Standard IV(C) Responsibilities of Supervisors

Standard IV(C) states that members and candidates must promote actions by all employees under their supervision and authority to comply with applicable laws, rules, regulations, and firm policies and the Code and Standards.

Any investment professional who has employees subject to her or his control or influence—whether or not the employees are CFA Institute members, CFA charterholders, or candidates in the CFA Program—exercises supervisory responsibility.

The conduct that constitutes reasonable supervision in a particular case depends on the number of employees supervised and the work performed by those employees. Members and candidates with oversight responsibilities for large numbers of employees may not be able to personally evaluate the conduct of these employees on a continuing basis. These members and candidates may delegate supervisory duties to subordinates who directly oversee the other employees. A member’s or candidate’s responsibilities under Standard IV(C) include instructing those subordinates to whom supervision is delegated about methods to promote compliance, including preventing and detecting violations of laws, rules, regulations, firm policies, and the Code and Standards.

At a minimum, Standard IV(C) requires that members and candidates with supervisory responsibility make reasonable efforts to prevent and detect violations by ensuring the establishment of effective compliance systems. An effective compliance system goes beyond enacting a code of ethics; it also includes establishing policies and procedures to achieve compliance with the code and applicable law and reviewing employee actions to determine whether they are following the rules.

To be effective supervisors, members and candidates should implement education and training programs on a recurring or regular basis for employees under their supervision. Such programs will assist the employees with meeting their professional obligations to practice in an ethical manner within the applicable legal system. Further, establishing incentives—monetary or otherwise—for employees not only to meet business goals but also to reward ethical behavior can be an effective method for encouraging employees to comply with their legal and ethical obligations.

Often, especially in large organizations, members and candidates may have supervisory responsibility but not the authority to establish or modify firm-wide compliance policies and procedures or incentive structures. Such limitations should not prevent members and candidates from working with their own superiors and within the firm structure to develop and implement effective compliance tools, including but not limited to a code of ethics,

• compliance policies and procedures,
• education and training programs,
• an incentive structure that rewards ethical conduct, and
• adoption of firm-wide best practice standards (e.g., the GIPS standards and the CFA Institute Asset Manager Code of Professional Conduct).

A member or candidate with supervisory responsibility must bring an inadequate compliance system to the attention of the firm’s senior managers and recommend corrective action. If the member or candidate clearly cannot discharge supervisory responsibilities because of the absence of a compliance system or because of an inadequate compliance system, the member or candidate should decline to accept supervisory responsibility until the firm adopts reasonable procedures to allow adequate exercise of supervisory responsibility.

Members and candidates with supervisory responsibility must understand what constitutes an adequate compliance system for their firms and make reasonable efforts to see that appropriate compliance procedures are established, documented, communicated to covered personnel, and followed. “Adequate” procedures are those designed to meet industry standards, regulatory requirements, the requirements of the Code and Standards, and the circumstances of the firm. Once compliance procedures are established, the supervisor must also make reasonable efforts to ensure that the procedures are monitored and enforced.

To be effective, compliance procedures must be in place prior to the occurrence of a legal or ethical violation. Although compliance procedures cannot be designed to anticipate every potential violation, they should be designed to anticipate the activities most likely to result in misconduct. Compliance programs must be appropriate for the size and nature of the organization. The member or candidate should review model compliance procedures or other industry resources to ensure that the firm’s procedures are adequate.

Once a supervisor learns that an employee has violated or may have violated the law or engaged in unethical behavior, the supervisor must promptly initiate an assessment to determine the extent of the wrongdoing. Relying on an employee’s statements about the extent of the violation or assurances that the wrongdoing will not reoccur is not enough. Reporting the misconduct to the appropriate compliance and management personnel and warning the employee to cease the activity are also not enough. Pending the outcome of the investigation, a supervisor must take steps to ensure that the violation will not be repeated, such as placing limits on the employee’s activities or increasing the monitoring of the employee’s activities.

Members and candidates with supervisory responsibility must also make reasonable efforts to detect violations of laws, rules, regulations, and firm policies as well as unethical behavior. Supervisors exercise reasonable supervision by establishing and implementing written compliance procedures and ensuring that those procedures are followed through periodic review. If a member or candidate has adopted reasonable procedures and taken steps to institute an effective compliance program, then the member or candidate may not be in violation of Standard IV(C) if he or she does not detect violations that occur despite these efforts. The fact that violations do occur may indicate, however, that the compliance procedures are inadequate. In addition, in some cases, merely enacting such procedures may not be sufficient to fulfill the duty required by Standard IV(C). Members and candidates may be in violation of Standard IV(C) if they know or should know that the procedures designed to promote compliance, including detecting and preventing violations, are not being followed.

Members and candidates are encouraged to recommend that their employers adopt a code of ethics. Adoption of a code of ethics is critical to establishing a strong ethical foundation for investment advisory firms and their employees. Codes of ethics formally emphasize and reinforce the client loyalty responsibilities of investment firm personnel, protect investing clients by deterring misconduct, and protect the firm’s reputation for integrity.

There is a distinction, however, between codes of ethics and the specific policies and procedures needed to ensure compliance with the codes and with securities laws and regulations. Although both are important, codes of ethics should consist of fundamental, principle-based ethical concepts that apply to all the firm’s employees. In this way, firms can effectively convey to employees and clients the ethical ideals that investment professionals strive to achieve. Supervisors implement these concepts through detailed, firm-wide compliance policies and procedures. Compliance procedures help employees fulfill the ethical responsibilities enumerated in the code of ethics and facilitate compliance with these principles in the day-to-day operation of the firm.

Standalone codes of ethics should be written in plain language and should address general ethical concepts. They should be unencumbered by numerous detailed procedures or boilerplate legal terminology. Codes presented in this way are the most effective in conveying to employees that they are in positions of trust and must act with integrity at all times. Mingling compliance procedures in the firm’s code of ethics is contrary to the goal of reinforcing the ethical obligations of employees in a simple, straightforward manner. To ensure a culture of ethics and integrity rather than one that merely focuses on following the rules, the principles in the code of ethics must be stated in a way that is accessible and easily understandable.

Members and candidates should encourage their employers to provide their codes of ethics to clients. A simple, straightforward code of ethics, unencumbered by compliance procedures, will be effective in conveying that the firm is committed to conducting business in an ethical manner and in the best interests of the clients.

A supervisor complies with Standard IV(C) by identifying situations in which legal or ethical violations are likely to occur and by establishing and enforcing compliance procedures to prevent such violations. Adequate compliance procedures should,

• be contained in a clearly written and accessible resource that is tailored to the firm’s operations,
• be drafted so that the procedures are easy to understand,
• designate a compliance officer whose authority and responsibility are clearly defined and who has the necessary resources and authority to implement the firm’s compliance procedures and investigate potential legal and ethical violations,
• describe the hierarchy of supervision and assign duties among supervisors,
• implement a system of checks and balances,
• describe the scope of the procedures,,
• include procedures to document the monitoring and testing of compliance procedures
• detail permissible conduct, and
• delineate procedures for reporting violations and sanctions.

Once a compliance program is in place, a supervisor should,

• disseminate the contents of the program to appropriate personnel,
• seek to periodically update the program to ensure that the compliance measures are relevant, effective, and legally adequate,
• continually educate personnel regarding the compliance procedures,
• issue periodic compliance reminders to appropriate personnel,
• incorporate a professional conduct evaluation as part of an employee’s performance review,
• monitor and review the actions of employees to ensure compliance and identify violators; and
• take the necessary steps to enforce the procedures once a violation has occurred.

Once a violation is discovered, a supervisor should,

• respond promptly,
• ensure a thorough investigation of the activities is conducted to determine the scope of the wrongdoing,
• increase supervision or place appropriate limitations on the alleged offender pending the outcome of the investigation, and
• review procedures for potential changes necessary to prevent future violations from occurring.

Regular ethics and compliance training, in conjunction with adoption of a code of ethics, is critical to employers seeking to establish a strong culture of integrity and to provide an environment in which employees routinely engage in ethical conduct and comply with the law. Training and education assist individuals in both recognizing areas that are prone to ethical and legal pitfalls and identifying those circumstances and influences that can impair ethical judgment.

By implementing education programs, supervisors can train their subordinates to put into practice what the firm’s code of ethics requires. Education helps employees make the link between legal and ethical conduct and the long-term success of the business; a strong culture of compliance signals to clients and potential clients that the firm has embraced ethical conduct as fundamental to the firm’s mission to serve its clients.

Even if individuals want to make the right choices and follow an ethical course of conduct and are aware of the obstacles that impair ethical conduct, they can still be influenced to act improperly by a corporate culture that embraces a “succeed at all costs” mentality, stresses results regardless of the methods used to achieve those results, and does not reward ethical behavior. Supervisors can reinforce an individual’s natural desire to act ethically by building a culture of integrity in the workplace.

Supervisors and firms must look closely at their incentive structure to determine whether the structure encourages profits and returns at the expense of ethically appropriate conduct. Problematic reward structures may not take into account how desired outcomes are achieved and encourage dysfunctional or counterproductive behavior. Employees will work to achieve a culture of integrity when compensation and incentives are tied to how outcomes are achieved rather than how much revenue is generated for the firm.

Mattock is senior vice president and head of research at H&V, Inc., a regional brokerage firm. She is responsible for H&V’s compliance procedures related to dissemination of research. Mattock has decided to change her recommendation for Timber Products from buy to sell. She orally advises other H&V executives of her proposed actions before the report is prepared for publication, as required by H&V’s compliance procedures. However, Mattock did not implement procedures designed to prevent dissemination of or trading on the information by those who are informed of changed recommendations. As a result of Mattock’s conversation with Frampton, one of the H&V executives reporting to Mattock, Frampton immediately sells Timber’s stock from his own account and from certain discretionary client accounts. In addition, other personnel inform certain institutional customers of the changed recommendation before it is printed and disseminated to all H&V customers who have received previous Timber reports.

Edwards, a trainee trader at Wheeler & Company, a major national brokerage firm, assists a client in paying for the securities of Highland, Inc., by using anticipated profits from the immediate sale of the same securities. Despite the fact that Highland is not on Wheeler’s recommended list, a large volume of the company’s stock is traded through Wheeler in this manner. Mason is a vice president at Wheeler, responsible for supervising compliance with the securities laws in the trading department. Part of her compensation from Wheeler is based on commission revenues from the trading department. Although she notices the increased trading activity, she does nothing to investigate or halt it.

Tabbing is senior vice president and portfolio manager for Crozet, Inc., a registered investment advisory and registered broker/dealer firm. She reports to Claudius, the president of Crozet. Crozet serves as the investment adviser and principal underwriter for ABC and XYZ public mutual funds. The two funds’ prospectuses allow Crozet to trade financial futures for the funds for the limited purpose of hedging against market risks. Claudius, extremely impressed by Tabbing’s performance in the past two years, directs Tabbing to act as portfolio manager for the funds. For the benefit of its employees, Crozet has also organized the Crozet Employee Profit-Sharing Plan (CEPSP), a defined contribution retirement plan. Claudius assigns Tabbing to manage 20% of the assets of CEPSP. Tabbing’s investment objective for her portion of CEPSP’s assets is aggressive growth. Unbeknownst to Claudius, Tabbing frequently places S&P 500 Index futures purchase and sale orders for the funds and the CEPSP without providing the futures commission merchants (FCMs) who take the orders with any prior or simultaneous designation of the account for which the trade has been placed. Frequently, neither Tabbing nor anyone else at Crozet completes an internal trade ticket to record the time an order was placed or the specific account for which the order was intended. FCMs often designate a specific account only after the trade, when Tabbing provides such designation. Crozet has no written operating procedures or compliance manual concerning its futures trading, and its compliance department does not review such trading. After observing the market’s movement, Tabbing assigns to CEPSP the S&P 500 positions with more favorable execution prices and assigns positions with less favorable execution prices to the funds..

Rasmussen works on a buy-side trading desk and concentrates on in-house trades for a hedge fund subsidiary managed by a team at the investment management firm. The hedge fund has been very successful and is marketed globally by the firm. From her experience as the trader for much of the activity of the fund, Rasmussen has become quite knowledgeable about the hedge fund’s strategy, tactics, and performance. When a distinct break in the market occurs and many of the securities involved in the hedge fund’s strategy decline markedly in value, however, Rasmussen observes that the reported performance of the hedge fund does not at all reflect this decline. From her experience, this lack of an effect is a very unlikely occurrence. She approaches Blair, her supervisor and the head of trading, about her concern and is told that she should not ask any questions and that the fund is too big and successful and is not her concern. She is certain that something is not right, so she contacts Saunders, the firm’s compliance officer, and is again told not to pursue the hedge fund reporting issue.

Burdette is hired by Fundamental Investment Management (FIM) as a junior auto industry analyst. She is expected to expand the social media presence of the firm. Burdette’s supervisor, Graf, encourages Burdette to explore opportunities to increase FIM’s online presence and ability to share content, communicate, and broadcast information to clients. Graf has not yet established policies and procedures for the firm that govern online communications.

As part of her auto industry research for FIM, Burdette is drafting a report on the financial impact of Sun Drive Auto Ltd.’s new solar technology for compact automobiles. This research report will be her first for FIM, and she believes Sun Drive’s technology could revolutionize the auto industry. In her excitement, Burdette posts a summary of her “buy” recommendation for Sun Drive Auto stock on her personal social media accounts.

Sokol is an investment adviser at a regional branch of Final Frontier Wealth Management (FFWM). Bartlett, FFWM’s compliance officer, is responsible for overall compliance of the firm’s investment advisers at all the company’s branches. For several years, Sokol directs over 100 of his retail clients to invest in a Feeder Fund, which provides its clients access to invest in another fund, the Alpha Fund. Alpha’s strategy uses complex option strategies and synthetic futures positions, which carry speculative and substantial risks with high volatility. Sokol recommends that his clients invest in the Feeder Fund without adequately assessing whether the product is suitable for them. Consequently, some of his clients with low risk tolerances and conservative trading preferences invest in the Feeder Fund. Due to extreme volatility in equity markets, Alpha loses about 35% of its value, resulting in losses of approximately $16 million for Frontier’s clients who invested in the Feeder Fund.

D’Addario is a trader for a broker/dealer, BOAC. D’Addario enters into an agreement with Amity Point Investments, a significant customer of BOAC, to provide artificially inflated price quotes for mortgage-backed securities in return for the promise of security trades being sent to BOAC. Amity Point uses those quotes to inflate the value of securities it holds and report inflated monthly valuations and net asset values for several of its funds. As part of the arrangement, Amity Point tells D’Addario the prices it wants to receive for certain bonds in the funds’ portfolios, and D’Addario gives Amity Point the valuations it requests. Bartolucci, BOAC’s chief executive officer, who is responsible for overall supervision at BOAC and is also D’Addario’s supervisor, knows that D’Addario is providing price quotes to BOAC customers as part of the brokerage business. However, Bartolucci does not develop policies or procedures concerning the provision of price quotes to clients.