Series 63 Module 7 – Obligations and ethical practices

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The Uniform Securities Act exists for two main purposes.

Firstly, it brings about state securities law uniformity. 

Secondly, it protects the public by ensuring industry players act ethically.  

This section looks specifically at the obligations that those in the industry have to act ethically. 

Part of that is understanding what constitutes unethical business practices and other prohibited actions as laid out in NASAA policy. 

Antifraud provisions and the Uniform Securities Act 

The act covers fraudulent activities covering the sale of securities and passing on investment advice. 

It stops parties from making a profit through deceitful practices. 

What are seen as fraudulent practices?

Unethical or prohibited practices and those deemed fraudulent do have a legal difference between them.  

Those committing fraud will go to jail when caught.

Punishment isn’t as severe for unethical or prohibited practices and could include fines, revocation of a license, or suspension, for example.

In the case of fraud, those offering, selling, or buying securities (both directly or indirectly) is prohibited from:

  • Fraudulently deceive others through a scheme, device, or deception
  • To gain an advantage, use misleading statements or leaving out material facts
  • To commit fraud by taking part in an act, practice, or business that attempts to do so

When taking the Series 63 exam, it helps to understand the phrase “material”.

Investors can only make a properly informed decision when presented with all the material facts, both good and bad.

Leaving some facts out is fraudulent behavior. 

Here are some examples of the types of fraudulent actions that might appear on the exam. 

First, untrue/misleading statements.

Registered representatives can operate in a fraudulent manner in numerous ways. 

  • Providing inaccurate market quotations
  • Misstatements related to dividends, projected earnings and issuer earnings, markup, markdowns, or commissions 
  • To suggest they have inside information regarding a security but in reality, they do not
  • Giving false information regarding a security’s listing status 
  • Declaring a new registered security regulatory approval when it hasn’t received it yet
  • Misrepresenting a customer’s account status  
  • Offering to perform services for the customer without intending to or without proper qualifications to do so
  • Informing customers that the broker-dealer’s ability is administrator approved 

Let’s move on to stating material facts.

It is not necessary to provide all information about an investment to the client, but critical information cannot be left out. 

That’s because it’s this information that allows a client to make an informed decision regarding a security or piece of investment advice.

Information given to a client should never mislead them and true information cannot be given if other critical information that’s coupled with it is not passed on. 

What do we mean when we speak about material facts?

Here’s the best way to sum it up.

It’s the information that a client will need so they can make the best investment decision based on their unique situation. 

We need to discuss the use of inside information too. 

You are not allowed to make recommendations about a security based on inside information you might have.

This might be related to the stock or the issuer. 

The agent should immediately notify a compliance office or supervisor when privy to inside information.

Should it be considered material, non-public inside information (MNPI), only when the information is made available to the general public, can it be used by a securities professional.

You might be asked which party is guilty in a certain scenario on the Series 63 exam.

Consider these:

  • No transactions have occurred but a compliance officer has passed on information they shouldn’t have. 
  • An agent executes a trade on behalf of a client based on inside information they have received

It’s only the second that’s a violation of the law because a trade has taken place. 

While passing information and no trade taking place isn’t a violation, doing so isn’t advisable. 

Next, we move on to the manipulation of the market.

Plain and simple, this is considered to be fraud because as a result, there has been a violation of the integrity of the market.  

Markets are usually manipulated in these two common ways:

  • Matched orders: By buying and selling a security to each other, two market participants can create the impression that it is a very actively traded security and that will bid up the prices. When the price moves up, they can then sell the shares that they hold to make a profit.  
  • Wash trade: This also looks to influence the price of a security by generating an interest in it that isn’t there at all. A wash trade is carried out when one brokerage account is used to buy securities and another is used to sell them. Essentially in this situation, the buyer and seller are the same and the securities have not had a change of beneficial ownership. The market, however, won’t be aware of this and the price or volume of the security on it will rise. 

Other examples of market manipulation include:

  • Providing false trading information
  • Front running
  • Holding back shares from an IPO

In an instance in which a security is bought on one market and traded on another one to take advantage of a price difference, market manipulation has not taken place.

The term arbitrage is used for this process. 

Ethical behavior related to broker-dealers and agents 

There are several ethical considerations that these two groups need to adhere to.  

Dishonest and unethical business practices

NASAA believes that several types of business practices are dishonest and unethical.

These are listed in their Statement of Policy on Dishonest or Unethical Practices of Broker-Dealers and Agents (SOP).

Broker-dealers: Unethical practices

The first unethical practice we cover is delivery delays that cannot be justified by the broker-dealer or are simply unreasonable. 

Specifically, these are related to payments that have been requested or the delivery of purchased securities but can include other aspects, such as the delivery of free credit balances on accounts. 

When we speak specifically of delayed deliveries, if a customer requests a certificate of a security, the delivery thereof should be as quick as possible. 

Next, we look into commingling firm and customer assets.

Customers can ask broker-dealers to safely hold their securities.

If this is the case, they must always be kept separately from any other securities that the firm holds, be it their own, or those of other customers. 

Client shares could be at risk if they are allowed to be mixed together. 

Another unethical practice is improper hypothecation.

Immediately following the first transaction, a broker-dealer must secure a signed hypothecation agreement from the customer if their securities are to be used for hypothecation.

They cannot be used in this manner if this document is not obtained. 

Then there are excessive servicing fees.

Broker-dealers carry out a range of services for their customers daily. 

Charging excessive fees is not allowed when carrying out these services.

Of course, specialist services, which are something that not all broker-dealers will offer, can be charged extra. 

But all fees should be disclosed to a client for any services that they want to be carried out. 

Next, we look at when quotes are dishonored.

If a broker-dealer makes a quote on a stock, they should always honor it.  

This is the ethical thing to do. 

Next, we have withholding public offering shares.

Public offering shares that are allocated to a member firm acting as broker-dealer, underwriter, or selling group member must always be distributed.

They shouldn’t be held back. 

Member firms cannot keep any shares, especially in an oversubscribed IPO where the prices rise.

If this is the case, the shares should be passed on to interested clients equitably. 

In an equitable manner, these shares must instead be allocated to clients.

Our last unethical act is agreeing to waivers.

As per stipulations in the Uniform Securities Act, agreeing to waivers is prohibited.

All binding provisions, stipulations, or conditions for those receiving advice on investments or buying securities cannot waive the compliance aspect of the act.

Should they do that, nothing is legally binding and declared void. 

Broker-dealers and agents: Unethical practices

We will now discuss unethical practices that broker-dealers and agents must consider. 

We start with commissions/markups that are excessive.

Customers cannot be charged too much for securities.

For example, the offering price should be comparable to what the market price is currently. 

Also, all commissions charged must be justifiable. 

A certain way of making large profits that will not be considered unethical is allowed under regulations.

This takes into account that when giving customers a quote, the current market price of a security must always be taken into consideration.

Next is churning.

Trading that is excessively frequent and large is considered unethical.

This is related to the account’s character, size, objectives, and financial resources available to the customer, however. 

As an example, trades that are deemed excessive on the account of a retiree won’t be on a younger client who is actively involved in stock trading. 

Next, we have unsuitable recommendations.

Any recommendation made to a customer always must have their best interests in mind and be made with reasonable ground in doing so.

This is what should always be considered:

  • Financial status
  • Investment objectives
  • Needs
  • What risk can they take on
  • Other relevant information pertaining to the client

What happens if the client doesn’t provide all the necessary information you need to make a proper recommendation?

In that situation, an agent should only accept unsolicited orders from the client. 

 A broker-dealer or agent cannot:

  • Suggest securities transactions without knowing the investments, needs, and financial situation of any client
  • Carry out lots of transactions (in size and frequency) to generate more commissions 
  • Without having reasonable grounds, suggest a specific security
  • Withholding important facts and the risks coupled with a transaction or security 
  • Making a blanket recommendation of the same security to all their clients 

And if everything is handled by the book but a client doesn’t agree with what the broker-dealer or agent has suggested? 

Well, perhaps they don’t understand everything as explained but it’s important that it’s never you who will make the final decision, but the client. 

There is a possibility that the exam will include a question on what is known as a  free lunch seminar

This is not covered in the NASAA’s Statement of Policy.

These are marketed as educational workshops but do want those that attend to buy into a certain product or they want to get contact details of participants so they can follow up on potential sales in the future. 

It’s unethical for agents or broker-dealers to attend these events or to sponsor them. 

The next unethical behavior is unauthorized transactions.

This is when a broker-dealer executes a transaction on a client’s behalf without first receiving the client’s authorization without discretionary authority 

Even if a spouse asked for the transaction to be processed, it cannot be, unless the account includes an authorization for third-party trading.

It’s also considered as unauthorized trading when the instructions of a client are not carried out to the letter, for example, buying more shares of a particular security than instructed. 

Unauthorized transactions also cover situations where the client’s instructions are not followed, for example, buying more or less of a security they want to purchase.

Next, we look at exercising discretion.

Written discretionary authority must be given by the client if a broker-dealer or agent wants to trade on their account. 

This is with the exception of situations when the discretionary power relates to the price or time of order execution.

Then there is the timely delivery of a prospectus.

A prospectus is a critical document that all investors should receive regarding a security that they are investing in. 

Customers who buy securities in an offering must have access to a preliminary or final prospectus by the date of confirmation of the transaction.

Our next unethical behavior is guaranteeing against loss.

Should a customer suffer a loss, there can be no guarantee provided to them that they will get their money back. 

Performance guaranteed should never be provided either. 

Next, spreading trading information that is false.

If a broker-dealer or agent spreads false information about trading, it is considered market manipulation.

Unless they believe that it is true, this relates to the bid or ask price of a security or any sale or purchase thereof. 

Next, it’s deceptive advertising practices.

Advertising may never look to deceive or mislead clients or prospects. 

Conjectured information, nonfactual or unrealistic data, or unfounded claims are examples of this.

This includes not only advertising but graphs and charts that may appear in presentations. 

Failing to disclose a conflict of interest is also an unethical practice that’s not allowed. 

If a broker-dealer or agent has a relationship with the issuer of the security they are suggesting a client buys, this always needs to be disclosed. 

This could be an affiliation, a controlled or controlling relationship, or they could be under the common control of the issuer. 

This should be carried out in writing.

If not and the client is only told by word of mouth, on the day the transaction is finalized, they should be told in writing as well. 

Then we have responding to complaints.

Clients should always receive information that they have requested (and are privy to) timeously.

If not, and it was a reasonable request, this is unethical. 

The same can be said of responding to formal written requests and complaints. 

Any written complaints need to be acted on with the client raising the complaint receiving notice of the action, along with the person who the complaint is against, if any. 

If received by an agent, the complaint must be brought to their supervisor. 

We move on to front running.

If a personal order is put in before that of a client front running is said to have taken place.

This is most prevalent when a firm gets an institution order of 10,000 shares or more, known as a block order.

When put through, this will cause the market to move, so a personal order placed in front of it can lead to a profit.  

Spreading rumors is behavior that’s not allowed either. 

Untrue rumors can significantly affect a stock’s price.

It is the agent’s duty to immediately report rumors to their supervisor if they are passed to them or heard through other sources, especially those on which recommendations of certain shares are made. 

Then we have accurate records.

All documents, as well as records, must indicate the right dates for tax and other purposes.

This means that backdating can never take place as it is unethical to do so because certain advantages, for example, to do with tax, can be obtained from doing so. 

Last is lending to or borrowing money or securities from customers.

For the most part, a broker-dealer can borrow money from a customer but there is an exception if the customer is part of the securities industry themselves. 

 Examples of this are:

  • Another broker-dealer
  • An affiliate of the professional
  • A financial institution that loans money

When it comes to loaning money to customers, the same applies.

For the exam, however, this can cause some headaches as NASAA and FINRA policies differ on this matter.  

This is a NASAA exam, so only go with what their policy states on the matter as covered above. 

The policy is in effect when a client relationship exists and not with non-clients. 

The following clients can be borrowed from:

  • Those financial institutions that make loans
  • An affiliate or fellow employee of the firm
  • Broker-dealers in a margin account

These cannot be borrowed from:

  • A lending institution employee who will give the go-ahead for your loan or who processes it
  • Broker-dealer agent who works on your margin account
  • Mortgage broker

Unethical practices linked to investment company sales

The NASAA instituted this policy statement in 1997 refers.

It has a specific reference to unethical practices related to investment company shares and will appear on the Series 63 exam from time to time. 

Broker-dealers or agents taking part in one of the practices we will cover can be suspended, have their registration taken away, or suffer other consequences should they do so. 

The first unethical behavior is communications regarding sales loads.

The customer cannot be told that investment company shares are no-load shares when they are bought if:

  • There is a front-end load
  • There is a contingent deferred sales load (CDSC)
  • They have a Rule 12b-1 fee or service fee above a total of 0.25% of the average net fund assets per annum

What about breakpoints and the unethical practices associated with them?

For investment company shares, it’s unethical to disclose any:

  • Discounts at or above the breakpoint on purchased shares, in dollars
  • Letters of intent lowering sales charges, where applicable

Next, it’s unfair comparisons.

An insured bank’s savings account and a money market fund cannot be compared.

As an investment, money market accounts are relatively safe, but they don’t have FDIC insurance, hence no comparison should be made. 

Moreover, there is no guarantee if the principle fluctuates which often is the case. 

The next unethical practice is selling dividends.

 With investment company shares the following cannot be implied:

  • Buying them before the ex-dividend date is a smart move, unless clear advantages do exist in doing so. 
  • Some income yield on these shares comes from long-term capital gains distributions

Lastly, we have to share classes.

A multi-class fee arrangement or sales charge must be suitable and appropriate for a client when they are recommended a specific class of shares of an investment company.

Whether it is  suitable and appropriate must consider:

  • Investment objectives
  • Other securities they hold
  • Their financial situation
  • Fees and other associated transaction charges

Unethical practices related to agents

We begin with selling away.

A broker-dealer must provide written authorization for the sale of securities before execution takes place if an agent does not want the transaction to go through the broker-dealer.

An unethical practice has taken place without that authorization.

In most cases, however, this occurs because the agent simply doesn’t know about the regulation, or that the product offered is a security.

In the Series 63 exam, an example is when someone the agent knows asks if they know anyone who would be interested in investing in a new venture that is seeking funding.

If the agent obtains a written authorization, this is fine otherwise, it’s a violation to suggest this investment to clients. 

Then there are fictitious accounts.

The agent can’t establish and maintain an account in order to execute transactions that are otherwise prohibited.

As an example, the exam might include a question in which the net value of a client is exaggerated in order to make it seem they have more net value than they actually do.

This relates to making it look like the client has more investment experience than they really do have. 

Sharing in accounts is not allowed.

In order to share directly or indirectly in the profits or losses of an account, either the customer or the broker-dealer the agent represents must give their written consent.

NASAA and FINRA policies differ in this regard.

As long as this does happen, FINRA regulations require that agents contribute to the shared account which isn’t necessary according to the NASAA policy. 

You need to know for the exam that only agents are allowed to share a customer account with the permissions, broker-dealers and other industry players cannot. 

Splitting commissions are not permissible either. 

A person who is not a registered agent for the same broker-dealer cannot divide or split compensation earned from buying or selling securities, including profits and commissions.

Whether under indirect or direct control, this applies to broker-dealers under common control.

As long as the transaction cost isn’t increasing, you will not need to disclose that your manager is splitting commissions with another agent as they are registered.

Then we have the exploitation of vulnerable adults.

This rule applies to anyone that’s either covered by the Adult Protective Service laws of various states.

This includes those over 65 years old and mentally disabled persons over 18.  

In cases where the beneficiary is an eligible adult, investment advisers or broker-dealers can elect to delay disbursement as well as from accounts of eligible adults.

A delay may be initiated if:

  • If the disbursement is made, the eligible adult might be exploited financially. Such a determination can only be made after an internal review.
  • A proposed delay is notified in writing at least two days before disbursement. The document must include the reasons as to why they want to delay the transaction and is sent to all relevant parties. This step is not required if they believe the eligible person is being exploited.
  • No later than two days after the disbursement request is received, they notify the relevant state agencies

A disbursement delay will expire earlier if one of the following factors occurs:

  • As long as it can be established that the disbursement of funds won’t result in financial exploitation of the eligible adult
  • Disbursement will be released 15 days after the delay has been first requested unless there is a request to extend it. In the event an extension is granted, it cannot exceed 25 days in total unless it is terminated by a state agency or court order.

Courts of competent jurisdiction can also extend the delay.

Ethical behavior pertaining to investment advisers and those who represent them  

We’ve covered broker-dealers and their agents in terms of ethical behavior and now we move on to advisers and representatives. 

Unethical business practices related to investment advisers

There are various unethical behaviors prohibited by the Uniform Securities Act for those who give investment advice.

Investment advisers provide information in numerous ways when it comes to valuing securities.

Fraud, deceit, or unethical business practices are not allowed.

You will find this all under the NASAA Model Rule on Unethical Business Practices of Investment Advisers, Investment Adviser Representatives, and Federal Covered Advisers.

The first place to start is suitability of recommendations.

Suitability is the foundation on which providing advice to a client should be built. 

All recommendations that investment advisers make must be done on reasonable grounds.

Defining suitability always looks at investment objectives, financial situation, as well as the needs of a client and it’s unethical if these aren’t considered. 

There’s more fiduciary responsibility associated with investment advisers and representatives than with broker-dealers, for example. 

Misrepresenting qualifications is the next unethical behavior type to cover. 

It’s against the regulations for an investment adviser or any of their employees to misrepresent their qualifications as well as the nature of the services they provide.

You can also be in trouble if you misrepresent fees or other material facts a client should know. 

Then we have unreasonable advisory fees.

If they are considered by NASAA to be unreasonable, you simply cannot charge them. 

Fees between advisers that offer similar services and have similar qualifications are checked by the NASAA and they should be similar.

If one is charging way too much, they will be taken to task unless they can prove reasons as to why they are doing so. 

State administrators have the power to rule on fees in situations like this. 

It is unethical to disclose a client’s information without their consent unless the law requires it.

Any information that is collected from a client must be kept confidential at all times unless a client has given the go-ahead for it to be disclosed.

Of course, any information that is required by law can be passed on without the client’s consent. 

Consent is not needed from a party when an investment adviser wants to discuss matters with the other if they hold a joint account. 

Improper custody is our next unethical behavior.

An investment adviser is in violation of this rule when they have custody or possession of funds or securities of a client, and they do not adhere to NASAA Model Rule on Custody. 

Beneficial interest in these funds or securities must be held by the client for this rule to be in effect. 

Other unethical practices

Here are some other unethical practices:

  • Excessive trading/churning on customer accounts  
  • Selling or purchasing orders on a customer account without permission 
  • Borrowing to or lending from a client (in some circumstances, this is possible)
  • Guaranteeing specific outcomes with the advice they pass on to clients  
  • Using testimonials in advertising
  • Share profits and losses generated by a client’s account, not even with their consent  

The fiduciary responsibility of investment advisers

We’ve spoken of the fiduciary responsibility that investment advisers and their representatives have towards clients. 

Thus, if they wish to act as an agent or principal for the client, they will need consent to do so.

Investments can act as fiduciaries effectively by disclosing potential conflicts of interest or eliminating them.

Any non-securities-related activities that could create a conflict of interest should be disclosed to clients too.

If a client won’t provide an investment adviser with the relevant information they need, it might be worthwhile skipping on them as a client.  

It’s simply not possible to act with fiduciary responsibility if you don’t know the full picture. 

FINRA is not as strict on broker-dealers when it comes to fiduciary responsibility as it is on investment advisers.

For the Series 63 exam question about a blanket recommendation made to all the clients of an investment adviser might come up. 

Just remember, making a blanket recommendation means you never carried out your duties with proper fiduciary responsibility. 

Fiduciary duties are clearly defined in state laws that specifically deal with trustees.

We should therefore examine 1994’s Uniform Prudent Investors Act (UPIA) and how it has affected the investment advisory industry. 

Essentially the UPIA was a major update in trust investment law, with modern portfolio theory having a major impact thereon.

Fiduciaries are required by the act to use caution and skill in making investment decisions for their clients.

Working as a principal or as an agent 

Here, we will examine the restrictions placed on investment advisers regarding compensation and trading.

Most of their compensation will be fee-based.

The fee is based on the assets they manage for their clients, and sometimes, commissions.

In this regard, let’s examine two examples, beginning with disclosure of capacity.

Yes, investment advisers give their clients advice, but occasionally, they can buy from or sell to a client while operating as a principal.

They can also operate as an agent.

This means they bring together a buyer and a seller.  

For both of these to happen, two things need to occur:

  • In a full written disclosure to the client, the investment adviser must state in what capacity they are operating as
  • The client must approve, either orally or in writing

 Agency cross transactions are another example. 

The investment adviser or their representative will operate on behalf of two parties should this occur in the role of broker-dealer. 

These parties are their client and then the other is the party that’s taking part in the trade. 

A client will need to provide written consent for this to take place.

Other information will need to be disclosed as well. 

  • The investment adviser will be paid commissions from both sides of the trade
  • There is a conflict of interest owing to the division of loyalties between both parties
  • A statement summary of the account must contain the numbers of transactions as well as the remuneration received from these transactions each year
  • Termination of the arrangement can occur at any point
  • The investment adviser or any of their representatives will not affect any transactions with sellers or purchasers

Investment advisers must still strive to obtain best execution and price for any transaction carried out and a written trade confirmation is always necessary. 

Now let’s look at Section 28 (e) safe harbor and soft-dollar compensation.

One of the services that brokerage firms provide is that of research and it’s a fundamental aspect of the money management industry. 

Through soft-dollar arrangements, there is a link between the money management industry’s need for and the brokerage industry’s supply of research.

Broker-dealers provide two types in the form of proprietary research and third-party research.

  • Proprietary research: Created and provided by broker-dealers, this is for tangible research products with access provided to both traders and analysts 
  • Third party research: Here, research carried out involves a third party and it is from them that the broker-dealer sources the research. 

When we speak of soft dollars, what do we mean? 

Basically, that’s when a section of commissions earned is allocated to fund the research.

These are often called directed transactions on the exam.

Be aware that a fiduciary is not permitted to benefit from the use of assets that are entrusted to clients.

The SEC deems that when research is bought by an adviser using the commissions gained from clients, a benefit has been received. 

The reason for this is that the research has not been produced by the adviser and they haven’t paid for it out of their own pocket. 

A conflict of interest will arise if the adviser receives inferior execution prices for transactions that use soft dollars.

That conflict of interest is because the client wants to pay the lowest commissions while receiving the best possible research and the necessity of acquiring the research. 

Congress created a safe harbor provision in Section 28 (e) of the 1934 Securities Act.

Investment advisers are protected against clients who claim that their fiduciary duties have been broken by this. 

In other words, they were billed higher rates of commission in exchange for research and execution.

Investment advisers are required by the SEC to inform clients about all soft-dollar arrangements.

If their client paid more than the lowest commissions available, the investment adviser has broken laws or fiduciary duty if:

  • Commissions are calculated in good faith and reasonable 
  • The commission paid is linked to  research and brokerage services 

The importance of investment advisers’ production and distribution of research is further demonstrated by Section 28 (e).

The list below, according to Section 28 (e) would be considered under safe harbor.

  • Researching the performance of either a stock or a company and providing a report thereon
  • Trade journals or financial newsletters with the appropriate details to be considered as research 
  • Quantitative analytical software
  • Conferences and seminars covering the appropriate content deemed to be research
  • Effecting and clearing the trade of securities

These do not fall under the safe harbor requirements in Section 28 (e).

  • Rent
  • Telephone rental or internet services
  • Computer hardware
  • Office furniture
  • Travel expenses
  • Software that does not cover securities analysis
  • Payment for training

Conflicts of interest

Broker-dealers and investment advisers need to be aware of potential conflicts of interest.

Conflicts of interest: Broker-dealers

These could be considered conflicts of interest:

  • Offering proprietary products like a house fund, for example.  This is because these types of products generate higher commissions.
  • If the broker-dealer is an affiliate of the sponsor of a DPP offered to a client
  • Non-disclosure of an affiliation between the firm and the issuer of a security offered to clients 
  • Agents are rewarded for selling sponsored products
  • When the securities professional has an interest in the security they are recommending to their clients 
  • When going public, placing shares of their own stock into discretionary accounts of clients 
  • Publishing favorable stock reports for a stock they’ve underwritten 

Conflict of interest: Investment advisers

NASSA’s Model Rule on Unethical Business Practices of Investment Advisers, Investment Adviser Representatives, and Federal Covered Advisers covers all conflicts of interest that could arise for investment advisers. 

As always, a client should be told of any of these before advice is passed on to them and always in writing.

Anything that could impair their capacity to give objective advice without bias must be included including:

  • Any compensation arrangement other than that received from their clients forms part of their advisory services provided  
  • If they will charge additional fees, like an adviser fee.

It must be disclosed to the investor if an investment adviser or representative passes along any advice that is going to have a conflict of interest.

SEC Release IA-1092 is one of the most comprehensive lists of disclosures available, and many states have incorporated it into their state legislatures.

It covers a range of disclosures, including:

  • When an investment adviser has a personal interest in a transaction that could compromise their client’s interests, they should not proceed with it
  • Any financial impact caused by an investment adviser’s recommendations to a client must be disclosed if he structures his own personal securities transactions around that
  • Clients should be informed if any investment advice given to them is inconsistent with their own personal transactions
  • The investment adviser must disclose any compensation received from the issuer of the security he/she recommends to their clients

Security sales at financial institutions

Due to an increase in the sale of securities on the premises of financial institutions using broker-dealers three decades ago, a new set of NASSA rules was drawn up.

They did so because of the potential for conflicts of interest and confusion for clients.

The first rule requirement deals with setting.

If possible, broker-dealer services should be performed in an area away from the retail deposit area of the financial institution.

In the event that it is not, customers need to be made aware that broker-dealer services are different from those of financial institutions, therefore it should be clearly marked.

Our second rule requirement is written acknowledgment and customer disclosure.

When opening an  account for a customer on the premises of a financial institution, broker-dealers have to:

  • Disclose orally and in writing that there is no Federal Deposit Insurance Corporation (FDIC) insurance for any transactions performed. They must also mention all the investment risks possible and that the client loses their principal. 
  • Try to get written acknowledgment of these disclosures from each customer.

 Public communication is the third requirement. 

A certain logo format can be used as a way to highlight disclosures in literature linked to advertising and sales.  

These include:

  • Not FDIC insured
  • No bank guarantee
  • May lose value

Disclosure is not necessary as long as there is no misleading advertising.

The fourth rule requirement is SIPC coverage.

Securities Investors Protection Corporation (SIPC) insurance is not as widely known as FDIC coverage is.

If a broker-dealer should go under, clients have SIPC protection and help return their assets to them.

They do this by appointing their own trustees. 

The SPIC doesn’t provide any protection against a decline in the value of a securities portfolio, however. 

If the broker-dealer is a SIPC member, they should have signs in their offices showing this fact to their clients and they should use the SIPC logo in their advertising.

The last requirement is currency transaction reports (CTRs).

Regulations state that a CTR on FinCEN Form 112 must be filed by the financial institution when cash transactions exceed $10,000.

This covers transactions purchasing any of the following too: certificates of deposit, mutual funds, stocks, bonds, and other forms of investment. 

Protection of customers

Let’s now look at how broker-dealers and investment advisers should go about protecting customer funds.

Custody rules

The term custody is used when a broker-dealer or adviser holds either money or securities of a client and there are regulations that govern this. 

It’s mostly broker-dealers that this pertains to, although advisers might at times too, hold money and securities although they would have to inform the state administrator if they do.

Some states don’t allow it, however. 

Let’s look at broker-dealer custody first. 

With most broker-dealers holding FINRA registration which includes custody regulations (Rule 15c3-3 and the Customer Protection Rule), the NASAA is happy that this fulfills their responsibility to their customers.  

Customer securities and funds are provided protection by this rule, specifically those that the broker-dealer holds.

This rule protects investors if a broker-dealer has financial difficulties and it ensures that no commingling of funds or securities occurs.

We move on to investment adviser custody.

When an investment adviser has custody over funds of securities of a client, they are governed by the NASAA Model Rule on Custody.

This means that:

  • Securities belonging to customers must be kept separate and clearly identified as such
  • If customer funds are kept, they will be deposited into separate accounts
  • Investment advisers inform all clients of where and how funds and securities are kept
  • An investment adviser must provide a customer with an inventory list of what they are holding every three months.
  • All funds and securities held by an investment adviser must be verified annually by an independent CPA.  

Custody of client funds and securities is terminated if:

  • State administrators don’t allow it
  • If a Form ADV was not used by the adviser to inform the state administrator of the custody
  • Clients have not been sent activity statements every four months

If they hold customer securities or funds, the services of a qualified custodian must be used who will see to it that the deposits are insured by the Federal Deposit Insurance Corporation.

It’s usually a savings association or a bank that operates in this capacity, but it can be an SEC-registered broker-dealer as well.

The adviser won’t have to carry out certain administrative tasks if the client funds are managed by a custodian.

For the Series 63 exam, note that an adviser won’t need to make use of a custodian should state laws allow it, but a Form ADV will need to be sent to the state administrator to inform them. 

No state administrator permission is necessary. 

What about the custody by investment advisers definition? 

The term ‘custody’ refers to the authority to receive client funds or securities and hold them, both directly and indirectly and it includes both controlled or controlling advisers and those working for them. 

Custody includes the following:

  • Funds and securities but not those sent in error. These must be returned in three days.
  • A general power of attorney or other arrangements. Here, authorization has been given that allows the withdrawal of securities or funds on instruction, together with a custodian.
  • When a supervisory person has access to securities or funds. This could be in the case of a trustee or in a limited partnership.
  • An investment adviser associated with a broker-dealer and those who handle client funds.

It does not include:

  • Investing discretion in an account
  • Recipient of client-drawn checks for unaffiliated third parties, if, within three days of having received them, they are passed on to the appropriate party 

 Here’s a good way to think of how custody works. 

The investment adviser/custodian physically holds the securities or funds.

In this scenario, most administrators require that the adviser places a surety bond, or holds a certain net worth. 

For the exam, you should remember that some investment advisers do not take custody, so cannot accept securities or funds delivered to them.

If they can accept assets, they will need to provide a receipt to the customer each time they do.

The custody rules as enforced by the NASAA will apply to an investment adviser too if an affiliated broker-dealer holds funds or securities of customers.

If this is the case, they should always inform the administrator of such an arrangement.

Discretionary account rules for broker-dealers and advisers

We know what a discretionary account is, so let’s cover some rules that govern them. 

When it comes to discretion, it’s connected to three important factors:

  • The asset 
  • The action of buying or selling
  • The amount of shares bought and sold 

There is one exception when it comes to discretionary rules. 

For the purposes of bonding, minimum net worth (in the case of an investment adviser), or other financial requirements

If a client says the securities professional must find either the best price or time to trade one of their assets (security), this isn’t seen as discretion. 

This is notably for, in the case of an investment adviser, minimum net worth but also covers bonding or other financial requirements. 

Also, when it comes to passing on discretionary control to a broker-dealer/agent, a client cannot do this simply through regular instruction, it must be done in writing.

A different process is necessary for investment advisers. 

Here, oral authorization is fine for the first 10 business days. 

Following that, if further discretionary control is to take place, the client will have to confirm in writing.

Regular reviews must be held of these accounts to protect clients from excessive trading or churning. 

If a client has given discretionary authority, all orders need to be reviewed by a supervisory person designated to do so as well as giving final approval when the trade is to be made

Data protection and cyber security measures

The NASAA produced a list a few years ago as a guide in setting up cybersecurity programs.

This guide deals with the following factors:

  • Preparedness: Is it understood how threats could impact the business? Are systems in place to protect against these threats? 
  • Compliance program: Do training programs, procedures and written policies exist to protect client information?
  • Social media: Do training programs, procedures and written policies exist for the use of social media?
  • Insurance: If a breach does occur, is some form of cyber insurance in place?  
  • Expertise: Is cyber security needs handled internally or through a consultant outside of the company?
  • Confidentiality: Does the firm have confidentiality agreements in place for third parties that have access to its technology systems?
  • Incident: If the firm has experienced an incident, have the right steps been taken to close cybersecurity holes?
  • Disposal: Are old electronic data storage devices that might contain sensitive information disposed of properly?
  • Continuation: Can the firm continue with its business should a cybersecurity incident occur?  
  • Losses: What plans are in place if electronic devices belonging to the company are stolen?
  • Safeguards: What are the firm’s cybersecurity safeguards? This could include anti-virus software, for example.

The safety of client information

Broker-dealers are a goldmine of information for those with these nefarious intentions.

Consider all the personal information a client would provide to a broker-dealer when opening an account, for example, and this makes identity theft a real worry. 

Identity theft has many red flags that security professionals must be able to pick out. 

Regulators are also concerned about covered accounts, which include margin accounts and some brokerage accounts too. 

Investment advisers, who can transfer funds between accounts of individuals, are also exposed to fraud risks similar to those faced by financial institutions, especially when third parties are involved. 

SEC Regulation S-ID covers all the rules regarding identity theft and financial institutions.

These are not only adhered to by broker-dealers but investment advisers as well, and this means cybersecurity is a concern for them too.  

A written program must be implemented for maintaining covered accounts, according to regulations.

This is specifically aimed at preventing identity theft, by detecting any attempts to do so. 

Policies in this program should:

  • Observe the kinds of red flags that apply to the covered accounts  
  • Integrate those red flags into their program that assesses cybersecurity 
  • Detect and then respond to those red flags when they happen
  • Keep the cybersecurity program up to date so it is aware of any changes in the risks posed by identity theft to customers, the institution, and creditors

Here are some of the common warnings that should be part of the cybersecurity program and that firms should be looking out for.  

  • Warnings, notices, alerts, or services provided by consumer reporting agencies or service providers
  • Documents that have been altered
  • Differences in physical appearances between a customer and their presented identification
  • The opening of an account with suspicious information like a strange address, or making a change of address request soon after an account is opened
  • Unusual activity related to the covered account
  • Law enforcement authorities notices 
  • Differences in the personal identifying information provided 
  • Incorrect personal identifying information 
  • Failure on complex challenge questions. These answers would not be readily available to someone trying to defraud a customer 
  • Mail returned as undeliverable while transactions on a covered account continue 

How firms can protect customers and themselves 

Here are some examples of protection measures that can be used:

  • ID/passwords
  • Key FOBS, secure IDs, and other dual-factor authentication options
  • Challenge questions  
  • Biometric authentication like fingerprint scans for example
  • Anti-virus software

Other factors to consider:

  • How often is antivirus software updated?
  • Are files and devices encrypted?
  • Are backups of electronic files performed remotely?
  • Is a virtual private network (VPN) in place? 
  • Do you store client and personal information in the cloud?
  • Does the firm’s website provide access to client information?
  • Are clients able to access a portal online?
  • If third-party vendors are allowed access to the system, what control measures are in place?
  • When a vendor relationship ends, do measures exist to protect customer information they may have accessed?

Client data cannot be protected in a simple way.

The firm you work for will handle that for you, so unless you work for yourself, you won’t have to worry about it.

But it is critical to spot red flags and what to do when one pops up. 

Privacy-regulation S-P

Identity theft is the focus of this regulation and it stipulates that safeguards must be in place to prevent it. 

For example, having privacy policies that protect nonpublic personal information.

A privacy notice must be provided by member firms when an account is opened.

It is possible then for customers to opt out of having their personal nonpublic information shared,

Nonpublic personal information includes:

  • Social security numbers
  • Balances on their account
  • Account transaction history
  • Information collected by online cookies

Cookies are a way for websites to collect information about those who are visiting and because the information is not that specific, it’s called blind data. 

When it comes to cookies, there are no Regulation S-P requirements that need to be met. 

Regulation S-P does distinguish the difference between a customer to a consumer. 

A customer has a relationship with a firm, a consumer might have an initial contact, but nothing after that. 

This is important when it comes to privacy.

An initial privacy notice is all a consumer will need to see.

While this is something a customer will receive as well, as long as they remain a customer of the firm, they should get a new one each year. 

It should be noted that this regulation does not apply to institutions or businesses.

In conclusion

Remember, this study guide is just that, a guide.

It should be used in conjunction with the course notes for the Series 63 exam and never as a replacement for them. 

Good luck!

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