Passing Score - Series 7 Flashcards
What is the Securities Act of 1933?
Applies to the primary market (i.e., when new securities are issued). The first act of federal regulation which resulted from the abuses leading up to the 1929 stock market crash and the Great Depression. Ensures increased transparency through public disclosure and prohibits misrepresentation and fraudulent activities. Made filing of a registration statement with the SEC a requirement. The registration statement includes a prospectus which must contain detailed information about the company, its business risks and audited financial statements
What is the Securities Exchange Act of 1934?
Applies to the secondary market (i.e., securities purchased from other investors and dealers rather than directly from issuing companies). Established the Securities and Exchange Commission (SEC). Gives the Federal Reserve Board regulatory oversight over the extension of credit in the securities industry. Regulates exchanges, broker-dealers and securities trading in the secondary market including:Transactions:
- Extension of credit
- Prevention of market manipulationShort salesOversight of industry self-regulatory organizations (SROs)Companies with securities trading:
- Registration and filing: After total assets and number of shareholders reaches a certain level a corporation must register with the SEC. If engaging in interstate commerce registration and filing of an annual report with the SEC is requiredProxies: Proxies are a power of attorney signed by a shareholder granting another party the authority to vote on the shareholder’s behalf at annual shareholders’ meetings. Proxies must be in a standardized format and contain all necessary information. Proxies must be filed with the SEC. Solicitations of proxies by corporations must follow certain rules. Shareholders must receive a proxy statement outlining all voting topics and in certain circumstances, where a registered rep may benefit from advising a customer to vote, the rep must file information schedules with the SEC
- Insiders
What are Self-Regulatory Organizations (SRO)?
SROs set rules and regulations for its own members in order to maintain fair and orderly securities markets and to protect investors. SROs were established by the Maloney Act of 1938 and operate under the supervision of the SEC (Securities and Exchange Commission)
What is the Maloney Act of 1938?
An amendment to the 1934 Act that applies to the over-the-counter (i.e., non-exchange) market. Allows for the creation of non-exchange SROs (Self-Regulatory Organizations) which are designed to prevent unfair practices. For example, the National Association of Securities Dealers or NASD (now the Financial Industry Regulatory Authority or FINRA) and the Municipal Securities Rulemaking Board or MSRB
What is the Trust Indenture Act of 1939?
Applies to the bond market. Protects bond investors by requiring an indenture (i.e., agreement) between the issuing corporation and a trustee (typically a bank or trust company) who would represent the bond owners in the event of the corporation’s liquidation. Required for corporations issuing more than $10 million of debt. The SEC is responsible for the creation and implementation of regulations that enforce the act[Note: Municipal bonds, government bonds, and other exempt securities are not subject to the provisions of the Trust Indenture Act]
What is the Investment Company Act of 1940?
Applies to firms, such as mutual funds, that pool investors’ money in order to invest the pooled funds in securities. Defines responsibilities for disclosure of material information and financial status of the firm as well as limitations on some forms of investing such as short selling
What is the Investment Advisers Act of 1940?
Applies to investment advisers. Provides an exact definition for an investment adviser which specifically exempts broker-dealers, banks, accountants, lawyers, publishers, engineers, teachers and government securities advisors who provide related services but do not provide investment advice as the main source of their compensationAn investment adviser is anyone who offers their services to the public as an investment adviser and charges a separate fee for that service. Anyone that meets this criteria will be defined as an investment adviser regardless of their membership in the aforementioned exempt groups and must register with the SEC
What is the Securities Investor Protection Act of 1970 (SIPA)?
Applies to brokerage firms. Created an industry-funded insurance corporation for the customers of a brokerage firm in the event that it becomes insolvent. Most brokers, dealers, members of national exchanges and FINRA members are required to participate. The resulting non-profit insurance corporation is called the Securities Investor Protection Corporation or SIPC
What is Regulation T?
Federal Reserve Board Regulation T governs the extension of credit for the purchase of securities including customer cash and margin accounts. Rules include:
- The amount of credit a broker-dealer is allowed to extend to customers is 50%; of the total market value of the securities (e.g., If a customer purchases $10,000 of securities the maximum loan value is $5,000)Initial margin requirementsAdditional requirements for day traders The type of securities allowed to be purchased on credit aka margin (e.g., securities listed on registered stock exchanges and Nasdaq)Payment dates for securities
* The circumstances under which an account must be frozen
What are the initial margin requirements as stipulated by Regulation T?
Customers purchasing securities on margin are required to deposit in cash 50%; of the value of the margin transaction within two business days of the settlement date and will receive a Reg. T call for the amount. If depositing securities as collateral in lieu of cash the customer must deposit twice the amount of the call[Note: New issues may not be used as collateral for a margin loan until they have been held for at least 30 days. New issues may be purchased on margin after 30 days. Mutual funds may never be purchased on margin but may be used as collateral after they have been held for at least 30 days]
What are the additional requirements for day traders as stipulated by Regulation T?
A day trader is defined by the SEC as anyone the firm has reason to believe is a day trader or anyone who buys and sells the same security on the same day at least four separate times over any five business days. They are subject to additional requirements that include:The customer must be designated as a pattern day trader
* Pattern day traders must hold at least $25,000 in equity in their account prior to executing any day trades and must hold the $25,000 in their account for two business days following any day trading activityThe account must go for three months without a day trade in order to drop the day trader designation and restrictions
What are the payment due dates for securities as stipulated by Regulation T?
Customers must pay for securities at specified payment dates otherwise their account is frozen for 90 days where no credit may be extended and the broker-dealer will sell the unpaid securities. An extension of the payment date may, under certain circumstances, be requested on or after the payment date from the NYSE for securities listed on the NYSE and from FINRA for over-the-counter securities. The specified payment dates include:Corporate securities: 2 business days after regular-way settlement (5 business days total)Options: 4 business days after regular-way settlement (5 business days total)Cash transactions: Same day as settlement (same day as transaction)U.S. government securities are exempt from Regulation T and payment is typically due the same day as settlement (next business day)
* Municipal securities are exempt from Regulation T and payment is typically due the same day as settlement (3 business days)
What are the Regulation T requirements for basic options?
The premium for options must be paid in full. Like corporate securities, payment for option premiums must be made by the second business day after a regular-way settlement (five business days after the execution date). Margin is not required for writing covered options but is required for writing uncovered options. Options with expiration dates of at least 9 months may be used as collateral for a margin loan at 25%;Regulation T also specifies requirements for specific options including:
- Index options
- Writing covered calls
- Writing covered puts
- Writing uncovered options
What are the Regulation T requirements for index options?
Buyers of index options must pay the premium in full. Writers of index options are always considered to be uncovered and must deposit margin. The initial equity requirement is $2,000 and settlement is next day
What are the Regulation T requirements for writing covered calls?
The option account for writing covered calls may be cash or margin. To qualify as covered one of the following must be satisfied:Ownership of underlying stockOwnership of securities that are convertible into underlying stockOwnership of a long call with a strike price that is the same or lower and an expiration date that is the same or later than the written callAn escrow receipt that shows that the underlying stock is deposited at a bank and may be delivered upon exercise of the written call[Note: The qualifying securities or escrow receipt must be deposited into the account that holds the written call]Margin does not need to be deposited for covered calls. However, if the qualifying securities were purchased on margin the investor may need to deposit margin and may use 100%; of the premium received for writing the call to contribute to the margin requirement
What are the Regulation T requirements for writing covered puts?
The option account for writing covered puts may be cash or margin unless the put is covered by a short position in which case the account must be margin. To qualify as covered one of the following must be satisfied:Ownership of a put with a strike price that is the same or higher and an expiration that is the same or later than the written putA short position in the underlying securityCash deposited in the amount of the aggregate strike price
* A letter issued by a bank that guarantees that cash in the amount of the aggregate strike price is deposited at the bank and may be delivered upon exercise of the written putMargin does not need to be deposited for covered puts. However, if the qualifying securities were purchased on margin (i.e., a short position) the investor may need to deposit margin and may use 100%; of the premium received for writing the put to contribute to the margin requirement
What are the Regulation T requirements for writing uncovered options?
The option account for writing uncovered options must be a margin account. Margin must be deposited with a $2,000 initial equity requirement (CBOE and other exchanges have this requirement). The margin requirement is based on the current market value of the underlying security (CMV) and is the greater of:Current Premium Amount+20%; of CMV−Out-of-the-Money Amount-OR-Current Premium Amount+10%; of CMV
What are the Regulation T requirements for spreads?
Covered spreads do not require margin. Uncovered spreads must deposit marginCovered call spreads - To qualify as covered the long option must have a strike price that is the same or lower and an expiration date that is the same or later than the short optionCovered put spreads - To qualify as covered the long option must have a strike price that is the same or higher and an expiration date that is the same or later than the short option
What are the Regulation T requirements for straddles and combinations?
The buyer must pay the premium in full. The straddle or combination may not be used to meet any margin requirement. Short straddles and combinations must deposit margin based on the value of the underlying securities
What are the limits for the number of option contracts one investor may hold or exercise for the same underlying security?
The Options Clearing Corporation and the options exchanges impose limitations on the number of option contracts a single investor or a group of investors acting together may hold or exercise. Each underlying security has its own limit based on trading volume and outstanding shares. Limits are reviewed every six months. Limits are based on the same side of the market (i.e., bullish side versus bearish side). For example, if the contract limit is 50,000 contracts an investor may purchase up to 50,000 calls and also write up to 50,000 calls because long calls are bullish and short calls are bearish. However, if the investor purchased 50,000 calls and wrote 50,000 puts the investor would be over the limit because both long calls and short puts are bullish.The exercise limit is the number of times an investor may exercise an option in any given period of five consecutive business days. The contract limit and the exercise limit are the same number
What is market manipulation?
Market manipulation is prohibited subject to regulation by the Securities Exchange Act of 1934 and includes: Misrepresentation of informationOmission of informationRumors: No action should be taken on unsubstantiated news until the information becomes publicTransactions intended to unfairly influence the market price of the security such as:Matched orders. Transactions coordinated to create the appearance of increased trading volumePools or syndicates created in order to influence market price (e.g., capping the market price so that it does not go above a desired price or pegging the market price so that it does not go below a desired price[Note: All securities are subject to anti-manipulation regulation. There are no exemptions for fraud]
What is a late trading violation?
A mutual fund purchase or redemption that is placed after the 4pm deadline in order to profit from news or activity that occurs after the close. SEC and exchange rules prohibit this type of activity
What is SEC Regulation SHO?
Created January 2005 to avoid fail to deliver situations by updating and standardizing practices including: Locate requirement - A broker-dealer must locate a security prior to short-selling. In other words the dealer must reasonably expect that the security will be available to be borrowed and delivered at a specific date typically through “easy to borrow” lists that identify securities available for short-sellingClose-out requirement - If a security has a relatively high number of extended delivery failures the close-out requirement applies (i.e., additional delivery requirements are imposed)
What is an insider?
Any person with access to material information about a corporation that is not available to the public (e.g., officer, director, owner of 10%; or more of voting stock and their immediate family members).The Securities Exchange Act of 1934 stipulates that:Insiders must report their status within 10 days of becoming an insiderInsiders must report changes to their stock position within 2 business daysInsiders may not short sell stock of the corporation of which they have inside informationInsiders may write covered calls but may not write uncovered callsInsiders may not sell stock at a profit if owned for less than 6 monthsInsiders may not repurchase stock for at least 6 months if the stock was sold at a profitRule 10b-5: Prohibits fraudulent activities such as insider trading (transactions where material non-public information about a corporation is inappropriately used)Tipping is prohibited and occurs when material non-public information is given to an unauthorized person (the tippee). If the tippee uses the information to trade and is aware or should be aware that the information is confidential then the tippee has also violated the rule
What is an institutional investor?
The following are considered institutional investors:Financial institutions such as banks, insurance companies, savings and loans, investment companies and registered investment advisersGovernment entitiesQualified retirement plans with at least 100 participantsBroker-dealers and registered representativesAn individual or entity with assets greater than $50 million
* An agent acting on behalf of one of these institutional investors
What is the Employee Retirement Income Security Act of 1974 (ERISA)?
Applies to private qualified retirement accounts. ERISA guidance requires portfolio management with professional expertise as well as funding and nondiscriminatory requirements. Plan assets must be used solely for the benefit of plan participants. Pension plans in the U.S. must comply with ERISA
What is the Securities Acts Amendments of 1975?
Applies to the Municipal Securities Rulemaking Board (MSRB). The act established the MSRB as an SRO for firms that transact business in municipal securities. In 2010 the Dodd-Frank Act expanded the role of the MSRB to include regulation of advisors to municipal securities issuances
What is the Insider Trading Sanctions Act (ITSA) of 1984?
Applies to insider trading. Resulted from the abuses of the 1980s. Outlines specific civil and criminal penalties for various types of insider trading
What is the Insider Trading and Securities Fraud Enforcement Act (ITSFEA) of 1988?
Applies to insider trading. Resulted from the abuses of the 1980s. Permitted awards for whistle-blowers of up to 10%; of the penalty imposed and prescribed specific penalties for insider trading such as:Civil fines up to 3 times the amount of the profit gained or loss avoided from insider tradingCriminal fines up to $5 million for individuals and $25 million for corporations and other entities
- Imprisonment up to 20 yearsAlso required broker-dealers to write, maintain, implement and enforce policies and procedures intended to prevent the misuse of material non-public information which must include:A system to monitor trading occurring in the broker-dealer’s accounts and in employees’ personal accountsMaintenance of a list of securities of which inside information exists and restricting or monitoring trading activity for those securities (e.g., restricted lists and watch lists)Protection of files containing inside information including:Information barriers: Establishment of adequate physical and procedural barriers to the unintentional transmission of confidential information
- Employee training on insider trading
What is SEC Regulation Fair Disclosure (FD)?
Prevents disclosure of information to certain individuals (e.g., securities professionals, institutional shareholders, etc.) without disclosing the same information to the general public. If the disclosure was intentional disclosure to the public must be simultaneous. If the disclosure was unintentional disclosure to the public must occur within 24 hours or, in the case of weekends and holidays, disclosure must occur at the opening of the next trading day for the NYSE and Nasdaq. Public disclosure may be through any means designed to broadly reach the public such as a press release, the Internet or filing Form 8-K with the SEC[Note: Requirements to disclose to the public does not apply for information in relationships where professional responsibility requires information to remain confidential (e.g., information disclosed to lawyers, accountants, etc.)]
What is the Federal Telephone Consumer Protection Act of 1991?
Applies to telephone solicitations (aka cold calling or telemarketing) in which a call is made in order to profit from the call. Provides limitations on cold calling including:A do-not-call list must be maintained and entries on the do-not-call list must be maintained indefinitelyCalls must be made between 8:00 am and 9:00 pm (in the time zone of the person being called)Callers must provide their name, the name and contact address or telephone number of the individual or entity that the call is being made on behalf of and the caller’s purpose in making the callUnsolicited facsimiles are prohibited
* Autodialers and pre-recorded messages are prohibited unless an existing business relationship is in place or the caller is calling on behalf of a tax-exempt nonprofit organization
What is the Penny Stock Rule of 1991?
Intended to prevent abuse and ensure adequate information to the public for penny stocks. Penny stocks are OTC stocks with a relatively low price and market capitalization that are often highly speculative and are generally traded through the Pink Sheets and the OTCBB.These rules apply to all securities except:NYSE or Nasdaq securitiesInvestment company securitiesOCC-listed puts and callsSecurities trading above $5 per shareCompanies with average earnings for the last 3 years equal to $6 million or more; net tangible assets equal to $2 million or more for companies operational continuously for the last 3 years; or net tangible assets equal to $5 million or more for companies operational for less than 3 yearsSecurities transacted with an institutional accredited investorPrivately placed securitiesSecurities transacted with the issuer, officers, directors, general partners or owners with at least 5%; ownership
- Securities transacted by a broker-dealer if compensation from penny stocks equal 5%; or less of total commissions and markupsRules include:Suitability based on investment objectives and financial situation must be confirmed and a written statement of suitability must be provided and signed by the customerA Risk Disclosure Document must be provided to the customer that contains all SEC-required informationPrior to purchasing penny stocks the customer’s account must be approved to transact in penny stocksFor the first 3 penny stock transactions for an established customer (holding accounts with the broker-dealer for at least one year) a written agreement must be obtained from the customer with information regarding the name and quantity of securities to be purchasedFor each transaction the current quote, the compensation to the broker-dealer and the compensation for the registered rep must be disclosed
- Statements for accounts with penny stocks must be provided monthly (versus the quarterly statement requirement) and must include the name and quantity of shares of each penny stock and the estimated market value as best possibly determined
How is FINRA governed?
FINRA is governed by the Federal Reserve Board of Governors which includes the CEO of FINRA and the CEO of NYSE Regulation. The U.S. is divided into districts headed by a District Committee who is an agent of the Board of Governors
Who is eligible for membership in FINRA?
Those eligible for FINRA membership include:Brokers: Any individual or entity that charges a fee or commission for filling securities transactions on behalf of an investor
- Dealers: Any individual or entity that fills securities transactions for its own account as a regular business activityThose ineligible for FINRA membership include:Any individual or entity that fills securities for their own accounts that do not do so as a regular business activityBrokers or dealers suspended or expelled from a registered national securities association or exchangeBrokers or dealers suspended or barred from associating with members of a registered national securities association or exchange due to violations of fair and equitable practices
- Brokers or dealers prohibited by court order from doing any related securities business activities with other brokers, dealers, investment advisors, underwriters, etc.
How are FINRA members treated versus non-members and the public?
Business between a FINRA member and another FINRA member may be treated on a preferential basis (e.g., discounts, price concessions, etc.). Non-members must be treated the same as the public
What are the rules regarding FINRA designation?
The FINRA name may be used solely for identification and must be used together with the member firm’s name but in smaller type than the firm’s name. The FINRA name may be printed on:Trade directoriesConfirmations
* Member firm’s office door
What is the Taping Rule?
A member firm that meets the following criteria must begin taping conversations between registered reps and clients for three years and follow special procedures on review and retention of the taped material. Once notified of the requirement by FINRA the member firm has 60 days to comply and beging recording the conversations as well as send a report to FINRA every quarterEmploys between five and nine registered reps when 40%; or more have been employed by a disciplined firm in the last three yearsEmploys between ten and nineteen registered reps when 4 or more have been employed by a disciplined firm in the last three years
* Employs 20 or more registered reps when 20%; or more have been employed by a disciplined firm in the last three years
What are the 4 major sets of FINRA rules for over-the-counter securities?
Uniform Practice Code - A uniform set of rules for dealer-to-dealer transactions for all non-exempt OTC securitiesConduct Rules - Concerned with transactions between FINRA members and the public ensuring the member’s fair and equitable treatment of the publicCode of Procedure - A set of procedures for handling complaints and violationsCode of Arbitration - A set of rules for settling disputes among FINRA members and the public
What is the FINRA Uniform Practice Code?
A set of rules intended to establish uniform practices in dealer-to-dealer transactions for all non-exempt OTC securities (as defined by the Securities Exchange Act of 1934). Rules regarding transactions include:Delivery of securitiesConfirmations must be sent in written format the first business day following a regular-way transaction and on the same business day of a cash transaction
- Customer confirmations must state that the firm acted as either a principal or an agent and must state the commission amount if acting as an agentBroker-dealer confirmations must contain adequate information on the security and transaction clarifying the terms of the transaction. If a disagreement concerning the transaction arises the broker-dealer that receives the confirmation may send a Don’t Know (DK) noticeFidelity bonds must be posted (i.e., an insurance policy against the fraudulent acts of specified persons such as the member firm’s employees). If the amount of insurance is inadequate the firm’s assets are usedAn endorsement must be obtained on the certificate of a security that a customer is selling (typically the customer’s signature on the back of the certificate)An assignment must be obtained for a security that a customer is transferring. The assignment must be guaranteed by a member firm or commercial bank (i.e., a signature guarantee) and must be exactly as the name appears on the certificateUnits of delivery must be in certain allowed multiples. If delivering units other than the allowed multiples delivery of the certificate may be rejectedStock transactions should be delivered in units of 100 shares or multiples of 100 shares with the following exceptions:
- Certificates under 100 shares may be delivered if the total shares for the certificates add up to 100 shares (e.g., a certificate of 25 and another for 75 shares adds up to 100 shares total)
- Odd lots. A single certificate under 100 shares may be delivered (e.g., three certificates of 100 shares each and one certificate for 25 shares is acceptable because only one single certificate is under 100 shares)
What are the FINRA Conduct Rules?
A set of rules regarding fraud and unreasonable profit, fair trade and business practices, standards of commercial honor and integrity, and general protection of the public in transactions with FINRA member firms. Excludes exempt securities (e.g., municipal securities, U.S. government securities). However, the SEC’s antifraud provisions are always in force with no exemptionsRules and requirements regarding conduct include:Supervision of personnelSuitability of recommendations to customers
* Communications with the public
What is the FINRA 5%; Policy?
A guide to assist member firms in adhering to the industry rule that sales to the public must be fair and reasonable in relation to current market conditions. Stipulates that commissions (charged when acting as an agent) and markups (charged when acting as a principal) should equal 5%; of the current market value of the securityThe 5%; Policy is only a guide and markups above or below 5%; may be appropriate under certain circumstances including:Type (e.g., stock, bond) - Securities that are more speculative may justify a higher markupAvailability - A relatively inactive stock incurs additional cost and effort and may justify a higher markupPrice/transaction amount - A security with a low market price or a transaction with a small total amount incurs a greater percentage of cost and may justify a higher markup
- Exempt securities (e.g., securities sold under prospectus, new issues, mutual funds, etc.)The 5%; Policy generally applies to:Riskless or simultaneous transactions where an existing order from a customer is filledProceeds transactions where an order from a customer is filled with the proceeds from an existing order from that customer to sell a securityPurchase or sale of securities from inventory for a customerAgency transactions where a commission is charged
- Third market transactions where securities are traded between broker-dealers and large institutional investors
What is interpositioning?
The addition of a third party (e.g., an extra broker-dealer) on a trade typically as a means to provide the third party with commissions in exchange for referrals or other profit. Interpositioning is generally prohibited but may be permitted if proven that the intervention of a third party provided the customer with a better price
What is a principal?
Principals include sole proprietors, partners, managers, directors, and officers of firms of supervisory jurisdiction or any person actively involved in the management of the firm’s business
What is a Registered Representative?
Registered representatives conduct business for their firm and include employees who solicit business, trade, underwrite, train, etc. They must initially work for a broker-dealer who sponsors them to take an exam through FINRA to qualify as a registered representative
What are the requirements for registration of principals?
Personnel of FINRA or MSRB member firms are required to be registeredGenerally, the requirements for registration of principals include:File a Form U4
* Pass the General Securities Principal Exam (Series 24)
What are the requirements for registration of representatives?
Personnel of FINRA or MSRB member firms are required to be registeredGenerally, the requirements for registration of representatives include:File a Form U4
* Pass the General Securities Representative Exam (Series 7)
What are the requirements for registration of a representative selling municipal securities?
Personnel of FINRA or MSRB member firms are required to be registeredGenerally, the requirements for registration of representatives include:File a Form U4Pass either the General Securities Representative Exam (Series 7) or the Municipal Securities Representative Exam (Series 52)
* Serve a 90 day apprenticeship during which no commissions or dealings with the public are allowed
What is Web CRD?
The Central Registration Depository (CRD or Web CRD) is the central licensing and registration system for FINRA. It is used to process applications for registrations, employment history and disciplinary actions for broker-dealers and registered individuals
What is BrokerCheck?
BrokerCheck is a free tool to help investors research the professional backgrounds of current and former FINRA-registered brokerage firms, brokers, adviser firms and representatives. The information is shared from CRD filings and includes licensing status and history, employment history, disputes, arbitration, written customer complaints of sales practices, criminal or regulatory investigations and other issues
What is the Investor Education and Protection Rule?
This FINRA rule requires that member firms provide the following to customers in writing at least once a year: FINRA Public Disclosure Program hotline numberFINRA website address
* Notification that a brochure with information about BrokerCheck is available
What are the requirements for personnel whose duties are solely administrative or clerical?
Generally, personnel that act in a solely administrative or clerical manner are not required to be registered. In addition, personnel selling non-securities (e.g., fixed insurance, commodities) are not required to be registered
What are the supervision rules that FINRA and MSRB firms must follow?
Written proceduresDesignation of a partner, officer or manager in charge of carrying out procedures for every office of supervisory jurisdiction (OSJ) (i.e., an office that reviews certain activities such as customer orders, new accounts, advertising, etc.)Records for carrying out supervisory proceduresReview and endorsement, in writing, of all registered rep’s correspondence and transactions relating to securities transactionsApproval of customer accounts and periodic review of accounts for abusesAt least once annually, an inspection of each office of supervisory jurisdiction (OSJ)
* Examination of the qualifications, experience, reputation and character of potential registered representatives and continual monitoring of their good standing
What are the supervision rules for option activities?
Supervision rules for options are set by the Options Clearing Corporation and have been adopted by the options exchanges and by FINRAMember firms must have:Written procedures
* Designation of a partner, officer, etc. as the Registered Options Principal (ROP)
What are the continuing education rules that FINRA and MSRB firms must follow?
The Regulatory Element: One year after the initial securities registration of a registered representative and every 3 years thereafter Regulatory Element training must be completed. Training includes compliance, regulatory, ethical and sales-practice standards. Representatives that do not complete training within the specified time frames may not perform any activity or receive any compensation that requires securities registrationThe Firm Element: Individual broker-dealers must create and enforce an annual Firm Element continuing education for all representatives
What effect does military duty have on registered representatives?
When a registered representative enters active military service their status changes in WebCRD to special inactive. All licensing requirements are delayed during active service which includes the two-year inactive status limitation for registration with a member firm and continuing education. The representative may continue to receive compensation but cannot contact clients or perform other securities functions during their military inactive status
What are the account disclosure rules that FINRA and MSRB firms must follow?
Representatives, their spouses and minor children must disclose their association with a broker-dealer before opening any accounts. The opening firm must notify the broker-dealer in writing and await instructions before opening the account. For accounts with another member firm, prior written notification is required and approval of the employer may be required. For MSRB member firms duplicate confirmations must be sent to the broker-dealer only if requested. Mutual funds are exempted from disclosure requirements
What are the gifts and compensation rules that FINRA and MSRB firms must follow?
Each member firm employee may not give or receive gifts exceeding $100 in material value per year to outside parties. Exemptions include occasional meals, tickets to sporting or cultural events, reminder advertising (e.g., writing instruments, key chains, etc.) and expenses related to legitimate business travel. Exemptions also exist for gifts to family members of an employee for a social event (e.g., wedding)For non-registered employees of another member firm, member firms may only compensate these employees if there is a written agreement stipulating the nature of the employment, the exact compensation to be paid and the written consent of the other member firm is given. All gifts and compensation given must be recorded by the member firmNon-registered persons may not receive any gift or compensation for referrals. However, the referred customer may receive benefit from the referral (e.g., discounted services) as long a the customer receives the benefit and not the referrer
What are the profit and loss sharing rules that FINRA and MSRB firms must follow?
The sharing of profits or losses in a customer’s account is not allowed unless all of the following conditions are met:It is a joint account where the registered representative has obtained prior written consent from both the customer and their employerThe rep has made a financial contribution to the account
* The profit and losses are shared in direct proportion to the financial contribution
What are the outside business activity rules that FINRA and MSRB firms must follow?
Outside business activities only apply to activities in which the registered representative receives payPrior to participating in any business activities outside the scope of a registered representative’s normal relationship with their firm the rep must provide written notice to their employing firm. The firm may prohibit the representative from engaging in any particular outside business activity
What are the private securities transactions rules that FINRA and MSRB firms must follow?
Private securities transactions are outside the scope of a registered representative’s normal transactions with their employing firmPrior to engaging in private securities transactions the registered representative much obtain written approval from their employing firm. The firm may have specific procedures that must be followed in order to engage in the transaction. Transactions must be recorded in the firm’s books if the rep receives compensation for the transaction
What is the complaint process that the Department of Enforcement must follow when it believes a violation has been made by a member firm or person?
The Department of Enforcement must request authorization to issue a complaint from the Office of Disciplinary Affairs. The respondent (i.e., the member firm or person believed to be in violation) must file a response within 25 days. After 25 days the Department of Enforcement will issue a second notice. A non-response 14 days after the second notice can be treated as an admission to the violation charged in the complaintWhen filing a response the respondent may request a hearing. Not requesting a hearing waives the respondent’s rights to a hearing. Hearings are held before a Hearing Panel which consists of a Hearing Officer and two panelists appointed by the Chief Hearing Officer
What sanctions can a Hearing Panel impose on a member firm or person that the Department of Enforcement has issued a complaint against?
CensureFinesSuspension for either a specified period or until specified conditions are metExpulsion or cancellation of membership or registration[Note: This includes any type of association with a member firm including clerical or administrative activity]Suspension or barring from association with any member firmAny other fitting suspension[Note: This excludes imprisonment. Only a court of law may sentence imprisonment]
What is the appeal process once a Hearing Panel comes to a decision about a complaint that the Department of Enforcement has issued against a member firm or person?
The respondent has 25 days to file an appeal with the National Adjudicatory Council (NAC). A decision on the complaint will not be made until the appeal process is complete. The NAC can affirm, reverse, modify, increase or reduce any sanction. The NAC can also impose an entirely different sanctionThe respondent may appeal a final sanction of FINRA to the SEC and may appeal the SEC’s decision to a federal court
What is a Letter of Acceptance, Waiver and Consent (AWC)?
When a member firm or person (i.e., respondent) does not respond to a complaint issued by the Department of Enforcement, the Department of Enforcement may request the respondent to sign an AWCThe AWC describes the rules violated, the sanctions imposed and would waive the respondent’s right to an appeal. If the respondent does not dispute the complaint and consents to the sanction sanctions may include a fine of not more than $2,500 and censure of the respondentThe respondent may reject the AWC in which case the disciplinary process would proceed as normal
What is the difference between the Code of Arbitration and the Code of Procedure?
The Code of Arbitration covers settlement of disputes through arbitration while the Code of Procedure covers discipline for violation of rules and regulations
What parties does the Code of Arbitration cover?
Members against other members[Note: These disputes must be submitted to arbitration]Members and any clearing corporationMembers and public customers[Note: Public customers must give prior written consent in order to be brought to an arbitration and the majority of the arbitrators must consist of persons outside the securities industry]
What is the National Arbitration Committee?
The National Arbitration Committee is a panel that makes a final decision on disputes under the Code of Arbitration. The panel consists of three arbitrators. In cases where the amount in dispute does not exceed $50,000 the parties may choose simplified arbitration procedures in which only one arbitrator is required. The National Arbitration Committee’s decisions are final unless the law directs otherwise
What is mediation?
An attempt to resolve a dispute with the help of a third-party, the mediator, who facilitates a resolution. A mediator is initially suggested by FINRA, the parties, however, can select any mediator that they both agree on. The mediator fee is divided between the two parties. Meetings between each side and the mediator to help understand and resolve the issues are known as caucuses. Mediation will continue until either there is a written settlement, the mediator declares that no resolution can be reached or one of the parties withdraws in writing from the process. Mediation efforts can continue before or after arbitration proceedings have begun
What is the definition of correspondence?
Any written communication either on paper or electronically sent to 25 or less prospective or current clients during a 30-day period. Correspondence must be reviewed regularly and supervised but is not required to be preapproved by a principal or submitted to FINRA
What is retail communication?
Retail communication is paper or electronic distribution to more than 25 retail investors during a 30-day period. A distribution to 25 or less retail investors is considered correspondence. Any investor that does not meet the criteria of an institutional investor is considered a retail investor. Communications include:Material distributed to a wide audience such as though TV, web sites, magazines and radioA reprint of an article from a third-party sent to more than 25 retail investors during a 30-day period
* Distribution through social media venues
What are the preapproval rules for retail communications?
A principal must approve retail communications before public release or the FINRA filing except in the following cases:The material has already been filed with FINRA by another firm and it has not been materially alteredThe material is from a social media website such as Twitter
* The material does not recommend any investment, promote the products and services of the firm, is not considered a research report and does not provide financial advice (This includes normal contacts with customers and market letters)In most cases if the communication does not require preapproval than it does not need to be filed with FINRA
What are the FINRA filing requirements for retail communications?
Filed with FINRA 10 days prior to use:All broadly disseminated communications within the first year as a FINRA memberA firm that has been disciplined may be required to have its communications approvedRetail communications regarding registered investment company comparisons and rankings that are created by the firm
- Retail communications regarding security futuresFiled with FINRA within 10 days of use:Communications regarding the following:Mutual funds, ETFs, variable products, closed-end funds and unit investment trustsDerivativesCollateralized mortgage obligations
- Publicly traded direct participation programs
- Investment analysis tools and the resulting reports producedRoutine business communications such as recruitment ads, press releases and reprints of articles produced by third-parties do not have to be filed with FINRA
What investment company rankings are permitted in retail communications?
Ranking of investment companies can only be used in retail communications if they are created and published by a ranking entity or are based on the performance measurements of a ranking entity. A ranking entity is any organization that:Provides general information about investment companies to the publicIndependent from investment companies or their affiliates
* Not hired or compensated by an investment company or its affiliates to provide a fund ranking
What disclosures are required when using investment company rankings in retail communications?
The name of the investment category being rankedThe number of investment companies compared within the categoryName of the entity issuing the rankingThe time period involved in determining the rankingCriteria used in determining the rankingStatement that past performance is not a guarantee of future resultsWhether the ranking takes into account front-end feesThe use of either total return or current SEC standardized yieldThe publisher of the ranking information
* Explanation of any symbols, such as number of stars, used in the ranking
What is required when bond volatility ratings are disclosed?
Bond volatility ratings cannot be used in public advertisements only in supplemental sales literatureA prospectus has been or will be sent to the clientThe volatility rating is not described as a risk ratingThe most recent available ratings are usedObjective and quantifiable factors are used to determine the ratingThe issuing entity provides a detailed disclosure on the rating methodology to investors on a website or toll-free numberThe name of the entity issuing the ratingMost current rating and the dateDescription of the rating including the methodology, whether the fund paid for the rating and the types of risks measuredStatement there is no standard method for determining the bond fund volatility rating
* Statement that the portfolio may have changed since the date of the rating and there is no guarantee that it will stay the same
What is required when disclosing information about an investment tool?
Criteria, methodology and main assumptions of the investment toolThe range of investments to be analyzed as well as the process of selecting securitiesDisclose that investment results may vary over timeAny securities which the firm makes a market in or is serving as an underwriterThe following disclosure:IMPORTANT: The projections or other information generated by (name of the investment tool) regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results.
What is considered a public appearance?
A public appearance is when a person representing a broker-dealer or fund sponsor speaks in an unscripted format on TV, radio, at a conference or seminar. Any similar engagement that is not considered retail communication is a public appearance and is not required to be preapproved by a principal or filed with FINRA
What is the definition of a research report?
Any written communication on equity securities that contains adequate information to make investment decisions (e.g., rating, recommendation, price target). Prior to the use of a research report approval must be obtained by a Supervisor Analyst. Research reports must disclose:If the analyst or the analyst’s immediate family is an officer, director or advisory board member of the companyOwnership information of the security if owned by the analyst or the analyst’s immediate familyOwnership information if the firm owns 1%; or more common shares of the securityIf the firm is a market maker for the securityCompensation information if the issuer provided compensation for underwriting services to the firm within the last 12 months
- Firms may not issue research reports if underwriting services for the security (i.e., as a manager or co-manager) were performed within the last 40 days for IPOs and within the last 10 days for secondary offeringsIn order to prevent conflict of interest a firm’s research department must be separate from the investment banking department
- Any material conflict of interest
What are the filing requirements for advertisements for the first year a broker-dealer is in business vs. established broker-dealers?
For the first year broker-dealers must file all advertisements with FINRA at least 10 days prior to publicationFor established broker-dealers copies of all advertisements must be kept in an internal file for at least 3 yearsOtherwise, advertisements generally do not need to be filed with FINRA. Exceptions include advertisements for options, Collateralized Mortgage Obligations and investment companies
How long must broker-dealers retain copies of public communications?
Three years. The first two years must be readily available during a FINRA audit
What are the requirements for advertising, sales literature and educational materials for options?
Approval by ROP prior to useAdvertisements and educational materials must be submitted to the SRO ten days prior to useAdvertisements must be general (i.e., cannot make specific recommendations)Advertisements cannot reference past or future performanceIf provided to customers not yet approved for options trading sales literature must be accompanied with the Characteristics and Risks of Standardized Options which discloses risks and outlines relevant information associated with options
* If referencing past or future performance sales literature must either contain supporting documentation or contain notification that supporting documentation is available upon request
What information must be gathered in order to open a customer cash account?
Name and address of residenceIf the customer is of legal ageSignature of registered representative opening the accountSignature of principal, officer or partner approving the account (approval must occur on or before the day the account is opened)
- For accounts opened for businesses or organizations the names of the individuals authorized to transact business in the account must also be gatheredThere must also be a reasonable effort to obtain:Taxpayer ID number or Social Security NumberOccupation, employer, work addressIf the customer is associated with another broker-dealerIf associated with another member firm:
- Written notice must be provided to the member firm of the intention to open an account
- Copies of confirmations must be sent to the member firmIf the member firm provides any written instructions they must be followedInformation used to make recommendations such as risk tolerance, investment objectives, financial background, tax status, annual income, net worth, etc.[Note: Any information specifically withheld by the client should be documented]
- If a discretionary account the customer must give written consent
What are the additional requirements for opening a customer margin account?
A margin agreement must be signed by the customer stating that the customer must follow the requirements set by the Federal Reserve Board, the SRO and the brokerage firm. The margin agreement will typically contain:Credit agreement - Customer acknowledges the loan and accepts responsibility for interest and principal payments. All credit terms are outlinedHypothecation agreement - The customer agrees to hypothecate (i.e. pledge) securities in their account to the brokerage firm. In other words the securities in the account are used as collateral for the margin loan. The agreement also typically allows the brokerage firm to rehypothecate the securities at a bank for up to a value of 140%; of the debit balance. In this case the brokerage firm uses the securities as collateral to secure a margin loan with a bank. The maximum amount that may be used as collateral is 140%; of the balance that the customer owes (e.g., if the total value of the margin account is $20,000 and the customer deposits $10,000 in cash to meet the margin requirement then their debit balance is $10,000 and the maximum rehypothecation amount is $14,000)Loan consent agreement - Allows the brokerage firm to lend the customer’s securities (typically for short sales for other clients). Current regulations do not require that the customer sign the loan consent agreement
How is the interest rate of a margin account typically determined?
The interest rate is variable and typically follows the broker call loan rate which is the interest rate charged to brokerage firms for loans from a bank. The margin interest rate will typically be the broker call loan rate plus an additional percentageInterest is charged daily and posts to the account monthly. Interest payments are typically tax-deductible against investment income
How is the equity in a long margin account determined?
Each long margin position (i.e., a position owned by the customer in the hopes that it will increase in value) has a:Long market value (LMV):No. of Shares×Current Market PriceDebit Balance (DR): Amount owed to the brokerage firmEquity is determined by subtracting the debit balance from the long market valueEquity = LMV - DR
How is excess equity in a long margin account determined?
If the initial equity in the account is at 50%; of the long market value (in order to meet Regulation T’s 50%; initial requirement), and then the long market value increases there will be equity in excess of the 50%; requirementFor example, if the long market value of a customer’s account has increased to $50,000 and their debit balance is $20,000 the equity in their account is now $30,000 ($50,000 - $20,000). The 50%; requirement is $25,000 ($50,000 x 50%;). Therefore, their excess equity is $5,000 ($30,000 - $25,000)Excess Equity:Current Account Equity− (Long Market Value × 50%;)
What is a Special Memorandum Account (SMA)?
SMA is a line of credit with a brokerage firm that is generated by notating an eligible amount (such as cash additions to the account). These cash additions are used to pay down the debit balance which increases excess equity in the account. The customer may withdraw cash from their margin account up to the total of the notated amounts (aka the SMA) at which point the equity in their account will once again be at the 50%; margin requirement. Items that generate SMA include:Excess equityCash dividendsBond interestProceeds from the sale of securities
* Voluntary customer cash deposits
What is buying power?
The amount of money available for securities purchases. For cash accounts buying power is equal to the cash in the accountFor margin accounts buying power is equal to the cash in the account plus the SMA divided by 50%; (the margin requirement):Cash + SMA50%;For example if a customer had $1,000 in cash and $5,000 in SMA or excess equity they would be able to purchase $12,000 in securities ([$1,000 + $5,000] / 50%;)
What are the industry requirements for long margin accounts?
Federal Reserve Board Regulation T governs margin accounts. However, industry requirements are permitted so long as they are more stringent than Regulation T. They include:Initial margin requirement - The minimum customer deposit is the lesser of $2,000 or 100%; of the purchase price. In other words, for purchases of less than $2,000, the customer must deposit 100%; of the purchase price rather than Regulation T’s 50%; initial requirement. For purchases of $2,000-$4,000 the customer must deposit $2,000 which is higher than Regulation T’s 50%; requirementMaintenance margin requirement - Equity in the margin account must not fall below 25%; of the current market value of the account. If equity falls below 25%; the customer will receive a maintenance call to make an additional deposit or to liquidate securities in order to make the maintenance requirement. The result is that if the current market value falls below 4/3 of the debit balance the account would be below the 25%; maintenance requirement. Regulation T does not have a maintenance requirement:LMV × 4/3
What is a restricted margin account?
A margin account becomes restricted when the equity in the account falls below Registration T’s 50%; initial margin requirement. For restricted accounts:Margin purchases may still be made as long as the new purchase meets the 50%; margin requirementProceeds from any sales are used to reduce the debit balance and only 50%; of the proceeds of the sale is added to the SMA balance[Note: Cash may only be withdrawn from the SMA when the account is no longer restricted]Same-day substitutions occur when a purchase and a sale of securities is made on the same day
- For same-day substitutions of equal sale and purchase amounts no additional deposit is required
- For same-day substitutions where the purchase is greater than the sale amount the 50%; requirement is only required for the difference between the purchase and sale amount. For example, for a purchase of $10,000 and a sale of $5,000 on the same day a deposit of $2,500 ([$10,000 - $5,000] x 50%;) is required
- For same-day substitutions where the purchase is less than the sale amount SMA is credited 50%; of the difference between the purchase and sale amount. For example, for a purchase of $10,000 and a sale of $20,000 on the same day SMA would be credited an additional $5,000 ([$20,000 - $10,000] x 50%;)
How is the equity in a short margin account determined?
Each short margin position (i.e., a position borrowed by the customer in the hopes that it will decrease in value) has a:Short market value (SMV):No. of Shares×Current Market PriceCredit Balance (CR):Short Sale Proceeds+Reg T Initial Margin Req for Short PositionsEquity is determined by subtracting the short market value from the credit balance:Equity = CR - SMV
How is the equity determined in an account with long and short margin positions?
The equity of an account with long and short positions is equal to the equity of all long positions plus the equity of all short positionsLong market value (LMV):Shares of Long Positions×Current Market PriceDebit Balance (DR): Amount owed to the brokerage firm for long positionsShort market value (SMV):Shares of Short Positions×Current Market PriceCredit Balance (CR):Short Sale Proceeds+Reg T Initial Margin Req for Short PositionsEquity is determined by subtracting the debit balance and the short market value from the long market value and the credit balance:Equity:LMV + CR - DR - SMV
How is excess equity in a short margin account determined?
If the initial equity in the account is at 50%; of the short market value (in order to meet Regulation T’s 50%; initial requirement) and then the short market value decreases there will be equity in excess of the 50%; requirementFor example, if the short market value of a customer’s account has decreased from $60,000 to $50,000 and their credit balance is $90,000 the equity in their account is now $40,000 ($90,000 - $50,000). The 50%; requirement is $25,000 ($50,000 x 50%;). Therefore, their excess equity is $15,000 ($40,000 - $25,000)Excess Equity:Current Account Equity− (Short Market Value × 50%;)
What are the industry requirements for short margin accounts?
Federal Reserve Board Regulation T governs margin accounts. However, industry requirements are permitted so long as they are more stringent than Regulation T. They include:Initial margin requirement - The minimum customer deposit is the greater of $2,000 or Regulation T’s initial margin requirement. For short sales of less than $4,000 the customer must deposit $2,000 which is higher than Regulation T’s 50%; requirementMaintenance margin requirement - Equity in the margin account must not fall below 30%; of the equity in the account. If equity falls below 30%; the customer will receive a maintenance call to make the maintenance requirement. If the current market value falls below 10/13 of the credit balance the account would be below the 30%; maintenance requirement:SMV × 10/13Margin requirements for securities with a low market price:
- If less than $5 per share: Equity must be the greater of the current short market value or $2.50 per share
- If more than $5 per share: Equity must be the greater of $5 per share or 30%; of the current short market value
What is marking to market?
Re-evaluating a security to assess its current market value. For securities in a margin account used to meet margin requirements marking to market may occur to adjust the value of the securities and, if the marked to market securities fall under the margin maintenance requirements, the customer may experience a margin call to deposit additional assets
What are the industry requirements for margin accounts of exempt securities?
Exempt securities are not subject to Regulation T but are subject to SRO requirements. They include:U.S. Government Securities - 1%; to 6%; of the current market value depending on the amount of time remaining until maturity. The initial and maintenance margin requirements are the sameMunicipal Securities - 7%; of the current market value. The initial and maintenance margin requirements are the sameNonconvertible Corporate Bonds - 10%; of current market value for investment grade bonds. The greater of 20%; of market value or 7%; of the principal amount for noninvestment grade bonds. The initial and maintenance margin requirements are the sameConvertible Corporate Bonds - 50%; of the current market valueArbitrage - If a client has a long position that is convertible into an equal number of shares in a short position of the same security the maintenance margin requirement is 10%; of the current market value of the long positionShort against the Box - If a client has a long position and an equal number of shares in a short position of the same security the maintenance margin requirement is 5%; of the current market value of the long positionOptions - The initial margin requirement is 100%;
What are the procedures for opening an option account?
Member firms must have set procedures for approving accounts for options trading due to the risky nature of options. Required procedures are as follows:Registered reps must obtain financial and background information that shows the customer’s knowledge and experience and ability to understand the nature of options trading and the associated risksAn Options Account Agreement is completed by the registered rep stating the customer’s background informationThe member firm must send the agreement to the customer in order to verify the information. The customer’s lack of response or completion or correction of information in the agreement is considered verification of the agreement. Any refusal by the customer to provide information must be noted on the agreementThe agreement is also given to the ROP for review. After the ROP approves the agreement the account may execute options transactionsOn or before the approval date, the Characteristics and Risks of Standardized Options booklet that discloses risks and provides relevant information associated with options must be provided to the customerThe customer has 15 days from account approval date to sign and return the Options Account Agreement. Signing the agreement verifies the customer information and shows that the customer has agreed to abide by regulations, exercise and position limitsIf the signed Options Account Agreement is not returned the account is restricted to closing transactions only. No other types of options transactions may be made
* If a discretionary account the ROP must approve discretionary status of the account and maintain a written record of the approval. The customer must also provide written authorization of discretion for options trading prior to any discretionary options activity
What are common investment objectives?
Investment objectives are the primary goals that a client wishes to accomplish with a particular investment or investment account. They include:Current income - The primary goal is to provide a steady and stable stream of cash. For example, bonds and annuitiesGrowth - The primary goal is capital appreciation. For example, common stocks.[Note: For investments that may be considered speculative Registered Reps must ensure that the client understands and is able to bear the risks involved]Preservation of Capital - The client would like a return on their investment but does not want to put their principal at risk. For example, Treasury and money-market securitiesTax Relief - The primary goal is tax relief, especially for clients subject to higher taxes. For example, tax-exempt or tax-deferred investments
What is risk tolerance versus investment objectives?
Risk tolerance is the level of comfort with risk in losing one’s principal investment in return for higher potential gainsInvestment objectives are the primary goals that a client wishes to accomplish with a particular investment or investment accountRisk tolerance and investment objectives do not necessarily coincide
What is time horizon?
Time horizon is the length of time an investment is made or projected to be held before it is liquidated. Investments with shorter time horizons are typically less volatile while investments with longer time horizons have more flexibility in volatility
What are the different types of account ownership?
Individual - Opened by and for one person. A third party may be authorized on the account through express written authorization by the account ownerJoint - Two owners or more. Generally any joint owner may initiate account activity. However, the account may specify that all owners must jointly initiate and sign off on all activityCorporate - The customer is the corporation. The corporate resolution specifies persons authorized for the account and a copy of the resolution should be kept on filePartnership - Information and signatures for all partners should be obtained. The partnership agreement specifies persons authorized for the account and a copy of the agreement should be kept on fileFiduciary - The customer is acting on behalf of another and their investment decisions should be conducted in what would be deemed a prudent manner. Documentation of authority should be kept on file (e.g., Will, Trust)Incompetents - A fiduciary is appointed by a court for persons unable to competently act on their own behalf. Additional documentation may be necessary to grant authorityMinors - Minors are not allowed to open accounts
What are the most common types of joint accounts?
Joint Tenants with Right of Survivorship (JTWROS) - Both tenants own the property jointly and the account passes to the remaining owner in the event of deathTenants in Common (TIC) - Ownership is typically proportional to each owner’s contribution to the account and is passed to the deceased owner’s estate in the event of death rather than passing to each other
What are the most common type of accounts for minors?
Uniform Gifts to Minors (UGMA) - An adult gives an irrevocable gift to a minor (only one minor per account) and appoints a custodian for the account (only one custodian per account). There is no maximum limit to the gift, however, the gift may be subject to the gift tax. Custodians must act in a manner deemed prudent. The account is opened under the minor’s social security number but is registered in the name of the custodian as custodian for the minor. Taxation of any income generated from the account is the minor’s responsibility. The custodial relationship ends when the minor reaches the age of majority and assets should then be transferred out of the UGMA. If the custodian dies before the minor reaches the age of majority and has not appointed a successor the court will appoint a successor. If the minor dies the assets become a part of the minor’s estateUniform Transfers to Minors Act (UTMA) - A new version of UGMA that has been passed by most states. UTMA is similar to UGMA
What are trading authorizations?
A trading authorization is a power of attorney that allows a third party to trade in an account. A limited trading authorization allows the placement of buy and sell orders. A full trading authorization also allows withdrawals of cash and securities from the account. A written trading authorization with the date authority will be granted and signed by all account owners should be obtained prior to exercising trading authorityFiduciaries and persons not considered to be legal persons (e.g., minors, incompetents, decedents) may not grant trading authorizations to a third party
What is a discretionary account?
Generally an account where a registered representative is the third party authorized to trade in an account. Discretionary accounts must be approved by the customer and the principal prior to granting of the trading authorization. Each discretionary order must be approved promptly and reviewed frequently by the principal and must be identified as discretionary on tickets and confirmationsExceptions - A registered rep may trade in an account without it being considered discretionary if the customer requests:
- A specific number of shares
- A specific security
- Whether to buy or sellIf the customer specifies all of these things, leaving discretion only as to time and/or price, written authorization is not necessary. For verbal orders (versus written orders) the time and price discretion is limited to the trading day that the client placed the order. This information should be notated on the order ticket
What are the different types of brokerage accounts?
CashMargin
* Option
What is an Individual Retirement Account (IRA)?
Eligible to anyone that receives income from working (e.g., wages, salaries, commissions, etc., however, interest income, dividends and capital gains are excluded). The annual contribution limit for the years 2008 to 2012 is the lesser of $5,000 or $5,500 in 2013 or 100%; of annual compensation. If aged 50 years old or more an additional $1,000 catch-up contribution is permitted. Further limits may be imposed if an individual’s income is above a specified levelThe contribution deadline is the date the individual’s tax return is due, typically on April 15th (e.g., the deadline for a 2012 IRA contribution is April 15, 2013, when the 2012 tax return is due). Contributions must be made in cashIRAs provide certain tax incentives. However, if an individual contributes more than the maximum allowable amount the excess contribution amount is penalized at 6%;. The excess contribution amount is also not eligible for tax incentive benefits[Note: Enrollment in qualified retirement plans does not affect eligibility for IRAs]
What are the rules for IRA for married couples?
A married couple may open two separate IRAs if both spouses receive working compensation. If only one spouse is working the working spouse may open a Spousal IRA for the non-working spouse. IRAs for married couples are subject to the same contribution limits as individuals (i.e., $5,500 for each IRA in 2013)
What are allowable investments for an IRA?
Allowable investments for IRA include stocks, bonds, mutual funds, annuities, real estate and other financial assets. Life insurance policies, art and antiques are not allowable investments. The custodian bank may also have their own limitations on what investments they will allow
What is the role of a bank or brokerage firm for an IRA?
The bank or brokerage firm acts as a custodian or trustee of the account only. They may also assist in setting up the account and may service the account. The customer makes investment decisions in the account
What are the different types of IRA?
Traditional IRA (often referred to as an IRA)Roth IRASimple IRA * SEP IRA
What are the tax benefits of IRA?
After-tax contributions are not taxable. Pre-tax contributions and capital gains are tax-deferred (i.e., pre-tax contributions and gains are not subject to federal and state income taxation until withdrawal)Withdrawals may not occur until the individual reaches the age of 59 1/2 without a penalty. Early withdrawals are subject to a 10%; penalty unless the following applies:
- Death
- Disability or mental incompetence
- Withdrawals are used for certain medical expenses
- Withdrawals are used for qualified higher education expenses
- Withdrawals are used for certain expenses related to the purchase of a first-time homeWithdrawals of after-tax contributions are not taxed. Withdrawals of pre-tax contributions and gains are taxed as ordinary income in the tax year in which the withdrawal is madeAnnual withdrawals of tax-deferred contributions and earnings are mandatory beginning April 1st after the individual reaches the age of 70 1/2. The annual Required Minimum Distribution (RMD) is calculated by the IRS based on the individual’s life expectancy. Any RMD amounts not withdrawn are subject to a 50%; tax penalty
What are the rules for moving assets from one retirement account to another?
Retirement assets may move from one retirement account to another without tax penaltyA trustee-to-trustee transfer is a transfer where assets are sent directly from one trustee to another trustee (i.e., the individual never receives the assets). The transfer may be electronic or may be a check sent directly to the receiving trustee and made payable to the receiving trustee. The number of allowable trustee-to-trustee transfers is unlimited.A rollover is a transfer where the assets of the transferring account are distributed in the form of a check sent directly to the individual. Rollover checks must be deposited into the receiving account within 60 days of receipt. Rollovers are limited to once every 12 months. Rollover distributions may be subject to 20%; backup withholding (where the IRS requires that the trustee withhold 20%; of the distribution amount)
What is a Roth IRA?
A Roth IRA is an IRA where contributions to the account are not tax-deferred. The individual must pay any required taxes on contributions. Qualified distributions of Roth IRA (contributions and capital gains), however, are not subject to taxationRoth IRA do not have a Required Minimum Distribution. Withdrawals once the individual reaches the age of 70 1/2 are not mandatoryContributions may be made at any age. Unlike Traditional IRA, contributions are not required to stop after the age of 70 1/2Eligibility to contribute to Roth IRA are phased out at the following adjusted gross income (AGI) limits for 2012:Single tax filing status:$110,000 - $125,000Joint tax filing status:$173,000 - $183,000Eligibility to contribute to Roth IRA are phased out at the following adjusted gross income (AGI) limits for 2013:Single tax filing status:$112,000 - $127,000Joint tax filing status:$178,000 - $188,000
What is an HSA?
Health Savings Accounts are tax-advantaged individual accounts to pay for qualified medical expenses. Pretax contributions are made into an account and invested with all withdrawals also tax-free as long as they are used to pay for qualified medical expenses. Any withdrawals made for other purposes are subject to a 20%; tax penalty. Any withdrawals made after the age of 65 are not subject to the penalty
What is a qualified retirement plan?
A plan that meets the requirements of the Employee Retirement Income Security Act of 1974 (ERISA) and therefore qualifies for certain tax benefits which include:
- Employer deducts contributions to the plan from employee income
- The retirement fund is exempt from taxesQualified retirement plans have an early withdrawal penalty of 10%; if distributions are made before the age of 59 1/2
What are the ERISA requirements for qualified retirement plans?
The plan must be either a defined contribution plan or a defined benefit plan. Defined contribution plans, also known as money purchase plans, are plans where the employer must contribute an amount into the plan on behalf of the employee based on the employee’s annual compensation. Defined benefit plans promise benefit payments each year to the employee when the employee retires typically based on age, compensation history and years of service. Employers must deposit an amount into the plan each year, determined by actuarial calculations, in order to meet the promised retirement benefitsThe plan must have an IRS-approved vesting schedule (e.g., full vesting after three years of service). Vesting is the amount an employee may retain if withdrawing from the planThe plan must have eligibility requirements such as 21 years of age or older, one full year of service or more, 1,000 hours worked per year or more, etc. Eligibility requirements must not be discriminatory (i.e., must be established for the benefit of all employees)Plans must be in writing. At inception and through annual updates plan provisions must be communicated to employeesThe trustee of the plan must be a fiduciary under the prudent man standard (i.e., in the best interest of participants). Generally, the plan should be diversified, have liquidity and have reasonable returns given benefit payment schedules
* Contributions into the plan are not included in the employee’s income until distributed from the plan. Contributions and gains are tax-deferred
What are the different types of qualified retirement plans?
Corporate:401(k)
- Profit-Sharing
- Employee Stock Ownership Plan (ESOP)Self-Employed/Employer
- Keogh (HR-10)
- Simplified Employee Pension (SEP)Government/Non-Profit
- 457
- 403(b), Tax-deferred annuity, tax-sheltered annuity, or qualified annuity
What is a 401(k)?
A qualified defined contribution plan. Employee contributions on a pre-tax basis, deducted from their salary, are a maximum of $17,500 for 2013 and $17,000 per year for 2012 ($16,500 for 2009 to 2011). Individuals over 50 years old may contribute an additional catch-up contribution of $5,500 in 2012 and 2013. Employers may choose to match employee contributions with a limit between both contributions of $51,000 in 2013 or $50,000 in 2012 ($49,000 for 2009 to 2011). The employee contribution portion is always fully vested. Employer contributions may be subject to a vesting schedule. Investments are selected from a list of options
What is a profit-sharing plan?
A qualified defined contribution plan. Employees share in the profits made by the company. Contributions into the plan are made by the employer and vary at the employer’s discretion. Contributions cannot exceed 25% of covered compensation and they do not have to come from income or retained earnings, but must be substantial and recurring
What is an employee stock ownership plan (ESOP)?
A qualified defined contribution plan. Contributions into the plan are made by the employer and varies at the employer’s discretion. Contributions are invested into the stock of the company. Benefits of this type of contribution include employer tax deductions based on the market value of the stock and not having to use cash. Disadvantages include the risk of a decline in the value of the stock. ESOPs are also used in the hope that the plan will motivate employees to improve company performance and therefore increase the value of their plans
What is a Keogh (HR-10) plan?
For self-employed individuals and their eligible employees. May be set up as a defined contribution plan or a defined benefit plan. The 2013 maximum contribution is the lesser of $51,000 (2012 was $50,000) or 20%; of pre-tax self-employment income. Employee limit is $17,500 and the employer may contribute up to $33,500 for a total limit of $51,000. Contribution rates must be the same for both the employer and employeesKeogh plans must be opened prior to the end of the tax year and contributions must be made by the date the individual’s tax return is due (e.g., a 2012 contribution must be made in Keogh plan established by December 31, 2012 and the contribution must be deposited by April 15, 2013)Contributions are deducted on the individual’s tax return. Contributions and gains are tax-deferred. Keogh plans have Required Minimum Distributions. Early withdrawals before the age of 59 1/2 are subject to a 10%; penalty[Note: Enrollment as an employee in an employer-sponsored retirement plan does not affect eligibility for a Keogh plan]
What is a Simplified Employee Pension (SEP) plan?
For employers and self-employed individuals and their eligible employees. The maximum contribution is the lesser of $50,000 in 2012, $51,000 in 2013 or 25%; of the employee’s salary. Contributions are immediately 100%; vested and are placed into the employee’s individual SEP IRA. All employees aged 21 and over must be included in the plan if they have worked for the employer in three of the last five years earning at least $550. Self-employed individuals have a limit determined by calculations of their net profit
What is a 403(b)?
A qualified defined contribution plan. Only for tax-exempt, non-profit organizations qualified under section 501(c)(3) (e.g., churches, public schools, etc.). Also known as tax-deferred annuities (TDA), tax-sheltered annuities (TSA), or qualified annuities. Similar to 401(k) plans. Typical investments include annuities or mutual funds
What is a 457?
A qualified defined contribution plan. Only for certain non-profit or government organizations (e.g., public universities, school districts, etc.). Similar to 401(k) plans, except:The contribution limit is independent of 401(k) and 403(b) plans that the individual participates in. The combined contribution limit for all 401(k) and 403(b) plans is $17,500 for 2013. Individuals may contribute up to an additional $17,500 in a 457 plan even if they have reached the maximum combined contribution amount for their 401(k) and 403(b) plansEarly withdrawals are not subject to a 10%; penaltyNon-governmental plans are limited to higher compensated employeesNon-governmental 457 plans cannot be rolled over into other qualified retirement plans but may be rolled over into other non-governmental 457 plans
* Any contributions that are not vested are the property of the employer
What are the different types of non-qualified retirement plans?
Payroll deduction planDeferred compensation plan
* Nonqualified annuity
What is a payroll deduction plan?
A voluntary retirement plan. All contributions are after-tax. Payroll deductions may be used to pay for insurance premiums, investment accounts, etc. Employers may match employee contributions
What is a deferred compensation plan?
Employees enter into a contractual agreement to defer compensation until termination, retirement, disability or death. May be used so that income will be earned in a year where the individual anticipates their tax bracket will be lower. Employers determine eligibility. Contributions are after-tax. The employee has no rights to the contributions. The employee does not pay tax on contributions until they receive the money in either installments or a lump sum
What is a non-qualified annuity?
An annuity purchased by an individual with after-tax dollars
What is a Coverdell Education Savings Account (ESA)?
A Coverdell Education Savings Account or education IRA is a tax-advantaged savings account created to pay for future education expenses. After-tax funds can be invested in a tax deferred account until needed for qualified education expenses. These can include tuition, books and other related materials for primary through university level education. Contributions can be made to the account until the beneficiary turns 18 unless they are a special needs beneficiary. Qualified withdrawals can be made until the beneficiary is 30 years old after which the account can be changed to another member of the family under 30 with qualified education expenses. Withdrawals made for nonqualified uses are subject to a 10%; penalty and taxed as ordinary income
What is a Section 529 plan?
A Section 529 plan is a savings plan designed for higher education expenses for a designated beneficiary. Prepaid plans allow the purchase of tuition at current prices to be used in the future. The investment then grows at the same rate as tuition inflation and are administered by states or higher education institutions. Contributions exceeding $13,000 per year increasing to $14,000 in 2013 may be subject to the gift tax, unless it is the initial contribution which has a limit of $65,000 increasing to $70,000 in 2013 (initial gifts are treated as if the gift was made over a 5-year period). There are no income limits for 529 plans. Contributions are made with after-tax dollars but withdrawals are tax-free for qualified education expenses. Qualified expenses include tuition, books, supplies as well as room and board at accredited colleges, universities or vocational schools. Each state determines plan rules such as tax-deductibility of state taxes, investment options, etc. Rollovers for 529 plans from one state to another are limited to once every 12 months. Rollovers between 529 plans and Coverdell ESAs are not allowed
What type of investment recommendations would violate suitability standards?
Recommendations to customers must be suitable. Recommendations that are profitable but unsuitable to the customer’s financial situation and needs would still violate the fair dealings standardUnsuitable recommendations include:
- Purchases beyond the customer’s ability to pay
- Excessive account activity
- Mutual fund shares which by their nature are not suitable as trading vehicles
- Any fraudulent activities[Note: Registered reps may execute unsolicited orders that are unsuitable. Prior to execution the rep must provide an explanation of why they believe the trade is unsuitable to the client. Solicited orders and trades in discretionary accounts, however, must always be suitable]
Under what conditions may a registered representative personally borrow or lend to a client?
Borrowing and lending between a registered representative and a client can only occur if the firm has implemented specific written procedures and under one of the following conditions:Registered rep and the client are immediate family membersThe client is a financial institution in the business of providing credit or loansBoth parties are registered with the same firmThere is a personal relationship between the two parties on which the loan is based
* There is a business relationship between the two parties apart from the client-member firm relationship
What is Transfer and Hold?
Where securities are transferred into the customer’s name but held in a firm’s vault in segregation
What is Transfer and Ship?
Where securities are transferred into the customer’s name and delivered to the customer
What are street name securities?
Where securities are registered under the name of the brokerage firm as nominee. They may be held in the firm’s vault, safekeeping area or a centralized depository (e.g., the Depository Trust Company or DTC) and are transferred on a book-entry basis
What is commingling?
Where the securities of a broker-dealer are mixed with the securities of a customer. Commingling is a violation of the Securities Act of 1934. All customer securities held in a firm vault must be segregated and the customer must be identified as the owner
What is DVP and RVP?
DVP - Delivery Versus Payment is a system that ensure the securities are delivered to the buyers custodial account at the same time that payment is made from their custodian bank. The broker-dealer delivers the purchased securities and receives payment for them at the same time
* RVP - Receive Versus Payment is the same process when a security is sold from an institutional account. The dealer receives the securities from the custodian bank at the same time payment is madeThese are both known as COD or cash on delivery systems whose primary purpose is to reduce the risk of payments or securities being delivered with no offsetting transaction
What are prohibited uses of customer accounts?
Profit or loss sharing (unless approved by a principal and the gains and losses are shared in proportion to ownership of assets)Lending securities that have been fully paid by the client (unless written approval is obtained identifying the security name and amount)
* Informing clients that securities are guaranteed against loss
What types of customer account information are particularly important to update?
- Address changes
- Financial situation
- Investment objectives
What are the procedures for customer death?
Mark the customer’s account “deceased.”Cancel all open ordersFreeze all assets in the account until receiving the necessary legal documents from the executor or administer of the customer’s estate. These generally include:
- Copy of death certificate
- Letters testamentary (gives authority to act on estate’s behalf, e.g., will or court appointment)
- State inheritance tax waiverAffidavit of domicile (certifies deceased customer’s place of residence at time of death)Close account and transfer assets to an estate account so that the executor or administrator may transact business in the estate account[Note: Any existing power of attorney is automatically cancelled upon death of the customer]
What is a transfer on death provision?
A transfer on death provision allows the accountholder to specify a beneficiary on the account in case of death. This process is in place in most states through the Uniform Transfer on Death Security Registration Act which simplifies the transfer by avoiding probate but estate taxes will still apply
What is a durable power of attorney?
A regular power of attorney is no longer effective once the grantor becomes incapacitated due to physical or mental issues. A durable power of attorney specifies that in these cases the power of attorney should continue to be in effect. The power of attorney will continue until the death of the grantor
What are the requirements for account statements?
Broker-dealers must send account statements quarterly for inactive accounts and typically monthly for active accounts. Accounts statements should show all activity for the statement period, account balances, all current long and short positions and debits and credits
What are the rules for delivering client mail?
Clients may have their mail delivered to either a physical address or PO BOX. A physical address is required, however, when the account is opened. A client may leave written instructions to hold mail for up to two months if traveling domestically or three months if travelng internationally
What are the requirements for transferring an account internally (e.g., when a rep leaves the firm)?
Account records must be amended. Does not require customer approval, new account forms or notification to any regulatory authority
What are the requirements for transferring an account to another member firm?
The carrying firm is the firm that currently holds the customer account and the receiving firm is the firm that will hold the customer account upon transferReceiving firm must receive written instructions from customerReceiving firm must immediately submit transfer request to carrying firmWithin one business day carrying firm must either validate instructions or take exception. For non-transferable assets the carrying firm must inform customer and request instructions (e.g., liquidation of non-transferable assets or retention by carrying firm or a third party)
* Within three business days of validation carrying firm must complete transfer of account
What is ACATS?
The Automated Customer Account Transfer Service (ACATS) is a system to standardize and automate account transfers when both firms are members of the system. ACATS is part of the National Securities Clearing Corporation (NSCC) but other clearing agencies have similar systems
When may a carrying firm protest a request to transfer an account?
The firm does not have any record of the accountThe transfer instructions are not complete
* The instructions do not have a valid signature
What kinds of assets are nontransferable to another member firm?
Proprietary funds of the carrying firmThe receiving firm does not have the required selling or distribution agreements to hold the asset such as a mutual fund
* Private investment interests
What are the requirements for confirmations?
The broker-dealer must provide a confirmation to the customer at or before completion of a transaction, usually the settlement date. Confirmations must include:Name of the securityWhether the security was bought or soldPriceNumber of shares, units or the principal amountAny remunerations received (e.g., commissions)[Note: Markups must be disclosed in riskless principal transactions where the broker-dealer does not purchase the security until it receives the order from the customer in principal transactions in Nasdaq stocks, and in principal transactions in NYSE or Amex stocks traded over the counter (OTC)]Date of transactionTime of executionSettlement dateCapacity in which the broker-dealer acted (e.g., agent for customer, third party or as principal for its own account)For debt securities:
- Dollar price
- Yield
- Par value
- Name if issuer
- Maturity
- Type of bond
- Coupon rate if applicable
- Amount of accrued interest, principal and transaction total if applicableCall features if applicable
- Whether the security is callable
What is the difference between a commission and a markup?
A commission is the charge for executing a trade on behalf of the customerA markup is the difference in price of a principal transaction that is charged to the customer and the prevailing price charged between broker-dealers
What are the guidelines for the amount of a commission or a markup?
Commissions, markups and markdowns must be fair and reasonable. Factors that determine the amount may include:Current market price of the securityTransaction-related expenses
* The firm’s right to earn profits
What are the requirements for errors detected after a trade is made?
All errors made by a registered rep must be recorded and an error account must be maintained by the broker-dealer[Note: Transactions made with an incorrect account number may be corrected with the permission of a registered principal by transferring the transaction to the correct account number]
When must a broker-dealer become a member of the Securities Investor Protection Corporation?
Whenever a broker-dealer uses any means of interstate commerce (e.g., calling or mailing to another state). In practical terms this requires that almost all broker-dealers become a member of SIPC
What does SIPC coverage provide?
If a broker-dealer becomes insolvent SIPC coverage provides up to $500,000 for each customer of which up to $250,000 may be for cash losses. These are not trading losses but failure of the brokerage firm to be able to cover cash and securities held for its clients. Any losses incurred above the maximum amount can still be claimed in the resulting bankruptcy proceedings. The customer would become a general creditor for the excess amount not covered by SIPC and would receive the same priority as the failed broker-dealer’s other general creditors[Note: SIPC coverage only applies to public customers. It does not apply to securities held by other broker-dealers]
What is the SEC Regulation S-P?
Requires all SEC-registered members to reasonably protect customer privacy (i.e., confidential information) and to provide to the customer a privacy notice at the initiation of an ongoing relationship and annually thereafter. Additionally, a privacy notice must be provided to any new consumer prior to disclosure of any nonpublic personal information to a nonaffiliated third partyPrivacy notices must include:Type of personal information collectedCategories of affiliated and non-affiliated third parties that may receive the personal information
* Notification of client’s right to opt out of disclosure to non-affiliated third parties
What is the difference between a consumer and a customer?
A consumer is someone who has provided information for a potential transaction with the firmA customer has an ongoing relationship with the firm
When must a Currency Transaction Report (CTR) and Currency and Monetary Transportation Report (CMIR) be filed?
CTRs must be filed whenever a customer’s cash transactions during one business day (the aggregate total of all transactions) exceeds $10,000.CMIRs must be filed whenever a customer transports an aggregate total of $10,000 into or out of the United States
When must a Suspicious Activity Report (SAR) be filed?
Whenever a transaction or group of transactions equals $5,000 or more and the firm suspects that any of the following might apply:Violation of federal criminal lawsThe transaction(s) involve funds related to illegal activitiesThe transaction(s) are designed to evade reporting requirements
* After examining all available facts and circumstances regarding the transaction(s), it does not appear to have a legitimate purpose or reasonable explanation
What are AML Compliance Programs?
Anti Money-Laundering (AML) Compliance Programs are mandatory. They must be in writing and must be approved by a member of senior management. They must also include:Policies and procedures reasonably designed to detect and report suspicious transactionsA compliance officer designated to be responsible for the firm’s AML programAn ongoing employee training program
- An independent audit program established to ensure that the AML program is effectivePenalties for violation of AML laws may be incurred for both direct participation and lack of due diligence and include:Jail sentences of up to 20 years
- Fines up to the larger of $500,000 or twice the money involved
What is the Office of Foreign Assets Control (OFAC) list?
A list maintained by the Treasury Department’s OFAC of known and suspected terrorists and other criminals. Firms must not transact business with persons on the OFAC list
What is a Customer Identification Program (CIP)?
A requirement for a firm’s AML Compliance Program. The CIP must be written.The information that must be obtained for clients that are U.S. Citizens are:
- Name
- Date of birth
- Address
- Taxpayer identification numberFor non-U.S. citizens, at least one of the following must additionally be obtained:
- Taxpayer identification number
- Passport number and country of issuance
- Government issued document with photograph that provides evidence of nationality
What is a bond?
A bond is a contract between an issuer (e.g., government entity, private business, etc.) and an investor. The investor lends money to the issuer, making the investor a creditor and the issuer the debtor. The issuer promises to pay interest on the loan and to pay back the principal amount when the bond matures. Bonds are debt securities
What is a bearer bond?
No longer issued in the U.S., bearer bonds do not have a record of the owner listed on the actual bond or on the books of the issuer. The bond contains interest coupons that the bondholder detaches and deposits at a bank when an interest payment is due. When the bond matures the bondholder redeems the bond by presenting the bond certificate
What is a registered bond?
Registered bonds have a record of the owner’s name and address both on the bond and on the books of the issuerBonds may be registered in the following ways:Registered as to principal only - Bondholder of record receives written notices and payment of principal amount at maturity. Interest payments are received by detaching interest coupons when interest payments are due and depositing them at a bankFully registered - Bondholder of record receives written notices, payment of principal amount at maturity and interest payments (via a check from the issuer every 6 months)Book entry form - No physical bond is issued. Digital entry of owner’s name and address in a computer system is the only evidence of ownership
What is the par value of a bond?
The principal or face amount of a bond. This is the amount paid back at the maturity of the bond often set at $1,000 each
What is the market price of a bond in relation to its par value?
The price investors are willing to pay (i.e., market price) for a bond may be much higher or lower than its principal amount (i.e., par value)Bonds selling for less than par value are sold at a discountBonds selling for more than par value are sold at a premiumThe market price of a bond is typically stated as a percentage of its par value where each 1%; increment in price is known as a point. For example:A market price of 95 is discounted 5 points and equals 95%; of the par value of bond
You have purchased a 5%; bond at 98. How much did you pay for the bond?
Purchase Amount:=Bond Price × Par Value= $98 × $1,000=$980
What are the different methods of structuring the maturity dates of a bond issue?
Serial bond issue. When bonds mature serially (e.g., $1M in bonds matures Jan 2010, another $1M Jan 2011, another $1M Jan 2012)Term bond issue. All bonds mature on the same dateBalloon bond issue. A portion of bonds mature serially but the majority of bonds mature in one specific year
What is coupon rate?
Also known as the nominal yield. Coupon rate is the amount of interest that a bondholder receives until the bond matures, typically every 6 months. The amount received is the interest rate multiplied by the bond’s par value. If coupon rate is 5%; the bondholder will receive $50 annually (5%; x $1,000 par value). Each semi-annual payment will be $25 ($50/2)
You have purchased a 5%; bond at 98 that matures in 30 years. What will you receive when the bond matures?
You will receive the principal amount (par value) and the last semi-annual interest paymentPrincipal Amount = $1,000Semi-Annual Interest Payment:=Annual Interest Payment2<!--padding-->= Coupon Rate × Par Value2<!--padding-->=5%; × $1,0002<!--padding-->= $502<!--padding-->=$25Last Payment:=Principal Amount+Semi-Annual Interest Payment<!--padding-->= $1,000 + $25<!--padding-->=$1,025You will receive $1,025 when the bond matures
What is a zero-coupon bond?
Zero-coupon bonds have no coupons and do not pay interest at regular intervals. They are offered at a deep discount from their par value, usually discounted further the longer the period until the bond matures. The difference between the discounted price and the par value is interest which is paid as a lump sum when the bond matures. Yields on zero-coupon bonds are typically higher than interest-bearing bonds. The prices of zero-coupon bonds are typically more volatile than interest-bearing bonds
What are the different methods for calculating the return received from a bond?
Nominal Yield. The stated interest rate that the issuer promises to the bondholder. The rate does not change over the life of the bond. Typically paid every 6 monthsCurrent Yield. The interest rate relative to the bond’s current market priceCurrent Yield =Total Annual DividendCurrent Market PriceYield to Maturity. The overall rate of return of a bond purchased at today’s market price and held until the maturity, assuming that interest is reinvested and compounded. Generally calculated with specialized tools. One basis point is equal to 1/100 of 1%; (e.g., 5.75%; is 75 basis points higher than 5.00%;). Stated as yield or basis interchangeably (e.g., 5.25%; yield to maturity, 5.25%; yield, or 5.25%; basis)Yield to Call. Similar to yield to maturity, however, rather than using the maturity date it reflects the bond’s interest rates until it is called
You have purchased a 5%; bond at 90 that matures in 10 years. What is the nominal yield?
The nominal yield is always the same as the coupon rate. The nominal yield is 5%;
You have purchased a 4.5%; bond at 90 that matures in 10 years. What is the Current yield?
Current Yield:=Total Annual DividendCurrent Market Price<!--padding-->= Coupon Rate × Par ValueCurrent Market Price<!--padding-->=4.5%; × $1,00090%; × $1,000<!--padding-->= $45$900<!--padding-->=0.05The current yield is 5%;
What is the relationship between the market price of a bond and interest rates?
The coupon or interest rate of a bond does not change over the life of the bond. However, as interest rates in the market change, new bonds will be issued with a coupon rate higher or lower than existing bonds. As interest rates increase the market price of existing bonds decrease. As interest rates decrease the market price of existing bonds increase. The market price of bonds has an inverse relationship to yields
What is interest-rate risk?
The coupon or interest rate of a bond does not change over the life of the bond. However, as interest rates in the market change new bonds will be issued with a coupon rate higher or lower than existing bonds. If interest rates increase after a bond is purchased the bond must be sold at a discount to be more attractive than newer bonds at a higher coupon rate. This is known as interest-rate risk.Longer term bonds and bonds with lower coupon rates are more susceptible to interest-rate risk
How does nominal yield, current yield, and yield to maturity change as the market price of a bond changes?
For par bonds:The nominal yield is always fixed for the life of the bondThe current yield is the same as the nominal yieldThe yield to maturity is also the same because the bond was purchased at par and will be redeemed at par when the bond matures.For discount bonds:The nominal yield is always fixed for the life of the bondThe current yield is higher than the nominal yield because the bond is sold at a discountThe yield to maturity is higher than the current yield because the bond was sold at a discount but will be redeemed at the full value when the bond maturesFor premium bonds:The nominal yield is always fixed for the life of the bondThe current yield is lower than the nominal yield because the bond is sold at a premiumThe yield to maturity is less than the current yield because the bond was sold at a premium but will be redeemed for the original value when the bond matures
How do interest rate fluctuations affect longer term bonds versus shorter term bonds?
Longer term bonds have higher interest rates. When interest rates fluctuate longer term bonds will increase or decrease in value more dramatically than shorter term bonds. Investors receive a higher interest rate for the extra risk they incur with longer term bondsThe coupon rates for shorter term bonds change more quickly than longer term bonds. When interest rates fluctuate the change is reflected more quickly for shorter term bonds being newly offered than for longer term bonds being newly offered
What is a yield curve?
A yield curve is a graph of the yields of bonds at differing maturities. They are typically used to infer the direction that interest rates are heading. The different yield curves are:Normal Yield Curve. Positively sloped, where yields increase as maturities lengthen. Exists under most market conditions. Also known as: normal, positive, ascending, upward slopingInverted Yield Curve. Negatively sloped, where yields decrease as maturities lengthen. Relatively rare. Also known as: negative, descending, downward slopingFlat Yield Curve. No slope, where yields are similar across all maturities. Occurs when there is a similar demand and supply for money
What is the real interest rate?
The real interest rate is the interest rate a bondholder receives after inflation is taken into account.Real Interest Rate =Interest Yield− Inflation Rate
What is inflation or purchasing-power risk?
The risk that the inflation rate will be higher than the interest rate that a bondholder receives over the life of the bondFor example, if a bondholder purchases a bond earning a 3%; coupon rate for $1,000 that matures in one year and the inflation rate that year is 4%;, the purchasing power of the bond plus interest after one year will be lower than the purchasing power of the bond when it was originally purchased
What is reinvestment risk?
The risk that future distributions of interest and principal will have to be reinvested at a lower rate of returnFor example, if a bondholder purchases a bond earning a 5%; coupon rate that matures in one year and bond coupon rates are lower after one year, the bondholder will receive the interest and principal at the maturity date and will have to reinvest the proceeds at a lower interest rate
What is credit risk?
The risk that an issuer of a bond may default and not be able to pay interest and principal to bondholders
What are bond ratings?
Bond ratings measure the credit risk of an issuer or the risk that the issuer may default and not pay interest and principal to bondholdersU.S. government issued bonds are considered to have no credit risk because they are backed by the government’s virtually unlimited ability to tax and print moneyCredit risk is relatively difficult to measure. Therefore, the responsibility of bond ratings are generally entrusted to rating services such as Moody’s, Standard & Poor’s and Fitch Investors Service. The bond issuer must pay for the analysis which is periodically reviewed and updated by the rating service
What is a call provision?
A provision in a bond that allows the issuer to redeem the bonds before the maturity date by paying the principal in full plus any accrued interest. No interest payments are made after the bond is redeemedBonds are typically called when interest rates have declined. If an issuer calls all of its outstanding bonds and issues new bonds at a lower interest rate, it is known as refundingSome calls may only be exercised on specific dates after the first call date, others may be exercised at any time after the first call date and are referred to as continuous call
What is call risk, call protection, and call premium?
Call risk is the risk that a callable bond will be called when interest rates are falling and the bondholder will not be able to reinvest their money at the same rate of returnCall protection is a restriction on how soon the call feature on a callable bond can be exercised, typically 5-10 years from the issue dateCall premium is amount above par value that the issuer pays the bondholders to compensate them for the call risk
You have purchased a 5%; bond at 98 that matures in 30 years and is callable at 110 in 15 years. If the bond is called in 15 years, what will you receive?
Payment Amount:=Par Value×Call Premium<!--padding-->= $1,000 × 110%;<!--padding-->= $1,100
What is prefunding?
Applies to callable bonds. Prefunding is when an issuer decides to lock in a lower interest rate prior to a scheduled call date by creating a new issue or refunding issue. The proceeds from the new issue or prefunded bonds are typically invested in government securities and deposited at a bank after signing an escrow agreement that guarantees that the securities on deposit plus any earnings will be used to pay interest and principal (i.e., refunded) on the original issue. After the original issue is secured by escrow securities the issuer is no longer responsible for payment of interest or principal and the bondholders no longer have the original rights and liens under the original indenture (i.e., bond agreement). The original issue is said to be defeased and the elimination of the issuer’s responsibilities and the bondholder’s rights is known as defeasanceThe market value of the refunded issue typically increases because it is secured by U.S. government securities and poses no credit risk. Trading of the refunded bonds is based on yield to call
What are sinking funds?
A special fund used by issuers to deposit the money needed to redeem their bonds. Generally used to gradually redeem a portion of the issue beginning a few years prior to the maturity date
What is an indenture?
The bond agreement of a bond issue. It is the contract which details the legal obligations and rights of the bond issuer and bondholders. A trustee is assigned in the indenture to represent the rights of bondholders
What is a put provision?
A provision in a bond that allows the bondholder to redeem the bonds at a specified date or dates before the maturity date. The bondholder typically receives the par value of the bond, but may also redeem the bond at a discount or a premiumThe put feature allows bondholders to redeem the bonds when interest rates have risen and therefore invest their money at a higher interest rateBonds with a put feature typically have a lower yield due to the extra protection from interest rate risk that the put feature affords
What is a control relationship between a broker-dealer and an issuer?
When the broker-dealer controls the issuer or any person with responsibilities regarding the debt service on the securitiesWhen a broker-dealer sells debt securities in which a control relationship exists the broker-dealer must:Prior to execution disclose to the customer that the control relationship exists. The disclosure may be verbal, however, verbal disclosures must also be disclosed in writing by the settlement date
* Prior to execution obtain written authorization if a discretionary account
What are the general rules for the pricing of bonds?
The pricing of bonds refers to the calculation of the dollar price of a bond sold at a yield or the calculation of the yield of a bond sold at a dollar price. The calculation will be different depending on whether the bond is priced to the maturity date or to the call date. The MSRB requires that the lower of the two calculations be used and has stipulated the following general rules:Bonds selling at a discount should be priced to maturityBonds callable at par that are selling at a premium should be priced to the call
* Bonds callable at a premium that are selling at a premium should be priced at the lower of the price to maturity or the price to the call
What is the dated date?
The dated date is the date at which interest begins to accrue on a fixed-income security which may be the date of issuance, in which case the dated date would be the same date as the issue date
What are senior securities?
Corporate bonds are sometimes referred to as senior securities because corporations generally must pay interest on bonds before paying dividends on stocks and, in the event of a bankruptcy, must pay bondholders and other creditors before stockholders
What is a closed-end versus open-end indenture?
A closed-end indenture provides the greatest protection to bondholders because it does not permit the corporation to issue additional bonds secured by the same claim on the same assets as the original issueAn open-end indenture does permit the issuance of additional bonds secured by the same claim on the same assets. Because this dilutes the original bondholder’s protection an earnings test or additional bonds test is typically stipulated in the indenture that requires that the corporation achieves a specific level of earnings before issuing additional bonds
What is the difference between secured and unsecured corporate bonds?
Unsecured and secured corporate bonds are backed by the full faith and credit of the issuing corporation.Secured corporate bonds are additionally backed by specific corporate assets
What are debentures?
Unsecured corporate bonds (i.e., backed only by the full faith and credit of the issuing corporation)
