This case centers on whether a person in a position of authority effectively exercises supervisory responsibility. CFA Institute Standard IV(C): Supervisory Responsibility requires CFA Institute members to make reasonable efforts to ensure that those subject to their authority comply with regulations, firm compliance procedures, and fundamental ethical principles. At a minimum, members must make reasonable efforts to prevent and detect violations by establishing an effective compliance system. In this case, the compliance procedures are not reasonably designed to ensure the suitability of mutual fund switch transactions and to prevent churning because they rely solely on the portfolio manager to self-report and alert the firm about the transaction.
Regal has no supervisory mechanism in place to initiate a review of mutual fund switches in the event that a portfolio manager fails to complete the required form or otherwise fails to notify Regal of the transaction. This lack would allow unscrupulous portfolio managers to escape supervisory scrutiny by the firm. As a general matter, it would be acceptable and effective for a firm to verify trades using trader reports generated by its clearing firms. But in this case, these reports are incomplete because they do not identify mutual fund switch transactions. Acknowledgment by a client is ineffective if those trades that require acknowledgment are not made known to the supervisor, compliance officer, and client by a portfolio manager who does not follow the firm’s compliance procedures to obtain prior approval of the trade. Choice D is the best response.
This case is based on an enforcement action by the US Financial Industry Regulatory Authority from June 2019. In the case, two portfolio managers took advantage of the inadequate supervisory system to place mutual fund switch trades in which clients incurred unnecessary front-end sales loads of close to US$400,000 in losses.