Mid-afternoon snack (Ethics)

No harm in getting these going again … try not to cheat. Applejack/McGarnicle Case Scenario Chandra McGarnicle, CFA, is a senior fixed-income analyst at Outer Rim Financial Corporation. McGarnicle develops financial models for predicting changes in bond prices. On the premise that bonds of firms targeted for leveraged buyouts (LBOs) often decline in value, McGarnicle develops a model to predict which firms are likely to be subject to LBOs. McGarnicle works closely with another analyst, Dakari Applejack, CFA. Applejack uses McGarnicle’s model frequently to identify potential LBO targets for further research. Using the model and his extensive research skills, Applejack makes timely investment recommendations and develops a strong track record. Based on this record, Applejack receives an employment offer from the asset management division of Rain Man Investments, Inc., a diversified financial services firm. With McGarnicle’s consent, Applejack downloads the model before leaving Outer Rim. At Rain Man, Applejack presents the idea of predicting LBO targets as a way to identify bonds that might decline in value and thus be good sell recommendations. After Applejack walks his boss through the model, the supervisor comments, “I like your idea and your model, Dakari. I can see that we made the right decision in hiring you.” Because Rain Man has both an Investment Banking (IB) and Asset Management (AM) division, Applejack’s supervisor reminds him that he should not attempt to contact or engage in conversation with anyone from the Investment Banking division. The supervisor also directs him to eat in the East end of the company cafeteria. “The West end is reserved for the IB folks, and you may laugh at this, but we actually put up a wall, between the two ends. If anyone were to accuse us of not having a firewall, we could actually point to it!” Dakari’s supervisor also tells him, “There should be absolutely no conversation about divisional business while in the hall and elevator that serves as a common access to the cafeteria for both divisions. We are very strict about this.” The following week, Applejack is riding alone in the elevator when it stops on an IB floor. As the doors begin to slide open, Applejack hears a voice whispering “I am so pleased that we were able to put the financing together for Softcore Industries. I was concerned because the leverage will go to 80%—higher than our typical deal.” As soon as the doors open enough to reveal that the elevator is occupied, all conversation stops. Late that afternoon, Applejack uses the LBO model to measure the probability of Softcore Industries receiving an LBO offer. According to the model, the probability is 62%—slightly more than the 60% Applejack generally requires before conducting additional research. It is late in the afternoon and Applejack has little time to research the matter fully before the end of the trading day. He checks his inputs to the model. In the interest of time, Applejack immediately recommends selling Softcore Industries’ senior bonds held in any long-only accounts. He also recommends establishing positions in derivatives contracts that will benefit from a decline in the value of Softcore Industries’ bonds. The next morning, after the firm has established the derivatives positions he recommended, Applejack calls McGarnicle. Knowing that his former associate will be preparing Outer Rim’s monthly newsletter, he tells her “I ran Softcore Industries through your model and I think it is likely that they will receive an LBO offer.” Applejack explains some of the inputs he used in the model. At the conclusion of the conversation McGarnicle responds, “You may be right. Softcore Industries sounds like a possible LBO candidate, and thus, a sell rating on their senior bonds would be in order. If I’m lucky, I can finish researching the issue in time to include the recommendation in the upcoming newsletter. Thanks. It was good talking with you, Dakari.” After the conversation with Applejack, McGarnicle quickly runs Softcore Industries through the model. Based on her inputs, the model calculates that the probability of an LBO is 40 percent—not enough, in McGarnicle’s opinion, to justify further research. She wonders if there is a discrepancy between her inputs and Applejack’s. Pressed for time, McGarnicle resumes her work on the upcoming newsletter rather than investigating the matter. Applejack soon begins searching the Internet for information on companies that the model predicts have more than a 60% probability of an LBO offer. He scours blogs and company websites looking for signs of a potential offer. He uses evidence of rumored offers in developing sell recommendations on various corporations’ bonds. 26. When downloading the model from Outer Rim Financial Corporation, does Applejack violate any CFA Institute Standards of Practice and Professional Conduct? A. No. B. Yes, because he does not have written permission from McGarnicle. C. Yes, because he does not have permission from Outer Rim Financial Corporation. 27. When using the model at Rain Man, Applejack is least likely to violate the Standard relating to: A. misrepresentation. B. loyalty to employer. C. material nonpublic information. 28. When making the recommendation regarding Softcore Industries, does Applejack violate any CFA Institute Standards? A. No. B. Yes, relating to diligence and reasonable basis. C. Yes, relating to material nonpublic information. 29. In his phone conversation with McGarnicle, Applejack least likely violates the CFA Institute Standard relating to: A. suitability. B. integrity of capital markets. C. preservation of confidentiality. 30. When analyzing the probability of an LBO of Softcore Industries, does McGarnicle violate any CFA Institute Standards? A. No. B. Yes, relating to independence and objectivity. C. Yes, relating to diligence and reasonable basis. 31. When searching blogs does Applejack violate any CFA Institute Standards? A. No. B. Yes, because he misuses company resources. C. Yes, because he seeks inside information on the blogs.

I can’t believe your ready to jump back in again … as a fellow L2 failer, my answers are below: 26. C 27. C 28. B 29. A 30. A 31. A

Very close … 26. C is correct. McGarnicle, as an employee, developed the model on behalf of Outer Rim. Therefore, Outer Rim, not McGarnicle, is the owner of the model. Applejack violates Standard IV(A) Duties to Employers: Loyalty when he downloads the model without proper written permission from Outer Rim Financial. Applejack is misappropriating employer assets. 27. C is correct. Applejack is least likely to violate Standard II(A) regarding Material Nonpublic Information when using the model at Smith and Garner. Applejack likely violated Standard IV(A), Loyalty, when he used the model. The Standard prohibits members who leave an employer from taking records or files—such as the model—without the written permission of the employer. Applejack also likely violated Standard I© Misrepresentation when he failed to correct his supervisor’s impression that the investment idea and the model were Applejack’s creation. 28. C is correct. Applejack violates Standard II(A) Material Nonpublic Information. He has a reasonable belief that the conversation that he overhears is from a reliable source and would have a material impact on security prices. According to CFA Standards, he must not act, nor cause others to act on the information. Applejack does not violate the Standard relating to Diligence and Reasonable Basis because he bases the recommendation on a reliable model and checks his inputs prior to making the recommendation. 29. A is correct. Applejack least likely violates Standard III© which relates to suitability during his phone conversation with McGarnicle. According to the Standard, members in an advisory relationship with a client must determine an investment’s suitability within the context of the client’s portfolio. The Standard also requires that members make reasonable inquiries into a client or prospective client’s investment experience; risk and return objectives; and financial constraints prior to making investment recommendations. McGarnicle is neither a client nor a prospective client, thus Applejack is not bound by the Standard of Suitability during their conversation. Applejack is, however, in jeopardy of violating other Standards—specifically those relating to Integrity of Capital Markets and Preservation of Confidentiality by revealing material nonpublic information about a Rain Man client. According to Standard II(A), Applejack, who is in possession of material nonpublic information, must not act, nor cause others to act on the information. According to Standard III(E), members must keep information about current, former, and prospective clients confidential. 30. A is correct. McGarnicle uses her usual process in researching Softcore Industries. She is not in possession of material nonpublic information and she maintains her objectivity. Her use of the model provides a reasonable basis for the decision not to pursue additional research or make an investment recommendation regarding Softcore Industries. 31. A is correct. Blogs and company websites are in the public domain and thus do not constitute inside information. Applejack’s use of blog sites to supplement his current research process is acceptable.

I swear I read this exact scenario and the same questions in the curriculum yesterday. Did the company names or something just change?

Names were changed to protect the innocent.