CFA Level 1 - Ethical and Professional Standards Session 1 - Reading 3 (Notes, Practice Questions, Sample Questions) 1. An investment advisor with ﬁduciary responsibilities over client assets is 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 theproperty of the client 2. Scott Burroughs is a portfolio manager for a ﬁrm that claims it is in compliance with CFA Institute Soft Dollar Standards. In purchasing bondsfor the account of the pension fund of Sheets Company, no commissionswere paid, but there was a spread charged by the broker between thepurchase and sale price of the bonds. The trade is governed by theInvestment Company Act of 1940 which requires that the trade mustbeneﬁt only the client. Which of the following statements regarding clientbrokerage is CORRECT? The speciﬁc brokerage from the 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 from theother 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 fundamental principles involved in evaluating any soft dollar arrangements? A)The investment manager must not enter into any agency relationships. B)All client commissions paid to a broker are the property of the client. C)The advisor must maintain independence and objectivity Explanation — All client commissions paid to a broker are the propertyof the client 4. Which of the following best describes one of the two fundamental principles 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 agency relationships 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 best execution. C)the ordering of the transactions must be properly prioritized Explanation — The quality of the transaction refers to an optimizationof the balance between transactions costs and execution. This does not
necessarily 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 soft dollars generated on this account to obtain municipal bond research for anassociate whose fund is small and does not generate a sufﬁcient level ofsoft dollars for his municipal bond research needs. With regard to thisaction, which of the following statements is most accurate? This action 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 equityclients to the clients of the municipal fund. This is in violation of theCode and Standards 7. Springﬁeld Investment Advisors uses soft dollars generated with mutual fund transactions to get software that is only useful for the management ofclient assets. Which of the following statements is CORRECT? This is: A)permissible, since items purchased with soft dollars must provide abeneﬁt to the client. B)not permissible, since items purchased with soft dollars must provide abeneﬁt 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 Investment Ofﬁcer 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 statements concerningCFA 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 of ProfessionalConduct concerning soft dollars and can chose to accept some of theCFA 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 in compliance with CFA Institute Soft Dollar Standards. In purchasing bonds for theaccount of the pension fund of Richards Company, no commissions werepaid but there was a spread charged by the broker between the purchaseand sale price of the bonds. The brokerage on the trade is not governed byany securities regulation. The speciﬁc brokerage from the trade: A)cannot be used to beneﬁt any other client. B)can be used to beneﬁt another client as long as Davis receives priorconsent from Richards. C)can be used to beneﬁt another client as long as Richards beneﬁts fromother 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 Asset Management. He has received a request from the Gail Foundation, one ofhis clients, to review Bradshaw's soft dollar policy, since Bradshaw claimsto comply with the CFA Institute Soft Dollar Standards. Bishop must beprepared 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 maintainknowledge and to comply with all applicable laws, but this is StandardI(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 the client Explanation — Items purchased with soft dollars must provide a beneﬁtto the client. If this beneﬁt is less than 100 percent to the client, softdollars can 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? The research: A)provides a beneﬁt to Johnson and may be released to Wisnewski withthe permission of the source. B)does provide a beneﬁt to Johnson but may not be released to Wisnewskiwith or without the permission of the source.C)does not provide a beneﬁt to Johnson but may be released to Wisnewskiwith 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 meeting ﬁduciary 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 meeting ﬁduciary 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 beneﬁtto the client 16. Which of the following is one of the four requirements for meeting ﬁduciary obligations with regard to soft dollar arrangements?Commissions: A)paid must be reasonable in relation to the research and executionservices 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 17.1 William Nagle, CFA has his own money management ﬁrm. He has a wide range of clients. Some of his clients are entirely invested in the
money 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 the opportunityto buy shares in initial public offerings for his clients. The amount of IPOstock offered to Nagle is proportional to the amount of commissions thatNagle has generated. As a rule, Nagle allocates the IPO shares to theclients who generated the most commissions in the previous year. Hediscloses this practice to all his clients, and since Nagle started dealingwith Presley Brothers Brokerage, all of the IPOs Presley Brothers hasunderwritten have made a proﬁt for Nagle’s clients. Therefore, Nagle hasa standing order with Presley Brothers to purchase as much of each IPOthat Presley Brothers can give him. Once Nagle gets the IPO issue, hedivides it into three allocations and begins calling his clients one at a time,beginning with the top commission-generating client, and offers to sell anallocation to each client until all three allocations 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 resort wherePresley Brothers gives seminars to managers like Nagle who haveexceeded the commission quota. The trip does include seminars thatprovide 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, Nagle has
exceeded the commission quota and has been able to take the trip. Hismain focus on the trips has been to learn something at the seminars thathe can offer to his larger clients who generate the most business. The tripshave given Nagle sufﬁcient information on Presley Brothers’ products sothat Nagle has decided to satisfy all of his clients’ needs with PresleyBrothers products. By choosing to use Presley Brothers Brokerage for theindicated reason, has Nagle broken the standard concerning soft dollars? A)No, because although his clients pay higher fees, the services are worthit. B)Yes, because his clients pay higher fees and he gets free Internetservice and the services of a research ﬁrm. C)Yes, because his clients pay higher fees and he gets free Internet serviceonly Explanation — Nagle is receiving free Internet service, and does notpass the savings on to his clients. The research beneﬁts some of theclients; therefore, there must be some clients paying a higher fee and notgetting anything from Nagle or Presley Brothers for the extra expense 17.2 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 practice tohis clients.C)a violation of the standard on soft dollars. Explanation — Nagle needs to give all of his clients an opportunity toparticipate in proﬁtable deals. In Nagle’s current system, it is possiblefor long-time clients who generate a consistent level of business per yearto never be able to participate in a proﬁtable IPO
17.3 Nagle’s standing order to purchase as much as much as possible of each Presley Brothers’ IPOs is a violation of the standard because: A)Nagle should get advanced notice of his clients’ interest in the IPO. B)Nagle is, in effect, distributing soft dollars.C)of no reason, it is actually an acceptable practice because all the IPOshave been proﬁtable. Explanation — The standard on Trade Allocation: Fair Dealing andDisclosure requires that Nagle get an advanced indication of clientinterest 17.4 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 beforetaking the allocations. Apparently, taking the trips has led to Naglelimiting his choices of possible products for his clients. Nagle needs to bemore thorough in researching the needs of his clients 17.5 With respect to the trip that Nagle has been taking each year Nagle: A)should disclose it to his clients because it provides him with informationabout stock market activities other than those of Presley Brothers. B)should disclose it to his clients because it could represent a conﬂict ofinterest 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 sincehe has started only using Presley Brothers’ products. The clients need tobe aware that a signiﬁcant portion of Nagle’s information is coming fromthe one ﬁrm that executes his trades and provides all of his clients’products 17.6 Being able to offer his clients discount commissions on option trades after generating a certain amount of commissions is: A)a violation because it beneﬁts those clients who are inclined to dooption trading. B)not a violation because it is a beneﬁt that all clients can share in if theyso choose.C)a violation because commissions on option trades are the quintessentialsoft dollars. Explanation — Clearly some of Nagle’s clients will beneﬁt from thisarrangement more than others 18. Centurion Rivals (CR), an investment advisory ﬁrm, receives the following 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 CFA Institute’s3-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 the following 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 Insititutesoft dollar standards because it does not directly assist the investmentmanager in the investment management process. Rather, it is a beneﬁt tothe ﬁrm which should not be paid with client brokerage 20. A brokerage ﬁrm has just purchased a new computer system that will facilitate trades for its customers and supply research to the brokersdirectly aiding in their investment recommendations. Which of the
following statements regarding the application of the CFA Institute SoftDollar Standards is CORRECT? A)Only the portion of the costs that will be attributed to research can bepaid 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 threelevels are satisﬁed, the Investment Manager can use Client Brokerage topay for 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 money management company that claims it is in compliance with CFA Institute Soft DollarStandards. Last year he purchased a Bloomberg system for the portfoliomanagers to get information concerning investment decisions. He used softdollars from brokers to pay for the system. Because the system has comeup for renewal, he has an assistant audit the use of the terminal for aweek. The assistant reports that the system is only used about 20 percentof the time for investment decision-making activities and 80 percent forother uses. Sanders: A)can use soft dollars to pay for 20 percent of the system for the next yearand must reimburse clients for 80 percent of the cost of last year's system.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 the nextyear and need not take any action concerning last year's soft dollars
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 tolast year's expenditures