Ethics in the Financial Services Industry

7/31/2019 Ethics in the Financial Services Industry

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Ethics in the Financial Services

Industry

By A.V. Vedpuriswar

(Based on the CFA Institutes code

of ethics)


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Professionalism

Knowledge of the law compliance with applicable laws &

regulations

Independence & Objectivity not accepting gifts, benefits,

compensation that might affect independence and objectivity.

Misrepresentation Need for integrity in areas like

investment analysis, recommendations, etc.

Misconduct Avoiding dishonesty, fraud and deceit.


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Duties to clients

Need to act with prudence, loyalty and care. Place clientsinterests before employer and self interest.

Fair dealing while making investment analysis,

recommendations and taking investment actions.

While in an advisory relationship with clients, investment

recommendations should be made after taking into account

clients investment experience, risk and return objectives.

Investments must be made suitable to the client's financialsituation, and in the context of the client's total portfolio.


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Duties to clients

In case of portfolio management, investment actions mustbe taken that are consistent with the stated objectives and

restraints of the portfolio.

Investment performance information must be fair, accurate

and complete.

Information about clients must be kept confidential unless

the activities are illegal,

disclosure is required by law or

the client permits disclosure.


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Duties to Employers

Exercise loyalty to employer.

Avoid additional compensation/benefits that can lead to

conflict of interest.

Have adequate supervision. Supervisors must anticipate and

prevent violation of rules, laws and regulations.


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Investment analysis, recommendations &

actions

Exercise diligence, independence and thoroughness.

Reasonable and adequate basis, supported by research and

appropriate investigation.

Communication to clients and perspective clients must befair, outlining the general principles underlying the investment

processes.

While presenting investment analysis and recommendations,

fact and opinion should be distinguished.

Records should be kept to support the investment analysis

and recommendations.


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Conflicts of interest

Matters should be disclosed that could lead to conflict of

interest.

Investment transactions for clients and employers must

have priority over investment transactions in which amember or candidate is the beneficial owner.

Disclosure should be made to employers where

compensation or benefits are received for recommending

products and services.


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The CFA membership/candidature

No action allowed that can compromise on the

reputation/integrity of the CFA Institute/ examinations.

Members/candidates must not misrepresent or exaggerate

the meaning/implications of membership of the CFA Institute,holding the CFA designation or candidacy in the CFA

program.


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SECTION 1

Professionalism


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Knowledge of the law

When there is conflict, comply with the more strict law, rule

and regulation.

When there are reasonable grounds to believe that imminent

nor ongoing client/employee activities are illegal, or unethical,analysts should disassociate from such activities.

In special cases, it may be appropriate to disclose violations

to the appropriate government or regulatory authority or the

CFA Institute.


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Independence and Objectivity

Members must reject any offer of gift or entertainment thatcould be expected to threaten their independence and

objectivity.

Members may accept bonuses or gifts from clients but must

disclose this to their employers. The conflicts of interest that arise when research and

investment banking departments collaborate must be

recognised.

Sell side firms must foster a corporate culture thatencourages independence and objectivity and protects

analysts from undue pressure by investment banking

colleagues.


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Independence and Objectivity

Investment banking staff should not be allowed to

approve/disapprove/make changes to research

recommendations.

Issuer paid research is fraught with potential conflicts.

Investors can be led into believing that research appears tobe from an independent source when actually it has been

paid for by the subject company.

Analysts must fully disclose potential conflicts including the

nature of their compensation.

Best practice is to accept only a flat fee for the work prior to

preparing the research report without regard to the report's

conclusions or recommendations.


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Misrepresentation

A misrepresentation is any false statement or omission of a

fact or any statement that is otherwise misleading.

Clients should not be guaranteed specific returns on

investments that are inherently volatile.

Plagiarism in the preparation of material for distribution to

employers, associates, prospects, or the general public, is

prohibited.

Quotations and summaries must be attributed.


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Misconduct

Conduct that reflects poorly on the professional integrity,

reputation, competence of the analyst must be avoided.

Lying, cheating, stealing and other dishonest conduct must

be strictly avoided.

Conduct that damages trustworthiness or competence can

include behaviour that may not be illegal but could negatively

affect the analysts ability to perform their responsibilities.


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SECTION 2

Integrity of capital markets


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What is Material Non Public Information?

Information is non public until it has been disseminated ormade available to the market place in general, as apposed to

a select group of investors.

Members who possess material non public information that

could affect the value of an investment must not act or causeothers to act on the information.

The specificity of the information, the extent of its difference

from public information, its nature and its reliability are key

factors in determining whether a particular piece ofinformation fits the definition of material.

.


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The Mosaic Theory

The less reliable a source, less likely that the information can

be considered material.

The more ambiguous the effect on price, the less material the

information.

The analyst may use significant conclusions derived from the

analysis of public and non material non public information as

the basis for recommendations, even if these conclusions

would have been material inside information had they beendirectly communicated to the analyst by a company.


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Building Chinese walls

To the extent possible, firms should consider the physical

separation of departments and files to prevent the communication ofsensitive information.

The investment banking and corporate finance departments can be

separated from the sales and research departments.

Authorised people should review and approve communicationsbetween departments.

Firms should impose appropriate restrictions on personal trading by

employees and should carefully monitor both proprietary trading

and personal trading by employees.

Firms should require employees to make periodic reports of their

own transactions and transactions made for the benefit of family

members.


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Proprietary trading

A prohibition on all types of proprietary activity when a firmcomes into possession of material non public information is notappropriate.

For example when a firm acts as a market maker, a proprietary

trading prohibition would be counterproductive to the goals tomaintaining the confidentiality of information and market liquidity.

But firms that continue market making activity while inpossession of material non public information should instructtheir market makers to remain passive to the market, that is take

only the contra side of unsolicited customer trades.


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Arbitrage trading

In arbitrage trading, the case for a trading prohibition is

more compelling.

The impetus for arbitrage tradition is neither passive

nor reactive and the potential for illegal profits is

greater.

It may make sense to suspend arbitrage activity when

a security is placed on the watch list.


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Market Manipulation

Members should not engage in practices that distort prices

or artificially inflate trading volume with the intent to mislead

market participants.

Market manipulation can take the form of:

- Misleading transactions

- Dissemination of false or misleading information.

Transactions that artificially distort prices or volume to givethe impression of activity or price movement in a financial

instrument are not allowed.


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Market Manipulation

It is also unethical to secure a controlling, dominant position

in a financial instrument to exploit and manipulate the price of

a related derivative and /or the underlying asset.

Spreading false rumours to induce trading by others is illegal.

This standard is not to prohibit transactions done for tax

purposes or to exploit differences in market power,

information or other market inefficiencies.


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SECTION 3

Duties to Clients


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Loyalty, Prudence & Care

Investment actions must be carried out for the sole benefit of

the client and in a manner the manager believes to be in the

best interest of the client given the known facts and

circumstances

Prudence implies caution and discretion.

Risk and return must be balanced in line with the interests of

the client.


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Fair dealing

Fairly means no discrimination among clients when

disseminating investment recommendations or taking investmentaction.

Members can differentiate their services to clients but different

levels of service must not disadvantage or negatively affect

clients.

The different service levels must be disclosed to clients.

Information should be disseminated in such a manner that all

clients have a fair opportunity to act on every recommendation.All clients must be informed at approximately the same time.

Selective, discriminative disclosure is not allowed.


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Fair dealing

When an investment recommendation changes, greater

caution must be exercised.

While making investments in new/secondary offerings they

should be distributed to all customers for whom investmentrecommendations are appropriate .

Members should not take advantage of their position in the

industry to the detriment of clients.

Compliance procedures must be established to support the

fair treatment of clients.


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Taking precautions

In general, it is a good idea to make reasonable efforts to

limit the number of people who are privy to the fact that arecommendation is going to be disseminated.

Firms must limit the amount of time that elapses between the

time the decision is made to make an investment

recommendation and when it is actually made.

If a detailed report is under preparation, that will take a long

time to publish, an advance summary report might be

published.

People with prior knowledge of an investment

recommendation must not discuss with others or take action

on the pending recommendation.


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Fair dealing

Periodic reviews are recommended to ensue that no client or

customer is being given preferential treatment.

When in an advisory relationship, recommendations should

be made only after a thorough understanding of the clients

risk tolerance, returns objectives and financial constraints.


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Fair dealing

When managing a portfolio according to a specific Mandate,

strategy or style, candidates must make recommendationsthat are consistent with the stated objectives and constraints

of the portfolio.

When communicating investment performance information,

efforts should be made to ensure that it is fair, accurate andcomplete.

Information about past/expected performance must be fair

and complete.

It is unethical to guarantee a rate of return that was

generated in the past.


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Fair dealing

Information about current, former and prospective clientsmust be kept confidential unless:

the information concerns illegal activities on the part of

the client.

disclosure is required by law

the client permits disclosure of the information.

Confidentiality is by and large guided by applicable law.

Confidentiality must be maintained even after the client

relationship has ended.


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SECTION 4

Duties to Employers


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Loyalty

Employees must use their knowledge, skills and abilities for the

benefit of their employer.

They must not divulge confidential information or otherwise causeharm to their employer.

Employees must comply with the policies and procedures

established by their employer unless they conflict with applicablelaws, rules and regulations.

Members should not indulge in an independent competitive activitythat conflicts with the interests of employers without takingpermission.

Members seeking alternative employment must not contact existingor potential clients prior to leaving their employer for the purposes ofsoliciting business for the new employer or take records or fileswithout the written permission of the previous employer.


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Loyalty

But these clients can be contacted as long as the contact

information does not come from the records of the former

employer and there is no violation of any non compete

agreement.

Whistle blowing is permitted when the employer engages in

unethical or illegal activity.

Members must obtain permission from their employer before

accepting compensation or other benefits from third parties

for the services rendered to the employer or for any services

that might create a conflict of interest.

Members should disclose the additional compensation they

receive.


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Supervision

Supervisors must make reasonable effort to detect and prevent

violations of applicable laws, rules, regulations and the code of

Ethics by anyone subject to their supervision or authority.

Compliance procedures must be established and implemented.

The supervisor must decline supervision responsibilities if suchprocedures have not been laid down.

Codes of ethics and compliance policies and procedures must be

distinguished.


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Keep it simple and straightforward

Codes of ethics consist of ethical and fiduciary concepts

based on fundamental principles .

They must be written in plain language and address general

fiduciary concepts, without including numerous detailed

procedures.

Simple straight forward codes of ethics if communicated to

clients can help in conveying the message that the firm in

committed to conducting business in an ethical manner and in

the best interests of the clients.

I l i d i d


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Investment analysis, recommendations and

actions

Diligence, independence and thoroughness must beexercised in analysing investments, making investment

recommendations and taking investment actions.

Analysis and recommendations, must be backed by

appropriate research and investigation.

Clients must be kept informed about the general principles of

the investment processes used to analyse investments,

select securities, construct portfolios.

The factors important while making investment analysis,recommendations and actions must be communicated to

clients.

I t t l i d ti d


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Investment analysis, recommendations and

actions

A distinction must be made between fact and opinion whilepresenting investment analysis and recommendations.

For example, changes in outlook for dividends, earnings

estimates, etc are opinions, not facts.

Records must be kept to support investment analyses.

These records are must not be taken by the employee while

leaving the firm.

It is the responsibility of the firm to ensure that records are

kept.


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Conflicts of Interest

Anything that might affect the objectivity with which the

interests of clients and the employer are safeguarded mustbe disclosed in simple clear language.

Conflicts of interest must be carefully and clearly

communicated.

Requiring members and candidates to disclose all matters

that might impair objectively allows clients to judge motives

and possible biases for themselves.

The most obvious conflicts of interest are relationships

between the members or their firm and issuer

(director/consultant), investment banking, underwriting and

financial relationships, brokers/dealer market making

activities and material beneficial ownership of stock.


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A typical conflict is a members orcandidates ownership of stock incompanies that they recommend to clients.

Sell side members must disclose any materially beneficial

ownership interest in an investment that is being recommended.

Ownership of stock analysed or recommended, participation inoutside boards and financial and other pressures that may influence

a decision must be disclosed to the employer.

Members should disclose special compensation arrangements with

the employer that might conflict with client interests such as

bonuses based on short term performance criteria, commissions,

incentive fees, performance fees and referral fees.


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Investment transactions for clients and employers must havepriority over investment transactions in which a member or

candidate is the beneficial owner.

Family accounts that are client accounts should be treated like any

other firm account and should neither be given special treatment nor

be disadvantaged because of an existing family relationship with theanalyst.

Participation in private placements raises conflict-of-interest issues

that are similar to issues surrounding IPOs.

Investment personnel should not be involved in transactionsincluding private placements that could be perceived as favours or

gifts that seem designed to influence future judgment or to reward

past business deals.


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Some eagerly awaited IPOs may rise significantly in value shortlyafter the issue is bought to market.

Purchase of IPOs by investment personnel create conflict of interest

in two ways:

- Participation in an IPO may have the appearance ofappropriating an attractive investment opportunity from clients for

personal gain.

- Because opportunities to participate in IPOs may be limited,

there may be an appearance that the investment opportunity is

being bestowed as an incentive to make future investment

decisions for the benefit of the party providing the opportunity.


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Members must disclose to their employer, clients any

compensation, consideration or benefit received from of paid

to, others for the recommendation to products or services.

The nature of the consideration flat fee or percentage basis,

one time or continuing benefit based on performance, etc

must also be disclosed.

R ibiliti CFA I tit t b


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Responsibilities as a CFA Institute member

or candidate

Members and candidates must not do anything that

compromises the reputation or integrity of the CFA Institute

or the CFA designation or the CFA examinations.

Members/candidates must not misrepresent or exaggeratethe meaning or implications of membership in CFA Institute,

holding the CFA designation or candidacy in the CFA

program.

The use of the CFA designation must be accompanied by an

accurate explanation of the requirements that have been met

to earn the right to use the designation.


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SECTION 5

Global Investment Performance

Standards (GIPS)

Global In estment Performance Standards


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Global Investment Performance Standards

(GIPS)

GIPS have been framed, taking into account various

misleading practices like:

Representative accounts Selecting a top performing

portfolio to represent the firm's overall investment results for a

specific mandate.

Survivorship bias Presenting an average performance

history that excludes accounts whose poor performance was

weak enough to result in termination of the firm.

Varying time periods Presenting performance for aselected time period during which the mandate produced

excellent returns or outperformed its benchmark making

comparison with otherfirms results impossible.



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(GIPS)

GIPS aim at establishing a standardised industry wide

approach for investment firms to follow in calculating and

reporting their historical investment results to prospective

clients.

They help avoid misrepresentations of performance and to

communicate all relevant information that prospective clientsshould know in order to evaluate past results.

Complying with GIPS is voluntary.

Only investment management firms that actually manageassets, can claim compliance with GIPS.

Compliance is a firm wide process that cannot be achieved

on a single product or composite.


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Composites

One of the key concepts in GIPS is composites.

A composite is an aggregation of discretionary portfolios into

a single group that represents a particular investment

objective or strategy.

The determination of which portfolios to include in the

composite should be done according to pre established

criteria, not after the fact.

This ensures that the firm does not include only the best

performing portfolios in the composite.



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(GIPS)

GIPS covers the following areas:

- Input data

- Calculation methodology

- Composite construction

- Disclosures

- Presentation & reporting

- Real estate

- Private equity

Ethics in the Financial Services Industry

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