless they reasonably determine that it is suitable to the client's financial situation, investment experience and investment objectives (policy) * Care should be taken so that prospects and clients are treated fairly when disseminating investment recommendations or taking investment action. The term “fairly” does not state "equally" because members could not possibly reach all clients simultaneously. However, members should avoid practices that will discriminate against one client group in favor of another. « Clients and employers have priority over transactions in which the member is a beneficial owner, as. the member's personal transactions should not operate adversely to the clients or employer's interests. A member must avoid acting too fast an trades, before giving clients and the employer sufficient time to act on buy/sell recormmendations. * Amember should not make any oral or written statements that misrepresents the investment services that they or the firm can perform, as well as the member or member firm’s professional credentials or qualifications. Members should never provide a guarantee of investment performance results. + Amember should disclose any potential conflict of interest to their client or prospect including when a member serves on a firm's board of directors, the member has a material ownership in the stock being analyzed, and when the member's firm performs consulting services, underwriting transactions or broker/dealer market activities for the company/investment in consideration * _Amember that possesses material nonpublic information should not take an investment action (trade) if such activity would breach a fiduciary duty, was misappropriated or relates to a tender offer. A perceptive analyst that uses material public information and nonmaterial nonpublic information to reach an investment conclusion (the Mosaic Theory) does not violate Standard V (A), the Prohibition against Use of Material Nonpublic Information * Standard V (B), Performance Presentation, encourages full disclosure of reporting investment performance results to clients and prospects. Although it is recommended that members adopt either the CFA Institute Performance Presentation Standards or the Global Investment Performance Standards, it is not required to be in compliance with Standard V (B). However, if claim compliance with either of these voluntary Standards, the investment firm must be in full compliance with all mandatory requirements ar will violate Standard V (B) * Acovered person may be subject to disciplinary sanctions for: 1) violating the Code and Standards and other bylaws or rules; 2) an authoritative agency imposing disciplinary sanctions; 3) being convicted of or pleading guilty to a felony; 4) being permanently or indefinitely barred from registration or participation as a professional under security laws; 5) the failure to complete, sign, and return the annual professional conduct statement; 6) falsifying information on CFA candidate or membership applications; and 7) any just cause including a failure to cooperate with a CFA Institute investigation regarding a covered persan's conduct. * The types of disciplinary sanctions that may be imposed on a member include a private or public censure, a timed suspension of either membership or the right to use the CFA designation, a revoeation of either membership or the right to the use the CFA designation, a summary suspension, and the suspension or revocation from the further participation in the CFA designation study and examination program,Stalla Review for the CFA® Exam Level 2, Study Session 1 + Ethical and Professional Standards 1 Topical Studies * Proxies have economic value and must be voted in the interest of the ultimate shareholder or plan beneficiary. The failure to vote proxies or to vote proxies without careful analysis can adversely affect the value of a client's portfolio and results in a breach of a member's fiduciary duty. * Generally, soft dollar payments to brokers are permitted as long as the product, research or service obtained by the investment manager aids the manager in the investment decision process that benefits the member's clients. * Determining what constitutes research under the Soft Dollar Standards is determined based on a three-level approach as follows: Level | defines the product or service that constitutes the research; Level II attempts to determine whether the primary use of the research directly assists the investment manager in the investment decision-making process; Level II actually determines which portion of the mixed-use research may be paid for with elient brokerage (include only that portion that is used directly by the investment manager to assist in the decision-making process and disallow the pertion that only helps in the overall management of the investment firm) Prudence In Perspective «= The three basic fiduciary duties of trustees include loyalty, prudence and impartiality. + The five principles of the New Prudent Investor Rule are: 1) diversification as a means to minimize risk; 2) determine the risk tolerance of a trust; 3) trustees should only incur expenses that are reasonable and justifiable; 4) trustees must reach an impartial compromise between the current income objectives of the income beneficiaries and the long-term capital growth objectives of the remaindermen; and 5) when the trustees lack specific investment expertise, they have the duty and authority to delegate these responsibilities. * Under the New Prudent Investor Rule the standard of prudence applies to the entire portfolio (trust) rather than a specific investment. An individual investment may on a stand-alone basis be deemed risky, but if in a portfolio context reduces the risk of the trust's portfolio it may be an acceptable investment. This differs from the Old Prudent Man Rule that looks at individual investments on a stand-alone basis (anly) 2005 OeUry/Backer Educational Development Carp. All ights reserved LTS