Ethical and Professional Standards · Reading 102
Application of the Code and Standards: Level I
CFA Level I · Ethical and Professional Standards · Reading 102 · about 31 min
What you'll learn
- LOS 102.a Evaluate practices, policies and conduct against the CFA Institute Code of Ethics and Standards of Professional Conduct.
- LOS 102.b Explain why particular practices, policies and conduct do or do not violate the Code and Standards.
Module 102.1
Ethics Application
This reading tests two skills: evaluating practices, policies and conduct against the Code and Standards, and explaining why a given act does or does not violate them.
This reading applies the whole Code and Standards to short cases. It introduces no new rules; the skill tested is recognizing which Standard a fact pattern touches and whether the conduct crosses the line. Three questions help with every case: (1) whose interests are at stake (market, clients, employer, CFA Institute)? (2) which fact decides the outcome? (3) what should the member have done instead?
LOS 102.a — Evaluating practices, policies and conduct against the Code and Standards
Standard I: Professionalism
Key concept
| Standard | Key judgment in application cases |
|---|---|
| I(A) Knowledge of the Law | On learning of illegal or unethical conduct, the member first tries to stop it through supervisors or compliance. If that fails, the member must dissociate (e.g., ask to be reassigned, refuse to work on the affected clients, resign from a board). A partial fix is not enough: if some clients are still affected, the member must not keep working on those accounts. The Code and Standards do not require reporting to regulators unless the law requires it, although it may be advisable. Ignoring red flags (e.g., money-laundering indicators because the client is well connected) or forging signatures for convenience is a violation. |
| I(B) Independence and Objectivity | Gifts, political contributions or benefits intended to win business or influence judgment violate the Standard. |
| I(C) Misrepresentation | No guaranteeing returns on risky investments; no omission of material facts (e.g., key staff named in a proposal who have since left must be disclosed); no false statements such as claiming financing that does not exist. Plagiarism: charts, text or models copied from others must be attributed. Two exceptions: projections, statistics and tables from recognized financial and statistical reporting services may be used without acknowledgment, and models or research by colleagues at the member's own firm may be used without naming colleagues who have left, as long as the member does not present that work as solely his or her own. |
| I(D) Misconduct | Has two parts: no professional conduct involving dishonesty, fraud, or deceit, and no act that reflects adversely on professional reputation, integrity, or competence. The second part reaches only work-related professional responsibilities and professional activities; acts outside the member's professional capacity are not covered. Minor offenses committed during civil disobedience to express personal beliefs are not necessarily a violation. Using an error-correction process to put personal money into a client account to flatter performance is deceit. |
| I(E) Competence | Accepting a new role (e.g., supervisory duties) requires taking steps to gain the needed competence. |
Standard II: Integrity of Capital Markets
- II(A) Material Nonpublic Information. Overheard takeover news, or a regulator's reaction shared with a small group of analysts (selective disclosure), may not be acted on. The mosaic theory permits acting on a conclusion built from public information and nonmaterial nonpublic observations.
- II(B) Market Manipulation. Violations include misleading the market about liquidity (e.g., listing fake shareholders to meet exchange requirements), spreading false information, and trading to create artificial prices or volume. Block trades to limit price impact in a thinly traded stock are legitimate.
Standard III: Duties to Clients
- III(A) Loyalty, Prudence, and Care. Members cannot contract out of their duties to clients: client agreements may not excuse the firm from acting in clients' best interests or restrict clients' legal claims. For a self-directed, execution-only account the duties are narrower than in an advisory relationship, but the member must still act in good faith and describe the services honestly. How the firm will act if the account has a margin shortfall is a term the client can negotiate when the account is opened. A client may be charged expenses incurred to lower that client's total costs, but never expenses that benefit other clients or the member personally. Soft dollars (client brokerage) may pay only for research and services that benefit clients. Office furniture and personal expenses do not qualify.
- III(B) Fair Dealing. Recommendation changes must be disseminated fairly to all clients for whom they are relevant, at the same time or as close to it as practicable; answering follow-up questions afterward is acceptable. A fee-based premium service is allowed if all clients know it exists and it never delivers recommendation changes ahead of other clients; disclosing the service does not make early delivery acceptable.
- III(C) Suitability. Investigate a client's circumstances before acting, even on a client-requested change. Tax advantages do not excuse excessive risk.
- III(D) Performance Presentation. Do not present separate-account composites as a new fund's long track record. A brief presentation must make detailed information available on request and say that it offers only limited information.
- III(E) Preservation of Confidentiality. Protect client data; downloading client files to unsecured personal systems is a breach, and a compliance head whose controls allowed such a download may also be in breach. Exception: confidentiality does not prevent a member from cooperating with a CFA Institute Professional Conduct Program (PCP) investigation, because the PCP keeps the information confidential.
Standard IV: Duties to Employers
- IV(A) Loyalty. While still employed, a member may not disparage the current employer or solicit for a future employer, and may not take client lists or other employer property (even to send thank-you notes). Before performing outside work that could compete with the employer, including advisory work for which any benefit is received, the member must obtain the employer's permission. Whistleblowing to regulators to protect clients is not a loyalty violation.
- IV(B) Additional Compensation Arrangements. Any benefit that competes with or could create a conflict with the employer's interest (a bonus from a company seeking coverage; perks from a broker tied to the volume of employer business) requires written consent from all parties involved. When the outside party has already made its offer in writing, the employer's written consent is what remains.
- IV(C) Responsibilities of Supervisors. Make reasonable efforts to prevent and detect violations by all persons supervised, including those who are not CFA charterholders: distribute the compliance program, send periodic reminders, and include professional conduct in performance reviews. Without adequate procedures or authority, decline supervisory responsibility in writing.
Standard V: Investment Analysis, Recommendations, and Actions
- V(A) Diligence and Reasonable Basis. Analysis must be independent and thorough; relying on another analyst's unsupported work is also a violation. Numbers supplied by company management must be reviewed critically. Research from third parties may be used after a reasonable and diligent review of whether it is sound: its assumptions, the rigor of the analysis, how timely it is, and the objectivity and independence of its recommendations. Firms should set criteria for evaluating external advisers and outside information providers and say how often the reviews are repeated.
- V(B) Communication with Clients and Prospective Clients. Disclose methodology changes and distinguish fact from opinion. Reports need not give every area equal emphasis.
- V(C) Record Retention. Keep written client records up to date.
Standard VI: Conflicts of Interest
- VI(A) Avoid or Disclose Conflicts. Disclose personal holdings in stocks one covers (to the employer, and in research sent to clients) and time-consuming outside roles such as a trusteeship of a large endowment (to the employer); disclose payments from subadvisers to clients.
- VI(B) Priority of Transactions. Clients and the employer come first. Front-running client orders, tipping friends and family ahead of client trades, allocating winning block trades to personal accounts after the close (losers to large clients), or giving family members priority are violations. Personal transactions, those in which the member is a beneficial owner, follow client and employer transactions. Family accounts that are fee-paying client accounts are treated like any other client account, neither favored nor disadvantaged.
- VI(C) Referral Fees. Disclose to clients and prospects any benefit received for referrals and any benefit given to others for referring clients (including a share of fees paid to a bank or landlord that refers clients, and rewards such as fee discounts, gifts or hospitality for clients who refer others).
Standard VII: Responsibilities as a CFA Institute Member or CFA Candidate
- VII(A) Conduct as Participants in CFA Institute Programs. Candidates may share general impressions of difficulty, but not specific questions or which topics were or were not tested. Soliciting such information is also a violation.
- VII(B) Reference to CFA Institute, the CFA Designation, and the CFA Program. There is no "CFA Level I" or "CFA Level II" designation. A candidate may state that he or she is a "Level II Candidate in the CFA Program" or has passed a given level. A member whose dues are unpaid may not use the designation, and a firm may not describe all its senior staff as charterholders if any of them is not an active member.
LOS 102.b — Explaining why conduct does or does not violate the Standards
Most application questions offer three outcomes: no violation, violation of the right Standard, and violation of a plausible but wrong Standard (or the right Standard for the wrong reason). The explanation must name the deciding fact:
Some Standards cover neighboring ground. Ask what the conduct is about: a misstatement of any kind, performance figures, or what clients are told about the process; fairness among clients, or the member's own trades against clients'. (Gifts, outside pay, conflicts and referral fees are compared in the Standard VI notes.)
| Standard | What it governs | Typical breach |
|---|---|---|
| I(C) Misrepresentation | Any knowing misstatement or omission in professional activities, including plagiarism and false guarantees | Promising a fixed return on a stock fund; copying another analyst's chart without credit |
| III(D) Performance Presentation | Performance information for clients and prospects: fair, accurate and complete | Showing only the best accounts as the firm's record; implying past returns will be repeated |
| V(B) Communication with Clients and Prospective Clients | Services and costs, the investment process and changes to it, risks and limitations; fact versus opinion | Not telling clients about a switch to a new valuation model; stating a forecast as fact |
| III(B) Fair Dealing | Fairness among clients when disseminating recommendations and allocating trades | Giving favored clients a rating change first; allocating the best fills to the largest accounts |
| VI(B) Priority of Transactions | Order of trades: clients and employer before accounts the member beneficially owns | Buying for one's own account ahead of a client order or a pending recommendation |
Key concept
| Deciding fact in the stem | Typical conclusion |
|---|---|
| Information came from a general newswire | Public, so II(A) is not the issue; look at priority of transactions or fair dealing instead |
| Member told a relative before acting for clients or employer | VI(B) Priority of Transactions |
| Member receives a benefit tied to employer business | IV(B): obtain written consent |
| A client's bonus rewards results already achieved and carries no condition on future performance | I(B): a client gift, disclosed to the employer; IV(B) written consent applies when the bonus depends on future performance |
| Member refers clients or shares fees for referrals | VI(C): disclose to clients and prospects |
| Member serves on outside boards or owns stock under coverage | VI(A): disclose to the employer, and to clients and prospects when it could affect research or advice |
| Management revised the analyst's numbers | V(A): the analyst must review them independently |
| Only general topics of the exam were shared | Still VII(A) if they reveal which topics were tested or not tested |
Example. An analyst learns from a radio broadcast that an issuer will buy back shares at a premium, first come, first served. She tenders her sister's shares first and the pension clients' shares an hour later. The information is public, so II(A) is not the issue. Putting a family account ahead of clients violates VI(B) Priority of Transactions.
Common exam traps
- "Resign" or "refuse the benefit" is usually too extreme when disclosure or written consent solves the conflict.
- The mosaic theory makes many "wait until it is announced" answers wrong when the pieces were nonmaterial or public.
Exam shortcuts
- If the information in a stem came from a general newswire, it is public, so Standard II(A) is not the issue and the answer usually lies in priority of transactions or fair dealing.
Bottom line
- Application questions test which Standard a fact pattern touches and whether the conduct crosses the line, and the explanation must name the fact that decides the outcome.
- Under Standard I(A), a member who cannot stop a violation through supervisors or compliance must dissociate, and a partial fix that leaves some clients affected is not enough.
- Members cannot contract out of their duties to clients, so a client agreement may not excuse the firm from acting in clients' best interests or restrict clients' legal claims.
- Soft dollars may pay only for research and services that benefit clients, never for office furniture or personal expenses.
- A fee-based premium service is allowed if all clients know it exists and it never delivers recommendation changes ahead of other clients, and disclosing the service does not make early delivery acceptable.
- Under Standard IV(B), a benefit that competes with or could create a conflict with the employer's interest needs written consent from all parties involved, and when the outside party has already made its offer in writing, the employer's written consent is what remains.
- Putting a family member's account ahead of clients violates Standard VI(B) even when the information acted on is public.
- Candidates may share general impressions of exam difficulty but not specific questions or which topics were or were not tested, and soliciting such information also violates Standard VII(A).
Quick check
Kwame Mensah, CFA, finds that his manager has breached a national securities regulation. Mensah raises the matter with his firm's compliance department, which does nothing about it. Under the Code and Standards, Mensah is required to:
Show answer and explanation
Correct answer: C
Under Standard I(A) Knowledge of the Law, Mensah has already tried to stop the violation by going to compliance. Because that failed, he must dissociate from the activity; one way is to request a move away from the work involved. Reporting to regulators is not something the Code and Standards demand unless applicable law requires it, and a personal confrontation with his manager is not required either.
Why the other options are wrong
- A. Reporting to regulators may be advisable, but the Code and Standards do not require it unless the law does.
- B. He has already made a reasonable attempt to stop the violation through compliance; a personal confrontation is not required.
Key takeaway Escalate internally first; if that fails, dissociate. Reporting to authorities is required only when the law requires it.
Practice Questions
Dmitri Volkov, CFA, an investment adviser, uses soft dollars generated by client trades to pay for two things: a subscription to a macroeconomic research service that he uses in managing client portfolios, and new leather chairs for the reception area where he meets clients and prospects. Under Standard III(A) Loyalty, Prudence, and Care:
Show answer and explanation
Correct answer: A
Client brokerage (soft dollars) belongs to the clients and may be used only for goods and services that benefit them. Research used in managing client portfolios qualifies, although the adviser should ensure it does benefit the clients. Office furniture does not benefit clients, so paying for it with soft dollars violates Standard III(A).
Why the other options are wrong
- B. The research subscription is a permitted use because it is used in managing client portfolios.
- C. Chairs for the reception area are an office expense that does not benefit clients; paying for them with client brokerage is a violation.
Key takeaway Soft dollars may pay for research that benefits clients. Furniture and overhead do not qualify.
Imogen Achterberg, CFA, runs portfolios for about 350 private clients and has little spare research capacity. Several of her largest clients ask her to add a 4% to 6% allocation to emerging market local-currency bonds, so she plans to base her bond selections on reports bought from an outside research provider that specializes in that sector. In judging whether the provider's research gives her a reasonable basis, the factor Achterberg should least likely rely on is:
Show answer and explanation
Correct answer: B
Under Standard V(A) Diligence and Reasonable Basis, a member who uses third-party research must make reasonable and diligent efforts to judge whether it is sound. The review looks at the assumptions used, how rigorous the analysis is, how timely the research is, and how objective and independent its recommendations are. One year of high returns on a model portfolio is not one of these tests and says little about whether the research itself is sound.
Why the other options are wrong
- A. Reviewing the assumptions and the rigor of the analysis is a core part of judging whether third-party research is sound.
- C. Timeliness, objectivity and independence are among the qualities a member checks before relying on outside research.
Key takeaway Judge third-party research by its assumptions, rigor, timeliness, objectivity and independence; a recent high return is not a test of its soundness.
Tariq Haddad and Lena Vogt each cleared the Level I exam and have registered to sit for Level II. The headline of Haddad's online professional profile reads "Tariq Haddad, CFA Level I." Vogt's résumé describes her as a "Level II Candidate in the CFA Program." Under Standard VII(B) Reference to CFA Institute, the CFA Designation, and the CFA Program:
Show answer and explanation
Correct answer: A
There is no designation for having passed Level I, II or III, so "CFA Level I" after a name implies a designation that does not exist and violates Standard VII(B). A candidate may, however, accurately state candidacy ("Level II Candidate in the CFA Program") or that a level has been completed.
Why the other options are wrong
- B. Vogt's wording correctly describes her status as a candidate registered for Level II, which is permitted.
- C. Only Haddad's wording implies a partial designation; Vogt's is acceptable.
Key takeaway Never write "CFA Level I/II/III" as if it were a title; describe candidacy or completed levels instead.
This reading has 28 questions in the full bank. Practice all of them.
Key Takeaways
- Escalate internally first; if that fails, dissociate. Reporting to authorities is required only when the law requires it.
- Soft dollars may pay for research that benefits clients. Furniture and overhead do not qualify.
- Judge third-party research by its assumptions, rigor, timeliness, objectivity and independence; a recent high return is not a test of its soundness.
- Never write "CFA Level I/II/III" as if it were a title; describe candidacy or completed levels instead.