Customer Recommendations, Professional Conduct, and Taxation

Question 1

Professional Conduct in the Securities Industry

Answer 1

The securities industry is a highly regulated industry. All broker dealers are required to regulate their employees. A broker dealer must designate a principal to supervise all of the action of the firm and its employees. The broker dealer and all of its employees are also regulated by a self-regulatory organization (SRO), such as FINRA or the NYSE. The SROs and all industry participants answer to the SEC. The SEC is the ultimate securities industry authority. Additionally, each state has adopted its own rules and regulations regarding securities transactions that occur within the state. Violations of industry regulations may lead to fines and expulsion from the industry. Violations of state and federal laws may result in fines, expulsion from the state or industry, or a jail term. Industry participants are expected to adhere to all of the industry’s rules and regulations, as well as all state and federal laws.

Question 2

Fair Dealings with Customers

Answer 2

All broker dealers are required to act in good faith in all of their dealings with customers and are required to uphold just and equitable trade practices. FINRA’s rules of fair practice, also known as the rules of conduct, regulate how business is conducted with members of the general public. The rules of conduct prohibit all of the following: churning, manipulative and deceptive practices, unauthorized trading, fraudulent acts, blanket recommendations, misrepresentations, omitting material facts, making guarantees, selling dividends, recommending speculative securities without knowing the customer can afford the risk, short-term trading in mutual funds, switching fund families.

Question 3

Churning

Answer 3

Most representatives are compensated when the customer makes a transaction based on their recommendation. Churning is a practice of making transactions that are excessive in size or frequency, with the intention to generate higher commissions for the representative. When determining if an account has been churned, regulators will look at the frequency of the transactions, the size of the transactions, and the amount of commission earned by the representative. Customer profitability is not an issue when determining if an account has been churned. In addition to churning where the agent or firm executes too many transactions to increase revenue, a practice known as reverse churning is also a violation.

Question 4

Manipulative and Deceptive Devices

Answer 4

It is a violation for a firm or representative to engage in or employ any artifice or scheme that is designed to gain an unfair advantage over another party. Some examples of manipulative or deceptive devices are: capping, pegging, front running, trading ahead, painting the tape/matched purchases/matches sales.

Question 5

Capping

Answer 5

A manipulative act designed to keep a stock price from rising or to keep the price down.

Question 6

Pegging

Answer 6

A manipulative act designed to keep a stock price up or to keep the price from falling.

Question 7

Front Running

Answer 7

The entering of an order for the account of an agent or firm prior to entering a large customer order. The firm or agent is using the customer’s order to profit on the order it entered for its own account.

Question 8

Trading Ahead

Answer 8

The entering of an order for a security based on prior knowledge from a soon to be released research report.

Question 9

Painting the Tape

Answer 9

A manipulative act by two or more parties designed to create false activity in the security without any beneficial change in ownership. The increased activity is used to attract new buyers.

Question 10

Unauthorized Trading

Answer 10

An unauthorized transaction is one that is made for the benefit of a customer’s account at a time when the customer has no knowledge of the trade and the representative does not have discretionary power over the account.

Question 11

Fraud

Answer 11

Defined as any act that is employed to obtain an unfair advantage over another party. Fraudulent acts include: false statements, deliberate omissions of material facts, concealment of material facts, manipulative and deceptive practices, forgery, material omission, lying.

Question 12

Blanket Recommendations

Answer 12

It is inappropriate for a firm or a representative to make blanket recommendations in any security, especially low-priced speculative securities. No matter what type of investment is involved, a blanket recommendation to a large group of people will always be wrong for some investors. Different investors have different objectives, and the same recommendation will not be suitable for everyone.

Question 13

Selling Dividends

Answer 13

Selling dividends is a violation that occurs when a registered representative uses a pending dividend payment as the sole basis of a recommendation to purchase the stock or mutual fund. Additionally, using the pending dividend as a means to create urgency on the part of the investor to purchase the stock is a prime example of this type of violation. If the investor was to purchase the shares just prior to the ex dividend date simply to receive the dividend, the investor in many cases will end up worse off. The dividend in this case will actually be a return of the money that the investor used to purchase the stock, and then the investor will have a tax liability when the dividend is received.

Question 14

Misrepresentations

Answer 14

A representative or a firm may not knowingly make any misrepresentations regarding: a client’s account status, the representative, the firm, an investment, fees to be charged.

Question 15

Omitting Material Facts

Answer 15

A representative of a firm may not omit any material fact, either good or bad, when recommending a security. A material fact is one that an investor would need to known in order to make a well-informed investment decision. The representative may, however, omit an immaterial fact.

Question 16

Guarantees

Answer 16

No representative, broker dealer, or investment advisor may make any guarantees of any kind. A profit may not be guaranteed, and a promise of no loss may not be made.

Question 17

Recommendations to an Institutional Customer

Answer 17

FINRA recognizes an institutional customer as one that has at least $10,000,000 in assets. The agent’s or member’s suitability determination can be met if the customer: can independently evaluate the investment risks and merits, can independently make its own investment decisions. If the customer meets the above criteria, the member or agent may recommend almost any investment to the customer and allow the customer to determine if it is suitable.

Question 18

Recommending Mutual Funds

Answer 18

A representative recommending a mutual fund should ensure that the mutual fund’s investment objective meets the customer’s investment objective. If the mutual fund company or broker dealer distributes advertising or sales literature regarding the mutual fund, the following should be disclosed: the highest sales charge charged by the fund, the fund’s current yield based on dividends only, graph performance of the fund versus a broad-based index, the performance of the fund for 10 years or the life of the fund, whichever is less, not imply that a mutual fund is safer than other investments, source of graphs and charts.

Question 19

Periodic Payment Plans

Answer 19

When recommending or advertising a periodic payment plan, the following must be disclosed: a statement that a profit is not guaranteed, a statement that investors are not protected from a loss, a statement that the plan involves continuous investments, regardless of market conditions.

Question 20

Mutual Fund Current Yield

Answer 20

When advertising or recommending a mutual fund, any statement of claim regarding its current yield must be based solely on the annual dividends paid by the fund and may not include any capital gains distributions. Additionally, the public offering price, used to calculate the current yield, must contain the highest sales charged by the fund and may not be based on a breakpoint schedule or sales reduction charge.

Question 21

Information Obtained from an Issuer

Answer 21

If a broker dealer obtains information during the performance of duties to an issuer of securities, it may not use that information to solicit business. A broker dealer may obtain information from an issuer while acting as: an underwriter, transfer agent, paying agent, investment banker.

Question 22

Disclosure of Client Information

Answer 22

Registered representatives and broker dealers may not disclose any information regarding clients to a third party without the client’s expressed consent or without a court order. If the client is an issuer of securities and the broker dealer is an underwriter, transfer agent, or paying agent fo the issuer, then the broker dealer is precluded from using the information it obtains regarding the issuer’s security holders for its own benefit.

Question 23

Borrowing and Lending Money

Answer 23

Borrowing and lending of money between registered persons and customers is strictly regulated. If the member firm allows borrowing and lending between representatives and customer the firm must have policies in place that will allow for the loans to be made. Loans may be made between an agent and a customer if the customer is a bank or other lending institution, where there is a personal or outside business relationship and that relationship is the basis for the loan, or between two agents registered with the same firm. The firm must provide the agent with written pre-approval for the loan unless the loan is being made between the agent and an immediate family member or a bank. The approval documentation must be maintained for three years from the date when the loan was repaid or three years from the re’s termination.

Question 24

Gift Rule

Answer 24

Broker dealers may not pay compensation to employees of other broker dealers. If a broker dealer wants to give a gift to an employee of another broker dealer, it must: be valued at less than $100 per person per year, be given directly to the employing member firm for distribution to the employee, have the employing member’s prior approval for the gift. The employing member must obtain a record of the gift, including the name of the giver, the name of the recipient, and the nature of the gift. These rules have been established to ensure that broker dealers do not try to influence the employees of other broker dealers. An exception to this rule would be in cases where an employee of one broker dealer performs services for another broker dealer under an employment contract. Occasional meals, tickets to sporting events, and lucite plaques and prospectuses are all acceptable. The key to determine if tickets to events are entertainment is if the person providing the tickets attends the event. If this is the case the tickets are not deemed to be a gift.

Question 25

Outside Employment

Answer 25

If a registered representative wants to obtain employment outside of his or her position with a member firm, the registered representative must first notify the employing member prior to engaging in the activity. Prior approval is not required but the employer has the right to refuse or limit the outside business activity. Exceptions to this rule are if the registered representative is a passive investor in a business or if the representative owns a rental property. All other outside business activities must be disclosed to the member firm.

Question 26

Private Securities Transactions

Answer 26

A registered representative may not engage in any private securities transactions without first obtaining the broker dealer’s prior approval. The registered representative must provide the employing firm with all documentation regarding the investment and the proposed transaction. An example of a private securities transaction would be if a representative helped a startup business raise money through a private placement. If the representative is going to receive compensation, the employing member firm must supervise the transaction and the transaction must be run through the books o the broker dealer. If a representative sells investment products that the employing member does not conduct business in without the member’s knowledge, then the representative has committed a violation known as selling away.

Question 27

Customer Complaints

Answer 27

All written complaints received from a customer or from an individual acting on behalf of the customer must be reported promptly to the principal of the firm. The firm is required to: maintain a copy of the complain in a supervising office of supervisory jurisdiction for 4 years, electronically report all complaints to FINRA within 15 days of the end of each calendar quarter, report complaints within 10 days to FINRA if the complaint alleges misappropriation of funds/securities or forgery.

Question 28

Investor Information

Answer 28

All broker dealers that carry customer accounts must send their customers information detailing FINRA’s BrokerCheck public disclosure program at least once per calendar year. The BrokerCheck program, accessible via the FINRA website, provides detailed registration and disciplinary history for firms and agents maintained at the central registration depository (CRD). The information must contain the program’s 1-800 number, FINRA’s website address, and a statement that an investor brochure includes the same information and is available.

Question 29

Reverse Churning

Answer 29

Reverse churning is the practice of placing inactive accounts or accounts that do not trade frequently into fee based programs that charge an annual fee based on the assets in the account. This fee covers all advice and execution charges. Since these inactive accounts do not trade frequently, it will cause the total fees charged to the account to increase and makes a fee based account unsuitable for inactive accounts and for accounts that simply buy and hold securities for a long period of time. These accounts will generally be charged an annual fee in the range of 1%-2% of the total value of the assets in lieu of commissions when orders are executed.