Chapter 4: Communication with Customers and Prospects - F. Administrative Provisions and Actions

Question 1

Scope of Uniform Securities Act

Answer 1

The Uniform Securities Act (USA) empowers the administrator to amend or rescind any rule that is deemed necessary to carry out the provisions of the Act. The administrator also monitors and directs the state’s securities laws. A final order issued by the administrator or a rule adopted by the Act may be subject to a judicial review in accordance with the state administrative procedure act. The only provisions of the Act that the administrator cannot change are those relating to defined exempt securities.

For example: a public utility issues a bond in state X, and wants to sell it to a pension fund in state Y. Public utility stocks are exempt from registration, and a sale to a pension fund with more than $5 million is an exempt transaction. An administrator may not impose registration requirements or other solicitation hurdles because the bond is an exempt security. But remember, an administrator always has jurisdiction if fraud is involved.

Question 2

State

Answer 2

A state is defined as any state, territory, or possession of the United States, District of Columbia, or Puerto Rico.

Question 3

Jurisdiction

Answer 3

The Uniform Securities Act (USA) gives the state administrator jurisdiction over any offer to buy or sell, or any acceptance of the offer, when the following conditions exist:

• The transaction was effected or accepted in the state; or
• The offer was directed (originated) from the state or directed into the state.
  An offer can be made either orally or in writing. The Act gives these provisions a broad scope. This same broad scope also applies to investment advice.

Application example: Let’s say the agent is located in Michigan and his client resides in Ohio. The agent makes an offer to sell securities while the client was at home in Ohio; however, the client was not ready to accept the offer at that time. The client then leaves for vacation, and decides to purchase securities while in Tennessee, so he accepts the offer. The client does not mail the check, however, until arriving to Florida, his final vacation destination. Which state administrator(s) would have jurisdiction over this transaction?

The answer is Michigan, Ohio, and Tennessee: Michigan, because that’s the state where the agent is located; Ohio, because that’s where the offer originated, and Tennessee, because that’s where the offer was accepted. Florida, however, would not have jurisdiction over the transaction because it is unimportant what state the check was mailed from.

Question 4

Media offerings

Answer 4

If an offer is made in a bona fide newspaper that has a regular, paid circulation, the offer is not considered made in the state if the newspaper is not published in the state. The offer is also not made in the state if the newspaper is published in the state but has more than two-thirds of its circulation outside of the state over the past 12 months.

Any offer that is made through television or radio that is broadcast in the state is not considered to be made in that state if the communication originates outside the state.

Question 5

Unlawful representations

Answer 5

Unlawful Representations

No person may make false or misleading statements with respect to the sale or purchase of a security. Examples of prohibited statements include the following:

• Stating to a client that the registration of a security means that either the state or the SEC has approved the security;
• Stating to a client that the registration of an agent means that either the state or the SEC has approved of the agent;
• Stating to a client that a security is safe because it is regulated by securities industry authorities;
• Advising a client of an anticipated exchange listing for a security without knowing the information to be true;
• Promising to perform certain services for a client without the intention or ability to do so;
• Using inflated language or exaggerated statements about an investment, its performance history, past earnings, or future earnings projections;
• Misrepresenting or overstating the status of a customer’s account;
• Making inaccurate market quotations;
  Inaccurately stating the commission or markup/markdown charged on a securities transaction; and
• Spreading false statements, rumor or hearsay to a client or recommending a securities transaction to a client on the basis of such information.

Question 6

Front-running and Shadowing

Answer 6

Investment advisers, adviser representatives, broker/dealers, agents, and registered representatives, are all prohibited from front-running their clients’ orders, a practice where a securities professional executes personal or firm trades prior to the client’s trade. It is a violation of SEC rules for members and associated persons to use material nonpublic information to trade ahead of block trades and customer orders. A block trade is generally a transaction involving 10,000 shares of a security or securities with a market value of $200,000 or more.

Furthermore, investment advisers, broker/dealers, and their associated persons must not “shadow” client accounts, a practice where the investment adviser copies the trades in the client’s account.

Question 7

Record keeping- overview

Answer 7

The Securities Exchange Act of 1934 and the Investment Advisers Act of 1940 have established the following recordkeeping regulations that registered broker/dealers and investment advisers must follow:

• Registered broker/dealers and investment advisers must make and maintain all the accounts, correspondence, books, records, or any other communication by written or electronic media pertaining to each client, including emails that involve advisory activity and are sent to clients. This does not include personal emails of investment adviser employees or emails that are not related to advisory activities.
• The broker/dealer records may be kept in any form of data storage acceptable under the Securities Exchange Act of 1934, if they are readily accessible to the administrator.
  State-covered investment adviser records may be kept in any form of data storage required by the rules or orders issued under the Uniform Securities Act. Federal-covered advisers may use any form of data storage acceptable to the SEC.
• Data storage methods include a variety of forms of electronic media. Data stored by electronic means generally should include some form of backup media, as well as data security measures, to avoid compromising the information. Also, the firm must have the ability to readily print electronic records.

Question 8

Record keeping - Media

Answer 8

To comply with record-keeping requirements under NASAA Model Rules, investment advisers must maintain and preserve the records for the required time, and must immediately produce or reproduce them in any of the following forms:

• Paper or hard copy form, as those records are kept in their original form;
• Micrographic media, including microfilm, microfiche, or any similar medium; or
• Electronic storage media, including any digital storage medium or system that meets the terms of this section.

Question 9

Record keeping- electronic media

Answer 9

In the case of records created or maintained on electronic storage media, the investment adviser must establish and maintain procedures to do the following:

Maintain and preserve the records, so as to reasonably safeguard them from loss, alteration, or destruction;
Limit access to the records to properly authorized personnel and the Administrator (including its examiners and other representatives); and
Reasonably ensure that any reproduction of a non-electronic original record on electronic storage media is complete, true, and legible when retrieved.

Question 10

Record keeping after registration

Answer 10

The state administrator may require registered broker/dealers and investment advisers to maintain the following records:

• Customer accounts;
• Correspondence;
• Trade memoranda;
• Partnership papers;
• Financial books; and
• Other records required by the Act.

Note that with customer account at a broker/dealer, it can either be a cash account (securities are fully paid for) or margin accounts (money is borrowed to purchase the securities). Margin accounts are governed under Regulation T set by the Federal Reserve Board (FRB), and currently require the customer to deposit 50% of the purchase price

Question 11

Record keeping- cash vs. margin accounts: Cash

Answer 11

A cash account (sometimes called a “Type 1” account) is the traditional brokerage account. In a cash account the investor must pay in full for all purchases by the settlement date. In other words, buyers must deposit cash to pay for purchases if the account does not have a sufficient amount of cash already. For that reason, most broker/dealers require sufficient funds in the account before they will accept an order to buy. Brokerage houses may require a significant deposit (as much as $10,000) in order to open a cash account.

FINRA requires the principal who approves the account to sign the new account form. The customer’s signature is not required by FINRA but is required by most broker/dealers.

FINRA requires 3 signatures on each new discretionary account:

1. The customer’s;
2. The registered representative’s; and
3. The principal’s.

In a discretionary account, the registered representative is authorized to effect discretionary trades on the customer’s behalf.

Question 12

Record keeping- cash vs. margin accounts: Margin

Answer 12

A margin account (sometimes called a “Type 2” account) allows investors to purchase securities on credit and/or to take out loans against securities that they own in the account. This means the broker/dealer is essentially extending credit to the investor; before opening a margin account, however, the investor must undergo a screening procedure. Even if buying on margin is not planned, investors should remember that that all short sales must occur in a margin account.

When opening a margin account, the investor must sign a separate margin agreement allowing the broker/dealer to use securities held in the margin account as collateral for the loan. This pledging of securities as collateral is called hypothecation, and the customer is hypothecating the securities to the broker/dealer as collateral for the margin loan.

Question 13

Record keeping - Options accounts

Answer 13

When an investor wants to open a new account to trade options, the broker-dealer will generally require the following forms:

• New Account Agreement;
• Options Account Agreement, including the customer background and financial information; and
• Margin Agreement (if a margin account is opened).

Question 14

Books and Accounts

Answer 14

The recordkeeping requirements for broker/dealers are different than those for investment advisers. For broker/dealers, accounting records, financial statements, order tickets, customer account files, correspondences and other such records must be kept on file for a period of at least 3 years. The most recent 2 years must be readily accessible; the third year may be in long-term storage. Investment advisers must keep records on file for a period of at least 5 years. Records kept include financial records, client account records, and personal securities transactions of the adviser. Email communications related to the investment adviser’s business are required to be retained as correspondence.

Question 15

Audits or Inspections

Answer 15

All required records of registered broker/dealers and investment advisers are subject to periodic or special examination by representatives of the administrator without prior notice. Reviews can be coordinated with representatives of the SEC, FINRA, or administrators from other states to avoid duplication of examinations. The administrator may assess a reasonable charge for conducting an audit or inspection.

Question 16

Applicant’s Qualifications

Answer 16

The administrator cannot deny registration based solely on the applicant’s lack of experience. Consideration must be given that the applicant will be working under the supervision of a registered broker/dealer or investment adviser, and need not have the same qualifications as the employing firm.

The disqualification of an agent or investment adviser representative may not be used against the employing firm unless the order was the result of lack of supervision.

Question 17

Cancellations and Withdrawals of registration of a representative

Answer 17

The administrator may cancel the registration if a registered person

1. Is no longer in existence (deceased);
2. Is found to be mentally incompetent; or
3. Cannot be located after a reasonable search.

Note that cancellation does not require a hearing. Since the individual has stopped doing business within the state, the administrator has the authority to cancel the registration.

If an investment adviser ceases to conduct business as an investment adviser, the adviser must withdraw its registration by filing a Form ADV-W. Withdrawals become effective 30 days after the filing date for investment advisers, investment adviser representatives, broker/dealers and agents.

Withdrawals are not permitted if legal proceedings are present against the registrant. Proceedings can be initiated within a 1-year period following the termination date of the registration.

In effect, this means that a person is not truly terminated until one year has passed without legal action, because the person is still considered under the jurisdiction of the state administrator.

If a broker/dealer loses or withdraws its registration, its agents’ registrations are no longer in effect. Agents must re-register under another registered broker/dealer within 2 years without having to retake the registration examination. Agents cannot register directly with the state, in most cases. This is also true for investment advisers and their representatives. However, a federal covered investment adviser may have investment adviser representatives that are registered in the state even though the investment adviser is not registered at the state leve

Question 18

Termination of Employment or Association

Answer 18

When an agent terminates employment or association with a registered broker/dealer or issuer, both the broker/dealer or issuer and the agent must inform the administrator that the relationship has terminated. In the case where the agent changes broker/dealers or issuers, all three parties must inform the administrator: the old broker/dealer or issuer, the new broker/dealer or issuer and the agent. When an investment adviser representative terminates employment or association with an investment adviser, the responsibility to notify the administrator depends on whether the adviser was a federal covered or a state-registered adviser. If the investment adviser was federal covered, only the terminated investment adviser representative is required to inform the administrator. On the other hand, if the investment adviser is registered at the state level, it is the investment adviser’s responsibility to inform the administrator of the representative’s termination.

If an agent or an investment adviser representative ends employment or association with one broker/dealer or investment adviser, and begins employment or association with another, and the application for registration is filed by or on behalf of the registrant within 30 days after the termination, the registration is immediately effective as of the date of the completed filing if the agent’s Central Registration Depository (CRD) record has no new or amended disciplinary disclosure within the previous 12 months. The registration will become temporarily effective if the agent’s CRD record contains a new or amended disciplinary disclosure in the preceding 12 months. CRD is a national database used by FINRA and NASAA to store information on broker/dealers and their registered representatives (agents); and investment advisers and their investment adviser representatives.

Question 19

Actions Against Registration

Answer 19

If the Administrator determines that it is in the public’s best interest, and there is just cause in accordance with the Uniform Securities Act, the Administrator is empowered to do any of the following:

-Issue a cease and desist order; and/or
- Deny, suspend, or revoke any registration or registration statement.

The Administrator’s order must be promptly served to each person subject to the order, with a notice that the order has been entered. The notice must include the following information:
- Whether the Administrator will seek a civil penalty or costs of the investigation;
- Reasons for the order; and
-A notice that within 15 days after receipt of a request from the person, the matter may be scheduled for a hearing.

If a hearing is not requested by the person and is not ordered by the Administrator within 30 days after the date of the service of the order, the order becomes final

Question 20

Disciplinary actions

Answer 20

If the administrator finds that it is in the best interest of the public, the administrator may impose the following disciplinary actions upon a broker/dealer, agent, investment adviser or investment adviser representative:

• Deny an application;
• Suspend, revoke or limit the registration; or
• Censure or impose a bar on activities not serving the public.

Question 21

Reasons for disciplinary action

Answer 21

A person may be disciplined for any of the following actions:

• Filing an application that is materially incomplete, false, or misleading;
• Willfully violating or failure to comply with provisions of the Act (contumacy);
• Failing to pay proper filing fees (this denial is vacated upon the receipt of the fees);
• Being determined to be insolvent;
• Being convicted of a misdemeanor involving securities or has been convicted of any felony within the past 10 years;
• Being subject to a state Administrator’s order denying, suspending, or revoking the registration;
• Having been found to be in violation of federal or any state’s securities or commodity laws within the past 10 years;
• Engaging in dishonest or unethical business practices within the past 10 years;
• Failing to reasonably supervise employees to ensure compliance with the Uniform Securities Act;
• Being determined to be insufficiently qualified based on level of experience, training, or securities knowledge (lack of experience alone is not enough);
• Being permanently or temporarily prohibited from engaging in the securities business by a court of law; or
• Refusing to allow the Administrator to conduct an audit or inspection of the registrant’s office.

The Administrator is permitted to summarily
deny, postpone, or suspend a registration pending a final determination. The registrant and the employing broker/dealer or investment adviser must be given written notice of the order, the reason for the action, and that within 15 days after the receipt of a request, the matter will be scheduled for a hearing. If no hearing is scheduled, all orders are final within 30 days of the order.