Ethics - soft dollar

CFA Level II
#1

Any thoughts on the below please;

Kaplan Qbank; Question ID: 1687250

“Perley & Sons is an investment advisor company that just signed a contract with full discretionary power for the management of assets for Bright Future, a charitable fund. Without consultation, portfolio manager Martin Brown, CFA, decides to trade the funds’ assets through a brokerage firm that provides, as an additional benefit, research reports for companies in the microchip industry. These companies represent the main investment interest for most of the Perley & Sons clients. The Bright Future portfolio does not hold any equities in the microchip industry, and, because of its risk profile, is unlikely to ever do so. Which of the following activities represents a possible breach with the CFA Institute standards?”

A) Lack of action in consulting with the client before choosing the brokerage firm.

B) Exercising a selection principle that does not comply with the idea of best trade price and execution.

C) Accepting research reports from the brokerage firm that do not benefit client portfolios.

I assumed the answer is C, but it turned out B!! with following explanations from Kaplan:

“The problem refers to the fiduciary duties of the analyst and brokerage contracts involving soft money. Trades placed with a broker that provides the firm with research are implicitly paying for the research. In a competitive marketplace, it is probable that the trades could have been as effectively placed with a broker that was able to provide research that would apply to the holdings of Bright Future. According to Standard III(A) Loyalty, Prudence, and Care, it is permissible to direct trades of the client portfolio through a broker who provides research that does not directly benefit the client portfolio, but the client should be informed about the situation.”

Does this chunk sound true: “it is permissible to direct trades of the client portfolio through a broker who provides research that does not directly benefit the client portfolio, but the client should be informed about the situation.”

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#2

You should always be basing your decision of broker on best price and/or best execution. No exception, to my knowledge.

If the broker, let’s say, did offer best execution and/or best price, but they also had this benefit for the microchip industry research, then what Brown is doing is fine as long as the arrangement is disclosed, and they also inform the clients that they are indeed getting best price/execution.

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#3

This is a hairy question, because that portion you have quoted at the bottom points to A being the correct answer. I tend to agree with the other responder here: if in doubt, focus on best price/execution as the top priority. The “it is probable” bit is believable but still shaky, in my opinion, but that is the logic the CFA is going with.