Series 66 Module 4 –  Guidelines, Regulations and Laws (including prevention of unethical business practices)

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Securities are regulated by a variety of guidelines and laws.

This module covers investment advisers and their representatives, as well as broker-dealers and their agents and the regulations that govern them. 

 A. Investment Adviser (inclusive of state-registered and federal covered) laws, regulations, and guidelines 

As a starting point, let’s look at the Uniform Securities Act’s definition of an investment adviser:

“Investment adviser means a person that, for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of securities or the advisability of investing in, purchasing, or selling securities or that, for compensation and as a part of a regular business, issues or promulgates analyses or reports concerning securities.”

Note three critical elements:

  • Securities are the subject of investment advice provided by investment advisers
  • Their regular business activity includes giving this advice
  • Those who provide this advice to others will be compensated

Giving advice related to securities

Stocks and bonds, mutual funds and limited partnerships, as well as asset allocation, fall under this category and include advice that could be determined to be indirect. 

According to regulators, providing advice on other investment types does not qualify as securities advice. 

This includes

  • Real estate
  • Commodities
  • Collectibles
  • Precious metals

Providing advice as part of your business

Individuals are considered to be an investment advisers by doing the following:

  • Provides securities advice regularly and not necessarily as their main task 
  • Presents themselves as an adviser to the public and advertises that they provide investment advice

A general newsletter that contains nonspecific investment advice that is issued by an individual would not be covered by the act.

Is compensated 

Investment advisers are those who receive compensation for providing investment advice. 

There are various forms of compensation that can be paid, including commissions and advisory fees. 

Release IA-1092 of the SEC

In the 1980s the SEC defined the activities an investment adviser could carry out as regulations allowed and this was done via Release 1A-1092.

Because of this, the following were included under the definition of an investment adviser:

  • Financial planners
  • Pension consultants
  • Sports and entertainment representatives
  • Those giving some form of investment advice 

Here are those that are excluded:

  • Bank holding companies
  • Saving institutions
  • Trust companies
  • Broker-dealers (offering traditional services)
  • Their agents
  • Lawyers
  • Accountants
  • Engineers
  • Some publishers 

The advice that is incidental to their profession is not included in the final three examples.

What of the exemptions?

Despite meeting the definition of an investment adviser, these individuals will not need to register as such:

  • Intrastate advisers 
  • Insurance company advisers
  • Private fund advisers (managing less than $150 million in assets)
  • Foreign private advisers

Investment advisers and their registration requirements

In current practice, advisers are either registered with the SEC or in the state they are based while it’s not necessary to register in both. 

When is someone seen as a federal covered investment adviser?

Generally, they work in big securities firms and will carry SEC registration. 

There are three categories in which they are tested most often in the exam:

  • SEC-registered: This is due to the fact that they control $100 million in assets under management. This makes them eligible because they meet the minimum threshold of assets under management ($110 million)
  • A person contracted by an investment company that falls under the Investment Companies Act, such as a mutual fund, to manage its assets.  
  • Non-registered individuals excluded from the definition of an investment adviser as per the SEC.  

Assets under management

State registration requirements for federally covered advisers have been eliminated due to assets under management (AUM).

There are three thresholds created by Dodd-Frank in this regard, so let’s examine each one. 

Large investment advisers

These advisers deal with AUM of $100 million and higher.

They are eligible for SEC registration if AUM is at this figure but if it moves over $110 million, that becomes mandatory.  

Those that fall into either exempt or excluded categories won’t have to register with the SEC. 

State registration is not necessary.

Mid-sized investment advisers

These advisers have AUM from $25 million to $100 million. 

These advisers are generally required to be registered with their states, but not with the SEC unless they work for an investment company registered under the Investment Company Act. 

For a mid sized firm of advisers, there are other ways to get SEC registration.

  • More than 15 states are required for registration
  • The buffer may be used by them (which we look into later)
  • The administrator does not subject them to examination when they are registered as advisers
  • The adviser doesn’t have to be state registered where they maintain their main office and conduct business

Small investment advisers

Here AUM of $25 million or lower is in play.

Investors who work for companies registered under the Investment Company Act can register with the SEC but if not, this form of registration is not allowed but state registration is then required. 

Registration with the SEC is permitted if the adviser needs to register with 15 or more states.

Buffers 

We’ve already mentioned buffers above, but how do they work? 

Take the example of a state-registered adviser with an AUM of $100 million.

This provides the two registration options, either stay registered with the state with the $10 million buffer or opt for SEC registration. 

 When AUM reaches $110 million, then SEC registration becomes mandatory. 

What happens if their AUM falls below $100 million?

Should they drop their SEC registration and register with the state?

No, because the $20 million buffer is in operation.

SEC registration only needs to be dropped should AUM pass below $90 million. 

Time frames for reporting AUM

It’s a given that AUM fluctuates, but advisers need to report it annually.

In other words, if it drops below a registration threshold, a change is not necessary immediately. 

If it is at a new threshold when it comes time for AUM to be reported, then changing registration is necessary.  

How the registration process works

Registration is completed using Form ADV. 

It consists of four parts: 1A, 2A, 2A, and 2B.

This form is needed for registration with:

  • SEC
  • State administrator
  • Making amendments

The layout of Form ADV  

It comprises four sections:

  • Part 1A: Whether it’s state or SEC registration, this must be completed.  
  • Part 1B: Advisers applying to register with the SEC do not need to complete this portion, as it is for those that are going to be state-registered.
  • Part 2A: The advisory firm must provide a narrative brochure that provides details about itself here. 
  • Part 2B: Certain supervised individuals must be detailed in brochure supplements provided here. 

Form ADV: How it is updated

Each year an adviser will update their Form ADV. 

Any amendments between this must be filed with the SEC or the state administrator, with AUM one of the most critical aspects. 

Other changes that must be updated include:

  • A change of name has been made to the registrant
  • Business has moved to a new location
  • Records and books are now kept in a different location
  • There has been a change in the person in charge of preparing Form ADV
  • Changes have been made to the organization of the company
  • The Form ADV brochures contain inaccurate information
  • There has been a change in questions regarding disciplinary actions
  • The way in which customer funds and securities are handled has changed

Service of process: Consent

An adviser must agree to this aspect of state registration.

It is now the state administrator’s responsibility to deal with any noncriminal securities-related complaints that come against the applicant.

It is effective immediately once consent is given and this consent is in force permanently from then on. 

Renewals of registrations and effective dates

In the event of no irregularities, SEC registration takes effect 45 days after the filing of a complete application, while for a state-registered adviser, this period is 30 days. 

A Form ADV-W must be completed if they cease to operate as an investment adviser.

Withdrawals for SEC-registered advisers require 60 days, whereas withdrawals for state-registered advisers take 30 days.

They remain under administrator jurisdiction for a year following their withdrawal, however.  

Financial requirements pertaining to registration as an investment adviser

In order to be registered as an adviser, a person must meet the minimum financial requirements set out by state administrators.

Fee payments

Both state and federal law offer additional protection to investment adviser clients who have made fund advances, known as substantial prepayment of fees.

It would apply if federal covered advisers collected $1,200 per client in advance for at least six months.

This, however, differs from NASAA’s model rule. 

Even though the six-month period is the same, the amount collected drops significantly and is only $500. 

Requirements regarding balance sheets

When substantial prepayment fees are received by federal covered investment advisers, their Form ADV Part 2A has to be accompanied by an independently audited balance sheet.

State-registered advisers are no different. 

In addition, an audited balance sheet is required for those who handle customer funds and securities. 

It’s also required if the custodian is an affiliated broker-dealer.

An unaudited balance sheet is required if the advisor has discretionary control over account transactions of their clients but does not have control of funds or securities in the account. 

Disclosures of possible financial impairment

For advisers having discretionary control or if clients pay substantial prepayment of fees, if advisers know of a financial condition that could stop them from meeting their contractual commitments, the client must be told.

Lack of ability to maintain minimum net worth levels

According to NASAA’s model rule, financial advisers must have a minimum net worth.

It must be notified to the administrator by the end of the next business day if it falls below the minimum set out. 

After the first notice is filed, a financial report must be filed by the end of the next business day.

An adviser must disclose the number of client accounts they work with as part of this information.

A bond will then be required by the administrator and taken out by the adviser and the amount will depend on the net worth deficiency of the adviser. 

Record requirements as outlined by federal and state law

The following books and records must be kept for a period of five years by advisers that are not exempt, according to federal and state requirements:

  • Journal 
  • Auxiliary and general ledger
  • Orders pertaining to securities transactions, or when instructed by a client
  • Checkbooks 
  • Bills
  • Statements
  • Internal audit working papers 
  • Financial statements
  • Trial balances
  • Any written communications pertaining to securities as well as client assets
  • Records of discretionary authority 
  • Any client/advisor agreements  
  • Adviser-circulated communications
  • Litigation involving the adviser or employee in writing
  • Staff registration details at the advisory firm

Supervisory requirements

To ensure compliance with federal and state securities laws, registered investment advisers must have written policies and procedures.

Each year, these procedures should be reviewed by the designated chief compliance officer (CCO). 

A key factor in this regard is the supervision of other advisors.

Definition: Supervisory person

Typically, investment adviser representatives fall under this definition.

This category will also include any other persons under control or supervision.

Officers, directors, partners, and other employees are included.

 B. Investment Adviser Representative and regulations pertaining to them

Having covered various regulations related to investment advisers, let’s discuss their representatives a bit more.

The purpose of this section is to define these representatives (IARs), look at some exclusions, and then note the regulations that apply to them.

The definition of an IAR falls under anyone carrying out the following:

  • Advising or recommending securities to clients
  • Manages client portfolios and accounts
  • Establishes the type of advice or recommendations that should be given to a client
  • Investment advisory services are negotiated, offered, or sold
  • Provides supervision to any staff performing the duties listed above

IAR exclusions and exemptions

IAR exclusions

Staff that perform only administrative and clerical duties won’t be required to register as IARs. 

No registration is required for individuals who do not regularly solicit, communicate with, meet with clients or who only give impersonal investment advice.

As for impersonal investment advice, it includes oral statements and written materials without specific objectives or tailored to individual needs.

In other words, it’s general advice, the kind you would find in a brochure advertising an advisory service. 

IAR exemptions

We will cover three exemptions for those defined as IARs in this section.

  • A de minimis exemption applies to those who work for state-registered advisers. Here, registration won’t be needed if they don’t have a state-based place of business and haven’t had five retail customers there within the past 12 months.
  • There is also an exception for IARs under the snowbird rule. It means that they only serve existing clients who are non-residents (temporarily) in that state and they themselves do not have a business presence in the state.
  • There is also a special exemption for IARs working for covered investment advisers. A person must register their IARs only in the state where they operate a business.

Registration criteria for Investment advisers representatives 

Registration as an IAR takes place at state level only and is carried out through the completion of a Form U4.  

This includes completing the Disclosure Reporting Pages (DRP).

A listing of any disciplinary events from their past must be included here. 

It is common for the Series 65 exam to test the following regarding registration.

Firstly, the function that an IAR performs will determine their registration, not just their title.

This is addressed by the Uniform Securities Act which says: “Registration of an investment adviser automatically constitutes registration of any investment adviser representative, who is a partner, officer, or director, or a person occupying a similar status or performing similar functions.”

State-registered advisers must register in another state if they expand their business and start operating there. 

As stated by the rule, it includes information about individuals who act as IARs for their businesses, for example, partners, directors, and others. 

They will be automatically registered in this case if they hold the positions mentioned above. 

For existing IARs who are not in those positions, a Form U4 must be completed for the new state of operation.

Secondly, testing is also part of the process.

It is necessary to pass the Series 65 or 66 exams unless a waiver is granted to a candidate.  

Termination methods

When an investment adviser terminates employment, the notification requirements depend on how they are registered.

  • Those that are state-registered will have to ensure their firm notifies the administrator  
  • Those that are federal covered advisers will need for the IAR to notify the administrator  

IAR financial and recordkeeping obligations  

A person acting as an IAR is not required to keep financial records.

C. Broker-dealers and agents and how they are regulated

Broker-dealers can operate by themselves or form part of a brokerage company with many clients.  

If they work for a broker-dealer, it is in the capacity of an agent/registered representative.   

A broker-dealer acting as an agency is one who buys and sells securities on behalf of others.

For their own accounts, they act as dealers.

Exclusions and exemptions 

For the purpose of state regulation, the definition of a broker-dealer doesn’t include the following:

  • Agents
  • Issuers of securities
  • Trust companies
  • Banks
  • Savings institutions
  • Those without a physical presence in the state but operating as broker-dealers

Federal exemption when it comes to registration

Broker-dealers who conduct all their business in one state do not have to register with the SEC.

They are known as intra-state broker-dealers. 

The transactions they carry out must take place only within the borders of the state, however. 

They will have to be registered in the state they operate in, however. 

State exemption when it comes to registration

A broker-dealer without a place of business in a state is exempt from registration if the transactions in that state are with the issuer involved.

Agents

Broker-dealers and issuers are represented by agents.

A commission is paid to them for facilitating the sale or purchase of securities. 

The term registered representative refers to any person who sells securities, regardless of whether they are registered or not.

Agents can only be natural persons such as an individual but never a brokerage firm, for example. 

Let’s also focus on the definition of an associated person while we discuss agents. 

Associated persons would include directors, officers as well as partners of a broker-dealer. 

It can also include persons controlled by a broker-dealer.

Those who only undertake clerical tasks won’t meet this definition, however.

Exclusions and exemptions pertaining to agents

Those who work in clerical positions for a broker-dealer will not have to register. 

They only handle administrative tasks.

Exclusion related to personnel representing issuers

Securities issuers may have personnel who represent them, and they must be registered as agents when selling securities but only in the states where these transactions take place. 

These individuals are excluded from the definition of agent in certain situations including:

  • When selling exempt securities
  • When handling exempt transactions
  • Taking part in transactions with the issuer’s partners, directors, or employees for which they are not compensated

Agent exemptions

Agents are not able to fall back on a de minimis exemption as it applies to broker-dealers. 

This means that even if there is no place of business in a state, they will need to be registered there, no matter if they only deal with one or two clients. 

Some exemptions to this rule do exist, however. 

As we discussed earliest when dealing with investment advisers and IARs, the snowbird rule applies here too. 

Firms excluded from the definition of broker-dealer are also exempt.

They will only work with institutions as well as other broker-dealers.

To do so, it’s not necessary to have a place of business in the state.

They also do not require registration in the state because their employees are not considered agents. 

D. Broker-dealers and their registration requirements

Everyone who doesn’t fall under the exemptions or exceptions already covered must register as a broker-dealer.

It applies to both individuals and companies that serve as broker-dealers and a SEC Form BD is used to register with the state.

Application submission

Initial application submissions (and any renewals after that) will be sent to the state securities administrator.

A Form BD is used by broker-dealers to do so, while a Form U4 is used by their agents. 

Payment/renewal of filing fees 

The broker-dealer must pay filing fees when applying for the first time as well as anytime they renew. 

When renewing, these will have to be filed on the last day of December each year. 

Record requirements

Broker-dealers are required to keep the following records:

  • Accounts
  • Blotters
  • All non-personal correspondence
  • Papers
  • Books
  • Memorandums
  • A list of all other records required by the administrators 

If any amendments need to be made to these records, they must be filed immediately. 

An administrator’s requirements when it comes to record keeping cannot supersede those of the SEC.

Financial requirements pertaining to broker-dealers

It is possible for administrators to impose certain net capital requirements on broker-dealers. 

It is important to note, however, that these cannot exceed the requirements as per the Securities Exchange Act.

Broker-dealers may be required to post a surety bond if they have custody of client funds and securities or discretionary account authority.

If the broker-dealer’s net capital exceeds the administrator’s requirement, a surety bond isn’t needed. 

Agents and their registration requirements

Registration is required by completing Form U4.

As soon as that has been granted, they can transact securities in that particular state. 

There is no de minimis exemption for broker-dealers, so registration at state level is necessary. 

Agent licenses at state level will fall away should the broker-dealer they work for have their registration terminated.  

The administrator must be informed when an agent terminates their contract with a broker-dealer.

Both they and the firm they work for will have to do this.  

Financial requirements pertaining to agents

No net worth requirements are applied to agents. 

However, the administrator may require that they are bonded should they hold discretion over a client’s account. 

Multiple broker-dealers and registration

This is not allowed under current regulations for both brokers and issuers.

The administrator may grant an exception if there is a direct or indirect common control between the broker-dealer and the issuer. 

A second registration will be necessary if this happens, however. 

E. Regulations pertaining to issuers and securities

Regulation of securities transactions and issuers of securities is the responsibility of state securities administrators.

What is a security considered to be?

The term “security” is a crucial part of the Uniform Securities Act, the guideline for all financial workers.

Defining what it is, is no simple task. 

According to the US Supreme Court, an instrument must include money that has been invested in a common enterprise in order to qualify as a security. 

An investor expects a profit from their investment, which comes from the actions of another party. 

While you know the many different instruments seen as securities, sometimes focusing on those that aren’t is a better idea. 

They include:

  • Insurance, endowment policies with fixed lump sum payments 
  • Annuity contracts with fixed lump sum payments
  • Retirement plans  
  • Collectibles
  • Commodities  
  • Condominiums used by an individual as a residence
  • Currency in any form

Investing in non-securities

The sale of those non-securities that we listed above is not regulated by state securities laws. 

Many people do look to them as a way to invest their money, however, as they are attractive investments.

Under state securities laws, a registered person would not be in violation if he or she committed fraud when selling or buying these types of items for clients.

Other regulations, however, may include antifraud provisions that can be used to prosecute them. 

Annuities that provide fixed payments are not securities, as we have discussed.

A variable annuity, however, is considered a security.

That’s because the performance of the securities within the annuity determines how well it does. 

Issuers

The issuer of securities is the party that originates them.

First, they will propose to issue them and then distribute them for investors to purchase.

When you think of an issuer, the most obvious that spring to mind are large corporations.

There are numerous other large issuers, including the federal, state, and municipal governments, and subdivisions and agencies thereof. 

Certain issuers are considered to be nonexempt and as such, their securities will need to be registered when issued.

That registration will be necessary for multiple states should the securities be sold in them. 

Transactions carried out by issuers

Securities transactions that result in all proceeds going to the issuer are known as issuer transactions. 

Newly insured securities are an example of an issuer transaction, which is an initial public offering (IPO). 

Securities can also be sold by a company to investors, which is also an issuer transaction

This is because the company will receive all proceeds from it.  

Transactions considered as non issuer

With these, the issuer who put up the initial IPO won’t receive the sale proceeds generated by the securities. 

For example, any securities sold on exchanges are considered as non issuer transactions. 

Investments put up for sale on an exchange are sold by investors, who profit from the sale.

Primary offering

An initial offering always involves the public offering of new securities. 

An IPO is the form this takes.

This is always an issuer transaction because the proceeds are generated by the sale of these securities. 

Securities that don’t require registration 

Under the Uniform Securities Act, securities sold to the public are regulated. 

Investors should have access to all the information necessary to make informed decisions about their investments when securities are not exempt from this act.

It depends on the type of transaction as well as who issues the security and whether it needs to be registered under state and/or federal law.

State law prohibits the sale of unregistered securities unless they meet the following criteria:

  • In accordance with the Uniform Securities Act, it has been registered
  • In accordance with the act, the security is not required to be registered
  • According to the act, the security transaction is exempt from registration
  • This is a federally covered security 

Let’s determine what a federal covered security is.

This type of security will not require registration at the state level. 

For some, such as mutual funds, notice filings must be sent to the state when they are put up for sale. 

Categories of federal covered security  

These include:

  • Issued by open-ended or closed-ended investment companies 
  • Issued by registered unit investment trusts or face amount certificate companies
  • Securities listed on the various stock exchanges. Bonds and preferred stock (higher in seniority than these securities) are also included, as are rights or warrants with higher seniority
  • Securities qualifying under the private placement transaction exemption provision of Regulation D Rule 506 (b) and (c)
  • Exempt securities as per the Securities Act

Exemption registrations 

Transactions can also be seen as exempt, while exempt securities will retain their exemption from the moment they are issued and any trading thereafter. 

Exempt securities must, however, be justified before each transaction. 

The exemption must be established before each transaction if the transaction is exempt. 

Federal covered securities cannot be revoked, suspended, or denied by a state administrator.

Exempt transactions are defined by either the person to whom a sale is made or the manner in which it is made with each judged on its merits. 

Securities considered as exempt

Here’s a list of exempt securities that you should remember:

  • Those from the U.S. and Canadian government 
  • Those from foreign governments
  • Those from depository institutions 
  • Those from an insurance company 
  • Those from public utility and common carrier  
  • Those that are federal covered securities
  • Those from a non-profit organization 
  • Those issued by employee benefit plans
  • Some money market instruments

Transactions considered as exempt

We will focus on transactions that may appear on the Series 65 exam since there are many transactions that are considered exempt.

  • Isolated non issuer transactions
  • Unsolicited brokerage transactions 
  • Underwriter transactions 
  • Conservator, guardian, or bankruptcy transactions 
  • Institutional investor transactions 
  • Limited offering transactions  
  • Preorganization certificates 
  • Transactions with existing security holders
  • Non issuer transactions by pledges

Exempted securities under the Securities Act

These include:

  • Securities issued or guaranteed by the United States.  
  • Commercial papers. It must not take more than 270 days (9 months) from the date of issuance to maturity. Proceeds must only be used for working capital by the issuer. 
  • Those issued for religious, educational, fraternal, charitable, or benevolent purposes. 
  • Railroad equipment trust interests
  • Federal and state bank-issued securities

Exempt transactions under the Securities Act

Series 65 exams generally include only two exempt transactions under the Securities Act.

  • Private transactions  
  • Issuer transactions that are not considered to be a public offering

Federal law requirements pertaining to the registration of securities

Securities must be registered according to the SEC’s procedures.

A variety of documents will need to be filed in order to provide details about the relevant securities.

We won’t spend too much time on this, since it’s covered in the coursework and various other exams, like Series 6 and Series 7. 

As part of this registration process with the SEC, we will mention some critical documents that are required, however. 

Registration statement

In order to issue securities, a registration statement must be filed with the SEC.

This will include the following information:

  • What the issue is primarily about
  • Price range expected for the public offering
  • Discounts and commissions of underwriters
  • Any promotion costs
  • How the proceeds from the offering will be used
  • Balance sheet
  • Statements of the issuer’s earnings for the last three years
  • Information about officers, directors, and stockholders who own more than 10% of the company’s shares 
  • Copies of the underwriting agreement
  • Copies of the articles of incorporation of the company making the issue

As soon as the SEC receives the registration document, a 20-day cooling-off period begins.

The registration becomes effective after this period has passed.

After that, sales can be solicited. 

Preliminary prospectus

For prospective purchasers who show interest in a security issue, this document is a crucial one and it is sometimes known as a red herring. 

It must be available when the issue is filed with the SEC and until it is available for sale. 

This is used to gauge investor interest but it also provides interested parties with information about the issue.

In contrast to a registration statement, it does not serve as a confirmation of a sale. 

Additionally, the preliminary prospectus cannot include the final offering price.

It does have to include a price range of the relevant shares, however. 

Final prospectus

It is unlikely that every potential investor will read through the registration statement.

This is why a prospectus is required, which is a shorter document that contains important investor information.

An overview of the registration document can be found here. 

Prospectuses must be sent to any investor interested in an issue. 

Registration statement and the filing thereof

State administrators require the following information for all applications:

  • How many securities will be issued in their state
  • All the states where the securities will be offered to investors
  • If there is an adverse order/judgment against the offering
  • The anticipated date on which the offering will be made available
  • How proceeds will be used

Methods pertaining to the state registration of securities  

Securities issuers have a few methods of registering securities under the Uniform Securities Act which are:

  • Notice filing
  • Coordination
  • Qualification

Notice filing registration

When a federal covered security is sold, notice filings may be required from state administrators, particularly for investment companies registered with the SEC.

By filing notices, the state is able to collect revenue in the form of filing fees. 

In order to file a notice for sale of federal covered securities, the following documents are required:

  • Any documents filed with the SEC and accompanying the registration statement
  • Amendments filed with the SEC
  • Report on the value of securities in the state in which they are offered
  • A service to process consent

Coordination registration

Especially for multistate offerings, coordination is the most common way to register securities that aren’t federally covered.

The Securities Act permits this method of registration when securities have been filed in connection with the same offering. 

Records must also be provided along with a consent processing service and they include:

  • A copy of the latest prospectus 
  • Articles of incorporation and bylaws copies
  • Underwriting agreement copies
  • Other information filed with the SEC as requested by the administrator
  • A list of all amendments to the prospectus 

Registration by coordination also becomes effective at the same time as the federal registration.

Qualification registration

For those securities that cannot be registered through the first two methods above, this is the only option available.

The purpose of this type of registration is most often to register securities for sale in a single state. 

Along with a service to process consent, below are the details that need to be provided:

  • Various details pertaining to the organization
  • Particulars of persons who own outstanding shares of the issuer (10% or higher) 
  • Proceeds raised estimates and how the issuer will make use of them
  • Copies of the prospectus, any circulars, pamphlets and other sales literature
  • A specimen copy of the relevant security certificate

On an order from the state administrator, registration by qualification becomes effective.

One year is the validity period for all of the above registration methods.

Unsold shares (by both issuer and underwriters) will continue to be registered as long as they remain at the original POP. 

Antifraud provisions provided by the Uniform Securities Act

These will pertain to fraud related to securities, investment advisers and broker-dealers.

Antifraud provisions apply to even exempt securities as well. 

These antifraud provisions do not apply to investments that do not qualify as securities, however. 

In that respect, there are other laws that protect investors.

F. Administrative provisions

The administrative provisions of the Uniform Securities Act are discussed in this section.

Furthermore, we discuss the remedies that administrators have over securities transactions in their jurisdictions. 

State administrators and the jurisdictions afforded to them

State administrators are responsible for overseeing securities transactions in their states as part of their overall jurisdiction.

Additionally, this jurisdiction covers those directed to the state as well as those accepted there.

Their jurisdiction includes any:

  • Sale or sell
  • Offer 
  • Offer to sell

There are exclusions to this, including:

  • Pledges or loans 
  • Gifts of nonassessable stock  
  • Stock dividends and splits
  • Class vote by stockholders

Administrators actions

Administrators have four main powers when acting in their states:

  • It is possible for them to make, change, and revoke rules and orders when it comes to the use of specific forms
  • Where necessary, they can conduct investigations and serve subpoenas
  • It is possible for them to serve cease and desist orders and file injunctions
  • Registrations and licenses can be denied, suspended, revoked, or canceled by them

Make, change and revoke rules and orders pertaining to forms

It is pretty self-explanatory, but it is important to remember that rules differ from orders.

While an order applies only to one instance, a rule applies to everyone.

Carry out investigations and serve subpoenas

An administrator or someone designated by them can handle an investigation in the following ways:

  • For the issue being investigated, obtain written and under oath statements
  • Publicize the facts surrounding the issue under investigation
  • Issue subpoenas  
  • Document evidence in book form, if necessary, including correspondence, books, and papers.

File injunctions, serve cease and desist orders

If they have to stop an act that is violating the provisions as set out in the Uniform Securities Act, administrators have the power to:

  • Serve a cease-and-desist letter without a hearing
  • Grant a temporary/permanent injunction to enforce orders

If administrators receive information beforehand from whistleblowers, for example, they can prevent a potential violation.

Deny, suspend, cancel or revoke registrations

Broker-dealers, investment advisers, and anyone representing them are all affected in this regard.

Securities and their registration are also included. 

Let’s look at this by starting with broker-dealers, investment advisers and their representatives

These powers can be put into effect should the groups above have:

  • Provided incomplete, false, or misleading registration applications 
  • If they have carried out a willful violation of the Uniform Securities Act
  • Been disqualified from membership to any regulatory body related to securities or commodities because of an act carried out in the last decade
  • Hold a felony conviction from the last 10 years 
  • Been prohibited from dealing in securities by law
  • Been suspended, denied, or had their license revoked by another administrator in a different state 
  • Been involved in previous unethical or dishonest securities practices 
  • Been declared insolvent
  • Been the subject of a prior adjudication that declared them to have broken rules from any one of the five pertinent Acts
  • Not paid their application fees
  • Been declared guilty of not supervising others correctly in their role as a broker-dealer 
  • Deemed not to be qualified because of a lack of experience in, knowledge of, or training in the securities business  

What about securities issues?

Administrators can also deny, suspend, revoke, or cancel their authorizations.

This can happen in the following circumstances:

  • Misleading or incomplete registration statements are filed
  • In the event that the terms of the offer are unfair, unjust, inequitable, or unjust
  • Securities registrants have charged unreasonable or excessive fees
  • The control person in charge of securities has a previous securities-related conviction
  • The securities registrant is the subject of a court injunction
  • An illegal business method is being used by the securities registrant
  • An administrative stop order against the securities registrant is in effect from another state

Registration can also be denied if a filing fee is not paid on time.

When all other procedures are followed, the order will be removed once this is paid.

Nonpunitive terminations pertaining to registrations

Registration can still be terminated by the administrator even if there hasn’t been a violation under the Uniform Securities Act.

Cancellation may be due to a withdrawal request or a lack of qualifications.

Withdrawal

Withdrawal of registration can be requested by the individual concerned. 

As long as there are no proceedings against the individual, this will take effect within 30 days after the administrator receives it. 

If there is a withdrawal, the administration can still institute suspension or revocation proceedings within a year after it has become effective. 

Cancellation

An administrator may choose to cancel the registration of a registrant or applicant if they no longer practice or operate a business. 

G. Client/prospect communication

When someone first gets in contact with a securities professional, they are first considered as a prospect. 


Prospects and clients are different in terms of the way you would communicate with them.  

As a result, not only is the prospect or client protected, but also the securities professional.

Capacity disclosures  

The securities industry relies heavily on disclosure, especially if it wants to avoid disciplinary action.

Securities professionals will be fine as long as they disclose properly to prospects/clients. 

When broker-dealers carry out transactions, they can operate in two capacities: as a principal or as an agency.

As principals, they are on the other side of the trade or contra party to it.

In this case, the security is being sold out of the firm’s inventory to the client.

The securities profession will make a profit from a markup. 

In the event that the client sells from their inventory, the firm that buys it again acts as the principal. 

Profits are generated by markdowns in this case.

It’s different when you’re working in an agency capacity.

Firms act as agents or brokers to connect sellers with buyers or vice versa. 

Commissions are earned in this situation. 

A broker-dealer’s capacity must be clearly indicated on trade confirmations. 

In addition to the markup or markdown, if they acted in an agency capacity, the commission must also be included.

Investment advisers and disclosure of capacity

Although an adviser’s main role is to provide investment advice, they can occasionally act as a principal or as an agent.  

Regulators have recognized that advisers have the potential to engage in self-dealing in both principal and agency transactions. 

They are concerned about principal transactions because they can lead to abuse, like placing unnecessary securities in a client’s account or manipulating prices.

If advisers take part in an agency transaction that earns extra compensation for them on behalf of their clients, that can also cause a conflict of interest.

While regulators do not prohibit advisers from carrying out these transactions, certain disclosure and consent requirements must be met if they do.

Included in this are the following:

  • Clients are informed in writing in which capacity the adviser will act in specific situations
  • Prior to doing so, the client’s consent must be obtained

Additionally, we should mention agency cross transactions here. 

On one side of the trade, advisers act as the agents for their clients, but on the other, they are also involved in the role of the other party. 

In accordance with regulations, this can be done with written consent and disclosures of the following information:

  • A commission will be collected from both sides by the adviser
  • It is possible for there to be a conflict of interest due to the division of loyalties between both sides of the transaction
  • Annual statements must show the number of these transactions made and the remuneration received by the advisor for carrying them out
  • Indicate that these arrangements can be terminated at any time
  • If an investment adviser or anyone associated with them recommended a transaction to either a buyer or a seller, the transaction cannot be completed. 

Before or at the conclusion of an agency transaction, a client must receive a written trade confirmation that includes the following information:

  • A statement describing the nature of transactions
  • When it occurred (date specifically, but the time too, if requested by the client)
  • An adviser’s or their associate’s remuneration and the source thereof.

Requirements regarding disclosure  

A client should be provided with literature, usually a written statement that makes the relevant disclosures by their adviser. 

Disclosure would include the following:

  • Whether the adviser was subjected to state or regulatory action for violating any rules or statutes
  • If permanent injunctions or other similar court proceedings are in place against individuals or firms relating to investment-related activities or felonies
  • If any regulatory action taken against an adviser resulted in the firm’s registration being revoked. Additionally, if an individual was suspended, barred, expelled, or fined $2,500 or more, this must be disclosed

Examples of material information not disclosed to clients include:

  • Not informing them of all the fees they need to pay.  
  • Clients are not informed of the broker-dealer’s affiliation with other securities professionals or issues
  • An adviser must disclose a financial condition that could compromise their ability to meet contractual commitments with clients. It applies to state-registered advisers with discretionary authority over client accounts, or if clients have paid $500 ($1,200 for federal advisors) upfront
  • A firm’s allocation policy is not disclosed when allocating securities to accounts participating in bunched trades or doesn’t use the average price paid
  • Clients should be informed of any material legal action taken against an adviser

Disclosures regarding conflicts of interest

Clients expect their investment advisers to do what is best for them. 

Even though fiduciary relationships exist in the client-adviser dynamic, conflicts of interest are possible. 

Some examples of that are as follows:

  • Asking clients if they are interested in participating in a proprietary product the advisor has an affiliation with
  • Clients considering DPPs, but the sponsors thereof are affiliates of the advisor
  • Selling investment or insurance company products that provide rewards for the advisor for doing so
  • Recommending securities in which they have an interest
  • Placing shares of their own stock into the discretionary accounts of their clients
  • The publication of favorable research reports about a stock issue underwritten by the same broker-dealer

Disclosing fees

Fee structures cannot be set in stone for all securities professionals, since not all offer the same services.

However, regulators want to ensure that fees charged to clients are not excessive. 

In addition, when fees are not disclosed to clients, a violation has occurred.

Customers of securities professionals often don’t understand how their account fees work, according to research.

In order to simplify disclosure for them, you can do the following:

  • Providing them to new clients at account opening 
  • Notifying clients of new fee schedules when they become effective 
  • Provide as much information as possible about fees and charges.  
  • The terms used by firms should be uncomplicated and standardized so prospects and clients can compare fees easily

Misrepresenting the registration of a securities professional 

The registration of a securities professional as well as that of securities cannot be misrepresented.

If you are a security professional, registering within a state, for example, is never an approval by the state administrator, and a client can never be told this. 

In that state, you are only a broker-dealer, adviser, agent, or representative working there. 

Securities registrations that are falsely represented

Let’s also discuss securities while we’re at it.

The registered security has not been approved by any regulatory body or state administrator.

There will also be a disclaimer in the prospectus that confirms this.

A criminal prosecution can be brought against those who tell their clients that a specific security is approved by a regulatory authority. 

Performance guarantees

Clients cannot receive guarantees from securities professionals regarding the performance of a security.  

As a result, guaranteed securities cannot include gains. 

Giving guarantees against losses

A performance guarantee cannot be offered to a client.

So you can’t guarantee a client that you’ll buy back shares that don’t perform or make up the difference if they don’t earn a certain amount over time.

Certain circumstances, however, allow for performance-based compensation.

Here, the securities professional receives a higher compensation if the investment returns exceed a selected index, for example. 

A poorer performance will also result in a lower compensation for the client.

Investment advisory contracts

The following information must be disclosed in an investment advisory contract:

  • The services that will be carried out
  • The terms of the contract
  • Fees to be charged or the formula used to calculate them
  • How prepaid fees will be calculated or charged if the contract is terminated
  • If discretionary power is provided to the adviser or their representatives by the contract
  • To assign a contract, the client must give consent to the adviser
  • Clients must be informed when minority interests in a partnership are altered
  • It is not possible for fees to be waived if losses are suffered on the investment  

Communication

Social media and correspondence

Communicating with prospects or clients in a fair manner is essential at all times.

The key here is to keep disclosure of the necessary information they need to receive at the top of your mind at all times.   

This includes when communicating through social media, which has exploded in popularity. 

When it comes to social media sites, securities firms should have policies and systems in place to ensure that they are both supervised and reviewed. 

Investors’ concerns about social media

While social media has changed how we communicate, there are a number of phony investment schemes looking to take advantage of the unwary.

Securities professionals have the responsibility of protecting their clients in this regard.  

Social media content generally falls into two categories: static and interactive. 

When static content is posted, it remains the same until it is changed.

Interactive content allows persons viewing it to interact, and the firm can then also reply to those interactions, for example, a Facebook or Twitter post. 

Securities professionals should alert investors to online red flags, which include:

  • A high-return investment with promises no risk
  • Operations offshore where U.S. regulators cannot enforce their authority
  • Sites that only accept e-currencies
  • An investment opportunity that encourages others to recruit their friends, family, and other acquaintances
  • Websites that may look professional, but provide little information about their owners and no contact details or locations
  • The potential investment is not fully described in writing and no prospectus is available to download
  • Testimonials. It is common for scammers to pay high returns to early investors in order to dupe others.  

Regulators and their concerns regarding social media 

When it comes to social media and the use thereof, the SEC, FINRA, and other regulatory bodies have policies in place which are updated regularly.  

As an example, FINRA’s guidance encompasses not only social media but other forms of online communication as well. 

Determining a communication’s category is more crucial for establishing supervisory and filing requirements and this is where the content thereof plays a role.

The compliance responsibility remains the same, whether face-to-face or online, according to FINRA. 

A securities professional must always follow the policies and procedures established by his or her employer, within regulations, of course. 

Inappropriate use of social media and email can result in hefty fines. 

It is important to remember that those representing securities firms must adhere to online communication regulations, even during their private time.

Advertising

The NASAA does not allow for the use of misleading advertising or sales presentations. 

This includes:

  • Using nonfactual data and then distributing it to clients, for example
  • Conjecture-based material or presentations
  • Advertisements that make unrealistic or unsubstantiated claims
  • Prospectuses should not contain any information that might detract from, defeat, or supersede its purpose

Broker-dealers and advertising

When making recommendations to the public, websites can play an important role for broker-dealers. 

The suitability of social media recommendations is no different from that of any other method. 

For the suitability rule, it’s not always obvious when communication is considered a recommendation. 

Taking into account what is and isn’t a recommendation can help. 

When a broker-dealer acts as an order-taker in a transaction, these below would not be considered recommendations. 

  • An electronic library or research report with buy and sell recommendations by brokers and available on their website. 
  • A broker-dealer website with a search engine for customers to sort stock performance, industry sector and other results 
  • Broker-dealers offer their clients a subscription email that gives news about securities they own or might want to own.

As a recommendation, however, we would consider the following: 

  • A client or group of clients is sent an electronic message advising them to consider investing in a certain security.
  • Providing electronic communications to clients suggesting that they purchase stock from a particular sector. This would include the stock from companies the firm thinks are best to buy
  • Offering clients a portfolio analysis tool that allows them to provide their specific investment goals as well as their particulars, like age, for example. 
  • Utilizing data mining to evaluate a client’s financial activity and suggest investments based on that evaluation 

These are just some of the examples of recommendations, there are many more. 

 

Investment advisers and advertising

NASAA model rules state that advertisements that do not adhere to Investment Advisers Act requirements should never be used. 

According to SEC regulations, advertisements include notices, circulars, websites, letters, and others.

A number of people could receive them, and they include:

  • Publications, reports, or analyses of securities
  • Graphs, charts, and formulas that help clients decide how to invest in securities
  • Advisory services for security investments

Investment adviser advertising cannot:

  • Include false statements of material fact
  • Have testimonials in them
  • Provide devices such as charts and formulas that indicate the purchase and sale of securities by themselves
  • When analysis reports won’t be free, say they will
  • Include previous profitable recommendations  
  • Provide gross performance information
  • Infer that the adviser has been recommended, sponsored, or approved by either the state administrator or the SEC

Issues related to agents

Agents should be aware of the following:

  • We have outlined the rules that apply to them if they wish to communicate with clients on social media using their own devices
  • There may be times when supervisory approval is required, depending on the type of media the agent is using.
  • Whenever you link to third-party websites, be aware that the information on those sites might violate SRO regulations.

Supervisory actions pertaining to broker-dealers/Investment advisers 

Using social media for business should be governed by policies and procedures. 

Regular training should also be provided to staff.

It is important that they understand the difference between static and interactive content, for example.

The same applies whether the communication is business- or non-business-related, or if it is deemed to be retail, which means pre-approval must first be sought. 

Social media use also requires consideration of privacy.

As a result, a firm’s social media policies should address relevant privacy concerns. 

All policies must:

  • Be in a written format
  • Full communicated to all staff
  • Be clear
  • Be concise
  • Point out each person’s responsibilities when it comes to social media use 
  • Describe how social media usage is monitored by the company

H. Fiduciary obligations and ethical practices

Our focus here will be on ethical considerations and fiduciary responsibilities.

Investment advisers: Fiduciary responsibility

Investor advisers must act ethically and have fiduciary responsibilities when providing their services.

The consent of a client will be required if you are acting as a principal or agent during trades, for example. 

As part of their fiduciary responsibility, advisers must always find conflicts of interest and eliminate them, as well as tell their clients about them. 

Compensation disclosure

The disclosure of compensation is a crucial part of any fiduciary relationship. 

The following information should always be provided to clients:

  • Compensatory methods used by advisers and how these are calculated
  • What the prepaid fees are and how they are refunded, if necessary
  • The compensation method used by the adviser  
  • If the securities issuer offers compensation or incentives which would be a conflict of interest

It’s important to note that performance-based compensation isn’t permitted, but there are some exceptions. 

These are available to qualified clients only including:

  • During the time the contract is entered into,  a company or natural person with more than $1 million
  • Prior to entering into a contract with a company or natural person, the adviser believes they have a net worth of over $2.1 million  
  • Officers/directors and IARs of the adviser who are considered natural persons and who have a least a year’s experience in the industry

If it is calculated using the average amount of money under management over a certain period, you cannot consider it a performance fee and this is good to remember for the exam. 

In addition, state-registered advisers are subject to one major difference in a rule than federally-covered ones.

For any contract for which an adviser receives compensation based on a share in capital gains or if there is capital appreciation on a client’s funds, they must provide in writing the following information to the client:

  • Fee arrangements can create an incentive for advisers to invest in more risky or speculative investments in order to benefit from them
  • When relevant, the adviser might get more compensation if the client’s account shows realized gains and unrealized appreciation
  • Indicators used to measure investment performance, as well as their significance and relevance

Federally covered advisers do not have to make these disclosures to their clients. 

The most common of these fees is called a fulcrum fee.

In this case, the fee is averaged over a specific period of time (but not less than 12 months).

An average is calculated by comparing the investment’s performance to a securities index, for example, the S&P 500.

Cash referral fees

Referral payments must be accounted for when discussing compensation.

In accordance with the Investment Advisers Act and the Securities and Exchange Commission, cash referral fees are not prohibited.

In order for solicitors to receive these fees, four conditions must be met, three of which are specific to cash referrals. 

  • Registration under the Advisers Act is required for the adviser
  • Statutory qualifications are not currently applicable to them
  • These fees must be agreed upon in writing before payment can be made

Cash referral payments could still be denied if one of these three conditions are not met: 

  • Advisory fees are paid for impersonal services
  • The adviser pays a referral fee to an affiliate
  • It goes to solicitors who are not affiliated with the firm 

Fees received by third-party solicitors not affiliated with the adviser must be disclosed.

These disclosures include:

  • The client must be told who the third party is, except when impersonal advisory services are provided
  • Third parties’ sales approaches and scripts are under the adviser’s control

In order to comply with the SEC’s regulations, referrals and solicitors must keep the following:

  • A written agreement shows that the adviser is a party to the payment of these fees
  • An acknowledgment signed by the client that they have received both the advisor’s and solicitor’s disclosure statements
  • An investment advisor’s and a solicitor’s written disclosure document

In order to solicit on behalf of state-registered advisers, an investment adviser representative must be registered.

Soft dollar compensation/safe harbor

The concept of soft dollars and safe harbor will be discussed next. 

What are they?

Safe harbor means acting in a legal manner. 

Section 28 (e) relates to when a broker-dealer compensates an investment adviser ethically. 

What is the process?

Other than executing transactions, broker-dealers provide a variety of services to others, including research. 

One type is proprietary research, and it’s something that investment advisers often need. 

There are times when a certain dollar amount is specifically allocated for the research component.

The term used to describe these are soft dollars. 

Soft dollar practices are referred to as directed transactions by the SEC.

This is a product or service from the broker-dealer that has nothing to do with the adviser’s acquisition of securities.

Broker-dealers receive client brokerage transactions in exchange. 

Clients must always be informed of any soft dollar arrangements.

Form ADV Part 2A must also disclose the brokerage allocation policies of registered investment advisers.

Regulations also require advisers who accept soft dollar perks to mention the following:

  • Due to the fact that they don’t pay for the research or produce it, the adviser benefits from it
  • Advisors are then encouraged to recommend broker-dealers that will offer them these benefits rather than getting clients the best execution.

Funds and securities custody rules

This section examines how broker-dealers and advisers are required to protect clients’ securities and funds. 

Safekeeping

To hold a client’s funds or securities, an investment adviser must comply with the following conditions:

  • Custodians are qualified. A separate account is kept for each client’s funds or securities. Where an adviser or broker-dealer is a trustee or agent for them, they can keep them in their account
  • Upon opening accounts with qualified custodians, the client must receive a notification as well as the details of the custodian, how they will keep the funds/securities, and more
  • An account statement must be provided to clients either by a qualified custodian or an adviser
  • A Form ADV is used by the adviser to notify the administrator as per the NASAA model rule 

A qualified custodian could be a savings association or even a bank that has FDIC insurance. 

A registered broker-dealer or foreign financial institution (under certain conditions) can also qualify. 

NASAA’s model rule also covers direct fee deductions. 

As a result of fees being deducted directly from the client’s account that an adviser also has custody of, these safeguards must be put in place:

  • Whenever advisory fees are to be deducted from a client’s account that is held by a qualified custodian, the advisor must obtain written authorization from the client to do so first
  • Fee deduction notices must be sent to clients before fees are deducted. 
  • Form ADV must state that these safeguards will be implemented by the adviser.

Investment discretion

You will often find that investment discretion is tied to the custody of client funds or securities. 

For the exam, you should be able to tell the difference between the two since they aren’t the same thing at all.

Discretionary accounts allow the securities professional to make transactions as they see fit with client approval.

Clients will need to give the adviser preapproval authority first, of course. 

Securities professionals who are given discretion can decide:

  • The security 
  • The number of units thereof
  • If it’s to be a buying or selling transaction

A securities professional who controls a client’s account can encounter conflicts of interest.

For example, a broker-dealer’s compensation is based on the transactions that occur in the client’s account.

Because it’s transaction-based, it generates more income through more trading.

It’s easy to see how that conflict of interest could arise then. 

As advisers and IARs, trading action from an account is rarely compensated, so this is less of a concern. 

Time and price discretion are also important considerations. 

Customers give this orally.

This is an exception to the requirements we have discussed above. 

It’s important to understand how long this type of discretion lasts.

It only applies to the day when the customer gives it to you.

An extension is possible with a signed and dated customer instruction. 

Time and price discretion purchases and sales of securities must be reflected on the order ticket as they would be for regular discretion.

Discretion: Investment advisers

It would have been necessary for an adviser to obtain prior written authorization before operating in an advisory capacity. 

NASAA’s model rule has a pretty unique provision. 

The account is permitted to have oral discretionary authority for the first 10 business days following the first discretionary transaction date. 

After that period, however, written authorization is required for any further transactions.

The adviser may not trade using that client account if that information is not received. 

Third parties trading authorizations

Clients also give others the ability to control their accounts.

If a third-party trading authorization is obtained beforehand, for example, a spouse can give instructions on an account.

No instructions need to be followed if there isn’t one. 

It is also prohibited for an adviser not to follow through on an instruction they receive from their client if one exists.

Commingling

This term is no doubt familiar to you. 

Segregating customer securities from firm securities is always a necessity.

In contrast to collateral pledged for margin accounts, these securities do not have liens on them. 

In finance, these securities are called free securities.

What’s the problem with commingling securities?

Basically, the company will have greater borrowing power and leverage when this occurs. 

A default will also jeopardize the client’s securities which obviously is a problem. 

Improper hypothecation

Unless the customer consents, their securities cannot be pledged as collateral (or hypothecated).

It is also necessary to obtain this consent in writing. 

Considerations pertaining to anti-money laundering 

In laundering money, those with criminal intentions convert proceeds from criminal activities into funds that appear to have been generated through legal means. 

Using this method, criminals can conceal the money they get from these illegal activities. 

Money laundering can be combated in many ways by securities professionals.

Customer transaction reports (CTRs) are of particular importance in this regard. 

It is required by the Bank Secrecy Act to file a CTR for each transaction over $10,000 within 15 days.

The act also requires reporting of wire transfers of $3,000 or more. 

A deposit that is specifically designed to be under $10,000 is considered a prohibited activity.

It is important for financial institutions to have systems in place for detecting this practice (known as structuring). 

Prudent investor rule

Advisers and IARs should always keep the prudent investor rule in mind when making recommendations to their clients. 

A three-decade-old law called the Uniform Prudent Investors Act (UPIA) guides this process. 

As a result, prudent investing criteria were modified as follows:

  • The standard of prudence applies not to individual investments but to investments included in a portfolio
  • It is the fiduciary responsibility to always take risk and return into account when making investments
  • There are no longer any categorical restrictions on investment types. As a result, any investment can be made by the fiduciary as long as it contributes to the risk and return objectives of the account and is in accordance with other prudent investing guidelines
  • It is now a requirement that investments be diversified as part of prudent investing
  • Before the UPIA, trustees could not delegate investment functions. Delegations are now permitted, but fiduciaries must exercise caution

Broker-dealer/agents and statement of policy concerning unethical business practices 

Securities professionals can be held accountable for unethical practices under NASAA’s model rule (covering investment advisers) and statement of policy (covering broker-dealers). 

This policy includes some dishonest and unethical business practices as listed below.  

Delivery delays

The delivery process should not be delayed unreasonably or unjustifiably.

Customers who request money from their account or any free credit balances that reflect completed transactions, in addition to the delivery of securities they have purchased are covered here. 

In addition, it is prohibited to hold back a certificate a client requests for a security they may have purchased. 

When the request is made, this must be delivered to them.

Making unsuitable recommendations

A customer’s investment objectives, needs, financial situation, ability to assume risk, and other critical information must always be considered when buying, selling, or exchanging securities on their behalf. 

The client must provide all relevant information as requested, and if they are unwilling to do so or do not indicate what their objectives are, then recommendations should not be made to them. 

While orders can still be taken from clients who act in this manner, only unsolicited orders can be accepted. 

Due to the fact that investment advisers are compensated for the advice they provide, they should not open an advisory account if a client fails to provide the required information. 

You should know that blanket recommendations to a range of clients are considered unethical and a question often pops up in the exam about this.  

Seminars

NASAA doesn’t specifically include free lunch seminars in its statement policy, but you should be aware of them, especially when they are for seniors.

Financial service firms use these seminars to sell their products and attract clients by providing a free meal. 

In spite of the fact that they are marketed as informational seminars, that’s not what they are meant to accomplish.

Ideally, they would like people to sign up for their products or at least provide them with contact information. 

NASAA considers both the firm that sponsors such seminars and the registered individuals involved to have engaged in a prohibited business practice when doing so.  

Withhold public offering shares

Broker-dealers must make public offerings of all securities allotted to them if they acquire them as an underwriter, as part of a selling group, or from someone acting in those capacities.

As a result, shares cannot be withheld at any time or kept for the firm. 

Complaints

Customers should be granted access to any information they are entitled to upon reasonable request and not doing so is a prohibited offense. 

Similarly, failing to respond to written requests or formal complaints is illegal. 

Front running

Front running (or trading ahead) is placing one’s personal orders in front of a customer order that has been received previously. 

Institutional orders of massive size can cause the market to move because by putting their order in front, the firm representative can make big profits when this move occurs. 

Rumors

If any agent or IAR hears a rumor, they should report it immediately. 

Rumors should not be spread at all and certainly shouldn’t form the foundation of client recommendations.  

Backdating

Records cannot be backdated at any time.

When a purchase order was placed, for example, it should always reflect the actual day on which it occurred. 

Clients might ask you to backdate trade confirmations for tax or other reasons.

Always refuse, as this is unethical.

Borrowing/lending

Engaging occurs when a company borrows or lends money to or from a customer.

This practice pertains not only to money but can include securities as well.  

Professionals in the securities industry are allowed to borrow money from clients to purchase securities.

It is required, however, that the client be either a financial institution, a broker-dealer, or an affiliate of a professional.

In terms of lending money to clients, that’s allowed if the firm is a broker-dealer or a financial institution and part of their business is lending these funds. 

Clients who are affiliates of the firm can also be served in this manner. 

Agent-specific practices

Until now, we have discussed unethical practices for both brokers and agents, but there are some that relate only to agents. 

Using fictitious accounts

Both establishing and maintaining accounts with fictitious information are prohibited.

For example, a client’s net worth could be inflated so that they are allowed to trade options and margins.

Account sharing

Agents who don’t have the necessary authorization are not allowed to participate directly or indirectly in customer accounts, including profits or losses.

Client consent must be confirmed in writing by the individual. 

The agent must also receive written authorization from the broker-dealer he or she represents. 

A joint account can be opened if the agent has the necessary authorization we have covered above. 

Broker-dealers, investment advisers, and IARs cannot share profits or losses generated by customer accounts. 

Commission and the splitting thereof

No commissions, profits, or other types of compensation may be split with other brokers-dealers working under direct or indirect control and not registered as agents. 

It is not necessary to inform the client about commission splitting if the conditions are met as outlined above. 

Unethical/criminal activities

Let’s look at a few to remember.

Client information and the confidentiality thereof

Clients, advisers, and their representatives maintain a confidential relationship at all times.

The provision of client information to other parties, such as identity, financial affairs, or investments, is prohibited, unless required by law, or if the client gives consent. 

Inside information and the misuse thereof

An adviser or their representatives should not make recommendations to their clients based on material inside information regarding a particular security or issuer. 

A compliance officer or supervisor should be notified as soon as you are privy to information like this from another individual. 

In accordance with regulations, a research report is considered inside information if it contains information generated internally before it becomes public knowledge. 

In securities regulations, any nonpublic information about a company that could impact the value of a security is known as material nonpublic inside information (MNPI).

Trading based on MNPI is prohibited for insiders or control persons (individuals who own more than 10% of the voting stock of a company) and they may not pass it on to other parties to act on either. 

Violations are only chargeable once a transaction has been completed, however.  

Chinese wall doctrine

The investing public won’t know about confidential information that broker-dealers are exposed to when dealing with investment banking and mergers and acquisitions.

That’s where the Chinese Wall analogy comes into play, serving as a barrier to prevent this information from being shared with other departments of the broker-dealer. 

Essentially, Chinese Walls refer to the measures the firm follows to ensure information isn’t leaked.

From time to time, this will be called an information barrier. 

Selling away

Carrying out securities transactions that have not been recorded in a broker-dealer’s books or records is illegal and that’s what selling away essentially is

As long as these transactions have been authorized beforehand in writing, this shouldn’t be an issue. 

Churning/excessive trading

As a means of generating extra compensation, churning involves generating excessive transactions on a client’s account.

If a customer’s account has excessive transactions, a number of factors need to be considered to help establish if this is churning. 

For example, the account of someone who is 80 years old, won’t have a need to have excessive transactions taking place, because of their risk profile.

Someone who is younger, and who is prepared to take more risks will have an account with more transactions taking place. 

Manipulating the market 

Manipulating or fraudulently inducing securities sales or purchases is fraud. 

There are two types of market manipulation that are most common: wash trades and matched orders. 

We start with matched orders

In this case, securities are bought or sold knowing that an opposite order will be executed soon after, or has recently been executed. 

In either case, the idea is to create the appearance that the security in question is actively traded. 

In the end, this can lead to unwitting investors purchasing the security, which will then drive its price higher. 

A large profit is made by those who initiated the match orders by selling the securities they hold. 

Next is a wash trade.

A purchase or sale of securities does not change beneficial ownership.

There are several reasons why this is done:

  • Creating the illusion that the security is actively traded when this is not actually the case
  • To make it appear that there is an active market for the security 

This is accomplished by buying the security with one brokerage account and then selling it through a different account, resulting in no ownership change. 

In the market, however, it appears that the price and/or volume are rising. 

In terms of taxation, this is not a wash trade.

This occurs when the security is sold and then bought back within a 30 day period. 

Due diligence

Regulatory bodies have noted that a range of alternative investments are being recommended to their clients by investment advisers over the last few decades. 

With their fiduciary responsibilities in mind, the adviser or manager should always determine in advance:

  • Do these alternative investments meet the investment objectives of each client they are recommended to?
  • Is the manager’s disclosure of investment principles and strategies in their offering materials aligned with those disclosed to the adviser?

Alternative investment strategies are complex, so ensuring due diligence isn’t easy, but it’s crucial that it’s not thrown by the wayside.  

Compliance programs

Following an overview of the various rules and regulations that are imposed on securities professionals, we examine how regulators ensure compliance. 

In order to ensure that federal securities laws are not violated, companies working in the securities field must have written policies and procedures in place that guide employees. 

These policies and procedures must be reviewed annually and updated where necessary, something regulatory bodies will check into. 

Each company must appoint a chief compliance officer (CCO) to be in charge of all of this. 

The Investment Advisers Act (and rule 206 (4)-7, in particular) says that SEC-registered firms must have policies and procedures in place to ensure that their advisers or representatives do not violate the act. 

Those who fail to do so can’t give their clients investment advice, and they are breaking the law should they attempt to.  

Policy and procedure should always be drafted with fiduciary obligations in mind. 

To begin, it is necessary to identify what creates the firm’s risk exposure, 

This can be achieved by identifying conflicts and compliance factors. 

Those risks can then be mitigated through the necessary policies and procedures or by making amendments to current ones. 

Adviser reporting

Let’s examine the types of reporting that investment advisers must file.

SEC-registered advisers Section 13(f) filings

In order to comply with this requirement, the SEC requires the quarterly filing of a Form 13F.

This value is calculated on the last trading day of any of the preceding 12 months. 

Essentially, this rule ensures that institutional investment managers disclose their substantial portfolio holdings periodically. 

Let’s quickly clarify what 13(f) securities are.

The SEC website will list 13(f) securities at the end of each calendar quarter. 

They include:

  • Warrants
  • Closed-end investment company shares
  • Convertible debt securities
  • Equity options
  • Exchange-traded stocks

Code of ethics pertaining to investment advisers

In order for investment advisers and IARs to carry out their duties ethically and to put their clients at the forefront of all their decisions, an ethics code will need to be prepared 

According to the NASAA, this should apply to state-registered advisers as well. 

In various firms, the CCO is responsible for enforcing the code of ethics.

The CCO should review the securities transactions and holdings of each adviser’s access person each quarter. 

As a result, they will be able to identify patterns of trading that are clearly unethical.

Let’s take a closer look at who is considered an access person.

The adviser supervises them, but there are other factors as well.

For example:

  • Clients’ nonpublic material information, such as sales of securities and purchases, will be available to an access person.
  • Furthermore, they may recommend securities to clients or have access to nonpublic information about these recommendations

As a result, access persons would be the directors, partners, and officers of an investment advisory firm. 

In regards to current and former access persons, regulations require that a record of their activities must be maintained within a five-year period.

Regulations regarding access persons are designed to prevent violations by IARs and other staff members of the firm.

The following elements should always be included in the procedures for trading personal securities by employees of the firm:

  • It is mandatory to clear all personal securities transactions in advance and with written approval
  • The firm should draw up a list of the issuers it recommends to clients or analyses. Consequently, staff members should not be allowed to trade these securities for their own accounts 
  • Information about restricted issuers that the firm has insider knowledge of. Personal accounts of staff members should not be used to trade these securities. 

Political contributions and the pay to play rule

An SEC regulation prohibits advisers from receiving compensation for advising government entities if they have made a political contribution to a candidate or public official who hold positions where they could award the advisory firm some business. 

After a contribution is made, this remains in effect for two years.

However, there is a de minimis exception

Contributions of up to $350 can be made by covered employees if they have the right to vote for these officials and $150 if they do not have the right to vote.  

Firms can never contribute.

When we talk of covered employees, these are:

  • General partners, executive officers, managing members, or any similar other positions  
  • Advisory firm employees who solicit government work 
  • Supervisors of the employees mentioned above
  • A political action committee controlled by advisers

Newly hired covered associates are an exception.

If they made political contributions up to six months prior to starting their job, the ban will not apply. 

If their role involves soliciting new clients rather than providing investment advice, this exception falls away with a two-year look back period in place as well. 

Protecting data, client privacy and overall cybersecurity 

It is common for advisor firms to keep a lot of sensitive information about their clients. 

Steps need to be taken to protect both the firm and its clients from potential loss.

Cybersecurity 

In 2014, NASAA conducted an extensive survey on cybersecurity and provided its recommendations in this regard.

  • Firms must be prepared at all times in terms of cybersecurity, particularly vulnerabilities and threats.  
  • There should be a compliance program in place to help safeguard client information
  • Procedures and policies should govern the use of social media  
  • Is there cyber insurance in place to cover a data breach, for example? 
  • Are you using the right people to handle cybersecurity?  
  • Particularly when third-party service providers are involved, confidentiality is crucial and this means that confidentiality agreements must be put in place.  
  • Has the firm ever experienced a cybersecurity breach? Have the necessary steps been taken to ensure this doesn’t happen again?
  • Is there a procedure in place for disposing of electronic data storage in a secure manner?  
  • How will the firm continue to operate during a cyber-attack?
  • Is there a plan in place to deal with a stolen laptop or storage device?
  • In addition to anti-virus software and encryption, what anti-malware programs does the firm use? 

The protection of client information

Securities professionals possess a lot of confidential information about their clients, which is crucial for keeping them safe from those with malicious intentions.

You must keep an eye out for identity theft, or someone trying to request funds on behalf of another person, it happens more often than you think.  

Identity theft schemes often have numerous red flags that securities professionals should be aware of. 

Covered accounts are the main concern for regulators. 

These are:

  • Multiple-payment accounts maintained by firms that are intended for personal, family, or household use. 
  • Various accounts maintained by firms that are subject to identity theft, financial risks, reputational risks, compliance risks, and litigation risks. They can be customer accounts or those of other financial institutions.

For advisers to be able to direct funds, payments, or direct transfers from an individual’s account to others, the required programs must be in place so their identities can be verified. 

A written program must be implemented when maintaining covered accounts, as required by regulations. 

By doing so, identity theft attempts can be detected and prevented. 

Procedures and policies must be included in these programs in order to achieve the following objectives:

  • Look for red flags when dealing with covered accounts
  • To prevent identity theft attempts, ensure that a course of action is followed when they are detected
  • Ensure customer safety and reflect the risk of identity theft by keeping them up to date

Identifying red flags

In dealing with identity theft, firms should pay attention to these red flags:

  • When a request for a consumer report is received, a credit freeze notice is sent.
  • Documents that looked like they have been forged 
  • There is a discrepancy between the physical description on the identification or the photograph and the person carrying it
  • The provision of suspicious personal information, such as a change of address
  • Suspicious activities on covered accounts 
  • Customers’ personal identification information does not correlate with other information, such as a date of birth not matching an SSN range  
  • The use of personal information that is usually associated with identity theft. An invalid phone number or fictitious address could be included in this category
  • Account challenge questions cannot be answered
  • Returning mail from the customer for a wrong address while the account is still active and transactions are occurring

Protecting the firm and customers

The company and customers can both be protected from identity theft by implementing a number of security measures:

  • The use of single factor authentication
  • The use of dual factor authentication like key fobs, for example
  • The use of challenge questions as part of adaptive-factor authentication
  • Authentication using biometrics, such as fingerprints
  • Installing antivirus software

It is also important to consider the following:

  • How often is antivirus software updated?
  • Do files and devices have encryption?
  • Backups of sensitive information and files are done online or remotely?
  • Are there any security measures in place, such as a virtual private network (VPN)?
  • Is personal client information stored on free cloud services like Google Drive or Dropbox?
  • Is the firm’s website able to provide access to client information?
  • Does the firm’s website have a client portal?

Regulation S-P and privacy

As part of Regulation S-P, firms are required to maintain effective privacy policies and procedures to protect their client information from identity theft. 

An initial privacy notice must be provided to new customers when they open an account. 

In addition to those sent to new clients, all existing customers should also receive a privacy notice annually. 

As long as customers do not object, Regulation S-P gives firms the option of sharing nonpublic personal customer information with trusted third parties when necessary. 

Regulation S-P distinguishes between consumers and customers. 

Consumers are people who obtain a service or a financial product from a company but have no further contact with them afterwards, as a customer would.  

An initial privacy notice will be sent to both parties, followed by an annual update to customers. 

Businesses and institutions are not covered by Regulation S-P,  just individuals  

A firm’s policies and procedures must be adopted in order to keep customer information confidential as required by Regulation S-P. 

If employees are to access customer information remotely, appropriate security measures must be taken to ensure that this is done securely. 

Succession plans and business continuity

State-registered advisers and their business continuity plans are governed by a NASAA model rule, which is similar to Rule 4370 applied by FINRA to member broker-dealers.  

Under this rule, all advisers are required to prepare and implement a Business Continuity and Succession Plan (BCP). 

A firm’s plan will depend on a variety of factors, including its size, what services it offers, and where it has business locations. 

The plan should provide for the following:

  • Books and records are protected, backed up, and can be recovered, if needed.
  • Communicating with stakeholders can take place in a variety of ways in the case of a disruption.
  • Office relocation in the event of a temporary or permanent loss of the firm’s primary office
  • If key personnel die, reassign their duties to other qualified staff members until their replacement is found
  • In the event of a significant business interruption, ensure that service interruptions are minimal

BCP purpose

By having a BCP in place, a firm can ensure that, in the event of some disaster, critical business functions can continue without too much disruption.

Natural disasters, utility outages, terrorist attacks and other events that can cause significant setbacks should be covered by BCPs. 

A succession plan is another aspect of a BCP that should be included, as this forms part of an adviser’s fiduciary duty. 

In conclusion

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

It should be used in conjunction with the course notes for the Series 66 exam and never as a replacement for them. 

Good luck!

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