2006 CFA Level 1 - Study Session 1 - Ethical and Professional Standards

Study Session 1

Ethical and Professional Standards

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2006 CFA Level 1 - Study Session 1 - Ethical and Professional Standards

A. The Code of Ethics

Members and Candidates must:

• Act with integrity, competence, diligence, respect, and in an ethical manner with
the public, clients, prospective clients, employers, employees, colleagues in the
investment profession, and other participants in the global capital markets.

• Place the integrity of the investment profession and the interests of clients above
their own personal interests.

• Use reasonable care and exercise independent professional judgment when

conducting investment analysis, making investment recommendations, taking
investment actions, and engaging in other professional activities.

• Practice and encourage others to practice in a professional and ethical manner

that will reflect credit on themselves and the profession.

• Promote the integrity of, and uphold the rules governing, capital markets.

• Maintain and improve their professional competence and strive to maintain and
improve the competence of other investment professionals.

The Code of Ethics establishes the framework for ethical decision making in the
investment profession.

This applies to CFA Institute's members, CFA charterholders and CFA candidates.

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2006 CFA Level 1 - Study Session 1 - Ethical and Professional Standards

Standard I - Professionalism
a. Knowledge of the Law.

Members and Candidates must understand and comply with all applicable laws,
rules, and regulations (including the CFA Institute Code of Ethics and Standards of
Professional Conduct) of any government, regulatory organization, licensing agency,
or professional association governing their professional activities. In the event of
conflict, Members and Candidates must comply with the more strict law, rule, or
regulation. Members and Candidates must not knowingly participate or assist in
and must dissociate from any violation of such laws, rules, or regulations.

This standard adopts principles that apply to the general activities of members and
candidates. As with any job service there are certain rules and regulations that members
and candidates need to abide by, although they are not required to have detailed
knowledge of all laws.

A. Relationship between the Code and Standards and local law.

Members and Candidates should always aspire to the highest level of ethical
conduct. This statement assists members in avoiding legal and ethical traps and
violations of the Code of Ethics.

In general, members in all countries should comply at all time with the Code and
Standards. Since laws in different countries may establish different standards, the rule of
thumb is to choose the stricter regulations:
1. If the law is tougher than the Code and Standards, adhere to the laws.
2. If there are no laws, or if the Code and Standards are tougher, adhere to the Code and
Standards.
3. If a member or candidate lives or works in a foreign country, or works for foreign
firms outside of his or her own country, he or she should comply with the strictest of
his/her country's law, the foreign country's law, and the Code and Standards.

Example

You are working in the foreign office of a U.S.-based firm. Analysts in this foreign
country routinely solicit insider information and use it as the basis for trading decisions.
You are told that this is not illegal in this country. In this case, the Code and Standards
are stricter. They prohibit use of material nonpublic information. You should refrain from
trading on the basis of insider information.

B. Don't participate or assist in violations.

Don't knowingly break or help others break laws. If a member:

• Feels that a standard or law has been violated (e.g. receiving information
contradictory to a registration statement), he or she should seek advice of the firm's

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counsel. If the member believes that the counsel is both competent and unbiased and
he or she follows the counsel's advice, there is no violation.
• Knows that a standard or law has been violated (e.g. discovering that a client has
knowingly misstated information on a prospectus), he or she should report the
incident to the appropriate supervisory person in the firm. If the situation is not
remedied, the member should disassociate from the situation. He or she may also seek
legal advice to see if other actions should be taken.

Note:
• Members are not required by the Code and Standards to report violations to the
appropriate governmental or regulatory organizations. However, if the law requires an
individual to report he or she must do so.
• Members are encouraged, but not required, to report violations to CFA Institute.

Example

An associate of yours is engaging in illegal trading practices and he tells you to refrain
from disclosing this because it will make the firm look bad and it is highly profitable.
You should choose one of the three actions above. If you seek legal counsel and are told
that the activity is actually not illegal, you have covered your obligation. This assumes
that you believe the legal counsel to be competent. If you report this to your supervisor
and are told to ignore it, you should take steps to disassociate yourself from the practice.

C. Procedures for compliance

Members and candidates can acquire and maintain knowledge about applicable laws,
rules and regulation by:
1. Maintaining current files of applicable statutes, rules, regulations and important cases
in a readily accessible manner and encourage the employer to distribute such information
to the members for this purpose.
2. Keeping informed about any changes of laws. Counsel can provide assistance in this
regard.
3. Reviewing procedures - compliance procedures should be reviewed on a regular basis
to ensure that they reflect current law.

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2006 CFA Level 1 - Study Session 1 - Ethical and Professional Standards

b. Independence and Objectivity.

Members and Candidates must use reasonable care and judgment to achieve and
maintain independence and objectivity in their professional activities. Members and
Candidates must not offer, solicit, or accept any gift, benefit, compensation, or
consideration that reasonably could be expected to compromise their own or
another’s independence and objectivity.

Every member must avoid situations that may result in a potential conflict of interest.
External sources may try to influence the investment process by offering investment
managers a variety of perks. Excessive gifts or lavish investor relation functions could
prejudice a member’s opinions about a sponsor. One type of benefit is the allocation of
shares in oversubscribed IPOs to investment managers for their personal accounts. Every
member shall avoid situations that might cause or be perceived to cause a loss of
independence or objectivity in recommending investments or taking investment action.

Modest gifts and entertainment are acceptable. For example, gifts that do not exceed
$100 may be accepted as well as entertainment.

Gifts from clients can be distinguished from gifts given by other parties seeking to
influence a member to the detriment of clients. Gifts from clients are deemed less likely
to impair a member’s independence than gifts from other parties seeking to influence the
member’s outlook. Members and candidates must disclose to their employers any such
benefits from clients.

Example 1
You are an analyst for the banking industry. The head of investor relations for one of the
larger firms in this industry offers to take you to dinner at a posh restaurant and discuss
the upcoming quarterly earnings figures. He provides you with a new, state of the art,
titanium golf club as his limo drops you off at the end of the evening. He calls you the
next day to ask if your report on his firm is progressing and indicates that there is a job
waiting for you at the bank if you decide to leave your current position. First, the bank
officer may have violated his fiduciary duty to his shareholders if he provided you with
material nonpublic information. Regardless, you have been wined and dined, received a
gift and a job offer from a senior officer of a firm you evaluate. Even if these
inducements do not compromise your independence and objectivity, they may provide
that perception. This violates the standard.

Example 2
An analyst follows the stock of company XYZ. He is invited by XYZ for a visit to the
company. XYZ pays all travel expenses for him. In general, when allowing companies to
pay for expenses, analysts should ensure that such arrangements do not impinge on their
independence and objectivity. In this case, as long as the trip is strictly for business
without lavish hospitality, such payment is acceptable.

Example 3

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An analyst is asked by the firm's executives to issue favorable recommendations to secure

the client's business. The analyst should conduct the review and make the
recommendation based on his or her own independent and objective view. Note that
members may experience pressure from their own firms to issue favorable reviews of
certain companies. In a full-service investment house, the corporate finance department
may be an underwriter for a company’s securities and be loath to antagonize that
company by publishing negative research reports.

Example 4
Steve, a portfolio manager, directs a large amount of his commission business to a
London brokerage house. In appreciation for all the business, the London brokerage
house gives Steve two tickets to travel anywhere in Europe. Steve fails to disclose
receiving this package to his supervisor. Steve has violated the standard because
accepting these perks, worth more than $100, may hinder his independence and
objectivity.

Procedures for compliance

Members should follow certain practices and should encourage their firms to establish
certain procedures to avoid violations of this standard.

• Protect integrity of opinions. Members and their firms should establish policies
stating that every research report on issuers by a corporate client reflects the unbiased
opinion of the analyst. Firms should also design compensation systems that protect
the integrity of the investment decision process by maintaining the independence and
objectivity of analysts.

• Create a restricted list. If the senior managers at a member's firm are unwilling to
permit dissemination of adverse opinions about a corporate client, the firm should
remove the controversial company from the research universe and put it on a
restricted list so that the firm disseminates only factual information about the
company.

• Restrict special cost arrangements. When attending meetings at an issuer's

headquarters, a member should pay for commercial transportation and hotel charges.
No corporate issuer should reimburse a member for transportation. Members should
encourage issuers to limit the use of corporate aircraft to situations in which
commercial transportation is not available or in which efficient movement could not
otherwise be arranged. Members should take particular care that when frequent
meetings are held between an individual issuer and an individual member, that the
issuer is not always the host of the member.

• Limit gifts. Members should limit the acceptance of gratuities and/or gifts to token
items. $100 is the maximum acceptable value for a gift or gratuity. The standard does
not preclude customary, ordinary, business-related entertainment so long as its
purpose is not to influence or reward members.

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• Review procedures. Members should implement (or encourage their firms to

implement) effective supervisory and review procedures to ensure that analysts and
portfolio managers comply with policy relating to their personal investment activities.

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2006 CFA Level 1 - Study Session 1 - Ethical and Professional Standards

c. Misrepresentation.

Members and Candidates must not knowingly make any misrepresentations

relating to investment analysis, recommendations, actions, or other professional
activities.

Members and candidates shall not make any statements, orally or in writing, that
misrepresent
• The services that they or their firms are capable of performing.
• Their qualifications or the qualifications of their firm.
• Their academic or professional credentials.

A misrepresentation is any untrue statement of a fact or any statement that is otherwise

false or misleading. This standard relates to misrepresentations by members about their
qualifications and services, and it disallows any misleading guarantees about investments
and their returns.

Members and candidates shall not make or imply, orally or in writing, any assurances or
guarantees regarding any investment except to communicate accurate information
regarding the terms of the investment instrument and the issuer's obligations under the
instrument. It prohibits statements or assumptions that an investment is “guaranteed”, or
that superior returns can be expected based on the member’s past success.

This standard applies to oral representations, advertising, electronic communications

(including web pages, emails) and written materials (whether publicly disseminated or
not).

Note: This standard does not rule out correct statements that some investments are
actually guaranteed in some way with guaranteed returns. Examples of these types of
investments would be insurance contracts or short-term treasury securities.

This standard also prohibits plagiarism in the preparation of material for distribution to
employers, associates, clients, prospects or the general public. Plagiarism involves
copying or using substantially the same materials as prepared by others without
acknowledging the source of the material. The only exception is to copy factual
information, as published by several recognized financial institutions, as well as
statistical information.

• Members and candidates should always attribute quotations, projections, data,

model/product idea, methodologies to their sources and/or authors.
• The standard applies to written materials, oral communications, visits with clients,
use of audio/video media and electronic data transfer.
• Members and candidates can use recognized sources (S&P, Moody’s) of factual
information (information that is already in the public realm) without
acknowledgement.

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• The situation also depends on whom the member is representing: members are not
required to attribute ideas, methodologies etc., developed by people within their firm,
when speaking with clients and prospects.
• Members and candidates should keep copies of materials that were used in preparing
research reports.

In ethical terms, a member or candidate indulging in plagiarism is not conducting himself

or herself with integrity. By plagiarizing, he or she is not only stealing the ideas of others,
but is also exposing himself or herself to violations of other standards by making
recommendations that may not have a reasonable basis and may not avoid material
misrepresentations.

Procedures for compliance

Members can prevent unintentional misrepresentations of the qualifications of services

the member or the member’s firm is capable of performing if each member understands
the limit of the individual's or firm's capabilities and the need to be accurate and complete
in presentations.

Firms can provide guidance for employees who make written or oral presentations to
clients or potential clients by providing a written list of the firm’s available services and a
description of the firm’s qualifications, and compensations that are both accurate and
suitable for client or customer presentations. Firms can also help prevent
misrepresentation by specifically designating which employees are authorized to speak
on behalf of the firm. Whether or not the firm provides guidance, members should make
certain that they understand the services the firm can perform and its qualifications.

In addition, each member should prepare a resume of the member's own qualifications
and a list of the services the member is capable of performing to use in accurate
presentations to clients. Members should use a written resume and job description of firm
services when making a presentation to a client or prospective client to help the member
focus on the firm's and the member's own strengths and limitations. Firms can aid
member compliance by also periodically reviewing employee correspondence and
documents that contain representations of individual or firm qualifications.

To avoid plagiarism, members and candidates should take the following steps:
• Maintain all copies of the information used to generate a report.
• Attribute quotations other than recognized financial and statistical reporting services.
• Attribute summaries to the relevant author.

A member or candidate is in violation if a member or candidate:

• Uses excerpts from reports done by others without acknowledgement.
• Cites quotes attributable to “leading analysts” and “investment expert” without
specific reference.
• Uses charts and graphs without stating sources.
• Copies computer spreadsheets without obtaining the permission of the owner(s).

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• Presents a firm’s own research in an expert witness situation without attributing the
research to its specific source.
• Presents a firm’s own research to clients, prospects and the general public: NOT a
violation as the member does not need to attribute the source specifically in this case.

Example 1
Your prospective client is unsure whether to contract with you for services. You mention
that investment decisions are made by a team of five professionals, each a CFA
charterholder. This is an above-average level of expertise for a firm of this size and
should lead to superior investment performance. Even if individuals holding CFA
charters make decisions, you cannot infer that this will lead to superior performance. If
you could substantiate the superior level of expertise among managers in your firm, then
that part of your statement is okay.

Example 2
An analyst calls himself a “portfolio management specialist”. In fact the analyst is just a
trainee. The analyst violates the standard for misrepresenting his or her qualifications.

Example 3
A firm advertises that investors can increase their returns by investing in money market
funds rather than municipal funds. The firm doesn’t mention that the statement is not true
for investors in the highest tax bracket. The firm, therefore, violates the standard because
the advertisement predicts performance for all investors without distinguishing the impact
on investors in the highest tax bracket.

Example 4
Kevin is the president of Shapiro Inc., an investment relations company. Kevin contracts
with six publicly traded companies to electronically promote their stock. Kevin posts a
profile and a strong buy recommendation for each company on Market Strategy's Internet
site. Kevin also sends unsolicited Internet email to 250,000 potential investors indicating
that the stock is guaranteed to increase in value. The six companies compensate Kevin for
the promotion with cash and stock. Neither the Internet site nor the emails disclose the
compensation arrangement between Kevin and the six companies. Kevin has violated this
standard because the Internet site and emails are misleading to potential investors. Kevin
should not have guaranteed that the securities would increase in value. Kevin has also
violated Standard VI. C (Referral Fees) by not disclosing the existence of an arrangement
with the six companies through which he receives compensation in exchange for his
services. Kevin may have also violated Standard V. A (Diligence and Reasonable Basis)
if he failed to perform a diligent and thorough investigation appropriate to the
circumstances of his investment recommendations.

Example 5
An analyst is working late to complete an evaluation of a biotechnology firm. She finds
another analyst's report which provides detail supporting her general opinion of the firm.
She includes these details and slightly edits the conclusion of the report to include in her

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own. The analyst has violated this Standard by not recognizing the source of her analysis.
If she provides attribution to the original analyst, she should be okay.

Example 6
An analyst includes information regarding historical interest rates collected from a
Federal Reserve website. He uses this information as part of a report without attribution.
If the source is considered well recognized and the information is purely factual, then this
is not a violation of the standard.

Example 7
Your firm develops a product in which you had no contribution. If you then use it as a
representative of the firm, you need not say that you had nothing to do with it. However
if you use it in your own private capacity, e.g. to give expert advice as a witness, then you
need to attribute it to the firm’s specific staff and not to yourself.

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d. Misconduct.

Members and Candidates must not engage in any professional conduct involving
dishonesty, fraud, or deceit or commit any act that reflects adversely on their
professional reputation, integrity, or competence.

Members and candidates shall not compromise the integrity of the CFA designation, or
the integrity or validity of the CFA examinations.

Standard I.A. states the obligation to comply with all applicable laws and regulations.
This standard addresses personal behavior that will reflect poorly on the profession as a
whole. Any act that involves lying, cheating, stealing, or other dishonest conduct, if the
offence and that reflects adversely on a member or candidate’s professional (not personal)
activities, would violate the standard.

Procedures for compliance

Members and candidates should encourage their employers to:

• Adopt a Code of Ethics to which every employee must subscribe. Make clear that any
personal behavior that reflects poorly on the individual involved, the institution as a
whole, or the investment industry will not be tolerated.
• Disseminate to all employees a list of potential violations and associated disciplinary
sanctions, up to and including dismissal from the firm.
• Conduct background checks on potential employees to ensure that they are of good
character and not ineligible to work in the investment industry because of past
infractions of the law.

Example 1
An investment advisor executes excessive trading volume to generate fees for himself.
He tells clients that the high level of trading in their discretionary accounts is needed to
maintain proper diversification. If this statement is misrepresentative, the advisor is
clearly engaging in professional misconduct.

Example 2
A portfolio manager has three martinis at lunch and returns to the office to resume his
regular duties. If the manager’s judgment is impaired and he is engaging in investment
decision-making activities, he is in violation of this standard.

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Standard II – Integrity of Capital Markets

a. Material Nonpublic Information.

Members and Candidates who possess material nonpublic information that could
affect the value of an investment must not act or cause others to act on the
information.

Information is material if its disclosure may affect the price of a security, or reasonable
investors would want to know the information before investing. Topics which should be
considered material in an insider trading context include:
• A forthcoming dividend declaration or mission.
• Corporate reorganizations or takeovers.
• The acquisition or loss of a major contract.
• A major purchase or sale of company assets.
• An event of default.
• Knowledge of forthcoming press coverage of a company’s affairs, whether positive or
negative.
• Substantial increases or decreases in earnings projections.

The source or relative reliability of the information also determines materiality. The less
reliable a source, the less likely the information provided would be considered material.

Information is nonpublic if it has not been disseminated to the marketplace in general, or

investors have had an opportunity to react to the information. Note that disclosing the
information to a selected group of analysts does not make it public. For example, a
disclosure made to a room full of analysts does not make the disclosed information
“public”.

Note that this standard prohibits use of material nonpublic information, not:
• Nonmaterial public information.
• Nonmaterial nonpublic information.
• Material public information.

Members are prohibited from seeking out or using any inside information in analyzing
investments, making investment recommendations or making investment decisions if:
• Such trading would breach a duty;
• The information is misappropriated;
• The information relates to a tender offer;
• Members receive material information in confidence.

Mosaic Theory

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Insider trading violations should not result when a perceptive analyst reaches a
conclusion about a corporate action or event through an analysis of public information
and items of nonmaterial nonpublic information (i.e. a "mosaic" of information).

Under mosaic theory, financial analysts are free to act without risking liability. That is, a
financial analyst may use nonpublic information as the basis for investment
recommendations and decisions even if that conclusion would have been material inside
information had they been communicated directly to the analyst by a company.

Procedures for compliance

If members receive inside information in confidence, they shall make reasonable efforts
to achieve public dissemination of material nonpublic information disclosed in breach of
duty. This effort usually means encouraging the issuing company to make the
information public.

Members and their firms should adopt written compliance procedures designed to prevent
trading while in the possession of material nonpublic information. The most common and
widespread approach to prevent insider trading by employees is an information barrier
known as a “fire wall”. The purpose of a fire wall is to prevent communication of
material nonpublic information and other sensitive information from one department of a
firm to other departments. The minimum elements of such a precaution include the
following:
• Substantial control (preferably by the compliance department) of relevant
interdepartmental communications;
• Review of employee trading through effective maintenance of some combination of
“watch”, “restricted”, and “rumour” lists;
• Documentation of the procedures designed to limit the flow of information between
departments and of the enforcement actions taken pursuant to those procedures; and
• Heightened review or restriction of proprietary trading while the firm is in possession
of material nonpublic information.

Additional procedures, used typically in conjunction with an information barrier include:

• Restricting or prohibiting personal and proprietary employee trading;
• Careful monitoring of firm and personal employee trading. A pattern of trading on
inside information can be more easily detected if employees and firm members are
required to make periodic reports of their transactions on their own behalf or on
behalf of members of their families;
• Placing securities on a restricted list when the firm has or may have material
nonpublic information (unless the placing of a security on a restricted list would itself
tend to reveal outside the firm that the firm is engaged in a nonpublic engagement
relating to the security);
• Using a stock watch list known only to a limited number of people when the firm has
or may have material nonpublic information to monitor transactions in specified
securities;

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• Confining the dissemination of material nonpublic information to persons who have a

need to know the information in order to carry out their responsibilities;
• Designating a supervisor or compliance officer who will have the specific authority
and responsibility to decide whether information is sufficiently public or is
sufficiently lacking in materiality that it may be used as a basis for investment
recommendations or decisions.
• Firms should circulate written policies and guidelines to all employees. The policies
and guidelines should be coupled with a program of seminars and refresher courses
for the employees.

Example 1
An insider tells you that his firm will announce a significant drop in EPS for the
upcoming year. The announcement will be released in three days. You can’t trade. You
can’t recommend that your investors sell their positions. You can (and should) encourage
the firm to disclose the information immediately.

Example 2
You are at an analysts' briefing for Horton Industries attended by 20 analysts. During the
presentation, Horton’s president indicates that the firm is considering closing its Alberta
operations because of difficulty in controlling costs at that location. He asks the audience
not to act on this information yet because a final decision will not be made for at least
another week. The analysts’ briefing likely qualifies as a public disclosure. If you find
these comments to have reasonable basis, you can inform your clients of the new
information and trade on their behalf.

Example 3
Barnes, the president of XYZ decides to accept a proposed tender offer. He tells this
decision to his sister, who tells her daughter, who tells her husband Staple, who tells his
broker, who buys stocks for himself. The broker is prohibited from trading the XYZ stock
because the information involves tender offer. However, the broker has no reason to
believe a duty was breached in the transmission of the information.

Example 4
A passenger in an elevator overhears a conversation between two executives of a publicly
traded company. The passenger trades the stock based on that information. The passenger
does not violate the standard because the executives do not breach any duty and the
information is not misappropriated.

Example 5
Walsh overhears that someone sneaked into the CEO’s office and discovered information
about a pending tender offer. Walsh trades the stock subsequently. Walsh violates the
standard because the information is misappropriated and it concerns tender offer.

Example 6
An analyst fails to protect privacy when discussing nonpublic information in a conference
call. Another employee overhears the information, and subsequently trades for his

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clients’ accounts. The analyst violates the standard for lack of adequate procedures. The
firm should have established information barriers, also called fire walls, between
departments.

Example 7
A magazine has a weekly investment column. A magazine employee trades on
information in the column before it is published. The employee violates the standard
because the information is misappropriated.

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b. Market Manipulation.

Members and Candidates must not engage in practices that distort prices or
artificially inflate trading volume with the intent to mislead market participants.

Market manipulation is a deliberate attempt to interfere with the free and fair operation
of the market. It includes practices that distort security prices or trading volume with the
intent to deceive people or entities that rely on information in the market.

Market manipulation examples include:

• Price manipulation. Placing buy or sell orders (or both) into the trading system in
order to change or maintain the price of a stock. The motives for attempting to do this
vary: to increase the value of a position in the market for finance or accounting
purposes, to be able to issue new shares at a higher price or to cause such a price rise
that other investors are attracted to the stock, creating demand that the manipulator
can sell into (called “pump and dump”).

• Marking the close or ramping. Making a purchase or sale of a security near the close
of the day’s trading, with the objective of affecting published prices, particularly the
reported closing price. This might be done to avoid margin calls (when the trader’s
position is not self-financed) to support a flagging price or to affect the valuation of a
portfolio (called “window dressing”). A common indicator is trading in small parcels
of the security just before the market closes.

• Wash trades and pre-arranged trading. A wash trade is a trade in which there is no
change in the beneficial ownership of the securities - the buyer is, in reality, also the
seller. A pre-arranged trade involves two parties trading on the basis that the
transaction will be reversed later, or with an arrangement that removes the risk of
ownership from the buyer. “Pooling or churning” can involve wash sales or pre-
arranged trades executed in order to give an impression of active trading, and
therefore investor interest in the stock.

• False or misleading information. Companies can be tempted to re-release information

or present information in an over-optimistic manner, in order to generate interest in
the company’s securities or help a flagging market. In some cases this includes
unrealistic, unsubstantiated or incorrect data, projections or evaluations. When the
perpetrators use the demand generated by the false information they have spread to
sell their own shares, the operation is known as “hype and dump”.

• Capping and pegging. This involves activity on both the stock market and the
derivatives market. A trader writes an option, which obliges the trader to sell to (in
the case of a call option) or buy from (in the case of a put option) the option holder a
specified number of shares at a specified price. The trader then trades in the shares
covered by the option in order to affect the share price in a direction that will make
the option unprofitable to exercise.

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The intent of the action is critical to determining whether it is a violation of this standard.
The standard does not prohibit legitimate trading strategies that exploit a difference in
market power, information, or other market inefficiencies. It also does not prohibit
transactions done for tax purposes (e.g. selling and immediately buying back a particular
stock).

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Standard III – Duties to Clients

a. Loyalty, Prudence, and Care.

Members and Candidates have a duty of loyalty to their clients and must act with
reasonably care and exercise prudent judgment. Members and Candidates must act
for the benefit of their clients and place their clients’ interests before their
employer’s or their own interests. In relationships with clients, Members and
Candidates must determine applicable fiduciary duty and must comply with such
duty to persons and interests to whom it is owed.

This standard relates principally to members who have discretionary authority over the
management of client’s assets.

Fiduciary duty refers to the obligations of loyalty and care in regard to responsibility of
managing someone else's assets. A fiduciary duty is a position of trust.
• A fiduciary is someone with the duty of acting for the benefit of another party.
• Loyalty is owed to clients and prospects.
• Clients' interests come before yours.
• A heightened level of fiduciary duty arises if the fiduciary has “custody” or effective
control of the client’s assets.
• Governing documents (e.g. trust documents and investment management agreements)
are primary determinants of a fiduciary's powers and duties.

Fiduciary standards apply to a large number of persons in varying capacities, but the
exact duties may differ in many respects, depending on the nature of the relationship with
the client or the type of account under which the assets are managed. The first step in
fulfilling a fiduciary duty is to determine what the responsibility is and the identity of the
“client” to whom the fiduciary duty is owed.
• When managing personal assets of an individual, the investment manager owes
loyalty to that individual (i.e. the client).
• When managing the portfolios of a pension plan or trust, the investment manager
owes loyalty to beneficiaries of the plan or trust (i.e. the client), not the person who
hires the manager.

A fiduciary must make investment decisions in the context of the portfolio as a whole
rather than by individual investments within the portfolio. The fiduciary should
thoroughly consider the risk of loss, potential gains, diversification, liquidity and returns.

Often a manager may direct clients’ trades through a particular broker because an
investment manager often has discretion over the selection of brokers. The broker may
provide research services that provide a broader benefit to the manager. The manager has
thus used “soft dollars” to purchase beneficial services as brokerage is an asset of the
manager’s clients. Since the manager would expect to purchase research services anyway,
the soft dollar arrangement is not necessarily inappropriate. The manager must seek the
best price and execution, and disclose any soft dollar arrangements.

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2006 CFA Level 1 - Study Session 1 - Ethical and Professional Standards

Procedures for compliance

• Follow all the applicable laws and rules.

• Establish the investment objectives of the client, taking into account:
o The client’s needs and circumstances.
o The investment’s basic characteristics.
• Diversification - all portfolios should be adequately diversified, unless, the plan
guidelines state otherwise.
• Deal fairly with all clients.
• Conflicts of interest - all conflicts must be disclosed.
• Disclose compensation agreements.
• Proxy solicitations - proxies must be voted in the best interest of the beneficiaries.
• Confidentiality - members must maintain the confidentiality of their dealings at all
times.
• Best execution - that is reasonably available should be provided to all clients.
• Loyalty - members must always act in the best interest of their clients.

Example 1
A client anxiously tells you that he needs to liquidate a bond portfolio immediately
because he needs funds to pay for an operation for a relative. The bonds are highly liquid,
but you and a colleague purchase the securities for about 75% of their market value. This
is a clear violation of your fiduciary duty to the client. You have violated your position of
trust. Furthermore, you have engaged in a deceitful action, which dishonors the CFA
designation.

Example 2
A portfolio manager benefits the pension plan’s sponsor rather than the beneficiaries by
acquiring the sponsoring company’s stock with the pension fund to support its stock price,
and voting proxies in the support of the management, which are not in the best interest of
the beneficiaries. He violates the standard because he should have made investment
decisions solely for the interest of the pension plan, regardless of the sponsor’s benefits.

Example 3
A portfolio manager directs trades to a brokerage firm. In return, he gets favorable
treatment on his personal transactions. He violates the standard because he breaches his
fiduciary duty to clients. He should have hired a brokerage firm that offers the best
execution for the client.

Example 4
A portfolio manager receives research from a brokerage firm that does not directly
benefit the accounts being traded. He does not violate the standard as long as he gets the
best execution for his clients, and he discloses the soft dollar arrangement to them.

Example 5
An investment firm uses a large brokerage house ABC. ABC’s research is average, but
provides asset allocation studies to make up for the large commission charged. The firm

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2006 CFA Level 1 - Study Session 1 - Ethical and Professional Standards

is also very friendly with ABC senior management. The standard has been violated since
“soft dollars” have been paid but not for research activities.

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2006 CFA Level 1 - Study Session 1 - Ethical and Professional Standards

b. Fair Dealing.

Members and Candidates must deal fairly and objectively with all clients when
providing investment analysis, making investment recommendations, taking
investment action, or engaging in other professional activities.

“Fairly” implies that members must not discriminate against or favor any clients. Fairness
shall be maintained in quality and timing of services, and allocation of investment
opportunities. The term “fairly” is used, not “equally”, as this would be physically
impossible to reach all customers at the same exact instant, and not all recommendations
or investment actions are suitable for all clients.

Members and candidates are NOT required to give the same level of services to all clients,
for example. you can give more information and research to discretionary clients than to
transaction-only clients.

Members and candidates are required to adhere to the standard in:

• Dissemination of recommendations: Establish procedures for simultaneous

dissemination of recommendations; that is all clients must be informed at
approximately the same time.

An investment recommendation is any opinions on buying, selling or holding a

security or other investments. Good business practice dictates that initial
recommendations be made available to all customers who indicate an interest.
Although a member need not communicate a recommendation to all customers, the
selection process by which customers receive information should be based on
suitability and known interest, not on any preferred or favored status. A common
practice to assure fair dealing is to communicate recommendations within the firm
and to customers simultaneously.

A material change in a firm’s recommendation is one that could be expected to affect

a client’s judgment. A change in the recommendation from buy to sell is a material
change and therefore this standard needs to be abided by in disseminating the change.

• Investment actions: Develop trade allocation procedures to ensure fairness to clients

(both in priority of execution and allocation of price obtained on block trades),
timeliness of execution, accuracy of trade records and client positions.

Clients in discretionary accounts should be treated the same as those who are not in
discretionary accounts. Note that investment action can affect the market value of a
security.

If an issue is oversubscribed, members should forgo any sales to themselves or their

immediate families. Members must disclose to clients or prospects the allocation
procedures, and how they can affect the clients or prospects. Members shall not

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2006 CFA Level 1 - Study Session 1 - Ethical and Professional Standards

withhold “hot issue” securities for their own benefits or use such securities as rewards
or incentives for others. Members shall not trade ahead of the dissemination of
research reports or recommendations to clients.

Procedures for compliance

• Limit the number of people involved.

• Shorten the time frame between decision and dissemination.
• Publish personnel guidelines for pre-disseminations.
• Disseminate information simultaneously to all parties.
• Establish procedures for determining material change.
• Maintain a list of clients and their holdings.
• Develop and disclose written trade allocation procedures.
• Establish systematic account review.
• Disclose levels of service.

Members and their firms are required to take the following steps to ensure that adequate
trade allocation practices are followed:
• Obtain advance indications of client interest for new issues.
• Allocate new issues by client rather than by portfolio manager.
• Adopt a pro rata or similar objective method or formula for allocating trades.
• Treat clients fairly in terms of both trade execution order and price.
• Execute orders in an efficient and timely manner.
• Keep accurate records of trades and client accounts.
• Periodically review all accounts to ensure that all clients are being treated fairly.

Example 1
After attending an analysts’ briefing, you decide to re-evaluate your research report on
Horton Industries. You conclude that the company is no longer a “buy” but instead a
“strong buy”. The report is scheduled for release to your clients next week but you call
several large clients to inform them of this change. You have not treated all clients fairly.

Example 2
An analyst tells a client that he will soon issue a recommendation. He therefore violates
the standard because he should send the information to all clients before discussing it
with any specific client(s).

Example 3
Just 30 minutes before the close of the market, Huntington Biomedical releases a report
indicating that EPS for the upcoming quarter will be materially lower than previously
expected and sales growth for the firm will also be below expectations for the next four
quarters. You only have three clients with significant positions in Huntington. You
contact each of those clients and two of them direct you to liquidate their holdings in the
firm immediately. The third client elects to hold her position. Even if you have other

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2006 CFA Level 1 - Study Session 1 - Ethical and Professional Standards

clients with small positions in this firm, you have treated all clients fairly. You have
shown preference to clients with greater concern about the news release.

Example 4
An analyst’s employer low-balls earning projection for company XYZ. The analyst is
confident that the earnings should be higher, but goes along with the firm when issuing
his own recommendation. Then he passes his real estimate to his large clients. He
therefore violates the standard by not sharing his recommendation with all clients and not
treating all clients fairly.

Example 5
An analyst, Jessica, follows the mining industry. She finds that a small mining house has
just signed some significant deals with companies she researches or follows. She then
investigates it further and decides to write a report recommending the company purchase.
While the report is still in draft stage, Jessica then organizes a breakfast for her biggest
and best clients and then discusses this small company with them. At the breakfast she
tells her best clients that she has a buy recommendation on the report even though the
report will be released in three days time. Jessica has violated this standard because she
disseminated investment recommendation information that was contained in a research
report to her best clients before the report had been disseminated to all her clients fairly.

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2006 CFA Level 1 - Study Session 1 - Ethical and Professional Standards

c. Suitability.

1. When Members and Candidates are in an advisory relationship with a client, they
must:
a. Make a reasonable inquiry into a client or prospective client’s investment
experience, risk and return objectives, and financial constraints prior to making any
investment recommendation or taking investment action and must re-assess and
update this information regularly.
b. Determine that an investment is suitable to the client’s financial situation and
consistent with the client’s written objectives, mandates, and constraints prior to
making an investment recommendation or taking investment action.
c. Judge the suitability of investments in the context of the client’s total portfolio.

2. When members and candidates are responsible for managing a portfolio to a

specific mandate, strategy, or style, they must only make investment
recommendations or take investment actions that are consistent with the stated
objectives and constraints of the portfolio.

Members must always consider the appropriateness and suitability of the client’s
investment action and match this up against the needs and circumstances of the particular
client in order to determine the suitability of the investment for the client.

In the event that a new client is obtained or an existing client's previous investment now
matures, the member need not immediately obtain client information if he or she first re-
invests these funds in some form of cash equivalent. The member then obtains the
client’s investment preferences. He or she will need to determine from the client the level
of risk that the client is prepared to accept, in other words, the client’s risk tolerance level.
This needs to be ascertained before any investment action is taken.

You are required to:

• Know the type and nature of your clients.
• Know the return objectives and risk tolerance of your clients.
• Know the liquidity needs, expected cash flows, investable funds, time horizon, tax
considerations, regulatory and legal circumstances and other constraints of your
clients.

You are NOT required to change an existing client portfolio as soon as it comes under
your discretion -- it is best to take a bit of time, plan and implement actions in an
organized way.

Procedures for compliance

A written investment policy statement should be developed.

• Client identification: Identify the type and nature of clients, and the existence of
separate beneficiaries.
• Investor objectives:

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2006 CFA Level 1 - Study Session 1 - Ethical and Professional Standards

o Return objectives (income, growth in principal, maintenance of purchase

power).
o Risk tolerance (suitability, and stability of values).
• Investor constraints: Liquidity needs, expected cash flows (patterns of additions
and/or withdrawals), investable funds (assets and liabilities or other commitments),
time horizon, tax considerations, regulatory and legal circumstances, investor
preferences, circumstances, unique needs and proxy voting responsibilities and
guidance.
• Performance measurement benchmarks.

The investor’s objectives and constraints should be maintained and reviewed periodically
to reflect any changes in the client's circumstances. Annual review is reasonable unless
business or other reasons dictate more or less frequent review.

Example 1
After a five-minute interview, you advise a client how to invest a substantial proportion
of her wealth. You have violated the “Know your customer” rule. You do not have
adequate basis to make a detailed recommendation.

Example 2
An analyst tells a client about the upside potential, without discussing the downside risks.
He violates the standard because he should discuss the downside risks as well.

Example 3
When recommending an investment to a client, an analyst mainly focuses on the
characteristics of the specific investment. He violates the standard because the primary
focus for determining the suitability of an investment should be on the characteristics of
the entire portfolio.

Example 4
Should a firm move from a fundamental approach to selecting stocks to a more technical
based model, it would need to communicate this change to all of its current and
prospective clients. Clients must always be made aware of the risk of investing as well as
the possible downside risk. The portfolio must always be looked at as a whole.

Example 5
The portfolio managers at DD portfolio managers sit down with Danielle to analyze her
needs and circumstances. While discussing her position with her, they find out that a
wealthy cousin left her $500,000 as part of her inheritance. This triples the size of her
current portfolio. As a result of the increased funds, Danielle’s willingness to assume risk
has increased – she can now bear more risk. As such the portfolio managers should now
invest more funds in the equity side of her portfolio, to increase risk and potential returns.

Example 6
A client requests to change his investment strategy from investing in North-American
blue chips to emphasizing countries with high economic growth rates. The portfolio

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2006 CFA Level 1 - Study Session 1 - Ethical and Professional Standards

manager should explain the potential risks and returns to the client, and ask her to
consider them before changing the investment strategy.

Example 7
An investment manager uses the proceeds of some high yielding securities to invest 20%
of the client’s portfolio in a high-risk stock, on the basis that he believes that a merger is
in place and will push the price of the stock up. He will then sell the stock and repurchase
other high yielding securities. The client depends on the portfolio for her support. The
manager has violated this standard, since he has not considered the effects of each
transaction within the context of the entire portfolio.

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2006 CFA Level 1 - Study Session 1 - Ethical and Professional Standards

d. Performance Presentation.

When communicating investment performance information, Members and

Candidates must make reasonable efforts to make sure that it is fair, accurate, and
complete.

In the past there have been several practices that have hindered performance presentation
and comparability, such as:
• Representative accounts - only the best results are presented.
• Survivorship bias - accounts that have been terminated are excluded from the results
presented.
• Portability of investment results - results from previous employment are disclosed.
• Varying time periods - only the results for the good time periods are reflected.

A firm cannot claim that they are/were in compliance with CFA Institute's standards
unless they comply in all material respects with CFA Institute's standards.

Procedures for compliance

Misrepresentations about the investment performance of the firm can be avoided if the
member maintains data about the firm's investments performance in written form and
understands the classes of investments or accounts to which those data apply and the risks
and limitations inherent in using such data. In analyzing information about the firm's
investment performance, the member should ask the following questions:
• How many years’ past performance does this information reflect?
• Does it reflect performance for the prior year only, after several years of poor
performance, or an average of several years’ performance?
• Has the performance been measured in accordance with CFA Institute's standards?
• Does investment performance vary widely among different classes of funds or
accounts? If so, the member must describe investment performance by classes rather
than by an overall average figure and accurately explain what the performance figures
represent.

Example
Your bond fund has generated a below average performance for 4 of the past 5 years.
You use this as the basis for expectations of an above average performance for the
upcoming year. If your average, or expected performance, is properly determined, you
should have a 50% probability of meeting or exceeding that average. Thus, it is
inappropriate to declare that because performance was below average last year it is likely
to be above average next year.

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2006 CFA Level 1 - Study Session 1 - Ethical and Professional Standards

e. Preservation of Confidentiality.

Members and Candidates must keep information about current, former, and
prospective clients confidential unless:
1. The information concerns illegal activities on the part of the client or prospective
client.
2. Disclosure is required by law.
3. The client or prospective client permits disclosure of the information.

The analyst must preserve confidentiality when the following two criteria are met:
• The analyst must be in a relationship of trust with the client who has engaged him or
her, and
• The information received must result from or be relevant to that portion of the client’s
business that is the subject of the confidential relationship.

You are required to:

• Avoid discussing any information received from a client, except to fellow employees
working with the same client.
• Ask yourself if the disclosure is necessary and beneficial to the client in cases where
you have to disclose information.
• Forward confidential information to the PCP (CFA Institute's Professional Conduct
Program) if PCP requests, even if the client and you have a settlement agreement with
confidentiality clauses. This is because any information turned over to the PCP is kept
in the strictest confidence. Members and candidates, who will not provide necessary
information because of confidentiality, will be seen as failing to co-operate with the
investigation and will be subject to summary suspension of membership under CFA
Institute’s bylaws.

However, if the information concerns illegal activities by the client, the analyst may be
required to consult with his supervisor and with legal counsel, before deciding whether to
report the activities to the appropriate governmental organization.

Procedures for compliance

The simplest, most conservative, and most effective way to comply with this standard is
to avoid disclosing any information received from a client except to authorized fellow
employees who are also working for the client. In some instances, however, a member
may want to disclose information received from clients that is outside the scope of the
confidential relationship and does not involve illegal activities. Before making such a
disclosure, a member should ask the following questions:
• In what context was the information disclosed?
• If disclosed in a discussion of work being performed for the client, is the information
relevant to the work?
• Is the information background material that, if disclosed, will enable the member to
improve service to the client?

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2006 CFA Level 1 - Study Session 1 - Ethical and Professional Standards

Example 1
You work in the trust department of a large bank. A client tells you that she must sell a
significant portion of her personal stock portfolio in order to generate cash to meet the
payroll of her small business. Shortly after the meeting, a colleague in the commercial
lending department of the bank mentions seeing you with the client. She has applied for a
large business loan. He asks you if you have any information that could help the bank
with the loan decision. You cannot disclose the content of your meeting with the client. If
the colleague wants additional information, he should contact your client directly.

Example 2
The employer of a client asks to meet with you. The employer suspects your client of
embezzling funds from his place of work. You are aware that the client has made several
substantial additions into his discretionary account during the past two months. It may be
appropriate to provide information if it pertains to illegal activities. However, you are
expected to preserve client confidentiality unless there is a clear indication of these
activities. Contact your supervisor or legal counsel before providing information about
your client.

Example 3
A financial advisor learns that a client plans to make a charity donation. He tells a charity
to solicit donation from the client. The financial advisor violates the standard for
revealing confidential client information.

Example 4
An analyst claims that he cannot disclose client trading information to CFA Institute’s
PCP committee. He therefore violates the standard for not providing confidential client
information to the PCP.

Example 5
A member receives a request from a government department to review the client's records
on account of some suspicion. The member may have to disclose the information to the
government department.

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2006 CFA Level 1 - Study Session 1 - Ethical and Professional Standards

Standard IV – Duties to Employers

a. Loyalty.

In materials related to their employment, Members and Candidates must act for the
benefit of their employer and not deprive their employer of the advantage of their
skills and abilities, divulge confidential information, or otherwise cause harm to
their employer.

Independent practice

Members shall not undertake any independent practice that could result in compensation
or other benefit in competition with their employer unless they obtain written consent
from their employer.
• “Practice” means any service that the employer currently makes available for
payment.
• “Undertake” means that the member actually has to participate in such activities
while the member is still employed in order to violate this standard.

If members and candidates plan to engage in independent business while still employed,
they must provide a written statement to their employer describing the types of services,
the expected duration, and the compensation.

Note: Members have to participate in the activities. They do not actually have to receive
any remuneration for this standard to apply.

Leaving an employer

Until their resignation becomes effective, members and candidates must continue to act
in the employer’s best interest, and must not engage in any activities that would conflict
with this duty. A member can make preparations (but not undertaking competitive
business) to begin a competitive business as a departing employee, provided that the
preparations do not breach the employee's duty of loyalty. Examples of this would be
finding office space to rent for a member’s future business.

Nature of employment

You can be exempt from the standard if you are an independent contractor.

Definition of employee: someone in the service of another who has the power to control
and direct the employee in the details of how work is to be done. An employee is not a
contractor, whom you cannot control the details of how the contractor does the job.
Employment relationship does not require written or implied contract, or actual receipt of
monetary compensation.

Violations

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2006 CFA Level 1 - Study Session 1 - Ethical and Professional Standards

• You get a new job, but before leaving your current job you solicit your employer’s
clients (for both current and potential clients).
• Misuse of confidential information or misappropriation of trade secrets: taking home
client lists, investment statements, marketing presentations and buy lists.
• You provide consulting services on your own time: you must get written consent
from your employer.
• Copying your employer’s computer models and other property.
• Encourage colleagues to leave your employer to join your new company.

Example 1
You agree to serve as an investment advisor to a non-profit institution run by a friend.
Your firm provides similar services, but you elect to do this on your own for a very
modest fee. Even if no fee was involved, you are obliged to obtain written consent from
your employer.

Example 2
An independent investment advisor is hired by a brokerage firm, however, she wants to
keep the existing clients for herself. In this case she must get the employer's written
consent.

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2006 CFA Level 1 - Study Session 1 - Ethical and Professional Standards

b. Additional Compensation Arrangements.

Members and Candidates must not accept gifts, benefits, compensation, or

consideration that competes with, or might reasonably be expected to create a
conflict or interest with, their employer’s interest unless they obtain written consent
from all parties involved.

Outside compensation or benefits may affect loyalties and objectivity and create potential
conflicts of interest. They include direct compensations from clients and indirect
compensations or other benefits from third parties.

Note: Accepting gifts is allowed, but you must inform your employer in writing before
accepting.

Procedures for compliance

Members should make an immediate written report to their employer specifying any
compensation they receive or propose to receive for services in addition to compensation
or benefits received from their primary employer. Disclosure in writing means any form
of communication that can be documented (e.g. email). This written report should state
the terms of any oral or written agreement under which a member will receive additional
compensation; terms include the following:
• Nature of the compensation;
• Amount of compensation;
• Duration of the agreement.

Example 1
In an attempt to increase portfolio performance a firm's client offers the portfolio
manager an incentive, such as a free vacation. A conflict of interest exists in this case and
the portfolio manager must inform the firm before accepting the arrangement.

Example 2
One of your firm’s clients manages a ski resort in Colorado. She has told you that as long
as you are managing her assets, you are entitled to complimentary lift tickets at the resort.
To be in compliance with this standard, you must report this in writing to your employer.
The employer will want to ensure that this client receives no special consideration as a
result of the arrangement.

Example 3
Steve sits on the board of directors of ABC Inc. As a result of this he obtains unlimited
membership in ABC Inc.’s services. Steve does not disclose this relationship to his
employer, because he does not receive monetary compensation. Steve has violated this
standard by not disclosing the benefits he receives to his employer.

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2006 CFA Level 1 - Study Session 1 - Ethical and Professional Standards

c. Responsibilities of Supervisors.

Members and Candidates must make reasonable efforts to detect and prevent violations
of applicable laws, rules, regulations, and the Code and Standards by anyone subject to
their supervision or authority.

If you supervise large numbers of employees, you may not be able to evaluate the
conduct of each employee. In this case you may delegate supervisory duties, however,
such delegation does not relieve you of your supervisory responsibilities.

A supervisory member should rely on reasonable procedures to detect and prevent

violations. The presence of a compliance policy manual and/or compliance department,
however, does not remove his or her supervisory responsibilities.

Procedures for compliance

A supervisor complies with Standard IV. C. by identifying situations in which legal

violations or violation of the Code and Standards are likely to occur, and establishing and
enforcing compliance procedures to prevent such violations.

If a firm does not have a compliance system, or the system is not adequate, the member
or candidate should decline in writing to accept supervisory responsibility until the firm
adopts reasonable procedures to allow them to adequately exercise such responsibility.

Adequate compliance procedures should provide for the following:

• Be drafted so that the procedures are easy to understand;
• Designate a compliance officer and clearly define the officer’s authority and
responsibility;
• Outline the scope of the procedures;
• Outline permissible conduct;
• Delineate procedure for reporting violations and sanctions.

Once a compliance program is in place, a supervisor should take the following actions:
• Disseminate the contents of the program to appropriate personnel;
• Periodically update procedures to ensure that the measures are adequate under the law;
• Continually educate personnel regarding the compliance procedures;
• Issue periodic reminders of the procedures to appropriate personnel;
• Incorporate a professional conduct evaluation as part of the employee's performance
review;
• Review the actions of employees to ensure compliance and identify violators;
• Take the necessary steps to enforce the procedures once a violation has occurred.

Once a violation is discovered, a supervisor should take the following actions:

• Respond promptly;
• Conduct a thorough investigation of the activities to determine the scope of the
wrong-doing;

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2006 CFA Level 1 - Study Session 1 - Ethical and Professional Standards

• Increase supervision or place appropriate limitations on the wrong-doer pending the

outcome of the investigation.

If a supervisory member was unable to detect violations, he or she may not violate the
standard if he or she takes steps to institute an effective compliance program, AND
adopts reasonable procedures to prevent and identify violations.

Example 1
A supervisor in an investment management firm concludes that since all five equity
analysts working for her are CFA charterholders, she can trust them to refrain from
violations of laws, regulations, and the Code and Standards. While she can trust them to
refrain from such violations, this does not constitute reasonable supervision.

Example 2
You are offered a promotion to supervise all investment managers involved in
discretionary trading. You are told that there have been instances of improper trading in
some accounts and that at least one manager is likely performing additional investment
services for several of his clients. However, the operation is highly profitable so senior
management has no immediate concern regarding these issues. You are responsible for
prevention of violations of the Code and Standards. If there are known violations and
little or no control over the investment process, you should decline the supervisory
position until reasonable procedures can be established.

Example 3
A supervisor returns from a two-week vacation to find that one of his brokers has been
making personal trades in advance of the release of analysts’ reports to clients. If there
are established reporting processes to monitor employee trading and a reasonable effort is
made to evaluate the appropriateness of trades, then the supervisor has not violated this
standard. However, if there is no reasonable monitoring process, the supervisor has
violated the standard.

Example 4
A supervisor obtains a memo from an employee stating that all the portfolio managers
should purchase a certain stock. He doesn’t check the sources of the memo or anything
else, and disseminates the memo to all his portfolio managers and then leaves town. The
price of the stock declines sharply. The supervisor is in contravention of this standard,
since he was negligent and didn’t check the memo prior to disseminating it.

Example 5
A supervisor/vice president of a large investment company changes her opinion on a
specific stock from buy to sell. Prior to actually publishing the change of opinion, she
informs all of her colleagues (as is normal practice). Several of the employees sell the
stock prior to the dissemination of the report to the public. The supervisor was negligent
in the performance of her duties as she should have ensured that there were procedures in
place to ensure that no trade took place until the information was disseminated to the
general public.

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2006 CFA Level 1 - Study Session 1 - Ethical and Professional Standards

Standard V – Investment Analysis, Recommendations, and Actions

a. Diligence and Reasonable Basis.

Members and Candidates must:

1. Exercise diligence, independence, and thoroughness in analyzing investments,
making investment recommendations, and taking investment actions.
2. Have a reasonable and adequate basis, supported by appropriate research and
investigation, for any investment analysis, recommendation, or action.

Members must perform diligent and thorough investigation necessary to make an

investment recommendation or to take investment action. Three factors determine the
nature of the diligence, thoroughness of the research, and level of investigation required
by the standard:
1. Investment philosophy followed.
2. The role of the member or candidate in the investment decision-making process.
3. The support and resources provided by the employer.

Members must establish a reasonable basis for all investment recommendations and
actions. Diligence must be exercised to avoid any material misrepresentation. In other
words, members cannot be quick and negligent in making investment recommendations.

Example
You are very excited about a small, high-tech firm that is developing a new method of
making Internet connections more efficient. You advise your clients to buy this security
and tell them that a full report will be available shortly. Your recommendation is neither
diligent nor thorough. You have not provided reasonable basis for the recommendation. It
is impossible to distinguish between fact and opinion without further information.

Using secondary or third-party research

Secondary research: research conducted by someone else in the member or candidate’s

firm.
Third-party research: research conducted by entities outside the member or candidate’s
firm.

Members and candidates should check if the research is sound. Examples of criteria
include the assumptions used, the rigor of analysis, the timeliness of the research, and the
objectivity and independence of recommendations. If the research is suspected to lack a
sound basis, members and candidates should refrain from relying on it.

Applications:
• A quantitative analyst recommends an out-of-favor stock based on analysis of its 3-
year records: the recommendation is not based on through quantitative work. A
longer time period should be covered.

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2006 CFA Level 1 - Study Session 1 - Ethical and Professional Standards

• Because of restrictions from the firm’s executives, an analyst cannot obtain the
information necessary to perform analysis: the analyst must let the client know when
he/she is “conflicted” or “restricted”.

• Because of the lack of sufficient research resources, an analyst decides to estimate the
IPO prices based on the relative size of each company and justify the pricing later
when she has time: her analysis is not based on thorough research with reasonable
basis. She should take on the work only when she could adequately handle it.

• An investment banker presses the securities issuer to project the maximum production
level. He then uses these numbers as the base-case production levels during sales
pitches: he misrepresents the chances of achieving that production level. He should
have given a range of production scenarios during the pitch.

• An analyst recommends purchasing what the market, in general, has christened as

“hot” stocks without further research: conventional wisdom of the markets does not
form a reasonable and adequate basis.

• After a discussion with a vice president of a company, a senior analyst discovers that
there is a good chance that they will be awarded a large contract (thus pushing up the
stock price). The analyst then publishes in a report to his clients that they must all
purchase the stock based on the fact that the company will be awarded the large
contract. The manager has violated this standard since he published that the company
will definitely be awarded the contract, which is not necessarily the case.

• An investment analyst publishes a report based on a 5-year history of PE ratios of a

company. The report will materially affect the portfolios of the firm’s clients, since he
plans to use the results of the report to invest for his client’s portfolios. The analyst is
in contravention of this section since he should have done further research prior to
publishing and planning to implement such a huge proposal.

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2006 CFA Level 1 - Study Session 1 - Ethical and Professional Standards

b. Communication with Clients and Prospective Clients.

Members and Candidates must:

1. Disclose to clients and prospective clients the basic format and general principles
of the investment processes used to analyze investments, select securities, and
construct portfolios and must promptly disclose any changes that might
materially affect those processes.
2. Use reasonable judgment in identifying which factors are important to their
investment analyses, recommendations or actions and include those factors in
communications with clients and prospective clients.
3. Distinguish between fact and opinion in the presentation of investment analysis
and recommendations.

All important factors relating to the investment recommendation must be included in the
report. Members must include known limitations in the analysis and conclusions in the
report and consider all risks associated with the investment.

Members should consider including the following information in research reports:

• Expected annual rate of return, taking into account cash flows and expected price
changes during the holding period;
• Annual amount of income expected (current and future);
• Current rate of income return or yield to maturity;
• Degree of uncertainty associated with the cash flows;
• Degree of marketability/liquidity;
• Business, financial, political, sovereign, and market risks.

A report can be given in many forms: a written report, in-person communication,

telephone conversation, media broadcast, and transmission by computer (e.g. on the
Internet or by email).

Opinions should be distinguished clearly from facts, specifically:

• Past should be separated from future. Past represents facts, while forecast on future
represents opinions.
• In the case of quantitative analysis, facts should be separated from statistical
conjecture.

Procedures for compliance

• The selection of relevant factors is an analytical skill, and determination of whether a

member is in compliance depends heavily on case-by-case review. To assist the after-
the-fact review of a report, the member must maintain records indicating the nature of
the research and should, if asked, be able to supply additional information to the
client (or any user of the report) about factors not included.
• Members must take reasonable steps to assure themselves of the reliability, accuracy,
and appropriateness of the data included in each report. If the data has been processed

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2006 CFA Level 1 - Study Session 1 - Ethical and Professional Standards

in any way (e.g. into financial ratios), a member should ascertain that such processing
has been done in a manner consistent with the member’s analytical purposes.
• Acknowledgment of the source(s) should be made when appropriate.

Example 1
To simplify his report, an analyst leaves out details of the valuation models: he violates
this standard because clients need to fully understand the analyst's process and logic in
order to implement the recommendation.

Example 2
An analyst issues a “buy” recommendation on a stock, mainly based on his optimistic
assessment of the company’s operation. He violates this standard by failing to distinguish
between opinions from facts: his optimistic assessment about the company is just his own
opinion.

Example 3
An analyst issues a report promoting the firm’s new investment strategy. The report
stresses the likelihood of high returns. However, it does not describe the strategy in detail.
The analyst violates this standard because his report fails to describe properly the basic
characteristics of the investment strategy.

Example 4
An analyst has a duty to gather information about a company in order to make fully
informed recommendations about a company. As a result, the analyst is required to ask
management of the company to review his research report for inaccuracies. The analyst
still has a duty to examine and verify the information presented to him by the company he
is examining.

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2006 CFA Level 1 - Study Session 1 - Ethical and Professional Standards

c. Record Retention.

Members and Candidates must develop and maintain appropriate records to

support their investment analysis, recommendations, actions, and other investment-
related communications with clients and prospective clients.

Members and candidates should maintain files to support investment recommendations.

In addition to furnishing excellent reference materials for future work, research files play
a key role in justifying investment decisions under later scrutiny. Files can serve as the
ultimate proof that recommendations and actions, good or bad, were made based on the
same methodology that drove the analyst’s decisions.

• Records can be maintained either in hardcopy or electronic form (softcopy).

• CFA Institute recommends maintaining records for at least seven years.
• Records are the property of the member’s or candidate’s firm.

Example

If an analyst writes investment recommendations based on many sources such as stock

exchange data, interviews with senior management, onsite company visits, and other third
party research, he or she should document and keep copies of all the information that
goes into his recommendations.

A member should maintain files to support investment recommendations.

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2006 CFA Level 1 - Study Session 1 - Ethical and Professional Standards

Standard VI – Conflicts of Interest

a. Disclosure of Conflicts.

Members and Candidates must make full and fair disclosure of all maters that could
reasonably be expected to impair their independence and objectivity or interfere
with respective duties to their clients, prospective clients, and their employer.
Members and Candidates must ensure that such disclosures are prominent, are
delivered in plain language, and communicate the relevant information effectively.

Conflicts can occur between the interest of clients, the interests of employers, and the
member’s or candidate’s own personal interest. In the investment industry, a conflict, or
the perception of a conflict often cannot be avoided and full disclosure is required.

1. Disclosure to clients

Members shall disclose to their clients and prospects all matters, including beneficial
ownership of securities or other investments, that reasonably could be expected to impair
the members’ ability to make unbiased and objective recommendations.

A member must disclose to clients/prospects the following conflicts:

• Material ownership in the member’s firm’s investment account;
• Market-making activities;
• Corporate finance relationships;
• Directorships.

The most obvious conflict that arises is when members own stocks in a company that
they recommend to their clients.
• Sell-side members must disclose any material beneficial ownership in a security. A
sell side analyst working for a broker or dealer may be enticed, for example, by
corporate issuers to write research reports about certain companies.
• Buy-side members should disclose their procedures for reporting requirements for
personal transactions. A buy-side analyst, for example, will be faced with similar
conflicts as banks exercise their underwriting and security dealing powers. The
marketing division may ask an analyst to recommend the stock of a certain company
in order to obtain business from that company.

Service as a director of another firm poses three possible conflicts:

1. A possible conflict between the director’s fiduciary duty to his or her clients and the
director’s duty to the shareholders of the firm.
2. A director may receive options to purchase securities or actual securities in his or her
firm as part of a remuneration package. This may entice the director to push up the
price of the firm’s securities.
3. A director is likely to become aware of material nonpublic information, which may
place him or her in a position of possible conflict.

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2006 CFA Level 1 - Study Session 1 - Ethical and Professional Standards

Members should also disclose, with approval from their employer, special compensation
arrangements with the employer that might conflict with clients’ interest, such as bonuses
based on short-term performance, commissions, performance fees, incentive fees and
referral fees.

Procedures for compliance

Many firms require employees and their families to report all transactions by employees
and their families for purposes of detecting conflicts of interest and trading on material
nonpublic information. Whether such requirements exist or not, members should report to
employers, clients and prospective clients any material beneficial interest they may have
in securities and any corporate directorships or other special relationships they may have
with the companies they are recommending. Members should make the disclosures
before they make any recommendations or take any action regarding such investments.

There are two approaches to avoid potential conflicts of interest:

1. Avoidance - Personal investment through “blind trust” or “mutual fund”, in which
you have no influence on their investment decisions.
2. Disclosures - As soon as the member has made full disclosure of the potential conflict,
the client has all the relevant information to allow him or her to make a decision
regarding the investment.

Example 1
Failure to disclose a performance-based bonus plan - A manager gets a bonus from her
employer based on the performance of the pension accounts she manages. One of her
clients asks her why his pension plan seems to be weighted in favor of high beta stocks.
She says nothing about the bonus plan.

Example 2
You manage the pension fund for the Tremont Corporation. Huntington Biomedical is
one of the largest holdings in the fund. You also serve on the board of directors for
Huntington. You must disclose this relationship. While it is not unethical to have a
responsibility to the fund’s beneficiaries and to the shareholders of Huntington, you must
make sure that the fund’s board is aware of your other appointment.

Consider the same scenario, but instead of being on Huntington’s board, you own a
significant block of Huntington stock. You must disclose this beneficial ownership too.
As long as you do not violate other standards regarding Priority of Transactions or Fair
Dealing, disclosure of your holdings will be sufficient to meet this standard.

Example 3
An analyst recommends a stock. However, he fails to disclose that he is on the
company’s board or he has inherited a sizable amount of the stock, or his wife own 20%
of the company. The standard is violated by the analyst’s failure to disclose his
beneficiary interest in the recommended company.

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Example 4
Company XYZ is considering hiring John to manager its pension fund. XYZ asks John to
vote the XYZ stock proxies held in other accounts he manages in favor of XYZ’s
management. John will violate the standard if he accepts XYZ’s offer. He should vote the
proxies in the best interest of his clients.

2. Disclosure of conflicts to employers

Members and candidates should:

• Disclose to their employer all matters, such as beneficial interest (ownership of
securities), corporate directorships, trusteeships and any special relationships, that
reasonably could be expected to interfere with their duty to their employer or abilities
to make unbiased and objective recommendations;
• Comply with any prohibitions on activities imposed by their employer if a conflict of
interest exists;
• Discuss any action involving conflict of interest with their firm’s compliance officer.

Many firms restrict employees’ investment activities to avoid conflicts of interest.

Members should obey their employers’ guidelines. However, you are not required to
desist from personal trading and board memberships, if your employer allows them.

Procedures for compliance

• Report to employers any beneficial interest and special relationships (e.g. corporate
directorships) that may be considered conflict of interest.
• Discuss with compliance officer or supervisor before taking any actions that could
lead to such conflict.

Example 1
You come from a wealthy family that made much of its fortune in the automotive
industry. You and your family still have a considerable position in several stocks in the
industry. You are employed as an industry analyst in the automotive sector. You are
obliged to disclose your beneficial ownership to your employer.

Example 2
Mark makes personal trades without compliance with the firm’s prohibition as the firm
has no intention of trading these stocks, and Mark does not cover that particular industry
within the firm. Mark violates the standards for ignoring the firm’s trading prohibitions.
He should realize that the firm’s policy is designed to prevent material conflict of interest
and appearance of conflict.

Example 3
John acts as a trustee for another company. However he has not disclosed his
involvement to his employer. He violates the standard as it prohibits a member’s conflicts
of interest that might be detrimental to the employer’s business: being a trustee can be
time-consuming, and thus detrimental to the firm.

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2006 CFA Level 1 - Study Session 1 - Ethical and Professional Standards

Example 4
An investment manager with a large firm believes that his firm would not be interested in
equity linked notes, and as such purchases one for himself. One month later he prepares a
report for his firm suggesting that they should start investing in equity linked notes. The
manager has violated this standard since his ability to make an unbiased decision is
impaired since he already owns the notes himself.

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2006 CFA Level 1 - Study Session 1 - Ethical and Professional Standards

b. Priority of Transactions.

Investment transactions for clients and employers must have priority over
investment transactions in which a Member or Candidate is the beneficial owner.

This standard is designed to prevent any potential conflict of interest or even the
appearance of a conflict of interest with respect to the analyst’s personal transactions.
Transactions for clients and employers shall have priority over transactions in securities
or other investments of which a member is the beneficial owner so that such personal
transactions do not operate adversely to their clients’ or employer’s interests. If members
make a recommendation regarding the purchase or sale of a security or other investment,
they shall give their clients and employer adequate opportunity to act on their
recommendations before acting on their own behalf.

For purposes of the Code and Standards, a member is a "beneficial owner" if the member
has:
• A direct or indirect pecuniary interest in the securities;
• The power to vote or direct the voting of the shares of the securities or investments;
• The power to dispose or direct the disposition of the security or investment.

The standard applies to all access persons. Personal transactions include those made for
the member’s own accounts, family accounts and accounts in which the member has a
direct or indirect pecuniary interest. Note that family accounts that are also client
accounts should be treated like any other firm accounts. Neither special treatment nor
disadvantage should be given to such accounts.

Procedures for compliance

Members should encourage their firms to prepare and distribute a Code of Ethics and
compliance procedures, applicable to principals and employees, emphasizing their
obligation to place the interests of clients above personal and employer interests. The
form and content of such compliance procedures depend on the size and nature of each
organization and the laws to which it is subject. In general, however, the code and
procedures should do the following:

• Limited participation in equity IPOs.

Members and candidates should not benefit from the position that their clients occupy
in the marketplace – through preferred trading, the allocation of limited offerings,
and/or oversubscription.

• Restriction on private placements.

As participants in private placements have an incentive to recommend these
investments to clients, members and candidates should not be involved in these
transactions that could be perceived as favors or gifts that seem designed to influence
future judgment or to reward past business deals.

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2006 CFA Level 1 - Study Session 1 - Ethical and Professional Standards

• Establish blackout/restricted periods.

Managers or employees involved in the investment decision-making process should
be prevented from initiating trades in a security for which their firms have a pending
buy or sell order within a specific period before the order is executed or cancelled.
They should not be allowed to do “frontrunning”.

• Reporting requirements.
o Disclosure of holdings in which the employee has a beneficial interest.
o Providing duplicate confirmations of transactions. Investment professionals
should ask their brokers to supply duplicate copies to their firms of all their
personal securities transactions and copies of periodic statements.
o Pre-clearance procedures. Investment professionals should clear all personal
investments to identify possible conflicts before the execution of personal
trades.

• Disclosure of policies.

Example 1
You receive a news release that a small firm in the industry you follow has obtained a
major contract with a multinational firm. The contract will double sales for the small firm.
You note that the small firm’s stock price has already increased from $12 to $13. You
immediately submit an order to buy 1,000 shares. After your order is confirmed, you send
an email advisory to all clients summarizing the news and suggesting that this is a buying
opportunity. This is a clear violation of this standard. Clients had no opportunity to act on
this information prior to your personal trading.

Example 2
An analyst tells her father about a tender offer. She does not trade for her client until her
father has made the trade. She violates this standard by placing her father’s interest above
her clients'.

Example 3
An analyst maintains an account in his wife’s maiden name at another firm. By using that
account, he often buys hot issues while his clients cannot participate. He violates this
standard by trading for his wife before his clients can acquire the shares. He also should
disclose the trading for his wife’s account to his employer.

Example 4
David is a portfolio manager. He manages the retirement account established with the
firm by his parents. David does not trade for this account until all other accounts are
traded. He violates this standard by discriminating his parent’s account. As fee-paying
clients to the firm, his parent should be treated the same as any other clients.

Example 5
A member manages a portfolio of 20 clients and included in this portfolio is the portfolio
of a family member. The member may NOT first allocate transactions to all the other

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2006 CFA Level 1 - Study Session 1 - Ethical and Professional Standards

clients in the portfolio and then only to the family member, as this would unfairly
prejudice the family member. The family members account must be treated like a normal
client account.

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2006 CFA Level 1 - Study Session 1 - Ethical and Professional Standards

c. Referral Fees.

Members and Candidates must disclose to their employer, clients, and prospective
clients, as appropriate, any compensation, consideration, or benefit received by, or
paid to, others for the recommendation of products or services.

Such disclosure should help the client evaluate any possible partiality shown in any
recommendations of services as well as evaluate the full cost of services.

Members and candidates are required to:

• Disclose the existence and terms of any referral fee agreements to all clients or
prospects who have been referred under such agreements;
• Describe the nature of the consideration and its estimated dollar value in this
disclosure. Consideration includes all fees, whether paid or not: in cash, in soft dollars
or in kind;
• Consult a supervisor and legal counsel concerning any prospective arrangement
regarding referral fees.

Example 1
You provide investment counselling on a fee-for-services basis. You encourage all of
your clients to place trades through a particular broker: Richard Jones. You have known
Mr. Jones for many years and feel that he is an excellent broker with fees and services
that are competitive for the type of clients you typically work with. Mr. Jones also
provides you with a “finder’s fee” for each client you refer to him. Even if the services
recommended are reasonable and appropriate, you must still disclose the referral fee.

Example 2
ABC Firm has an agreement with XYZ Firm that ABC will recommend prospective
pension clients to XYZ, and in return, XYZ will give ABC free research. ABC does not
disclose the arrangement to prospective clients. ABC violates this standard for not
disclosing the arrangement to prospective clients.

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2006 CFA Level 1 - Study Session 1 - Ethical and Professional Standards

Standard VII - Responsibilities as a CFA Institute Member or CFA

Candidate
a. Conduct as Members and Candidates in the CFA Program.

Members and Candidates 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 the CFA examinations.

This standard applies to anyone who cheats, or helps other people to cheat on the CFA
examination or any other examination. Improperly using the CFA designation is also
prohibited by the standard.

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b. Reference to CFA Institute, the CFA Designation, and the CFA Program.

When referring to CFA Institute, CFA Institute membership, the CFA designation,
or candidacy in the CFA Program, Members and Candidates must not misrepresent
or exaggerate the meaning or implications of membership in CFA Institute, holding
the CFA designation, or candidacy in the CFA Program.

CFA Institute’s members, CFA charterholders and candidates in the CFA program must
utilize their designation in the correct manner so as not to mislead the investing public.
Since achievement of the CFA charter signifies a certain degree of knowledge, the public
and clients expect a certain degree of knowledge when encountering the designation CFA.

CFA Institute membership

Requirements to be granted the right to use the CFA or Chartered Financial Analyst
designation:
1. Passed all three levels of the CFA program;
2. Received the charters;
3. Makes an ongoing commitment to abide by the requirements of CFA Institute’s
Professional Conduct Program (including filing an annual professional conduct
statement);
4. Due-paying (every year) charterholders in good standing.

If a member fails to meet either 3 or 4, he or she cannot claim him or herself as a member.

Members should reference membership in a dignified and judicious manner: if necessary,

with an accurate explanation of the requirements for obtaining the membership.

Using the Chartered Financial Analyst designation

CFA charterholders may use the marks “Chartered Financial Analyst” or “CFA” in a
proper, dignified, and judicious manner: again, if necessary, with an accurate explanation
of the requirements for obtaining the right to use the designation.

Referencing candidacy in the CFA Program

CFA candidates may reference their participation in the CFA Program, but the reference
must clearly state that an individual is a CFA candidate and cannot imply that the
candidate has achieved any type of partial designation.

• To be a candidate, a person’s application should have been accepted, and he or she

should be enrolled to sit for a specified exam (for which he or she has not received
exam results or failed to sit for the exam).
• There is no designation for someone who has passed Level 1, 2 or 3 of the CFA
examinations.

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2006 CFA Level 1 - Study Session 1 - Ethical and Professional Standards

• Candidates may indicate that they have completed Level 1, 2 or 3 of the CFA
program. However, candidates cannot imply that they have achieved partial
designation even if they have passed all three levels of the exam

About the CFA mark

• It is registered in many countries (along with Chartered Financial Analyst).

• It does not serve as an acronym, cannot be used as a noun, and should never be used
in the plural or the possessive.
• Only CFA or Chartered Financial Analyst should appear after the charterholder's
name.

Applications
• Advertisements: cannot mention that an individual has passed all three exams on the
first try, or an individual has accomplished what few others have done, or the
designation implies superior performance capabilities.
• Placing “CFA Level II Candidate” after candidate’s name implies that it’s a partial
designation, which is a violation.
• The designation “CFA” cannot be listed in a type set larger than that used for the
charterholder’s name.
Examples:
o Richard is a CFA (or Chartered Financial Analyst) -- WRONG!
o Richard is a CFA charterholder. He earned the right to use the Chartered
Financial Analyst designation. - CORRECT!

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2006 CFA Level 1 - Study Session 1 - Ethical and Professional Standards

Global Investment Performance Standards

a. Why were the GIPS standards created?

The financial markets and investment management industry has become increasingly
global in nature. A common problem when reporting investment performance across
different borders is that some countries have performance measurement and disclosure
that are tailored specifically to them but that differ greatly from other countries. Some
countries do not even have any standardized approaches for investment firms to follow to
ensure fair representation and full disclosure of performance information.

In the past, making meaningful comparisons on the basis of accurate investment

performance data was difficult because of some misleading practices such as:

• Representative accounts: Only the results of the best portfolio or securities are
presented;

• Survivorship bias: For example, many mutual fund databases provide historical data
about only those funds that are currently in existence. As a result, funds that have
ceased to exist due to closure or merger do not appear in these databases. Generally,
funds that have ceased to exist have lower returns relative to the surviving funds.
Therefore, the analysis of a mutual fund database with survivorship bias will
overestimate the average mutual fund return because the database only includes the
better-performing funds;

• Varying time periods: Only the results for the good time periods are reflected.

The GIPS standards lead investment management firms to avoid misrepresentations of

performance and to communicate all relevant information that prospective clients should
know in order to evaluate past results.

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2006 CFA Level 1 - Study Session 1 - Ethical and Professional Standards

b. Parties affected by GIPS.

1. Firms

The GIPS standards apply primarily to investment management firms. The performance
results of firms adopting GIPS will be more readily comparable. However, while firms
are encouraged to adopt GIPS, the standards are voluntary.

2. CFA Institute’s Members, CFA Charterholders, and CFA Candidates

• GIPS is a way of ensuring that no material misrepresentation of performance takes

place.
• It satisfies Standard V.B. - Communication with Clients and Prospective Clients.
• Members, charterholders and candidates should inform employers of GIPS and
encourage its adoption (but it is not mandatory)

3. Prospective and Current Clients

• They are the primary beneficiaries.
• Allows effective comparisons: they can directly compare the performance results of
firms adopting GIPS.
• Clients must still use due diligence.

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2006 CFA Level 1 - Study Session 1 - Ethical and Professional Standards

c. Composites.

It is defined as a group of portfolios that are managed with the same strategy or objective.
Rather than presenting performance of each individual portfolio, the firm can simply
disclose the composite return of the portfolios as a group.

The determination of which portfolios to include in the composite should be done

according to re-established criteria (i.e. on an ex-ante basis), not after the fact. This
prevents a firm from including only their best performing portfolios in the composite.

The composite return is the asset-weighted average of the performance results of all the
portfolios in the composite.

The following is not required for the Level 1 candidate but is provided as a reference only.

Composite construction
• All actual, fee-paying, discretionary portfolios must be included in at least one
composite.
• Firm composites must be defined according to similar investment objectives and
strategies.
• Composites must include new portfolios on a timely and consistent basis soon after
the portfolio is being managed.
• Terminated portfolios must be included in the historical record up to the last full
measurement period that the portfolio was under management.
• Portfolios must not be switched from one composite to another unless this is changed
and documented in the client guidelines or if there is a redefinition of the composite.
The historical results must remain with the old composite.
• Convertible and other hybrid securities must be treated consistently across time and
within composites.
• Before January 1, 2005, if a single asset class is carved out of a multiple-asset
portfolio and the returns are presented as part of a single-asset composite, cash must
be allocated to single asset returns and the allocation method must be disclosed.
• From January 1, 2005, carve-out returns must not be included in single asset class
composite returns unless the assets are actually managed separately and have their
own cash allocations.
• No model or simulated performance may be linked to actual performance.
Composites must include only assets under management.

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2006 CFA Level 1 - Study Session 1 - Ethical and Professional Standards

d. Verification.

Verification refers to the independent review of a firm’s performance measurement

processes and procedures. Verification applies to the firm as a whole, not to individual
composites.

Verification tests
• Whether the firm has complied with GIPS composite construction requirements on a
firm-wide basis;
• Whether the firm’s processes and procedures are designed to calculate and present
GIPS compliant performance results.

Again, the focus of verification is not on individual composites, but is on the processes
the firm follows to form composites and calculate and report performance.

At this point in time, verification is not mandatory, but it is strongly recommended. Firms
may claim compliance, but independently verified compliance adds credibility to those
claims. It is recommended though that firms have all years for which they are claiming
compliance verified.

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2006 CFA Level 1 - Study Session 1 - Ethical and Professional Standards

e. Why is a global standard needed? How is it being implemented?

The overall purpose of GIPS is to provide guidelines for fair and full disclosure of
investment performance. This will allow current and potential clients to properly interpret
investment results over time and between firms.

There are four goals of GIPS:

1. Bolster investor confidence by ensuring the completeness, fairness and

standardization of calculation and presentation of investment performance on a global
basis.
2. Serve as a minimum standard to which all investment managers in the world should
adhere.
3. Enable global investment management firms to present performance results that are
comparable with firms in other countries.
4. Facilitate communications between investment managers and their prospective clients
on evaluating historical performance results and developing future strategies.

In 1999, the Investment Performance Council (IPC) was created to provide an

implementation structure for the GIPS standards. All countries are encouraged to adopt
the GIPS standards as the common method for calculating and presenting investment
performance. When applicable local or country-specific law or regulation conflicts with
the GIPS standards, firms should comply with the GIPS standards in addition to those
local requirements.

As of December 2004, more than 25 countries had adopted or were in the process of
adopting the GIPS standards.

Now IPC is entering its second phase of the convergence strategy to the GIPS standards:
to evolve the GIPS standards to incorporate local best practices from all regional
standards.

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2006 CFA Level 1 - Study Session 1 - Ethical and Professional Standards

f. Vision statement.

A global investment performance standard leads to readily accepted presentations of

investment performance that
(1) present performance results that are readily comparable among investment
managers, without regard to geographic location, and;
(2) Facilitate a dialogue between investment managers and their prospective
clients about the critical issues of how the manager achieved performance results and
future investment strategies.

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g. Objectives and key characteristics of GIPS.

Objectives
• Obtain worldwide acceptance of a standard for the calculation and presentation of
investment performance in a fair, comparable format that provides full disclosure.
• Ensure accurate and consistent investment and performance data for reporting, record
keeping, marketing and presentation.
• Promote fair, global competition among investment firms for all markets without
creating barriers to entry for new firms.
• Foster a notion of industry self-regulation on a global basis.

Key characteristics
• Firm definition (LOS i).
• They are ethical standards, not legal standards, for performance presentation: the
objective is to present performance results fairly and with full disclosure.
• Composites (LOS c).
• Calculation and presentation requirements (LOS j).
• The integrity of input data (LOS j).
• Two components: requirements and recommendations.
• The appropriate disclosure when local laws or regulations conflicts with the
Standards (LOS h).
• The eight sections of GIPS standards (LOS j).
• The Standards will evolve to address new aspects of investment performance.

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h. The appropriate disclosure when the GIPS standards and local regulations are in
conflict.

GIPS standards serve as minimum worldwide standards: if local laws are stricter than
GIPS, local laws should be applied. If local laws don't exist or are less strict than GIPS,
the GIPS should apply. In cases of conflicts with GIPS, the standards require that local
laws and regulations take precedence over GIPS.

Firms should disclose the conflicts.

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i. The scope of GIPS standards with respect to definition of the firm, historical
performance record, and compliance.

Definition of the Firm

It is intended that GIPS compliance be available to any firm. A firm must comply with
GIPS on a firm-wide basis to claim compliance with the standards. All actual, fee-paying,
discretionary portfolios managed by the firm must be included in the performance
measurement process.

To be in compliance, an entity must state how it defines itself as a firm. A firm may be
defined as:
• An investment firm, subsidiary or division held out to be a distinct business unit for
managing investment assets. This could be part of a larger organization.
• Total firm assets must be the aggregate of the market value of all discretionary and
nondiscretionary assets under management within the defined firm. This includes
both fee-paying and non-fee-paying assets.
• Firms must include the performance of assets assigned to a sub-advisor in a
composite provided the firm has discretion over the selection of the sub-advisor.
• Changes in a firm’s organization are not permitted to lead to alteration of historical
composite results.

Historical Performance Record

Firms should present their long-term performance record. To be in compliance, a firm

must:
• Initially present a minimum of five years of compliant annual investment
performance results except for composites which have been in existence for less than
five years in which case composite performance since inception must be presented.
• Add an additional year of compliant performance results each year until they reach 10
years of results.

The goal is to have 10 years of GIPS compliant performance results presented. To

encourage firms to participate, GIPS only requires five years of data to initially come into
compliance allowing the full 10 years of performance results to be built over time. There
is nothing to prevent a firm from initially presenting a full 10 years of compliant results.
To maintain compliance a compliant firm presenting less than 10 years of performance
results must increase the number of years of performance results presented.

Claim of Compliance

Which version of GIPS standards to comply with?

The revised GIPS standards were adopted in 2005. They will be effective on January 1,
2006. Although early adoption of these revised GIPS standards is encouraged, firms can

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still use the old version for performance presentations that include results through
December 31, 2005.

In order to claim compliance, a firm must meet ALL the requirements set forth in GIPS.
Firms that fully comply with GIPS may use the following compliance statement in their
performance presentations: [Name of the firm] has prepared and presented this report in
compliance with the Global Investment Performance Standards (GIPS).

With regard to compliance, a firm is either in compliance or not in compliance. Firms

may not make any claims to being “in compliance except for...”.

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j. The eight major sections of the GIPS standards.

Following are the eight sections involved in GIPS. Each section has requirements and
recommendations. All requirements must be met in order to be fully compliant with the
GIPS. Firms are encouraged to adopt and implement the recommendations.

1. Fundamentals of Compliance. This section deals with firm definition, policies and
procedures documentation, compliance claiming, and fundamental responsibilities of
a firm. Please refer to los i and k for more details.

2. Input Data. Input data requirements set standards for the collection of the data
necessary for calculating performance results that will be comparable across firms.
For example, benchmarks and composites should be created /selected on an ex-ante
basis, not after the fact.

3. Calculation Methodology. Achieving comparability among firms’ performance

presentations requires uniformity in methods used to calculate returns. The Standards
mandate the use of certain calculation methodologies for both portfolios and
composites. For example, total returns methodology is required for compliance. Total
returns include realized and unrealized capital gains/loses, interest (accrued during
valuation period) and dividends paid (considered paid on the ex-date).

4. Composite Construction. Creating meaningful, asset-weighted composites is critical

to the fair presentation, consistency, and comparability of results over time and
among firms. See LOS c for more details.

5. Disclosures. Firms must disclose certain information about their performance

presentation and policies adopted. Disclosures are to be considered to be static
information that does not normally change from period to period.

6. Presentation and Reporting. After completing steps 1 to 4, the firm should incorporate
this information in a GIPS compliant presentation.

7. Real Estate. This section applies to any real estate investment or management. It
applies regardless of firm’s control over the management of the investment, the
profitability or financing of the real estate investment.

8. Private Equity. This section applies to all private equity investments other than open-
end or evergreen funds. Private equity refers to any investment in nonpublic
companies. Examples are venture investing, buy-out investing, mezzanine investing,
fund-of-funds investing, secondary investing, etc.

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k. Fundamentals of compliance.

This section deals with firm definition, policies and procedures documentation,
compliance claiming, and fundamental responsibilities of a firm.

Definition of the Firm

Please refer to LOS i.

Document Policies and Procedures

Firms must document, in writing, their policies and procedures used in establishing and
maintaining compliance with all the applicable requirements of the GIPS standards.

Claims of Compliance

Please refer to LOS i.

Firm Fundamental Responsibilities

• Firms must provide a compliant presentation for any listed composite, along with a
composite description, to all prospective clients.
• Discontinued composites must be listed for at least five years after discontinuation.
Firms cannot alter their performance history by excluding portfolios no longer under
management or no longer managed by the same manager, and by including the
performance of portfolios managed by current employees before they started working
for the firm.
• Firms should establish procedures to monitor GIPS requirements and the firm's
performance measurement and presentation to ensure continued compliance.

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The Corporate Governance of Listed Companies: A Manual for

Investors
a. Summary corporate governance considerations.

The Board

The primary responsibility of the Board is to foster the long-term success of the
corporation, consistent with its fiduciary responsibility to shareowners. To carry out this
responsibility, the Board must ensure that it is independent and accountable to
shareowners and must exert authority for the continuity of executive leadership with
proper vision and values. The Board is singularly responsible for the selection and
evaluation of the corporation’s chief executive officer and included in that evaluation is
assurance as to the quality of senior management. The Board should also be responsible
for the review and approval of the corporation’s long-term strategy, the assurance of the
corporation’s financial integrity, and the development of equity and compensation
policies that motivate management to achieve and sustain superior long-term
performance.

The Board should put in place structures and processes that enable it to carry out these
responsibilities effectively. Certain issues may be delegated appropriately to committees,
including the audit, compensation and corporate governance/nominating committees, to
develop recommendations to bring to the Board. Nevertheless, the Board maintains
overall responsibility for the work of the committees and the long-term success of the
Company.

Investors and shareowners should determine whether

• a Company’s Board has, at a minimum, a majority of Independent Board Members,
• Board Members have the qualifications the Company needs for the challenges it faces,
• the Board and its committees have budgetary authority to hire Independent third-party
consultants without having to receive approval from management,
• Board Members are elected annually, or the Company has adopted an election
process that staggers the terms of Board Member elections,
• the Company engages in outside business relationships with management or Board
Members, or individuals associated with them, for goods and services on behalf of the
Company,
• the Board has established a committee of Independent Board Members, including
those with recent and relevant experience of finance and accounting, to oversee the
audit of the Company’s financial reports,
• the Company has a committee of Independent Board Members charged with setting
executive remuneration / compensation,
• the Company has a nominations committee of Independent Board Members that is
responsible for recruiting Board Members and
• the Board has other committees that are responsible for overseeing management’s
activities in select areas, such as corporate governance, mergers and acquisitions,
legal matters, or risk management.

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Management

Investors and shareowners should

• determine whether the Company has adopted a Code of Ethics, and whether the
Company’s actions indicate a commitment to an appropriate ethical framework,
• determine whether the Company permits Board Members and management to use
Company assets for personal reasons,
• analyze both the amounts paid to key executives for managing the Company’s affairs,
and the manner in which compensation is provided to determine whether
compensation paid to its executives is commensurate with the executives’ level of
responsibilities and performance, and provides appropriate incentives and
• inquire into the size, means of financing and duration of share-repurchase programs
and price stabilization efforts.

Shareowner Rights

Investors and shareowners should determine whether

• the Company permits Shareowners to vote their shares by proxy regardless of
whether they are able to attend the meetings in person,
• Shareowners are able to cast confidential votes,
• Shareowners can cast the cumulative number of votes allotted to their shares for one
or a limited number of Board nominees (“cumulative voting”),
• Shareowners can approve changes to corporate structures and policies that may alter
the relationship between Shareowners and the Company,
• and under what circumstances Shareowners can nominate individuals for election to
the Board,
• and under what circumstances Shareowners can submit proposals for consideration at
the Company’s annual general meeting,
• the Board and management are required to implement proposals that Shareowners
approve,
• the Company’s ownership structure has different classes of common shares that
separate the voting rights of those shares from their economic value,
• the corporate governance code and other legal statutes of the jurisdiction in which the
Company is headquartered permit Shareowners to take legal or seek regulatory action
to protect and enforce their ownership rights, and
• how the structure of existing or proposed takeover defenses could affect the value of
shares in a normal market environment and in the event of a takeover bid.

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b. What is corporate governance?

Corporate governance is the system by which business corporations are directed and
controlled. The corporate governance structure specifies the distribution of rights and
responsibilities among different participants in the corporation, such as the board,
managers, shareholders and other stakeholders, and spells out the rules and procedures
for making decisions on corporate affairs. By doing this, it also provides the structure
through which the company objectives are set, and the means of attaining those
objectives and monitoring performance.

Corporate governance is about promoting corporate fairness, transparency and

accountability. The purpose is to prevent one group from expropriating the cash flows
and assets of one or more other groups.

Good corporate governance practices:

• Board Members act in the best interests of Shareowners.
• The Company deals with all stakeholders in a lawful and ethical manner.
• All Shareowners have the same right to participate in the governance of the Company
and receive fair treatment from the Board and management. All rights of Shareowners
and other stakeholders are clearly delineated and communicated.
• The Board and its committees can act independently from other stakeholders such as
management.
• Appropriate controls and procedures are in place covering management’s activities in
running the day-to-day operations of the Company.
• The Company’s operating and financial activities, and its governance activities, are
consistently reported to Shareowners in a fair, accurate, timely, reliable, relevant,
complete and verifiable manner.

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c. Board independence.

Board Members must make decisions based on what ultimately is best for the long-term
interests of Shareowners. In order to do this effectively, Board Members need three
things: Independence, experience and resources.

Independence promotes integrity, accountability and effective oversight. We will talk

about experience and resources in later discussions.

The term “Board Member” refers to all individuals who sit on the Board, including:
• Executive Board Members: the members of the executive management. They are not
considered to be Independent;
• Independent Board Members;
• Non-Executive Board Members: they may represent interests that may conflict with
those of other Shareowners.

An Independent Board Member is defined as one who has no direct or indirect material
relationship with the Company, its subsidiaries or any of its members, other than as a
Board Member or Shareowner of the Company. Stated simply, an independent board
member must be free of any relationship with the Company or its senior management that
may impair the Board Member's ability to make independent judgments or compromise
the Board Member's objectivity and loyalty to shareowners.

There are many different types of relationships between Board Members and the
Company that may be material and preclude a finding of Independence, including
employment, advisory, business, financial, charitable, family and personal relationships.

In making its determinations regarding Independence, the Board shall consider all
relevant facts and circumstances and shall apply the following guidelines:
• Independent Board Members should not be current or former employees of the
Company;
• Independent Board Members should not serve as or be affiliated with advisors
(including external auditors) to the Company or its senior management;
• Independent Board Members should not do business with the Company.

The Board should be comprised of a substantial majority of independent Board Members.

A Board with this makeup and one which is diverse in its composition is more likely to
limit undue influence of management and others over the affairs of the Board. The
decisions of such a Board will be more likely to aid the Company’s long-term success.

Things to consider for investors:

• Do Independent Board Members regularly meet without the presence of management,
and report on their activities at least annually to Shareowners?
• Is the Board Chair also the CEO of the Company? If yes, Executive Board Members
may have too much influence and impair the ability and willingness of Independent
Board Members to exercise their Independence judgment.

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• Is the Board chair a former chief executive of the Company? If yes, the chair may
hamper efforts to undo the mistakes he or she made before.
• If the Board Chair is not Independent, do Independent Board Members have a lead
Member?
• If some Board Members are aligned with a Company-related entity (supplier,
customer, auditor, etc.), do they recluse themselves on issues that may create a
conflict?

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d. Board Member qualifications.

Board Members who have appropriate experience and expertise relevant to the
Company’s business are best able to evaluate what is in the best interest of Shareowners.
They must be able to contribute business judgment to board deliberations and decisions,
based on their experience in relevant business, management disciplines or other
professional life. Depending on the nature of the business, this may require specialized
expertise by at least some Board Members.

If Board Members lack the skills, knowledge and expertise to conduct a meaningful
review of the Company’s activities, and are unable to conduct in-depth evaluations of the
issues affecting the Company’s business, they are more likely to defer to management
when making decisions.

The following attributes should be considered as desirable for Board Members:

• Experience. Board Members must have extensive experience in business, education,

the professions and/or public service so they can make informed decisions about the
Company’s future. Do they have the background, expertise, and knowledge in
specific subjects needed by the Board? Board Members should be able to act with
care and competence as a result of relevant expertise or understanding of
o the principal technologies, products, or services offered in the Company’s
business,
o financial operations,
o legal matters,
o accounting,
o auditing,
o strategic planning, and
o the risks the Company assumes as part of its business operations.

• Personal. The Board Member should be of the highest moral and ethical character.
Have they made public statements that can provide an indication of their ethical
perspectives?

• Relevant Board experience. Do they have experience serving on other Boards,

particularly with Companies known for having good corporate governance practices?
Have they had any legal or regulatory problems as a result of working for, or serving
on, the Board of another company?

• Availability. The Board Member must be willing to commit, as well as have,

sufficient time available to discharge the duties of Board membership. Do they serve
on a number of Boards for other Companies, constraining the time needed to serve
effectively? Do they regularly attend Board and committee meetings?

• Term limits. Does the Board have term limits? Term limits can help insure that there
are fresh ideas and viewpoints available to the Board. They can prevent a Board

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Member from developing a cooperative relationship with management that could

impair his or her willingness to act in the best interest of Shareowners. However, term
limits have the disadvantage of losing the contribution of Board Members who have
developed, over a period of time, valuable insight into the Company and its
operations and, therefore, provide an increasing contribution to the Board as a whole.

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e. Board resources.

There need to be internal mechanisms to support the Independent work of the Board,
including the budgetary authority to hire outside consultants without management’s
intervention or approval. This mechanism alone provides the Board with the ability to
obtain expert help in specialized areas, to circumvent potential areas of conflicts with
management, and to preserve the integrity of the Board’s Independent oversight function.

Why does the Board need outside, third-party consultants?

• Independent Board Members typical have limited time to devote to their Board duties.
They need support in gathering and analyzing a large amount of information relevant
to managing and overseeing the Company.

• Very specialized advice and expertise are needed when dealing with issues such as
compensation, proposed mergers and acquisitions, legal, regulatory, financial matters
and reputational concerns.

• Independent outside advisors, including public accountants, law firms, investment

bankers and consultants can be critical to the effectiveness of corporate governance
and enhance the legal and regulatory compliance of the corporate client.

The Board should have the authority to decide whether to hire external consultants,
whom should be hired, and how they are to be compensated, etc without having to
receive approval from management.

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f. Other Board issues.

Board Member Terms

Shareowners should determine whether Board Members are elected annually, or

whether the Company has adopted an election process that staggers the terms of
Board Member elections.

In annual votes, every Board Member stands for re-election every year. Such an approach
ensures that Shareowners are able to express their views on individual members’
performance during the year, and to exercise their right to control who will represent
them in corporate governance and oversight of the Company. Companies that prevent
Shareowners from electing Board Members on an annual basis limit Shareowners’ ability
to change the Board composition, for example, when Board Members fail to act on their
behalf, or to elect individuals with needed expertise in response to a change in Company
strategy.

Staggered Board - A Board of directors only a part of which is elected each year,
usually to discourage takeover attempts. In a classified or staggered Board, Board
Members are typically elected in two or more classes, serving terms greater than one year.
Using an example of a three-year staggered Board, at each annual meeting, one third of
the Board Members or nominees would be eligible for Shareowner ratification for a
three-year period.
• Proponents of staggered Boards argue that by staggering the election of Board
Members, a certain level of continuity and skill is maintained.
• Staggered terms for Board Members make it more difficult for Shareowners to make
fundamental changes to the composition and behavior of the Board, by making it
extremely difficult for any challenge to, or change in, board control. In circumstances
of deteriorating company performance, this difficulty could result in a permanent
impairment of long-term Shareowner value.

Corporate governance best practice generally supports the annual election of directors as
being in the best interest of investors.

Investors should consider whether:

• Shareowners may elect Board Members every year;
• Shareowners can vote to remove a Board member under certain circumstances;
• The size of the Board is appropriate. The Board should be large enough to allow key
committees to be staffed with independent, qualified directors but small enough to
allow all views to be heard and to encourage the active participation of all members.

Related-Party Transactions

Investors should investigate whether the Company engages in outside business

relationships with management or Board Members, or individuals associated with
them, for goods and services on behalf of the Company.

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Related-party transactions involve buying, selling, and other transactions with Board
Members, executives, partners, employees, family members and so on. They are not
illegal or necessarily a violation of any kind. Current accounting and auditing standards
require the disclosure of these transactions (only if material) but no more.

Board Members are supposed to make Independent decisions. Receiving personal

benefits from the Company can create an inherent conflict of interest. Board Members
should be discouraged from engaging in the following practices, among others:
• Receiving consultancy fees for work performed on behalf of the Company.
• Receiving finders’ fees for bringing merger, acquisition or sales partners to the
Company’s attention.

When reviewing the issue, investors should determine whether:

• the Company’s ethical code or the Board’s policies and procedures limit the
circumstances in which insiders can accept remuneration from the Company for
consulting or other services outside of the scope of their positions as Board Members,
• the Company has disclosed related-party transactions with existing Board Members,
such as finders’ fees for their roles in acquisition, and
• Board Members or executive officers have loaned, leased or otherwise provided
property or equipment to the Company.

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g. Board committees.

The Board should delegate certain functions to committees. Under new U.S. regulations,
three key committees must be comprised exclusively of independent directors: the audit
committee, the compensation committee and the corporate governance/nominating
committee. The new requirements have also greatly expanded the responsibilities and
necessary competencies of audit committee members. The credibility of the corporation
will depend in part on the vigorous demonstration of independence by the committees
and their chairs. Committees should have the right to retain and evaluate outside
consultants and to communicate directly with staff below the senior level.

The committees should report back to the board on important issues they have considered
and upon which they have taken action. They should meet in executive session on a
regular basis with inclusion of management personnel, if appropriate because of issues
under discussion, and also without such personnel being present. If the company receives
a shareholder proposal, the committee most appropriate to consider the matter should
review the proposal and the management response to it.

Audit Committee

Investors should determine whether the Board has established a committee of

Independent Board Members, including those with recent and relevant experience
of finance and accounting, to oversee the audit of the Company’s financial reports.

The audit committee of the Board is established to provide independent oversight of the
Company’s financial reporting, non-financial corporate disclosure, and internal control
systems. This function is essential for effective corporate governance and for seeing that
their responsibilities to Shareowners are fulfilled.

The committee represents the intersection of the board, management, independent

auditors, and internal auditors, and it has sole authority to hire, supervise and fire the
corporation’s independent auditors. When selecting auditors, the committee should:
• consider the auditor’s independence,
• ensure the auditor’s priorities are aligned with the best interests of Shareowners, and
• ensure the quality and integrity of the company’s financial statements.

When evaluating the audit committee, investors should determine whether:

• all of the Board Members on the committee are independent. Note that some
jurisdictions permit non-Independent members to be on the committee,
• any of the Board Members are considered financial experts,
• the appointment of the external auditors is subject to the Shareowner approval,
• the committee’s independence is compromised by the provision of non-audit services.
The committee should establish limitations on the type and amount of such services
that the auditor can provide. The committee should also consider imposing limitations
on the corporation’s ability to hire staff from the auditor and requiring periodic
rotation of the outside auditor,

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• the committee is responsible for the adequacy and effectiveness of the company’s
internal controls and the effectiveness of management’s process to monitor and
manage business risks facing the company. The committee should establish a means
by which internal auditors and other employees can communicate directly with
committee members,
• the committee and the external auditor had any discussions resulting in a change in
the financial reports as a result of questionable interpretations of accounting rules,
fraud, or other accounting problems, and whether the Company has fired its external
auditors as a result of such issues, and
• the committee controls the audit budget to enable it to address unanticipated or
complex issues.

Remuneration / Compensation Committee

Investors should determine whether the Company has a committee of Independent

Board Members charged with setting executive remuneration / compensation.

Executive compensation practices provide a window into the effectiveness of the Board.
Through the compensation committee, the Board should implement rational
compensation practices that respond to the Company’s equity policy, including
conditional forms of compensation that motivate executives to achieve performance that
is better than that of a peer group. With Shareowners’ interest and fairness in mind, the
committee should ensure that the executive compensation packages are commensurate
with the level of the responsibilities of the executive, and appropriate in light of the
Company’s performance. All policies should be disclosed to Shareowners upon adoption
by the full board.

The committee should have only Independent Board Members on the committee.
Committees lacking independence could award excessive compensation due to
management pressures, could provide incentives for actions that boost short-term share
prices at the expense of long-term profitability and value.

When evaluating this committee, investors should determine whether

• the composition of the compensation packages is appropriate, that is the terms and
options granted to management and employees and whether the terms are reasonable,
• the Company provided loans or the use of the Company property and equipment to
Board Members,
• members of the committee regularly attended meetings during the past year,
• there were any public disclosures of the compensation paid during the past year to the
Company’s five highest-paid executives and its Board Members,
• the Company intends to issue new registered shares to fulfill its share-based
remuneration obligations, or whether it intends to settle these options with shares
repurchased,
• the Company and the Board are required to receive Shareowner approval for any
share-based remuneration plans, and

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• senior executives from other Companies that have cross-directorship links with the
Company are members of the committee. This could create a conflict of interests.

Nominations Committee

Investors should determine if the Company has a nomination committee of

Independent Board Members that is responsible for recruiting Board Members.

In most corporations, currently, nominations of Board Members and for executive

officers of the Company are made by Board Members, most often at the recommendation
of, or in consultation with, the management of the company. In such circumstances, the
criteria for selection of nominees may favor management’s best interests at the expense
of the interests of Shareowners. Consequently, corporate governance best practice
requires that nominees to the Board be selected by a nominee committee comprising only
Independent Board Members.

The committee is responsible for:

• Recruiting new qualified Board Members,
• Regularly examining the performance, independence, skills and expertise of existing
Board Members,
• Creating nominations policies and procedures,
• Succession planning of executive management and the Board.

Investors should review the committee’s practices of recruiting Board Members who act
in the best interests of Shareowners. They should also review:
• The criteria for new Board Members, and whether the new nominees complement the
Board’s current portfolio of talents;
• The composition, background and areas of expertise of existing Board Members;
• How the committee searches for candidates;
• Whether the Company has a succession plan for executive management;
• The report of the committee which should include issues such as the number of
meetings held and meeting attendance during the past year, and the committee’s
policies and procedures.

Other Committees

Investors should determine whether the Board has other committees that are
responsible for overseeing management’s activities in certain areas, such as
corporate governance, mergers and acquisitions, legal matters or risk management.

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h. Implementation of code of ethics.

Investors should determine whether the Company has adopted a code of ethics, and
whether the Company’s actions indicate a commitment to an appropriate ethical
framework.

A Company’s Code of Ethics sets standards for ethical conduct based on basic principles
of integrity, trust, and honesty. It provides personnel with a framework for behavior while
conducting the Company’s business, as well as guidance for addressing conflicts of
interest. In effect, it represents a part of the Company’s risk management policies, which
are intended to prevent Company representatives from engaging in practices that could
harm the Company, its products or Shareowners.

Reported breaches of ethics in a Company often result in regulatory sanctions, fines,

management turnover and unwanted negative media coverage, all of which can adversely
affect the Company’s performance.

Investors should determine whether the Company

• gives the Board access to relevant corporate information in a timely and
comprehensive manner;
• is in compliance with the corporate governance code of the country where it is located;
• has an ethical code and whether that code prohibits any practice that would provide
advantages to Company insiders that are not also offered to Shareowners;
• has designated someone who is responsible for corporate governance;
• has an ethical code that provides waivers from its prohibitions to certain levels of
management, and the reasons why;
• waived any of its code’s provisions during recent periods, and why;
• regularly performs an audit of its governance policies and procedures to make
improvements.

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i. Personal use of company assets.

Investors should determine whether the Company permits Board Members,

management and their family members to use Company assets for personal reasons.

Company assets are used to conduct Company business. If they are used by anybody for
personal reasons, they are not available for investment in productive and income-
generating activities. For Board Members, such use also creates conflicts of interest.

When reviewing this issue, investors should determine whether the Company:
• has an ethical code or policies and procedures that place strict limits on the ability of
insiders to use Company assets for personal benefit;
• has lent cash or other resources to Board Members, management or their families;
• has purchased property or other assets such as houses or airplanes for the personal use
of Board Members, management, or their family members;
• has leased assets such as dwellings or transportation vehicles to Board Members,
management or their family members, and whether the terms of such contracts are
appropriate given market conditions.

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j. Executive compensation.

Investors should analyze both the amounts paid to key executives for managing the
Company’s affairs and the manner in which compensation is provided to determine
whether compensation paid to its executives is commensurate with the executives’
level of responsibilities and performance, and provides appropriate incentives.

Every year, shareowners learn of new jaw-dropping executive compensation packages

that seemingly defy rational explanation. In 2004, the average CEO of a major company
received $9.84 million in total compensation, according to The New York Times.

As described earlier, the Board is responsible for ensuring that an executive

compensation program is in place which will attract, retain and motivate strong
management. Compensation plans should encourage executives to achieve performance
objectives and in so doing, create long-term shareowner value.

Executive compensation has four basic components: base salary, bonuses, stock options
and various perquisites. The amounts paid and the manner in which executive
management is compensated can affect Shareowner value in various ways. Investors
should examine the reported:

• Remuneration/compensation strategy. Does the program reward long-term or short-

term growth? How does the remuneration / compensation committee set pay for
executives? Do it use outside consultants or rely on internal resources? Is the program
based on the performance of the Company relative to its competitors or other peers?

• Executive compensation. This requires the analysis of actual compensation paid to the
top executives during recent years and the elements of the compensation packages
offered to them. The analysis can help investors determine whether the investment
made in executive management is producing adequate returns for the Company.

• Equity-based compensation. Equity-based compensation can be a critical element of

compensation and can provide the greatest opportunity for the creation of wealth for
managers whose efforts contribute to the creation of value for shareholders. Thus,
equity-based compensation plans can offer the greatest incentives. Shareowner
interests are also greatly affected by equity-based compensation plans: the ownership
positions of existing Shareowners could be diluted, and executives could assume
additional risks because of stock options granted to them, etc.

o Investors should examine the size of grants, potential value to recipients, cost
to the company, and plan provisions that could have a material impact on the
number and value of shares distributed.
o Should all plans that provide for the distribution of stock or stock options to
executives be submitted to shareowners for approval?
o What’s the impact on the income statement? IAS and U.S. GAAP both require
Companies to expense stock options grants.

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o Are equity-based compensation plans linked to the long-term performance of

the Company?
o Option re-pricing: Companies might want to re-price downward the strike
prices pf stock options previously granted. This would remove the incentives
the original options created for management.
o Investors should examine the information about the extent to which individual
managers have hedged or otherwise reduced their exposure to changes in the
company’s stock price. They should also determine if managers have share
holdings other than those related to stock option grants.

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k. Shareowner proxy voting.

Investors should determine whether the Company permits Shareowners to vote

their shares by proxy regardless of whether they are able to attend the meeting in
person.

The ability to vote one’s shares is a fundamental right of share ownership. Sometimes a
Company makes it difficult for Shareowners to vote their common shares by not allowing
them the right to vote by proxy, or by accepting only those votes cast at its annual general
meeting.

In examining whether a Company permits proxy voting, investors may ask questions like:

• Is proxy voting permitted?

• How easy it is for Shareowners to cast their votes by proxy?

o Does the Company offer electronic delivery of proxy materials? Can
Shareowners view proxy materials online?
o Do Shareowners have to attend annual general meeting to vote, or does the
Company offer telephone or Internet voting, or some other remote mechanism?

• Does the Company coordinate the timing of its annual general meeting with other
Companies in its region to ensure they don’t hold their meetings on the same day but
in different locations? In some regions that require Shareowners to attend such
meetings to vote, Shareowners may not be able to attend all the meetings if they are
held at the same time but in different locations.

• Is the Company permitted to use share blocking? Proxy voting in certain countries
requires “share blocking.” Shareholders wishing to vote their proxies must deposit
their shares shortly before the date of the meeting (usually one-week) with a
designated depositary. During this blocking period, shares that will be voted at the
meeting cannot be sold until the meeting has taken place and the shares are returned
to the clients’ custodian banks.

• What are the state proxy regulations governing the Company?

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l. Shareowner proposals.

Shareowner-Sponsored Board Nominations

Investors should determine whether and under what circumstances Shareowners

can nominate individuals for election to the Board, or vote to remove a Board
Member. By doing so they can force the Board or management to take steps to address
Shareowner concerns and improve the Company’s financial performance.

Investors should determine how the Company handles contested Board elections.

Shareowner-Sponsored Resolutions

Investors should determine whether and under what circumstances Shareowners

can submit resolutions for consideration at the Company’s annual general meeting.

Shareowners are entitled to bring non-binding resolutions to a vote of the shareholders as

part of the company's annual meeting process. They may bring resolutions on a wide
variety of topics. The U.S. SEC Rule 14a-8 governs Shareowner-sponsored resolutions. It
appears to do more to protect corporations from shareowners: that is, the SEC allows
corporations thirteen circumstances under which a corporation can ignore a Shareowner’s
resolution. Investors, however, must understand what they can do if the Board or
management fails to act in the best interests of all Shareowners. The ability to propose
needed changes can prevent erosion of Shareowner value. This could pressure the Board
or management to change the way they do business.

Investors need to determine how much votes are needed to pass a resolution, whether
Shareowners can request a special meeting to address special concerns, and whether the
proposals benefit all Shareowners or just those making the proposals.

Advisory or Binding Shareowner Proposals

Investors should determine whether the Board and management are required to
implement proposals that Shareowners approve.

The Company may tend to ignore those proposals that have been approved but not
binding. Investors should determine whether the Company has implemented or ignored
such approved proposals before, or whether there are any regulatory concerns to
implement these proposals.

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m. Ownership structure.

Investors should examine the Company’s ownership structure to determine whether

it has different classes of common shares that separate the voting rights of those
shares from their economic value.

The management team and the Board should act in the best interests of all Shareowners.
However, if a Company has two classes of common shares (dual classes of common
equity):
• class A Shareowners have all the voting rights.
• class B Shareowners don’t have any voting rights.
then the management team and the Board are more likely to focus on the interests of class
A Shareowners. The rights of class B Shareowners may suffer as a consequence of the
ownership structure.

The Company’s ability to raise equity capital for future investment may be impaired as
it’s difficult to sell unattractive class B shares to investors. To finance future growth the
Company may need to raise debt capital and increase leverage.

If you are reviewing the Company, you should consider:

• Does the Company have safeguards in its articles of organization or by-laws that
protected the rights and interests of class B shareowners?
• If the Company was recently privatized by the government, has the government
retained voting rights that could veto certain decisions of management and the Board?
If so, it could hurt other Shareowners.
• Have the super-voting rights of class A Shareowners impaired the Company’s ability
to raise equity capital?

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n. Takeover defences.

Shareowners should carefully evaluate the structure of an existing or proposed

takeover defences and analyze how they could affect the value of shares in a normal
market environment and in the event of a takeover bid.

The consequences of mergers and takeovers may include redistribution of income,

closing of some plants and expansion of others, and elimination of specific managerial
and other positions and creation of others. Various anti-takeover defences (e.g. golden
parachutes, poison pills, and greenmail) tend to favor the interests of managers over those
of Shareowners. They often interfere with the ownership rights of Shareowners and
constitute an obstacle to efficient reallocation of resources.

The justification for the use of various anti-takeover defences should rest on the support
of the majority of Shareowners and on the demonstration that preservation of the integrity
of the company is in the long-term interest of Shareowners. However, it is also hard to
establish whether these defensive actions cause financial prejudice to shareowners.

Investors should consider the following things when reviewing a Company’s anti-take
over measures:
• Inquire whether the Company is required to receive Shareowner approval for such
measures prior to implementation.
• Inquire whether the Company has received any formal acquisition overtures during
the past two years.
• Is there a possibility that the Board or management will use the Company’s cash and
available credit lines to pay a hostile bidder to forego a takeover? In general this is
not good for Shareowners.
• Inquire whether the local or national government will interfere so the seller has to
change the terms of a proposed merger or acquisition.
• Consider whether change-in-control provisions will trigger large severance packages
and other payments to Company executives.

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