Series 63 Study Guide Navigation

When someone first shows interest in the services of a broker-dealer, for example, they aren’t considered a customer, but first, a prospect.

This is important because it impacts what they can be told as they move through the various stages.

This is to protect them and the securities professional they deal with. 

Regulatory authorities can take action if these regulations are not followed, including suspension or having licenses revoked. 


Here are the disclosure types that both clients and prospects need to hear.

Broker-dealer disclosures

When disclosures are handled properly, securities professionals’ lives are so much easier. 

We start with disclosure of capacity by broker-dealers.

We know there are two ways in which a broker-dealer can operate – as a principal or as an agency.

As the principal, they are a contra party to the trade, which means they are on the other side of the trade taking place. 

So they are selling a security that the client buys and that results in a profit for the firm. 

When the trade is the other way around, the firm is a principal too.  

In this case, the firm will earn a profit based on the markdown.

In an agent’s capacity, the firm has clients that are the buyer and seller.

The buyer or seller could be their clients or from time to time, both could be. 

Commission earned on these deals is how firms make a profit. 

To tell what capacity a firm is operating, look at the trade confirmation as it is recorded on it.

This will also include the settlement date as well as the commission or markup earned,  

Next, we have conflicts of interest and the disclosure thereof.

Any potential conflicts of interest must be disclosed to a client.  

But what is a conflict of interest?

It occurs when a broker-dealer takes advantage of the situation they are in with their client and does what is best for themselves and not the client.

By informing a client of a potential conflict of interest, the ball is then in their court as to what action should be taken. 

When telling a client about fees proper disclosure is critical too

Fee information should be available at all times and easy to access.

There are many ways that full disclosure regarding fees can be carried out:

  • When new accounts are opened, the fee structure should be passed on to clients. Any changes at any point should lead to communications with the client as well, with the NASAA saying this should happen 30 days before the changes come into effect.
  • Any fees and charges that the customer must pay must be clearly indicated on the relevant forms they completed. Up-to-date fee structures must be available on the firm’s website too.
  • For clients to be able to compare fees, standardized terminology must be used. 

When it comes to fees, these don’t need to be part of the disclosure document:

  • Commissions
  • Markups and markdowns
  • Advisory fees

There is a requirement to disclose them at all times, but fees are never part of the disclosure documents, but others.

Investment adviser brochure rule

Next, we will discuss the investment adviser brochure and the disclosures surrounding it.

This is a regulatory requirement that the clients of an investment adviser must receive this written document. 

It will have all the disclosures that the advisory client should know and helps ensure disclosure rules aren’t broken. 

This statement will also indicate any adverse interests of the broker-dealer, for example, the compensation the customer will pay on their account.

And if they are getting other compensation over and above the agreed advisory fee this must also be included.

Another disclosure to prospects and current clients is that of material disciplinary action taken against the adviser or firm over the last 10 years. 

Disclosure regarding this is as follows:

  • If a person in management or the adviser has violated any rules. Also, the regulatory proceedings that followed must be included and if that resulted in a denial, suspension or revocation of their license.
  • Court cases against the firm or its management resulting in temporary or permanent injunctions for investment-related activities or felonies
  • If the business lost its registration in proceedings against it from regulatory bodies. This would be as a result of the actions of either an adviser or management. Any expulsion, barring, fines, or suspension that resulted must be disclosed too.  

A registered or already registered investment adviser must provide the following information to prospective clients and advisory clients:

  • A written document or brochure which can be a copy of Part 2A of Form ADV (if a brochure) or including the information required by Part 2A of Form ADV (if a written document)
  • Part 2B brochure supplement copies if an individual has direct contact in this state and provides investment advice or exercises discretion over client assets (even without no direct contact).
  • Part 2A Appendix 1 wrap free brochure, when a wrap free account is sponsored or participated in by the investment adviser
  • Material changes summary, if applicable as a separate document or as in inclusion in Form ADV Part 2

Here are the requirements for brochure delivery outlined by the NASAA Model Rule. 

On initial delivery, prospective advisory clients must receive the Part 2A brochure and Part 2B supplements.

It has to be done prior to entering into an advisory contract with a prospective client or client, and at least 48 hours before.

After they have entered into an advisory contract, a client can terminate within five business days with a penalty imposed.

What about annual delivery?

This is necessary only if material changes have taken place.

Should that be the case, an updated brochure and supplement must be delivered (for free) within 120 before the end of the fiscal year.  

Or the client can receive just the material changes that have taken place.

This, however, must include information as to how they can get an updated brochure and supplement if they wish to.

These rules govern the delivery of the brochure if done electronically.

 This can be carried out if:

  • As part of an initial delivery, the client received a readable copy of both the brochure and any supplements and this can be verified. 
  • Client consent is received for further deliveries 
  • The format used for the electronic delivery is as that set out in the Form ADV Part 2 instructions
  • When delivered electronically, the format can be retained as is or printed, if needed
  • The personnel that send the electronic communications follow established procedures in doing so

Registrations: Unlawful representations 

Misrepresentation can be seen as fraud and should be avoided.

Two areas need to be considered:

  • The registration of the securities professional
  • A securities registration

Guarantees of performance

There are few things that can be guaranteed in the world of securities.

Let’s look at a guaranteed security.

This is when a party other than the issuer guarantees the principal and interest in a debt security or the dividend in an equity security.

The most critical aspect is that the performance of the investment cannot be guaranteed.

What about guarantee against losses?

It is not permissible to guarantee performance.

If the price of a stock does not reach a certain level, a securities professional isn’t allowed to make up the difference.

They cannot promise that should the investment not perform, they will buy it back at a little more than it cost the investor.

However, investment advisers are allowed to receive performance-based compensation under certain conditions.

A client’s advisory contract can show that if the investment return is higher than the index chosen, the advisor will receive higher compensation.

It is also true that fees are reduced if the index performs better than the account.

Any bona fide error can be corrected by a broker-dealer but not by an associated person.  

Customer agreements

There are various elements that regulations require regarding customer agreements.

Investment advisers and performance-based compensation

Certain performance fee arrangements cannot be included in advisory contracts when it comes to capital gains or appreciation.

For a qualified client contract, when it comes to performance provisions, there are exceptions and the fee cannot just be calculated on gains but also must include losses as well as depreciation and unrealized and realized losses. 

Fees that cover a certain period and take into account the average amount of money under the investment adviser’s management are not considered performance fees.

An administrator may grant an exception if they believe the client understands the risks and has the necessary investor sophistication, even if they don’t meet qualified client requirements.

Brokerage account agreement

New clients opening an account will complete a new account agreement.

As a contract between the parties, this agreement outlines not only the client’s rights and responsibilities, but vice versa as well.

It will also include what the client can expect in terms of what the broker-dealer will charge for their services. 

In addition, other information needs to be determined, such as:

  • Does the customer have the legal capacity to sign the agreement? 
  • Details about the client’s employment
  • Information related to the Customer Identification Program (CIP) including all the necessary details about the client
  • Visa or citizenship details
  • Financial information about the client

If the client is to open a margin account there are some extras.

Margin accounts enable investors to leverage their investment dollars.

Clients can pledge collateral using purchased stock.

This allows them to make more purchases using money they borrowed from the brokerage.  

Two agreements must be signed when a margin account is opened:

  • Credit agreement: This document outlines the terms on which the broker-dealer extends credit to its clients. 
  • Hypothecation agreement: In this agreement, a client gives permission to the brokerage to use the securities the client has loaned as collateral. 

There is a third optional form as well.

  • Loan consent form: Customers who fill out this form agree that their margin securities can be loaned out in short sales to other broker-dealers or customers.  

Risk disclosure documents are also associated with margin accounts.

This is a FINRA requirement. 

A client receives this when they open a margin account with their broker-dealer and once per year thereafter.

Risk disclosure documents highlights the following:

  • Margin accounts can cause investors to lose more than what they initially deposited
  • Clients can be forced to sell assets or securities in their account without their consent
  • If a request for additional funds is not met, the client cannot choose which securities to sell to meet their obligation
  • Customers are not entitled to an extension of time when meeting a margin call
  • Clients do not need to be notified in advance when house margin requirements are increased.

Now we look at option accounts.

NASAA does not have specific rules for when to open an options account, so we need to look at FINRA’s rules.

In order to open an options account, a supervisory person designated by the firm who is familiar with options trading has to approve it.

Options trading has a higher degree of risk when compared to trading bonds, stocks, or mutual funds and that’s the reason why. 

Most of the time, the person in this supervisory role will be a registered options principal (ROP).

Customers have to receive a special options disclosure document (ODD), which is published by the Options Clearing Corporation (OCC). 

When a broker-dealer or agent wants to open an options account for a client, they do their due diligence first.

That means they need to determine the following information from their client:

  • Investment objectives
  • Current financial situation
  • Overall investment knowledge and experience 

Normally, that last point isn’t required for brokerage accounts, but for options accounts, it’s essential.

If you’re looking to understand their overall knowledge, then you should consider the size and frequency of their trading and transactions carried out. 

For example, did they trade commodities, other financial instruments, options or just stocks and bonds?

This research helps the ROP make the correct decision on whether an options account should or shouldn’t be opened.

If account approval is given, this confirms:

  • An ODD has been received 
  • The transaction approval on the account, for example, discretionary, spreading, etc.
  • Which agent is assigned to the account
  • The supervisor who approved the account
  • Currency of account information’s verification date

Within 15 days of the account having been opened, the customer must provide a written agreement to the broker-dealer confirming their agreement to FINRA option trading rules. 

Part of this will confirm a client’s acknowledgment of OCC rules and the fact that they are bound by them. 

Next, we look at options basics.

Knowing how options work is critical for the Series 63 exam. 

An options contract is known as a two-party contract because it involves two parties.

One party has the right to buy or sell the underlying security.

This is known as exercising the contract.

The other part, they have an obligation towards the terms of the contract over a specific time period, but never longer than nine months. 

Buyers face a risk in this situation, as if the option expires worthless, the money they used to buy the contract is lost. 

The profit goes to the party selling the option, and what the buyer paid for it is the amount they earn. 

When the stock that’s bound to the option moves in the direction the buyer wants, they stand to make a profit.  

It’s almost as if the buyer is the winner here and the seller is the loser.

Both parties can see potentially unlimited profit but also loss.

That’s why broker-dealers must ensure that clients who trade in options understand the risk of unlimited potential losses. 

What about calls and puts?

Well, these are types of options available on stock. 

A call gives the buyer the right to buy stock at the specified exercise price because the seller has granted them the option to do so.

There is no obligation to purchase, however. 

The buyer is said to be bullish in this position. 

Let’s look at put options and how they work. 

Well, it’s essentially the reverse of how a call option operates. 

That means it’s the right of the buyer to buy or sell (or put) the stock and they carry this out to the put option seller at a specified exercise price. 

A buyer in this situation is said to be in a bearish position since they would profit if the price of the stock dropped.

Put buyers do not have the unlimited risk associated with short selling but they reap the benefits of an investor who is bearish and sells the stock short.

Correspondence and advertising

In any form of communication with clients, disclosure and fairness should always be at the forefront.

Whether it’s through traditional means (email, for example) or social media, all business communications should be treated equally.

As part of this, a firm must have policies and procedures in place regarding communication, effective systems to deal with it, and ways to assess that the systems are acting effectively. 

Electronic communication and social media

A couple of decades ago most communication was written correspondence. 

Connecting with prospective customers was carried out through print and other forms of advertising, like radio and TV. 

Things today have changed significantly when it comes to communicating with potential and current customers. 

Email is now a major roleplayer in communication and over the past decade, social media has become prominent too. 

But there are other modern techniques, websites, for example, or texts. 

So who does one reach out to prospects?

Well, TV, print and radio still play a role, there is no doubt about that, but social media is quickly becoming a prominent roleplayer in communication. 

That’s led to some concerns for bodies such as the NASAA.

They want to ensure that anything posted on social media and is seen by prospective clients provides all the necessary information, including risks.  

Here are other concerns regarding social media when it comes to investors.

Thanks to modern communication like social media, we can connect with clients and potential clients much faster than in the past.

But it has negative traits as well. 

There are many people with bad intentions who want to take advantage of investors.

Securities professionals must help protect clients from these scams.

Con artists use online social networks to penetrate online communities.

By building up trust with others, they can do this quickly and efficiently using social media and other online tools.

They can also get information on their victims without too much effort including date of birth, contact numbers, location and more. 

They use this information to con people, particularly pensions, out of their money.  

Red flags to out for from scammers include:

  • A promised high return with no risk.  
  • Not operating out of America. This is done so they can bypass various regulations. 
  • Using e-currency instead of regular currency. This forces those signing up for these schemes to start e-currency accounts and many of these websites get information out of them in this manner. 
  • Recruitment bonuses. Signing your friends up to make more money is often a trick used by scammers. 
  • Professional-looking websites, but without much substance, for example, no details about the company, not even a contact number 
  • Testimonials from others.

From those red flags, let’s discuss social media and the concerns regulators have.

NASAA gives guidance to players in the security industry when it comes to the devices and technologies used for business communications.

The guidance changes frequently as communication platforms and technology constantly evolve.

Aside from social networking sites like Facebook, Twitter, and LinkedIn, this guidance also includes information on using email, chat rooms, instant messaging, blogs, and websites.

Finding out what type of communication it is, for example, is it retail, correspondence, or institutional, can be challenging.

For this, the communication content is critical.

Regulations do state that communication using the internet is business-related and falls under the same regulations as public communication.  

When it comes to electronic communication, registered representatives must follow any internal policies that the firm they work for has.

If registered representatives are easily identifiable as representatives of a securities firm, regulations regarding electronic communications must be followed, even in their personal capacity.

Training is the easiest way to make sure that registered representatives understand what they can and cannot post, on business and personal accounts. 

Supervision and review of electronic communications

Electronic communication is not just emails, but all types of communication we now send on our phones, by email or put on the internet.

To start, we can look at advertising as a form of electronic communication.

A deceptive or misleading sales presentation or advertisement is unethical, according to the NASAA.

Types of misleading or deceptive practices would be:

  • Data distribution that isn’t factual
  • What is presented as fact is actually based on conjecture
  • A brochure, flyer, graph, or presentation that makes claims that aren’t realistic and not factual
  • Things that are contrary to the prospectus or certain disclosures

Let’s narrow in on broker-dealer advertising.

An important way in which a broker-dealer communicates with the public is through presenting recommendations.

They could even use their website to do so. 

Suitability constraints bind a broker-dealer if they are making recommendations using social media.  

But what constitutes a recommendation?

It’s not always that easy to determine, specifically with the suitability rule in mind. 

Here are communications not considered to be recommendations:

  • General information such as research reports that are available to customers and interested parties found on a broker-dealer’s website. 
  • On a broker-dealer’s website, a search engine allowing specific searches. These could include the performance of funds or stock in general, and not specifically those the broker-dealer recommends. 
  • Broker-dealers provide customers with tools on their website that allow them to screen a full range of securities.
  • By subscribing to electronic communications from the broker-dealer, customers can receive information and news about securities they hold in their portfolios. Clients select their own information to be received. 

Here are communications that will be considered as a recommendation:

  • An email that tries to persuade a recipient to buy a particular security
  • An email where a broker-dealer highlights the sector a client should invest in as well as the companies they should consider buying securities from.  
  • Broker-dealers encourage clients to provide personal information and investment goals into a portfolio analysis tool. Based on this, they send emails with a securities list that could meet their goals.  
  • By using data-mining technology, website users’ online and financial activity is analyzed. By sending investment suggestions, the company uses this information to encourage customers to buy or sell certain securities.

There are also advertisements for investment advisers.

For investment advisers, the following advertising is not allowed:

  • A statement of material fact that is exaggerated or untrue
  • Instead of spelling out registered investment adviser, use RIA as an initial
  • That includes testimonials
  • Refer to any recommendations previously made by the investment adviser, unless certain conditions are met.  
  • Offer free services, reports, or analyses that won’t be made available at no cost 

While brokers, dealers, and their agents may use testimonials, investment advisers are not permitted to do so.

There may be a question covering charting or similar systems.

As long as a client is adequately informed of the limitations of such programs, they can be used. 

In addition, the SEC recently updated its Investment Adviser Marketing Rule and this may appear on the exam.

You will need to remember the following about it:

  • The following is included in the definition of the word advertising. 

-Electronic chats, text, and other extemporaneous, live, written communication

-Communications to private fund investors

• Third-party information that the adviser assisted in preparing or has endorsed or approved. 

  • Form ADVs or other Information found in a regulatory or statutory notice. Presenting slides or scripts in a presentation may be viewed as advertising.
  • Testimonials/ endorsements can be found in ads if the following conditions are met:

You should clearly indicate that the testimonial was provided by a client (the promoter) and if they received payment. When a client “likes” a social media post of the investment adviser, this can be seen as a testimonial.

A solicitor can also be considered a promoter for the purposes of this rule.

Advisers and promoters must enter into a written agreement. If the promoter receives de minimis compensation or is an adviser affiliate, this isn’t necessary.

  • It is possible to include performance information in advertising within certain conditions. 

The following is not allowed:

  • Showing just gross performance
  • Showing performance results unless over a specific time period (5 years, for example)
  • Showing only portfolios that perform but not those that struggle (cherry-picking)
  • Showing hypothetical performance
  • Showing performance figures from a previous adviser and not the current one (unless accounts show and personnel involved are similar)

We move on to issues related to agents.

The broker-dealer is responsible for the supervisory burden that comes with using social media tools.

Agents, however, in their day-to-day work need to be aware of the following when it comes to communication.  

  • Personal devices they use are covered under communication rules, just like any hardware they use while in the office. 
  • Depending on the nature of the media used, they might require prior approval from a supervisory person, for example, any communication that is seen as retail must be approved.  
  • Providing data feeds from outside companies or having links to other third parties, could include information that is not allowed by NASAA.
  • With the exception of the first tweet, Twitter use isn’t under supervisory pre-approval.
  • The endorsing feature of LinkedIn should be deactivated by agents and testimonials cannot be posted. 

For the social media questions in the exam, be aware of adoption and entanglement.

In terms of content preparation, entanglement is if the firm or an associated person thereof has helped. 

With adoption, the firm or associated person implicitly or explicitly endorses content. 

Next, broker-dealer supervisory actions.

The use of social media for business purposes must be preceded by training and a thorough understanding of the firm’s policies surrounding it. 

The key here is what content is considered static and what is considered interactive, how business and non-business communication differs, and how to identify retail communication, which needs supervisory approval. 

Every year, follow-up training should take place too and by following this, compliance risks are lowered significantly. 

Social media policies implemented should:

  • Be available in written format and passed on to all 
  • Be short and to the point to eliminate confusion
  • Show the responsibilities of various parties  
  • Show how social media is monitored through various tools

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