Level 1 CFA® Exam Ethics, Standard I (B)
Standard I (B) is about how to maintain the professional qualities of independence & objectivity if you work for example as an analyst or a portfolio manager.
CFA members and candidates practicing the financial profession should by all means necessary strive to preserve their independence & objectivity.
To ensure that their research or investment recommendations or any other investment actions are free of bias, financial professionals should not accept gifts or any additional compensations for their work. Such benefits may influence or may be perceived to influence independence & objectivity.
As a CFA member or candidate, you must always ask yourself whether a given act of consideration may be perceived as compromising your behavior and whether it may be detrimental to your clients and your reputation. If the answers to these questions are positive, you should reject such a benefit.
Possible Sources of Pressure
- Client
Sometimes your clients may try to influence your decisions and your actions. Imagine that a company wants you to produce a recommendation because it is about to announce a new issuance of stock. The company hopes to receive a positive recommendation even though the shares are rather a bad investment. When making the recommendation you should maintain your independence & objectivity and not allow your client to persuade you to act against your judgment.
- Employer
You may also find yourself being pressed by your employer, who may want you – for example – to tend to the interests of some influential clients more than to the interests of the other clients. To maintain your independence & objectivity, you should not agree to such a thing.
- Other
The sources of possible pressures or biases are numerous. Even, information obtained during seminars or conventions that you attend may bias your professional decisions. You have to be aware of such situations and reject those that can have an adverse effect on your professional work.
Modest Gifts
So, what would you do if your client (an individual, and not a corporation) wanted to give you something? Let’s say that your client is a manufacturer of dolls and he wants to give you a doll so that you could present it to your daughter. This way he wants to appreciate your job.
Will you accept the doll?
Before you make your decision you should distinguish between modest gifts and gifts that are not so modest. You may consider accepting a modest gift, especially if it is from an individual client, because its effect on other clients’ interests is scarce, if any. This kind of gift could be perceived as a kind of bonus or supplement to the fee the client is already paying for the service.
However, in the case of a corporation that wants you to recommend its stocks, perhaps against your judgment, the situation is different. Here, accepting any kind of consideration may be to the detriment of other clients and, in fact, the whole market.
How to Accept a Gift?
When CFA members or candidates decide to accept a gift from their clients (either individual or corporate), they are obliged to disclose it.
As a rule, the disclosure should take place before the gift is accepted. But, if for any reason, you were unable to disclose acceptance, you should do it afterward as soon as you can. Your disclosure will enable your employer to judge whether the gift might have biased your conduct and to what degree.
This is rather an important step in your relationship with the client and the employer, as it allows an independent and objective judgment of your professional independence & objectivity.
As we have said, not always will you reject gifts or other benefits from your clients, but you may accept a gift too hastily, or perhaps you may not be aware of the value of the gift you accepted. This is why it is so important that you report to your supervisor whenever you accept a gift or any kind of consideration. By disclosing the fact that you accepted some bonus from your client, you make it clear that there is no hidden agenda behind it. Moreover, your relationships with the client and with your employer become transparent.
Also, employers should do their best to ensure that their employees feel comfortable and secure when acting according to their judgment and trying to maintain their independence & objectivity. Special policies should apply that promote the independence & objectivity of financial professionals. The procedures should be regularly reviewed and improved. It is also advisable that a special officer is put in charge of compliance procedures and that all employees are properly instructed on how to act in case of violations.
Such policies should precisely state that research reports conducted by analysts are to be independent and objective. What it means is that analysts should always present their opinions free of bias. To be able to produce an unbiased opinion, analysts should know what they can do and what they shouldn’t do when preparing a recommendation or a research report.
Max is an independent analyst and he is to make a research report for the first time. What are the possible problems that he may encounter?
(...)
Max is no longer an independent analyst but works in an investment bank. He gives a negative opinion about a company. Suppose that Max has an employer who tells him that the negative opinion he produced will not be disseminated. What should Max do in such a situation?
Should he produce a new and perhaps more favorable opinion?
(...)
Conflicts of Interest
One more thing.
Sometimes, there is an obvious conflict of interest that hinders the preservation of independence & objectivity. When you think about Max’s employer, what is a possible reason for which he may not want Max’s research report to be disseminated?
Suppose that Max’s firm provides investment banking services and that the company is not only the buyer of the report but also an investment banking client. Because income from investment banking is important to Max’s employer, he will not want to lose the client.
Additional conflict of interest may occur here if analysts work together with their investment banking colleagues. Though it allows firms to better understand risk and establish more adequate price levels, it exerts pressure on analysts (cf. Max and his employer).
When there is a cooperation between research analysts and investment banking professionals, special regulations should be applied. Firewalls should be introduced ensuring that the two functions remain separate when required and appropriate violation reporting procedures should be used.
- As a rule, financial professionals should not accept gifts or any additional compensations for their work if such benefits may influence or may be perceived to influence independence & objectivity.
- It is important to distinguish between modest gifts and gifts that are not modest. You may consider accepting a modest gift.
- You should disclose the acceptance of a gift. As a rule, the disclosure should take place before the gift is accepted.
- Special policies should apply that promote the independence & objectivity of financial professionals at a workplace.
- An independent analyst should take into consideration many different things, e.g. compensation arrangements – it’s best if a flat fee (which does not change depending on e.g. the company’s stock performance) is paid for the services.
- A conflict of interest hinders the preservation of independence & objectivity. Firewalls and appropriate violation reporting procedures should be introduced.
CFA Exam: Independence and Objectivity
To protect your independence and objectivity, when recommending investments or taking investment actions:
ALWAYS AVOID situations that could compromise your independence and objectivity or any appearance of compromising your independence and objectivity.
Possible sources of compromising your independence and objectivity while preparing a research report:
- EXTERNAL PRESSURE: e.g., from buy-side institutional clients (e.g., an investment fund) that may be afraid of a rating downgrade (stock prices are usually sensitive to rating changes) and its adverse effect on the portfolio’s performance, as well as the manager’s compensation (usually tied to portfolio performance) and the manager’s professional reputation
- INTERNAL PRESSURE: e.g., intrafirm pressure from other departments willing to offer the client other services or products like underwriting a debt offering
- RELATIONSHIPS: e.g., concerns that a negative research report might (i) jeopardize a close rapport nurtured with the client over the years or (ii) destroy the atmosphere at work and good relations with the supervisor or colleagues from other departments
- BENEFITS: e.g., gifts, travel costs covered by the client, additional compensation arrangements, favors, job referrals, etc.
- COMPENSTION ARRANGEMENTS: e.g., accepting a bonus in addition to a flat fee if the outcome of the research report is favorable
Other potentially detrimental issues:
- PERSONAL TRADING: it is often limited and regulated by the employer to avoid, e.g., employees’ participation in oversubscribed IPOs, which offers quick profit unavailable to others
- ISSUER-PAID RESEARCH: unless accounted for, investors may be misled into believing that the research is from an independent source when, in reality, it has been paid for by the subject company (issuer)
- ENTERTAINMENT AT WORK: ordinary business-related entertainment is ok when it does not affect your work by rewarding you