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Ethics Case Study of the Week: Resetting the Clock

By Gary Sarkissian posted 08-02-2021 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 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 Standards I(A) Knowledge of the Law, I(D) Misconduct, and III(A) Loyalty, Prudence, and Care.


Resetting the Clock
Danaher works as a corporate bond broker for AFB Financial (AFB), an interdealer broker that only trades dealer to dealer. Danaher and AFB’s other brokers are paid entirely by commissions and deal only with large banks, institutions, and other dealers, not with retail investors. AFB does not take positions in
any securities and executes trades in a matched principal capacity. One of Danaher’s biggest and most demanding accounts is that of NOVA Capital. NOVA is represented by Elliott who works on NOVA’s corporate bond trading desk. NOVA requires a capital reserve for bond positions that age more than 180 days (aged inventory) and charges that reserve against Elliot’s inventory book. Aged inventory cash reserves affect the profit and loss calculations of Elliot’s proprietary account and, as a result, reduce Elliott’s compensation.

At Elliott’s request, Danaher agrees to occasionally purchase bonds from NOVA and sell back the same bonds later in the day. Danaher understands that these trades allow Elliott to “reset the clock” to avoid aged inventory reductions in the profits of the proprietary account he manages for NOVA and to avoid negative effects to his compensation. Danaher does not immediately reverse the trades but holds these securities for four to six hours during the day. He also does not sell NOVA’s bond positions to another firm before selling them back to Elliott and NOVA at the original price. Danaher’s actions are

A. inappropriate.
B. appropriate because he is executing the trades in the time and manner requested by his client.
C. appropriate because the four to six hours between trades creates market risk.
D. appropriate because Elliott and NOVA are sophisticated institutional clients that are expected to have full knowledge and understanding of their trading strategy.
E. none of the above.


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 misconduct, violation of the law, and loyalty to clients. The CFA Institute Standards of Professional Conduct prohibit members from engaging in any professional conduct involving dishonesty, fraud, or deceit (Standard I(D)), require members to refrain from participating in legal or ethical violations (Standard I(A)), and require members to place their client’s interests before their own interest (Standard III(A)). In this case, NOVA is a client of AFB, and Danaher is AFB’s employee handling that account. Danaher understands that Elliott, NOVA’s representative who is responsible for managing the firm’s account with AFB, is engaged in a fraud against his employer.

Although there would be no issues with a customer buying and selling the same security on the same day, provided the customer assumed market risk, such risk is not established by how long a party holds a position. In this case, there was no market risk because Danaher never sold NOVA’s positions to another firm before selling them back to NOVA at the same price. To placate Elliott, Danaher agrees to assist Elliott in fraudulently updating the “age” of Elliott’s corporate bond inventory on NOVA’s books so that Elliott will not be financially penalized. These trades are not truly at the request of the client but rather are executed on behalf of a duplicitous employee. Furthermore, in meeting this request, Danaher knows that NOVA will have to pay AFB commissions for non-bonafide transactions in which there was no beneficial change in ownership. Danaher personally benefits from these transactions because he receives a portion of AFB’s commissions on the trade as compensation. By assisting in this fraud against NOVA, Danaher fails to protect the interest of his client. The fact that NOVA is a sophisticated investor that fails to discover its own employee’s deceitful and fraudulent activity, does not excuse Danaher’s misconduct. Choice A is the best choice.

This case is based on a June 2019 Financial Industry Regulatory Authority Enforcement Action.




Image by FunkyFocus from Pixabay

© 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.


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