Views on improving the integrity of global capital markets
23 May 2019

Ethics in Practice: Co-Investing with Clients. Case and Analysis–Week of 20 May

Check the analysis of this week’s case (20 May) to see if you made the right choice.

Case

Stansfield is hired by Roudabush Securities Inc. (RSI) to manage a staff of investment advisers. Delorme, one of the investment advisers Stansfield supervises has been with RSI for more than 30 years and is the sister-in-law of the owner of the firm. Delorme is involved in a pump-and-dump trading scheme with an investment adviser outside of RSI in which Delorme buys or encourages her clients to buy speculative “penny” stocks to boost demand and price of the securities controlled by the outside adviser. In return, Delorme receives compensation from the outside adviser. Stansfield becomes aware of these activities from Delorme’s emails, which are flagged by the email monitoring system Stansfield put in place to detect misconduct on the part of his subordinates.

Morrison serves as the investment adviser to two private funds (the Funds). The private placement memoranda for the Funds permit Morrison to “pursue any objectives, utilize any investment techniques, or purchase any type of security that [Morrison] considers appropriate and in the best interests of the Funds.” Through a mutual associate, Morrison is introduced to an individual from another country who purports to trade international notes for huge profits. Morrison has more than 30 phone calls with the individual to discuss his investment strategy. He conducts internet searches and learns that the individual supposedly owns an oil and gas trading operation under a name he gave to Morrison via email. Morrison never meets the individual in person.

Morrison personally loans $100,000 to the individual and his company under the promise that Morrison will receive $1 million in 25 days. When the payment comes due, Morrison agrees with the individual’s suggestion to roll the purported proceeds into another investment. Morrison then invests $4 million from the Funds’ assets with the individual and his company, which promises to pay $40 million to the Funds in 90 days. Shortly after the Funds’ investment, Morrison receives a payment of $250,000 from the individual. After several months, the individual makes a payment to the Funds of $2.5 million, but no other proceeds of the Funds’ investment are forthcoming. Morrison’s actions are

  1. acceptable because the Funds’ mandate allows him to make any type of investment.
  2. conducted sufficient due diligence on the investment scheme.
  3. unacceptable because he did not disclose a conflict of interest to the Funds.
  4. unacceptable because he should not have co-invested in the fund with his clients.
  5. none of the above.

Analysis

This case relates to CFA Institute Standard of Professional Conduct VI(A): Disclosure of Conflicts, which requires CFA Institute members to make full and fair disclosure of all matters that could reasonably be expected to impair their independence and objectivity or interfere with their duties to clients. Morrison did not disclose to his clients that he had personally loaned $100,000 to the individual and his company. Therefore, he failed to disclose a conflict of interest arising out of his status, through his personal loan, as a creditor of the individual and his company. Morrison’s loan is not, in and of itself problematic. In some cases, co-investing with clients may be appropriate and even advisable. But in this case, the loan was not disclosed. In addition, Morrison had an incentive to invest the Funds’ assets because it would provide money that could be used to repay Morrison personally. Although the mandate of the Funds gave Morrison wide discretion on how he could invest the Funds’ assets, it did not absolve him of disclosing any conflicts of interest with those investments.

The amount of appropriate due diligence an investment adviser must make when investigating a potential investment entails an investigation of the facts and circumstances of each case. Morrison performed limited due diligence on the investment, and the information he obtained is questionable, but it would be difficult to make a definitive call on the reasonableness and due diligence of the investment without further information. But Morrison’s failure to disclose the conflict of interest is apparent. Choice C is the best response.

This case is based on an April 2019 US SEC Enforcement Action.

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Have an idea for a case for us to feature? Send it to us at ethicscases@cfainstitute.org.


More About the Ethics in Practice Series

Just as you need to practice to become proficient at playing a musical instrument, public speaking, or playing a sport, practicing assessing and analyzing situations and making ethical decisions develops your ethical decision-making skills. The Ethics in Practice series gives you an opportunity to “exercise” your ethical decision-making skills. Each week, we post a short vignette, drawn from real-world circumstances, regulatory cases, and CFA Institute Professional Conduct investigations, along with possible responses/actions. We then encourage you to assess the case using the CFA Institute Ethical Decision-Making Framework and through the lens of the CFA Institute Code of Ethics and Standards of Professional Conduct. Then join the conversation and let us know which of the choices you believe is the right one and explain why. Later in the week, we will post an analysis of the case and you can see how your response compares.


Image Credit: ©CFA Institute

About the Author(s)
Jon Stokes

Jon Stokes is the Director of Ethics and Standards Education at CFA Institute. His responsibilities include design and creation of on-line ethics education, development and maintenance of the CFA Institute Code of Ethics and Standards of Professional Conduct, and the design and management of the CFA Institute Ethical Decision-Making and Giving Voice to Values education programs. Stokes holds a JD degree.

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