12 RELATE TO SHIRLEY SMITH. SHIRLEY SMITH, CFA, HAS JUST B...

Questions 7-12 relate to Shirley Smith.

Shirley Smith, CFA, has just been promoted to the position of Chief Investment Officer (CIO) at

Kirk Investment Co (KIC), a large investment management firm that offers mutual funds as well

as managed accounts for individuals and employment benefit plans. As a CFA charterholder,

Smith's first task is to ensure that KIC is in compliance with the Asset Manager Code of

Professional Conduct. For the past few weeks, Smith has encountered the following issues:

Employee Incentive Scheme

KIC has recently changed its portfolio managers' compensation scheme and has tied manager

bonuses to portfolio performance. The change was outlined in a letter that was sent to clients

and prospects before the new bonus structure took effect. David Lee, CFA, is one of the best

portfolio managers at KIC and manages both individual investors and institutional investor

employee benefit plans. His clients have done extremely well, but lately they have

underperformed due to limited exposure to the biotech sector, one of the strongest performing

sectors over the recent few months. Lee placed an order for all employee benefit plans to receive

an allocation of Star, Inc.'s initial public offering (IPO). Star is expected to be over-subscribed

and Lee knew that this IPO would make money for his employee benefit plans. Lee did not

consider allocating any shares to his individual clients.

KIC is considering allowing its portfolio managers and other staff to buy IPO shares as a form of

incentive compensation. For the scheme to work in an orderly manner, KIC is thinking of

centralizing all the purchase of IPO shares through a designated department. For portfolio

managers, they are allowed to buy up to 5% of the IPO shares that they purchased on behalf of

their client accounts. For other staff, they are allowed to purchase IPO shares by placing an

order with the designated department. KIC will allocate IPO shares to the portfolio managers'

clients first, then, if sufficient shares are available, to the portfolio managers and finally, any

excess IPO shares are then allocated to the other staff.

Pricing methodology

KIC has a fund that invests in small capitalization issues. Due to the risk related to these small

cap issues, the fund is only available to very high net worth clients. Some of these small cap

stocks are thinly traded, and hence prices of these securities for monthly statements that are

sent to clients are often difficult to obtain. Ryan Haywood, the portfolio manager that is managing

this fund uses various methods-third party services and in-house valuation models-to price these

small cap stocks. Sometimes, Haywood will enter an order during the last trading hour of the

month to purchase a small number of these illiquid shares to establish a market price. Typically,

Haywood has to offer a premium to the last traded price to ensure that a trade will be executed.

The executed price will then be used as the market price in the monthly statements. These

trades do not materially affect the overall shareholding in any specific company due to the small

number of shares purchased. Shirley Smith has met with Haywood and is concerned about the

multiple pricing methods used by Haywood. Smith suggests that Haywood adopt one pricing

method and apply it consistently. Haywood disagrees with Smith and mentioned that as long as

pricing sources are fully disclosed to clients, it is acceptable to use various methods.

Trade allocation

Peter Armstrong, a portfolio manager for individual clients, is interested in the IPO of Telstar, Inc.

Telstar is a firm in the telecom industry and is expected to have excellent growth prospects.

However, due to recent political events, Armstrong believes that the stock volatility could be quite

high in the first year. He places an order for the Telstar IPO and begins to allocate the IPO

shares among his clients. He divides his clients into two groups-an income-based group and a

capital gains-based group. The income-based group of clients is more risk-averse than the

capital gains-based group, so he decides to allocate Telstar IPO only to his capital gains-based

group of clients. Within the capital gains-based group of clients, he allocates the shares pro rata

to the size of assets in each account.

...

Has David Lee violated the Asset Manager Code of Professional Conduct by investing in Star,

Inc. IPO for the employee benefit plans?

A) Yes. Lee did not allocate the trades fairly to all his clients.

B) No. Lee has used reasonable care and prudent judgment when managing client assets since he

knew that Star, Inc. would be a profitable trade.

C) Yes. Lee did not manage the employee benefit plans according to the plans' mandates.

Question #8 of 60

Is KIC's new compensation scheme of linking bonuses to portfolio performance a potential

violation of the Asset Manager Code of Professional Conduct?

A) Yes. Portfolio managers may take investment actions that conflict with client interests.

B) No. The Asset Manager Code of Professional Conduct does not deal with compensation issues.

C) No. KIC's compensation scheme would ensure that portfolio managers provide the best service to

clients in order to retain clients' accounts.

Question #9 of 60

Is Shirley Smith's recommendation to Haywood or his response correct?

Shirley Smith Ryan Haywood

A) Correct Correct

B) Correct Incorrect

C) Incorrect Correct

Question #10 of 60

Is Peter Armstrong's trade allocation method in violation of the Asset Manager Code of

Professional Conduct?

Divide Clients

Allocate according

into two groups

to size of account

A) No No

B) Yes No

C) Yes Yes

Question #11 of 60

Would the proposal of how IPO shares are allocated and purchased among portfolio managers

and staff be a potential violation of the Asset Manager Code of Professional Conduct?

Portfolio Manager Other staff

A) Yes Yes

C) No Yes

Question #12 of 60

Does trading stocks during the last trading hour of a month to establish a fair market price violate

the Asset Manager Code of Professional Conduct?

A) Yes. Haywood has no reasonable basis to execute the trades.

B) No. Haywood is simply acting in the client's best interests to obtain fair market price to value the

fund assets.

C) Yes. This is a form of market manipulation to depress the price for the securities.

Question #13 of 60