Ethics and Standards - Standard V-B: Communication With Clients And Prospective Clients

Members and Candidates must:

Standard V-B: Communication with Clients and Prospective Clients

Members and Candidates must:

1. Disclose to clients and prospective clients the basic format and general principles of the investment processes used to analyze investments, select securities and construct portfolios, and must promptly disclose any changes that might materially affect those processes.

2. Use reasonable judgment in identifying which factors are important to their investment analyses, recommendations or actions, and include those factors in communications with clients and prospective clients.

3. Distinguish between fact and opinion in the presentation of investment analysis and recommendations.

Reasoning behind Standard V-B
This Standard establishes guidelines for one specific product of an analyst: the research report that is prepared for public dissemination, rather than being tailored for use by a particular individual's account. Of course, some analysts write reports for a particular individual account or fund, and these guidelines apply in these cases as well. However, Standard V-B was drafted with the idea that many reports are researched and distributed by banks, full-service brokers and research boutiques, among other entities. Traditionally, these types of entities employ a staff of analysts that will be assigned a certain industry or sector and be required to write a buy, sell or hold recommendation on a number of the companies in the sector and maintain a watch list over the entire group.

Look Out!

The term "research report", as it applies to this Standard, is very broad and covers much more than the traditional research reports as defined above.

For example, any form of communication can potentially apply, including (but not limited to):

  • face-to-face recommendation
  • speech or panel discussion
  • telephone conversation
  • TV appearance
  • internet webcast or blog

For example, any form of communication can potentially apply, including (but not limited to):

  • face-to-face recommendation
  • speech or panel discussion
  • telephone conversation
  • TV appearance
  • internet webcast or blog

Because many reports are packaged as soundbites or recommended lists, the Standard provides for an inclusion of the caveat that additional information is available upon request. In other words, it is not a violation to publish a recommended list with a quick sentence or two on a large list of companies, provided the analyst implemented a diligent and thorough process to arrive at that buy or sell conclusion on the security, and his or her company can provide more detail to those who are interested.

A number of research methodologies are more quantitative or technical in nature – for example, the analyst may employ a technique that takes short positions from a list of stocks that are trading within 5% of their 52-week high prices, have reached a technically overbought condition based on the shape of their price charts and have experienced a reduction in institutionally based trading volume over the last month. These reports and techniques are fully compliant with this Standard, provided they are supported by reference material and the applied methodology is consistent with previous recommendations.

Applying Standard V-B
Here are some questions to consider when applying this Standard:

  • Are opinions and projections separated from factual information?
    When presented with a hypothetical situation on the exam, start by asking this question. If the CFA exam addresses Standard V-B in a question, the most likely reason for a violation will be that the author of the research report either presented his or her own opinions as factual information, or else was not clear to differentiate between data that represented actual results and that which represented projections. Quantitative methods can be particularly confusing in this regard – for example, many methodologies assemble a statistical fair price for a security, which is then used in such a careless manner that it appears to represent the actual price of the security.
  • In the gathering of information on a company, has this information been reviewed for accuracy by a representative of that company?
    Such techniques are perfectly legitimate – after all, acquiring and reviewing a company's most recent 10-K is usually a good initial step to discover more about that firm. However, a company's internal projections of its own revenue and earning potential may be excessively optimistic or misleading. A fundamental research report should include those areas of greatest importance in the mind of the analyst, not the data most relevant to the public-relations specialists at the company.
  • Has a newsletter or watch list omitted too much relevant information?
    The Standard indicates that it is the prerogative of the author of the research to use reasonable judgment when presenting a report and deciding which factors to include and exclude. However, there are cases where the resulting package will fail to cover pertinent information related to technique. For example, a complex analytical system may produce a monthly list of recommended mutual funds within a 401(k) plan and a second list of funds to reduce or sell. If a manager's reputation was built on managing and trading accounts within that plan based on a correlation model, it would be a violation of Standard V-B to simply list the five to seven highest-rated funds in a newsletter without including any information on the underlying methodology and techniques for allocating the funds into a portfolio. Focusing purely on recommendations is a likely violation without any appropriate caveats.
  • Has a research report adequately outlined the risk factors, or failed to analyze less optimistic scenarios?
    The CFA Program tends to place a great deal of emphasis on analyzing risk and protecting the investing public from downside risk as a result of the actions of its members. A derivative or synthesized product, for example, may be excessively risky in periods of rising interest rates, and if a research report recommending the security simply assumes that interest rates will fall, the report is in violation of this Standard.
  • Does a research report omit the analyst's real reason for making a specific recommendation?
    For example, Wall Street observers in recent years have coined the term "whisper number" to refer to a quarterly earnings-per-share (EPS) result or quarterly revenue number that some analysts (if not a consensus of analysts) believe is most likely for the firm in question. However, since none of the leading experts covering a stock are prone to updating EPS projections, the public consensus estimate for quarterly earnings remains the same. If an analyst chooses to upgrade a company recommendation based on the rising whisper numbers (or reduces the stock to a hold because the whisper numbers are plummeting), the research report outlining the reason for change needs to address the relevant factors, as required by this Standard.

    Look Out!

    The CFA exam is usually very topical in presenting its ethical situations to candidates, and the quality (or lack of quality) in Wall Street-produced research has been a primary point of discussion in recent years, especially following the bear market earlier in this decade. Debacles involving firms such as Enron and Worldcom uncovered the fact that the leading analysts were little more than cheerleaders for the main companies they cover, arousing concern. Why is virtually every leading stock reported as a buy or a strong buy? The Standards relating to research reports may be of particular importance to the CFA examiners in this climate.


    How to Comply
    Each subsection of this Standard relates to a specific goal that needs to be addressed when preparing research reports for public distribution:

  • Using Reasonable Judgment on Factors to Include/Exclude - This procedure is in many ways the most subjective requirement within this Standard, as it is largely a function of an analyst's experience in preparing research reports and understanding what factors are of greatest importance to readers and users of the research. A specific checklist is not relevant to a standard of conduct where each case needs to be individually evaluated. As with the other Standards guiding the investment process, one would start by archiving all records relating to the report, so that conclusions can be explained and additional information can be supplied upon request.
  • Distinguishing between Facts and Opinions - This goal avoids the most obvious violations of the Standard, but given that most reports use facts as the basis for investment opinions (i.e. all reports will have both), it's important to make such distinctions in as clear a manner as possible. Moreover, any data presented as fact must be properly scrutinized for reliability and accuracy. Financial databases that cover hundreds of data points for thousands of companies may produce misleading data – for example, they may show a negative price-to-earnings (P/E) ratio on a cyclical company, which then draws down the average P/E of a portfolio. In such a case, an analyst must ensure that the data presented is processed in a manner that provides for such situations.
  • Indicate Basic Characteristics - This goal in particular provides some indication of the degree of risk that an investor will assume. A star system (1 through 5 stars, with 5 being safest) or a letter grade ("A" being the safest) will accomplish the task in the least amount of space. Other summary reports specify low, medium, high or very high risk. These labels are often an invaluable guide to determine whether the research should be used.
Standard V-C: Record Retention

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