Ethics in Practice: Independent Research. Case and Analysis–Week of 23 September
Check out the analysis to see how you did in analyzing this week’s case (23 September) and determining which CFA Institute Standard was involved.
Case
Corix Bioscience is a startup company seeking to begin operations manufacturing and selling cannabidiol (CBD) products. To promote the company, Corix hires Harrelson, an independent research analyst, to write and distribute a research report on the company. Corix informs Harrelson that it has a joint venture with Native American tribes, enabling the company to access tribal lands for farming commercial hemp and cannabis and to sell hemp and cannabis products in retail outlets on tribal lands. Corix also tells Harrelson that the company has obtained a certificate of compliance from regulators that allows the company to transport, process, and export industrial hemp products. Finally, Corix discloses to Harrelson that the prior year’s harvest of hemp surpassed expectations in both quality and quantity, resulting in a substantial inventory of product. Based on these statements by the company, Harrelson includes all of this information in a research report and provides a positive analysis of the company.
In reality, Corix does not have agreements with Native American tribes; the company did not seek or obtain regulatory approval; the certificate of compliance is a forgery; and Corix never cultivated, planted, or harvested significant quantities of industrial hemp. Chong, a research analyst at Natures Harvest Investment Management (NHIM), incorporates the information and conclusions from Harrelson’s research report as part of his own internal research on Corix and includes a “buy” recommendation. Chong’s report is distributed to only portfolio managers at NHIM. Broadus, a NHIM portfolio manager, reviews Chong’s research and purchases substantial holdings in Corix for a number of his clients. Corix is ultimately shown to be a sham operation, leading to substantial losses for Broadus’s clients. Which of the following characters most likely acted in violation of the CFA Institute Code of Ethics and Standards of Professional Conduct and why?
- Harrelson.
- Chong.
- Broadus.
- Harrelson, Chong, and Broadus.
- None of the above.
Analysis
This case relates to diligence and reasonable basis in making investment recommendations and taking investment action. CFA Institute Standard of Professional Conduct V(A): Diligence and Reasonable Basis states that CFA Institute members must exercise diligence and thoroughness in analyzing investments and must have a reasonable and adequate basis supported by appropriate research and investigation for any investment recommendation. The issue in this case is whether Harrelson, Chong, and Broadus complied with the requirements of this standard.
By relying on the statements given by Corix and not conducting an independent investigation into the veracity of the information, Harrelson did not exercise diligence and thoroughness in analyzing the company. Chong seemingly relied on Harrelson’s research to formulate his “buy” recommendation without conducting his own independent research. Investment professionals who rely on third-party research conducted outside their firm by someone who is not their colleague must make reasonable and diligent efforts to determine whether such research is sound. The facts do not indicate that Chong independently verified the statements, critically assessed Harrelson’s research, or had reason to rely on Harrelson’s report based on past experience and familiarity with the quality of Harrelson’s work. Chong also did not appear to recognize that Harrelson’s work was issuer-paid research and thus subject to heightened scrutiny.
Broadus relied on the work of his colleague, Chong, in making the decision to invest in Corix stock for his clients. Investment professionals may rely on the work of colleagues in their firms when making an investment decision, under the assumption that the employer has fully vetted and approved of the diligence, quality, and thoroughness of their fellow colleagues’ work. Investment professionals may also rely on others in their firms to determine whether third-party research is sound and use the information in good faith unless there is reason to question its validity or the processes and procedures used by those responsible for the research. Under the facts provided, Broadus had no reason to be concerned that Chong had not adequately conducted internal research on Corix, or that NHIM was negligent in employing Chong as a research analyst. Under these circumstances, Broadus is entitled to rely on the work of his colleague and thereby meet the requirements of the diligence and reasonable basis standard. Since Harrelson and Chong most likely violated the standard and Broadus did not, choice E is the best response.
This case is based on an enforcement action by the US SEC from August 2019.
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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.
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D
Harrelson like violated Standard I(C) if he did not disclose his compensation arrangement with the issuer. A case can perhaps be made for a likely violation of Standard V(A) as well i.e. Harrelson is expected to conduct a thorough due diligence into Corix’s claims around regulatory compliance and its purported agreement with Native American Tribes rather than just taking the company’s word for it.
Depending on the level of disclosures contained in the Harrelson report (or lack thereof), Chong likely violated Standard I(C) if he in turn, failed to disclose the fact that he used Harrelson’s report as a source for his own findings. He also likely violated Standard V(C) by failing to conduct adequate due-diligence while using a third-party report that potentially had a material impact on his own internal recommendations.
Broadus violated Standard III (C) if his investments weren’t in line with the recommended allocation guidelines in the context of the overall portfolio.
My answer is D. All three of them should have performed due diligence regarding Corix. Harrelson should have been more cautious while coming out with the report in the first place and should have conducted his own independent research for checking the authenticity of the informations provided by the company.