Ethics Case Study of the Week: Violated Professional Standards or Not?

By Gary Sarkissian posted 10-05-2020 08:00


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 IV(C) Responsibilities of Supervisors.

Violated Professional Standards or Not?
Manley, Head of Research at a long–short equity fund, leads a team of four analysts. One of the fund’s portfolio managers asks Manley to look at a particular small-cap company as a possible investment target. Because there is little information available on the company, Manley assigns the challenging task to Chang, one of the fund’s top junior analysts, who spends a week conducting research. Chang builds a cash flow projection model that shows the company is deeply undervalued. Manley briefly reviews the model and publishes a research report on the company with the author listed as the Research Department that recommends a “Buy” at the current price. The fund makes a substantial investment in the company’s stock. Later, several brokerage houses come out with research pieces on the company that include cash flow projections that are considerably lower than Chang’s model. Over the course of six months, the investment loses 25% of its value. Manley thoroughly reviews Chang’s model and discovers two assumptions that eventually proved erroneous as well as an arithmetic mistake. Did either Manley or Chang violate the CFA Institute Code of Ethics and Standards of Professional Conduct (Code and Standards)?

A.  Manley violated the CFA Institute Code and Standards.
B.  Chang violated the CFA Institute Code and Standards.
C.  Manley did not violate the CFA Institute Code and Standards.
D.  Chang did not violate the CFA Institute Code and Standards.

What do you think is the correct choice?  Click the “Analysis” button below to see the analysis, and feel free to discuss in the comments below.  The completion of this case qualifies for 0.25 hour of Standards, Ethics, and Regulation (SER) credit

Many people choose response A, which is the easy answer; the subordinate’s work was flawed, so the supervisor must be responsible. And that can be true under some circumstances. But response C — no supervisor violation — could be just as correct given the right facts and circumstances. This case shows how you must identify all the relevant facts before making a decision to analyze a decision from an ethical perspective. Read on for arguments that could be made for each answer.

Case for Response A. Manley violated Standard V(A): Diligence and Reasonable Basis by relying on the erroneous work done by Chang. In addition, as Head of Research, Manley violated Standard IV(C): Responsibilities of Supervisors by failing to supervise Chang, who himself violated the standards (See Response B analysis). Manley only briefly reviewed Chang’s work. Finally, Manley misrepresented the author of the research report as that of “the Research Department” when Chang conducted the research.

Case for Response B. Chang violated Standard V(A): Diligence and Reasonable Basis. Chang included two erroneous assumptions in his model. It is not clear from the facts that he had a reasonable and adequate basis or that he thoroughly analyzed the information to create his model. Furthermore, he did not thoroughly check his model because he made an arithmetic mistake that contributed to skewing the model results.

Case for Response C. Manley did not violate the standards because he reasonably relied on the work of one of his colleagues, who had a track record of exercising diligence and thoroughness and conducting appropriate research. Furthermore, there is no indication from the facts that Manley failed to adequately supervise Chang. The facts of the case do not indicate the supervisory steps Manley or the fund have in place to monitor Chang’s work. A “brief” review by Manley of the research may be appropriate if other steps are in place (peer review, for example) to check the appropriateness of Chang’s analysis. And there is no indication that Chang violated the standards. (See Response D analysis). Finally, it is proper to have the author of the research report listed as the “Research Department” because the work is that of the firm.

Case for Response D. Chang did not violate the standards because there is no indication from the facts that he failed to exercise diligence and thoroughness or that his research was not supported by appropriate research and investigation. Although the two assumptions ultimately proved erroneous, that does not automatically mean that they were inappropriate when initially made by Chang given the facts he was aware of at the time. Being incorrect about an investment recommendation or prediction is common. An inaccurate prediction is not sufficient evidence that a violation of the CFA Institute Code and Standards occurred. It is also not clear from the facts that the arithmetic mistake was material or affected the outcome of the model.

This case is based on facts written by Tanuj Khosla, CFA, CAIA.


Image by Tumisu 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.