Ethics Case Study of the Week: Doing Too Much to Make Investments a Success?

By Gary Sarkissian posted 08-17-2020 09:36


CFA Institute’s Code of Ethics and Standards of Professional Conduct codify the ethical guidelines for the investment profession that are critical to maintaining the integrity of capital markets and investor trust.  Members, candidates, and even firms make a commitment to uphold these standards as they help elevate ethical decision-making universally around the globe.  

As investment professionals, we are certain to face important ethical decisions in our day-to-day activities.  Some scenarios we encounter will be straightforward, while others may be more complex.  No matter what circumstances we face, continuous learning remains imperative in an investment industry that continues to evolve with products undergoing innovation and a regulatory environment continuing to adapt. 

For that reason, each week we will feature a sample case from CFA Institute’s Ethics in Practice Casebook.  Each case is built upon a real-life example that may involve a regulatory matter or even a CFA Institute Professional Conduct investigation.  At the end of the case is a multiple-choice question that addresses the ethical nature of the actions taken in that case.  

This week’s case involves Standard I(A) Knowledge of the Law. 

Doing Too Much to Make Investments a Success?
Corrales manages a hedge fund that seeks out investment opportunities in developing markets. Using assets of the fund’s investors, the fund hires local companies to serve as “sub-advisers” to explore and obtain promising investment opportunities and navigate local laws and regulation. The sub-advisers often have very limited experience as financial consultants or advisers but do have close relationships and connections with local high-ranking government officials. The payments made by Corrales, through the sub-advisers, often cover substantial “deal fees” and other expenses that facilitate governmental support of each investment. Corrales does not require the local business partners to provide details of their activities or what specific expenses are covered by the fees. Corrales reports these expenditures to fund investors as operating expenses necessary to the success of the investment. Over several years, the hedge fund is very successful producing an 18% annual rate of return for its investors. Did Corrales actions violate the CFA Institute Code of Ethics and Standards of Professional Conduct?

A.  Yes.
B.  No because it is acceptable to hire sub-advisers and business consultants to assist in procuring investment opportunities and managing specialized assets.
C.  No because the payments to the sub-advisers represent legitimate expenses to ensure the success of investments and protect the interest of investors.
D.  No, as long as the sub-advisers provide more detail about the nature and purpose of the payments and this information is disclosed to the hedge fund investors.

What do you think is the correct choice?  Feel free to discuss in the comments below and make sure to check back later this week as we post the analysis.  The completion of this case qualifies for 0.25 hour of Standards, Ethics, and Regulation (SER) credit.  

[Update – 8/20/2020]
Welcome back!  Here is the analysis of this case:

To better serve clients, investment professionals may choose to delegate to third parties work that requires particular specialization, knowledge, or expertise. For example, an investment adviser may hire sub-advisers to handle a particular strategy or investment style outside the scope of the adviser’s ability or experience. A global adviser may hire a sub-adviser to manage an asset allocation invested in a particular market, and the payments to the sub-adviser would be legitimate investment expenses that could properly be passed on to investors in the fund.

But the facts of this case indicate that Corrales is not hiring a true sub-adviser but essentially paying locally connected officials to secure access to investment deals to ensure the success of the fund’s investments. The “sub-advisers” have no financial experience but are close to the government officials, and the “deal fees” are not supported by any documentation that details legitimate investment expenses. The “operating expenses” charged by Corrales to the fund are most likely funding corrupt transactions and bribes through local intermediaries. This practice violates multiple standards:

  • I(A): Knowledge of the Law because the conduct would violate any type of anti-bribery laws.
  • I(C): Misrepresentation because he is improperly labeling the expenditures as investment fees.
  • V(A): Diligence and Reasonable Basis because no reasonable and adequate basis for the “investment” action exists.
  • V(C): Record Retention because no appropriate records are being kept to support the action.
  • VII(A): Conduct as Participants in CFA Institute Programs because assuming Corrales is a charterholder, his conduct compromises the integrity to the CFA designation.

This case is based on a US SEC enforcement action from 2017.

Image by Jason Goh from Pixabay

© 2018 CFA Institute. All rights reserved. You may copy and distribute this content, without modification and for non-commercial purposes, provided you attribute the content to CFA Institute and retain this copyright notice. This case was written as a basis for discussion and is not prescriptive of how a business situation or professional conduct matter should or should not be handled or addressed. Certain characters mentioned are fictional to facilitate discussion, and any resemblance to actual persons is coincidental.