Knowledge of the Law

This reading covers Standard I, Professionalism: Knowledge of the Law, Independence and Objectivity, Misrepresentation, Misconduct and Competence. For each part a candidate must be able to explain what it requires, apply it to a fact pattern, and recommend practices and procedures that help prevent violations.

Standard I Professionalism has five parts: Standard I(A) Knowledge of the Law, Standard I(B) Independence and Objectivity, Standard I(C) Misrepresentation, Standard I(D) Misconduct, and Standard I(E) Competence. Questions on Standard I often bring in other Standards too, such as a trustee who trades on a tip or an adviser who never updates client data. Those related Standards are summarized in a table at the end.

LOS 95.a / 95.c — Standard I(A) Knowledge of the Law

Guidance

• Strictest rule wins. The Code and Standards set a minimum level of professional conduct. A member compares the laws that apply to the activity (those of the country where he or she resides and of the country where the business is done, to the extent each governs it) with the Code and Standards, and follows whichever is strictest on each point. Where applicable law is weaker or silent, the Code and Standards govern, so a country with no securities law relaxes nothing.
• A member cannot use a permissive local rule to do something the Code and Standards forbid. If a market legally allows trading on material nonpublic information, a member still may not trade on it, either for clients or for his or her own account.
• Knowledge of the law means keeping current. Members need not be legal experts, but they must know the rules that govern their jobs, including new rules. Breaking an applicable rule the member did not know about is still a violation, even if a regulator's grace period allows the breach to be corrected without penalty. Relying solely on the firm's compliance department is not enough.
• Knowingly participating or assisting includes looking the other way: a member who knows (or who is dealing with conduct whose illegality would be evident to anyone knowing the law) and takes no action to stop it or to dissociate can be treated as a participant. Senior management approval does not excuse a member. Passing the task to someone else, such as asking a supervisor to sign a document the member has refused to sign, is still assisting.
• Reporting. The Code and Standards do not require members to report wrongdoers to governmental or regulatory authorities, although local law may require it and reporting may be prudent. CFA Institute strongly encourages members to report potential violations of the Code and Standards by other members and candidates to the CFA Institute Professional Conduct Program.
• Escalation path. A member who learns that coworkers or clients are breaking applicable rules first goes to a supervisor or the compliance department to have the conduct remedied. If they will not or cannot fix it, the member must dissociate (e.g., stop working with a trading desk that allocates client trades unfairly, stop using marketing material the member knows or should know is misleading). In an extreme case, dissociation may mean resigning from the firm.
• Because the Code and Standards are themselves among the rules a member must obey, any violation of the Code and Standards is also a violation of Standard I(A).
• Standard I(A) covers the rules that govern professional activities. A scuffle at a recreational sports match or a traffic offense is personal conduct. It falls outside Standard I(A) and, for the same reason, outside Standard I(D) Misconduct (see below).

Recommended procedures (LOS 95.b)

• When in doubt about legality: consult a supervisor, compliance personnel or a lawyer (legal counsel).
• When dissociating: keep records documenting the violation, encourage the employer to bring it to an end, and remove one's name from documents one cannot stand behind.
• Members (or their employers) should: set up procedures that keep employees informed of changes in relevant laws, rules, and regulations; review the written compliance procedures regularly; and maintain copies of current laws, rules, and regulations.
• Firms should: have a code of ethics, give employees information on the laws, rules, and regulations that govern their professional activities, and have procedures for reporting suspected violations.

LOS 95.a / 95.c — Standard I(B) Independence and Objectivity

Guidance

• Gifts and entertainment. Modest gifts and ordinary business entertainment are acceptable. The test is objective: whether the item could reasonably be expected to compromise judgment, whatever the member believes about her own resolve. The Standard does not require token items from non-clients to be reported to the employer, although firm policy may. Distinguish the source:
  • a gift from a client usually rewards past service and is considered less likely to impair objectivity. It may be accepted, but it must be disclosed to the employer, before acceptance if possible and otherwise afterward. Standard IV(B) Additional Compensation Arrangements requires written consent when the benefit is compensation tied to future performance;
  • a gift from a party seeking to influence the member (an issuer, a broker, a fund sponsor) calls for more caution.
• Offering benefits. The Standard covers giving as well as receiving. A manager competing for a university endowment's mandate who treats the chair of its investment committee to a weekend at a luxury resort violates Standard I(B), even if his own firm approved the cost as a marketing expense.
• Pressure and inducements to give a security a particular rating, to select certain outside managers or vendors, or to produce favorable (or unfavorable) research all threaten objectivity. A member who lets them shape the analysis violates the Standard. Allocating shares of an oversubscribed IPO to one's personal account violates this Standard and Standard III(B) Fair Dealing.
• Sell-side and investment banking pressure. Research must reflect the analyst's own view even when the firm's investment banking department has a relationship with the issuer. Firms separate research from banking with firewalls. When a firm does not want to issue a negative opinion on a banking client, it places the company on a restricted list and publishes only factual information, instead of issuing favorable opinions it does not hold. A banker may tell a prospective corporate finance client that the firm will cover the company, but may not promise favorable research: the analysts must stay free to reach their own conclusion.
• Buy-side and issuer pressure. Portfolio managers who hold a stock may lean on analysts not to downgrade; companies may threaten to cut off access. Neither is a reason to change a rating.
• Issuer-paid research is permitted if compensation is a flat fee (best practice: agreed before the report is written) that is not tied to the report's conclusions, recommendations, or market impact, and if the fact that the research is issuer-paid is disclosed.
• Credit ratings. Ratings from recognized agencies are not automatically objective; members should consider the conflicts of interest in the rating process and may need independent research to judge a rating's soundness.
• Using outside research. A member may rely on third-party research (another firm's reports, a data vendor, a model licensed from outside) after a reasonable and diligent review of its assumptions and soundness. Nothing requires a member to use only his own or his firm's research.
• Other pressures include fund manager and custodial relationships, credit rating agency work, performance measurement, and the member's own holdings in a covered stock (disclose them).

Recommended procedures (LOS 95.b)

• Members: pay (or have the firm pay) for travel to company events when practicable; limit use of corporate aircraft to trips where commercial travel is not an alternative.
• Firms: restrict employee participation in IPOs and private placements and require pre-approval for participation; appoint a compliance officer, have written policies on independence and objectivity, and establish clear procedures for reporting violations; allow only token items as gifts from anyone other than clients.

LOS 95.a / 95.c — Standard I(C) Misrepresentation

Members and candidates must not knowingly make any misrepresentations relating to investment analysis, recommendations, actions, or other professional activities.

Guidance

• Misrepresentation includes knowingly misleading investors, omitting relevant information, presenting selective data to mislead, and plagiarism.
• Typical violations: presenting third-party research as one's own; guaranteeing a specific return on securities not explicitly guaranteed by a government body or financial institution; picking the valuation service that assigns the highest values to untraded holdings; choosing a benchmark that is not comparable to the strategy; performance or attribution data that omit accounts or relevant variables; false or misleading claims about the experience, expertise or capabilities of the analyst or the firm; and using misleading third-party marketing materials.
• Services and qualifications. Members must not overstate their own experience, credentials, or their firm's capabilities. Telling a client "our firm can handle all your needs" is acceptable if it is true, based on the firm's actual capabilities and the client's facts. A trainee claiming years of experience in areas she does not cover is a violation. Claiming a degree before it has been awarded (for example, by handing out business cards that show it) is a violation. Ordering cards to use once the degree is awarded is not.
• Guarantees. Accurately describing an instrument that really is guaranteed by a government body or financial institution (e.g., a government-backed bond) is not a misrepresentation. An opinion ("I think this stock looks attractive") is not a guarantee.
• Keeping information current. If a member is responsible for a firm website or marketing material, outdated or inaccurate content that clients rely on is a misrepresentation. An honest slip, such as a misplaced decimal point in a published report, is not a knowing misstatement when it is made. Once the member discovers it, she must stop its circulation and correct it promptly, because continuing to circulate it after that point would be a knowing misrepresentation.
• Plagiarism means taking charts, graphs, spreadsheets, models, forecasts, reports, ideas or quotations that others created and using them without crediting the source. Quotations attributed to "leading analysts" without naming them, and slightly reworded excerpts from another analyst's report used without credit, are plagiarism. Exception: projections, statistics, and tables from recognized financial and statistical reporting services (factual data such as government bond yields or published index levels, as distinct from someone's analysis or opinion) may be used without citation. Models or research developed by colleagues at the member's own firm may be used, and the names of colleagues who have left may be omitted, as long as the member does not present that earlier work as solely his own.
• Forecasts or statistics by others used with the source named but with their original qualifications stripped out still mislead.

Recommended procedures (LOS 95.b)

• Members: prepare a summary of their own experience, qualifications, and the services they can perform; cite the source of any summaries of others' material; keep copies of all reports, articles, and other materials used in preparing research; encourage employers to verify marketing materials provided by third parties.
• Firms: provide a written list of the firm's available services and qualifications, and periodically review employees' documents and communications (including websites) to catch any misstatement of the qualifications and capabilities of employees or the firm.

LOS 95.a / 95.c — Standard I(D) Misconduct

Members and candidates must not engage in any professional conduct involving dishonesty, fraud, or deceit or commit any act that reflects adversely on their professional reputation, integrity, or competence.

Guidance

• Any professional conduct involving dishonesty, fraud, or deceit is a violation: lying under oath (perjury) in a case involving the firm, padding expense reports, falsifying a résumé, making promises the member knows cannot be kept.
• The Standard applies only to conduct in professional activities; acts outside a member's professional capacity are not addressed by it. Professional activities include dealings with clients, employees, and coworkers; activities as a member, charterholder, or candidate; volunteer work for a CFA society or CFA Institute; attending industry events, meetings, or courses; writing about investments (articles, reports, message boards) even outside the workplace; and communications with regulators and professional organizations.
• Misconduct can involve legal as well as illegal acts. Behavior that impairs the ability to perform professional duties, such as excessive drinking during business hours or coming to work intoxicated, violates the Standard. So does failing to act when professional obligations require it, such as neglecting due diligence on a recommendation.
• Not every illegal act is misconduct: civil disobedience (such as being arrested at a peaceful protest) is generally not a violation because it does not reflect on honesty, integrity, or competence. Personal bankruptcy is not a violation unless fraudulent or deceitful professional conduct was part of the circumstances.
• Members must not use enforcement of this Standard to settle personal, political, or other disputes unrelated to professional ethics or competence.

Recommended procedures (LOS 95.b)

Firms should adopt a code of ethics that states plainly that unethical behavior will not be tolerated, provide employees with a list of potential violations and sanctions (up to dismissal), and check references of potential employees (background checks on character and eligibility to work in the industry). Such checks are a recommended practice and do not breach any privacy obligation under the Code.

LOS 95.a / 95.c — Standard I(E) Competence

Members and candidates must act with and maintain the competence necessary to fulfill their professional responsibilities.

Guidance

• Competence means having, and keeping up, the knowledge, skills and abilities that the member's professional responsibilities require.
• What counts as competent depends on the role the member takes on.
• When a member accepts a new or unfamiliar role, it is the member's own responsibility, not the employer's, to develop the abilities, skills, and knowledge the role calls for.
• Continuing education is recommended. The Standard does not require it.
• A poor outcome does not by itself show a lack of competence. A recommendation that turns out badly, made with reasonable analysis, violates neither I(E) nor V(A) Diligence and Reasonable Basis.

Recommended procedures (LOS 95.b)

Ways to maintain competence include continuing education, professional development and employer-provided training; earning professional designations; going to relevant seminars and conferences; joining professional organizations; and informal self-study.

Related Standards that appear in the same fact patterns

Each of these Standards has its own module with the full guidance. The table gives only the points that the questions in this module rely on.