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Subject 2. Case discussion

Several violations of the Code and Standards have occurred as a result of Karen Trader's involvement with an outside company, and her personal securities transactions violate U.S. securities laws as well as the Code and Standards.

Trader is neither a CFA charterholder nor a CFA Institute's member, but she is bound by CFA Institute's Code and Standards to the extent that they are incorporated in her firm's compliance policies.

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

Those with legal or compliance responsibilities, such as the designated compliance officer, do not become supervisors solely because they occupy such named positions. Determining supervisory responsibilities depends on a "facts and circumstances test," by which the SEC and CFA Institute's Standards essentially define a supervisor as a person who has authority to hire, fire, reward, and punish an employee. In this case, even though Trader does not report directly to Cuff, Cuff supervises the actions of all employees of the firm (and has the power to hire, fire, reward, and punish them) in her dual responsibilities as CPO and compliance officer. Therefore, she must comply with Standard IV (C).

As a supervisor, Cuff has a responsibility to take appropriate steps to prevent those she oversees from violating applicable statutes, regulations, or CFA Institute's Standards. As compliance officer, she must also ensure that the firm's policies are being followed and that violations of those policies are addressed.

Actions required

  • As a supervisor, Cuff should take corrective action after discovering the violations by reporting them to senior management. Cuff and Super Selection's senior managers should then take affirmative steps to ensure that the appropriate action is taken to address the misconduct.
  • As compliance officer, Cuff should direct or monitor a thorough investigation of Trader's actions, recommend limitations on Trader's activities (such as monitoring all trading done in her client accounts, prohibiting her from personal trading, and imposing sanctions on her, including fines), implement procedures designed to prevent and detect future misconduct, and ensure that her recommendations are carried out.
  • The senior managers should also consult an attorney to determine whether Trader's actions should be reported to appropriate legal or regulatory bodies. If senior management fails to act, Cuff may need to take additional steps, such as disclosing the incident to Super Selection's board of directors and to the appropriate regulatory authorities, and may need to resign from the firm.

Standard VI (A) - Disclosure of Conflicts and Standard IV (B) - Additional Compensation Arrangements

Trader violated both standards by (1) failing to disclose the conflict of interest that she had as a result of her ownership of Atlantis Medical Devices stock options and (2) failing to disclose to her employer the additional compensation she received as a director of AMD. The stock options and the cash compensation both should have been disclosed.

Actions required

  • To avoid the violation, Trader should have disclosed to her employer any additional compensation she was receiving, whether cash or any other benefit, and should have disclosed to her supervisor (and her clients) her ownership of the AMD stock options and her directorship. This disclosure would have provided her employer and clients the information necessary to evaluate the objectivity of her investment advice and actions.
  • Cuff, after discovering the violation, needs to ensure that proper disclosure is made to clients and a thorough review is made of Trader's client accounts and her personal accounts to determine whether any conflicts have occurred in addition to the IPO violation. If conflicts are discovered, Cuff has a responsibility to take appropriate action, e.g., limit behavior, impose sanctions, and so on.

Standard V (A) - Diligence and Reasonable Basis

Trader had previously determined that AMD was not a suitable investment for her clients. Under pressure from James, Trader has reversed her stance on AMD and has thus violated Standard V (A).

Actions required

  • Trader should have diligently and thoroughly researched AMD again prior to making a decision on investing in this security for her clients' accounts. Once having concluded that AMD was not appropriate, she should not change her opinion. Trader must also inform clients of any conflicts she has as an AMD director and as an owner of AMD stock options.

  • Cuff should periodically-at least annually-review investment actions taken for clients by Super Selection employees to determine whether those actions were taken on a reasonable and adequate basis.

Standard III (A) - Duties to Clients: Loyalty, Prudence and Care

By investing in and influencing the public offering of AMD in order to boost the price of this stock, Trader misused her professional position for personal benefits and breached her fiduciary duty to her clients, thus violating Standard III (A).

Although Trader, as a director of AMD, has a duty to that companies' shareholders, she cannot void her obligation to her clients at Super Selection and, in the case situation, should have acted in client interests first.

Actions required

  • Trader should have taken investment actions that were for the sole benefit of her clients. She should not have been swayed by her ownership of any company into taking an investment action for her clients that she might not have taken in the absence of that ownership.

  • Cuff must thoroughly investigate Trader's activities to see whether other breaches of fiduciary duty have occurred. Following this type of breach and any others, Cuff must limit the activities of the wrongdoers, ensure the implementation of procedures to prevent and detect future occurrences, and follow up to make sure that her recommendations are carried out.

Standard III (C) - Duties to Clients: Suitability

Trader violated Standard III (C) when she purchased AMD stock for her clients and did not take into consideration their needs and circumstances.

Actions required

  • Trader should have considered clients' needs and circumstances prior to taking investment actions and should not have taken actions to benefit herself or her friends.

  • Cuff should establish a periodic review-to occur at least annually- to compare the suitability of investment actions taken for client accounts with the clients' written investment policy statements.

Standard VI (B) - Priority of Transactions

Trader violated Standard VI (B) by trading in close proximity to her clients' trades and may have benefited from the impact of her clients' trades on the stock price. The recommendations of CFA Institute's Personal Investing Task Force Report, which Super Selection had incorporated in its standards, require duplicate broker confirmations and preclearance on personal trades, but Trader did not follow these procedures.

Actions required

In this case, Trader circumvented Super Selection's procedures by not reporting trades and brokerage accounts. Nevertheless, Cuff should have made efforts to ensure that Super Selection's policies were being followed. Cuff should review her firm' s policies and procedures to make sure they are adequate and determine whether any adjustments should be made to implement or improve them. If adjustments are necessary, she should carry them out.

Cuff should also make sure that employees of Super Selection are periodically informed of the Code and Standards and its requirements so as to eliminate any uncertainty about which employees are covered and what responsibilities they have to comply with these standards.

Cuff needs to investigate Trader's personal transactions thoroughly and recommend appropriate sanctions for Trader's behavior. Cuff must also ensure that her recommended sanctions are followed to completion.

Study notes from a previous year's CFA exam:

2. Case discussion