CFA Level II Ethical and Professional Standards Practice Questions
Question 1
At a lunch, the chief financial officer of Halden Foods tells analyst Omar that a major customer contract will be lost. The loss has not been announced, and Omar covers Halden with a Buy rating and judges the news material. What should Omar do?
- A. Not act or cause others to act on the news, and take it to his compliance department
- B. Cut the rating to Hold in his next report without citing the news, so no client learns why
- C. Sell his personal Halden shares, since client accounts are not affected by the news
- D. Tell his largest clients so they can reduce their positions before the announcement
Show answer and explanation
Correct answer: A. Not act or cause others to act on the news, and take it to his compliance department
Under Standard II(A), a member in possession of material nonpublic information must not act or cause others to act on it. Omar should refrain from trading or recommending on it and involve compliance about proper handling. Tipping some clients or changing the rating are both uses of the information.
- A. Correct: no action on it and escalation to compliance is the required response.
- B. Wrong: changing the rating on the basis of the news is acting on MNPI, even if unexplained.
- C. Wrong: a personal sale is trading on MNPI, and the client accounts are not the only concern.
- D. Wrong: passing the news to selected clients is tipping and also breaches fair dealing.
Question 2
Dana is a sell-side analyst whose analysis supports a Hold rating on Corvane Industries. Her firm's investment banking unit is negotiating a debt underwriting for Corvane, and a banking director asks Dana to move the rating to Buy before the deal is announced. Which action best complies with the Standards?
- A. Upgrade to Buy and add a disclosure that the firm is negotiating an underwriting for Corvane
- B. Publish the Hold rating and report the banking director's request to compliance
- C. Drop coverage of Corvane and tell no one why, so the banking team has no rating to object to
- D. Publish Hold but omit the findings the banking team objected to, keeping the tone neutral
Show answer and explanation
Correct answer: B. Publish the Hold rating and report the banking director's request to compliance
Standard I(B) requires independent, objective research free of pressure from the firm's banking business. Dana should publish the rating her analysis supports and escalate the improper request to compliance. Disclosure under VI(A) does not cure a rating she does not believe.
- A. Wrong: disclosing the banking relationship does not make a rating she does not hold objective.
- B. Correct: she keeps her independent view and escalates the pressure to compliance.
- C. Wrong: silently dropping coverage lets the pressure succeed and withholds a view clients rely on.
- D. Wrong: omitting unfavorable findings to appease banking distorts the report and breaches objectivity and diligence.
Question 3
Beck manages a pooled fund whose offering documents describe a large-cap growth mandate. He finds an inexpensive small-cap value company and buys a 6% position, believing it will outperform. His research on the company is thorough and well documented. Which Standard is most directly violated?
- A. Standard III(C) Suitability, since the position departs from the fund's stated mandate
- B. Standard V(A) Diligence and Reasonable Basis, since small-cap analysis is less reliable
- C. Standard VI(A) Disclosure of Conflicts, since investors were not told about the purchase
- D. Standard III(D) Performance Presentation, since the fund's benchmark now fits poorly
Show answer and explanation
Correct answer: A. Standard III(C) Suitability, since the position departs from the fund's stated mandate
When managing a pooled fund, a manager's suitability duty is to invest consistently with the fund's stated mandate. A well-researched position outside that mandate still breaches Standard III(C). Diligence is satisfied, and nothing about a conflict or a benchmark is at issue.
- A. Correct: investments must be consistent with the stated mandate.
- B. Wrong: his research was thorough, so diligence is met.
- C. Wrong: no personal conflict exists, and trade-level disclosure is not the issue.
- D. Wrong: benchmark fit is a reporting matter and is not the breach described.
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Rina's client accounts pay commissions at market-level rates to Brokerco. In return, Brokerco supplies research and software that Rina's firm uses solely for its own proprietary trading desk and for no client account. How should Rina's arrangement be assessed under the Standards?
- A. Permitted, because soft dollar research is an accepted and common use of client commissions
- B. Permitted if the firm describes the arrangement in its marketing brochure
- C. Permitted when the commission rates match those charged by comparable brokers
- D. A violation of III(A), because client commissions fund a benefit that goes to the firm
Show answer and explanation
Correct answer: D. A violation of III(A), because client commissions fund a benefit that goes to the firm
Client brokerage is an asset belonging to clients. Under Standard III(A), it should be used for their benefit, such as research that helps manage their accounts. Using it to fund research for the firm's own trading desk benefits the firm at the clients' expense, even at market rates.
- A. Wrong: soft dollars are acceptable only when the research benefits the clients who paid.
- B. Wrong: a brochure mention does not turn a firm-only benefit into a client benefit.
- C. Wrong: market-level rates do not fix the problem that the benefit does not reach clients.
- D. Correct: the clients bear the cost while the firm captures the benefit.