Series 7 Study Guide 2.2 – Secures and updates information about customers along with relevant information and documents

Series 7 Study Guide Navigation

• Series 7 Study Guide Home
• 1.1 Contact with potential and current customers, marketing material development, approval, and distribution
• 1.2 Describing investment products to potential and current customers
• 2.1 Tells potential customers about the account types available and discloses their restrictions
• 2.2 Secures and updates information about customers along with relevant information and documents
• 2.3 Gather customer investment profile information
• 2.4 Get necessary supervisory approval to open accounts and make account changes
• 3.1 Passing on all investment strategy information to customers
• 3.2 Analyze customer’s portfolio of investments as well as product options to determine suitability
• 3.3 Disclose to clients characteristics and risks of investment products
• 3.4 Communications with customers
• 4.1 Providing current quotes for investors
• 4.2 Processing and confirming customers’ transactions as per regulations
• 4.3 Notifies the correct supervisor, helps with solving discrepancies, disputes, errors, and all complaints
• 4.4 Dealing with margin issues

It’s the know your customer rule (KYC) that is the most important aspect when it comes to suitability.

Also known as FINRA 2090, the member firm and associated person dealing with a customer has an obligation to request information from them that will help determine suitability requirements.

It’s not easy, however, because customers aren’t in any way obligated to provide all the information they are asked for.

Luckily, there is flexibility in the KYC rule if a customer doesn’t supply the information that has been asked for.

If this is the case, then there are limits in place as to what can be recommended to the customers when it comes to investing, for example.

These recommendations can be made based on the information that the customer has given and on the basis that the firm believes it is suitable for that customer’s unique situation.

It’s not only financial information that needs to be covered to determine suitability but nonfinancial information as well.

But how do you go about getting this information?

Customer financial profiles

A customer profile is the best way to get the information you are looking for to help determine the suitability of each individual.

Gathering financial information

While a customer profile includes financial information, there’s also the need to look into the nonfinancial situation a customer might find themselves in.

A customer profile will do both.

Let’s look at some critical areas that make up a customer profile.

Customer balance sheet

Much like a business would, a customer has a balance sheet.

This takes a point in time in which a snapshot can show their current financial condition.

Their net worth is part of this.

To determine that, you will need to take their liabilities from their assets.

Of course, asking the right questions can help determine a customer’s balance sheet.

These include questions that will find out:

• The value of any CDs, saving accounts, or cash they have. Savings accounts are an important requirement for investing in securities.
• The value of their tangible assets (their home, car, jewelry, art, or any other collectibles)
• The value of any long-term investment accounts they might have
• The cash value of any life insurance they might have
• Their current liabilities (do they own money on their vehicle or their house, for example)
• Do they have any outstanding loans?
• The value of their current credit card debt

Customer income statement

This too plays a critical role in determining a customer’s income situation.

Again, asking the right questions is the place to start.

These include questions that will find out:

• The value of their total gross income
• The value of their total family income (including their spouse, for example)
• The value of their net spendable income after expenses
• How much of their net spendable income is available to invest
• Is their employment secure and if so, how secure is it

This information is necessary from a suitability point of view as it indicates to a registered representative if the client can make a lump-sum investment.

That would be possible if their balance sheet shows that they have a large portion of net assets available.

The income statement plays a part too as it indicates a positive or negative cash flow.

Customer nonfinancial profiles

While gathering information on a customer’s financial status is the first step, don’t underestimate the need to look into their nonfinancial status as well.

While they aren’t a client’s cash flow and cannot be expressed as a sum of money, in reality, they can play far more of a role in helping to determine suitability.

Nonfinancial considerations include:

• The client’s age
• If they are married or not
• If they have dependents. If they do, how many and what are their ages
• Are they employed
• If applicable, are their family members employed
• If applicable, family education needs, both currently and in the future
• If applicable, family health needs, both currently and in the future
• The client’s risk tolerance
• Their attitudes and values
• Their tax status

Again, the financial status tells us about a client’s ability to invest but it is their motivation to invest and acceptance of it that will help define the type of portfolio that would work for them.

Therefore, finding out their attitude to investment is a necessity.

A registered representative can do this by asking the right kinds of questions.

These should be based on:

• The risks a client can afford while investing
• If their investments should be liquid or not
• How tax considerations will affect their investments
• Do they want to invest in the short-term or are they looking towards more long-term options
• If they have any investment experience or not
• If they have any investments currently and if so, what are they
• How they would react to a small loss, for example, 5%.
• How they would react to a big loss, for example, 50%
• What they consider a poor, good or excellent level or return to be
• How do they react to stable investments, do they get bored
• Their income stability
• If they see any financial changes in their future

At the end of the day, a customer and the registered representative should always have similar ideas relating to risk tolerance.

What happens in a situation when a customer wants to purchase securities that clearly aren’t suitable.

In that situation, the registered representative must inform the client as to why they should be purchased, outlining all the valid reasons.

If the client goes ahead, the registered representative can purchase the securities but in that situation, the trade should be marked as unsolicited.

The process of verifying the customer

The process of qualifying the customer begins after the registered representative has gained all the financial and non-financial information they need.

Qualifying the customer is a process in which the information they give is verified to the best of the registered representative ability.

Verification of customer information

While there is no set method to obtain the information needed most registered representatives will make use of a combination of things.

To start, clients will often fill in a very detailed questionnaire.

Once that’s complete, a face-to-face interview will take place.

This can be in the office, at the client’s home, or even carried out online.

A form is not going to help a registered representative to try and suss out a client’s risk tolerance and attitude to investment.

That makes an interview a must.

Other data gathering will see the registered representative ask the client for account statements, any insurance policies they hold, information about 401 (k) plans, tax returns, and more.

All of the information in these documents, along with the questionnaire and the one-on-one interview will help to determine suitability as well as in measuring the overall sophistication of the client as a potential investor.

Obviously, if they held any previous securities or still hold some, that’s critical information as well.

Accredited investors

Who qualifies as an accredited investor?

Well, that’s someone who:

• Has a net worth of over $1 million (not counting the equity from their primary residence)
• Income of over $200,00 for the last two years, or $300,000 with a spouse (and have an excellent chance of doing it again in the current year).

FINRA wants its members to try to determine if someone should have accredited investor status even though the legal obligation to do so actually is with the issuer.

So to do this, the registered representative can:

• Secure W-2s or tax returns from the client for the last two year period
• Get a written representation from the individual outlining that they should qualify as an accredited investor by reaching the necessary income level.
• For accredited investors on the basis of $1 million net worth, the registered representative can review bank statements, brokerage statements, or credit reports from the last three months

The member firm can also take steps in this regard by:

• Getting written confirmation from a person or entity that they have verified the purchaser in the last three months as an accredited investor.

This confirmation can come from a registered broker-dealer, an SEC-registered investment adviser, a licensed attorney, or a certified public accountant.

Opening special accounts

There’s various documentation that needs to be completed when opening special accounts.

In this section, we look specifically at options, margin, and discretionary accounts.

Options accounts

When it comes to option accounts, there is a range of unique requirements to consider when opening them.

When compared to stocks, bonds and mutual funds, trading options (puts and calls) are riskier, for the most part.

For an account to be opened that will trade in them, a designated supervisory person that is an expert on options must provide approval for the account to be opened.

Any prospective options customer must always receive a special options disclosure document (ODD) when looking to open an options account.

Due diligence must always come to the fore when a registered representative or member firm wants to get one of their customer accounts approved to open an options account.

That due diligence comes from finding out essential facts relevant to each customer that wants to trade in options.

And ultimately, that includes them having knowledge of investments and some experience in trading.

In fact, you will find that question as part of a new options account form, but not for other types of regular investment accounts

What’s necessary to find out here is the size of trades they may have made as well as the number of years they’ve spent trading.

Other questions could include the type of options, stocks, commodities, and bonds traded, the frequency of that trading, and whether they’ve used other financial instruments.

The information that is collected here is used by the designated supervisory person to either give the account the go-ahead or not approve it at all.

If account approval is given, this shows the following:

• The ODD date on which it was passed on to the client
• Transaction types the client can carry out, for example, buying, covered or uncovered writing, spreading, etc
• The name and contact details of the account’s registered representative
• The name and contact details of the account’s supervisor who approved it
• The date on which the account was approved
• Currency of account information verification date

A special options account agreement will also need to be signed by the customer.

This highlights the rules that must be followed when taking part in options trading as well as that they understand the risks that are associated with it.

It also stipulates that any changes in investment objectives or financial situation must be reported to the member firm by the client.

This must be received by the member firm within 15 days of account approval.

Margin accounts

There are three documents needed when opening a margin account.

These are:

• Mandatory credit agreement
• Mandatory hypothecation agreement
• An optional loan consent agreement

By the time the first trade is made on a margin account, the two mandatory agreements must be signed and with the member firm as stipulated by FINRA.

Let’s look at these various agreements a little closer.

The terms of credit extended by the broker-dealer will be found in the credit agreement.

It will include how interest is calculated and what conditions will lead to a change in the interest rates.

The hypothecation agreement provides a lien on the customer’s margin securities for the broker-dealer.

For a margin account, the security purchase on margin is the collateral.

Lastly, the loan consent form.

Remember, this is not mandatory.

When a client does sign it, however, they give permission for short sales primarily.

This means that the firm can loan customer margin securities.

This is normally loaned out to other broker-dealers or customers.

Following the various customer agreement forms, a member firm is also tasked with making a risk disclosure to a customer.

This highlights margin trading risks including:

• If a maintenance call is not met, customers cannot choose which securities can be sold
• Initially, more money may be lost than what was deposited by the customer
• The time to meet a margin call will not be extended
• Without advance notice, firms are allowed to raise in-house margin requirements

Discretionary accounts

When a registered representative has been authorized to make investment decisions on an account by a customer, this is known as a discretionary account.

Those decisions include what security they are going to invest in, the number of shares or units to be bought or sold, and when to buy or sell.

This can be a conflict of interest, however, especially for agents or broker-dealers.

That’s because their fees are transaction-based, so the more trading takes place on customers’ accounts where they have discretionary powers, the more income they can make.

Carrying out any discretionary power by a broker-dealer within the account of a customer is prohibited under FINRA rules unless:

• Written authorization in the form of a power of attorney has been obtained from the customer and for the registered agent
• As evidenced in writing by the firm, an account has been accepted by them

If this authorization isn’t on file, then no discretionary transactions may take place.

Note that if authorization is given, the client may still trade on his account along with the registered representative.

Before we end this section, let’s talk about time or price discretion.

If a customer orally requests that a specific share gets purchased or sold, that instruction only lasts until the end of the business day.

Should they intend it for an extended period, the instruction cannot be given orally but must instead be given in writing.

If they do give a time or price discretion, the order ticket must reflect that.

Also, when it comes to the timing of an investment or the price at which it is bought, discretion does not apply to those kinds of decisions.

In closing, remember that discretionary accounts are subject to these rules:

• When entered for execution each discretionary order must be identified as one
• While a partner or officer of the brokerage house must approve orders in writing and quickly, it’s not a requirement to do this before order entry
• All transactions must be recorded
• No churning or excessive trading should occur on a customer account. This is relative to the account size as well as the investment objectives of the client
• Discretionary accounts must be regularly checked to confirm all trades are above board

Fiduciary accounts

In a nutshell, fiduciaries can act on behalf of other people and have been given the legal power to do so.

Here are some examples of what a fiduciary is:

• The trustee that supervises a trust
• The executor of a will
• An administrator liquidating an estate (where no will is present)
• The guardian handling the affairs of a minor until the point they reach 18 years old
• UGMA or UTMA custodians
• A bankruptcy receiver
• Someone acting for an incompetent person in the role of conservator

Fiduciary accounts are normally opened and evidence is provided – usually by a court – of the fiduciary’s appointment and their overall authority.

For example, with an executor of an estate or as a guardian, proof of capacity must be provided.

For UGMA and UTMA accounts, however, no documentation is required, while for a trustee fiduciary account, the limitations placed on the fiduciary will appear in the trust agreement.

All appointed fiduciaries must follow the Uniform Prudent Investor Act (UPIA).

Business accounts

Let’s briefly work through a few business accounts that might come up on the Series 7 exam.

Corporate accounts

To open a corporate account, the registered representative must find first establish:

• If the business has a legal right to do so
• If there are any limitations that various entities (like the owners, stockholders, a court of law, or others) has placed on the business that might affect the securities they are allowed to invest in
• On account transactions, who will be the representative for the business

Corporate accounts can only be opened if a broker-dealer has copies of their corporate charter and corporate resolution.

Partnership accounts

In terms of investment accounts, retirement, margin, and cash accounts are often favorites of partnerships.

To open an investment account for a partnership, a partnership agreement covering which of the partners can make transactions is necessary.

Note, that the investment limitations for a margin account must also be noted if this is the type of account opened by the partnership.

As for sole proprietorship accounts, because they are a straightforward form of organizing a business, they are treated as if they are an account for a single investor.

Numbered accounts

A numbered account means that the investor’s name is not associated with the account.

Instead, they are only identified by a multi-digit number or symbols of their own choosing.

Account authorizations

POA – Power of attorney

Power of attorney is necessary for people who aren’t named on the account but will have authority to trade.

If that’s the case, the broker-dealer can give that person access to the account, but first, the customer must file written authorization.

Without that authorization, they cannot trade on the account, only the account owner can.

That authorization can be effected through the power of attorney (POA).

There are two types:

• Full power of attorney: With this, those individuals who are not the owners of the account are allowed to deposit and withdraw securities or cash as well as make investment decisions on behalf of the owner of the account.
• Limited power of attorney: With this, the designated individual doesn’t have full power over an account. They do have some control, however, and this will be specified by the owner of the account, usually in the limited power of attorney document itself.

Usually, a limited power of attorney won’t allow for the drawing of funds out of the account but it will also have some trading authorization, like the entering of buy and sell orders.

A limited power of attorney is also known as limited trading authorization.

Lastly, we have to mention durable power of attorney.

This can be applied to both full or limited accounts.

When they are made “durable”, in the case that the grantor is incapacitated, those designated persons with power of attorney still maintain the power of the account.

This is often used in cases when physical or mental causes may incapacitate the grantor, for example, the accounts of the elderly.

Should either party die, however, this durable power of attorney falls away.