Members and Candidates must deal fairly and objectively with all clients when providing investment analysis, making investment recommendations, taking investment action, or engaging in other professional activities.
Reasoning behind Standard III-B
The Standard on fair dealing responds to the inclination to show overt favoritism toward one's largest and most profitable clients. In addition, this Standard (as well as the next one on the list regarding Priority of Transactions) highlights the temptation to place self-interest ahead of client interest. One of the CFA Institute's stated goals is to build and maintain the public's trust. Clients who hire an investment advisor have a right to trust that their advisor will not discriminate against them, simply because they represent a smaller account or a less established relationship.
While the biggest and most important clients are likely to end up receiving more attention (perhaps they will receive more shirts with the company logo on them, or play more complementary rounds of golf), this Standard focuses on the issue that matters most: the actual dissemination of changes in investment outlook and the actual trading of securities. When changes to the investment portfolio are made, procedures must be developed to ensure that every client, large and small, is treated fairly.
The Standard does not require that all clients be treated equally. Keep in mind that there is a difference. If total equality were the standard, it would logically mean that any investment change (say from buy to sell) must be disclosed simultaneously. For managers with thousands of accounts, there are practical limitations to doing this. On the other hand, with the ability to simultaneously reach a large group via bulk email, what was previously seen as impractical may eventually be possible. For now, there remains a limitation to email-based announcements: some people still do not use email.
Standard III-B addresses the issue of fairness with (1) the dissemination of an analyst's recommendations (particularly when they change) and (2) the actual trading on those recommendations.
1. Changes in Recommendation - This first part is specifically directed at those within the research function of any financial services organization that manages portfolios and/or makes investment recommendations to clients. It defines an "investment recommendation" as an expressed opinion to buy, hold or sell a security, and it recognizes that there is a period of time between the initial decision to make a change and the public awareness of that change. During this time, that change is regarded as material nonpublic information.
Standard II-A discusses the seriousness of using material nonpublic information for one's personal advantage. For the purposes of this Standard, it's important to appreciate that the opinion itself is material (knowledge of the change would prompt investment action) and nonpublic (it has yet to be traded upon); therefore, care must be taken to (a) keep the information nonpublic, until (b) a fair system to disseminate the information is utilized.
Potential methods to distribute the nonpublic information include the following:
- A detailed research report
- A brief update summarizing what is being done, with a summary of the rationale for the change
- Adding or deleting from a recommended list, with additional explanation highlighting what exactly was added or taken out
- Oral communication
2. Investment Action - This second part is directed at the portfolio administrators and traders who will carry out any change. Initiating a large across-the-board order to either buy or sell a stock can potentially impact market value; thus, there must be procedures in place to ensure that the price paid for a buy (or price received on a sale) does not discriminate against any group of accounts. In other words, how will block trades - a large quantity of shares to be bought and sold - be allocated? A process is based on the circumstances of the individual firm, but this process must be (a) fair and (b) clearly disclosed, in order to give clients the opportunity to make an informed decision.
Fairness with Initial Public Offerings
The opportunity to participate in an initial public offering, or IPO, receives the most attention in relation to this Standard, as it is the process in which the standard of fairness is likely to receive its greatest test. How a broker or advisor proceeds with a hot issue (an IPO that trades at a premium in the secondary market, due to an imbalance of demand for the issue) is of particular importance, because with hot issues the broker is basically handing the recipients an automatic profit. The temptation is to hand the easy profits to the most important clients - the people providing the firm with the most revenue. However, a standard of fairness and loyalty to clients requires IPO distributions to make bona fide public distributions of these securities.
On the exam, be prepared for questions looking at cases in which an IPO is oversubscribed. This means that more shares have been requested than the broker has available. If this situation comes up, know the term "pro rata". This term is a Latin phrase meaning "in proportion". With an oversubscribed IPO, a broker would allocate shares pro rata based on a fair allocation system. It's also very important to remember that the CFA member is obligated to forego shares for personal use (or the use of immediate family) in order to uphold a standard to place client interests first.
Applying Standard III-B
Case studies that test this Standard tend to place analysts in a situation where they are tempted to show favoritism toward one group over another. In determining the proper course of action, ask whether the individual's actions in any way discriminate against any subset of the firm's client base. Some of the more common situations to anticipate in a CFA exam question testing this Standard are described below.
1. Previewing Contents of a Yet-to-Be Published Research Report - An industry analyst is excited about an under-recognized company in her sector, and she is in the process of preparing a report to buy the stock. Currently the report is being fact-checked and is nonpublic information, but it will be sent to all clients following the fact-checking process. An important client calls and asks the analyst what she is currently researching. In this case, if she answers honestly, it is a violation of Standard III-B, given that the firm has a fair and defined process in place for distributing the new buy recommendation. She would simply need to tell the client that a new research report is awaiting publication and will be distributed shortly, and that she will be happy to discuss it once the client receives it.
2. No Time to Prepare a Report - Another industry analyst has a buy rating on a specialty medical-devices company, and he is considered a leading Wall Street expert on the industry in general and this company in particular. His initial study was rigorously detailed, about 50 pages in length and the product of two months of preparation. Each month, his firm publishes a recommended list (where this stock has been listed for the past year), followed by company commentaries. A couple of days before the list is published, he learns that one of the major products in the pipeline awaiting FDA approval will be indefinitely delayed, prompting the analyst to question his fundamental case. He switches to a hold recommendation but concludes he doesn't have enough time to prepare a report that conforms to his rigorous research standards, so he declines additional comment and requests that his summary be excluded from the publication. In a conference call with a mutual fund manager that is the largest owner of the stock, he indicates that he was no longer recommending it due to a change in fundamentals, but that he would need some time to put the report together. The fund manager immediately sells her entire position.
Is this action a violation? The analyst is in violation of Standard III-B, fair dealing. According to the Standard, he needed to recognize that his opinion counts as material information, and that if he made a change, he needed to include at least a summary outlining the reasons in the firm's monthly publication. He could follow up later with the rigor he deems necessary. As for the mutual fund manager, she is in violation of Standard V-A, Reasonable Basis, as she is trading out of the stock without knowing the detailed reasons. To avoid a violation, she would need to wait for the report to be disseminated.
3. Preparing for the Eventual Demand - Take a case where a brokerage is about to publish a brand new buy recommendation. The head trader for this brokerage learns of the news and buys a large block of the shares on the open market one week prior to publication, anticipating that there will be great demand for shares of this company among the clients of the firm. The company to be recommended is a small-cap stock that is thinly traded, so there might be liquidity issues if the trader does not act. Following firm policy, the portfolio administrators will faithfully allocate shares pro rata and give everyone the exact same price. However, this case is a clear violation of Standard III-B. Moreover, it's an example of the sort of tricks that show up on the CFA exam; there's an indication in the example that pro rata allocation was used so that a test taker sees a fair allocation procedure being implemented, which might obscure the fact that the trade itself was unethical. In fact, the brokerage must adhere to strict policies on disseminating its new recommendation, and it would never bepermitted to trade ahead of a research report. Such a trade is not only a violation of the CFA Institute's Standard; the fact that it happened when it happened is likely to capture the attention of the SEC.
4. Allocation of IPO - A portfolio manager occasionally will receive limited access to his firm's IPO underwriting activities. The number of shares varies depending on the outside demand for the issue, but these IPO allocations are typically insignificant compared to the accounts under management. It's never enough shares to make an across-the-board pro rata allocation worthwhile, as it would end up as an insignificant position in all portfolios. As a result, this manager simply disposes of these shares whenever she receives them by allocating them to her largest clients. Unfortunately, by allocating in this manner she is violating Standard III-B, as she systematically favors the largest portfolios (i.e. the smaller accounts never get a chance). Given that a pro rata procedure process is not always practical, the best way to comply with the Standard would be to select IPO participants at random from the entire client list and to establish a cycle where everyone must participate once before being chosen again.
5. Notification via Email - A manager and CFA charterholder wishes to treat his clients fairly and also comply with the Standards of Professional Conduct. He prepares a bulk email notification of a new buy recommendation being published by his full service brokerage firm. Two days following the email, he places a block trade for discretionary accounts and for those nondiscretionary accounts that notified him of interest. Does this process violate the fairness doctrine required by Standard III-B? While it would be nice to communicate fully with everyone via email, and be confident that everyone reads his or her email, the reality is that some people do not have email access. As a result, disseminating a recommendation in this manner discriminates against non-email clients and violates the Standard on fair dealing. To comply, the manager will first need to 'snail mail' the recommendation to the full client list.
How to Comply
Any particular compliance program is going to be a function of the unique factors present in that firm, such as its size and the scope of the activities in which it is involved. However, all procedures are going to share the common doctrine of fairness and develop processes that avoid systematic discrimination of one group of clients in favor of another.
The Handbook makes numerous worthwhile suggestions for developing a compliance program that adheres to the intent of this Standard:
- Disseminate Nonpublic Information as Quickly as Possible - Violations result from the fact that an analyst is required to keep a new idea secret for such a period of time that leaks develop.
- For Lengthy and Detailed Reports, Offer a Flash Summary - No one can be expected to rewrite a 50-page report in two days. However, changing a recommendation creates material nonpublic information. It's not necessary for such information to be held for weeks while the necessary labor is done to write up the report right. A brief flash summary that includes the essence and the conclusion, plus an indication that the laborious, detailed report is in progress, is sufficient to comply with the ethic of full disclosure.
- Guidelines for Pre-Dissemination Must Be Established - This is to insure that people who have access to this information are aware of the standards.
- Inform Everyone as Simultaneously as Possible - For example, a large brokerage can ensure that all branches receive the new research on the same day.
- Restrict Trading - Do not trade until all clients have a fair chance to receive the new recommendation. For example, place no trades for two to three business days following a mailing.
- Develop a Fair Process for Trade Allocation - Some common elements might include:
- All orders must be date and time-stamped.
- Have a process on a first in/first out basis, based on the time stamped.
- Block trades receive the same execution price and commission.
- Partially executed blocks should be allocated pro rata.
- For Hot IPO Issues, Obtain Indications of Interest in Advance - Allocation procedure should be systematic (e.g. pro rata, random draw) and not based on favoritism.
- Do Not Withhold Shares - Refrain from holding shares in hot issues for personal accounts, leaving out any interested clients, and make a bona fide effortto publicly distribute.
- Disclose - Discloseall trade allocation procedures to clients.
- Review Accounts Systematically - A supervisor or compliance officer can develop a process that indicates whether some accounts are being given preferential treatment - for example, whether trade executions in certain accounts appear to be better than average, or certain accounts seem to receive more shares in a hot IPO than what would be expected.
- Disclose the Presence of Tiers of Service - Many organizations offer both discretionary and nondiscretionary advisory service, but because of the differences in those accounts, they might find it necessary for practical reasons to take action in the discretionary accounts first, before they take the same action within the nondiscretionary accounts. Such procedure is not discriminatory since discretionary accounts are paying a premium; however, clients must be fully aware of this practice.
(See more) Standard: III-C: Suitability
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