In this section, we are going to talk about offerings, trades, and transactions on customer accounts.
Let’s refresh our knowledge about trading securities in the secondary market.
You never know if the Series 6 exam might include a question that encompasses some overall knowledge of the various markets and those that operate in them.
As we know, the securities industry is regulated to ensure that investors are protected.
It’s been this way since the 1930s when the Securities Exchange Act was instituted and the SEC was created.
That regulation is carried out by the SEC and other SROs, for example, FINRA, which is the largest of the SROs.
There are others, however, like the MSRB and the CBOE.
No matter what the SRO, they all are accountable to the SEC.
As you know, the OTC market doesn’t have a central trading location and that means that it’s through negotiation that the securities sold here are priced.
In the OTC market, broker-dealers will have an inventory of securities that they sell to other broker-dealers.
They are also sometimes called market markers.
The price they ask for these securities in their inventories is known as the asked or offering price.
The price at which they buy securities from other broker-dealers is known as the bid price.
The customers of broker-dealers therefore can buy and sell securities on the OTC market.
The critical thing to remember here is:
- Bid price: This is the price at which customers sell and market makers buy securities at
- Ask price: this is the price at which customers buy and market makers sell securities at
Customers can receive the lowest price from market makers because there is competition among them.
This is regardless of whether they are buying or selling securities.
Let’s look a little more into the different parties at play in the OTC market.
The following are considered to be included under the definition of a broker:
- When a firm or individual executes, sells or buys orders that are put forward by an individual or another firm and they charge commission or other fees for doing so.
- When a brokerage firm carries out duties in the capacity of an agent for a customer and charges fees or commission for doing so
- When an individual’s role involves them carrying out securities transactions on other parties’ accounts. These parties cannot be banks, however.
When making a trade on behalf of others, a broker/agent will receive a commission or fee for doing so.
When a trade takes place and a brokerage firm acts as the principal therein, they are known as a dealer.
When buying or selling a security on their own account and taking the risk on themselves, a firm is acting as a dealer as well.
Following that, they can charge a markup or markdown to the customer.
Let’s just compare a broker to a dealer using a handy table.
- Broker: Also known as an agency or agent. They don’t have an inventory of securities but instead buy and sell on behalf of their customers. A commission is charged for carrying out those transactions. Because they have no securities of their own, a broker isn’t exposed to much capital risk.
- Dealer: Also known as a market maker or principal. They maintain an inventory of securities from which they buy and sell. The difference between the buy and sell prices, also known as the spread, markup, or markdown is how they make their profit. Because they have securities in their own inventory, they have capital at risk.
Some firms act as both brokers and dealers but can never do so when it comes to the same trade.
Let’s refresh ourselves on securities markets, particularly the secondary market, where securities are bought and sold.
There are two basic types, the OTC market which we’ve briefly mentioned, and then exchanges.
The difference between them is that on the OTC market, prices are negotiated while when it comes to exchanges, prices are determined by auction.
Let’s delve a little deeper into exchanges.
When you think of exchanges, you’d probably immediately have the NYSE jump into your mind.
That’s an example of a national exchange but there are others, even regional exchanges.
For the Series 6 exam, questions will likely be based on the NYSE, however.
For those exchanges that are more localized, or regional, stocks and bonds for companies from those areas are likely to be found.
For national exchanges, stocks for massive companies that have a national interest will be bought and sold.
Of course, for a company to list its stocks on either a regional or a national exchange, it will have to meet various requirements.
When it comes to pricing systems in operation at exchanges, there are a few things that you need to note.
First, exchanges do operate in a number of ways.
Yes, it’s electronically where most of the trading will take place, but they act as double-auction markets.
All this means is best prices are possible because buyers are in competition with buyers and sellers with sellers.
On the exam, should you see the term auction market used, it just means an exchange.
What about the OTC market?
Well, the over-the-counter market is for unlisted securities and it acts as an interdealer market.
Here, it’s telephone and computer networks that bring dealers from all over the United States together.
A large variety of securities are traded here, including municipal securities, government securities, stocks, and bonds.
There’s also the third market sometimes called OTC-listed.
When exchange-listed securities are traded on the OTC market, it’s often called the third market.
Third-market transactions in listed securities are carried out through broker-dealers.
They must be registered as OTC market makers to be able to carry out these transactions.
So when is a security considered to be trading on the third market?
Well, there are two conditions.
First, an exchange must be the principal trading market for that security.
Second, it’s from that exchange floor where the security is traded.
There is a fourth market as well.
This is where large blocks of stock are traded but mainly for institutional investors.
These stocks can be both listed and unlisted.
Interestingly, there are no broker-dealers involved in these trades and they are always negotiated privately between the institutional investors that want to trade them.
When it comes to trading, this is all carried out through electronic communication networks.
For the Series 6 exam, there might be a question regarding stock trade sizes on the secondary market.
Trades take place in round lots.
These round lots will always be 100 shares, so if the question mentions seven round lots, you know that is 700 shares.
Any number of shares under 100 will be called an odd lot.
Most states have various conduct laws relating to the financial situation of a customer and it’s something that a broker-dealer, registered representative, or investment adviser has to delve into.
That’s because before they can provide a recommendation to the customer about what securities to buy, sell or exchange, knowing this information is a necessity.
So what information is necessary?
Well, the following is key:
- What securities do they hold?
- Their income
- Their net worth
- Their financial goals
- Their objectives
When it comes to fair dealing, these activities are considered to be violations:
- The recommendation of unsuitable investments based on the risk tolerance and financial situation of the customer
- Mutual funds short-term trading
- Carrying out prohibited transactions by setting up fictitious accounts
- Making use of funds in an authorized manner
- Carrying out unauthorized transactions
- Based on the customer’s ability to pay, suggesting purchases that they would struggle with
- Carrying out any fraudulent activities. This includes making misstatements, leaving out material facts, as well as forgery, for example
- Providing a guarantee against loss for the customer
Sharing and guarantees in customer accounts
We’ve mentioned it above briefly, but let’s talk about providing guarantees to customers.
This is simply something that broker-dealers, investment advisers, agents, or investment adviser representatives may not do at all when it comes to protecting against a loss that the customer might incur.
That’s not all, either.
Profits or losses in a customer account cannot be shared by representatives, advisers, or members either.
This is possible on an approved joint account, however, and that approval will have to come from the member firm.
Should a joint account be shared, there are some aspects to remember.
According to the financial contributions made by the parties involved in the account, sharing should be proportionate.
Should an associated member share an account with an immediate family member, it’s not required that direct proportionate sharing on the account takes place.
When we speak about immediate family members, we are talking about those that are parents, children, in-laws, spouses, and siblings as well as anyone dependent from a financial aspect on the employee.
FINRA Rule 3170 – Registered persons and tape recordings
In some situations, for example, if a firm hires someone who previously worked for another member firm that FINRA has disciplined, those new staff will need to be monitored.
FINRA considers firms that have been expelled from any SRO membership or had an SEC order passed against them that revokes their broker-dealer license as a disciplined firm.
This monitoring will have to be in relation to any telemarketing that they carry out and to do that, certain procedures will need to be drawn up.
Interestingly, it’s not only those new staff that need to be monitored but Rule 3170 says that if they have been hired, all registered staff’s telemarketing activities must be kept track of.
FINRA uses the following criteria:
- Level A: Number of employed registered representatives: Between 5 and 9. Number of those from firms that have been disciplined: 40% and above
- Level B: Number of employed registered representatives: Between 10 and 19. Number of those from firms that have been disciplined: 4% and above
- Level C: Number of employed registered representatives: Between 20 and above. Number of those from firms that have been disciplined: 20% and above
In other words, should there be 15 registered representatives in a member firm and they hire another four (or more) from a firm that was disciplined within the three years before their hiring date, the calls of all registered persons must be monitored (including cold calls).
FINRA will advise firms as to when these procedures must be instituted.
Once they have received the instruction, all telephone conversations must be recorded and there is a 60-day period for the firm to install a system that does so.
Any quarterly reports from these registered representatives as well as the recordings will need to be kept on record for a three-year period.
Interestingly, when firms are first notified by FINRA regarding this rule and the need to implement the correct recording procedures, they have the chance to opt-out.
They can only do this, however, by dropping below the threshold levels.
To do this, they will need to change their current staff numbers.
This means they can terminate contracts but not any staff that doesn’t come from the disciplined firms – it is only their contracts that can be terminated.
Obligations linked to best execution practices
Best execution is something that should be at the forefront of a broker-dealer’s mind for every transaction that they are involved in.
Essentially, best execution is a way for the investor to have protection when it comes to the transaction.
This means that at all times, the best possible terms available must be found for a customer when the broker-dealer is executing an order for them.
This is related to any security, option, debt security, or whatever the investment is.
No matter if a transaction is for a customer or with them, FINRA Rule 5310 requires that the member firm or those associated with them at all times will look for the best possible market for the security, whether it is to buy or sell.
Ultimately, the aim is to find a price that favors the customer in the best possible way.
This describes when another broker-dealer is added to a transaction.
This can be transactions that are with a customer or for them.
Either way, the buyer or seller receives no benefit when this is carried out.
Note, however, that the practice of interpositioning is prohibited by regulatory authorities when another broker-dealer is added to the transaction and as a result of that, the client, either the buyer or the seller, is forced to pay extra commissions or fees.
Historically, when this has occurred, the broker-dealers involved have reciprocal agreements to add each other to their respective transactions, even when this is not necessary and then charge extra fees.
Note that for the Series 6 exam, know that the principal of the firm will review all trades in which the broker-dealer is involved.
This doesn’t always mean that they give approval, however.
Disclosing compensation when transferring accounts to a new firm, particularly that received from brokers or dealers
Finra instituted Rule 2273 as a way to protect customers when transferring accounts from one broker-dealer to another.
The main worry here was that customers weren’t always told about the direct costs involved as well as the other fees or compensation that they may need to pay when transferring their assets.
When an account is not linked to any lien for monies owed by the customer, member firms cannot interfere in a request to transfer said account should there be a change in employment of the customer’s registered representative.
The rule also says that education must be carried out by a registered representative should they move to another firm and ask their customers to move with them.
This should outline all the considerations that a customer must take into account.
This could include those things that could benefit the registered representative should the client move to the new firm, for example, if they receive a financial incentive for bringing them in.
This kind of educational information must be delivered when either the firm or the registered representative contacts one of their former clients as well as when a former client contacts their previous registered representative.
When we talk of a former customer, it is someone that has their securities account at the previous firm of the representative and assigned to a registered person.
Above, we spoke about the educational information that a client must receive when the possibility exists that they will transfer their business to another firm, even if they are going to follow their registered representative who is changing jobs.
This communication must highlight the following:
- If a conflict of interest will be created by any financial incentives a representative receives
- Cost may be incurred to liquidate some assets that cannot be directly transferred to the new firm or if they leave them with the old firm, account maintenance fees will still apply
- Other potential costs that result from the transfer. This could include different fees and pricing structures at the new firm as opposed to their old one
- The differing services and products offered between the customer’s current firm and the one they would like to move to
When it comes to contacting the customer regarding educational information, this can be carried out in several ways.
It could be face-to-face, by telephone, in writing, or electronically.
Most firms will send this information electronically or include a hyperlink in an email directing a customer to a website where they will find all the educational information as outlined above.
Oral communication isn’t just about telling the customer but also then informing them that they will receive a written copy of the educational information as well.
This will be sent to them within three business days after the initial oral communication has taken place and must include all the important considerations as highlighted above and that will impact their decision as to whether they will transfer their assets or not.
Educational communication must be delivered with the documentation related to account approval if the former customer tries to transfer their assets before they have been contacted regarding the educational information.
There are communication exceptions related to FINRA Rule 2273.
For example, if a former client that’s contacted by a registered representative or their new firm indicates they do not want to transfer their assets, no educational information has to be sent to them, which is pretty understandable.
Should they change their mind, however, it must be sent, if they have not received any further individualized contract.
This is only applicable within three months from the date their former registered representative starts their job at the new member firm.
The last thing to know about FINRA Rule 2273 is that it only applies to natural persons and not other institutions that are transferring assets.