Standard I (B) – Independence and Objectivity

Members and Candidates must use reasonable care and judgment to achieve and maintain independence and objectivity in their professional activities. Members and Candidates must not offer, solicit, or accept any gift, benefit, compensation, or consideration that reasonably could be expected to compromise their own or another’s independence and objectivity.

Members and Candidates should maintain independence and objectivity for the benefit of their clients. External stakeholders should bear no influence on the investment recommendation or advice that Members and Candidates give. Members and Candidates should avoid any actions or scenarios that may appear to facilitate the loss of independence. Members and Candidates should disclose any gift received to their employers before receiving it (if possible) or immediately thereafter.

Members and Candidates may be pressured into issuing favorable research reports by their employers, especially if there is an existing investment banking relationship. Members and Candidates are responsible for maintaining their independence and objectivity, and any recommendations must be a true reflection of the Members’ and Candidates’ views on the company.

Guidance: Independence and Objectivity

Gifts

Members and Candidates are permitted to accept modest gifts. It is the responsibility of the candidate to distinguish between a modest gift, e.g., company merchandise, and what may be a gift intended to influence the outcome of a research report, e.g., a fully paid luxury trips to conduct a field visit. When in doubt, disclosure is best.

Buy-Side Clients & Public Companies

Buy-side clients – often finance professionals that purchase large blocks of securities for fund managers – are a major source of business for sell-side research firms. Sell-side research analysts may be pressured into altering their recommendations or tone down views that differ from (buy-side) portfolio managers. Negative reports may have adverse effects on the stock price (of the company in question) and may dampen portfolio manager performance. Portfolio managers should refrain from putting undue pressure on sell-side research analysts.

Fund Managers & Custodial Relationships

Members and Candidates who are tasked with the selection of hiring third-party custodians or external managers should not accept gifts as this may appear to impact their independence

Performance Measurement & Attribution

Members and Candidates who work within the Performance Measurement department must maintain their independence and objectivity. Members and Candidates may come under pressure from managers – who may be seeking to improve their performance. They must fully execute their assessment of performance and attribution without consideration of external influences.

Manager Selection & Procurement Process

Members and Candidates that are involved in the management selection process should not accept gifts, contributions, or any other compensation when hiring investment managers. Accepting any solicitations or gifts that do not directly benefit the Member or Candidate is still considered in conflict with Standard I(B) – Independence and Objectivity.      

A potential hire may offer to donate to the Member or Candidate’s favorite charity. Although the Member does not receive any payment, acceptance of this donation may be perceived as impairing the independence and objectivity of the hiring manager. Additionally, Members and Candidates that are looking to find new investment allocations should not offer gifts, donations, or any other forms of compensation to influence the decision of the hiring manager.

Issuer Paid Research

There has been a general decrease in sell-side research coverage. As a result, firms that are not widely followed may seek to hire independent research analysts to produce reports that are intended to be disseminated to potential and current investors. Issuer paid research may present significant conflicts of interest.

If a Member or Candidate is hired as an independent analyst, he must perform thorough, unbiased analysis and must also disclose the nature of his compensation. Members and Candidates should strictly limit their compensation to a flat fee. Any compensation that is tied to the result of the analysis, e.g., stock warrants, company equity, may influence the Member to write a favorable recommendation. 

Travel Funding

It is recommended that analysts refuse paid travel by the companies they cover. Accepting paid travel, e.g., privately chartered flights and lavish accommodations, may appear to influence their objectivity. To avoid any appearance of compromised independence, Members and Candidates or their firms should cover all necessary travel expenses. If there is no commercial transport available to get to a location, Members and Candidates are permitted to accept modest transportation offered.

Compliance Recommendations

• Protect the integrity of opinion: Members and Candidates should only give investment recommendations and advice that reflects their unbiased views. Firms should set up compensation structures that promote the integrity of the investment decision/recommendation process.
• Creation of a restricted list: If the firm is hesitant to publish an adverse/negative report of a corporate client, Members and Candidates should encourage firms to remove the company from the research universe and place the company on a restricted list. The firm should only disseminate reports that contain factual information about the companies they follow.
• Restrict Special Cost Arrangements: Members and Candidates or their firms should pay for all expenses related to commercial transport and accommodation. Members and Candidates should encourage issuers – the companies they follow – to limit the use of corporate transport and events/meetings that are difficult to travel to by commercial means. Additionally, Members and Candidates should attempt to have a balance in the frequency between hosting issuers and attending meetings at their corporate offices.
• Limit gifts: Members and Candidates should limit the acceptance of gifts to only token items. Firms should consider implementing a cap on the monetary value of token items that can be accepted over a given year.
• Restrict Investments: Members and Candidates should encourage firms to set up policies related to employee purchases of securities and IPO’s. Firms should require Members and Candidates to seek permission before participation in an IPO and disclosures on investment actions after the IPO.
• Review procedures: Members and Candidates should encourage firms to set up supervisory and review procedures to ensure that analysts comply when it comes to their investment actions.
• Independence policy: Firms’ Members and Candidates should institute a formal policy on independence and objectivity of research and put in place review policies to ensure that research analysts remain independent and objective while they are conducting their analysis.
• Appointed officer: Firms should have a senior official tasked with overseeing that the company complies with the firm’s code of ethics and laws and regulations.

 Application 1: Research Independence

Susan Watts is a research analyst that specializes in technology stocks and has quickly become a valued member of her firm. Her boss holds a positive outlook on Space Technologies – a stock that he owns. He has made it very clear that under no circumstance should Susan change the firm’s “Strong Buy” recommendation. Susan goes on to do a thorough independent analysis and concludes that Space Technologies is a “Strong Buy.” She goes on to publish the report.

Has Susan violated Standard I(B) – Independence and Objectivity? 

     A. No, because she conducted her independent analysis and happened to come to the same conclusion as her boss.

     B. Yes, because she reached the same “Strong Buy” recommendation as her boss.

     C. Yes, because she was compromised by the opinions of her boss.

Solution

The correct answer is A. 

Standard I(B) – Independence & Objectivity emphasizes that Members and Candidates should always perform analysis and disseminate investment reports that are a reflection of their independent opinions. If Watts believed that her independence has been compromised, she should have discontinued her coverage of Space Technologies. In this case, Watts carried out her independent analysis and reached the same recommendation as her boss. Therefore, she has not violated Standard I(B).

Application 2: Gift from a Client

A fund manager receives a generous all-expenses-paid trip from a client for his superior performance over the year because he managed to significantly beat the agreed-upon benchmark. The manager accepts this gift and goes on the trip a few months later.

Is the fund manager in violation of Standard I(B) – Independence & Objectivity?   

      A. Yes, because the fund manager accepted a generous gift from the client.

      B. Yes, because accepting this gift may affect the effort and consideration that the manager gives to all his clients in the future.

      C. Yes, because the manager fails to disclose this gift to his supervisor.

Solution

The correct answer is C. 

The manager violates Standard I(B) – Independence and Objectivity because he failed to disclose the trip to his employer. If the manager had disclosed the gift, he would be compliant.    

The nature and value of the gift are not material in this case because the gift was offered based on the manager’s historic performance. If the gift was centered around future performance, the manager would have to receive permission from his employer. This disclosure is required to ensure that the manager gives equal effort and consideration to all his clients.

Application 3: Paid Issuer Research

David James, CFA is a well-respected securities analyst. Recently, Magic Productions had contracted James to write a research report. Magic Productions has not been widely researched, and the management believes that a research report could bring about new interest to the company and revive interest in current shareholders.

James and Magic Productions have agreed on a flat fee, plus a percentage bonus if there is substantial interest by new investors.

Are James and Magic Productions in violation of Standard I(B) – Independence and Objectivity?    

       A. Yes, both James and Magic Productions are in violation.

       B. Only James is in violation.

       C. Neither James nor Magic Productions are in violation.

Solution

The correct answer is B. 

James violates Standard I(B) – Independence and Objectivity. James’ compensation is directly tied to the conclusions of his report. The structure of the compensation may bias his conclusions – a favorable report may attract more interest. To avoid violating Standard I(B) – Independence and Objectivity, James should agree to be compensated on a flat-fee. Magic Productions is not held to the Codes and Standards; therefore, they cannot violate Standard I(B) – Independence and Objectivity.

Application 4: Research Independence

Stephen Olibai, CFA is a junior equity analyst who is researching HealthU Corp. After performing extensive research, he finds that HealthU is overvalued at its current market price. Just before he issues his “Sell” recommendation, he receives an email from his colleague in the investment banking division. His colleague informs him that the firm is competing to secure the underwriting process of HealthU’s substantial debt offering. Olibai is conflicted about publishing his report, in fear that it could lead to his firm losing potential business. Olibai goes on to publish his report.

Is Olibai in violation of any Standards?    

      A. No, because he maintains his “Sell” recommendation.

      B. Yes, because his communication with the investment banking division may have compromised his independence.

      C. No, because his analysis leads him to a “Sell” recommendation.

Solution

The correct answer is A. 

Olibai should not feel pressured to change his recommendations based on any influence from the investment banking division in his firm. Because Olibai does not change his investment recommendation, he does not violate Standard I(B) – Independence and Objectivity.

To avoid compromising his objectivity, the firm should have placed HealthU on a restricted list. Olibai should base his recommendations on fundamental information, external stakeholders should not influence the outcome of his recommendation. 

Application 5: Influencing Manager Selection

Todd Martinez, CFA receives a tip from a friend – XFM Pension fund is in search of a new external fund manager. His friend tells him that the selection manager is an avid golf player and frequently visits his local golf course. Martinez’s friend introduces him to the selection manager, Michael Yang. Martinez intends to establish a close rapport with Yang. In his attempt to gain XFM Pension Fund’s business, Martinez gifts Yang with expensive golf clubs and pays for several lunches at the golf club.

Which of the following individuals has violated Standard I(B) – Independence and Objectivity?  

       A. Martinez

       B. Yang

       C. Both Martinez and Yang

Solution

The correct answer is C. 

Both Martinez and Yang are both in violation of Standard I(B) – Independence and Objectivity. Martinez is knowingly trying to influence Yang’s selection decision. Additionally, as a selection manager, Yang should not accept and gifts because it may impair his independence and objectivity.

Application 6: Research Independence

Rick Martin, CFA, is a corporate finance analyst at Spector Finance Group (SPG). Martin is in the middle of the presentation with a potential client. At the end of the presentation, Martin proposes that an added benefit of contracting her firm will be research coverage on SPG.    

Is there a violation of Standard I(B) – Independence and Objectivity?    

       A. Yes, because Martin is offering free research coverage of SPG in exchange for new business.

       B. No, because she has not guaranteed positive research coverage of SPG.

       C. No, because Martin is allowed to use any means to bring in new business.

Solution

The correct answer is B. 

This is not in violation of Standard I(B) – Independence and Objectivity. Martin is allowed to offer coverage of SPG but cannot promise that the firm will produce research with a positive/buy recommendation. Any investment recommendation or reporting must be based on the analysts’ independent and objective analysis of SPG.

Reading 46: Guidance for The Standards of Professional Conduct (I-VII)

LOS 46 (a) Demonstrate a thorough knowledge of the CFA Institute Code of Ethics and Standards of Professional Conduct by applying the Code and Standards to specific situations.