Chapter 15- Ethics, Recommendations And Taxation Flashcards
Rule makers for Securities industry
SEC, FINRA and other regulatory bodies
Duty of broker/dealers to regulate each other
Written procedures manual and at least one supervisor of the rule book per firm
Principal must review and approve all correspondence and review transactions
Customer ethics and responsibilities
Must provide accurate information
Full and honest disclosure
Ethical business practices
Maintain written supervisory procedures
Principal enforces the rules
Must be at least as stringent as self-regulatory organization
Conduct rules deal with ethical treatment of customers
Manipulative and fraudulent devices
Manipulative/fraudulent devices- cannot use manipulation to induce sales
Act of 1934 gives 3 year period of statue of limitations and 1 year from discovery
No dollar limit on penalty
Outside business activity
Associated persons cannot work for any other company other than member firm without disclosing
Must provide written notice
Member firm can restrict or reject if a conflict arrises
Includes serving as office or director of a company or owning an interest in another financial firm
May make a passive investment without disclilosing
Private securities transactions
Selling outside of regular business
Known as Selling away
To do so a person must: Provide notice to employer Describe the transaction in detail Describe role in transaction Disclose whether he may or has received compensation
If there is compensation attached, the employing member either has to treat the transaction as if it were happening on own books or ban the transaction
If no compensation then the employing member must acknowledge he was asked for permission and may require adhearance to procedures
No compensation and for a family member is excluded from this rule
Investment recommendations
Must be in customers best interest, be consistent with risk tolerance and objectives
Investments should be explained fully
Paying for referrals
FINRA prohibits reps from paying for referrals
Even if gift was given first and a referral was given upon receipt
Activities violation fair dealing conduct rules
Recommending investments not suitable for customers financial position or risk tolerance
Short term trading of mutual funds
Setting up fictitious accounts that other worlds would be prohibited
Making unauthorized transactions or use of funds
Committing forgery or misstating facts
Guaranteeing against loss
Churning
Excessive trading to generate commissions
Excessive frequency or excessive size abnormal from customer trait
Self regulatory orgs take deeper looks into discretionary accounts
Discussion with registered rep should take place
Reverse churning
Placing clients in expense accounts who don’t trade often
Fee based accounts have a flat fee each year
Must be an appreciably greater amount
Gratuities to other firms
May not distribute business related compensation to other firms
Allowed to extend gift if:
Not conditional on sales
Employing member prior approval
Does not exceed $100 per year
Vacations/season tickets are always violations
Employment contracts
Leasing of employees is acceptable if there is written consent between all parties
Borrowing and lending to clients
Written notice of agreement
And one of following has to be present:
Immediate family member (no notice needed)
Customer is in business of lending (no APPROVAL needed, need notice)
Both registered persons with firm
Personal relationship outside of client relations
Business relationship outside of broker-consumer
Misrepresentations
May not misrepresent education, services offered, fees to be charge
Misrepresentation to inaccurately state or fail to state a material fact
Research reports
Adviser or broker dealer is prohibited from presenting info prepared by other persons without disclosing name of said person or firm
Soft dollar arrangements- client pays a higher commissions for research done by firm before a trade occurs
Security Exchange Act of 1934 on Soft Dollars- must meet the following requirements for it to be legal:
- Eligibility of the research being charged
- Lawful and appropriate assistance in investment decision
- Reasonableness of commission paid
- Disclosed to client
Would not include: Telephone lines Office furniture Rent for office space Software not used for analysis Training services
Safe Harbor Rules gor soft dollar: what qualifies and what doesn’t
Qualifies: Research reports Financial newsletter/trade journal Quantitative analytical software Seminars and conferences with appropriate content
Not qualified: Providing computers and equipment Travel expenses to seminars Rent for office space Internet services Training services
Guarantees and sharing in customer accounts
May not guarantee against loss
May not share in profit/loss of accounts
Exception: Joint account in which registered rep only gets his share and the account must be approved
If with a family member, proportion does not apply
Painting the tape
Selling same shares twice in a day with the idea that shares will be sold at same price
Intent to boost activity
Marking the close
Effecting trades or falsely reporting trades to influence closing price
Also can’t pay for favorable reviews of companies
Front running
Placing individual trades due to prior knowledge of a block order (10,000 shares)
Interpositioning
Adding another broker/dealer when there is no benefit to the client
Generally a reciprocal relationship
Both receive commission from client
Where to file tips
FINRA via the regulatory tip line in Washington DC
To know your customer you must
Understanding a customers financial status
Net worth and net income
Investment objective
All facts essential in making recommendations
FINRA and SROs mandated
Does not include non security items
FINRA definition does not include other brokers and certain potential investors
If not a client and no compensation for the advice was received, then Rule would not apply
Non-financial considerations
Customers age Marital status Number and ages of dependents Customer employment status Employment of customer family members Customers current and future financial needs
Risk tolerance and investment goal questions
What kind of risks can you afford
How liquid must Investments be
How important are tax considerations
Long term or short term investments
What is your investment experience
What investments do you currently have
Current income generation
Short term debt, income oriented mutual funds, money market funds and annuities
Investment pyramid goes safety, growth and speculation
Capital growth
Most common growth investments are common stock and common stock mutual funds
Investment retirement accounts
Allow earnings to accumulate tax deferred (pay money on withdrawls)
Diversification
Objective to move away from having a single asset for retirement
Investment objectives and recommendations
Preservation of capital= Gov securities/Ginnie MAEs
Growth= common stocks or common stock mutual funds
Balanced or moderate growth= Blue chip stock
Aggressive growth/sepculation= tech stocks or sector funds
Income- bonds, but not zero coupons
Tax free income- munis or muni bond funds
High yield income- corp bonds or corp bond funds
Income oriented stock portfolio- preferred stock and utilities
Liquidity- money market funds
Keep pace with inflation- stock portfolio
Unsuitable trade
Investor wants to partake in a trade deemed by rep as unsuitable
Reg rep must explain why and would mark the trade unsolicited if customer went forward
Inflation risk
Purchasing power risk
Rising prices past investor return such as a bonds yield going lower than inflation
Capital risk
Potential to lose some or all money
Unrelated to an issuers financial strength
Timing risk
Investing at the wrong time and incurring loss or lower gains
Interest rate risk
Sensitivity of investment value to fluctuations in interest
Reinvestment risk
Difficulty to reinvest proceeds when interest rates decline during time period
Mortgage backed securities are susceptible due to refinancing of loans
Best answer for not susceptible to reinvestment risk is a zero coupon bond
Call risk
Risk a bond might be called before maturity and the investor will not be able to reinvest at a similar rate
Call protection can be bought to defend against that and most issues come with some years of it
Market risk
Systematic risk
Losing principal to price volatility in a security
Cannot be diversified away, rather it can only be minimized
Credit risk, financial or default risk
Danger of losing Principal through an issuers failure
Liquidity (marketability) risk
May not be able to sell
Municipals may be less marketable outside of local areas
Legislative risk
Congress changing laws affecting securities
Reps should warn about impending law changes
Alpha
Measure of performance that adjusts risk relative to a known benchmark
Basically excess return from predictions of benchmark
Beta
Measure of volatility in relation to entire market
1 moves inline with market
1+ are more volatile in relation to overall market
Higher beta means the stock will return better than its pears by whatever it is over 1
Measures systematic risk, usually considered aggressive if over 1
High beta= Tech and automobile
Low= utilities and drug
Nonsystematic risk
Risks specific to a stock instead of the market
Duration
Measures time in years a bond takes to mature
Lower coupon generally signals higher duration
Interest bearing bonds usually have a shorter duration than maturity
Zero coupon are exactly maturity
Knowing duration means you can predict what an interest rate decrease would do to return
9 year duration and 1% decrease in rates would be a 9% increase in bond
Defensive investment strategy
May have growth or income as objective but will be mostly invested in:
Blue chip stocks and AAA bonds
Examples include: food, utility and drug companies
Aggressive strategy
Assume higher risk by investing in:
Highly volatile or Beta stock
Buying securities on margin
Using put and call option strategies
Most investors fall somewhere in between
Modern portfolio theory
Emphasizes relationship between risk and reward
Derived from Capital Asset Pricing Model which states a stock price takes into account systematic and non systematic risk
Ways to diversify
Type of instrument
Industry
Companies in an industry
Length of maturity
Investment rating and geography
Dollar cost averaging
Periodic purchasing of a fixed dollar amount in one or more common stocks or mutual funds
Fluctuating market average prices would be lower than average price bought
Constant Rationplan
Buy and sell in a way to keep equity and debt balanced
Usually start at 60 equity -40% debt
Constant Dollar plan
Buy and sell to keep a set dollar amount invested at all times
Sell as prices rise and buys when markets fall
Asset allocation
Balancing of different asset classes
Primary factor in performance is allocation
Strategic asset allocation
Proportion of investments that should compose long term investment portfolio
Subtract age by 100 to find stock bond split
Tactical asset Allocation
Short term portfolio adjustment that adjusts portfolio mix between asset classes in consideration of current market conditions
Try to time market instead of having set boundaries
Active management vs passive
Relies on managers stock picking and market timing ability
Passive- belief that no particular management style will consistently outperform the market
Usually will try to mirror a specific index and seek a low cost means of generating return
Growth portfolio
Focus on companies that outpace earnings of other companies
Will often buy companies at the high end of 52 week price range as growth is usually priced into stocks
Value
Undervalued and out of favor Stock whose prices are low relative to company’s earnings or book value
Bottom of 52 week high/low
Regressive taxes
Sales, excise, payroll, property, and gasoline
Levied equally regardless of income
Low income families pay higher percentage because a greater majority of their incomes than they do save
Progressive taxes
Estate and income taxes
Increase with income
Three types of income
Earned income- salary, bonuses and income derived from active participation in a business (GP)
Passive income- rental property, LPs, and enterprises in which someone is not actively involved. Passive loses are only allowed to be used against passive income
Portfolio income- dividends, interest, and net capital gains, taxed during year of receipt
Capital loss usage
Can only offset earned income by 3000 in a particular year
Can carry forward indefinitely
Interest income
Interest paid on debt securities, tax differs
Corporate bonds- taxable by fed, state and local gov
US Gov securities- Tbill, Tnote, and bonds are not taxable at state and local levels but taxed at fed
Agency issues- Similar to US gov securities except when mortgage backed securities. These are taxed at all levels.
Fannie Mae and Freddie Mac- taxed at all levels because they are corporations
Accrued Interest- When a bond is sold between interest payments, the trade confirmation will confirm how much accrued interest was received. Buyer deducts the interest paid to seller from total interest received
Municipal securities
Interest from municipal securities is exempt from federal state and local taxes
May not be exempt if not a resident of the state in which the bond or note is issued
Private purpose bonds (industrial revenue bonds) issued by states or municipalities are a tax preference item in the Alternative minimum tax
Qualified dividend income
Must be held more than 60 days during a 121 day period beginning 60 days before ex dividend day
Tax rate is specified by the IRS tax code
Nonqualified dividends are taxed as ordinary income
Dividends from mutual funds tax
Corporate bonds- taxed at ordinary income rate
Stock funds- in accordance with IRS not ordinary income
Taxed regardless of whether funds are reinvested into additional shares or taken as cash
Foreign security taxes
Taxed by country the investor is a citizen of
Us investor would be Federal, State and local (if applicable) taxes on foreign securities
Any withheld amount by foreign government can be used as a tax credit
Adjusting cost basis
Cost basis is increased by commissions paid to buy a security
Proceeds are reduced by commission paid
Buy at 90 but pay $1 in commission, 91 base
Sell for 92 but pay $1 commission, 91 basis no gain
Determination of which shares are sold
First in first out (FIFO)- assumed by IRS because it causes largest gain recognition
Share identification- must do before the transaction settles (Trade date + 3 business days)
Average basis- Usually used by mutual fund investors because its simplest with fractional shares
Wash Sales
May not use losses if selling a security and then repurchasing securities 30 days before or after trade date
Buying calls, rights, warrants and convertible bonds is considered repurchasing
Writing deep in the Money puts also included
Allowed to adjust the cost basis of reacquainted stock by amount of disallowed loss
Applies to short selling as well
Avoiding wash sale with Municipals
Change 2 of 3 factors
Issuer
Coupon
Maturity
Pre tax yield
Municipal bonds would have the lowest pre tax yield compared to us gov bonds
Bond premium Amortization
Bonds purchased at premium must amortize their loss
Reduces reported interest income during the year
Negative benefit for municipal bonds because it’s income is not taxed
Bond discounts accretion
Accretion depends on whether it was purchased as an original issue discount (new issue) or on secondary market
Beneficial for municipal bonds if buying at original issue
If bought on secondary, the accretion is taxable
Adjusting cost basis of corporate bond
Bond accretes if bought at discount
Investor has option to amortize or not
If the investor decides not to, his cost basis remains the same
Cost basis for donations
- Donation to charity- Donor receives a tax deduction equal to market value on date of donation, no tax liability if held for more than one year. Tax is due if not held for one or more years
Recipient cost basis is higher market value - Donations to others- no deduction, cost basis to recipient is original cost basis, subject to gift tax
- Inherited securities- Recipient cost basis is FMV as of date of death
Estate taxes
Paid by estate not the heirs, likewise for gifts
Both are progressive taxes
Married couples are allowed to transfer entire estate to surviving spouse tax free
Margin interest
Tax deductible expense except if used to purchase Municipals
Deductions can not exceed interest income, dividends and cap gains
Banks can deduct 80% of costs for financing
Short against the box
Selling shares short instead of selling a long position.
5% margin requirement applies on proceeds and firm may release 95% of proceeds
Cannot be used to stretch a short term gain to long term
Must be closed in 30 days and long for additional 60
Alternative minimum tax
Makes certain high income tax payers pay taxes
Adds back:
Accelerated depreciation on investment property
Certain DPP costs
Local tax and interest on investments that do not generate income
Incentive stock options exceeding FMV
Corporate dividend exclusion rule
Dividends received from other corporations are 70% exempt from taxation
