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Wanda Brunner, CFA, is preparing for her first meeting with the Johnsons—her firm's newest
clients. She makes notes regarding disclosure of the investment process. These notes most
likely include reminders to:
A)
anticipate changes in her clients’ investment objectives that could cause them to
leave her firm.
B) adequately disclose the basic security selection and portfolio construction process.
C)
notify her supervisors of any potential change in the security selection and portfolio
construction process.
William Fleming is an investment advisor for GlobalBank, a large, multinational financial
corporation. He is based in the New York office, and his client base consists of medium to
large institutional accounts in the United States and Western Europe. Roughly three-
quarters of his clients pay performance-based fees, while the remaining one-quarter pay
fees based on assets. GlobalBank's investment banking division is an industry leader, and
Fleming is able to offer his clients the opportunity to participate in some of the hottest initial
public offerings (IPOs) and secondary offerings brought to market.
One of Fleming's accounts, Waverly Capital Partners, has contacted him regarding an
upcoming secondary offering by DCH Corp., for which GlobalBank will serve as lead
underwriter. Waverly has already performed its due diligence on the offering and is
interested in purchasing a substantial position in the secondary offering in order to employ
the company's current surplus of cash. Waverly's representative tells Fleming over the
phone that they would like to purchase 5,000 shares of the offering but gives no other
details of its analysis of the offering. Fleming has not read the prospectus for the offering yet
and is not familiar with the details, but because he has confidence in Waverly's investment
expertise, he tells them that he too believes they should participate in the offering. Because
Waverly does a significant amount of business with GlobalBank's other divisions, Fleming
assures them that they will be able to obtain their desired allocation of the offering and
takes the order.
After taking the purchase order for the Waverly account, Fleming thoroughly reads the
prospectus and marketing materials for the offering, as well as past research reports on the
issuing company. He determines that DCH shares would be a suitable investment for one of
his other clients, The Crockett Foundation. He contacts the Chief Investment Officer (CIO) of
the foundation, explains how an investment in DCH would fit with its current risk and return
objectives as detailed in the foundation's investment policy statement (IPS) and provides her
with the prospectus for the offering. Fleming tells her that GlobalBank was the lead
underwriter for DCH's initial public offering three years ago and that since then, the stock
has outperformed the S&P 500 by at least 15% every year. Fleming also states that the
company's financial position is now even stronger and that the shares will perform at least
as well as the lowest return earned on the IPO shares in the last three years. He then
proceeds to tell her, "If the foundation is interested in the offering, you should place an
order immediately because the issue may be oversubscribed due to strong interest in the
offering from Waverly Capital Partners and other clients." This information is enough to
motivate Crocket's CIO to call a meeting with the foundation's investment committee.
After a quick meeting with Crockett's investment committee, the CIO calls Fleming to say
that the foundation is interested in the offering and would like to place a purchase order.
Crockett does not currently conduct any additional business through GlobalBank's other
divisions. Because of GlobalBank's trade allocation policy, coupled with the high probability
that the offering will be oversubscribed, Crockett is unlikely to be allocated as many shares
of the offering as they would like to purchase. In order to obtain the desired number of
shares for the client, Fleming devises a plan. He plans to add the Crockett Foundation's
order to Waverly's order, and once the order is filled he will re-allocate the extra shares back
to the foundation's account at the end of the day. He feels that his action is justified because
Crockett has maintained its account with Fleming and GlobalBank for over ten years. In
addition, Fleming has traders at GlobalBank sell large blocks of DCH over several days in
order to push the stock price lower. The drop in value causes smaller investors at
GlobalBank, who are not Fleming's clients, to withdraw their orders for shares of DCH's
secondary offering. Fleming determines that the fewer number of purchase orders and the
plan to piggyback on Waverly's order will allow Crocket to acquire its desired allocation of
shares in DCH's secondary offering. Having achieved his goal, Fleming allows GlobalBank's
traders to repurchase the firm's shares of DCH.
Twelve months pass, and the shares of DCH's secondary offering have declined in price by
nearly 20%. The CIO of the Crockett Foundation calls a meeting with Fleming to discuss the
poor performance of the security and to review the basis upon which Fleming recommended
the investment. Fleming prepares Crockett's file to take with him to the meeting. The file
contains Crockett's IPS, a detailed account of the purchase order and all conversations held
between Fleming and the CIO. In accordance with his own established procedures, however,
Fleming maintained the original analysis supporting the purchase of shares in DCH's
secondary offering for nine months after the investment was made.