Ethics Case Study of the Week: Investment Thesis Gone Up in Smoke

By Gary Sarkissian posted 04-04-2022 14:45

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.

Investment Thesis Gone Up in Smoke
Corix Bioscience is a startup company seeking to begin operations manufacturing and selling cannabidiol (CBD) products. To promote the company, Corix hires Harrelson, an independent research analyst, to write and distribute a research report on the company. Corix informs Harrelson that it has a joint venture with Native American tribes, enabling the company to access tribal lands for farming commercial hemp and cannabis and to sell hemp and cannabis products in retail outlets on tribal lands. Corix also tells Harrelson that the company has obtained a certificate of compliance from regulators that allows the company to transport, process, and export industrial hemp products. Finally, Corix discloses to Harrelson that the prior year’s harvest of hemp surpassed expectations in both quality and quantity, resulting in a substantial inventory of product. Based on these statements by the company, Harrelson includes all of this information in a research report and provides a positive analysis of the company.

In reality, Corix does not have agreements with Native American tribes; the company did not seek or obtain regulatory approval; the certificate of compliance is a forgery; and Corix never cultivated, planted, or harvested significant quantities of industrial hemp. Chong, a research analyst at Natures Harvest Investment Management (NHIM), incorporates the information and conclusions from Harrelson’s research report as part of his own internal research on Corix and includes a “buy” recommendation. Chong’s report is distributed to only portfolio managers at NHIM. Broadus, a NHIM portfolio manager, reviews Chong’s research and purchases substantial holdings in Corix for a number of his clients. Corix is ultimately shown to be a sham operation, leading to substantial losses for Broadus’s clients. Which of the following characters most likely acted in violation of the CFA Institute Code of Ethics and Standards of Professional Conduct and why?

 A. Harrelson.
 B. Chong.
 C. Broadus.
 D. Harrelson, Chong, and Broadus.
 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 diligence and reasonable basis in making investment recommendations and taking investment action. CFA Institute Standard of Professional Conduct V(A): Diligence and Reasonable Basis states that CFA Institute members must exercise diligence and thoroughness in analyzing investments and must have a reasonable and adequate basis supported by appropriate research and investigation for any investment recommendation. The issue in this case is whether Harrelson, Chong, and Broadus complied with the requirements of this standard.

By relying on the statements given by Corix and not conducting an independent investigation into the veracity of the information, Harrelson did not exercise diligence and thoroughness in analyzing the company. Chong seemingly relied on Harrelson’s research to formulate his “buy” recommendation without conducting his own independent research. Investment professionals who rely on third-party research conducted outside their firm by someone who is not their colleague must make reasonable and diligent efforts to determine whether such research is sound. The facts do not indicate that Chong independently verified the statements, critically assessed Harrelson’s research, or had reason to rely on Harrelson’s report based on past experience and familiarity with the quality of Harrelson’s work. Chong also did not appear to recognize that Harrelson’s work was issuer-paid research and thus subject to heightened scrutiny.

Broadus relied on the work of his colleague, Chong, in making the decision to invest in Corix stock for his clients. Investment professionals may rely on the work of colleagues in their firms when making an investment decision, under the assumption that the employer has fully vetted and approved of the diligence, quality, and thoroughness of their fellow colleagues’ work. Investment professionals may also rely on others in their firms to determine whether third-party research is sound and use the information in good faith unless there is reason to question its validity or the processes and procedures used by those responsible for the research. Under the facts provided, Broadus had no reason to be concerned that Chong had not adequately conducted internal research on Corix, or that NHIM was negligent in employing Chong as a research analyst. Under these circumstances, Broadus is entitled to rely on the work of his colleague and thereby meet the requirements of the diligence and reasonable basis standard. Since Harrelson and Chong most likely violated the standard and Broadus did not, choice E is the best response.

This case is based on an enforcement action by the US SEC from August 2019.

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© 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.