This standard has two parts:
A. Diligence and Reasonable Basis
This standard states that the member must exercise diligence, independence, and thoroughness while analyzing investments, making recommendations, and taking investment actions.
The member must also have a reasonable basis supported by research and investigation for investment analysis, recommendations, and actions.
Example of Violation
- Example 1: An investment advisor comes across a stock that is expected to substantially rise in value because of a change in government regulations. However, the investment advisor does not have sufficient resources to conduct research on this matter. Instead he goes by his gut feeling and recommends the stock to his clients. This is a violation of law as the investment advisor has not conducted sufficient due diligence before making a recommendation to his client.
- Example 2: A student of finance, while pursuing his education becomes a part-time analyst at an investment firm. He is expected to provide one research report with his recommendation every month. Because of the time pressure due to studies and work, he prepares the next month’s report based on the news reports and general discussions about a stock in the discussion forums. This is a violation of law because his research and recommendation does not have a reasonable basis.
- Example 3: An investment analyst has just completed his research report, after one month of researching. The report is due to be published in the next two days. Just then he finds out that one of the sources of information has updated their data correcting a major reporting error concerning the stock. The investment analyst gets to know about this update but does not update his research report with the updated information. Two days later, the report is published as it is. This is a violation of the law.
- Example 4: A small investment firm makes recommendations to their clients based on third-party research. The members can rely on third-party research but if they don’t make reasonable effort and diligence to validate the report’s recommendations, then it will be considered a violation of law.
B. Communication with Clients and Prospective Clients
This standard states that the members disclose their investment processes to clients and prospective clients. This includes information such as formats, investment principles, and changes in the processes, etc.
The members should reasonably identify the important factors affecting their investment processes and communicate them to their clients.
The members while presenting investment analysis to clients should distinguish between facts and opinions.
Examples of Violation
- Example 1: An investment firm sends out a paid investment newsletter to high net worth individuals. In the newsletter it only includes information about the top buy and sell recommendations. But does not specify the process of investment valuation and basis of the recommendations. This is a violation of law, as the newsletter should at the minimum provide the basic process and logic behind the recommendations.
- Example 2: An energy analyst provides a buy recommendation for an energy company. Based on indirect information, he made his own estimate of the energy generation capacity of the firm but in his report he stated it as a fact. This is a violation of the standard as he has stated his opinions as facts.
- Example 3: An investment fund has been consistently doing well and invests only in dividend stocks. The investment manager decided to change its policy and starts including growth stocks in the fund. If the investment manager does not communicate this change in investment philosophy to his clients, he will be violating the standard. Another example of a similar violation would be if a fund whose processes are inclined towards active fund management decides to change the processes to focus on passive management strategies.