Ethics Case Study of the Week: Capitalizing on Tax Benefits Is OK, Right?

By Gary Sarkissian posted 20 days ago


CFA Institute’s Code of Ethics and Standards of Professional Conductcodify 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 III(C) Suitability. 

Capitalizing on Tax Benefits Is OK, Right?
Marte is an asset manager in Puerto Rico, a US territory. Residents of Puerto Rico receive significant tax advantages by investing in local securities. To capitalize on this advantage, Marte’s firm offers clients shares in a closed-end investment fund, organized under Puerto Rico’s financial laws and regulations, that holds at least 67% local securities and is permitted to borrow against up to 50% of its assets. The fund is usually leveraged to the extent legally permitted. Many of Marte’s clients have a modest net worth and conservative or moderate investment objectives. Marte convinces them to invest 85% or more of their assets in shares of the closed-end fund. Marte’s actions are

A.  appropriate because they take advantage of the fund’s unique tax benefits for his clients.
B.  inappropriate because the fund uses leverage to boost returns.
C.  appropriate as long as Marte fully discloses the risks and benefits of the fund to his clients.
D.  inappropriate because the fund is an unsuitable investment for his retail clients.

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 – 9/10/2020]
Welcome back!  Here is the analysis of this case:


CFA Institute Standard III(C): Suitability states that CFA Institute members and candidates in an advisory relationship with clients must “determine that an investment is suitable to the client’s financial situation and consistent with the client’s written objectives, mandates, and constraints before making investment recommendations or taking investment action.” In this case, given the favorable tax advantages of the investment vehicle, investment in shares of the closed-end fund may be suitable and appropriate for his clients at some level. In addition, the fund’s use of leverage may not be inappropriate or make the investment unsuitable. That said, Marte should always fully disclose the risks and benefits of his recommendations to his clients.

But choice D is actually the best response. Given the financial circumstances and investment objectives of his clients, the high concentration of the fund’s shares in his clients’ accounts combined with the leverage make the weighty investment in the fund unsuitable. Despite the favorable tax advantages, highly concentrated clients bear the increased risk that a single market event affecting the value of the fund’s shares would significantly decrease their total account value. This risk is exacerbated by the fact that the closed-end fund is internally leveraged, which could magnify the fund’s loss during a market event that causes share values to drop steeply.

This case is based on a FINRA (Financial Industry Regulatory Authority) enforcement action from 2015.


Image by Jessica Castillo 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.