Ethics Case Study of the Week: Pay No Attention to those Bad Loans!

By Gary Sarkissian posted 11-08-2021 07:00

CFA Institute’s Code of Ethics and Standards of Professional Conduct outline 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 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 the circumstances, continuous learning remains imperative in an evolving investment industry and an adapting regulatory environment. 

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 III(D) Performance Presentation, III(A) Loyalty, Prudence, and Care, V(A) Diligence and Reasonable Basis, I(C) Misrepresentation, I(A) Knowledge of the Law, and IV(C) Responsibilities of Supervisors.

Pay No Attention to those Bad Loans!
Prosper Funding (Prosper) is a marketplace lender that enables borrowers to obtain unsecured consumer loans and allows investors to purchase securities linked to the performance of those loans. Prosper creates individual account pages for each investor on its website, which provides information on the consumer loans, gives the annualized net return (ANR) performance of each investor’s account, and includes a link through which they can invest in Prosper securities. Prosper calculates the ANR for each
investor using an automated process developed some years ago by personnel no longer with the firm.  ANR results are reported prominently on each investor’s online account page.

After several years, Prosper implements a “debt sale program” through which eligible nonperforming, charged-off consumer loans linked to Prosper securities are sold. Because of an unforeseen effect of a previous, unrelated change to the original coding in the program, Prosper reports an ANR to its clients that excludes the impact of the worst-performing securities that they previously held but that have since been sold to third-party debt purchasers. Periodically, Prosper reviews all of the computer processes used by the company, and through that review, it becomes clear that current employees lack an understanding of the ANR calculation process. The review is always general and at a high level, and thus Prosper does not identify the error in the ANR calculation. Because of the error, Prosper reports to a majority of its investors that their investments are earning up to double the returns they actually had earned.

When certain affected investors raise questions about the accuracy of the ANR calculations they received, Prosper’s customer service department handles the complaints and confirms the reported figures were calculated erroneously because of a flawed computer program. The customer service employees do not elevate any of these complaints to Prosper’s product, engineering, or compliance departments. Prosper has also solicited new investors for its securities based on the miscalculated ANR by sending hundreds of emails that highlight their ANR performance (albeit erroneous) and has recommended that investors “add funds and build on their solid returns.” Prosper does not identify the error for several years and discovers it only after receiving a complaint from a large institutional investor. Prosper notifies investors that it miscalculated and misstated their ANR and provides a current, correct calculation of the ANR to investors at that time.

Choose one of the following Prosper personnel and explain how that employee may have violated the CFA Institute Code of Ethics and Standards of Professional Conduct (Code and Standards) and why.

A. Employee responsible for the computer program that calculates the ANR.
B. Customer service employee responding to client complaints about the ANR.
C. Marketing employee using the ANR performance calculations to solicit investments.
D. Compliance employee responsible for firm policies and procedures.
E. CEO of Prosper.

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.

A. Prosper’s issues begin with ANR performance that is calculated incorrectly and posted to client accounts. The CFA Institute Standard of Professional Conduct III(D): Performance Presentation requires CFA Institute members to make reasonable efforts to ensure that investment performance is presented in a fair, accurate, and complete manner. The ANR is calculated using a computer program that was created many years earlier, and over the years, it has developed a defect that leads to dropping underperforming accounts from the calculation. Although the person currently responsible for calculating the ANR did not create the computer program, that employee does not understand the program’s process and has not adequately reviewed the calculation method to ensure that it is accurate, thus allowing the error to continue.

B. Although the customer service employee responding to client complaints is not responsible for the ANR calculation error, that employee is responsible for acting in accordance with Standard III(A): Loyalty, Prudence, and Care to protect client interests once the issue has been raised. That employee failed to elevate any of the investor complaints to Prosper’s personnel responsible for the calculation and apparently simply recalculated the ANR using the same flawed code. The customer service employee did not engage with or investigate the client complaints with sufficient reasonable care, diligence, competence, or professionalism, as required by Standard V(A): Diligence and Reasonable Basis and the Code of Ethics.

C. The marketing employee using erroneous ANR performance is not responsible for the calculation error. Team members should be able to rely on the work of others in their firm (in this case, those calculating the ANR) to fulfill their responsibilities in an appropriate manner to produce accurate work. But in this case, the marketing employee is ultimately responsible for distributing misleading information that misrepresents the true performance of the securities, which violates Standard I(C): Misrepresentation. Once the marketing employee becomes aware that the information is inaccurate, that employee must take steps to remediate the error and distribute accurate and complete information.

D. The compliance employee has a responsibility to review the firm’s policies and procedures to ensure that they meet relevant regulatory and ethical requirements. Prosper only sporadically reviews all the computer programs and processes used by the company, uses employees to calculate the ANR performance that lack an understanding of the ANR calculation process, and conducts only a high-level review that would not catch the error in the ANR calculation. Similar to the customer service employee, the compliance employee did not exercise sufficient care, diligence, competence, or professionalism as required by Standard V(A): Diligence and Reasonable Basis and the Code of Ethics to ensure that an adequate compliance program was in place to address errors or properly investigate problems once discovered.

E. The Prosper CEO likely has no direct involvement with the calculation and presentation of performance, addressing client complaints, or creating and implementing compliance procedures. But the CEO does have overall responsibility to ensure that the firm complies with the law (Standard I(A): Knowledge of the Law) and protects client interests (Standard III(A): Loyalty, Prudence, and Care) as well as overall supervisory responsibility for firm employees (Standard IV(C): Responsibilities of Supervisors). The CEO is allowed to delegate this responsibility. But the Code and Standards require those with supervisory responsibility to make reasonable efforts to ensure that those under their supervision comply with applicable laws and the Code and Standards. The breakdown of the policies and procedures of the firm designed to accurately calculate performance, adequately address complaints, and implement an appropriate compliance program are all red flags indicating a potential failure of the CEO to properly supervise employees of the firm.

This case is based on an April 2019 US SEC Enforcement Action.

Image by mohamed_hassan 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.