Ethics Case Study of the Week: Just Be Gentle…

By Gary Sarkissian posted 03-14-2022 09:00

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 IV(C) Responsibilities of Supervisors.

Just Be Gentle…
Stansfield is hired by Roudabush Securities Inc. (RSI) to manage a staff of investment advisers. Delorme, one of the investment advisers Stansfield supervises has been with RSI for more than 30 years and is the sister-in-law of the owner of the firm. Delorme is involved in a pump-and-dump trading scheme with an investment adviser outside of RSI in which Delorme buys or encourages her clients to buy speculative “penny” stocks to boost demand and price of the securities controlled by the outside adviser. In return, Delorme receives compensation from the outside adviser. Stansfield becomes aware of these activities from Delorme’s emails, which are flagged by the email monitoring system Stansfield put in place to detect misconduct on the part of his subordinates.

He limits her trading in the last hour of the day and restricts her from trading in certain penny stocks, but he allows her to continue to interact with customers, process orders, and make investment recommendations and decisions for her clients. He tells colleagues that because of Delorme’s senior position at the firm, he wants to “be gentle” in terms of restrictions and not take excessively harsh action. But during this time, Delorme continues to act as an accomplice in the stock manipulation scheme. Eventually, two clients complain to RSI about the securities bought for their accounts when they become worthless. The complainants note that the deals had to be handled through a different broker/dealer, apparently because of RSI’s trading restrictions on Delorme.

Finally, the local regulator notifies RSI that they are investigating Delorme’s conduct. RSI policies do not specify whether an employee’s supervisor, compliance personnel, or the firm’s legal department have responsibility for investigating misconduct. Nevertheless, Stansfield begins an internal investigation into Delorme’s conduct. RSI policies do not specify how the results of the investigation are to be documented or reported or who within the firm has responsibility to address potential employee misconduct once discovered. Stansfield’s actions with respect to Delorme are

 A. acceptable because he put an effective email monitoring system in place to detect misconduct. 
 B. acceptable because he restricted Delorme’s activities once alerted of potential misconduct. 
 C. acceptable because he takes the initiative to investigate Delorme’s activities in the face of ambiguous firm policies.
 D. unacceptable.
 E. none of the above.

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 effective exercise of supervisory responsibility. CFA Institute Standard IV(C): Responsibilities of Supervisors states that CFA Institute members must make reasonable efforts to ensure that those subject to their supervision comply with applicable laws, rules, and regulations as well as with the CFA Institute Code of Ethics and Standards of Professional Conduct. Effective supervisors enact policies and procedures to encourage compliance and investigate and punish employee misconduct when it arises. In this case, a number of red flags alert Stansfield to Delorme’s misconduct, including emails, client complaints, and a regulatory investigation. In the face of these red flags, Stansfield must promptly initiate an assessment to determine the extent of wrongdoing and take steps to ensure that the misconduct does not continue. Stansfield’s policies and compliance practices (email monitoring system) successfully reveal Delorme’s misconduct, and he initiates an investigation. He does then take some steps to limit Delorme’s activity. But because he is deferential to Delorme’s seniority, the measures he takes are inadequate, and Delorme works around the restrictions to continue the misconduct.

In addition, RSI’s compliance policies are vague and incomplete when it comes to addressing misconduct. They lacked any reasonable coherent structure to provide guidance to supervisors and other staff for investigating possible misconduct, and they lacked reasonable procedures regarding the investigation and handling of red flags. If a CFA Institute member cannot discharge supervisory responsibilities effectively because of an inadequate compliance system, he or she should not accept a supervisory position until an adequate compliance system is put in place. Given the nature of Delorme’s misconduct and the clear danger to client interests, Stansfield should have taken stronger action to remove Delorme from the investment management process. Additionally, in the face of RSI’s inadequate compliance system, Stansfield should not have accepted supervisory responsibility. Choice D is the best response.

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

Image by Karolina Grabowska 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.