Ethical and Professional Standards
Reading 3. Guidance for Standards I-VII
Learning Outcome Statements
a. demonstrate the application of the Code of Ethics and Standards of Professional Conduct to situations involving issues of professional integrity;
b. distinguish between conduct that conforms to the Code and Standards and conduct that violates the Code and Standards;
c. recommend practices and procedures designed to prevent violations of the Code of Ethics and Standards of Professional Conduct.
CFA Curriculum, 2020, Volume 1
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Subject 15. Standard V (A) Diligence and Reasonable Basis
A. Diligence and Reasonable Basis.
Members and Candidates must:
- Exercise diligence, independence, and thoroughness in analyzing investments, making investment recommendations, and taking investment actions.
- Have a reasonable and adequate basis, supported by appropriate research and investigation, for any investment analysis, recommendation, or action.
Members must perform the diligent and thorough investigations necessary to make an investment recommendation or to take investment action. Three factors determine the nature of the diligence, thoroughness of the research, and level of investigation required by the standard:
- Investment philosophy followed.
- The role of the member or candidate in the investment decision-making process.
- The support and resources provided by the employer.
Members must establish a reasonable basis for all investment recommendations and actions. Diligence must be exercised to avoid any material misrepresentation. In other words, members cannot be quick or negligent in making investment recommendations.
You are very excited about a small high-tech firm that is developing a new method of making Internet connections more efficient. You advise your clients to buy this security and tell them that a full report will be available shortly. Your recommendation is neither diligent nor thorough. You have not provided reasonable basis for the recommendation. It is impossible to distinguish between fact and opinion without further information.
Using secondary or third-party research
Secondary research: research conducted by someone else in the member or candidate's firm.
Third-party research: research conducted by entities outside the member or candidate's firm.
Members and candidates should check if research is sound. Examples of criteria include the assumptions used, the rigor of analysis, the timeliness of the research, and the objectivity and independence of recommendations. If the research is suspected to lack a sound basis, members and candidates should refrain from relying on it.
- A quantitative analyst recommends an out-of-favor stock based on analysis of its 3-year records: the recommendation is not based on thorough quantitative work. A longer time period should be covered.
- Because of restrictions from the firm's executives, an analyst cannot obtain the information necessary to perform analysis: the analyst must let the client know when he/she is "conflicted" or "restricted."
- Because of the lack of sufficient research resources, an analyst decides to estimate IPO prices based on the relative size of each company and justify the pricing later when she has time: her analysis is not based on thorough research with reasonable basis. She should take on the work only when she can adequately handle it.
- An investment banker presses a securities issuer to project the maximum production level. He then uses these numbers as the base-case production levels during sales pitches: he misrepresents the chances of achieving that production level. He should have given a range of production scenarios during the pitch.
- An analyst recommends purchasing what the market, in general, has christened "hot" stocks without further research: conventional wisdom of the markets does not form a reasonable and adequate basis.
- After a discussion with the vice president of a company, a senior analyst discovers that there is a good chance that this company will be awarded a large contract (thus pushing up the stock price). The analyst then publishes a report to his clients indicating that they must all purchase the stock based on the fact that the company will be awarded the large contract. The manager has violated this standard since he published that the company will definitely be awarded the contract, which is not necessarily the case.
- An investment analyst publishes a report based on a 5-year history of the PE ratios of a company. This report will materially affect the portfolios of the firm's clients, since the analyst plans to use the results of the report to invest for his clients' portfolios. The analyst is in contravention of this section since he should have done further research prior to publishing and planning to implement such a huge proposal.
User Contributed Comments 6You need to log in first to add your comment.
shouldn't make recommendations until a thorough pursue of evidence.
Sometimes, analysts are wrongly predict/conclude a recommendation should they be subject violation of standards or be sued???
why do we need longer than 3 year period?
AUAU - No. As long as their analysis was thorough and they did due diligence, they have not violated the standard.
Kforcfa - 3 years is too short of a time period. The time frame should longer, i.e. 10 year time horizon or back to inception if available
Isn't the issue with the investment banker not giving a range of production numbers something other than a violation of diligence and reasonable basis?
Sounds like misrepresentation to me. Standard I.C. I believe?
No, it is V(A) Diligence. He failed to do his homework of churning out a range of production scenarios (best case to worst case), which demands a lot of effort.