Chapter 14 Investment Risks, Returns and Disclosures Flashcards
A municipal securities dealer is required to disclose to a
client all material information that’s either known or reasonably accessible to the market. These time of trade
disclosures are required to be made __________ the time of the trade and can be made either verbally or in
writing. The main purpose of this rule is to require dealers to disclose to clients all of the relevant
information concerning the securities that they’re considering purchasing or selling. Many municipal
securities have unique features and characteristics that should be disclosed to a client.
Note: A municipal securities dealer may NOT satisfy its disclosure obligation by
simply directing a customer to an established industry source or through a disclosure that’s made in
general advertising materials.
A municipal securities dealer is required to disclose to a
client all material information that’s either known or reasonably accessible to the market. These time of trade
disclosures are required to be made at or prior to the time of the trade and can be made either verbally or in
writing. The main purpose of this rule is to require dealers to disclose to clients all of the relevant
information concerning the securities that they’re considering purchasing or selling. Many municipal
securities have unique features and characteristics that should be disclosed to a client.
Time of Trade Disclosures (MSRB Rule G-47)
An __________ occurs when the broker-dealer buys or sells securities in the
marketplace on behalf of a customer. The firm charges the client a commission, which is disclosed on the
customer’s confirmation
Compensation and Disclosure on Equity Trades
An agency transaction occurs when the broker-dealer buys or sells securities in the
marketplace on behalf of a customer. The firm charges the client a commission, which is disclosed on the
customer’s confirmation
In an _______, the broker-dealer matches a sale from one of its clients
with a purchase from another client and charges both a commission. Commission must be disclosed
on the confirmations that are sent to both customers
In an agency cross, the broker-dealer matches a sale from one of its clients
with a purchase from another client and charges both a commission. Commission must be disclosed
on the confirmations that are sent to both customers
Principal Transactions: The Broker-Dealer’s Grocery Store Approach
Imagine a broker-dealer as a grocery store, and securities as the items on the shelves. When a customer (investor) comes to the store to buy or sell items (securities), the store owner (broker-dealer) facilitates the transaction using its inventory.
Inventory risk: Just like a grocery store owner, the broker-dealer stocks up on securities, holding them in its inventory. The value of these securities can fluctuate based on market conditions, exposing the broker-dealer to risk. If the prices of securities in the inventory decline, the broker-dealer may incur a loss when selling them to customers.
Markup and markdown: To cover the costs and make a profit, the grocery store owner adds a margin to the price of the items being sold. Similarly, when a customer purchases a security from the broker-dealer’s inventory, the broker-dealer charges a markup above the market price of the security. This markup compensates the broker-dealer for the risks associated with holding inventory and providing a service to the customer.
On the other hand, when a customer sells a security, the broker-dealer buys it back into its inventory. However, the broker-dealer pays the customer a slightly lower price than the current market value by applying a markdown. This is again to compensate for the risks and costs associated with holding and managing the inventory.
In a principal transaction, the broker-dealer sells securities out of its inventory or buys
securities into inventory when executing a customer order.
When a firm buys into inventory to fill preexisting customer orders, its capacity
is that of a ______ principal.
For instance, in quick succession, a dealer receives 10 customer market
orders to each purchase 100 shares of stock. The firm may choose to buy 1,000 shares (100 x 10) as principal and
then resell the securities to its customers at the same price, plus a markup.
The firm must disclose its
capacity as _______ principal, since the purchase by the firm and sale to the customers did not expose
the dealer to price risk
Riskless Principal
Remember, the Markup or Markdown performed by the Principal (dealer) is in order to cover the costs and risks associated with holding and maintaining an inventory of securities, as well as to generate profits.
If a dealer in purchasing shares from a customer, had then sold the securities to the customers at a different
price than the price paid by the dealer, the executions are described as occurring on a _ basis. In a _ trade, the dealer profits by charging a different price for the securities, rather than charging a
markup.
Net-Basis
FINRA rules place disclosure and consent requirements on dealers executing net-basis trades
with customers
If a firm intends to execute a net-basis transaction with a customer, it must disclose the conditions for handling the order and obtain the client’s permission prior to the execution of the trade. The rule applies to transactions between a dealer
and a customer, rather than dealer to dealer
▪ For non-institutional (retail) customers, written consent must be obtained on an order-by-order basis, prior to the execution of net-basis trades.
▪ For institutional customers, the firm may obtain consent in one of three different ways:
- Oral permission before each net-basis transaction, or
- Written permission before each net-basis transaction, or
- Blanket permission through the delivery of a negative consent letter. The letter discloses the terms and conditions of handling the order and gives the client an opportunity to opt out.
If the client doesn’t express any objections, the dealer may interpret this as permission to execute net-basis trades in the future.
■ For fiduciaries, the broker-dealer must:
- Provide disclosure to the party that’s been granted trading authorization
- Obtain permission from the party that’s been granted trading authorization
- Follow the same disclosure and consent requirements that apply to institutional customers if the fiduciary is an institution
The following conditions apply to net-basis transactions
_ dollars are broadly defined as commission rebates that money managers (IAs) receive for
channeling some or all of their trades through certain brokerage firms. When an adviser uses _ dollars
to obtain products or services, its clients are paying for more than simple execution and, accordingly, using
_ dollars may result in clients paying a higher commission on their trades.
Soft dollars
Soft dollars are a form of indirect payment that investment advisors (IAs) receive from brokerage firms. Instead of receiving cash, IAs receive benefits in the form of research, software, or other services that help them make better investment decisions on behalf of their clients.
When it is said that an adviser “uses soft dollars to obtain products or services,” it means that the adviser is directing their client’s trades through a specific brokerage that, in return, provides the adviser with certain benefits.
Section _ (e) of the Securities Exchange Act of 1934 recognizes soft-dollar arrangements as an acceptable means of conducting business (safe harbor). However, to rely on the safe harbor, the following three conditions must be satisfied:
- The adviser must be exercising investment discretion over the accounts of others.
- The broker-dealer must provide the adviser with services that assist the adviser in making investment decisions for client accounts.
- The adviser must determine that the value of these services is reasonable in relation to the commissions being charged by the brokerage firm.
Section 28e
The key is that the service(s) received by the adviser as part of a soft-dollar arrangement must benefit its clients and be reasonable in relation to commissions paid. Provided the investment adviser is using soft dollars to purchase items (e.g., research reports) that assist them in the investment process and clients receive full disclosure, the SEC permits the arrangement.
At least _ , broker-dealers are required to provide customers with a statement of account. Also,
the typical practice is to provide monthly statements for any account in which activity has occurred.
At a minimum, the account statement must contain:
Client Notifications: Account Statements and Other Notifications
- A description of all security positions
- All money balances
- All account activity since the last statement
Account activity includes:
purchases, sales, interest credits or debits, charges or credits, dividend
payments, transfer activity, securities receipts or deliveries, and/or journal entries relating to securities
or funds in the possession or control of the broker-dealer
_ regulations require a brokerage firm to provide a current financial statement (balance sheet with net capital computation) to a customer on request. The justification for this requirement is that customers have the right to know the financial condition of the company with which they’re doing business.
Financial statements are typically sent to customers on an _ basis. Although a balance sheet must be provided, the firm’s income statement (or P&L) is not required.
From time to time, customer accounts may be transferred internally. This can be the case when an RR leaves a firm and his customer accounts are transferred to another RR of the firm. Account records must be amended whenever an internal transfer of an account is made. However, this change doesn’t require the reapproval of the customer, the completion of a new account form, or the notification of a regulatory authority.
Broker-Dealer Financial Information
SEC regulations
Financial Statements are typically sent to customers on an annual basis
Under Rule 10b-10, the SEC requires broker-dealers to provide customers with a detailed confirmation of
each _ or _ . The confirmation must be given or sent at or before the completion of any
transaction—which is generally the settlement date.
Confirmation Statements
Under Rule 10b-10, the SEC requires broker-dealers to provide customers with a detailed confirmation of
each purchase (Buy) or sale (Sell). The confirmation must be given or sent at or before the completion of any
transaction—which is generally the settlement date.
State registration requirements are contained in a set of rules that are referred to as the _
State registration requirements are contained in a set of rules that are referred to as the Blue-Sky laws
If a customer’s address changes, it’s important to note whether she now lives in a different state. In order to conduct business in the new state, both the registered representative and his firm must be properly registered in the new state.
lso, if a request is made to change a customer’s address, member firms must send notification of the change to both the previous address on file and to any registered personnel who are responsible for the account.
Note
For better or for worse, a customer’s financial picture can change very quickly. It’s important for representatives to occasionally verify that the customer’s information on file is accurate. While some customers may keep the firm well-informed of any changes, others may not be as forthcoming. Changes in the patterns of purchases and sales may indicate a different financial situation.
Updated Objectives Over time, almost all customers will change or modify their investment objectives. This is especially true as customers grow older, since their investment time horizons, tax situations, and goals may change. All such changes should be documented.
Note
If a customer provides a broker-dealer with updated account information, the broker-dealer must send a copy of the revised account record to the customer within 30 days after it received notification of the change or at the time the next statement is mailed to the customer. Examples of account record modifications include items as simple as changes to a customer’s name, address, or investment objective.
FINRA Updating Requirement
Broker-dealers must maintain records for a certain number of years after creation. The SEC allows for the maintenance of records in forms other than paper. For example, firms may maintain their files on micrographic media or electronic storage media. Micrographic media includes microfilm, microfiche, or similar methods, while electronic storage media includes methods of digital storage (e.g., CD-ROM).
If a firm decides to use electronic storage media, it must notify its primary regulator prior to the beginning of its use. Also, if a firm changes the form of electronic storage media that it’s currently using, it must notify its regulator at least 90 days prior to using the other method.
Recordkeeping Formats
a firm that uses micrographic or electronic storage media must establish a location from which the SEC and the firm’s SRO can immediately review stored files and have duplicates of the files available.
When maintaining records using electronic storage media, the firm must:
■ Maintain records in non-rewriteable and non-erasable formats
▪ Automatically confirm the quality and accuracy of the media recording process
▪ Maintain records in serial form with time and date information that documents the required retention period for the information stored
■ Be able to download the indexes and records maintained to any medium that’s accepted by the SEC or other SRO of which the firm is a member
All duplicates of the files being maintained must be kept separate from original records. The records (original and duplicates) must be accurately organized and indexed. The indexes are required to be duplicated, kept separate from originals, and made available for examination by regulators if a review is requested.
Note
FINRA and the MSRB also have recordkeeping requirements for any books and records that were not specifically referenced under SEC Rules. For FINRA, the requirements are found in Rule 4511; however, for the MSRB, the requirements are found in Rule G-8 (the records that must be kept) and Rule G-9 (how long the records must be kept).
FINRA created a hotline for seniors who had questions or concerns about their brokerage accounts. One of the major issues that was highlighted by these investors was suspected financial exploitation. In order to address this issue, FINRA created Rule _ which is titled Financial Exploitation of Specified Adults.
Rule 2165
According to FINRA’s rule, the term specified adult is defined as:
▪ Any person who is age 65 or older
▪ Any person who is age 18 or older and who the firm reasonably believes has a mental or physical impairment that renders the person unable to protect his own interests. This determination should be based on the facts and circumstances that are observed in the firm’s business relationship with the person.
Firms may now contact a customer’s designated _ and, when appropriate, place a temporary hold on a disbursement of funds or securities from a customer’s account. A _ must be age 18 or older and is essential in assisting the firm in protecting the customer’s account and its assets and also responding to possible financial exploitation.
- may be a family member, attorney, accountant, or another third party who the customer trusts with this responsibility
- this person is not given the authority to execute transactions or make decision in the account. That type of authorization requires written power of attorney.
trusted contact person
Although the trusted person’s contact information is not required to open the account, a firm should make a reasonable effort to obtain it. This step doesn’t apply to an institutional account.
According to FINRA’s rule, financial exploitation includes:
- Wrongful or unauthorized taking, withholding, appropriation, or use of a specified adult’s funds or securities; or
- Any act or omission taken by a person, including through the use of a power of attorney, guardianship, or any other authority, regarding a specified adult, to:
- Obtain control, through deception, intimidation, or undue influence, over the specified adult’s money, assets or property; or
- Convert the specified adult’s money, assets or property
Note
Today, the rule permits a firm to place a _ on the disbursement of a specified adult’s funds or securities and also permits the firm to place a temporary hold on any transaction when there’s a reasonable belief that the customer is being financially exploited. The temporary hold may apply to both a single disbursement and a transfer of an entire account.
However, if the firm places a hold on an account, it must allow disbursements if there’s no reasonable belief of financial exploitation (e.g., normal bill paying).
Today, the rule permits a firm to place a temporary hold on the disbursement of a specified adult’s funds or securities and also permits the firm to place a temporary hold on any transaction when there’s a reasonable belief that the customer is being financially exploited. The temporary hold may apply to both a single disbursement and a transfer of an entire account.
However, if the firm places a hold on an account, it must allow disbursements if there’s no reasonable belief of financial exploitation (e.g., normal bill paying).
The temporary hold also applies to the transfer of assets from one account to another account at the same brokerage firm.
For example, the temporary hold applies when a relative or friend of an account owner is attempting financial exploitation and initiates the transfer of assets to her account which is held at the same brokerage firm.
John is 67, his RR Adil believes John may be being financially exploited.
Adil places a temporary hold on the account. How long does Adil have to inform John of this hold?
no later than two business days after the date that the member first placed the temporary hold on the disbursement of funds or securities, the member firm must provide notification, either orally or in writing (which may be electronic), of the temporary hold and the reason for the hold. The notification must be provided to:
- All parties who are authorized to transact business in the account, unless a party is unavailable or the firm reasonably believes that one party has engaged, is engaged, or will engage in the financial exploitation of the specified adult; and
- The trusted contact person(s), unless this person is unavailable or the firm reasonably believes that the trusted contact person(s) has engaged, is engaged, or will engage in the financial exploitation of the specified adult
A temporary hold will expire by
No later than 15 business days after the date that it was first placed on the account, unless it was otherwise terminated or extended by another authorized regulatory entity.
If a member firm’s internal review of the facts and circumstances supports its reasonable belief that the financial exploitation of the specified adult has occurred, is occurring, has been attempted or will be attempted, the firm may extend the temporary hold for
No longer than 10 business days following the date identified above, unless it was otherwise terminated or extended by another authorized regulatory entity.
Lastly, to provide greater protection, if the firm’s internal review still supports its reasonable belief of the potential for financial exploitation, the temporary hold may be extended by the member firm for:
No longer than 30 business days following the date identified above, unless it was otherwise terminated or extended by another authorized regulatory entity.
member firms are able to maintain a temporary hold on disbursements or transactions for a maximum of _ business days.
55
If a customer wants to transfer an account from one member firm (the carrying firm) to another member firm (the receiving firm), the customer must provide written instructions to the _ firm.
receiving firm.
When both the carrying member and the receiving member are participants in a registered clearing agency that has automated customer securities account transfer capabilities, they must use that system. An example is the National Securities Clearing Corporation’s Automated Customer Account Transfer Service (ACATS). Both member firms are required to coordinate their activities in order to expedite the transfer.
The _ firm must submit the transfer request to the _ firm immediately at the time of receipt from the customer and, within one business day, the carrying firm must either validate the instructions or take exception to the transfer.
The receiving firm must submit the transfer request to the carrying firm
