CFA Level 2 - Ethical and Professional Standards Session 1 - Reading 3 (Practice Questions, Sample Questions) 1. An investment advisor with fiduciary responsibilities over client assetsis guided by some basic duties and principles concerning “soft dollars.”Which of the following is NOT one of these duties or principles? A) All commissions paid to a broker are the property of the broker. B) The quality of the transaction comes first.C) To act in the clients' best interest.(Explanation: All (client) commissions paid to a broker are the property ofthe client.) 2. Scott Burroughs is a portfolio manager for a firm that claims it is incompliance with CFA Institute Soft Dollar Standards. In purchasingbonds for the account of the pension fund of Sheets Company, nocommissions were paid, but there was a spread charged by the brokerbetween the purchase and sale price of the bonds. The trade isgoverned by the Investment Company Act of 1940 which requires thatthe trade must benefit only the client. Which of the following statementsregarding client brokerage is CORRECT? The specific brokerage fromthe trade:A) can be used to benefit another client only if Burroughs receives priorconsent from Sheets. B) cannot be used to benefit any other client. C) can be used to benefit another client as long as Sheets benefits fromthe other client's brokerage in the future.(Explanation: The Soft Dollar Standards do not supersede any law, andthe law states that the brokerage must be used solely for the client'sbenefit. The client cannot wave these provisions by consent.) 3. Which of the following best describes one of the two fundamentalprinciples involved in evaluating any soft dollar arrangements?A) The investment manager must not enter into any agencyrelationships. B) All client commissions paid to a broker are the property of theclient.
C) The advisor must maintain independence and objectivity.(Explanation: All client commissions paid to a broker are the property ofthe client.) 4. Which of the following best describes one of the two fundamentalprinciples involved in evaluating any soft dollar arrangements? A) The quality of the transaction comes first. B) The priority of the transactions comes first.C) The investment manager must not enter into any agencyrelationships.(Explanation: The quality of the transaction (execution & cost) comesfirst.) 5. The statement “the quality of the transaction comes first” means:A) lowest price execution regardless of other transactions costs. B) minimization of transactions costs in the context of the bestexecution. C) the ordering of the transactions must be properly prioritized.(Explanation: The quality of the transaction refers to an optimization ofthe balance between transactions costs and execution. This does notnecessarily imply that either the transactions costs or the price must beminimized, although minimization of the price is likely to be a higherorder concern. It has nothing to do with the priority of transactions.) 6. Sharon Fischer manages an equity mutual fund, and she uses softdollars generated on this account to obtain municipal bond research foran associate whose fund is small and does not generate a sufficientlevel of soft dollars for his municipal bond research needs. With regardto this action, which of the following statements is most accurate? Thisaction is: A) not permissible; Fischer is in violation of her fiduciary duties. B) not permissible; Fischer is not in violation of her fiduciary duties.C) permissible; Fischer is not in violation of her fiduciary duties.(Explanation: Since the research purchased is not relevant to the clientassets generating the soft dollars, the action is not permissible. By thisaction, she is effectively transferring assets belonging to the equity
clients to the clients of the municipal fund. This is in violation of the Codeand Standards) 7. Springfield Investment Advisors uses soft dollars generated withmutual fund transactions to get software that is only useful for themanagement of client assets. Which of the following statements isCORRECT? This is: A) permissible, since items purchased with soft dollars mustprovide a benefit to the client. B) not permissible, since items purchased with soft dollars must providea benefit to the firm.C) not permissible, since items purchased with soft dollars must betangible, and software is intangible.(Explanation: This action is permissible, since the software is relevantand provides a benefit to the client.) 8. Elaine Black, CFA has recently been hired as the Chief InvestmentOfficer at a money management company that does not claim it is incompliance with CFA Institute Soft Dollar Standards. Her formercompany was in compliance. Which of the following statementsconcerning CFA Institute Soft Dollar Standards is CORRECT? Black:A) cannot use soft dollars to pay for research services except when thecommissions originate from principle trades.B) must ignore all provisions set forth in the CFA Institute Soft DollarStandards except when they are consistent with the Standards ofProfessional Conduct. C) must abide by the conditions set forth in the Standards ofProfessional Conduct concerning soft dollars and can chose toaccept some of the CFA Institute Soft Dollar Standards. (Explanation: Black must abide by the Standards of ProfessionalConduct, but can still follow any of the Soft Dollar Standards that shedesires.) 9. Liz Davis is a portfolio manager for a firm that claims it is incompliance with CFA Institute Soft Dollar Standards. In purchasingbonds for the account of the pension fund of Richards Company, nocommissions were paid but there was a spread charged by the broker
between the purchase and sale price of the bonds. The brokerage on thetrade is not governed by any securities regulation. The specificbrokerage from the trade:A) cannot be used to benefit any other client. B) can be used to benefit another client as long as Davis receivesprior consent from Richards. C) can be used to benefit another client as long as Richards benefitsfrom other the client’s brokerage in the future.(Explanation: Prior consent must be given in the case of a principaltrade) 10. Steve Bishop is a portfolio manager with Bradshaw AssetManagement. He has received a request from the Gail Foundation, oneof his clients, to review Bradshaw's soft dollar policy, since Bradshawclaims to comply with the CFA Institute Soft Dollar Standards. Bishopmust be prepared to present the client with all of the following EXCEPT: A) the total amount of brokerage paid by Bradshaw to each broker. B) the aggregate percentage on Bradshaw's brokerage derived throughclient-directed brokerage.C) the total amount of Gail's commissions generated through soft dollararrangements.(Explanation: The disclosure of the total amount of brokerage paid byBradshaw is recommended but not required, and there is no mention ofdisclosure of brokerage paid to each broker.) 11. Which of the following is NOT one of the basic fiduciary duties? To:A) place their client’s interest before their own. B) maintain knowledge of and comply with all applicable laws. C) exercise prudent judgment.(Explanation: CFA Institute members have a duty to maintain knowledgeand to comply with all applicable laws, but this is Standard I(A),Knowledge of the Law, not a fiduciary duty.) 12. Which of the following statements about soft dollars is CORRECT?A) Fiduciaries must disclose actual, but not potential, conflicts of interest.B) Items purchased with soft dollars must provide a benefit to the firm.
C) Items purchased with soft dollars must provide a benefit to theclient. (Explanation: Items purchased with soft dollars must provide a benefit tothe client. If this benefit is less than 100 percent to the client, soft dollarscan only be used to purchase the item in proportion to the benefitderived by the client.) 13. Carl Johnson, a large equity client of Madison Investment Advisors,directs Madison to pass along old copies of any research purchased withsoft dollars generated by trades in his account to his friend JacobWisnewski. Madison receives about ten such reports per year, and, afterthese have been reviewed in the context of their relevance to Johnson’saccount, they are forwarded on to Wisnewski. With regard to thisprocedure, which of the following statements is CORRECT? Theresearch: A) provides a benefit to Johnson and may be released toWisnewski with the permission of the source. B) does provide a benefit to Johnson but may not be released toWisnewski with or without the permission of the source.C) does not provide a benefit to Johnson but may be released toWisnewski with the permission of the source.(Explanation: Since the research received is relevant to and is used forthe benefit of Johnson, there is nothing inherently wrong with passingthe reports to Wisnewski unless precluded from doing so by the providerof the research.) 14. Which of the following is one of the four requirements for meetingfiduciary obligations with regard to soft dollar arrangements? Investmentmanagers must:A) avoid agency relationships. B) seek the best price and execution. C) minimize transactions costs.(Explanation: Investment managers must seek the best price andexecution.)
15. Which of the following is one of the four requirements for meetingfiduciary obligations with regard to soft dollar arrangements? Itemspurchased with soft dollars must:A) provide a benefit to the firm. B) provide a benefit to the client. C) provide at least 50% of their benefits to the client.(Explanation: Items purchased with soft dollars must provide a benefit tothe client.) 16. Which of the following is one of the four requirements for meetingfiduciary obligations with regard to soft dollar arrangements?Commissions: A) paid must be reasonable in relation to the research andexecution services provided. B) paid must be held in escrow for the benefit of the client.C) paid must be minimized.(Explanation: Commissions paid must be reasonable in relation to theresearch and execution services provided. This does not imply thattrades are always directed to the lowest cost broker.) 17. William Nagle, CFA has his own money management firm. He has awide range of clients. Some of his clients are entirely invested in themoney market while others like to actively trade stocks including hot newissues and options.Over the years Nagle has developed a good relationship with PresleyBrothers Brokerage who executes his trades. One of the reasons Nagleinitially chose and continues to use Presley Brothers is that PresleyBrothers provides to Nagle a free high-speed Internet service plus theservices of a top-rated research firm over the Internet. That serviceprovides up-to-the minute recommendations. Although the fees PresleyBrothers charges Nagle’s clients per trade are slightly higher thancompeting firms, Nagle feels their speed of execution is worth the cost.Nagle has found the recommendations from the Internet research firmhave been useful for some of his more active clients.Presley Brothers also underwrites stocks and gives Nagle theopportunity to buy shares in initial public offerings for his clients. Theamount of IPO stock offered to Nagle is proportional to the amount of
commissions that Nagle has generated. As a rule, Nagle allocates theIPO shares to the clients who generated the most commissions in theprevious year. He discloses this practice to all his clients, and sinceNagle started dealing with Presley Brothers Brokerage, all of the IPOsPresley Brothers has underwritten have made a profit for Nagle’s clients.Therefore, Nagle has a standing order with Presley Brothers to purchaseas much of each IPO that Presley Brothers can give him. Once Naglegets the IPO issue, he divides it into three allocations and begins callinghis clients one at a time, beginning with the top commission-generatingclient, and offers to sell an allocation to each client until all threeallocations are sold.Presley Brothers also offers Nagle another perk for doing business withthe firm. If Nagle generates a certain minimum in commissions, thenPresley Brothers provides Nagle with the opportunity to offer discountcommissions on option trades. In addition to that, exceeding thecommission quota earns Nagle an all-paid weekend trip to a resortwhere Presley Brothers gives seminars to managers like Nagle whohave exceeded the commission quota. The trip does include seminarsthat provide valuable information on the products like mutual funds thatPresley Brothers offers and financial markets in general, but it also takesplace at a posh resort with many free amenities. In recent years, Naglehas exceeded the commission quota and has been able to take the trip.His main focus on the trips has been to learn something at the seminarsthat he can offer to his larger clients who generate the most business.The trips have given Nagle sufficient information on Presley Brothers’products so that Nagle has decided to satisfy all of his clients’ needs withPresley Brothers products. By choosing to use Presley BrothersBrokerage for the indicated reason, has Nagle broken the standardconcerning soft dollars? A) No, because although his clients pay higher fees, the services areworth it. B) Yes, because his clients pay higher fees and he gets freeInternet service and the services of a research firm. C) Yes, because his clients pay higher fees and he gets free Internetservice only.
(Explanation: Nagle is receiving free Internet service, and does not passthe savings on to his clients. The research benefits some of the clients;therefore, there must be some clients paying a higher fee and not gettinganything from Nagle or Presley Brothers for the extra expense. (StudySession 1, LOS 3.b)) The method that Nagle uses to allocate the IPO issues to his clients is: A) a violation of the standards on fair dealing. B) not a violation of the standards because Nagle discloses the practiceto his clients.C) a violation of the standard on soft dollars.(Explanation: Nagle is receiving free Internet service, and does not passthe savings on to his clients. The research ben Nagle needs to give all ofhis clients an opportunity to participate in profitable deals. In Nagle’scurrent system, it is possible for long-time clients who generate aconsistent level of business per year to never be able to participate in aprofitable IPO. (Study Session 2, LOS 8.a)) Nagle’s standing order to purchase as much as much as possible ofeach Presley Brothers’ IPOs is a violation of the standard because: A) Nagle should get advanced notice of his clients’ interest in theIPO. B) Nagle is, in effect, distributing soft dollars.C) of no reason, it is actually an acceptable practice because all theIPOs have been profitable.(Explanation: Nagle is receiving free Internet service, and does not passthe savings on to his clients. The research ben The standard on TradeAllocation: Fair Dealing and Disclosure requires that Nagle get anadvanced indication of client interest. (Study Session 2, LOS 8.a)) Nagle has violated the standards on research objectivity by:A) his standing order for IPOs but not by his using only Presley Brothersinvestment products. B) his standing order for IPOs and his using only Presley Brothersinvestment products. C) his only using Presley Brothers investment products but not by hisstanding order for IPOs.
(Explanation: Nagle is not doing any research on the IPOs before takingthe allocations. Apparently, taking the trips has led to Nagle limiting hischoices of possible products for his clients. Nagle needs to be morethorough in researching the needs of his clients. (Study Session 1, LOS4.a)) With respect to the trip that Nagle has been taking each year Nagle:A) should disclose it to his clients because it provides him withinformation about stock market activities other than those of PresleyBrothers. B) should disclose it to his clients because it could represent aconflict of interest and hinder his objectivity. C) does not need to disclose it to his clients because it provides him withvaluable information.(Explanation: Nagle’s objectivity has clearly been compromised since hehas started only using Presley Brothers’ products. The clients need to beaware that a significant portion of Nagle’s information is coming from theone firm that executes his trades and provides all of his clients’ products.(Study Session 1, LOS 2.a,b)) Being able to offer his clients discount commissions on option tradesafter generating a certain amount of commissions is: A) a violation because it benefits those clients who are inclined todo option trading. B) not a violation because it is a benefit that all clients can share in ifthey so choose.C) a violation because commissions on option trades are thequintessential soft dollars.(Explanation: Clearly some of Nagle’s clients will benefit from thisarrangement more than others. (Study Session 1, LOS 2.a,b)) 18. Centurion Rivals (CR), an investment advisory firm, receives thefollowing services in return for directing client brokerage to another firm:Research reports supporting trades surrounding IPOs, mergers, andbankruptcy proceedings.Access to an online database to track current, former, and prospectiveclients for marketing purposes.
CR wants to advertise that it is in compliance with CFA Institute’s softdollar standards. CR should:A) advertise compliance until notified by CFA Institute of a violation. B) determine whether its policies are in compliance using CFAInstitute’s 3-tiered analysis. C) advertise partial compliance based on the differing treatment betweenthe research reports and the online marketing database.(Explanation: CR should determine whether its policies are incompliance using CFA Institute’s 3-tiered analysis. CR will learn fromthis analysis that the online marketing database is a violation. Nodescription of partial compliance is permissible.) 19. Centurion Rivals (CR), an investment advisory firm, receives thefollowing services in return for directing client brokerage to another firm:·Research reports supporting trades surrounding IPOs, mergers, andbankruptcy proceedings.·Access to an online database to track current, former, and prospectiveclients for marketing purposes.Which of the following standards has CR most likely violated?A) Standard V(A) Diligence and Reasonable Basis. B) CFA Institute Soft-dollar Standards. C) Both CFA Institute Soft-dollar Standards and Standard V(A) Diligenceand Reasonable Basis.(Explanation: The marketing database is a violation of CFA Insititute softdollar standards because it does not directly assist the investmentmanager in the investment management process. Rather, it is a benefitto the firm which should not be paid with client brokerage.) 20. A brokerage firm has just purchased a new computer system that willfacilitate trades for its customers and supply research to the brokersdirectly aiding in their investment recommendations. Which of thefollowing statements regarding the application of the CFA Institute SoftDollar Standards is CORRECT? A) Only the portion of the costs that will be attributed to researchcan be paid for with Client Brokerage. B) The full cost of the computer system can be paid for with ClientBrokerage.
C) Only the software applications and not the hardware can be paid forwith Client Brokerage.(Explanation: Soft Dollar Standards set forth a three-level analysis toassist the Investment Manager in determining whether or not a productor service is Research. In nearly all cases, if the criteria of all three levelsare satisfied, the Investment Manager can use Client Brokerage to payfor the Research. The final step in the analysis is to determine whatportion of the Research will be used in the Investment-Decision-MakingProcess and pay only for that portion with Client Brokerage.) 21. David Sanders is the Chief Investment Officer at a moneymanagement company that claims it is in compliance with CFA InstituteSoft Dollar Standards. Last year he purchased a Bloomberg system forthe portfolio managers to get information concerning investmentdecisions. He used soft dollars from brokers to pay for the system.Because the system has come up for renewal, he has an assistant auditthe use of the terminal for a week. The assistant reports that the systemis only used about 20 percent of the time for investment decision-makingactivities and 80 percent for other uses. Sanders:A) can use soft dollars to pay for 20 percent of the system for the nextyear and must reimburse clients for 80 percent of the cost of last year'ssystem.B) cannot use soft dollars to pay for any part of the system for the nextyear, but need not take any action concerning last year's soft dollars. C) can use soft dollars to pay for 20 percent of the system for thenext year and need not take any action concerning last year's softdollars. (Explanation: Sanders must make a good faith estimate for theproportion of the system that is used for investment decision-making anduse that proportion to determine the amount of money that can be usedfor soft dollar purchases. He need not take any action with respect to lastyear's expenditures.)