study

Topical Study





Corporate Governance

Generalities



 Corporate governance can be generally

defined as the system by which

corporations are directed and controlled

 Common stocks shareholders may

influence management by voting rights;

not exercising these rights ignores a

valuable ownership right that could be

managed for the benefit of the portfolio

Generalities (cont’d)



 Shareholders frequently delegate their

votes (proxy voting) to the investment

managers

 To meet their fiduciary duties, managers

must adopt procedures to ensure that

proxy issues are noted, analyzed and

considered

Proxy Voting



 Basic elements of a proxy voting policy:

– Creation of a proxy policy

– Administration of the policy

 Creation of a proxy policy:

– Designate a policy-making body or an

individual to recommend proxy policy and

monitor implementation

– Identify major proxy issues by particular

account

Proxy Voting (cont’d)

 Administration of the policy:

– define responsibility for proxy voting

– develop a system to monitor any

delegation of proxy voting responsibility to

others

– Provide for record keeping

– Provide for a process to monitor

performance of a custodian to ensure

timely receipt of proxies

– Avoid or minimize conflicts of interest

– Educate and train staff

Topical Study





Client Brokerage - Soft Dollars

Definitions



 Brokerage refers to the amount given to a

broker as payment for execution services

 Soft dollar practices involve the use of client

brokerage by an investment manager to

obtain certain products and services to aid

the manager in its decision-making process

 Soft dollar arrangement refers to the research

and benefits given back to the client or the

client’s manager by the broker for directing

the trade to the broker

AIMR Soft Dollar Standards

 AIMR Soft Dollar Standards (AIMR-SDS) are

consistent with and complement the AIMR

Standards of Professional Conduct (AIMR-

SPC)

 Purpose of AIMR-SDS:

– define “soft dollars”

– identify “allowable” research

– establish standards for soft dollar use

– create model disclosure guidelines

– provide guidance for client-directed brokerage

arrangements

AIMR Soft Dollar Standards

(cont’d)

 AIMR-SDS are voluntary and are

divided in mandatory and recommended

standards (to claim compliance

mandatory standards must be followed)

 Compliance with AIMR-SDS does not

supplant the responsibility to comply

with applicable law

AIMR Soft Dollar Standards

(cont’d)

 Fundamental principles of AIMR-SDS:

– Manager must disclose any benefit

receives through client’s brokerage

(fiduciary duty)

– Proprietary and third party research are to

be treated the same

– Research must directly assists the

manager in its investment decision-making

process (not in the management of the

firm)

Comparison with Current

Practices

 Research includes proprietary

(generated by the broker) as well as

third-party research (purchased by the

broker)

 Soft dollar arrangements include

transactions conducted on an agency or

principal basis

 Enhanced disclosure (more than under

the current law)

Comparison with Current

Practices (cont’d)

 Research requires that the primary use

of the soft dollar product or service to

directly assist the investment manager

in its investment decision-making

process and not in the management of

the firm

 Compliance statement (only to the client

that the compliance statement relates)

AIMR-SDS - General

 Brokerage is the property of client

 Manager has duty to ensure quality of

transactions including:

– seeking to obtain best execution

– minimizing transaction costs

– using client’s brokerage to benefit clients

 Manager must act in the best interest of

client

 Manager may not allocate client’s

brokerage based on referral fees

AIMR-SDS - Relationship with

Clients

 Manager must inform client that he or

she may engage in soft dollar

arrangements before doing so

AIMR-SDS - Selection of Broker



 Selecting a broker is a key component

of the manager’s ability to add value

 Manager must consider the capabilities

of the broker to provide the best

execution

AIMR-SDS - Evaluation of

Research

 Criteria to use client brokerage to pay

research:

– must meet the definition of research

– directly benefit the client

– can be documented

– not precluded under fiduciary regulations

(e.g. ERISA)

 If research does not meet the criteria,

do not use client brokerage to buy it

AIMR-SDS - Evaluation of

Research

 In determining the portion of Mixed-use

research to be paid with client

brokerage, manager must:

– make a reasonable allocation of cost of

research vs expected usage

– pay with brokerage only the portion use in

decision-making process

– reevaluate the allocation at least annually

AIMR-SDS - Client Directed

Brokerage

 Brokerage is an asset of the client

 Manager must not use Brokerage from

another client account to pay for

research purchased under the Client-

Directed Brokerage Arrangement

AIMR-SDS - Disclosure, Record

Keeping

 Manager should disclose soft dollar

arrangements to client

 Manager must keep all records required

by applicable law

Topical Study





Fiduciary Duty

Generalities

 Generally means to hold someone to a

higher standard of loyalty and care than

the standard to which most people are

held

 Extent of a fiduciary’s duty depends on

each particular relationship

 A fiduciary is charged with having more

knowledge than the average person

 AIMR members entrusted with assets

that belong to others are charged with

fiduciary duties

Trust Management

 Prudent Man Rule was initially

measuring the behavior of trustees:

– the fiduciary has an obligation to manage

assets entrusted to him with the same care

and discretion that a prudent person would;

generally, the duty has been defined has

avoidance of undue risk, preservation of

capital and acting in the best interests of

the beneficiaries of the trust

 This rule led to legal list statutes limiting

managers in choice of investment

Trust Management (cont’d)



 Underlying concepts of Prudent Man Rule:

– fiduciary expected to be cautious and conservative

– fiduciary’s main goal is to protect the principal

– speculation is prohibited

– fiduciary can be held responsible for a loss of

principal

– each investment is considered on its own merits

– some classes of securities are deemed imprudent

(e.g. options, futures, etc.)

– delegation of investment authority is forbidden

Trust Management (cont’d)

 Modern Portfolio Theory (MPT) (viewing

entire portfolio rather than individual

investment) has evolved Prudent Man Rule

into the Prudent Investor Rule:

– requires a trustee to act prudently and with

caution, discretion, loyalty and care but does not

restrict the assets in which a trustee can invest

(diversification)

– fiduciary’s central consideration is the trade-off

between risk and return

– act with prudence in deciding whether and how to

delegate authority (PMR: no delegation)

– be cost conscious when investing

Trust Management (cont’d)

 Underlying concepts of Prudent Investor

Rule:

– focus on portfolio construction and trade-off

between risk and return

– no restrictions on classes of securities deemed

imprudent under PMR (make sense in a portfolio

context)

– investment must fit client’s overall portfolio

– delegation of investment authority is permitted

– process-oriented (not focus on performance but

rather on portfolio construction)

– dynamic process (review client’s objectives)

– duty to diversify (unless the client’s best interest is

not to diversify)

Employee Retirement Income

Security Act (ERISA)

 ERISA governs every qualified private

employee benefit plan in the U.S.

 Every fiduciary to the plan must be in

accordance with:

– plan documents

– laws governing the plan

– ERISA’s definition of fiduciary duty

Employee Retirement Income

Security Act (ERISA) (cont’d)

 Under ERISA, a person is a fiduciary if:

– exercises any discretionary authority or

control with the management of the plan or

the plan assets

– renders investment advice for a fee with

respect to plan asset

– has discretionary authority or responsibility

in the administration of the plan

Employee Retirement Income

Security Act (ERISA) (cont’d)

 ERISA trustees cannot delegate their

fiduciary duties but may delegate

investment management responsibilities

 ERISA fiduciary needs to be as prudent

as the average expert (not simply as the

average person)

Employee Retirement Income

Security Act (ERISA) (cont’d)

 Fiduciaries must discharge their duties with

respect to the plan:

– solely in the interest of plan beneficiaries

– for the exclusive purpose of providing benefits to

participants and defraying plan expenses

– with the care, skill, prudence and diligence under

the circumstances then prevailing that a prudent

person acting in like capacity and familiar with

such matters would use in the conduct of an

enterprise of a like character and with like aims

(Prudent Expert Rule)

– by diversifying the investment of the plan to

minimize risk of large losses

Employee Retirement Income

Security Act (ERISA) (cont’d)

 ERISA fiduciaries must adhere to the

following procedures:

– establish a written investment policy for the

plan

– diversify plan assets

– make investment with skill and care of a

prudent expert

– monitor investment performance

– control investment expenses

– avoid prohibited transactions (e.g. conflicts

of interest)

Employee Retirement Income

Security Act (ERISA) (cont’d)

 A person gives investment advice under

ERISA if he or she, for a fee or other

compensation (interpreted broadly):

– gives advice about the value of plan assets

or makes investment recommendations

– has discretionary authority or control with

respect to purchasing plan assets

– gives such advice on a regular basis and

serves as the primary basis for investment

decisions

Others...



 Public Pension Plans:

– laws follow ERISA but vary widely among

jurisdictions

 Money Management:

– also held to a fiduciary duty

 Brokers/Dealers:

– held to higher standard of care than

average person (shingle theory)

Topical Study





Insider Trading

Definitions

 Inside information:

– generally defined as information about a

cie that is both material and nonpublic

 Material information:

– if investor consider it significant in making

an investment decision or if it have an

impact on price (dividends, contracts, etc)

 Nonpublic information:

– if it has not been generally disclosed to the

marketplace

Traditional Theory (Chiarella v.

U.S)

 The mere possession of material nonpublic

information does not give rise to a duty to

disclose that information

 The duty to disclose or abstain from trading

arise only when a fiduciary relationship of

trust and confidence is involved between

parties to a transaction

 Liability may extend to “temporary insiders”

when those parties obtain access to

corporate information by their special

relationships with the corporation

Traditional Theory (cont’d)

 Liability under the traditional theory was

extended to “tippees” (Dirks v. SEC)

 “Tippee” is a person who learns material

nonpublic information from a corporate

insider

 Tippee “inherits” the insider’s fiduciary

duty when:

– insider breach a fiduciary by disclosing

information

– tippee knows or should know that the

insider is acting improperly by disclosing

the information

Traditional Theory (cont’d)



 A breach of a fiduciary duty occurs if the

insider personally benefits from the disclosure

(directly or indirectly). Benefits can be:

– pecuniary or reputational

– through a quid pro quo relationship

– a “gift” of information to others

 Trading is specifically prohibited on material

nonpublic information related to a tender offer

(no breach of duty need to occur)

Misappropriation Theory (U.S v.

O’Hagan)

 A person is liable when misappropriates

material nonpublic information in breach

of a duty owed to an employer or any

other person who is not the securities

issuer and uses that information in a

securities transaction or communicates

it to others (in general also violates

Standard V(A))

Defenses to Insider Trading: The

Mosaic Theory

 May use significant conclusions derived from

the analysis of public material and

nonmaterial nonpublic information as the

basis for investment recommendations and

decisions even if those conclusions would

have been material inside information had

they been communicated directly to the

analysis by a cie

 Should document all research

 Existence of an independent reason for an

investment decision does not provide a valid

defense against charges of insider trading

Selective Disclosure



 When a corporation determines that

information is material and should be made

public, it must disclose the information to the

marketplace generally (not to a chosen few)

 Information made available to analysts

remains nonpublic until it is made available to

investors in general

 Cies should develop and follow disclosure

policies to disseminate information in a n

equitable manner (no blacklist)

Procedures for Compliance



 Adopt procedures to prevent misuse of

material nonpublic information:

– review of employee and proprietary trading

– documentation of firm procedures

– supervision of interdepartmental

communications (Fire Walls)

– restricted lists

Procedures for Compliance

 Minimum elements of Fire Walls:

– substantial control of interdepartmental

communications

– review of employee trading

– documentation of procedures designed to

limit the flow of information

– heightened review or restriction of

proprietary trading while a firm is in

possession of material nonpublic

information

Obligations under AIMR’s Code

and Standards

 Members may receive information as a

result of their confidential relationship

with securities issuers (temporary

insiders)

 Members may receive information

where no confidential relationship exist

(must determine if inside information or

not)

Topical Study





Personal Investing

Fiduciary Responsibilities of

Investment Industry Personnel

 Members have a duty to put the interests of

their clients, firm and profession over and

above their own self-interest

 Manager can make personal trading profit as

long:

– client is not disadvantaged by the trade

– manager does not benefit personally from trades

undertaken for clients

– manager complies with applicable regulatory

requirements

Task Force Recommendations

 AIMR’s Personal Investing Task Force was

formed to examine issues related to personal

investing of managers

 Task Force recommends that firm should

adopt certain basic procedures to address the

conflict areas created by personal investing:

– no participation in equity IPO’s

– restriction on private placements

– establish blackout periods (restricted periods)

– no short-term trading (60 days)

– gifts (maintain independence)

– Reporting requirements

– Disgorgement and disclosure of policies

AIMR Performance Presentation

Standards

Goals of AIMR-PPS

 Achieve greater uniformity and

comparability

 Improve the services offered to the

clients

 Enhance the professionalism of the

industry

 Bolster the notion of self regulation



 Note: intended to be performance

presentation, not measurement performance

Parties affected by AIMR-PPS

 Firms:

– entity registered with the appropriate

regulatory authority

– an autonomous investment firm

– all assets managed to one or more base

currencies

 AIMR members, CFA Charterholders

and CFA Candidates (to remain in

compliance with V(A))

 Prospective and current clients

Main Topics of AIMR-PPS



 Creation and maintenance of

composites

 Calculation of returns

 Presentation of results

 Disclosures

Claim of Compliance

 Some aspects of AIMR-PPS are

mandatory (must be followed to claim

compliance); other aspects only

recommended (should be followed)

 The firm must comply with the

Standards on a firmwide basis

 Firms with no assets under

management cannot make a claim of

compliance but can claim to endorse

the Standards

Claim of Compliance (cont’d)



 Strict adherence to the basic requirements

does not guarantee fair an adequate

performance reporting (requirements may not

cover specific situations of every firms); firm

must keep in mind the spirit and objectives of

the Standards: fair representation and full

disclosure

 Cannot have partial compliance

Claim of Compliance (cont’d)



 Statements referring to the calculation

methodology used in a presentation “as being

in compliance with AIMR-PPS” are prohibited

 Use only the AIMR compliance statement

 AIMR members who misuse the term AIMR,

AIMR-PPS or the compliance statement are

subject to disciplinary sanctions under

Standards V(B)