In: Accounting
The Case
This case was developed by the MIT Sloan School of Management. It
is part of their “Learning Edge,” a free learning resource. This
case was prepared by John Minahan and Cate Reavis. This case is
based on actual events. Actual names are changed; some of the
narrative is fictional.
In early 2012, as he prepared to enter a meeting with the board of
trustees of a state pension fund, Harry Markham, CFA, couldn't help
but feel professionally conflicted.
Since earning his Master of Finance in 2004 at one of the top
business schools in the United States, Markham had worked for
Investment Consulting Associates (ICA), a firm that gave investment
advice to pension funds.
Since joining the firm, Markham had grown increasingly concerned
over how public sector pension fund liabilities were being valued.
If he valued the liabilities using the valuation and financial
analysis principles he learned in his Master of Finance and CFA
programs, he would get numbers almost twice as high as those
reported by the funds.
This would not be such a problem if he were allowed to make
adjustments to the official numbers, but neither his clients nor
his firm was interested in questioning them. The board did not want
to hear that the fund's liabilities were much larger than the
number being captured by the Government Accounting Standards Board
(GASB) rules and his firm wanted to keep the board of trustees
happy.
How, Markham wondered, was he supposed to give sound investment
advice to state treasurers and boards of trustees working from
financials that he knew were grossly misleading?
Markham's dilemma came down to conflicting loyalties: loyalty to
his firm, loyalty to the boards of trustees and others who made
investment decisions for public pensions and who, in turn, hired
his firm to provide investment expertise, and loyalty to the
pensioners themselves, as Markham believed was called for by the
CFA Code of Ethics and Standards of Professional Conduct.
In his role as investment advisor, the differing views on how to
value pension liabilities challenged Markham on both a practical
and an ethical level. "My role is not to decide the value of
liabilities," he explained.
That is the actuary's job. My role is to give investment advice.
However, as an investment advisor, the first thing you want to
understand is the client's circumstances. That is a basic ethical
precept. The CFA professional standards say you should never give
advice without knowing what your client's circumstances are. And so
what happens is that we have these funds that are grossly short of
money, but the accounting does not show them as being grossly short
of money. I make the case within my firm that we need to know where
we
are starting before we give advice. And perhaps our advice would be
different if the client knew they were starting from a
multi-billion-dollar hole that they're seemingly not aware
of.
In addition to the fact that Markham was constrained by not having
what he believed were accurate accounting figures to work with, he
was also well aware that his clients did not like bad news. He
feared that if he was to raise the liability issue, he and his firm
could very well be fired:
Most plan sponsors want to minimize near-term contributions to
their pension fund, and this makes them predisposed to points of
view that justify higher discount rates. Furthermore, investment
committees and staffs consider their mandate to be to earn, at
least, the discount rate assumed by actuaries. The social pressure
to embrace overly optimistic return expectations can be enormous.
As one plan sponsor told me, ‘It would not be in plan members'
interest to lower the discount rate because the increase in
liabilities would so shock the taxpayers and the state legislature
that it would undermine political support for the plan.' Given this
context, plan sponsors do not want to hear the news that they are
less well funded than the numbers show and may blame the messenger.
Moreover, if it is an elected official you are dealing with; they
do not want a crisis on their watch.
Nevertheless, an investment advisor has a professional
responsibility to help plan sponsors make sound investment
decisions, and understanding one's financial condition is a
necessary precursor to making sound investment decisions. This may
require telling plan sponsors things they do not want to hear. If
investment advisors do not do this, they become enablers of their
clients' denial and of the poor decisions that result from that
denial.
As a CFA charterholder, Markham annually attested to his compliance
with the Code of Ethics and Standards of Professional Conduct.
Specifically, CFAs must not knowingly make any misrepresentations
in investment analysis recommendations. "So if you have an
investment recommendation that is based on bad numbers," Markham
began, "numbers that are legal and comply with the rules, but you
know they are bad, are you violating this ethical rule?"
As Markham was summoned into the conference room to begin his
presentation to the board of the state pension fund, he was
wrestling with whether or not to raise the liability issue. He knew
there were risks either way. There was the risk that his client
would choose to take their business elsewhere if he told them what
he believed to be the fund's financial reality. Furthermore, such a
move would not only result in lost business but would likely be
interpreted as disloyalty towards his firm.
Then he thought about what did not happen during the 2008 financial
crisis, and this reality gnawed at him:
When the subprime crisis played out, everybody was asking why, even
though all these people had a role in making it happen, no one
spoke up? Therefore, does somebody who is playing a bit part in
creating a reprise of the last crisis have a responsibility to
speak up on behalf of the pensioners
themselves even though this is contrary to the wishes of their
employer and the board of trustees who has hired their employer to
provide investment advice?What are the alternatives with which Mr.
Markham must select? Be sure to discuss relevant laws, codes,
standards, and regulations.
CFA Code of Ethics and Standards of Professional
Conduct:
The CFA Institute Code of Ethics and Standards of Professional
Conduct are fundamental to the values of CFA Institute and
essential to achieving its mission to lead the investment
profession globally by setting high standards of education,
integrity, and professional excellence. High ethical standards are
critical to maintaining the public’s trust in financial markets and
in the investment profession. Since their creation in the 1960s,
the Code and Standards have promoted the integrity of CFA Institute
members and served as a model for measuring the ethics of
investment professionals globally, regardless of job function,
cultural differences, or local laws and regulations. All CFA
Institute members (including holders of the Chartered Financial
Analyst[CFA] designation) and CFA candidates must abide by the Code
and Standards and are encouraged to notify their employer of this
responsibility. Violations may result in disciplinary sanctions by
CFA Institute. Sanctions caninclude revocation of membership,
revocation of candidacy in the CFA Program, and revocation of the
right to use the CFA designation
THE CODE OF ETHICS
Members of CFA Institute (including CFA charterholders) and
candidates for the CFA designation (“Members and Candidates)
must:
1)Act with integrity, competence, diligence,respect, and in an
ethical manner with the public, clients, prospective
clients,employers, employees, colleagues in the investment
profession and other participants in the global capital
markets.
2)Place the integrity of the investment profession and the
interests of clients above their own personal interests.
3)Use reasonable care and exercise independent professional
judgment when conducting investment analysis, making investment
recommendations, taking investment actions, and engaging in other
professional activities.
4)Practice and encourage others to practice in a professional and
ethical manner that will reflect credit on themselves and the
profession.
5)Promote the integrity of and uphold the rules governing capital
markets
6)Maintain and improve their professional competence and strive to
maintain and improve the competence of other investment
professionals.
INTEGRITY OF CAPITAL MARKETS
1.Material Nonpublic Information. Members and Candidates who
possess material nonpublic information that could affect the value
of an investment must not act or cause others to act on the
information.
2.Market Manipulation. Members and Candidates must not engage in
practices that distort prices or artificially inflate trading
volume with the intent to mislead market participants.
DUTIES TO CLIENTS
A. Loyalty, Prudence, and Care. Members and Candidates have a duty
of loyalty to their clients and must act with reasonable care and
exercise prudent judgment. Members and Candidates must act for the
benefit of their clients and place their clients’ interests before
their employer’s or their own interests.
B. Fair Dealing. Members and Candidates must deal fairly and
objectively with all clients when providing investment analysis,
making investment recommendations, taking investment action, or
engaging in other professional activities.
C. Suitability.
1. When Members and Candidates are in an advisory relationship with
a client, they must:
a. Make a reasonable inquiry into a client’s or prospective
client’s investment experience, risk and return objectives, and
financial constraints prior to making any investment recommendation
or taking investment action and must reassess and update this
information regularly.
b. Determine that an investment is suitable to the client’s
financial situation and consistent with the client’s written
objectives, mandates, and constraints before making an investment
recommendation or taking investment action.
c. Judge the suitability of investments in the context of the
client’s total portfolio.
2. When Members and Candidates are responsible for managing a
portfolio to a specific mandate, strategy, or style, they must make
only investment recommendations or take only investment actions
that are consistent with the stated objectives and constraints of
the portfolio.
D. Performance Presentation. When communicating investment
performance information,Members and Candidates must make reasonable
efforts to ensure that it is fair, accurate, and complete.
E. Preservation of Confidentiality. Members and Candidates must
keep information about current, former, and prospective clients
confidential unless:
1. The in formation concerns illegal activities on the part of the
client or prospective client,
2. Disclosure is required by law, or
3. The client or prospective client permits disclosure of the
information.
DUTIES TO EMPLOYERS
A. Loyalty. In matters related to their employment, Members and
Candidates must act for the benefit of their employer and not
deprive their employer of the advantage of their skills and
abilities, divulge confidential information, or otherwise cause
harm to their employer.
B. Additional Compensation Arrangements. Members and Candidates
must not accept gifts, benefits, compensation, or consideration
that competes with or might reasonably be expected to create a
conflict of interest with their employer’s interest unless they
obtain written consent from all parties involved.
C. Responsibilities of Supervisors. Members and Candidates must
make reasonable efforts to detect and prevent violations of
applicable laws, rules, regulations, and the Code and Standards by
anyone subject to their supervision or authority.
INVESTMENT ANALYSIS, RECOMMENDATIONS, AND ACTIONS
A. Diligence and Reasonable Basis. Members and Candidates
must:
1.Exercise diligence, independence, and thoroughness in analyzing
investments, making investment recommendations, and taking
investment actions.
2.Have a reasonable and adequate basis, supported by appropriate
research and investigation, for any investment analysis,
recommendation, or action.
B.Communication with Clients and Prospective Clients.
Members and Candidates must:
1. Disclose to clients and prospective clients the basic format and
general principles of the investment processes they use to analyze
investments, select securities, and construct portfolios and must
promptly disclose any changes that might materially affect those
processes.
2.Use reasonable judgment in identifying which factors are
important to their investment analyses, recommendations, or actions
and include those factors in communications with clients and
prospective clients.
3. Distinguish between fact and opinion in the presentation of
investment analysis and recommendations.
C. Record Retention. Members and Candidates must develop and
maintain appropriate records to support their investment analyses,
recommendations, actions, and other investment related
communications with clients and prospective clients.
Keeping in View the above codes, standards and Regulations, Mr. Markham shall disclose all the material facts that effects their clients decision.