R03 Application of the Code and Standards 2019 Level II Notes

Introduction ............................................................................................................................................................ 2
1. Edvard Stark ....................................................................................................................................................... 2
2. Subath Agarway ................................................................................................................................................ 5
3. Peter Sherman ................................................................................................................................................... 6
4. Preston Partners ............................................................................................................................................... 8
5. Super Selection ............................................................................................................................................... 10

This document should be read in conjunction with the corresponding reading in the 2019
Level II CFA® Program curriculum. Some of the graphs, charts, tables, examples, and figures
are copyright 2018, CFA Institute. Reproduced and republished with permission from CFA
Institute. All rights reserved.

Required disclaimer: CFA Institute does not endorse, promote, or warrant the accuracy or
quality of the products or services offered by IFT. CFA Institute, CFA®, and Chartered
Financial Analyst® are trademarks owned by CFA Institute.

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R03 Application of the Code and Standards 2019 Level II Notes

R03 Application of the Code and Standards

Introduction
This reading has five cases that demonstrate how to apply the Code and Standards in
situations where professional and ethical judgment is required. Exhibit 1 of the reading
(R03) shows a framework to guide individuals in their ethical decision- making process and
application of the Code and Standards.
Exhibit 1(R03) A Framework for Ethical Decision Making
Relevant facts, stakeholders and duties
Identify: owed, ethical principles, conflicts of interest
Consider: Situational influences, additional guidance,
alternative actions
Decide and act
Reflect: Was the outcome as anticipated? Why or
why not?

The following cases must be read from the perspective of how applying the framework
might have helped each individual’s decision making process.
We have covered the most important points of each case. We suggest that you read the cases
given in the curriculum to get a thorough understanding of the material.

1. Edvard Stark
Case facts
Edvard Stark, CFA is a private client advisor for Eyearne Bank. He has recently become
interested in cryptocurrencies of their rapid appreciation in value. Stark believes
cryptocurrencies may provide clients with higher returns and diversification benefits.
Cryptocurrencies are held in online wallets to facilitate secure transactions over the internet.
Account holders can earn additional cryptocurrencies tokens through an activity called
‘mining’.
After studying top cryptocurrencies over two weekends, Stark decides to go with a newer
digital currency called Meerine. To limit his risk of being wrong, Stark decides to give a buy
recommendation to only a few small clients. He recommends a 1% position in Meerine to
these clients.
Stark continues learning more about cryptocurrencies. He attends conferences and
workshops. Stark believes mining Meerine’s currency will help him understand
cryptocurrencies and the technology supporting them. Consequently, he will make better
cryptocurrency investment recommendations for his clients. He starts mining Meerine’s

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R03 Application of the Code and Standards 2019 Level II Notes

currency by running the mining software as a background process on his home computer for
several months. This provides him a way to supplement his salary by adding tokens to his
Meerine account. He believes that he now competent in his understanding of
cryptocurrencies and their underlying technology. During this time, Meerine’s price
continues to rise strongly.
In his client review meetings, Stark explains the low correlation of cryptocurrencies with
traditional assets and shows the strong performance of Meerine since his initial
recommendation. He tells clients about mining the Meerine currency and recommends 3% buy
for each client. His clients know very little about cryptocurrencies. They have few questions
and no objections. Stark feels his recommendation has been well received. He offers his
larger clients the opportunity to buy Meerine tokens directly from him. This will provide
them with an opportunity to participate in any potential appreciation of Meerine while
establishing their positions.
Case discussion
Standard III (B) - Duties to Clients: Fair Dealing
Stark has violated Standard III(B) By offering only his largest clients the opportunity to buy
Meerine tokens directly from him.
Action required:
Stark should either (1) make this offer to all his clients and then allocate available tokens in
proportion to the clients’ investments or (2) not offer to any of his client.
The firm can adopt a policy where such transactions are executed as a block trade,
allocations are made on a pro-rata basis and everyone receives the same execution price.
Standard III (C) – Duties to Clients: Suitability
Starks initial recommendation of 1% to only his smallest clients and later recommendation
of 3% to all clients are a violation of Standard III(C).
Action required:
Stark should consider each client’s risk tolerance, goals and objectives to determine if that
client can invest in Meerine and what is the appropriate level of exposure for that client.
The firm should adopt a policy to consider the impact of the proposed recommendation on
portfolio diversification, how the investment’s risk parameters align with the client’s
assessed risk tolerance, and whether the proposed investment fits within the overall
investment strategy, taking into account the client’s time horizon, return objectives, and
constraints.
Standard IV (B) – Duties to Employers: Additional Compensation Arrangements

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R03 Application of the Code and Standards 2019 Level II Notes

By mining Meerine, Stark is supporting a service that competes with his employer Eyearne’s
services . This creates a conflict of interest. Also he is earning additional compensation
through mining and has not disclosed this to his employer. Therefore Standard IV (B) is
violated.
Action required:
Stark needs to disclose to his employer, his intention to mine Meerine and the potential
earnings expected from this activity. He needs to obtain written consent before beginning
this activity.
As a policy, employees should be required to disclose any external employment or
compensation arrangement to the firm and receive written permission before undertaking
any such arrangement. Failure to comply should be considered a violation subject to
disciplinary procedures that may lead to termination.
Standard V (A): Investment Analysis, Recommendations, and Actions: Diligence and
Reasonable Basis
Although Stark had done some research, he was still in the learning process when he made
the 1% buy recommendation. Therefore Standard V (A ) was violated.
Action required:
Stark should develop a written report detailing the background information and decision
framework that support his recommendation.
The firm can create a ‘Approved List’ for securities. Only securities on this list can be
recommended or purchased. Securities can be added to this list only after they have been
approved by an Investment Committee.
Standard VI (A) Conflicts of Interest: Disclosure of Conflicts
Stark’s mining of Meerine and his recommendation that clients invest in Meerine is a conflict
of interest. If Meerine appreciates due to his client’s purchases it will directly benefit Stark.
Stark’s lack of full disclosure is a violation of Standard VI (A).
Action required:
Stark should clearly disclose to his clients and Eyearne Bank his conflict of interest. He
should also determine suitable alternative cryptocurrencies for clients who are
uncomfortable with this conflict.
The policy statement should require employees to not use their position, directly or
indirectly, for private gain or financial benefit, to advance personal interests, or favors for
their families, or any other person. Effective conflict management requires all
employees to identify and disclose to the company all actual or potential conflicts of interest

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R03 Application of the Code and Standards 2019 Level II Notes

as they become aware of them. All employees should be required to exercise sound
judgment, seek advice when appropriate, obtain review of certain
activities and other applicable business and jurisdiction specific policies and procedures
while maintaining highest ethical standards.

2. Subath Agarway
Case facts
Subath Agarway has recently joined CrowdWisdom as vice president, andin charge of due
diligence. CrowdWisdom offers an online matching platform that matches investors with
startup companies in need of capital. Agarway’s role is to identify suitable companies to list
on the online matching platform.
CrowdWisdom’s co-founders Craig and Stephane created a subgroup of investors called
‘Investor Club’ by selecting the most active investors on the online platform. This subgroup
has access to market intelligence research in addition to the research on the CrowdWisdom
listed companies.
Agarway’s due diligence process consists of a two-step process he developed at his previous
company FunderWise. He is confident in his process and has personally invested in several
FunderWise listed companies using this approach.
Agarway has identified a very promising start-up company called Deko. Most of Deko’s
customers are pre-teens and teenagers. CrowdWisdom could approach these customers for
future investor funding activities. The company’s strategy is to market its crowdfunded
shares through email communications. The email states that the offer is available to adults
over the age of 18.
Agarway’s responsibilities have increased over time. His stack of applications for review
grows to 300 companies. To meet CrowdWisdom’s aggressive growth goals, the company co-
founders ask Agarway to target a 10% acceptance rate. They suggest that he find ways to
reduce the time spent on each application. They also recommend the acceptance of two
companies whose founder’s they met at the recent conferences.
Case discussion
Standard I (A) - Professionalism: Knowledge of the Law
Agarway should review the global rules governing online marketing to Deko’s teen and
preteen customers. They may be at risk of prosecution because it is illegal in many countries
to collect information on such individuals over the internet without first obtaining parental
permission. Unless Agarway can confrm that Deko is in compliance with this requirement,
the use of CrowdWisdom’s platform to solicit preteens could be against the law and subject
to prosecution.

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R03 Application of the Code and Standards 2019 Level II Notes

Action required:
Agarway and CrowdWisdom should establish a procedure to regularly inform employees
about changes in applicable laws and regulations. CrowdWisdom should have legal counsel
available to review planned additions to the platform to ensure that the company’s strategy
is not in conflict with relevant laws.
Standard I(B) - Professionalism: Independence and Objectivity
Pressure from the founders to increase the number of listings and reduce the review
timeframe are likely to compromise Agarway’s independence and objectivity.
Action required:
Agarway and CrowdWisdom’s senior leaders need to create and document a company
approved due diligence process that is acceptable to both Agarway and the founders.
Standard VI(A) - Conflicts of Interest: Disclosure of Conflicts
Two possible conflicts of interest in this case are:
• Investor Club getting access to additional market intelligence research.
• Agarway’s personal investments in several companies that could be listed on
CrowdWisodom’s platform in the future or may compete with the platform listed
companies.
Action required:
The benefits of Investor Club should be disclosed to all investors.
Aggarway’s personal investments need to be disclosed to his supervisor and
CrowdWisdom’s compliance officer. If the firms are listed on CrowdWisdom’s platform, then
disclosures should be made to the platform users as well.

3. Peter Sherman
Case facts
Peter Sherman, CFA, worked for five years at Pearl Investment Management as a primary
analyst for emerging market. While at Pearl he served as a consultant to several emerging
market companies. This arrangement was fully disclosed to Pearl. Sherman then switched
jobs and joined the Glenarm Company. He did not inform Glenarm about his consulting
services to emerging market companies.
Glenarm is a small equity-oriented management firm that was recently investigated,
censured and fined by the U.S. Securities and Exchange Commission. Glenarm believed that
hiring a CFA charterholder like Sherman as a portfolio manager will enhance its credentials.
To entice Sherman, Glenarm offered him a large portion of the first-year investment

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R03 Application of the Code and Standards 2019 Level II Notes

management fee for any of the Pearl clients that he would be able to solicit and bring to
Glenarm.
Sherman started soliciting clients for Glenarm while he was still at Pearl. He:
• contacted Pearl’s existing clients after business hours.
• contacted Pearl’s potential clients.
• contacted clients that Pearl had rejected in the past.
Also, Sherman took the following items from Pearl to his new job:
• Sample marketing presentations he prepared.
• Computer program models for stock selection and asset allocation that he developed.
• Research material for several companies he followed.
• News articles he collected that contain potential research ideas.
• A list of companies that he suggested in the past deserved further research and
possible investment and that were rejected by Pearl.
Case discussion
This case depicts violations of the following standards:
Standard IV (A) - Duties to Employer: Loyalty
Sherman’s solicitation of Pearl’s existing and potential clients is a violation of Standard IV
(A)
Note: Sherman’s solicitation of clients that Pearl had rejected in the past is not a violation of
this standard.
All items that Sherman took were the property of Pearl and this was a violation of Standard
IV (A).
Actions required:
To avoid violations of this Standard, Sherman should not have solicited any of Pearl’s
existing and potential clients while still employed at Pearl. Also, he should have obtained
Pearl’s permission to take copies of any work he prepared on behalf of Pearl in the course of
his employment there.
Standard IV (B) - Duties to Employers: Disclosure of Additional Compensation
Arrangements:
Sherman disclosed his consulting arrangements to Pearl but not to Glenarm. Thus he
violated Standard IV (B).
Note: Sherman’s consulting arrangements are also a violation of Standard VI (A) - Disclosure

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R03 Application of the Code and Standards 2019 Level II Notes

of Conflicts, and Standard I (B) - Independence and Objectivity.

Actions required:
Sherman must disclose to Glenarm all outside compensation arrangements and describe in
detail the activities that gave rise to this compensation. He must obtain written permission
in advance of entering into these relationships.

4. Preston Partners
Case facts
Preston Partners (PP) is a medium-sized investment management firm that specializes in
managing large-cap portfolios of U.S. equities for individuals and pension funds. Sheldon
Preston, CFA, is the senior partner in Preston Partners.
Preston Partners had adopted the CFA Institute Code of Ethics and Standards of Professional
Conduct as part of its policy and procedures manual. Preston had written the manual
himself. However, he stuck to the key elements and did not address all policies in detail. He
ensured that every employee received a copy of the manual when he or she joined the firm.
Every day Preston reviews all Preston Partners trades and major price changes in the
portfolios. In one such review, Preston found that several weeks ago, while he was on
vacation, Gerald Smithson, CFA, a portfolio manager at Preston Partners, had added to all his
clients’ portfolios the stock of Utah BioChemical Company and Norgood PLC. Utah
BioChemical and Norgood PLC had just announced a day earlier that they were going to
merge. The announcement prompted a 40% rise in the share prices of both companies.
Preston is aware of the fact that Smithson and Arne Okapuu, President and CEO of Utah
BioChemical have a long-standing relationship. In fact, Okapuu’s personal portfolio and Utah
BioChemical pension fund are managed by Smithson. Preston, therefore, called Smithson to
his office for an explanation.
Smithson explained that he had seen Okapuu in a restaurant dining with the chairman of
Norgood PLC. To get more information on Norgood, he called his old analyst friend, Andrew
Jones. Jones sent Smithson, his latest research report which recommended a ‘hold’ on
Norgood stock. After Smithson thoroughly analyzed both companies he concluded that both
stocks were selling at attractive prices. He observed that Norgood’s stock was relatively
stable and had risen consistently in the past. Utah BioChemical’s stock had been a high-
growth stock but had dropped in recent years. But based on his analysis, Smithson projected
strong cash flow for Utah BioChemical in future. Smithson also recognized that both
companies were in complementary businesses. This information, coupled with the fact that
he saw Okapuu and the chairman of Norgood dining together, led Smithson to believe that
the two companies were planning a merger.
Hence, Smithson put in a block trade for 50,000 shares of each company. He referred to

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R03 Application of the Code and Standards 2019 Level II Notes

Preston Partners’ policy and procedures manual on how to allocate shares, but was unable
to find sufficient information. So, he decided to allocate the shares to his largest accounts
first, gradually working down to smaller accounts. Smithson’s clients ranged from very
conservative personal trust accounts to pension funds with aggressive objectives and
guidelines.
When Smithson had decided to make the share purchases, Utah BioChemical and Norgood
were trading at $10 a share and at $12 a share. In the following two weeks, their stock prices
increased significantly, but no merger or takeover announcement was made – until a day
earlier.
Case discussion
Standard V (A) – Diligence and Reasonable Basis:
This standard was not violated. Smithson conducted proper research and did not base his
decision solely on the fact that Okapuu and the chairman of Norgood were dining together.
He neither possessed not acted on inside information.
Standard III(C) - Suitability:
Smithson’s accounts ranged from conservative, for his personal trust accounts, to aggressive,
for his pension fund clients. Norgood appears to be a conservative stock, whereas Utah
BioChemical seems to be an aggressive stock. Hence by purchasing shares of the two
companies for all his clients Smithson may have violated Standard III(C).
Actions required:
It is unclear whether Smithson’s clients have written investment objectives and guideline
policy statements. If they do not, Preston should require Smithson to prepare such written
guidelines for all accounts. Smithson should review the guidelines for every account for
which he bought shares of Utah BioChemical and Norgood and assess the suitability of these
shares. In those accounts for which the investment is unsuitable, he should sell the shares,
and Preston Partners should reimburse any losses.
Standard III (B) – Fair Dealing:
In the absence of detailed written guidelines, Smithson discriminated against the smaller
clients by his block-trade allocation method. Hence he violated this standard.
Actions required:
Preston Partners should formulate trade allocation procedures that ensure:
• Fairness to clients.
• Timeliness and efficiency in the execution of trades.
• Accurate records for trade orders.

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R03 Application of the Code and Standards 2019 Level II Notes

Standard IV (C) – Responsibilities of Supervisors:

Preston Partners did not have supervisory procedures in place that would have prevented
Smithson’s allocation approach. The compliance policy was not clear. Preston’s lack of
adequate procedures resulted in the violation of Standard IV(C): Responsibilities of
Supervisors. Actions required:
Establish proper procedures. Assign a designated compliance officer to ensure that all
policies, procedures, laws and regulations are being followed by employees.

5. Super Selection
Case facts
Super Selection Investment Advisors (SS) is a money management firm registered with SEC
to manage both separate accounts and mutual funds. SS has incorporated the CFA Institute
Code and Standards into the firm’s compliance manual. Patricia Cuff is the CFO and
compliance officer for SS. She is also a member of CFA Institute. Karen Trader is a portfolio
manager at SS.
A board member of Atlantis Medical Devices (AMD) informed Cuff of Trader’s possible
misconduct. Trader recently bought the stock of AMD for all her portfolios. Cuff is now
investigating the incident. She is reviewing Trader’s brokerage statements, which were not
previously submitted by Trader.
Trader has been a portfolio manager at SS for almost five years. Trader’s friend Josey James
is the president of AMD, a local biotech company. Over the past five years James has
provided Trader with information regarding attractive investment opportunities in biotech
firms. Trader used this information for both her SS portfolio and her personal portfolio.
However, she has often purchased stocks for her personal account before purchasing them
for her clients.
Three years ago, James asked Trader to serve as an outside director for AMD, to which
Trader agreed. Since AMD was in shaky financial condition at that time, it compensated its
directors with stock options rather than cash payments. The options were essentially
worthless at the time. Trader did not disclose her relationship with AMD to SS. Recently, due
to record sales and earnings AMD has started paying a quarterly fee of $5,000 to its
directors.
Several months ago, the IPO market was very hot and therefore AMD directors voted to take
the company public. Trader was eager to exercise her stock options. Further she had begun
construction of her new home and needed cash, hence she also voted in favor of the IPO.
However, shortly before the public offering date, James informed Trader that the IPO market
had reversed and asked her to commit to purchase a large amount of AMD offering for her SS
accounts. This would provide support to the offering. Trader had previously decided that

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R03 Application of the Code and Standards 2019 Level II Notes

AMD was a questionable investment for her clients, but she proceeded to purchase the
shares for them anyway.
Case discussion
Standard IV (C) – Responsibilities of Supervisors:
As a CFO and compliance officer, Cuff is assumed to be the supervisor. Therefore, she must
comply with Standard IV(C). Cuff has a responsibility to take appropriate steps to prevent
any violation by those she oversees of applicable statutes, regulations, or CFA Institute
Standards. As compliance officer, she must also ensure that the firm’s compliance policies
are being followed and that violations of these policies are addressed.
Actions required:
• Cuff should report the violations to senior management. Cuff and SS’s senior
management should take appropriate actions to address the misconduct.
• Cuff should start a thorough investigation of Trader’s actions, limit Trader’s activities
and implement procedures to prevent future misconduct.
• Senior managers should consult an attorney to determine if Trader’s actions need to
be reported to local regulatory/ legal authorities. If senior management fails to act,
Cuff should report this incident to SS’s board of directors. She may need to resign
from the firm.
Standard VI (A) – Disclosure of Conflicts:
Trader violated this standard by not disclosing the stock options and cash compensation she
received as an AMD director to SS.
Actions required:
• Trader should have disclosed to SS the compensation she was receiving as an AMD
director, her ownership of the AMD stock options and her directorship.
• Cuff needs to ensure that proper disclosure is made to clients. Cuff also needs to
thoroughly review Trader’s client accounts and her personal account to determine if
any conflicts have occurred in addition to the IPO violation. If additional conflicts are
discovered, Cuff should take appropriate action.
Standard V (A) – Diligence and Reasonable Basis:
Trader had previously determined that AMD was not a suitable investment for her clients.
Under pressure from James, Trader has reversed her stance on AMD and has thus violated
this standard.
Action required:
• Trader should have conducted thorough research prior to making an investment

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R03 Application of the Code and Standards 2019 Level II Notes

decision. She should not have changed this decision without adequate basis. Also, she
must inform clients of her directorship and compensation arrangements with AMD.
• Cuff should review investment actions taken for clients by SS employees at least
annually to determine if those actions were taken on a reasonable and adequate
basis.
Standard III (A) – Loyalty, Prudence, and Care:
By investing in and influencing the IPO of AMD, Trader placed her interests before those of
her clients and hence violated this standard.
Actions required:
• Trader should have taken investment actions that were for the sole benefit of her
clients.
• Cuff should start a thorough investigation of Trader’s activities to determine if any
other breaches of this standard have occurred. Following any type of breach, Cuff
should limit Trader’s activities and implement procedures to prevent future
violations.
Standard III (C) – Suitability:
Trader violated this standard when she purchased AMD stock for her clients and did not take
into consideration their needs and circumstances.
Actions required:
• Trader should have considered clients’ needs and circumstances prior to taking
investment actions.
• Cuff should establish at least an annual review to compare the suitability of
investments made for clients with their written policy statements.
Standard VI (B) – Priority of Transactions:
Trader violated this standard by trading prior to her clients’ trades.
Actions required:
• Trader bypassed SS’s procedures by not reporting trades and brokerage accounts.
Yet, it was Cuff’s responsibility to ensure that SS’ policies and procedures were being
followed.
• Cuff should review the firm policies to ensure they are adequate. She should make
sure that SS employees are periodically informed about the Code and Standards.
• Cuff needs to investigate Trader’s personal transactions, recommend sanctions and
ensure that the sanctions are followed.

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