Ethics and Standards - Standard VI-B: Priority Of Transaction

Investment transactions for clients and employers must have priority over investment transactions in which a Member or Candidate is the beneficial owner.

Reasoning behind Standard VI-B
This Standard addresses the personal investing of those in the investment profession and establishes that there must be a certain hierarchy of interests in order to maintain the public trust: first client and employer interests, then personal interests. The underlying principles of the Standard are directed to those individuals who are in a position to have acquired advance knowledge of pending activity by their employer. Lacking any standards or guidance, these individuals are likely to consider their own self-interest and trade for themselves ahead of any pending activity. In some cases (e.g. a small, independent advisor), the impact of this pending activity is probably negligible. In other cases (e.g. a major Wall Street brokerage changes a recommendation), such announcements can be a significant factor in driving the price of the security.

In either case, front running transactions is considered unethical behavior - and not necessarily because of any potential positive or negative impact on the stock. Front running is prohibited because of the importance of the duty of loyalty that investment professionals owe to their clients, and the fact that this duty is compromised whenever professionals place their personal interests before those of their clients.

The issue of personal investing continues to be debated by the members of the CFA Institute. Many have suggested that the most sensible way to resolve the issue - and address the public's perception that self-interest guides the behavior of investment professionals - is to prohibit all personal investing by active practitioners. Such a ban would eliminate the need to scrutinize everyone's personal activities for potential conflicts of interest. At the same time, such an extreme measure would likely prompt many talented individuals to leave the investment business and would discourage others from ever entering, which would hurt the average investor in a broader sense.

So, as it stands today, investment personnel are not completely banned from personal investing. However, the CFA Institute has adopted a series of recommended guidelines, including a ban on participation in IPOs and strict limits on acquiring securities in private placements. While these are not yet required, they are designed to address areas of conflict and reinforce a culture that will restrain blind self-interest in these matters.

Personal transactions include any activity in the following:

  • A member's own account
  • Accounts of family members, including spouse and children (and this includes personal transactions "hidden" in an account carrying one's wife's maiden name)
  • Direct or indirect pecuniary interest - which might include trust or retirement accounts

Applying Standard VI-B
The intent of this Standard on priority of transactions is to ensure fairness and avoid conflicts of interest. When you encounter these situations in an exam question, start by asking whether a standard of fairness has been applied. Allowing preferential treatment for oneself or one's family members is obviously a violation, but less obvious are situations where the Standard has been misinterpreted or excessively applied. The following are some of the more common situations that test whether the Standard has been violated:

  • Initiating or Changing a Recommendation - In a case where an analyst wishes to change a recommendation on a security, it is a violation of this Standard to withhold the change until a personal transaction is completed. To be in compliance, the analyst would need to first announce the change and then allow time for the information to be disseminated, and only then could he or she act on his or her personal behalf in an account regarded as a personal account. If an analyst wishes to recommend a stock but temporarily withholds the idea so he or she can buy for a personal account, he or she will be in violation of Standard VI-B because he or she will be attempting to personally benefit from information or knowledge he or she acquired, rather than practice a duty of loyalty and permit clients to benefit first.
  • Family Account at a Disadvantage - Take a situation where an analyst has access to an IPO and private placement shares from time to time. His parents' retirement account and the college trust funds of his three nieces and two nephews are under the custody of his firm and are under his full discretion to manage. This analyst is familiar with the CFA Code and Standards and is concerned about showing any favoritism in accounts where he believes he might be perceived as having an indirect pecuniary interest. Therefore, when IPO shares are available for him to allocate, he excludes his personal accounts, as well as those of his parents and other relatives, and distributes those shares on a systematic pro rata basis to all other portfolios. Only when remaining shares are available does he include any relatives' accounts. In this case, even though the analyst may have been trying to do the right thing, he has misinterpreted the Standard and violated it. He has a fiduciary duty to manage in the best interests of all accounts, including those of his parents, nieces and nephews, and they are entitled to the same treatment as all other accounts, since they are also fee-paying clients of his firm.
  • Boss's Account - A portfolio manager is given occasional access to IPO shares. Following her firm's allocation guidelines, she distributes hot IPOs based on a random draw of those accounts that have shown interest. Not every account is able to participate every time, given the relatively modest number of IPO shares available to her. However, as a rule, she always includes her boss's account (which she also manages). This account does not meet the definition of beneficial ownership as established by Standard VI-B, and she has no direct or indirect pecuniary interest. However, she has misinterpreted the Standard and is in violation. The intent of the Standards is to remove any degree of favoritism and ensure that all clients are treated fairly. Her boss was given automatic priority ahead of other accounts - moreover, even without a pecuniary interest, the portfolio manager has a vested interest in having this account perform well.
  • Institutional Buying - The relationship between the research and trading functions of a large organization is often tested for proper conduct. Has the firm established a blackout/restricted period between the announcement of a new or changed recommendation and the execution of trade orders? Keep in mind that while Standard VI-B does not specifically require a blackout period, it includes the language "adequate opportunity to act on the recommendation" to encourage firms to establish such guidelines. If an exam question presents a case in which a trader acted immediately on a recommendation (within minutes, for example, or any time that same day), that action is likely to be judged a violation as clients were not given a proper chance to react.

How to Comply
The following issues and ideas should be addressed when considering Standard VI-B:

  • What Is a Beneficial Owner? Beyond the minimum definition provided by the Standard, sensitive circumstances may call for stricter guidelines.
  • What Is an Investment? The Standard (and situations addressing the Standard) tends to focus on stocks, bonds and derivative securities, but if a firm invests in real estate, collectibles or currency (for example), it would need to regulate those transactions.
  • Implement Firewalls - A firewall is designed to protect sensitive information by preventing its dissemination from one group to another. A large, diverse organization needs to adopt firewalls in certain cases - for example, between trading and research, to prevent a violation of front running prior to disclosing a recommendation.
  • Limit Access to Persons - The more people there are with access to sensitive information, the more likely it is that information will leak out. By limiting the number of people who have access to material nonpublic information, information can be protected and violations minimized.
  • Be Clear about Prohibited Transactions - Given the scope of a firm and its particular obligations to clients, it may choose to restrict trading in certain securities. For example, a restricted list may be compiled that prohibits trading in companies that have engaged that firm in a business relationship (perhaps as an underwriter). The CFA Institute has recommended (but not absolutely required) that participation in equity IPOs be restricted for a firm's employees in favor of client needs. Some firms have adopted those guidelines. Whatever is prohibited or restricted needs to be clearly communicated to all employees to ensure compliance.
  • Use Blackout/Restricted Periods - As there are so many unique factors, the guiding principle should involve what is best for clients. For example, at a large firm, a total ban on trading for two business days following the dissemination of a new or changed recommendation may be the most appropriate course of action. For small firms, the guidelines may allow trades at any point following the completion of client trades.
  • Report Personal Transactions - Typically, employees should report all transactions on a quarterly basis, though individuals with particularly sensitive responsibilities may need to report more frequently. Sending duplicate copies of confirmations and statements to the internal compliance officer is a worthwhile exercise, as it allows timelier discovery of inappropriate activity.
  • Enforce Prior Clearance of Personal Transactions - A process that requires pre-approval of personal transactions is a good way to prevent a violation from occurring in the first place.
  • Disgorge Trades Made in Violation - While procedures should be designed to prevent violations, it is also worthwhile to establish guidelines on how to proceed when violations occur. When a trade is made in violation of company policy, a request can be made to break the trade as soon as possible, completely reversing the transaction, with any resulting profits distributed in some manner that does not benefit the individual or the firm.
  • Establish Disciplinary Procedures - Establish a process for internal investigations, and determine how compliance procedures will be enforced.
Standard VI-C: Referral Fees
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