Analysis of the situation

Gerald Smithson's story describes some perfectly legitimate actions but also some actions in clear violation of CFA Institute's Code and Standards.

• Standard V (A), Diligence and Reasonable Basis.
  In researching and making the decision to purchase shares of Utah BioChemical and Norgood for his client accounts, Smithson complied with Standard V (A), Diligence and Reasonable Basis. He observed a meeting between the heads of two public companies in related businesses, which sparked his interest in researching the companies further. He already had some knowledge of the biochemical industry through some clients' investments and through his relationship with Arne Okapuu, and he carried out his own due diligence on the companies. Smithson had a reasonable basis, supported by appropriate research and investigation, for his investment decision, and he exercised diligence and thoroughness in taking investment action. Smithson neither possessed nor acted on insider information.

• Standard II (A), Material Nonpublic Information
  He did not actually overhear a conversation; rather, after his research was complete, he "put two and two together" and speculated that the executives might have been discussing a merger or takeover. Viewing the two company leaders together was only one piece of his "mosaic" and was only a small factor in his investment decision-making process. If Smithson had based his decisions solely on his chance viewing of the dinner meeting, the investment decisions would have been inappropriate.

Smithson failed to comply, however, with aspects of the Standards related to the suitability of the investments for his clients and the allocation of trades. In addition, Sheldon Preston failed to exercise his supervisory responsibilities.

Standard III (C) - Duties to Clients: Suitability

Smithson purchased shares for all of his client portfolios without first determining the suitability or appropriateness of the shares for each account. An investment manager must consider the client's tolerance for risk, needs, circumstances, goals, and preferences in matching a client with an investment.

Actions required

• The case does not make clear whether Smithson's clients have written investment objectives and guideline policy statements. If they do not, Preston should direct Smithson to prepare such written guidelines for all accounts.
• Smithson should review the guidelines for every account for which he bought shares of Utah BioChemical and Norgood and assess the characteristics of those investments in the light of the objectives of the clients and their portfolios. In those accounts for which either investment is unsuitable and inappropriate, he should sell those shares, and Preston Partners should reimburse the accounts for any losses sustained by them.

Standard III (B) - Duties to Clients Fair Dealing

Members shall deal fairly with clients when taking investment actions. In this case, the firm did not have detailed written guidelines for allocating block trades to client accounts. So, Smithson simply allocated trades to his largest accounts first, at more favorable prices, which discriminated against the smaller accounts. Certain small clients were disadvantaged financially because of Smithson's block-trade allocation method.

Whenever an investment manager has two or more clients, he or she faces the possibility of showing one client preference over the other. The Code and Standards require that the investment advisor treat each client fairly but do not specify the allocation method to be used. Moreover, treating all clients fairly does not mean that all clients must be treated equally. Equal treatment, given clients' different needs, objectives, and constraints, would be impossible.

Action required

Because Preston Partners has only vague policies for portfolio managers on allocating block trades, Preston needs to formulate detailed guidelines. The trade allocation procedures should be based on guiding principles that ensure

• Fairness to clients, both in priority of execution of orders and in the allocation of the price obtained in the execution of block trades,
• Timeliness and efficiency in the execution of trades, and
• Accuracy in the investment manager's records for trade orders and maintenance of client account positions.

In advance of each trade, portfolio managers should be required to record the account for which the trade is being made and the number of shares being traded.

Block trades are often executed throughout a day or week, which results in many small trades at different prices. To assure that all accounts receive the same average price for each segment of the trade, trades should be allocated to the appropriate accounts just prior to or immediately following each segment of the block trade on a pro rata basis. For example, if 5,000 shares of Norgood and 5,000 shares of Utah BioChemical traded on Day 1, Smithson would have immediately allocated each set of shares to each appropriate account according to the relative size of the account. Each account would thus pay the same average price. If 10,000 more shares traded later that day, or the next day, or so on, Smithson would follow the same procedure.

Preston Partners should disclose procedures for trade allocation to clients in writing at the outset of the client's relationship with the firm. Obtaining full disclosure and the client's consent does not, however, relieve the manager of the responsibility to deal fairly with clients under the Code and Standards.

Standard IV (C) - Duties to Employers: Responsibilities of Supervisors

Preston Partners did not have in place supervisory procedures that would have prevented Smithson's allocation approach. Preston's failure to adopt adequate procedures violated Standard IV (C). Preston Partners had adopted the Code and Standards; thus, anyone in the firm with supervisory responsibility should have been thoroughly familiar with the obligation of supervisors under the Code and Standards to assure that proper policies and procedures are in place and are being followed. Supervisors and managers must understand what constitutes an adequate compliance program and must establish proper compliance procedures, preferably designed to prevent rather than simply uncover violations.

The case notes that certain sections of the policy and procedures manual were unclear. Supervisors have a responsibility to assure that compliance policies are clear and well developed. Supervisors and managers must document the procedures and disseminate them to staff. In addition to distributing the policy and procedures manual, they have a responsibility to ensure adequate training of each new employee concerning the key policies and procedures of the firm. Periodic refresher training sessions for all staff are also recommended.

Ultimately, supervisors must take the necessary steps to monitor the actions of all investment professionals and enforce the established policies and procedures.

Actions required

Preston should assure that proper procedures are established that would have prevented the violation committed by Smithson. Preston should assume the responsibility or appoint someone within the firm to become the designated compliance officer whose responsibility is to assure that all policies, procedures, laws, and regulations are being followed by employees.