6. Supervising the Delivery of Products and Services Offered by the BD

Question 1

What are three categories of investment companies under the Investment Company Act of 1940?

Answer 1

1) management companies — open-end (mutual fund); closed-end (CEF)

2) Unit investment trusts (UITs)

3) Face-amount certificates (FAC) companies - these are rare

Question 2

In what circumstances does the 34 Act allow for “soft dollars” or non-cash compensation from an investment advisor to a BD?

Answer 2

Soft dollar bundles can include:

1) research services provided by the BD

2) educational or research seminars and meetings (EXCLUDING T&E)

3) Information systems or computer software that assists with investment and market analysis

NOTE - soft dollars cannot be redeemed for items that don’t DIRECTLY benefit the investment advisor’s clients (i.e. marketing assistance, office equipment etc)

Question 3

In context of open ended fund, how is NAV calculated?

Answer 3

(Total fund assets - total fund liabilities) / number of outstanding shares

Question 4

True / false: a mutual fund sponsor (underwriter) buys shares from mutual funds at the NAV and resells to end customer or BDs at a higher price, the public offering price

Answer 4

true

Note if BDs acquire from sponsors it’s at a discount to POP and they then resell at POP to end customer

Question 5

What is the 75-5-10 rule (mutual funds)?

Answer 5

It’s a rule that…

75% of the total assets must be invested in securities issued by THIRD PARTY companies (relative to the investment company);

Within the 75%, no more than 5% of the funds total assets can be invested in ONLY ONE ISSUER; and

Within the 75%, the fund can own no more than 10% of the outstanding voting securities of ANY ONE ISSUER

NOTE - the remaining 25% is free from restriction / concentration rules

Question 6

How often must open ended funds calculate their NAV?

Answer 6

daily

Question 7

When investors purchase mutual fund shares OR UITs from a BD of the investment advisory firm, what is the maximum sales charge (sales load) they can charge?

Answer 7

a maximum of 8.5% of the Public Offer Price

Question 8

In context of mutual funds, what are the annual fees called that are charged in addition to sales charge that covers the marketing and distribution expenses?

What is the maximum amount of this fee that can be charged?

Answer 8

12b-1 fees

The maximum 12b-1 fee that can be charged is 1% of a Fund’s NAV (if a load fund) or 0.25% (if a no-load fund)

Question 9

What are the four classes of shares that a mutual fund can sell?

What are the features of each class?

Answer 9

Class A = shares have front-end sales charges (loads) paid at the time the shares are purchased; can offer breakpoints (bulk discounts); typically lower 12b-1 fees / lowest expense ratio

Class B = have back end deferred sales charges paid that is paid when investor redeem inside a certain number of years; NO breakpoints; typically higher 12b-1 fees

Class C = do not impose an upfront sales charge but instead charges a flat ongoing fee (level load) in addition to high 12b-1 fees; NO breakpoints

No Load = mutual fund shares sold at their NAV (NAV and POP are the same) - NO sales charge added but are bought directly from the investment company vs. BD

Question 10

What type of investor are Class A mutual fund shares most suitable?

Answer 10

investors who intend to hold their shares for the long term (7+ years) as well as those making large purchases and want to take advantage of breakpoints

Question 11

What type of investor are Class C mutual fund shares most suitable?

Answer 11

Investors who want to make short term mutual fund investors (btwn 1 - 3 years)

Question 12

If a fund charges the maximum sales charge / load - what three features must they offer?

Answer 12

if they charge a 8.5% sales charge they must offer…

1) Breakpoints - bulk discounts based on amount of money invested in the funds; investors are allowed to sign LOIs and invest over 13 month pd (and can be backdated 90 days)

2) Rights of accumulation - sales charge on NEW investment is determined by adding the new investment to the account balance (including any benefit from accumulation); no need for LOI / no time limit

3) automatic reinvestment of dividends at NAV (no additional sales charge)

NOTE - Without these features the maximum sales charge is 6.25%

Question 13

True / false: all of open ended, closed ended and UITs are actively managed

Answer 13

false - only open ended (mutual) and closed ended funds are actively managed; unit investment trusts are NOT actively managed

Question 14

True / false: both mutual funds and UITs are non traded in secondary market and must be redeemed by trust

Answer 14

true - both can be bought back at NAV

Must buy / sell from the trust vs. other investors

Question 15

What are certain benefits of UITs over mutual funds?

Answer 15

1) cost is lower (given passive management / fixed investment strategy)

2) tax efficiency (given not actively traded)

Question 16

True / false: UITs have fixed termination dates

Answer 16

true - trust terminations range from 13 mos to 30 years

Question 17

True / false: ETFs are traded based on their NAV

Answer 17

False - the shares can trade at a premium or discount to NAV driven by supply / demand (which fluctuates throughout the day)

Question 18

Between ETFs and CEFs, which are likely to trade at a wider premium / discount to NAV

Answer 18

CEFs - often trade at prices 10 - 20% higher or lower than NAV vs. ETDs which traded within narrow range of NAV

Question 19

Unlike mutual funds, with CEFs or ETFs when are sales charges applied?

Answer 19

investors pay commissions at time of each buy / sell transaction

Question 20

What are two types of ETFs?

Answer 20

1) leveraged ETFs - seek to generate a multiple of the return of the related benchmark index (negative returns are also magnified)

2) inverse ETFs - designed to move in the opposite direction of the benchmark it follows (using derivatives)

Question 21

True / false: Open ended funds have unlimited shares where as CEFs, UITs and ETFs have a fixed amount of shares

Answer 21

true

Question 22

True / false: UITs and mutual funds do NOT trade on exchanges whereas ETFs and CEFs do trade on exchanges

Answer 22

true

Question 23

This investment vehicle includes S-Corps and LPs and give investors a share in cash flows and tax benefits of an underlying entity without holding an active management role in the business

Answer 23

Direct participation programs or DPPs, which proportionally share both their losses and income with investors

Losses flow through and can be used to offset PASSIVE gains to reduce taxable income and reduce taxes (NOTE - ordinary income and capital gains cannot be offset by passive losses, only passive income from other sources)

Question 24

What type of investor would be suitable for a DPP?

Answer 24

high tax bracket investors who don’t have a high need for liquidity or high visibility into management

Question 25

True / false: most DPPs do not trade in the secondary market and are designed to be held to a specific termination date

Answer 25

true

Question 26

Firms that make public offers of DPPs must disclose

Answer 26

1) an annual per share estimated value of the DPP (based on reliable valuation) 2) explanation of the valuation methodology and the date of the valuation Note that this valuation method is also disclosed on a customer’s account statement and the fact that distributions may include return of capital (reducing per share value) and investments may be illiquid, and if sole, price received may be lower than what’s indicated

Question 27

true / false: with variable whole life insurance products both a minimum cash and death value are guaranteed

Answer 27

false - minimum cash value is not guaranteed, and the actual amount of cash value in the policy is based on the performance of the sub accounts chosen by the investor A minimum death value IS guaranteed

Question 28

True / false: with universal life insurance (variable or fixed), the premiums are flexible in amount and due date but if sufficient premium is not paid the policy will lapse

Answer 28

true

Question 29

What is the maximum interest rate assumption allowed by FINRA for illustrations for both variable life insurance and variable annuities?

Answer 29

12% And if a 12% column is shown, a column must be shown with 0% return as well Illustrations must always reflect the maximum mortality, expense and admin fees the insurer can impose

Question 30

What are the two phases of a variable annuity?

Answer 30

the accumulation phase - time during which an annuity owner is paying into the contract (there is a death benefit of getting max of amount contributed or value of accounts) The annuitization phase - where distributions can begin without penalties at age 59.5 (early withdrawals subject to 10% penalty on earnings)

Question 31

What are four annuity payout options?

Answer 31

1) straight life - gurantees payments for life of annuitant regardless of how long lives (no payment to beneficiaries upon death) 2) life w certain period - guarantees a minimum timeframe for payments to be made (i.e. for 10 to 15 years - beneficiary only protected during the guaranteed minimum period) 3) joint w last survivor - ensures that income will continue through death of a SECOND annuitant, regardless of who dies first (ie. For married couples); can be full or partial payment to survivor 4) unit refund - provides a residual benefit to named beneficiary of annuitant should death occur during annuity payout phase IF teh amount paid prior to death is less than account value

Question 32

True / false: all applications for VARIABLE annuities must be forwarded to an OSJ for suitability review by a S24 RP before application is submitted to insurance company

Answer 32

true Review must occur no later than 7 BUSINESS days after receipt of as complete application NOTE - a member can forward funds / check to the insurance company prior to principal approval (and pending such approval)

Question 33

True / false: a 1035 exchange allows an owner of an annuity to exchange an existing annuity or life insurance contract for a new annuity contract without paying any tax at time of the exchange

Answer 33

true The contract exchange must take place directly btwn teh insurance companies NOTE - 1) an annuity can be exchanged for another annuity; 2) a life insurance policy can be exchanged for another life insurance policy; 3) a life insurance policy can be exchanged for an annuity; BUT 4) an annuity CANNOT be exchanged for a life insurance contract

Question 34

The trust indenture act of 1939 requires corporate issuers of bonds to assign trustee if this amount of debt is issued

Answer 34

$50mm of non-exempt debt securities

Question 35

What are the two suitability standards that must be met for new products?

Answer 35

1) reasonable basis suitability - the security is suitable for at least SOME of the firm’s customers 2) customer specific suitability - that the product can be recommended to specific individuals based on their profile

Question 36

What is a key focus on suitability of offering DDPs to customers?

Answer 36

1) whether they have a tax profile that can take full advantage of the product’s features 2) does customer have high enough net worth to be able to sustain total capital loss

Question 37

True / false: a rep with discretionary authority to execute a DPP in a customer’s account must still receive prior written consent nws discretionary authority

Answer 37

true Yes, they are that risky

Question 38

Prior to a sale of a CMO product what much a RR offer to investors?

Answer 38

1) a glossary of terms 2) a set of questions an investor should ask the rep prior to investing (and then answering those questions)

Question 39

What is a DPP roll-up?

Answer 39

A transaction that combines multiple DPPs into one larger single entity

Question 40

What is required before a BD is able to solicit votes / tenders for a DPP roll-up?

Answer 40

A BD’s compensation (MAXIMUM 2%) is paid REGARDLESS of whether the LPs vote affirmatively or negatively in the proposed transaction (i.e. comps is not contingent upon a successful roll-up) NOTE - the general partners / sponsors must pay all solicitation expenses in event the transaction is rejected

Question 41

Qualified REITs can deduct dividend distributions paid (avoiding corporate double tax) if what is true?

Answer 41

1) the REIT must generate 75% of its income from real estate; AND 2) must maintain at least 75% of its assets in real estate; AND 3) must distribute at least 90% of its taxable income to shareholders annually

Question 42

By when must a non-traded REIT given an estimated value?

Answer 42

within 150 days of the second anniversary of the deal breaking escrow

Question 43

Open ended ICs (mutual funds) must disclose their average annual total return and after tax returns over what periods?

Answer 43

one year, five tear and ten year periods NOTE - if fund has not been existence for 1, 5 or 10 years, the time period during which the registration statement was in effect (how long it’s be in existence) is substituted for the final period

Question 44

True / false: a rep who tells a client who wants to make a large purchase of mutual funds to “buy into several mutual fund families” in order to assure diversification is engaging in a PROHIBITED breakpoint sale

Answer 44

true Single fund families offer numerous choices for diversification within their brand name and this is an attempt to prevent the client from aggregating purchases —> prohibited “breakpoint sale” HOWEVER a rep might reasonably place a client into 4 - 6 different mutual funds if the goal is to create a diversified portfolio across ASSET CLASSES

Question 45

True / false: would it be suitable for a rep to recommend to the owner of a company to fund the company’s 401k with a deferred variable annuity

Answer 45

false

Question 46

What is a reverse convertible bond?

Answer 46

a debt instrument that allows the issuer (not the investor) to convert the bond’s principal into shares of common stock

Question 47

True / false: a reverse convertible bond is likely suitable only for HNW retail investors or other sophisticated investors

Answer 47

true A reverse convertible bond might make sense for an investor who wants higher coupons / yield but subject to additional risk in addition to credit risk of issuer

Question 48

Are hedge funds subject to the 1940 Act?

Answer 48

No and are only sold to accredited investors