Ethics Case Study of the Week: Shopping for the Best Deal?

By Gary Sarkissian posted 01-18-2022 12:29

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 Standard V(A) Diligence and Reasonable Basis.

Shopping for the Best Deal?
Salazar works for IFS, a broker/dealer. He is hired by the Public Library District in Harvey, Illinois, to underwrite the issuance of a $6 million municipal bond offering intended to finance the expansion and renovation of the district’s library building. The district has never issued bonds before, and its board of trustees and director (a librarian) have no prior experience with the bond-offering process. The district does not hire an adviser to help select an underwriter for the bonds and does not conduct a competitive selection process or consider other underwriters before hiring Salazar and IFS. This job will be Salazar’s first experience serving as a bond underwriter. He discloses this fact to the Harvey Library District and, as a result, agrees to charge the district a reduced fee.

As the sole underwriter of the bond offering, Salazar is responsible for marketing and selling the bonds to investors. Despite the fact that the district’s bonds are insured, have an investment-grade rating, and are “bank qualified” (meaning they could be sold to regional or community banks), Salazar has difficulty finding buyers. Investors are confused about the relationship between the Harvey Library District and the City of Harvey, which has a history of regulatory action against it for fraudulent misuse of bond issue proceeds. Although the Harvey Library District is in the same geographic area as the City of Harvey, the district is a sovereign unit of government that is separate from the city and has separate taxing authority, governance, and finance. The regulatory actions against the city are unrelated to the Harvey Library District. Even though the bonds are bank qualified, Salazar does not market the bonds to banks. He also does not contact potential investors until several weeks after the start of the engagement and only a few days before the planned order period. Salazar’s marketing efforts and initial order period are also done before the bond insurance had been confirmed.

When Salazar is unable to identify any interested investors before or during the initial order period, he postpones the order period by several days. Eventually, Salazar is able to locate a single buyer, another broker/dealer, which offers to buy the bonds at a price of $115.73 and a 5.05% yield. Although the yield is higher than comparable bonds, Salazar convinces the district to accept the offer. On the same day their offer is accepted, the broker/dealer sells the bonds to a private fund at a price of $116.15 and a 5% yield for a profit of $25,260. The private fund sells the bonds to an investment bank at a price of $122.35 and a 4.3% yield. The investment bank then immediately sells the bonds to six small regional banks at a price of $124.86 and a 4.0% yield. Salazar’s actions are

 A. not acceptable because he has not been chosen as an underwriter under a competitive selection process overseen by a person or entity advising the district on the bond-ffering process.
 B. acceptable because he discloses to his client his lack of experience in serving as an underwriter and charges a discounted fee.
 C. acceptable because he fulfills his responsibility as an underwriter by finding a purchaser for the bonds and raising funds for the district.
 D. not acceptable because he fails in his responsibilities as an underwriter.
 E. none of the above.

What do you think is the best 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 an investment professional’s responsibility to act competently and diligently for his or her clients. The CFA Institute Code of Ethics and Standards of Professional Conduct require investment professionals to act with competence, diligence, and thoroughness in working for the benefit of their clients. In this case, Salazar has the duty to diligently and competently work for the Harvey Library District while serving as an underwriter and to market and sell the bonds to investors to maximize proceeds of the bond issue. The information provided indicates that Salazar failed to exercise this duty because his marketing efforts were insufficient. Specifically, Salazar

  • failed to market the bonds immediately and had a short marketing period,
  • failed to identify parties interested in buying the bonds or to obtain preliminary orders or “indications of interest” before opening the order period,
  • failed to market desirable bank-qualified bonds to banks,
  • failed to adequately resolve investors’ confusion between the Harvey Library District and the City of Harvey, and
  • failed to confirm that the bonds would be insured before his marketing efforts.

These failures resulted in bonds that sold for a lower price and higher yield than comparable bonds. A high yield and low price means that the issuer pays more interest over the life of the bond. The fact that a number of intermediaries sold the bonds on better terms immediately after issue for a healthy profit is evidence that Salazar did not diligently and competently obtain fair market value for the issue. Salazar’s inexperience as an underwriter and his discounted fee does not absolve Salazar of his duty to act competently and with thoroughness and diligence in fulfilling the responsibilities for which he was hired. Although the Harvey Library District would have been advised to hire an adviser to provide guidance on the bond issue and conduct a competitive underwriter selections process, it is not the responsibility of Salazar or IFS to decline the underwriting business if the district failed to follow best practices. Choice D is the best response.

This case is based on a June 2019 US SEC Enforcement Action.

Image by Michal Jarmoluk 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.