Ethical and Professional Standards · Reading 93
Ethics and Trust in the Investment Profession
CFA Level I · Ethical and Professional Standards · Reading 93 · about 28 min
What you'll learn
- LOS 93.a Explain what ethics means: shared beliefs about good (acceptable) and bad (unacceptable) behavior, balancing self-interest against effects on stakeholders.
- LOS 93.b Describe how a code of ethics communicates a group's values and how it can help define a profession; distinguish a code of ethics from standards of conduct.
- LOS 93.c Describe what makes an occupation a profession and the ways professions build and keep public trust.
- LOS 93.d Explain why investment management needs especially high ethical standards and how unethical conduct harms clients, firms and the wider economy.
- LOS 93.e Explain professionalism in investment management, including the difference between a suitability standard and a fiduciary standard.
- LOS 93.f Identify the main challenges to ethical behavior, especially situational influences and overconfidence in one's own ethics.
- LOS 93.g Compare ethical standards with legal standards and explain why neither is a subset of the other.
- LOS 93.h Describe the Identify / Consider / Decide and act / Reflect framework for ethical decision making.
Module 93.1
Ethics and Trust
This reading defines ethics, codes of ethics and standards of conduct, explains how professions establish trust and why investment management needs high ethical standards, and contrasts the suitability and fiduciary standards. It then covers the challenges to ethical behavior, the difference between ethical and legal standards, and a four-step framework for ethical decision making that a candidate must be able to apply.
LOS 93.a — What ethics means
Ethics is the body of shared beliefs about which behavior is good (acceptable) and which is bad (unacceptable). Ethical conduct is behavior that conforms to moral principles and meets the ethical expectations of society.
A second, practical description: ethical conduct is behavior that improves outcomes for stakeholders, meaning everyone directly or indirectly affected by a decision. For an investment professional the stakeholders include clients, coworkers, the employer and the investment profession as a whole. Ethical behavior therefore balances self-interest against the impact on others. A decision can bring good results for the person who makes it and still have negative consequences for a stakeholder such as a coworker.
LOS 93.b — Codes of ethics and standards of conduct
A code of ethics sets down in writing the moral principles that tell members of a group what behavior is acceptable. It communicates the group's values, principles and general expectations to its own members and to the public. A code may be principles-based (broad statements), rules-based (specific requirements) or a mix of the two.
Standards of conduct go further. They set out the minimum level of acceptable behavior in particular situations. A code of ethics may include standards of conduct, but it does not have to: a code can consist of general principles alone.
Key concept
| Code of ethics | Standards of conduct | |
|---|---|---|
| Purpose | States values and general expectations | Sets a minimum acceptable level of behavior |
| Level of detail | Usually general principles | Specific guidance for situations |
| Relationship | The overall statement | Optional part of a code |
A profession is made up of people who use specialized knowledge and skills in the service of others and who commit to a code of ethics. A professional code tells the public that members will apply their expertise for clients' benefit in an honest and ethical way, which can increase public trust. It cannot guarantee that every member will behave ethically. A profession may properly point to its code when it presents itself to the public.
LOS 93.c — Professions and how they establish trust
A profession is an occupational group (doctors, lawyers, engineers) whose core requirement is specialized expert knowledge, usually combined with a focus on ethical behavior and on service to society. A profession may also have:
- a code and standards of professional behavior, with a regulatory body that enforces them and monitors members' conduct;
- attention to clients' needs, with client interests placed first;
- a focus on, or a requirement for, continuing education.
Professions establish trust by:
- demanding a high level of expertise, knowledge and skill;
- setting standards of ethical behavior;
- monitoring professional conduct;
- encouraging continuing education;
- focusing on clients' needs;
- mentoring and inspiring others in the profession.
Example. An actuarial society admits only members who pass a series of exams, publishes a conduct code, investigates complaints and requires 30 hours of study a year. Each of these requirements is a way to establish trust.
LOS 93.d — Why investment management needs high ethical standards
Investment professionals are entrusted with client wealth and must use their specialized skills both to protect it and to grow it. Investment advice and management are intangible products. Their quality and value are harder for a client to judge than those of a meal or a laptop, so trust matters more than in most businesses.
Unethical behavior has consequences at three levels:
- Clients lose wealth.
- Firms and professionals find it harder to succeed, because potential investors are less likely to use their services.
- Society suffers. The financial industry links savers with businesses that need financing. Less trust means less money entrusted to the industry and a higher perceived risk of investing, so investors require higher returns and the cost of capital rises. Misleading or false information also misallocates capital away from the most productive firms, which slows economic growth and harms everyone in the economy.
Key concept
| Effect of unethical conduct on | Direction |
|---|---|
| Perceived investment risk | Increases |
| Cost of capital for businesses | Increases |
| Amount of capital invested | Decreases |
| Efficiency of capital allocation | Decreases |
| Rate of economic growth | Decreases |
| Use of investment firms' and professionals' services | Decreases |
LOS 93.e — Professionalism: suitability vs fiduciary standards
Clients often know little about securities, fee structures and possible sources of bias in recommendations, so they rely on the adviser's expertise, judgment and ethics. Some financial professionals must meet a suitability standard; others must meet a fiduciary standard:
| Suitability standard | Fiduciary standard | |
|---|---|---|
| Requirement | The characteristics of recommended securities must match the client's return requirements and risk tolerance | Professional must use knowledge and expertise to act in the best interests of the client |
| Strength | Weaker | Stronger |
LOS 93.f — Challenges to ethical behavior
- Overconfidence in one's own ethics. People tend to rate their own behavior as more ethical than other people's and to overstate how much their personal traits determine what they do.
- Situational influences. External pressures are thought to shape the ethical quality of behavior more strongly than a person's internal traits do. Examples are social pressure from colleagues, loyalty to a supervisor, employer or coworkers, and the prospect of more money or prestige. These pressures push people to put self-interest and short-term results ahead of long-term consequences.
- Rules-focused compliance cultures. A firm that concentrates on strict, rules-based compliance can breed a culture in which staff ask only what they can do (what is allowed). The question of what they should do, based on ethical principles and long-term effects, often goes unasked.
A lack of ethical principles is a personal trait of the decision maker, so it is not a situational influence.
LOS 93.g — Ethical standards vs legal standards
Law and ethics overlap, but neither is a subset of the other:
- Some legal acts are unethical. Recommending a relative's company without disclosing the relationship may break no law.
- Some illegal acts are considered ethical by many. Examples are whistle-blowing that breaks a confidentiality law to expose harm to clients, and civil disobedience.
| Legal | Illegal | |
|---|---|---|
| Ethical | Most everyday professional conduct, such as disclosing a conflict to clients | Breaking a curfew to drive an injured neighbor to hospital |
| Unethical | Keeping a referral fee secret from clients where no law requires it to be disclosed | Fraud, such as sending clients falsified account statements |
Ethical principles often set a higher standard than law and require more judgment about the impact on many stakeholders. Laws are more specific and often respond to past misconduct: the 1929 crash led to the Glass-Steagall Act, the Securities Act of 1933 and the Securities Exchange Act of 1934; the Enron and WorldCom scandals led to Sarbanes-Oxley; and the 2008 crisis led to the Dodd-Frank Act. New laws can in turn create opportunities for new kinds of unethical behavior.
LOS 93.h — A framework for ethical decision making
Building ethics into a firm's decision process is an important part of developing an ethical culture. Adopting a code of ethics is the first requirement, and backing from senior management matters a great deal. It gives the firm a routine for teaching ethical decision making and reinforcing it through practice, and it lets teams weigh alternative actions and their short- and long-term consequences for different stakeholders. A framework helps people identify the issues, examine them from several perspectives, develop judgment and avoid unanticipated (unintended) ethical consequences.
The ethical decision-making framework has four steps:
Key concept
| Step | What to do |
|---|---|
| 1. Identify | Relevant facts (those known and those wanted), stakeholders and the duties owed to each, ethical principles, conflicts of interest |
| 2. Consider | Situational influences and personal biases; additional guidance (mentor, colleagues, legal/compliance); alternative actions and their short- and long-term effects |
| 3. Decide and act | Choose and carry out the action |
| 4. Reflect | Was the outcome as anticipated? Why or why not? Were duties and principles properly weighed? |
Example. A fund manager is offered a paid trip by a broker. Identify: the facts, her duties to clients and employer, and the conflict. Consider: pressure from the broker relationship, advice from compliance, and alternatives such as declining or paying her own way. Decide and act: she pays her own way. Reflect: did the decision work out as expected?
Common exam traps
- One person's private beliefs about right and wrong are not ethics in this sense, and a written code or firm rulebook is only one way of expressing ethics.
- Standards of conduct are not a statement of best practice.
- Fair dealing is Standard III(B), a duty under the CFA Institute Standards. It is not another name for the suitability standard or the fiduciary standard.
- Higher pay, or seeing work as a calling, does not make an occupation a profession. Putting clients first is a common characteristic of professions but is not the definition.
- The framework's steps differ from the qualitative characteristics of financial reports (relevance, faithful representation) and from the steps of a financial analysis project.
Bottom line
- Ethics is the body of shared beliefs about which behavior is good and which is bad, and ethical conduct can also be described as behavior that improves outcomes for stakeholders, balancing self-interest against the impact on others.
- A code of ethics states a group's values, principles and general expectations, while standards of conduct set the minimum acceptable behavior in particular situations and are an optional part of a code.
- Professions establish trust through demanding requirements for expertise, knowledge and skill, standards of ethical behavior, monitoring of professional conduct, continuing education, a focus on clients' needs, and mentoring others in the profession.
- Investment advice and management are intangible products whose quality clients find hard to judge, and unethical conduct raises perceived investment risk and the cost of capital while reducing capital invested, the efficiency of capital allocation and economic growth.
- The suitability standard requires recommended securities to match the client's return requirements and risk tolerance, while the stronger fiduciary standard requires acting in the client's best interests.
- The challenges to ethical behavior are overconfidence in one's own ethics, situational influences and rules-focused compliance cultures; a lack of ethical principles is a personal trait, not a situational influence.
- Law and ethics overlap but neither is a subset of the other: some legal acts are unethical, and some illegal acts, such as whistle-blowing or civil disobedience, are considered ethical by many.
- The ethical decision-making framework has four steps: identify the facts, stakeholders, duties, principles and conflicts; consider influences, guidance and alternatives; decide and act; and reflect on the outcome.
Quick check
Ethics is best described as:
Show answer and explanation
Correct answer: B
Ethics is a set of shared beliefs about what behavior is good or acceptable and what behavior is bad or unacceptable. It is broader than any particular written rulebook and broader than one person's view.
Why the other options are wrong
- A. A written code of standards is one way a group expresses its ethics; it is narrower than ethics itself.
- C. A single person's belief about proper conduct is a personal view. Ethics rests on beliefs that are commonly shared.
Key takeaway Ethics means commonly shared beliefs about good and bad behavior. It is broader than one person's view or a single written code.
Practice Questions
Which of the following best distinguishes the members of a profession from people working in an ordinary occupation? Members of a profession:
Show answer and explanation
Correct answer: C
What sets a profession apart is that its members commit to following one shared code of ethics. That commitment, together with specialized expertise, is what lets the public trust members of a profession.
Why the other options are wrong
- A. Pay levels do not define a profession; many well-paid occupations are not professions.
- B. How an individual views his or her work is personal and is not a defining characteristic of a profession.
Key takeaway A profession combines specialized knowledge with a shared code of ethics.
Anika Dorsey, a junior trader, goes along with her desk's habit of delaying the reporting of losing trades. She does so because her supervisor and colleagues expect it and her bonus depends on the desk's reported profits. Lapses like Dorsey's are most likely to be explained by:
Show answer and explanation
Correct answer: A
Situational influences are pressures external to the decision maker, such as social pressure from colleagues, loyalty to a supervisor, and the lure of money or prestige. They are considered a more important determinant of the ethical quality of behavior than internal (personal) traits.
Why the other options are wrong
- B. The problem is not a lack of skill or knowledge; Dorsey is responding to pressure and incentives.
- C. People tend to overemphasize the role of their own personal traits in ethical behavior; external influences are considered the stronger driver.
Key takeaway Peer pressure, loyalty and money are situational influences, which are considered a stronger driver of ethical lapses than personal traits.
Which of the following lists the steps of the ethical decision-making framework presented in the Level I CFA curriculum?
Show answer and explanation
Correct answer: C
The framework has four steps. Identify covers the relevant facts, the stakeholders and duties owed, the ethical principles and any conflicts of interest. Consider covers situational influences, additional guidance and alternative actions. The last two steps are Decide and act, and Reflect (was the outcome as anticipated, and why or why not?).
Why the other options are wrong
- A. These are qualitative characteristics of useful financial information from financial reporting. They are not steps in an ethical decision process.
- B. This resembles the steps of a financial analysis project; it has no step for identifying stakeholders and duties or for reflecting on ethical outcomes.
Key takeaway The four steps, in order: Identify, Consider, Decide and act, Reflect.
This reading has 24 questions in the full bank. Practice all of them.
Key Takeaways
- Ethics means commonly shared beliefs about good and bad behavior. It is broader than one person's view or a single written code.
- A profession combines specialized knowledge with a shared code of ethics.
- Peer pressure, loyalty and money are situational influences, which are considered a stronger driver of ethical lapses than personal traits.
- The four steps, in order: Identify, Consider, Decide and act, Reflect.