Chapter 7 Study notes

Question 1

Correspondence

Answer 1

FINRA’s new definition is more precise. Correspondence is now
defined as written or electronic messages sent by a member firm to 25 or fewer retail investors
within any 30-calendar-day period. The 25 or fewer clients may be any type of client—existing or
prospective.

Question 2

Institutional Communications Guidelines

Answer 2

Under FINRA rules, a member firm must have policies and procedures in place that are designed to
prevent institutional communication from being forwarded to retail investors. One acceptable
method is to a place a legend on the communication stating “for use by institutional investors only.”
If a member firm becomes aware that an institutional investor (e.g., another broker-dealer) is
making institutional communication available to retail investors, the firm would be required to treat
future communication to that institutional investor as retail communication.

Question 3

Website and Blogs

Answer 3

An interactive blog that is used by retail investors is considered retail
communication, but is exempt from both principal preapproval and FINRA filing requirements. Any
interactive blog as well as institutional communication and correspondence (e.g., instant messaging
services) are subject to supervision and review.

Question 4

Public Appearances

Answer 4

A public appearance includes any situation in which an employee who is
associated with a broker-dealer participates in a television or radio interview, seminar or forum,
makes a public appearance, or engages in a speaking activity that is unscripted.

Question 5

Public Appearance guidelines

Answer 5

 If a security is recommended, the associated person must have a reasonable basis for the
recommendation and disclose if she has a financial interest in the security itself or any derivative of the
security
 At the time of the public appearance, disclosure is required of any material conflict of interest that a
firm or associated person knows or has reason to know
 Each firm must establish policies and procedures that are appropriate to supervise public appearances.
Any scripts, slides, handouts, or other written or electronic materials that are used for a public
appearance are considered communication and must comply with all other provisions of this rule.

Question 6

Retail Communications that don’t require pre-approval

Answer 6

1. Retail communications
   – Material that makes NO financial or investment recommendation and does NOT promote a product or
   service of the member firm
   – Market letters that make NO financial or investment recommendation
   – Material that is posted on an online interactive electronic forum
2. Correspondence
3. Institutional communications

Question 7

Retail Communication First Year

Answer 7

For the first year as a FINRA member, a new brokerage firm is required to file with FINRA all broadly
disseminated retail communications 10 business days prior to their first use. The term broadly
disseminated is meant to indicate that the materials have been created for generally accessible Web sites,
the print media, or television or radio. FINRA may also require any firm that has had disciplinary issues to
file some or all of its communications 10 business days prior to use.

Question 8

Retail Communications Filed with FINRA prior to first use.

Answer 8

10 business days
1. Investment company communications that
include self-created rankings
2. Security futures communications
3. Bond mutual fund communications that
incorporate volatility ratings

Question 9

Retail Communications Filed with FINRA after first use.

Answer 9

10 business days
1. Investment company communications with NO selfcreated
rankings
2. Direct participation program (DPP) communications
3. Collateralized mortgage obligation (CMO)
communications
4. Derivative communications, such as exchange-traded
notes (ETNs)
5. Any template for written reports produced by an
investment analysis tool
6. Broker-prepared, widely disseminated free writing
prospectuses (FWPs)

Question 10

Exclusions from the Filing Requirements

Answer 10

The following types of communications are not required to be filed with FINRA:
 Retail communications that have been previously filed with FINRA’s Advertising Department and are
being used without any material changes
 Retail communications that are based on templates that were previously filed with FINRA’s Advertising
Department and any changes are limited to updates of more recent statistical or other non-narrative
information. If the template itself is changed, a new filing requirement would be triggered.
 Retail communications that do not make any financial or investment recommendation and do not
promote a product or service by the member firm. This broad category is also exempt from the
principal pre-use approval requirement and includes:
– Recruitment advertising
– Advertising relating to changes in a broker-dealer’s name, personnel, electronic or postal
address, ownership, office, business structure, officers or partners, or telephone number
– Advertising related to a merger with or acquisition by another member firm
 Retail communications that simply identify a member firm’s national securities exchange symbol, or
identify a security for which the member is a registered market maker, or identify that the member
firm offers a specific security at a stated price
 Retail communications that are posted on an interactive electronic forum (e.g., social media websites
and online bulletin boards). Although the various forms of social media are considered
communications, they are exempt from FINRA’s filing requirement.
 Tombstone advertisements, prospectuses which have been filed with the SEC, and mutual fund
profiles. It is important to remember that this exclusion does not cover broker-created, broadly
disseminated

Question 11

Retail communications

Comparisons

Answer 11

In retail communications, any comparisons between investments or services must
disclose all material differences between them, including (as applicable) investment objectives,
costs and expenses, liquidity, safety, guarantees or insurance, fluctuation of principal or return, and
tax features.

Question 12

Retail communications

Disclosure of Firm Name

Answer 12

All retail communications and correspondence must contain the name
of the member firm that is sponsoring the material. If the firm has a fictional name or alias by which
it is commonly known, that name must also be included.
For blind recruiting ads, a firm’s name is not required to be provided. However, recruiting ads must be
reasonable; they may not exaggerate the opportunities available or the salaries that potential
employees should expect.

Question 13

Retail communications

Tax considerations

Answer 13

In retail communications and correspondence, unless income is free from all applicable taxes, any references to tax-free or tax-exempt income must indicate which income taxes apply. If income from an investment company that invests in municipal bonds is subject to state or local income taxes, this fact must be stated, or any illustration must make it clear that the income is free only
from federal income tax.

Question 14

Testimonials

Answer 14

In member firm communications, if a testimonial is used that relates to a technical aspect
of investing, the provider must have the knowledge and experience to form a valid opinion. Any retail
communications or correspondence which includes a testimonial about the investment advice or
investment performance of a member or its products must prominently disclose the fact that the
testimonial:
 May not be representative of the experience of other customers
 Is not a guarantee of future performance or success
 Is a paid testimonial (which is the case if more that $100 is paid to the provider of the testimonial)

Question 15

Communications recommendations

Answer 15

Any retail communications or correspondence may not refer to past specific recommendations of
the member firm that were or would have been profitable unless the following is provided:
 A list of all recommendations for the same type of security for the past year. Longer periods may be
displayed if they are shown consecutively and include the last year.
 The communication must state the name of each security recommended, the date and nature of
each recommendation (whether it was a buy, hold, or sell), the date and the price at the time of the
recommendation, as well as the price or price range on which any recommendation was to be acted
 A cautionary legend which appears prominently and warns investors not to assume that future
recommendations will be profitable
A research report is exempt from these recommendation requirements if it makes the proper
disclosures (discussed in Chapter 4).

Question 16

Use of FINRA’s Name

Answer 16

A firm is permitted to use FINRA’s name, or any other corporate name
owned by FINRA, in one of more of the following ways:
 In any communication—Provided that it neither states nor implies that FINRA or any other SRO
endorses or guarantees the firm’s business practices, selling methods, the type of security offered, or
any specific security. Any reference to FINRA’s review is limited to “Reviewed by FINRA” or “FINRA
Reviewed.”
 In a confirmation statement for an OTC transaction—Provided it states, “This transaction has been
executed in conformity with the FINRA Uniform Practice Code.”
 On a member’s website—Provided that the member firm includes a hyperlink to FINRA’s internet
address in close proximity to its indication of FINRA membership. For example, XAM is a registered
broker-dealer and FINRA member (http://www.finra.org/).

Question 17

Misleading Fund Names

Answer 17

The SEC amended the Investment Company Act to prohibit fund names that were likely to mislead investors. Under these rules, a registered investment company whose name suggests that it focuses on a particular type of security or industry must invest at least 80% of its assets in those securities.

Question 18

Communications/Rankings

SEC Standardized Yields

Answer 18

For rankings based on yield, the SEC has established two standardized yields that must be used. Money-market funds are required to use a seven-day standardized yield, while bond funds are required to use a 30-day standardized yield. In addition, any rankings based on total return must be accompanied by these yield rankings.

Question 19

Communications

Ranking Entity

Answer 19

Members may not use investment company rankings in any retail communication
other than (1) rankings created and published by ranking entities or (2) rankings created by an
investment company or an investment company affiliate, but based on the performance
measurements of a ranking entity. A ranking entity is defined an organization that provides the
public with general information about investment companies, is independent of the investment
company and its affiliates, and has not been hired by the investment company or its affiliates to
assign the fund a ranking (e.g., Morningstar).

Question 20

Communications

CMO Disclosure Standards and Required Education Materials

Answer 20

All retail communications and
correspondence must include the term collateralized mortgage obligation within the name of the
product and must disclose that any applicable government agency backing only relates to the face
value of the securities, not any premium paid. Claims about safety, guarantees, product simplicity,
and predictability must be accurate and not misleading. Due to their unique characteristics, CMOs
may not be compared to any other types of investments, such as a certificate of deposit. A statement
must be included which indicates that a CMO’s yield and average life (expected return of principal)
will fluctuate depending on (1) the actual rate at which holders prepay the mortgages underlying the
CMO, and (2) changes in current interest rates.

Question 21

cmo education materials

Answer 21

Broker-dealers must offer retail investors with educational material about the features of CMOs
which must include:
 A discussion of the structure of a CMO. This would include the different types of structures, tranches,
and risks associated with each type of security. It is also important to explain to a client that two
CMOs with the same underlying collateral may have different prepayment risk and different interestrate
risk.
 A discussion of the characteristics and risks of CMOs. This would include how changing interest rates
may affect prepayment rates and the average life of the security, tax considerations, credit risk,
minimum investments, liquidity, and transactions costs.
 A explanation of the relationship between mortgage loans and mortgage securities
 Questions an investor should ask before investing
 A glossary of terms applicable to mortgage-backed securities

Question 22

Hypothetical Illustrations of Variable Life Insurance Policies
Guidelines

Answer 22

 No assumed rate of return may be higher than 12%
 One of the assumed rates of return must be 0%
 The assumed rates of return must be reasonable given the market conditions and investment options
 The cash values and death benefits must reflect the policy’s maximum mortality and expense charges
for each assumed rate of return