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 feature a sample case from CFA Institute’s Ethics in Practice Casebook. Many cases are built upon real-life examples that may involve a regulatory matter or even a CFA Institute Professional Conduct investigation. At the end of each 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(B) Fair Dealing.
Name Your (Bond) Price!
Zhang is an investment adviser offering clients fixed-income investment advice through numerous separately managed accounts and two pooled investment vehicles. She charges clients an advisory fee for assets under management (AUM) and does not charge clients based on trading activity. Zhang generally invests her fixed-income portfolios in nonrated, tax-exempt, and thinly traded municipal bonds that are issued to finance the construction of senior living facilities, schools, and prisons. Zhang often holds a controlling institutional position in the bonds held across client accounts. Zhang frequently arranges for authorized cross-trading in these securities to facilitate portfolio management and provide liquidity for terminating clients. By effecting cross trades among clients, rather than trading in the secondary market, Zhang provides selling clients with liquidity in an otherwise illiquid market while maintaining a controlling position in the securities.
At the end of each month, Zhang prices the holdings in each client’s portfolio by obtaining bid-side evaluation quotes (bid price) from the various broker/dealers who underwrote each of the bonds. Frequently, Zhang challenges the prices quoted by the broker/dealers as too low and, in certain instances, the broker/dealers revise their quotes to Zhang’s proposed alternative price. When arranging cross trades, Zhang selects broker/dealers who are willing to execute cross trades at favorable, predetermined spreads that are narrower than the average bid–ask spread of trades in the same or similar securities executed in the secondary market. The trades are executed at the bid price obtained for month-end valuation purposes. Zhang’s actions are
B. appropriate because Zhang charges an advisory fee for AUM and thus does not benefit from the cross trades.
C. appropriate because Zhang is valuing thinly traded securities in her clients’ portfolios by using price quotes from the underwriting broker/dealers who are familiar with the securities.
D. appropriate because Zhang seeks best execution by using broker/dealers who are willing to execute the cross trades at favorable bid–ask spreads that are narrower than spreads in the secondary market.
What do you think is the correct choice? Click the “Analysis” button below to see the analysis for this case, 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.
This case relates to CFA Institute Standard III(B): Fair Dealing, which requires CFA Institute members to deal fairly and objectively with all clients when taking investment action. Zhang’s actions violate this standard. By cross-trading securities at the bid price rather than obtaining and using an average or midpoint between the bid and ask prices, Zhang’s actions favored the buying clients over the selling clients. At the same time, Zhang favored the selling clients in those instances in which she successfully challenged the valuations of the securities as too low. Cross-transactions subsequently executed at these higher price levels disadvantaged Zhang’s buying clients, who ended up paying more than they would have had the bonds been available for purchase in the secondary market at terms similar to prior trades. Zhang’s disclosure of these practices would not help in this case because disclosure does not cure or excuse treating clients unfairly. It is not clear from the facts why Zhang challenged the price of the securities as too low, but this also represents a conflict of interest for Zhang in that a higher valuation presumably benefited her investment performance history. It is also not clear that Zhang inappropriately influenced or manipulated the bond prices quoted by simply asking the brokers to reconsider their initial price. The brokers only occasionally revised the price upward. Zhang did not personally hold a controlling position but held the position by virtue of her many clients’ investments.
Although Zhang did not benefit from the cross trades as her fees were based on AUM, Zhang failed to discharge adequately her best price and best execution obligations for her selling clients. Seeking valuation of thinly traded securities using broker–dealer quotes is appropriate; but in this case, Zhang used quotes from the broker/dealers who were the original underwriters of the securities and not the executing broker/dealers who were trading the same or similar securities and who would have a better idea about recent bid–ask trading activity. Finally, even if the bid–ask spreads are narrower, Zhang failed to undertake any assessment as to whether the securities were available on better terms for buying clients in the secondary market. If the prices are too high, the valuation is inappropriate. Choice A is the best answer.
This case is based on a 10 August 2018 administrative action by the US SEC.
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© 2019 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.