IFT Notes for Level I CFA® Program
R58 Guidance for Standards I-VII
Standard III: Duties to Clients
Standard III (A) Loyalty, Prudence, and Care
Members and Candidates have a duty of loyalty to their clients and must act with reasonable care and exercise prudent judgment. Members and Candidates must act for the benefit of their clients and place their clients’ interests before their employer’s or their own interests.
Client interests come first, followed by the employer and, then. personal interests of the member or candidate. The only exception is that the integrity of capital markets must take precedence over the client’s interests if there is a conflict. Prudence requires caution and discretion. When handling funds of a client, prudence requires that you treat them with the same skill, care, and diligence as you would treat your own funds.
- Understanding the application of loyalty, prudence, and care: Investment advisers have different job roles; some have fiduciary responsibilities that are imposed by law and require a higher level of trust than other business roles. Irrespective of whether or not they are in a fiduciary role, members and candidates are expected to work in the client’s best interest, and be loyal, prudent, and exercise care in managing the client’s portfolio.
- Identifying the actual investment client: Identify who is the actual client. It’s often easy to define a client but there are instances when it may not be clear. For example, if a pension plan hires an investment manager, then the client is not the pension plan but the beneficiaries of the plan. In this case the hiring entity is not your client. In some cases, there may not be any direct clients or beneficiaries. Ex: a fund manager managing the fund to an index. In such cases, fund managers should invest according to the stated mandate.
- Developing the client’s portfolio: Care must be taken in developing portfolios, which are consistent with the clients’ objectives, circumstances, constraints, and risks. Investment decisions should be based on the overall portfolio, rather than the characteristics of an individual investment.
- Soft commission (dollar) policies: Assume a client has hired you to manage his funds. You have discretion over the selection of brokers to execute transactions. Conflicts may arise if you use client brokerage (money paid by the client for trade execution) to purchase research services from the broker. This practice is called “soft dollars” or “soft commissions.” If you pay a higher brokerage commission than you would normally pay, to allow for the purchase of goods or services, without a corresponding benefit to the client, you have violated the duty of loyalty to your client.
- Proxy voting policies: Assume you are an investment manager and you have purchased 1 million shares of General Electric on behalf of your client. Since you are managing your client’s portfolio, you can vote on behalf of the client. You should perform a simple cost-benefit analysis to decide whether or not to vote. When you vote it should be in the best interest of the client (shareholder), not the company management. Your firm’s proxy voting policies should be disclosed to clients.
Recommended Procedures for Compliance:
- Regular account information: Submit a quarterly statement to the client that includes credits, debits, securities holdings, and transactions during the period. Indicate whether the client must hold or sell assets. And if sold, where the proceeds should be invested in and when.
- Client approval: If unsure of what course of action to take with respect to a client, members and candidates must discuss with the client in writing and take approval.
- Firm policies: Encourage firms to adopt these policies:
- Follow all applicable rules and laws.
- Establish the investment objectives of the client: return requirements, risk profile, experiences, and constraints.
- Consider all the information when taking actions: the client’s needs and circumstances, the client’s portfolio, and an investment’s individual characteristics.
- Carry out regular reviews: If a client’s circumstances have changed (sudden need for large sums of money, or an unexpected inflow of money), then they must be addressed.
- Deal fairly with all clients with respect to investment actions.
- Disclose conflicts of interest.
- Disclose compensation arrangements: If a manager is compensated based on the returns generated for a client, then it must be disclosed to the client.
- Maintain confidentiality.
Standard III (B) Fair Dealing
Members and Candidates must deal fairly and objectively with all clients when providing investment analysis, making investment recommendations, taking investment action, or engaging in other professional activities.
The standard focuses on dealing fairly and objectively with all clients. It does not mean equally because the circumstances of every client will be different. Also, a firm may offer different levels of services. A client paying a higher fee for a personalized service cannot be treated in an equitable manner with one who is not. Moreover, it is also not possible to communicate information to all clients at the same time as the modes of communication may vary (e-mail, phone, and fax).
- Investment recommendation is any opinion to buy, sell, or hold a security/investment. Guidelines on how recommendations must be disseminated to clients:
- All your clients must have a fair opportunity to act on the investment recommendation.
- There should not be selective disclosure such that your large clients receive a report first and the smaller clients later. There may be practical difficulties in reaching all clients at the exact same time because of time differences and modes of communication, but an effort must be made to communicate in an equitable manner.
- There may be instances when you may change your recommendation. Let’s assume you issued a buy recommendation for a stock erroneously. You changed it later to sell and if there are clients who have acted on the buy order but are not aware of the change to sell, you must advise them of the change before accepting the order.
- Guidelines for members and candidates whose primary role is to take actions based on investment recommendations received either from within the firm or external sources:
- Take care to treat all clients fairly.
- IPO and secondary offerings: Distribute to all clients for whom the investments are appropriate. Allocation of the stock should be consistent with the policies of the firm.
- Oversubscribed issues: Distribute on a pro rata and round-lot basis. Refrain from buying for individual and family accounts. But, if a family-member is a fee-paying client, then the family member must be treated on an equal basis as any other client.
- Block trade: All accounts of clients in a block trade must be given the same execution price and charged the same commission fee.
- Orders must be time stamped.
- Orders are to be executed on a first-in and first-out basis.
- Disclose to the client the allocation procedures that the firm follows.
- Members and candidates must not withhold securities of IPOs, trading at a premium in the secondary market, for their benefit.
Recommended procedures for compliance:
- Develop firm policies.
- Limit the number of people who know that a recommendation is going to be disseminated.
- Shorten the time frame between the decision to make an investment recommendation and actual dissemination.
- Publish guidelines for pre-dissemination behavior: Firms must be encouraged to have guidelines that prohibit personnel, who know about the recommendation, from taking action or discussing.
- Simultaneous dissemination: Once dissemination to all clients has happened, members and candidates may follow up with individual clients.
- Maintain a list of clients and their holdings.
- Develop and document trade allocation procedures (discussed above).
- Disclose trade allocation procedures.
- Establish systematic account review: Conduct periodic review to ensure no client is receiving preferential treatment and trades are based on the account’s objectives. If the manager is selling from one account and buying it for another account, he must document the reasons for both the transactions.
- Disclose the levels of service and the associated fees to all clients.