Topics

Weighting Slide
 Ethics 10–15%
4
 Quantitative Methods 5–10%
30
 Economics 5–10%
60
 Financial Reporting 15–20%
85
 Corporate Finance 5–15%
133
 Equity 15–25%
171
 Fixed Income 10–20%
© Kaplan, Inc. 214 1
Questions

60%:40%

Conceptual Calculation-based
Questions Questions

The lessons
1. Don’t ignore the conceptual parts
2. Don’t overly focus on computations
3. Put on your analyst hat – what are the
implications of this (on valuation)?

© Kaplan, Inc. 2
Ethical and Professional
Standards
Study Sessions 1–2

Weighting 10–15%
Overview of Level II Ethics

SS1: Ethics and Professional Standards

1. Code of Ethics and Standards of Professional
Conduct
2. Guidance for Standards I–VII
3. CFA Institute Research Objectivity Standards

SS2: Ethics and Professional Standards

4. The Glenarm Company
5. Preston Partners
6. Super Selection
7. Trade Allocation: Fair Dealing and Disclosure
8. Changing Investment Objectives

© Kaplan, Inc. 4
Overview of the Code and Standards
Code of Ethics Standards of Professional Conduct

 Act in an ethical I: Professionalism V: Investment Analysis,

A. Knowledge of the Law Recommendations, and Actions
manner
B. Independence and Objectivity A. Diligence and Reasonable Basis
 Integrity is C. Misrepresentation B. Communications With Clients and
paramount and D. Misconduct Prospective Clients
clients always C. Record Retention
come first II: Integrity of Capital Markets
E. Material Nonpublic Information VI: Conflicts of Interest
 Use reasonable F. Market Manipulation D. Disclosure of Conflicts
care and be E. Priority of Transactions
independent III: Duties to Clients F. Referral Fees
G. Loyalty, Prudence, and Care
 Be a credit to the H. Fair Dealing
VII: Responsibilities as a CFA
investment I. Suitability Institute Member or CFA
profession J. Performance Presentation Candidate
K. Preservation of Confidentiality G. Conduct as Members and
 Uphold capital Candidates in the CFA Program
market rules and IV: Duties to Employers H. Reference to CFA Institute, the CFA
regulations L. Loyalty Designation, and the CFA Program
M.Additional Compensation
 Be competent Arrangements
N. Responsibilities of Supervisors
© Kaplan, Inc. 5
Standards of Professional Conduct
Standard I: Professionalism

I(A): Knowledge of the Law I(B): Independence and Objectivity

 Understand and comply with all laws, rules,
regulations (including Code and Standards)
governing professional activities
 Comply with more strict law, rule, regulation
 Do not knowingly assist in violation, otherwise
dissociate from activity
 Use reasonable care, judgment to
achieve, maintain independence in
professional activities
 Do not offer, solicit, accept any
compensation that could compromise
independence, objectivity

Guidance
 Most strict
 First, notify supervisor or compliance
 May confront wrongdoer directly
 Dissociate if necessary
 Inaction may be construed as
participation
 No requirement to report violations to
governmental authorities, but this
may be appropriate in certain cases
© Kaplan, Inc.
Guidance
 Modest gifts are okay
 Distinguish between gifts from clients and
gifts from entities trying to influence
 May accept gift from clients, but must
disclose to employer and must get permission
if gift is for future performance
 Investment banking relationships do not bow
to pressure to issue favorable research
 For issuer-paid research, flat fee structure is
preferred
6
Standards of Professional Conduct
Standard I: Professionalism
I(C): Misrepresentation
 Do not make misrepresentations
relating to investment analysis,
recommendations, actions, or other
professional activities
Guidance
 Standard covers oral, written, or
electronic communications
 Do not misrepresent qualifications,
services of self or firm, or performance
record, characteristics of an investment
 Do not guarantee a certain return
 No plagiarism – written or oral
communications
© Kaplan, Inc.
I(D): Misconduct
 Do not engage in any professional
conduct involving dishonesty, fraud,
deceit, or commit any act that reflects
adversely on professional reputation,
integrity, or competence
Guidance
This Standard covers conduct
that may not be illegal, but
could adversely affect a
member’s ability to perform
duties
7
Standards of Professional Conduct
Standard II: Integrity of
Capital Markets

II(A): Material Nonpublic Information

 Members in possession of nonpublic
information that could affect an
investment’s value must not act or
cause someone else to act on the
information
II(B): Market Manipulation
 Do not engage in practices that
distort prices or artificially inflate
trading volume with intent to
mislead market participants

Guidance
 Information is material if disclosure of information Guidance
would impact a security’s price or if reasonable  Do not engage in transaction-
investors would want the information before based manipulation – give false
making an investment decision
impression of activity/price
 Information is nonpublic until it has been made movement; gain dominant
available to the marketplace
position in an asset to
 Information made available to analysts is manipulate price of the asset or a
considered nonpublic until it is made available to
related derivative
investors in general
 Do not distribute false,
 Mosaic Theory
misleading information
© Kaplan, Inc. 8
Standards of Professional Conduct
Standard III: Duties to Clients
III(A): Loyalty, Prudence, and Care
 Act with reasonable care and exercise
prudent judgment
 Act for benefit of clients and place their
interests before employer’s or own interests
Guidance
 Take investment actions in client’s best
interests
 Exercise prudence, care, skill, and diligence
 Follow applicable fiduciary duty
 Manage pools of client assets according to
terms of governing documents
 Make investment decisions in context of total
portfolio
 Vote proxies responsibly and disclose proxy
voting policies to clients
 “Soft dollars” must benefit client
© Kaplan, Inc.
III(B): Fair Dealing
Deal fairly, objectively with all clients
when:
 Providing investment analysis
 Making investment recommendations
 Taking investment action
 Engaging in other professional activities
Guidance
 Different levels of service are
okay as long as disclosed and do
not disadvantage any clients
 Investment recommendations:
All clients must have fair chance
to act on every recommendation
 Investment actions: Treat all
clients fairly – consider
investment objectives,
circumstances
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Standards of Professional Conduct
Standard III: Duties to Clients
III(C): Suitability
 Know client’s risk and return
objectives, and financial constraints
 Update information regularly
 Make investment recommendations or
take investment actions that are
consistent with the stated objectives
and constraints
 Look at suitability in a portfolio context
Guidance
 When in advisory relationship, gather client
information at the outset and prepare IPS
 Update IPS at least annually
 Consider whether leverage (derivatives) is
suitable for client
 If managing a fund to an index or other
mandate, invest according to mandate
© Kaplan, Inc.
III(D): Performance Presentation
 When communicating investment
performance information, ensure
that information is fair, accurate,
and complete
Guidance
 Do not misstate performance or
mislead clients about investment
performance
 Do not state or imply ability to
achieve returns similar to those
achieved in the past
10
Standards of Professional Conduct
Standard III: Duties to Clients

III(E): Preservation of Confidentiality

Keep current and prospective client information confidential, unless:
 Illegal activities are suspected
 Disclosure is required by law
 Client or prospect allows disclosure of the information

Guidance
 In some cases, it may be required by law to report activities
to relevant authorities
 This Standard extends to former clients
 Exception: May provide confidential information to CFA
Institute for an investigation under Professional Conduct
Program

© Kaplan, Inc. 11
Standards of Professional Conduct
Standard IV: Duties to Employers

IV(A): Loyalty
 Must act for the benefit of their employer

Guidance
Loyalty – Independent practice:
 If planning to engage in independent practice, notify employer of services provided,
expected duration, and compensation
 Do not proceed without consent from employer
Loyalty – Leaving an employer:
 If seeking new employment, act in best interest of employer until resignation is
effective
 Do not take records or files without permission
 Simple knowledge of names of former clients is okay
 No prohibition on use of experience or knowledge gained at former employer
Loyalty – Whistleblowing:
 Permitted only if it protects client or integrity of capital markets
 Not permitted for personal gain

© Kaplan, Inc. 12
Standards of Professional Conduct
Standard IV: Duties to
Employers
IV(B): Additional Compensation Arrangements
 Do not accept gifts, benefits, compensation,
consideration that competes with, or creates a
conflict of interest with, employer’s interest unless
written consent is obtain from all parties involved
Guidance
 Compensation and benefits cover
direct compensation by the client
and other benefits received from
third parties
 For written consent from “all parties
involved,” email is acceptable
© Kaplan, Inc.
IV(C): Responsibilities of
Supervisors
 Supervisors must ensure that their
staff obey laws, the Code and
Standards, etc.
Guidance
 Supervisors must make reasonable
efforts to ensure that anyone
subject to their supervision or
authority complies with applicable
laws, rules, regulations, and the
Code and Standards.
13
Standards of Professional Conduct
Standard V: Investment Analysis, Recommendations, and Actions
V(A): Diligence and Reasonable Basis
 Exercise diligence, independence, and
thoroughness
 Have a reasonable and adequate basis,
supported by appropriate research, for
any investment analysis,
recommendation, or action
Guidance
 Make reasonable efforts to cover all
relevant issues when arriving at an
investment recommendation
 Determine soundness when using
secondary or third-party research
 Group research and decision
making: As long as there is
reasonable basis for opinion,
member does not necessarily have
to agree with the opinion
© Kaplan, Inc.
V(B): Communication With Clients and
Prospective Clients
 Disclose the basic format and general principles
of investment process. Promptly disclose
changes that might materially affect processes.
 Disclose significant limitations and risks
associated with the investment process
 Identify important factors and include them in
communications with clients/prospective clients
 Distinguish between fact and opinion in the
presentation of analysis and recommendations
Guidance
 Distinguish between facts and opinions
 Include basic characteristics of the security
 Disclose changes in investment processes
 Suitability of investment – portfolio context
 All communication covered, not just reports
14
Standards of Professional Conduct
Standard V: Investment Analysis, Recommendations, and Actions

V(C): Record Retention

 Develop and maintain appropriate records to support
their investment analysis, recommendations, actions,
and other investment-related communications

Guidance
 Maintain records to support research, and the
rationale for conclusions and actions
 Records are firm’s property and cannot be
taken when member leaves without firm’s
consent
 If no regulatory requirement, CFA Institute
recommends retention period of seven years

© Kaplan, Inc. 15
Standards of Professional Conduct
Standard VI: Conflicts of Interest

VI(A): Disclosure of Conflicts

 Must make full and fair disclosure to clients, prospects, or employer of all
matters that could reasonably be expected to impair their independence
and objectivity or interfere with respective duties

Guidance
Disclose to clients:
 All matters that could impair objectivity – allow clients to judge motives, biases
 For example, between member or firm and issuer, investment banking
relations, broker/dealer market-making activities, significant stock ownership,
board service
Disclose to employers:
 Conflicts of interest – ownership of stock analyzed/recommended, board
participation, financial, and other pressures that may influence decisions
 Also covers conflicts that could be damaging to employer’s business

© Kaplan, Inc. 16
Standards of Professional Conduct
Standard VI: Conflicts of Interest

VI(B): Priority of Transactions

 Investment transactions for clients and VI(C): Referral Fees
employers must have priority over investment  Must disclose to
transactions in which a Member or Candidate employer, clients, and
is the beneficial owner prospective clients

Guidance
Guidance
 “Beneficial owner” – has direct/
 Disclosure allows clients and
indirect personal interest in the
employers to evaluate full cost of
securities
service and any potential biases
 Client, employer transactions take
 Disclosure is to be made prior to
priority over personal transactions
entering into any formal agreement
(including beneficial ownership)
for services
 Family member accounts that are
 Disclose the nature of the
client accounts must be treated as
consideration
other client accounts

© Kaplan, Inc. 17
Standards of Professional Conduct
Standard VII: Responsibilities as a CFA Institute
Member or CFA Candidate

VII(A): Conduct as Participants in CFA Institute Programs

 Must not engage in any conduct that compromises the reputation or
integrity of CFA Institute or the CFA designation or the integrity, validity,
or security of CFA institute programs

Guidance
Conduct includes:
 Cheating on the exam
 Disregarding rules and policies or security measures related to
exam administration
 Giving confidential information to candidates or public
 Improper use of CFA designation to further personal and
professional objectives
 Misrepresenting the CFA Institute Professional Development
Program or the Professional Conduct Statement

© Kaplan, Inc. 18
Standards of Professional Conduct
Standard VII: Responsibilities as a CFA Institute
Member or CFA Candidate

VII(B): Reference to CFA Institute, the CFA Designation, and the CFA Program
 Must not misrepresent or exaggerate the meaning or implications of membership in
CFA Institute, holding the CFA designation, or candidacy in the CFA program

Guidance
CFA Institute membership:
 Complete PCS annually Failure to comply results in an inactive
 Pay membership dues annually member status
Using the CFA designation:
 Don’t misrepresent or exaggerate the meaning of holding the CFA designation
Reference to the CFA program:
 May reference participation but no partial designation
 Okay to say “passed all levels on first attempt,” but do not imply superior ability
Improper use of the CFA marks:
 The “Chartered Financial Analyst” and “CFA” marks must always be used either after a
charterholder’s name or as adjectives, not as nouns

© Kaplan, Inc. 19
CFAI Research Objectivity Standards
Objectives Procedures for
Compliance

Research
objectivity
Rating system
policy

Public Disclosure
appearances Investment
banking
Compliance
Personal and
Reasonable
investments enforcement
and adequate
basis and trading

Timeliness of research
Relationships reports and
Research with subject recommendations
analyst companies
compensation

© Kaplan, Inc. 20
CFAI Research Objectivity Standards
Objectives of the Standards
 Prepare research, recommendations, investment action – clients always first
 Full, fair, meaningful disclosures of conflicts
 Promote effective policies/procedures – minimize conflicts affecting
independence/objectivity
 Support self-regulation – adhere to specific, measurable standards, promoting
independence, objectivity
 Provide ethical work environment

Required Compliance Procedures

Research objectivity policy

 Provide written policy on research independence and objectivity
 Have supervisory procedures that ensure compliance
 Have a senior officer who attests to the firm’s implementation and adherence

Public appearances
 Require covered employees to disclose both personal and firm conflicts of interest to
the interviewer/host and, if possible, to the audience

© Kaplan, Inc. 21
CFAI Research Objectivity Standards
Required Compliance Procedures

Reasonable and adequate basis

 Appoint a supervisory analyst or a review committee to evaluate and approve research
report recommendations

Investment banking
 Separate research analysts from the investment banking division
 Research analysts are not supervised by or report to the investment banking
 Investment banking or corporate finance divisions are unable to modify, review, approve, or
reject research recommendations and reports

Research analyst compensation

 Compensation should reflect the quality and accuracy of the recommendations made
 Compensation should not be connected to the analyst’s involvement with investment
banking or corporate finance activities

Relationships with subject companies

Research analysts are not allowed to:
 Share research report with subject company prior to the publication of the research report
 Promise a favorable report or a certain price target to subject company or corporate issuer

© Kaplan, Inc. 22
CFAI Research Objectivity Standards
Required Compliance Procedures

Personal investments and trading

 Firm should have policies to ensure covered employees’ personal investment
dealings are properly managed

Timeliness of research reports and recommendations

 Reports should be issued on a timely and regular basis

Compliance and enforcement

 Effective compliance procedures should be in place
 The compliance procedures should be supervised and audited and maintain internal
audit records

Disclosure
 Firm to provide full disclose of conflicts of interest

Rating system
 Rating system should be helpful to investors in their decision-making process

© Kaplan, Inc. 23
CFAI Research Objectivity Standards

Recommended Procedures for Compliance

Research objectivity policy

 Identify and describe covered employees
 Covered employees to be trained regularly and indicate in writing their adherence to the
policy annually
 Disclose conflict of interest that covered employees face
 Identify factors on which research analysts’ compensation is based
 Disclose the terms for the purchase of research reports by clients

Public appearances
 Ensure that the audience of a presentation has enough information to make informed
judgments
 Be prepared to disclose conflicts of interest
 Firm should require research analysts that are participating in public appearances to
disclose investment banking relationship with the subject company and whether the
analyst has participated in marketing activities for the subject company
 Research reports on the companies discussed should be provided to the audience for a
reasonable fee

© Kaplan, Inc. 24
CFAI Research Objectivity Standards

Recommended Procedures for Compliance

Reasonable and adequate basis

 Develop written guidance for judging what constitutes reasonable and adequate basis
 Provide or offer to provide supporting information, and disclose current price of the
security

Investment banking
 Prohibit research analysts from communicating with the investment banking or corporate
finance department prior to the publication of a research report
 Investment banking or corporate finance personnel may review reports for factual
accuracies or to identify possible conflicts
 Implement quiet periods for IPOs and secondary offerings
 Analysts not be allowed to participate in marketing roadshows for IPOs and secondary
offerings

Research analyst compensation

 Compensation should be based on measurable criteria
 Direct link of analysts’ compensation with investment banking and corporate finance
activities is not allowed, but firm should disclose to what extent analysts’ compensation
depends on investment banking revenues
© Kaplan, Inc. 25
CFAI Research Objectivity Standards

Recommended Procedures for Compliance

Relationships with subject companies

 Implement policies that govern analysts’ relationship with subject companies
 Implement guidelines that only those sections of the report related to factual information
that could be verified by the subject company is shared before publication
 Compliance and legal departments get a copy of the draft report before it is shared with
the subject company

Personal investments and trading

 Approval required prior to trading in securities in the industries assigned to the analyst
 Should have procedures to prevent employees from trading ahead of executing client
trades
 Restricted period of at least 30 days prior and five days after a report is issued
 Analysts permitted to sell contrary to their recommendation when in extreme financial
hardship
 Covered employees to provide a list of personal investments
 Establish policies to prevent short-term trading of securities

© Kaplan, Inc. 26
CFAI Research Objectivity Standards
Recommended Procedures for Compliance

Timeliness of research reports and recommendations

 Reports and recommendations should be issued at least quarterly
 If the coverage of a firm is discontinued, a “final” research report should be issued

Compliance and enforcement

 Distribute a list of activities that constitute violations and the disciplinary sanctions

Disclosure
 Disclose investment banking or other corporate finance relationships and conflicts of
interests
 Provide information on their recommendations and ratings
 Disclose the valuation methods used to determine price targets, including risk factors

Rating system
 Rating systems should include recommendation and rating categories, time horizon
categories, and risk categories
 Absolute or relative recommendations are allowed
 Employees should be prohibited from communicating a recommendation contrary to
the current published one

© Kaplan, Inc. 27
Ethics and Professional Standards
Study Session 2 Topics

Case Studies Applications

of Standards

The Glenarm Super

Company Selection Trade Allocation:
Changing Investment
Fair Dealing
Objectives
and Disclosure

Preston
Partners

© Kaplan, Inc. 28