Ethics Case Study of the Week: Where is the Due Diligence?

By Gary Sarkissian posted 01-31-2022 08:00

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 Standard V(A) Diligence and Reasonable Basis.

Where is the Due Diligence?
Soto manages assets for high-net-worth individuals, family groups, foundations, endowments, and similar institutions. Many of his clients have expressed interest in investing a portion of their assets in alternative investments to boost their portfolio return. Soto recommends particular alternative assets, including hedge funds, to his clients and monitors those investments on his clients’ behalf. Soto has developed written policies and procedures that he consistently applies when evaluating potential hedge fund investments, but he does not disclose these policies and procedures to his clients. Soto generally meets in-person with the hedge fund managers at the funds’ offices to discuss their implemented investment strategy, understand the culture of the manager, have increased access to review documents, and speak with the fund’s personnel. Unless he sees a red flag, Soto does not conduct comprehensive background checks on the managers and their key personnel.

Several of the hedge fund managers he chooses as investments for his clients have undisclosed potential conflicts of interests, such as compensation arrangements or business activities with affiliates. When choosing potential hedge fund investments, Soto ensures that the investment style of the fund is suitable for his clients and intermittently checks to verify the fund’s commitment to that style over time. Although Soto does not independently verify the funds’ relationships with service providers, such as administrators and custodians, he does carefully evaluate the auditors of the fund when he is not familiar with the auditor. Some of the funds that Soto choses as investments for his clients have multiple changes in key third-party service providers over time. Soto relies on third party legal consultants to review legal documents to evaluate such issues as redemption terms and restrictions. Soto relies on marketing material prepared by the hedge funds to provide his clients with as accurate as possible information about the investment. What do you think of Soto’s actions?

 A. Soto’s actions are acceptable under the CFA Institute Code of Ethics and Standards of Professional Conduct.
 B. Soto’s actions violate the CFA Institute Code of Ethics and Standards of Professional Conduct.

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 involves CFA Institute Standard V(A): Diligence and Reasonable Basis, which requires CFA Institute members to exercise diligence, independence, and thoroughness in analyzing investments and making investment recommendations. In choosing hedge fund investments for his clients, Soto must undertake appropriate due diligence in evaluating the funds for potential investment for his clients. Does Soto’s actions meet the due diligence and reasonable basis requirement of the CFA Institute Code and Standards? Soto takes many steps to thoroughly evaluate the hedge fund investments, including consistently applying written policies and procedures when engaging in due diligence; holding in-person meetings at the funds’ offices to understand the investment strategy, evaluate the manager, meet with key personnel, and make sure the investment is suitable for his clients; investigating the auditor of the fund when it is unfamiliar; having the legal documents of the fund reviewed; and using the funds’ own statements and promotional material in an effort to accurately describe the fund to his clients.

But some of Soto’s actions may not have been as strong as they could be, leading him to miss potential red flags. Although he adopts due diligence policies and procedures, he does not disseminate those to clients. He does background checks of fund personnel only when he sees a “red flag” leading him to miss potential conflicts of interest on the part of fund personnel. He does not check employment history, legal and regulatory matters, news sources, and independent references of firm personnel. He checks on a fund’s strategy and suitability for his clients, but he does not regularly go back to check the fund for style drift. He does not independently verify the relationships with certain fund service providers (administrators, custodians) and looks into the auditor only when he is not already familiar with them, potentially missing business relationship or other conflicts of interests that could undermine their independence. He outsources the legal document review to a third party, which may be appropriate if Soto does not have legal expertise but could be an issue if the third-party review is not thorough or as complete as necessary. Finally, by relying on the marketing material of the fund and not creating his own independent information for his clients, he could be providing false or misleading information prepared by the fund itself. Assessing due diligence is a very facts and circumstances specific exercise. If a client were to challenge Soto’s due diligence efforts as insufficient under Standard V(A), whether his diligence is adequate would likely depend on the specific facts of the case.

This case is based on a 2014 Risk Alert by the US SEC Office of Compliance Inspections and Examinations.

Image by Arek Socha 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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