CFA Level III Ethical and Professional Standards Practice Questions
Question 1
Ramon, a retiree, has an investment policy statement with a low risk tolerance and an income objective. His adviser Elena places 5% of his account in a small-cap emerging-market fund because the fund's own risk-adjusted record is strong. She did not compare it with the policy statement or the rest of his portfolio. Which standard is violated?
- A. Performance Presentation
- B. Suitability
- C. Disclosure of Conflicts
- D. Fair Dealing
Show answer and explanation
Correct answer: B. Suitability
Suitability requires an adviser to determine that an investment is appropriate for the client's objectives, constraints and circumstances, and to judge it in the context of the total portfolio. A fund can be attractive on its own and still be unsuitable for this client's risk profile.
- A. No performance was presented to a prospect in the facts.
- B. Correct: the investment was not assessed against the IPS and the whole portfolio.
- C. No conflict of interest is described.
- D. No other clients were treated differently.
Question 2
A trader at a fund buys small amounts of thinly traded stocks in the final minutes of each quarter to lift closing prices and the fund's reported value. There is no investment rationale for the trades. Which standard is violated?
- A. Fair Dealing
- B. Priority of Transactions
- C. Market Manipulation
- D. Suitability
Show answer and explanation
Correct answer: C. Market Manipulation
Market Manipulation prohibits actions intended to mislead market participants by distorting prices or artificially inflating trading volume. Trading solely to raise closing prices and the reported value of holdings has that intent and effect.
- A. No client was favored over another in the facts.
- B. No personal-account trading is described.
- C. Correct: trades intended to distort prices.
- D. No client's investment profile is involved.
Question 3
Chen studies a retailer using public filings, channel checks with its suppliers, and a conversation in which a mid-level manager mentions generally weak store traffic. None of the pieces is material by itself. Combining them, Chen concludes earnings will miss and sells the fund's position before the report. What is the compliance determination?
- A. Violation, because the combined conclusion is material and was obtained from a company employee
- B. No violation, because the conclusion is built from public and nonmaterial nonpublic information
- C. Violation, because conversations with company staff are prohibited unless the issuer is notified
- D. Violation unless the fund discloses to clients the source of each piece of information
Show answer and explanation
Correct answer: B. No violation, because the conclusion is built from public and nonmaterial nonpublic information
Under the mosaic theory, an analyst may combine public information and nonmaterial nonpublic information to reach a material conclusion without violating the standard on material nonpublic information. The analysis is the analyst's own work product, and no single input was material and nonpublic.
- A. A material conclusion drawn from permissible inputs is not itself inside information.
- B. Correct: mosaic analysis is permissible.
- C. Speaking with company staff is allowed if no material nonpublic information is received.
- D. No rule requires disclosing each input to clients.
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Priya's firm directs client brokerage to a broker that bundles execution and research. Most of the research is used in managing client portfolios, but the firm also arranges for the broker to rebate part of the commissions to pay the firm's office rent. Which statement best describes the compliance position?
- A. Soft-dollar use is acceptable when disclosed, even for firm overhead, because clients pay the commissions
- B. Client commissions may be used for any firm expense provided best execution is shown on the trade tickets
- C. The research use is also improper, because all research must be paid in hard dollars by the firm
- D. Commissions belong to clients and may fund only items benefiting them; stop the rent rebate
Show answer and explanation
Correct answer: D. Commissions belong to clients and may fund only items benefiting them; stop the rent rebate
Brokerage commissions are client assets. Soft dollars may pay for research and execution services that assist the investment decision process for clients, but not for the firm's overhead. Using commissions for rent breaches the duty of loyalty, prudence and care, even if disclosed.
- A. Disclosure does not make firm overhead a permissible use of client commissions.
- B. Best execution evidence does not cure the use of client assets for firm expenses.
- C. Client-benefiting research under a soft-dollar arrangement is permitted with disclosure.
- D. Correct: research that benefits clients is permissible; rent is not.