Ethical and Professional Standards · Reading 99
Investment Analysis Recommendations and Actions
CFA Level I · Ethical and Professional Standards · Reading 99: Guidance for Standard V: Investment Analysis, Recommendations, and Actions · about 34 min
What you'll learn
- LOS 99.a Apply Standard V (Diligence and Reasonable Basis; Communication with Clients and Prospective Clients; Record Retention) to situations involving investment analysis, recommendations and actions.
- LOS 99.b Recommend practices and procedures that help prevent violations of Standards V(A), V(B) and V(C).
- LOS 99.c Identify conduct that conforms to Standard V and conduct that violates it.
Module 99.1
Guidance for Standards V(A), V(B), and V(C)
This reading covers Standard V, Investment Analysis, Recommendations, and Actions: Diligence and Reasonable Basis, Communication with Clients and Prospective Clients, and Record Retention. A candidate must be able to apply each part to a fact pattern, recommend practices that help prevent violations, and tell conduct that conforms from conduct that violates.
LOS 99.a — Applying Standard V to investment analysis, recommendations and actions
Standard V has three parts, each governing a different stage of the research-and-advice process: doing the work (V(A)), telling clients about it (V(B)) and keeping the evidence (V(C)).
Standard V(A) Diligence and Reasonable Basis
Members and candidates must: 1. Exercise diligence, independence, and thoroughness in analyzing investments, making investment recommendations, and taking investment actions. 2. Have a reasonable and adequate basis, supported by appropriate research and investigation, for any investment analysis, recommendation, or action.
How much work is "enough" depends on the member's investment philosophy, his or her role in the investment decision-making process and the resources and support the employer provides; the level of research also differs with the product or service offered. Before recommending or acting, a diligent analyst typically weighs global and national economic conditions, the company's financial results and operating history, the stage of the business cycle, a fund's fees and historical results, the limitations of any quantitative model used, and whether peer-group comparisons are appropriate for valuation.
Relying on others' research. A member may base a recommendation on third-party research or on the firm's own research department, but V(A) still requires reasonable and diligent efforts to judge whether that research is sound: review its assumptions, how rigorous the analysis was, how timely it is, and whether its recommendations are objective and independent. A member who has made that review and found no reason to doubt the research may use it. A rumor, a tip overheard at a lunch, or a single article in the popular press is not a reasonable and adequate basis.
Quantitative research. The limitations of any quantitative model used are one of the factors to consider before making a recommendation. Scenario testing is a recommended firm procedure: written procedures should set a minimum level of scenario testing for computer-based models, with standards for the range of scenarios, model accuracy over time and the sensitivity of cash flows to assumptions and inputs. A conclusion drawn from too short a data period, or a blanket instruction to swap one style of stock for another across all accounts regardless of client needs, lacks a reasonable basis.
Pressure to issue a favorable view. If an analyst's own diligent research does not support a positive rating, issuing one anyway (for example, to help the firm's investment banking business) violates V(A), because the published view has no reasonable basis. It also violates Standard I(B) Independence and Objectivity, because the analyst let others' interests override his or her judgment.
Example. An analyst has lost all her working papers for a report due tomorrow. She takes the company's own projections, trims them by a figure she "remembers", and pastes in charts from another firm's report without credit. She (1) has no reasonable basis (V(A)), (2) presents others' work as her own (Standard I(C) Misrepresentation: plagiarism), and (3) issues a report with no supporting records (V(C)).
Standard V(B) Communication with Clients and Prospective Clients
Key concept
Members and candidates must: 1. Disclose to clients and prospective clients the nature of the services provided, along with information about the costs to the client associated with those services. 2. Disclose to clients and prospective clients the basic format and general principles of the investment processes they use to analyze investments, select securities, and construct portfolios and must promptly disclose any changes that might materially affect those processes. 3. Disclose to clients and prospective clients significant limitations and risks associated with the investment process. 4. Use reasonable judgment in identifying which factors are important to their investment analyses, recommendations, or actions and include those factors in communications with clients and prospective clients. 5. Distinguish between fact and opinion in the presentation of investment analysis and recommendations.
Key applications:
- Reasonable judgment about what to include. An analyst may emphasize some matters, touch briefly on others and omit some altogether, provided there is a reasonable basis for those choices. A temporary event years ago that was quickly reversed may reasonably be left out; heavy recent selling by insiders is a factor a reasonable investor would want and should be included.
- Tailoring to the audience. A report written for a specific group of clients with known needs can generally leave out more basic facts than a report for a wide audience. This flexibility covers background facts only: every research report, whatever its audience, must still describe the basic characteristics of the security analyzed. Sending a report only to the clients for whom the idea is relevant is allowed.
- Fact versus opinion. Historical data ("earnings have grown about 8% a year for five years") is fact. A projection must be presented as an opinion ("we expect", "could", "our estimate is"). Writing that a future event "will" happen turns an opinion into an apparent fact and violates V(B); so does turning management's optimism into a certainty.
- Form of communication. A recommendation may be short (a buy list, an e-mail, a brief note). V(B) does not require a detailed report with every recommendation, but clients must be informed that the full analysis supporting it is available. V(B) does not require analysts to issue explicit buy or sell ratings on every security they cover.
- Changes in the process. A material change in strategy, models or style must be communicated promptly, together with any newly identified risks and limitations. The same applies when the risk characteristics of an investment or strategy change significantly.
- All forms of communication. V(B) covers every means of communicating with clients (meetings, calls, e-mails, messages), not only written research reports.
- Costs. Client-facing members describe the services and their costs when the relationship begins and again whenever the services or costs change. Specific money amounts are not required (a percentage fee may make that impossible), but the cost information must be reasonably detailed, including costs from third parties used to deliver the services.
- Risks and limitations. For nontraditional products (such as structured securities or allocation strategies), members must explain the investment-specific risk factors. In all cases, members should clearly communicate potential gains and losses in terms of total returns. Projections from quantitative models must come with the model's limitations and key assumptions; expectations produced by statistical models are not facts. When projected results are shown, they should cover a range of scenarios, including ones that run against the expected trend: a strategy built on a currency's appreciation should also show what happens if that currency depreciates. Two examples of inherent limitations are liquidity (the ability to exit an investment without significant extra cost) and capacity (the ability of a strategy or vehicle to absorb more money without lowering the returns it can earn).
Example. Brackenhill Partners markets a small-cap fund whose stocks have always been picked by its founding manager. When she retires, stock selection passes to a three-person committee, which also starts adding large-cap shares to the fund. Marketing updates the website and the pitch book for prospects the same week. Existing clients hear about the changes only at their annual reviews, several months later. Both changes can materially affect the investment process, so V(B) required prompt notice to current clients as well as prospects, together with any new risks, such as returns that may now depart further from the fund's small-cap benchmark.
Standard V(C) Record Retention
Members and candidates must develop and maintain appropriate records to support their investment analyses, recommendations, actions, and other investment-related communications with clients and prospective clients.
Records are the evidence behind V(A). When a client, the firm or a regulator later questions a recommendation or a trade, the file shows what analysis supported it and that the action followed the client's mandate. Without the file, even sound work cannot be demonstrated.
- Records can be in any medium: paper, electronic files, e-mails, messages and posts. The Standard does not say where they must be stored, so scanned copies kept off-site are acceptable.
- Records belong to the firm. A member who changes employers may not take them without permission. To reissue research at a new firm, the member must re-create the supporting records from public sources or information obtained from the covered company. Memory of files left behind is not a record.
- Where a regulator or firm policy sets a retention period, follow it. Where neither applies, the Standard recommends keeping records for at least seven years.
- Keeping records is generally the firm's responsibility, but a member must make sure the required records exist.
LOS 99.b — Practices and procedures that help prevent violations
Key concept
| Standard | Recommended practices |
|---|---|
| V(A) | A policy that research and recommendations must have a basis that can be substantiated as reasonable and adequate; detailed written guidance on research and due diligence; periodic review of third-party research (assumptions, rigor, timeliness, objectivity and independence); measurable criteria for research quality, with analyst pay linked to them; minimum scenario testing for computer-based models (range of scenarios, accuracy over time, sensitivity to inputs); policies for evaluating outside information providers and external advisers, including how often reviews are repeated |
| V(B) | Because choosing the relevant factors is a judgment call, keep records of the nature of the research and be ready to supply more information if a client or other user of the report asks |
| V(C) | If no regulation or firm policy sets a period, keep records for at least seven years; record keeping is generally the firm's responsibility |
If a member thinks the firm's procedures fall short (for example, records may not be kept long enough), the right step is to raise the issue with a supervisor or the compliance department and suggest improvements. Refusing to work and keeping personal copies of firm records at home are not appropriate responses. Taking copies home can itself conflict with Standard IV(A) Loyalty.
The Standards call for diligence, attribution of others' work and supporting records. Legal review of each report is not among their requirements or recommended procedures.
LOS 99.c — Conduct that conforms versus conduct that violates
Key concept
| Situation | Conclusion |
|---|---|
| Recommendation based on the firm's research department's work, after reviewing it and finding no reason to doubt it | Conforms to V(A) |
| Recommendation based on an outside broker's report for general distribution, after reviewing it and finding no reason to doubt it | Conforms to V(A) |
| Changing a rating because of a colleague's offhand comment | Violates V(A) |
| Trading all discretionary accounts on a vague, unverified overheard rumor after a quick web search | Violates V(A) |
| Research analyst e-mails a buy recommendation to all clients after careful work | Conforms |
| Using factual data from a recognized statistical service | No attribution needed, but data copied from a colleague's table should be checked for accuracy |
| "Company X will cut its dividend" | Violates V(B): a forecast stated as fact |
| A fee not disclosed in the client agreement | Violates V(B): cost of services not disclosed |
| Reissuing reports from memory at a new employer | Violates V(C) |
| Warning a client about the price impact of a quick liquidation, then executing | No violation |
Common exam traps
- Suitability (Standard III(C)) applies when advising a particular client. A research analyst publishing a general recommendation is judged under V(A); suitability for each recipient is not required.
- A vague, unverified rumor is generally not established material nonpublic information (MNPI). Materiality depends on specificity, reliability and likely price impact, so overheard information can be MNPI when it is specific and reliable.
- V(A) judges the work done before a recommendation, not how the investment turns out. A loss after careful, well-documented analysis is not a violation, and a gain does not cure a recommendation that rested on a tip or a hunch.
Exam shortcuts
- Standard V(A) judges the work done before a recommendation, so the investment's later loss or gain does not by itself decide whether the Standard was violated.
Bottom line
- Standard V(A) requires diligence, independence and thoroughness, and every analysis, recommendation or action must rest on a reasonable and adequate basis backed by appropriate research and investigation.
- How much research is enough depends on the member's investment philosophy, role in the decision-making process and the employer's resources and support.
- A member may rely on third-party or the firm's own research after a reasonable and diligent review of its assumptions, rigor, timeliness, objectivity and independence, but a rumor, an overheard tip or a single popular-press article is not a reasonable basis.
- Standard V(B) requires members to disclose the nature and costs of their services, the general principles and basic format of their investment process with prompt disclosure of material changes, and significant limitations and risks.
- A projection must be presented as an opinion, so writing that a future event will happen violates Standard V(B), while a short recommendation is allowed if clients are told that the full analysis is available.
- Under Standard V(C), records in any medium belong to the firm, and a member who changes employers must re-create supporting records from public sources or the covered company rather than rely on memory.
- Where no regulation or firm policy sets a retention period, records should be kept for at least seven years.
- Suitability under Standard III(C) applies when advising a particular client, while a research analyst publishing a general recommendation is judged under Standard V(A).
Quick check
Marisol Vega, CFA, runs a one-person advisory practice. She frequently bases client recommendations on research bought from several outside providers. The Code and Standards most likely require Vega to:
Show answer and explanation
Correct answer: C
Under Standard V(A) Diligence and Reasonable Basis, members who rely on third-party research must make reasonable and diligent efforts to determine that the research is sound, for example by reviewing its assumptions, rigor, timeliness and independence. Standard V(A) is about checking that the research is sound; it does not require her to name each provider in her recommendations.
Why the other options are wrong
- A. Relying on third-party research is allowed; the Standards do not require members to produce all research themselves.
- B. Naming each outside provider is not a requirement of Standard V(A); what the Standard requires is diligence about whether the research is sound.
Key takeaway A member who uses third-party research must make reasonable and diligent efforts to check that it is sound (Standard V(A)).
Practice Questions
Ines Moreau, CFA, is writing a report on Aldercrest Power. Over the past year, four of the six utilities in its region cut their dividends roughly in half to fund capital spending, and Moreau reasons that Aldercrest will face similar pressure. Her report states: "Aldercrest will reduce its dividend from $3.20 to $1.60 a share by the third quarter to pay for its capital program. Investors who buy at today's price of about $64 could earn a total return above 18%." With respect to Standard V(B) Communication with Clients and Prospective Clients, Moreau:
Show answer and explanation
Correct answer: B
Standard V(B) Communication with Clients and Prospective Clients requires members to distinguish between fact and opinion. The dividend cut is Moreau's prediction, yet she states it as something that "will" happen. Her comment that the total return "could" exceed 18% is properly phrased as an opinion.
Why the other options are wrong
- A. "Could earn a total return above 18%" is a qualified opinion. It does not promise or guarantee a return.
- C. Stating the predicted dividend cut as a certainty is a failure to separate opinion from fact.
Key takeaway Watch the verbs: "will" states a fact, "could" states an opinion.
Dominic Ashe, CFA, recently left a large bank's research department to open his own equity research boutique. All of the files supporting his earlier reports stayed with the bank. Relying on his detailed memory of those files, Ashe rewrites several of his former reports, publishes them under his new firm's name and signs up several clients as a result. Ashe has not reconstructed any supporting records. Ashe is most likely:
Show answer and explanation
Correct answer: C
Standard V(C) Record Retention requires records that support investment analysis and recommendations. The original records belong to the bank, and memory is not a record. Before reissuing the reports, Ashe must re-create the supporting documentation from public sources or information obtained from the covered companies.
Why the other options are wrong
- A. Publishing research with no supporting records breaches V(C).
- B. His analysis may well have been diligent and reasonably based when he did it; the specific failure is the absence of supporting records now.
Key takeaway Records belong to the employer. At a new firm, the member rebuilds the records from public or company sources before reusing old research.
This reading has 33 questions in the full bank. Practice all of them.
Key Takeaways
- A member who uses third-party research must make reasonable and diligent efforts to check that it is sound (Standard V(A)).
- Watch the verbs: "will" states a fact, "could" states an opinion.
- Records belong to the employer. At a new firm, the member rebuilds the records from public or company sources before reusing old research.