SIE Deck Flashcards
1
Q
Treasury Stock
A
Treasury stock is authorized stock that was previously sold to the public but was repurchased by the issuer. Because it is no longer outstanding, the company’s share count will fall, and the shares no longer receive dividends or have voting rights. Treasury
2
Q
Company Repurchases:
A
company that believes its stock is undervalued may repurchase shares in the open market (creating treasury stock).
3
Q
Voting Rights:
A
Holders of common stock have voting rights, which allow them to exercise control by electing the board of directors and voting on corporate policy. This contrasts with holders of preferred stock, who typically do not have voting rights.
4
Q
Statutory voting
A
allows a shareholder to vote one time per share for each seat on the board of directors. For example, if an investor owns 100 shares of common stock and there are three board seats to be filled, they can cast up to 100 votes for each of the three seats.
5
Q
Cumulative voting
A
allows the shareholder to pool their votes together and allocate them as desired. For example, the shareholder above can aggregate all of their votes – 300 total (100 votes x 3 seats) and allocate them however they choose (e.g. they could cast all 300 votes for one candidate or cast 200 for one candidate and the remaining 100 votes for another).
6
Q
Form 10-K:
A
Public companies must file annual financial reports (which includes financial statements) called 10-ks with the SEC within 90 days of year-end.
7
Q
Pre-Emptive Rights:
A
Pre-emptive rights allow a current shareholder to maintain their proportionate ownership interest and avoid dilution when a company issues additional shares.
8
Q
Warrants:
A
Warrants are typically issued by a company in conjunction with another security to make that other security more attractive to investors. For example, a company might use a warrant as a sweetener for investors as part of a debt deal. Unlike pre-emptive rights, warrants do not prevent dilution.
9
Q
Warrants As Equity Securities
A
Warrants are considered equity securities (not debt securities) because if the warrant is exercised, the investor will receive shares in the underlying company. Importantly, warrants do not make interest payments to investors.
10
Q
Value of Warrants
A
warrant provides an investor the ability to purchase a company’s stock at a specified exercise price for a set time period. For example, the investor is given the right to purchase the stock at $100 per share. The investor would want to exercise this right if the price increases above the exercise price (e.g. an investor wants to pay $100 for stock worth $150 not for stock only worth $50) and therefore the market value of a warrant is tied to the value of the underlying stock.
11
Q
Issuance Price of Warrants
A
Warrants are generally not issued with intrinsic value, meaning they are issued with an exercise price above the current market value of the stock. For example, if the current stock price is $50, the exercise price given to the warrants might be $80. For the warrants to be exercised by an investor, the price would have to increase above the exercise price.
12
Q
Define Penny Stock
A
Penny stocks are defined as OTC equity securities (i.e. unlisted) worth less than $5.00 per share.
13
Q
Blue Chip Versus Penny Stocks
A
Stocks of well-established, stable companies with a long history of steady earnings and dividends are known as blue chip stocks. Blue chip stocks typically trade on the major exchanges such as the NYSE or Nasdaq. Penny stocks are riskier, more volatile, and less liquid than blue chip stocks.
14
Q
Wilshire 5000:
A
The Wilshire 5000 is an index which measures the value of U.S. companies with actively traded stock
15
Q
Business Risk:
A
Non-systematic risk is business risk, which is the risk that a specific company may not be profitable.
16
Q
Risk of ADRs
A
American depositary receipts (ADRs) help to facilitate the trading of a foreign corporation’s stock in the US. Investors in ADRs face political risk, which is the risk that political instability and uncertainty in that foreign country might negatively impact their investment. Importantly, because ADRs are common stock and not debt securities, they do not have call risk or interest rate risk.
17
Q
Withholding Taxes:
A
When a foreign corporation pays a dividend, a bank will take the foreign dividend payment (e.g. Euro or Japanese Yen) and convert it into US dollars for the ADR holder. It is possible that the ADR holder might receive a lower dividend than was actually declared because the foreign government might withhold a percentage of the dividend for taxes.
18
Q
Cumulative Preferred Stock
A
Cumulative preferred stock allows investors to receive dividends in arrears. This means that if a dividend is skipped for cumulative preferred shareholders, they must receive both current and skipped dividend payments before any dividend payment can be made to common shareholders. This is a benefit for the investor as it entitles them to receive missed dividend payments
19
Q
Transfer Agent Versus Custodian:
A
A transfer agent of an issuer is responsible for issuing and cancelling certificates and processing investor mailings (e.g. proxies). A custodian, on the other hand, is responsible for holding investor assets or securities for protections. A custodian may also maintain certain investor records.
20
Q
Cash Dividend Taxation:
A
Cash dividends on stock received by an investor are taxable as ordinary income and do not increase the investor’s cost basis.
21
Q
Ex-Dividend Date:
A
The ex-date is the first day purchasers of the stock will not receive a dividend. This is because the trade will not settle on or before the record date. For a regular way trade, which settles T + 2 (two business days after the trade date), the ex-date is the business day before the record date.
22
Q
Order of Dividend Process:
A
Make sure to know the order of dates in the dividend payment process. 1) Declaration Date, 2) Ex-Dividend Date, 3) Record Date, 4) Payment Date.
23
Q
Stock Splits:
A
A stock split is an artificial adjustment in the issuer’s outstanding share count and stock price. Importantly, because the number of shares and price change in proportion with one another, the overall value of the company as well as the investor’s ownership position in the company remain unchanged. For example, if an investor owned $1,000 of stock before a stock split, they will still own $1,000 of stock after.
24
Q
Forward Stock Split:
A
In a forward stock split, the number of outstanding shares increases, and the share price is reduced proportionally. For example, after a 2-for-1 split an investor owning 100 shares of stock at $30 per share will now own 200 shares at $15 per share. Both before and after the split, the value of the investor’s position remains $3,000.
25
Reverse Stock Split
In a reverse stock split, the number of outstanding shares is reduced, and the share price is increased proportionally. Generally, a reverse split is used by a company to inflate their stock price and avoid falling below the minimum price required for exchange listing. For example, after a 1-for-10 split an investor owning 100 shares of stock at $1 per share will now own 10 shares at $10 per share. Both before and after the split, the value of the investor’s position remains $100.
26
Stock Dividend Taxation:
Stock dividends are not taxed when received by a shareholder. However, the basis of the investor’s position is adjusted downward to reflect the new number of shares.
• Example: Assume an investor holds 100 shares of stock valued at $50 per share and receives a 10% stock dividend. The $5,000 value ($50 x 100 shares) of the total position does not change, so the investor now has 110 shares with an adjusted basis of $45.45 (calculated as $5,000 total value/110 shares).
27
Short Sale:
Selling short is when an investor, believing the price of the security will decline, sells borrowed shares in the market, hoping to repurchase and replace the shares at a lower price than what they were initially sold for. Theoretically, because the price of the shares can rise indefinitely (rather than fall as the investor wants), short sellers have unlimited risk potential.
28
Discount Versus Premium Bond:
When the market value of a bond is greater than the par value, the bond is trading at a premium. If the market value of the bond is below par value, the bond is trading at a discount.
29
Nominal Yield:
Also referred to as the coupon, the nominal yield is the annual interest rate paid to the investor. Unlike other bond yields, the nominal yield is fixed and does not change over the life of the bond. For example, a bond that pays a 5% coupon, pays the same 5% of $1,000 (par value) or $50 of interest per year throughout the life of the bond.
30
Current Yield:
The current yield of a bond is calculated as the annual interest divided by the market price. If the semiannual coupon is provided, make sure to multiply by two to annualize.
• Example: A bond is trading at $960 and pays a $15 semiannual coupon. Current yield is calculated as the annual interest of $30 ($15 x 2) divided by the market price of $960. Therefore, current yield is 3.1%.
31
Interest Rate Risk
The risk that if interest rates increase, the price of outstanding bonds will fall. Long-term, low-coupon bonds (including zero-coupon bonds) have the greatest interest rate risk, meaning they are most sensitive to changing rates. Although a Treasury bond has no credit risk, as they are guaranteed by the full faith and credit of the US government, they still are very susceptible to interest rate risk given their long-term (e.g. 30 year) maturity.
32
Reinvestment Rate Risk
The risk that as interest rates fall, that the semi-annual coupon payments that an investor receives will be reinvested back into the market at a lower rate of return. Note that zero coupon bonds do not have reinvestment rate risk as there are no cash flows to reinvest.
33
Duration
Duration is a measure of a bond’s sensitivity to changing interest rates. Bonds with a longer duration are more sensitive to changing rates.
34
Bond Pricing
The price of a bond is affected most by interest rates. Factors like credit rating, market demand, and earnings potential of the company are not as impactful.
35
Serial Bonds
In a serial bond issue, the outstanding bonds mature at different intervals with a portion of the issue maturing each year.
36
Call Feature:
If a bond is callable, the issuer has the right to buy it back from the investor prior to maturity. Typically, the issuer will redeem a bond if interest rates decline, allowing the company to issue new bonds at a lower interest rate. A call feature benefits the issuer, not the investor.
37
Call Protection:
Issuers can call callable bonds at any time unless the bond has a call protection period. If there is call protection, the issuer must wait until the period expires. Callable bonds with call protection are safer for investors.
• Example: A 20-year bond with a 10-year call protection period could be called any time after year 10 through maturity.
38
Call Price
When an issuer calls bonds, it must pay the investor par value + any call premium (if applicable) + interest accrued to that date. Investors receive no interest after the bond is called.
39
Default:
If an interest payment is missed on an outstanding debt obligation, the bond will default.
40
Credit Ratings
Bond rating services publish credit ratings to inform investors of a bond’s credit quality. A bonds credit rating may change periodically while it is outstanding. Credit ratings are typically a big factor in the liquidity of bonds (even more so than the coupon or maturity).
41
Adjusting Premium Bonds by Amortization:
Bonds purchased at a premium (> $1,000 par) must be amortized over the life of the bond. Amortization means that the cost basis will be adjusted downwards each year so that at maturity an investor’s cost basis is $1,000 par. What will amortization effect? Amortization effects a bond’s cost basis (downwards) and should the investor sell the bond prior to maturity, the profit or loss on the transaction. Amortization does not affect sale proceeds (what a purchaser is willing to pay).
Example: When an investor purchases a bond at a premium, the cost basis will be adjusted downward towards par on a straight-line basis. This is referred to as amortization. For example, a 10-year bond bought at 110 would be adjusted by one point per year, calculated as: 10-point premium / 10 years to maturity = 1 point per year.
42
Accretion of Discount Bonds
Discount bonds will be accreted, which is similar to amortization, but the cost basis is adjusted upwards (towards par) each year.
43
Accrued Interest
Accrued interest is the interest paid by the buyer of the bond to the seller of the bond when the bond is trading between coupon dates. A bond the trades with accrued interest is said to trade “and” or “with” interest. The accrued interest is taxable for the recipient as ordinary income, though it does not impact the cost basis of the bond. A bond that trades without accrued interest (e.g. a bond in default, or a zero coupon instrument) is said to trade flat.
44
Dated Date
The dated date is the date when interest begins to accrue on fixed income securities. The dated date is only relevant for new issuances and once regular semi-annual coupon payments begin, it is no longer relevant.
45
Unsecured Corporate Debt
Unsecured corporate debt is not backed by collateral or a specific asset of the corporation. Instead, it is backed by the good faith and credit quality of the company. It is also referred to as a debenture bond.
46
Convertible Bonds:
Convertible bonds are a type of corporate bond where the investor has the right to convert the bond into the company’s underlying common stock. Because of this conversion benefit for the investor, convertible bonds pay a lower rate of interest compared to similar non-convertible bonds.
47
Convertible Bond Pricing
The value of a convertible bond is based on the value of the underlying common stock, since the investor can exchange the bond for the shares. The parity price is the value at which the investor is mathematically indifferent between owning the bond or converting into the underlying shares.
48
Non-Marketable US Government Securities
The US government issues both marketable and non-marketable debt securities. Marketable securities can be freely traded by investors and include US Treasury securities, such as Treasury bills, Treasury notes, and Treasury bonds. Non-marketable securities, for example US savings bonds, cannot be resold by investors and therefore have no secondary market.
49
Series I Bond:
A Series I bond is a non-marketable US Treasury savings bond. It pays a combination of fixed and variable interest (linked to the rate of inflation).
50
Risk of Treasury Securities
Treasury securities do not have credit risk but are subject to interest rate risk and purchasing power risk.
51
Taxation of Treasury Securities
The interest income from Treasury bonds is taxed at the federal level, but not at the state or local levels.
52
Treasury Receipts
Treasury receipts are zero-coupon bonds that are structured by broker-dealers but backed by cash flows from Treasury securities.
53
STRIPS:
STRIPS are zero coupon bonds that are issued and backed by the US Government. They are issued at a discount and mature to face value.
54
General Obligation Bonds:
GO bonds are municipal securities used to finance non-revenue facilities, such as public parks, public schools, and public libraries. The interest and principal is backed by the full taxing power of the issuing municipality.
55
Industrial Development Revenue Bonds
Industrial development revenue bonds are a type of taxable municipal security that is issued by a municipality on behalf of a corporation. Specifically, the municipality will issue to debt to build a facility on behalf of a corporation and then lease that facility to the corporation. Because the bonds are backed by lease payments made by the corporation, the debt is the responsibility and credit quality of the corporation.
56
Official Statement
The official statement is the primary disclosure document used in connection with a municipal security offering. It includes all relevant information for investors, such as the risks of the bonds.
57
Ginnie Mae:
Along with Fannie Mae and Freddie Mac, Ginnie Mae is an issuer of mortgage-backed securities (MBS). However, Ginnie is the only one of the three that is backed by the full faith and credit of the US government. Because Fannie and Freddie are government sponsored enterprises, they only have an implied, but not an explicit backing of the US government.
58
Agency Securities
Securities issued by Ginnie Mae, Fannie Mae, and Freddie Mac – sometimes collectively referred to as “Agency Securities” – are taxable at the federal, state, and local levels.
59
Money Market Instruments
Money market securities are short-term debt instruments with maturities of one year or less. Because of their short-term nature, they tend to be relatively liquid and low risk compared to longer-term bonds. Examples include Treasury bills, commercial paper, negotiable CDs, and banker’s acceptances. Additionally, once a Treasury bond has only one year or less remaining until maturity, it can trade in the money market.
60
Commercial Paper
Commercial paper is an unsecured promissory note, issued by corporations at a discount. It typically has a maximum maturity of 270 days.
61
Banker’s Acceptances
A banker’s acceptance is a money market instrument that is used to finance and facilitate international trade.
62
Eurodollar deposit
Eurodollars are U.S. Dollars held in a depository (bank) abroad. E.g. A swiss bank account denominated in U.S. dollars would hold Eurodollar deposits. These are used by foreign corporations (or individuals) who have US currency abroad.
63
Eurodollar bonds
Eurodollar bonds are bonds issued outside the United States (e.g. Argentina) but denominated in U.S. dollars. Par is $1,000 USD; coupon payments are made in USD. These are issued and trade outside the U.S. and are not registered with the SEC. Issuers use Eurodollar bonds to make their securities more marketable (e.g. the issuer’s home currency is unstable).
64
Summary Prospectus
The SEC allows a mutual fund to deliver a summary prospectus to shareholders, which is a compilation of highlights from the longer prospectus. A summary prospectus includes the fund’s investment objectives, fee structure, and other pertinent information. It must be provided to investors prior to or at the time of sale.
65
Mutual Fund Shareholder Reports:
Mutual funds are required to send financial reports to shareholders which include financial statements (e.g. a balance sheet and income statement) and detail the holdings of the fund’s portfolio. These reports must be sent semiannually.
66
Mutual Fund Custodian
A bank or trust company acts as custodian for mutual fund sand is responsible for the holding and safekeeping of the fund’s securities and cash.
67
Net Investment Income
Net investment income is the total profits that an individual earns from their investments. For mutual fund investments, this would include any dividends plus interest income plus net capital gains (capital gains minus capital losses).
68
Forward Pricing
When an investor purchases shares of a mutual fund, the price they pay is based on the next NAV (net asset value) calculation after the order is received. The NAV is calculated daily based on the closing price of the market. This is referred to as forward pricing. For example, if on Monday a customer places an order to buy shares at 5:00pm, which is after the market close, the price they would pay for the shares is based on Tuesday’s closing price. The share price is not calculated based on the prior day’s closing price or the next day’s opening price.
69
Expense Ratio
Every mutual fund has an expense ratio, which is the percentage of the fund’s total assets that will be used to cover the expenses of the fund. It is calculated as (management fees plus operating expenses) divided by the average annual net assets of the fund. The fund’s expense ratio would increase if the operating expenses of the fund were rising faster than the value of the fund’s investments.
70
12b-1 Fee
12b-1 fees are annual fees paid by mutual funds shareholders to cover the marketing and administrative expenses of the fund. 12b-1 fees do not cover management expenses or trading fees.
71
Fund Share Classes
Mutual funds can have different share classes. Class A shares have an upfront sales charge. Class B shares have a back-end load (aka contingent deferred sales charges or CDSCs), which investors pay when they redeem their shares. Class C shares have level loads. All share classes have 12b-1 fees, but Class B and C 12b-1 fees are usually higher than Class A shares. Class A shares are the only share class that can benefit from breakpoints.
72
No-Load Fund
No-load funds are mutual funds that do not charge a sales charge. They are purchased by investors at the NAV.
73
Mutual Fund Suitability
When deciding on a mutual fund investment, the investor’s investment objectives are the primary consideration. Fees are of secondary importance. Note that the size of the fund is typically the least important factor.
74
Letter of Intent (LOI):
A letter of intent allows a mutual fund shareholder to invest in installments and receive breakpoints, which are discounts off of the sales charge. A letter of intent can be used for up to 13 months and can be backdated 90 days.
75
Breakpoint Sale:
A breakpoint sale is a violation where a registered rep suggests than an investor purchases a mutual fund just below the point at which they would receive a discounted sales charge. For example, if there is a breakpoint at $250,000, suggesting the customer only invest $249,000 is a violation.
76
Municipal Bond Funds
A municipal bond fund, also referred to as a tax-exempt bond fund, is a mutual fund consisting of tax-free municipal bonds. These funds are most appropriate for high-net-worth investors in high tax brackets who will most benefit from the tax-free nature of the interest income. When the fund pays out its net investment income to investors, the dividends are tax-free because they represent the tax-free interest income, though any capital gains distributions are taxable.
77
Money Market Fund
Money market funds are mutual funds consisting of money market securities, which are debt securities with maturities of one year or less. Because of the nature of the securities they invest in, money market funds are extremely safe and highly liquid. These funds generally attempt to maintain a stable NAV of $1.00 per share, though the price can fluctuate above or below that amount.
78
Mutual Fund Investment Strategies
Mutual funds can invest in equities, corporate bonds and other registered securities.
79
Prohibited Mutual Fund Strategies
Mutual funds cannot sell stock short or borrow money.
80
Cost Basis:
Cost basis is the original value of an asset for tax purposes. If the asset is later sold for a profit, the difference between the cost basis and sales proceeds reflects the investor’s taxable capital gain. Importantly, any dividends reinvested by an investor would increase their cost basis as the investor will have already paid tax on that income. For example, if an investor’s original cost basis in a mutual fund is $1,000 and the investor receives $200 in dividends which they reinvest into the fund, their cost basis would be adjusted upwards to $1,200.
81
Mutual Fund Dividends
Mutual fund cash dividends are taxable for investors regardless of whether they are taken in cash or reinvested back into the fund.
82
Impact of Dividends on NAV
The NAV of a mutual fund share will decrease by the amount of the dividend on the ex-date. This is because the fund is paying out cash so the fund’s assets will fall.
83
Index Fund Reconstitution
Index funds are mutual funds that seek to track the performance of a specific index – i.e. the S&P 500. Because they simply track an index and are not actively managed they have lower fees and expenses than other types of mutual funds. Generally, the only time the portfolio changes is when a company is added or subtracted from the benchmark index. For example, when Facebook was added to the S&P 500, all of the index funds that tracked the S&P 500 purchased Facebook stock. The process of updating the portfolio to continue to mirror the underlying index is referred to as reconstitution.
84
Closed-End Fund Pricing
Similar to mutual funds, closed-end funds have a net asset value, which is the total assets of the fund minus the total liabilities. However, because closed-end funds are exchange-traded, they can trade at a price either above or below their NAV based on the supply and demand of the shares.
85
Unit Investment Trust (UIT):
A UIT is an investment company security that combines redeemable shares with a fixed portfolio. Specifically, the portfolio is assembled by a sponsor, who does not actively trade the portfolio.
86
Exchange-Traded Funds (ETFs):
ETFs are investment company securities that are designed to track a specific index or benchmark. Like closed-end funds, ETFs are exchange-traded and thus investors pay commissions when purchasing the shares.
87
ETFs Versus Mutual Funds:
Mutual fund shares are redeemable, which means they can only be bought from and sold back to the mutual fund. There is no secondary market for mutual funds. In contrast, ETFs are exchange-traded and can be bought and sold between investors throughout the day. Because ETFs have a secondary market, they are considered more liquid than mutual funds.
88
ETF Versus Mutual Fund Expenses:
Because mutual funds are actively managed, they typically have higher fees for investors than ETFs.
89
REITs:
A real estate investment trust (REIT) is a company that owns or operates income-producing real estate or real estate-related assets. It is not an investment company or direct participation program (DPP). REITs are not subject to corporate tax (they pass through gains, though not losses)) if they meet all three of the following criteria:
I. At least 75% of the assets must be invested in real estate
II. At least 75% of the REIT’s income must be derived from real estate, and
III. 90% of the gains must be passed through to investors
90
REIT Investment Objective:
The primary investment objective for a REIT investor is current income in the form of dividends. This is because REITs are required to pay out at least 90% of income to investors.
91
REIT Dividends
Dividends paid by a REIT are always taxed as ordinary income, regardless of the holding period. This contrasts with dividends paid by traditional corporations which are taxed at a lower rate as long as the investor holds the stock for greater than 60 days.
92
Equity REITs
Equity REITs own and operate income-producing real estate. They are professionally managed to generate income from rent received as well as sales from the properties they hold.
93
Depletion
Depletion is a tax deduction that compensates a limited partnership as they use up a natural resource such as oil or gas. Because real estate is not a natural resource it cannot be depleted.
94
Passive Gains and Losses
Direct participation programs (DPPs) pass through gains and losses to investors, which means there is no corporate taxation, instead only the investors in the program pay tax. If there is a passive loss, it can only be used to offset passive gains.
95
General Versus Limited Partners:
In a limited partnership, the general partner is the active partner in the business, managing the day-to-day, whereas the limited partner contributes capital and from that point has a passive involvement in the business. The general partner has unlimited personal liability, whereas the limited partners have limited liability.
96
Interest in a Limited Partnership:
An interest in a limited partnership is an equity security as it indicates the partner owns a piece of the partnership
97
S-Corp Versus C-Corp:
An S corporation is a type of DPP. Shareholders receive a pass-through of income and losses, and the S-Corp entity is not taxed. A C corporation is a taxable entity and shareholders receive dividends that were taxed at the entity level and will be taxed again at the shareholder level. Double taxation applies to dividends from C-Corps.
98
Raw Land Limited Partnership
Raw land LPs invest in a piece of land hoping that it increases in value over time and that it can eventually be sold for a profit. Because the land is not developed, there is no income or depreciation from the ownership interest.
99
Dissolution of a Limited Partnership
```
When a limited partnership is dissolved, the priority of claims against the partnership is:
I. Secured lenders
II. General creditors
III. Limited partners
IV. General partners
```
100
Hedge Funds
Hedge funds are typically only suitable investments for institutional and sophisticated investors. This is because they often pursue aggressive trading strategies, such as the use of derivatives as well as purchasing stocks of distressed companies or those of public companies looking to go private.
101
Hedge Fund Managers
Hedge fund managers receive management and performance fees which are typically higher than fees charged for other fund investments.
102
Fund of Hedge Funds
An investment in a “fund of hedge funds” offers the liquidity of a mutual fund, but with risk more associated with a hedge fund.
103
Prime Brokerage Accounts
Prime brokerage is a suite of bundled services offered to hedge funds and other large institutional investors by banks and wealth management firms.
104
Exchange-Traded Notes (ETNs):
ETNs are of unsecured corporate debt issued by a broker-dealer that combines principal protection with equity market upside exposure. Because they are unsecured, although their return is based on an underlying equity, they do not actually own that security. This contrasts with ETFs, which own the securities in their portfolio. The credit quality of an ETN is based on that of the issuing broker-dealer.
105
Options Clearing Corporation (OCC):
The OCC issues and guarantees all listed options contracts. Therefore, if an investor wants to exercise an options position, their broker-dealer would notify the OCC who would then assign their contract to an appropriate counterparty.
106
Listed Options
A listed option is issued by the OCC and not by the underlying corporation (e.g. Apple or Facebook). Therefore, listed options have no impact on the capital structure of a corporation as the company itself is not raising money. A stock or bond issuance by a corporation would impact the its capital structure.
107
American-Style Options
American-style options can be exercised at the strike price any time up to and including the expiration date. This contrasts with European-style options which can only be exercised on the expiration date.
108
LEAPS:
LEAP is a long-term option contract with a maturity of up to three years. Operating like a conventional short-term option contract, a LEAP provides an investor with longer exposure to the price movement of the underlying security.
109
At-the-Money
Options are at-the-money when the market value is equal to the strike price. When the option is at-the-money, the owner of the option would let is expire and lose their premium
110
Liquidate an Option
If an investor owns a call option which is in-the-money (e.g. they own a 50 call with the stock trading at $60), the investor will not necessarily exercise the option. Instead, they may opt to liquidate their position (sell the option contract to another investor).
111
Maximum Gain on Long Call
When an investor buys a call option, they have the right to buy the underlying stock at the strike price. Because there is no limit on how high the stock price can rise, the maximum gain is unlimited.
112
Obligation of Call Writer:
If a call writer receives an assignment notice, they will have an obligation to sell the stock at the strike price. In return for this obligation, they receive the premium. Options are always written to generate income in the form of the premium.
113
Risk of Uncovered Call:
When an investor sells an uncovered call, they are writing a call option without owning the underlying stock. This position has unlimited risk because no matter how high the price of the stock increases, the writer is obligated to purchase the shares in the market and then sell the stock at the strike price. Because of this risk profile, uncovered calls are typically inappropriate for retail investors.
114
Covered Call Breakeven
A covered call is a strategy where an investor sells a call option on a stock, while also owning that stock. To calculate the breakeven of a covered call, which is the market value where there is no profit or loss on the position, subtract the premium received from the purchase price of the stock.
• Example: Investor owns 100 shares of XYZ stock @50 and sells 1 XYZ Nov Call @5. The breakeven is $45 ($50 - $5). Put differently, the $5 premium received for writing the option provides investor with $5 of downside protection on their stock.
115
Long Put Breakeven
The breakeven of a put option is calculated as the strike price minus the premium. Take note, that purchasing multiple contracts would not impact the breakeven point.
• Example: Investor buys 3 ABC Nov 60 Puts @5. The breakeven is $55 ($60 - $5). The fact that the customer purchased three contracts does not change breakeven.
116
Protecting a Short Put:
If an investor sells (shorts) a put option, they have an obligation to purchase the stock at the strike price regardless of how far the price has fallen if they option is exercised against them. If the investor wants to hedge against some of the downside risk, they can buy a put option with a lower strike price in order to lock in a sale price for the shares.
117
Volatility Market Index (VIX):
The VIX, often referred to as the “fear index”, measures the volatility of S&P 500 index options.
118
Index Options:
Stock index options allow investors to speculate on the performance of an index (e.g. S&P 500 or Nasdaq 100) or hedge their existing stock portfolio. If an investor has a diversified portfolio of stocks and they are concerned about market risk, they can purchase puts on that an index to protect their portfolio. Index options are settled in cash; there is no stock transaction.
119
Option Contract Adjustment
Options contracts are adjusted for stock dividends. Specifically, the number of shares the contract represents will increase, while the strike price will decrease proportionately. The total value of the contract does not change.
• Example: An ABC 60 call is subject to a 6% stock dividend. The total value of the contract is $60 strike price x 100 shares per contract = $6,000. After the stock dividend, the investor will now have 106 shares (6% more). To find the new strike price: $6,000 total value divided by 106 shares equals $56.60.
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Institutional Threshold
Under FINRA suitability rules, an individual with assets of at least $50 million is considered an institutional investor.
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Preferred Stock Investment Objective
Preferred stock pays a fix quarterly dividend and is therefore appropriate for an investor seeking current income. However, because of the fixed dividend, preferred stock does not have as much potential for appreciation and capital gains. For an investor seeking growth, common stock would be more suitable.
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Liquidity Risk
A security that cannot easily be sold is said to have liquidity risk. Examples of illiquid investments include direct participation programs and thinly traded stocks, such as penny stocks.
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Safety and Preservation of Capital
An investment objective in which an investor seeks no decline in the value of their investments. Suitable investments for this strategy would include highly rated instruments such as Treasury and money market securities. Investments where there is a risk of loss of principal, such as common stock, penny stocks, direct participation programs, and high-yield bonds, are inappropriate.
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Fund Investing
If the manager of a fund believes there might be a short-term drop in the market, they could keep excess cash in cash and cash equivalents and then buy the dip.
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Total Return on Equity
The total return on a stock investment is calculated as (dividends plus capital gains) divided by the initial purchase price of the shares.
• Example: Jane purchased ABC stock for $100 and sold it one year later for $110. She also received $5 in dividends. Total return = ($5 dividend + $10 capital gain)/$100 purchase price = 15%
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Current Yield of Common Stock:
Another way to evaluate the return on common stock is by calculating its current yield, which is the annual dividend divided by the current market price. Make sure that if a quarterly dividend is provided that you annualize it by multiplying by four.
• Example: XYZ stock is trading at $15 and pays a quarterly dividend of $0.30. Current yield = ($0.30 x 4)/$15 = 8%
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Preliminary Prospectus
preliminary prospectus can be used to market to investors during the cooling-off period. The preliminary prospectus will generally not include the timely details of the transaction, such as the offer price or number of shares being registered. Instead, buyers must still receive a final prospectus no later than the settlement date of the transaction, which includes this information.
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SEC Effectiveness
When the SEC declares a new issue effective, it clears the securities for public sale. At this time a registered rep could say the issue has been deemed effective, but could not say that it has been approved by the SEC.
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Prospectus Delivery
A prospectus or notice of its availability must be delivered to investors for any sales for the first 25 days following an IPO.
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Rule 147:
Rule 147 allows an in-state business to raise capital in their home state and avoid SEC registration. Under 147, 100% of the securities must be sold to state residents who cannot resell outside the state for six months
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Regulation D:
Regulation D is an exemption from SEC registration for private placements. In a Reg D transaction, there are two types of investors – accredited and non-accredited. Accredited investors include 1) officers and directors of the issuer, 2) institutions with at least $5 million in assets, and 3) individuals with a net worth of at least $1 million, excluding the value of their primary residence or individuals who earned at least $200,000 in each of the past two years ($300,000 for married couples). Anyone who is not defined as accredited is considered a non-accredited investor. Although different types of private placement transactions exist, generally there can be an unlimited number of accredited investors and a maximum of 35 non-accredited participating in the deal.
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Retired Individuals Accredited Status
An individual who consistently made at least $200,000 during his or her career but has since retired would not be accredited because once he or she retires there is not a reasonable expectation for a similar income to continue.
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Private Investment in Public Equity (PIPE):
A PIPE deal is when a public company raises capital through a private placement. A company might do this in order to raise capital quickly and avoid the SEC registration process.
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Offering Memorandum
An offering memorandum is provided to investors for disclosure like a prospectus, except it is used for offerings that are exempt from SEC registration like private placements. Audited financial statements are not required in an offering memorandum.
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Regulation S:
Reg S is an exempt transaction which allows an issuer to raise money outside the U.S. and avoid SEC registration.
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Qualified Institutional Buyer (QIB):
Rule 144A allows QIBs to freely trade unregistered securities (e.g. private placements) among themselves. A QIB is defined as an institution that manages at least $100 million of discretionary assets.
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Tender Offer Minimum Threshold:
A tender offer is an offer by a company or an outside investor to purchase at least 5% of the company’s shares directly from the company’s shareholders. The purchaser making the offer might qualify a tender with a minimum number of acceptable shares. This means that unless shareholders agree to sell a certain number of shares, the investor making the offer will not go through with any purchases.
• Example: InvestorCo is looking to purchase up to 10 million shares of Company ABC at a price of $25 per share. InvestorCo sets a minimum threshold of 8 million shares. If the shareholders of Company ABC only agree to tender 6 million shares collectively, InvestorCo will not go through with any purchases since the minimum threshold was not met.
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All Holders Best Price:
All shareholders receive the exact same price in a tender offer. This is sometimes referred to as “all holders best price”.
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Oversubscribed Tender Offers:
If a tender offer is oversubscribed, the shares are accepted proportionally from those shareholders who tendered.
• Example: If an investor seeks to purchase 10 million shares in a tender offer, but shareholders collectively tender 100 million shares, only 10% of each shareholders’ shares will be accepted. Therefore, if a shareholder tendered 1,000 shares, only 100 of their shares (10%) will actually be accepted.
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Follow-On Offering
A follow-on is a public offering by an existing public company that has already had its IPO.
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Secondary Offering:
A secondary offering is a new issue (could be an IPO or follow-on) where shares are being sold by existing investors, not the company. For example, if a private equity firm liquidates a position in a company, this is a secondary offering.
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Shelf Registration
A shelf registration allows an issuer to preregister securities today and sell them at a later date when market conditions are favorable. A shelf is good for up to three years and can be used for both debt and equity follow-on offerings, but never for an IPO.
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Best Efforts
A best efforts is a type of underwriting where the underwriters act as agents and have no financial responsibility for any unsold securities.
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Restricted Persons:
FINRA rules prohibit restricted persons from investing in an IPO of common stock. Restricted persons include broker-dealers, portfolio managers for their own personal accounts, employees of broker-dealers, as well as their immediate family members. Under this rule immediate family members include the spouse, parents, siblings, children, and in-laws of the employee of a broker-dealer. Note who is not immediate family and therefore not restricted: grandparents, aunts and uncles, cousins, nieces and nephews, and ex-spouses.
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Regulation M:
Reg M is an SEC rule that aims to prevent market manipulation of IPOs and follow-on offerings by broker-dealers.
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Stabilization:
Stabilization allows an underwriter to bid on securities in the open market to prevent the price from declining following an IPO. The underwriters are allowed to stabilize at or below the POP (public offering price). For example, if XYZ stock went public at $30 per share, the underwriters could stabilize at or below $30.
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Settlement:
Settlement is the legal transfer of securities to a buyer’s account and cash to seller’s account. The standard settlement cycle varies for different securities:
• T+1 Treasures and listed options contracts
• T+2 Equities, corporate bonds and municipal bonds Note: Customers have a two-day grace period to pay for their securities under Regulation T, i.e. payment must be made by T+4.
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Dealer Capacity
When a firm acts as a principal or dealer they are a counterparty to the customer, trading from its own inventory. When the firm sells to the customer they charge them a mark-up and when they buy from the customer they charge them a mark-down.
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Backing Away
Backing away is a violation that occurs if a market maker fails to honor firm quotes.
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OTC Quotes
Quotes on the OTC Bulletin Board (OTCBB) and OTC Pink may be one-sided, meaning both a bid and ask are NOT required. Quotes on national exchanges such as the NYSE, NASDAQ, and BATS are required to be two-sided.
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OTCBB Requirements:
Companies that want to have their securities quoted on the OTCBB must file current financial reports with the SEC.
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Market Orders:
Market orders are executed immediately at the best available price.
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Partial Execution of Customer Orders
Limit orders can be partially filled if the trader cannot get the entirety of the order executed. However, because stop orders become a market order once the order is activated, there is no partial execution.
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Adjustment of Orders
On the morning of the ex-dividend date any orders that are entered at or below the market are adjusted downwards by the amount of the dividend. This includes buy limit, sell stop, and sell stop limit orders. Note that orders entered at or above the market, including sell limit, buy stop, and buy stop limit orders, are not adjusted
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Order Splitting:
Breaking a large customer order into smaller parts is allowed if it will help achieve best execution for a customer. It is not permitted if the sole purpose is to generate higher commissions.
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Front-Running:
Front-running is a prohibited activity whereby a registered rep or a firm becomes aware of a large customer order and trade for his personal account beforehand in the hopes the large order will increase the stock price.
• Example: A firm receives an order from a customer to purchase 20,000 shares of XYZ stock. If the firm buys XYZ stock for itself before executing the client’s order, that would be a front-running violation.
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Trading Ahead of Research Reports:
Trading ahead is a violation where a broker-dealer or registered representative trades a security based on nonpublic information contained in a research report prior to that report being released to the public.
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Arbitrage:
Arbitrage occurs when an investor takes advantage of a temporary price disparity in a security. An example is buying a stock on one exchange for a low price and then reselling it on another exchange for a higher price.
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Spoofing:
Spoofing is a form of market manipulation where a trader enters an order to manipulate prices to be higher or lower, with no intent to actually execute at the quoted price. In other words, spoofing refers to entering orders to entice other participants to join on the same side of the market, and then trading against the other market participants’ orders.
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Pump and Dump:
A pump and dump scheme is a form of securities fraud where an investor uses false or misleading statements to artificially inflate the price of an owned stock in order to resell the stock at a higher price. An example is when an investor is randomly solicited with positive information over email or social media to purchase shares in a penny stock or other risky investment.
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Marking the Open or Close
Marking the open or marking the close is when a trader attempts to manipulate the opening or closing price of a security by entering a number of buy or sell orders just prior to the open or close of trading.
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Elasticity:
Elasticity refers to the sensitivity of supply and demand of a commodity to a change of price. If a commodity is demand elastic, that means that as prices change, demand will change. For example, if prices increase, demand will decrease, and vice versa. Alternatively, if a commodity is demand inelastic, a change in price will have no impact on demand for that product.
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Recession:
A recession is defined as a decline in gross domestic product (GDP) for two or more consecutive quarters.
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Gross Domestic Product (GDP):
GDP is the total market value of good and services produced within a country. It is a coincident indicator.
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Economic Stabilizer
In a recession, the government would take steps to increase GDP. This is sometimes referred to as an economic stabilizer.
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Velocity of Money
The velocity of money is the rate of turnover of money, or how fast it is being spent. It is usually measured as a ratio comparing GDP to money supply. When money velocity is low, people are investing and saving instead of spending.
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Inverted Yield Curve
The yield curve graphs the relationship between interest rates and time until maturity. An inverted yield curve occurs when short-term rates are higher than long-term rates and can be a sign of a recession.
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Cyclical Stocks
Cyclical stocks are those that mirror the economy, strengthening when the economy is growing and declining as the economy contracts. Examples include auto and tech stocks.
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Defensive Stocks:
Defensive stocks are those that are resistant to downturns in the economy because they supply consumers with basic needs. Examples include utility and health care stocks.
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Impact of Inflation
Inflation describes rising prices for goods and services over time. Typically, as inflation increases, interest rates will also increase. Therefore, as inflation increases, bond prices will decrease (because of the inverse relationship between interest rates and bond prices). Conversely, in a deflationary environment, interest rates are falling, and bonds will increase in value. Note that in an inflationary environment bonds with longer maturities will have a greater price decrease than those with shorter maturities.
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Deflationary Environment:
In a deflationary environment, outstanding issues of corporate bonds are more attractive than new issues. This is because the new issue would have a lower coupon, reflecting the decline in interest rates that accompanies deflation.
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Working Capital:
Working capital is a metric that helps to measure how much cash a company needs to finance its current operations. It can be calculated from a company’s balance sheet as current assets minus current liabilities.
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Earnings Per Share (EPS):
Earnings per share (EPS) is calculated as a company’s net income divided by shares outstanding. Research analysts commonly provide EPS estimates.
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Adam Smith:
Adam Smith is considered the founder of classical economic theory, which states that the economy best functions without government interference.
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Keynesian Economics
Keynesian economists believe that the economy is best controlled through taxation and government spending.
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Federal Reserve
The Federal Reserve is the central banking system of the US. In its role of implementing monetary policy, the Fed has several tools including conducting open market operations, setting the discount rate, as well as reserve and margin requirements. To ensure compliance with these requirements, the Federal Reserve Board will audit member banks.
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Federal Reserve Stimulus
When the economy is slowing, the Fed cuts interest rates to stimulate financial activity. This will lead to a fall in different interest rates such as the federal funds rate, mortgage rates, and savings account rates.
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Curb Inflation
When inflation is increasing, the Fed will tighten the money supply by increasing interest rates. The Fed can tighten the money supply by increasing the discount rate, selling government securities, or raising the reserve requirement.
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Discount Rate
The discount rate is the rate of interest that the Fed charges banks for short term loans. To ease the money supply, the Fed would lower the discount rate as this would allow banks to borrow at a cheaper rate. To tighten the money supply, the Fed would raise the discount rate as this would make it more expensive for banks to borrow money.
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Order of Interest Rates
The order from highest to lowest is 1) prime rate, 2) broker’s call rate, 3) discount rate, and 4) federal fund rate
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Trade Surplus Versus Trade Deficit
A trade surplus (exports are greater than imports) will cause a company’s currency to appreciate. A trade deficit will cause the currency to depreciate.
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Purchasing Power Parity
Purchasing power parity compares the strength of a country’s currency by determining how much it costs to buy the same basket of goods. It is used to determine the exchange rate between the currencies of different countries.
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Telemarketing:
FINRA and the MSRB have telemarketing rules that allow firms to solicit new business by cold calling potential clients. Prior to making a cold call, the caller must ensure the individual is not on the national or firm’s do-not-call list. Cold calls are permitted between 8am and 9pm in the time zone of the person being called.
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Do-Not-Call List
Under the telemarketing rule, once an individual is added to the firm’s internal do-not-call list, they remain there indefinitely.
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Do-Not-Call List Exceptions
A registered rep can call an individual on the do-not-call list if the individual is an existing customer of the firm, the registered rep has a personal relationship with the individual, or if the individual has provided prior written consent.
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New Account Form
A new account form must be completed when a customer opens a new brokerage account with a broker-dealer. Required information includes the customer’s name, address, social security number, employment status, investment experience and objectives. The firm is required to maintain a record of this form.
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Numbered Account
A numbered account is a brokerage account that is represented by a symbol or number, allowing the account holder (e.g. a celebrity) to remain anonymous. The broker-dealer must still receive a written statement of ownership and proof of identity from the client.
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Free-Riding:
Free-riding is a violation under Regulation T where an investor sells their securities without ever paying for them. If this occurs, the customer’s account will be frozen for 90 days and transactions in the account will be limited to sell orders and purchases where the customer fully pays upfront prior to trade.
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Long Margin Account Initial Minimum Equity Requirement
Under FINRA rules, if a customer wants to purchase less than $2,000 of stock in a margin account, they must deposit 100% of the purchase price. For example, if a customer wants to buy $1,000 of stock on margin, they must deposit the full $1,000. If the customer wants to purchase between $2,000 and $4,000 in a margin account, they must deposit minimum initial equity of at least $2,000. For example, if a customer wants to buy $3,000 of stock on margin, they must deposit $2,000. For purchases above $4,000, the customer must deposit 50% of the purchase price (Regulation T).
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Short Sales in a Margin Account
All short sales must be executed in a margin account. Additionally, Reg T requires the customer to deposit 50% of the sale price. For example, if a customer sells short $100,000 of stock, they are required deposit $50,000 in equity into the account.
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Mark-to-Market
The value of a customer’s margin account is marked-to-market daily to determine equity balances and margin calls.
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Marginable Securities
The Federal Reserve Board determines whether a security is eligible to be purchased on margin. Those that can be include exchange-listed stocks, closed-end funds, ETFs, fixed income securities (e.g. Treasury bonds), and LEAPS options with more than nine months until expiration. Securities that cannot be bought on margin include options contracts with nine months or less until expiration, mutual funds, and annuities contracts.
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Hypothecation:
In a margin account, the customer borrows 50% of the purchase price from the broker-dealer to buy securities. In return the customer agrees to hypothecate, meaning pledge, the securities in their account as collateral for the loan.
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Loan Consent Form
The loan consent form is an optional component of the margin agreement. If signed by the customer, it allows the broker-dealer to lend stock held in the customer’s account to other investors to facilitate short sales.
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Discretionary Account
A discretionary account is a brokerage account where the customer has given their rep at the firm the written authority to make investment decisions and trade on their behalf. If a rep does not have discretionary authority, it would be a violation for them to conduct trades on behalf of a customer, even if they believe the transactions are in the best interest of their client, without the customer’s consent.
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Discretionary Account Approval
Discretionary accounts must be approved by a principal prior to the first trade and each discretionary trade must be approved by a principal promptly after execution
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Not Held Orders
A not held order is when the customer provides the asset, amount, and action, but allow the registered rep to choose the price and time of execution. For example, the customer states “Buy 100 shares of XYZ stock when the price is right”. Not held orders do not require discretionary authority.
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Trading Authority
The owner of an account has trading authority, which is the ability to trade the assets of the account. A non-account holder can only trade on behalf of the account if this right is granted in writing by the account holder.
• Example: An adult child can only make trades for their mother’s brokerage account if the mother grants this authority in writing.
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Power of Attorney (POA):
An existing power of attorney (POA) would be cancelled if a court declares the customer legally incompetent. An exception exists if the customer had a durable power of attorney, which would remain in effect. Note that all POAs end upon death of the customer.
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Fee-Based Accounts:
In a fee-based account, the customer pays a flat fee for as many trades as they would like. This type of account would not be appropriate for a buy and hold investor.
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Payments in Joint Accounts
In a joint account checks must be made payable to all parties.
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joint tenants in common (JTIC)
account is a divided account where each account owner specifies their percentage ownership of the account based on their contributions to the account. At each owner’s death, their portion of the account is distributed to their beneficiary, not the surviving account owners. JTIC account assets are subject to probate (the inheritance process via court) and are distributed as part of the deceased’s estate. Unrelated friends or siblings who want to leave their assets to their respective spouses might open at JTIC account together.
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joint tenants with rights of survivorship (JTWROS)
account is an undivided account, meaning all owners own 100% of the assets. If one of the owners dies, their share of the account passes to the surviving owners. In a JTWROS, the assets avoid probate and go straight to the survivor. A husband and wife might open a JTWROS account together.
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Transfer on Death (TOD) Account
A TOD account has a named beneficiary and avoid probate. This means the assets in the account bypass the estate settlement process and are transferred directly to the beneficiary at death.
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Minors Accounts:
UGMA and UTMA accounts are securities accounts that can be established for a minor. Because the minor owns the account, it is their social security number on the account and the minor is liable for any taxes. However, the account is managed by a custodian, who trades on behalf of the minor. The custodian can be the same individual that donates the assets to the account (e.g. a parent can gift the assets and be the custodian managing the account). Once the minor reaches the age of majority, which varies by state, they take control of the assets. Additionally, any assets that are gifted to the minor’s account are irrevocable, which means they cannot be taken back.
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UGMA New Account Registration Form:
The new account registration form for an UGMA account includes the name of the custodian. It would not include the name of an individual who donates funds to the account (unless the donor was also the custodian).
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Guardian:
An individual appointed by the court to manage the assets of a minor is referred to as a guardian.
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Trust Account
In a trust account, a beneficiary’s assets are managed by a trustee. The trustee has a fiduciary responsibility, meaning they must act on behalf of the beneficiary by ensuring that the terms set forth in the trust agreement are adhered to. One benefit of a trust is that it allows the creator of the trust, or grantor, to limit or restrict the use of the assets. For example, a grandparent can set up a trust for a minor that allows the assets to be used for educational expenses only. Another benefit is that certain types of trusts can be used by a customer to ensure their assets avoid probate and instead go straight to the named beneficiary.
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Trust Invalidation
A trust may be invalidated (aka overturned) due to undue influence (e.g. the individual signing the trust documents was coerced) or lack of capacity (e.g. the individual signing the trust documents was mentally incompetent).
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Customer Account Statements
Account statements, which are snapshots of the customer’s account, must be sent at least quarterly by the firm.
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Holding Customer Mail
If a customer will be travelling, they can request that their broker-dealer hold on to their mail, such as trade confirmations and account statements, for up to three months. The customer must make this request in writing.
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Regulation S-P:
Regulation S-P established privacy standards to ensure broker-dealers maintain the security and confidentiality of customer information. Reg S-P requires firm to provide clients with privacy notices at account opening and annually thereafter explaining what information the firm gathers about them, where this information is shared, and how the firm safeguards this data. Clients also have the option to opt out of having certain information shared with third parties unless at the request of a regulator (i.e. the IRS or FINRA) or otherwise legally required. Clients must be given 30 days to opt out.
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Commingling:
Customer and firm assets must be segregated from one another. Mixing the two is a violation referred to as commingling.
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Securities Investor Protection Corporation (SIPC):
SIPC is a not-for-profit corporation that protects each separate customer account in the event a broker-dealer goes bankrupt. Specifically, each separate customer is protected for up to $500,000 total, but not more than $250,000 in cash. Importantly, SIPC coverage protects customers’ cash and securities from a broker-dealer’s failure, but not from market losses. Note, that SIPC does not protect non-securities, such as a commodities or futures.
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SIPC General Creditor
If the SIPC limit of coverage is exceeded, the customer becomes a general credit of the broker-dealer.
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SIPC Securities Valuation Date
In the event of a broker-dealer insolvency, the market value used to determine the amount of an investor’s claim is based on the date the bankruptcy filing is made with the court.
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Clearing Versus Introducing Firm
A clearing firm is responsible for processing and settling customer transactions, as well as maintaining custody of customer cash and securities. This contrasts with an introducing firm which has the direct relationship with the client and can accept customer orders but does not handle customer assets or the mechanics of the actual trade. In a margin account, the securities positions are maintained by the clearing firm rather than the introducing firm.
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Depository Trust & Clearing Corporation (DTCC)
A clearing corporation with the primary role of facilitating the exchange, payment, and settlement process for securities transactions. The largest clearing corporation is the National Securities Clearing Corporation (NSCC). It is a subsidiary of the DTCC, which is jointly owned by all broker-dealers.
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Vulnerable Investors
FINRA defines vulnerable investors as those aged 65 and older as well as any person aged 18 or older who the firm or its reps reasonably believe has a mental or physical impairment that renders the individual unable to protect his or her own interests. If the firm believes that there has been or will be financial exploitation of a vulnerable investor by a party able to transact the account (e.g. the account’s trusted contact) then the firm can institute a 15-business day hold on the account to review the facts and circumstances. If after the 15-business day hold the firm has reason to believe that the malfeasance is ongoing, they can extend the hold on the account an additional 10 business days
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Inherited Securities’ Cost Basis:
When an investor inherits securities, the investor’s cost basis is adjusted to the fair market value of the security at the time of death. This is referred to as a “stepped-up basis.”
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Traditional IRA (pre-tax / tax-deferred):
Traditional IRA contributions are usually pre-tax, have tax-deferred earnings and growth, and all distributions are taxed as ordinary income.
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IRA Contribution Limits
The maximum contribution to an IRA is the lesser of $6,000 (this was updated from $5,500 on January 1st, 2019) or 100% of the individual’s earned income. Note, that only earned income (e.g. salary) can be contributed to an IRA. Investment income, such as capital gains or dividends, and income from a retirement plan (e.g. a pension plan) is not considered earned income and therefore cannot be contributed.
• Example: If an individual earns $3,000 from a part time job, $10,000 of investment income, and $40,000 of pension income, they can only contribute $3,000 to their IRA.
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Spousal IRA
A contribution of up to $6,000 per year may be made by a working spouse to a spousal IRA account in the non-working spouse’s name.
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Catch-Up Contribution
If an individual is 50 or older, they can contribute an additional $1,000 to their IRA ($7,000 total).
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Excess Contributions
If an investor makes an excess contribution (e.g. more than $6,000) to a Traditional or Roth IRA, they will be assessed a 6% tax penalty by the IRS.
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IRA Rollovers:
Individuals can move their IRA investments from one plan provider to another (e.g. Fidelity to Wells Fargo). This is referred to as a rollover and must be completed within 60 days to avoid potential tax liabilities and early withdrawal penalties.
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Roth IRA (post-tax / tax-free):
Contributions to a Roth IRA are always made with after-tax dollars. The earnings in the plan grow and accumulate tax-free and qualified distributions from a Roth are tax-free. To be qualified, distributions must be made after reaching age 59 ½ and the money must have been in the plan for at least five years.
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Roth IRA Eligibility
An individual is only eligible to contribute to a Roth IRA if their modified adjusted gross income is below a certain threshold. In 2020, the limit is $139,000 and this figure is adjusted annually for inflation. Focus on the concept rather than memorizing the specific threshold.
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Roth IRA Early Withdrawals
An individual under age 59.5 with a valid exception (e.g. first-time home buyer, qualified education expenses, death, disability, and major medical expenses) can withdraw funds from a Roth IRA that they have had for less than five years without being subject to a 10% early withdrawal penalty. However, in this situation the individual will be taxed on the earnings.
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10.Required Minimum Distributions (RMD):
The owner of a traditional IRA is required to begin taking distributions from the account by April 1st of the year following their turning 70 ½. The amount they are required to withdraw is referred to as the RMD and is calculated based on the owner’s account value and life expectancy. For Roth IRAs, because there is no age limit for making contributions, RMDs are not required from a Roth IRA until death of the account owner. Note that beginning in 2020, the Secure Act has raised the RMD age from 70 ½ to 72.
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SEP-IRA
simplified employee pension (SEP-IRA) is a type of employer-sponsored retirement plan that is typically offered by small businesses because it is inexpensive to set up and maintain. Instead of companies having to establish a new plan, a SEP-IRA allows the company to contribute directly to each employee’s IRA. Take note that only the employer, not the employee, can contribute to a SEP-IRA.
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Simple IRA:In a fixed annuity, the investor earns a guaranteed fixed return. The risk of negative performance of the investments is assumed by the insurance company. However, the investor still faces inflationary risk (the fixed return will not keep place with inflation). In a variable annuity, the investor earns a variable return based on the market performance of the investments they select within the insurance company’s separate account. The investor bears the risk of any reduced payout (market risk).
A Savings Inventive Match Plan for Employees (SIMPLE) is a type of employer sponsored retirement plan available to small businesses. It can only be used by companies that have 100 employees or less.
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Guaranteed Investment Contract (GIC):
A GIC is an insurance contract that function like a time deposit. An investor agrees to deposit cash with the insurance company for a fixed period and in return the insurance company provides them with a guaranteed rate of interest as well as the return of principal.
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Fixed Versus Variable Annuities
In a fixed annuity, the investor earns a guaranteed fixed return. The risk of negative performance of the investments is assumed by the insurance company. However, the investor still faces inflationary risk (the fixed return will not keep place with inflation). In a variable annuity, the investor earns a variable return based on the market performance of the investments they select within the insurance company’s separate account. The investor bears the risk of any reduced payout (market risk).
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General Versus Separate Account:
The general account of the insurance company seeks to provide a fixed return by investing customer premiums into conservative investment options, such as Treasury securities and high-grade corporate bonds. The separate account of the insurance company seeks to provide a variable return by investing in a wider range of securities including equities and mutual funds.
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Accumulation Units
When an individual invests money into a variable annuity, the dollars invested into the insurance company’s separate account purchase accumulation units. Each unit represents an interest in the underlying subaccount. The value of each unit will fluctuate based on the value of the securities in the portfolio. Therefore, both the number of accumulation units will vary (the number will increase as the individual invests more money) as will the value of each unit.
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Variable Annuity Payouts:
The payouts received by an investor from their variable annuity will fluctuate each month based on the performance of their separate account.
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Variable Annuity Payout Options
When an investor annuitizes, they begin to receive payments from the insurance company. One factor that impacts their monthly payment is the payout option the investor has chosen. A life option or life annuity makes payments for the life of the investor, but no payments to their beneficiary upon death. In contrast, a joint and last survivor option guarantees payments over two lives. Once the investor dies, the insurance company will then make payments to the beneficiary until their death. Because the life option is expected to have a shorter duration and is therefore riskier to the investor, it makes higher monthly payments.
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Surrender Charges
A surrender charge is a fee paid by an investor to the insurance company if the investor withdraws their capital prior to annuitization.
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1035 Exchange
A 1035 exchange allows an investor to transfer from one variable annuity to another with no tax consequences. Note that surrender charges may still apply.
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403(b) Plans
A tax-sheltered annuity, also known as a 403(b) plan, is a retirement plan used by employees of public schools and non-profits. Similar to a 401(k), it allows individuals to make pre-tax (tax-deductible) contributions. The investments in the plan grow tax-deferred and all distributions from the plan are taxed as ordinary income.
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529 Plan
A 529 plan is a tax-advantaged to save for education. Contributions to the plan are made with after-tax dollars. The earnings in the plan grow and accumulate tax-free and distributions for qualified education (e.g. tuition and books) are completely tax-free at the federal level. Technically, because 529 plans are offered by states, the maximum amount that can be contributed will vary state to state. Additionally, there is no age limit on the beneficiary of a 529 plan.
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Coverdell Education Savings Account
Similar to 529 plans, a Coverdell is another tax-advantaged investment account to save for education. The tax treatment is identical to that of a 529 plan. However, 529 plans are the much more popular of the two plans as a Coverdell has a much lower maximum contribution limit: $2,000 per year per child. Additionally, a Coverdell can be opened for any student who is under the age of 18, but the assets must be withdrawn or transferred by the time the student reaches the age of 30.
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ABLE Accounts
An ABLE account is a tax-advantaged savings account for individuals with disabilities. It may be opened for persons with disabilities up to the age of 26. It allows for a donor to contribute after-tax dollars on behalf of an individual with disabilities. The earnings in the plan grow and accumulate tax-free and distributions for qualified disability expenses (e.g. education, housing, health care, transportation, etc.) are completely tax-free at the federal level.
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Non-Qualified Retirement Plans – Credit Risk:
Non-qualified corporate retirement plans carry credit risk if the employer is insolvent or files for bankruptcy. A non-qualified plan does not meet certain federal legal requirements under ERISA (the federal law). The ERISA criteria are not tested.
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SEC Mission
The primary mission of the SEC is to maintain integrity of US markets and protect investors. FINRA is overseen by the SEC and its primary mission is to regulate broker-dealers and registered representatives. FINRA can make rules but they must be approved by the SEC before they are effective.
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Self-Regulatory Organization (SRO):
A SRO is a regulatory body, empowered by and accountable to the SEC, that has been delegated certain enforcement responsibilities within the securities industry. The primary mission of SROs is to provide investor protection and promote market integrity. Examples include FINRA and the MSRB. Note that the SEC is a government agency, not an SRO.
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Municipal Securities Rulemaking Board (MSRB):
The MSRB is SRO responsible for regulating the municipal securities industry. Importantly, the MSRB regulates municipal securities firms, advisors, and professionals, but not municipal issuers. Municipal issuers (e.g. New York City) are not subject to regulation by the SEC or SROs.
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MSRB Rules
Although the MSRB creates rules, it has no enforcement authority. Instead, MSRB rules are enforced by FINRA and other regulators.
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Pre-Dispute Arbitration Clause
FINRA rules require all registered representatives to sign a pre-dispute arbitration agreement as part of their Form U4. This clause requires any future dispute between the firm and rep, for example a financial disagreement, to be settled through an arbitration proceeding rather than the court. An exception is that any disputes regarding harassment or discrimination will only go to arbitration if both the firm and employee agree; otherwise, they will go to the court.
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Arbitrators:
FINRA arbitrators can be from both inside the industry and outside the industry. Those from outside are called public arbitrators. A law degree is not a required credential for arbitrators. Industry cases are decided by industry arbitrators, while cases involving the public must include arbitrators from the public sector.
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Fingerprinting Requirements
All registered representatives of a broker-dealer must submit fingerprints to FINRA as part of their registration. This requirement also applies to any partners of the firm or clerical staff who are involved in the handling or processing of securities or money. However, a partner of the firm or clerical employee not involved in those activities are exempt from fingerprinting requirements. For example, a partner of a broker-dealer, who has invested capital into the firm, but has no other involvement (e.g. a silent partner) is not required to submit fingerprints.
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Passing the SIE
When an individual passes the SIE exam, it does not qualify them to engage in securities business (e.g. solicit business or enter transactions). Instead, to become fully registered, the individual must also pass a top-off exam (e.g. Series 7 or Series 79). Note, the SIE credential is valid for four years.
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Amended U4:
All individuals seeking to be registered must complete a Form U4 upon joining a broker-dealer. Additionally, firms and reps have an obligation to amend and update any information required by Form U4 as changes occur within 30 days. For example, if an individual engages in an outside business activity away from the firm, changes their address, or has lien (e.g. tax lien) filed against them, an amended U4 must be filed.
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Registered Rep Credit:
Registered reps are required to notify compliance of any activity that may impact their credit. One example of such activity is a short sale of a home (mortgage) by a registered rep. This occurs if a rep sells a home for less than the outstanding mortgage balance owed to the lender (i.e. bank), with the bank then accepting the less-than-full repayment of the mortgage. Because the rep is unable to pay off their mortgage balance in full, this will have a negative impact to their credit.
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Form U5
A firm must file a Form U5 electronically with FINRA within 30 days of a registered rep’s termination. The firm must provide a copy of the U5 to the departing rep within 30 days and keep the terminated rep’s file updated for two years after termination.
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Registered Rep Termination
After a registered representative is terminated from a firm (i.e. a Form U5 is filed), the individual must keep their address updated with FINRA for two years after termination.
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Statutory Disqualification:
A statutory disqualification will occur if within the past ten years the individual has been convicted of a felony or a securities related misdemeanor. In this situation, the individual cannot be employed with a broker-dealer unless they receive a waiver from FINRA.
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FINRA Investigation:
If FINRA believes that a registered rep has committed a rules violation, they can investigate the matter. As part of this investigation, FINRA will typically send a written request for information to both the firm and rep, which seeks basic information about the event or complaint. Additionally, FINRA can require that the rep submit to an interview and meet with regulators as part of the investigation.
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Regulatory Element
Regulatory element continuing education must be completed within 120 days of an individual’s second anniversary of registration and every three years thereafter (e.g. year 2, 5, 8, 11, etc.).
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Registered Rep Re-Association
A registered rep who leaves the industry for between two and four years would need to retake their top-off exam (e.g. Series 7 or 79) to re-register. However, they would not need to complete the regulatory element CE until the 2nd anniversary of their new registration.
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Firm Element
Firm element continuing education must be completed at least annually, though firm policies can require it to be completed more frequently. It must be completed by all covered persons, meaning all registered individuals and supervisors who interact with customers.
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State Securities Laws / Blue Sky Laws
In addition to federal regulations, each state has securities laws in place designed to protect the investing public. These state regulations are often referred to as blue sky laws.
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NASAA:
The North American Securities Administrators Association (NASAA) is a membership organization for state securities administrators
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State Registration
Registered reps must be registered in each state they conduct business. If a client of a registered rep moves to another state, the rep cannot make a trade for that client until becoming registered in that state. If the client wishes to trade, the rep should forward the trade to someone at the firm who is registered in that state.
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Fiduciary Standard
Fiduciaries are legally obligated to act in the best interest of persons they represent. Examples of fiduciaries includes administrators of pension plans and Investment Advisers. Importantly, representatives of broker-dealers are not subject to a fiduciary standard. Instead, they are subject to a suitability standard.
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Investment Advisers
Investment advisers (IAs) are firms that provide securities related advice for a fee. Larger advisers (defined as those with over $100mm in assets under management) must register with the SEC. Smaller advisers, those with less than $100mm in assets, must register in each state they operate.
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Broker-dealer Books & Records (including advertisements):
Broker-dealers’ business records, which include advertisements, must be maintained for three years after the record is created. In the case of an advertisement used multiple times, the three-year clock restarts each time the ad is deployed. For the first two years of the record retention period the record must be easily accessible (i.e. stored on-site).
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Insider Trading
Insider trading is the illegal practice of trading (buying or selling) securities based on material non-public information.
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Inside Information
If a registered rep holds non-public material information, they can accept an unsolicited order from a customer.
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Penalties for Insider Trading
The 1934 Act provides for both civil and criminal penalties for insider trading. Civil penalties up to a maximum of three times the profits gained, or losses avoided. This is also referred to as treble damages. Criminal penalties include up to $5 million in fines and 20 years in prison.
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Bureaus within US Treasury Department:
The Internal Revenue Service (IRS), Office of the Comptroller of the Currency (OCC) and the Financial Crimes Enforcement Network (FinCen) are all bureaus of the US Treasury Department that help to prevent money laundering.
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Role of the IRS
The IRS is responsible for the collection of taxes and enforcement of tax laws. However, it is the responsibility of Congress to pass tax legislation.
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Currency Transaction Report (CTR):
A CTR must be filed with FinCEN whenever a financial institution receives a cash deposit in excess of $10,000 in a single business day from a customer. This can include a deposit of cash, a traveler’s check, a cashier’s check, money order, or a combination of the aforementioned which exceeds the limit. For example, if a customer deposits a $3,000 money order and $8,000 traveler’s check in a single day, a CTR must be filed.
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Suspicious Activity Reports (SAR):
A SAR must be filed with FinCEN upon discovery of suspicious activity. Examples include insufficient or questionable account information, avoidance of recordkeeping requirements, unanticipated changes in transaction patterns, and inconsistent business activity, which are all red flags for suspicion of money laundering activity.
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Anti-Money Laundering (AML) Compliance Programs:
AML compliance programs are subject to annual independent audit and testing. The testing can be completed by someone from within or outside the firm.
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Customer Identification Program (CIP)
The Customer Identification Program is a provision of the USA Patriot Act that requires financial institutions to verify the identity of each customer who opens an account. The purpose is to help the government fight terrorism and money laundering activities.
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Outside Business Activities (OBAs):
A registered rep that wishes to engage in outside employment (e.g. a second job) away from their firm must notify their firm prior to engaging in the activity. For example, a registered rep that wants to accept a weekend job as a bartender must first notify their firm. Note that passive investments are exempt from the rule (i.e. do not require notification).
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Selling Away
Sometimes referred to as private securities transactions, selling away is when a registered rep conducts securities business away from their firm. FINRA rules require the rep to notify their firm of this activity and if the rep will receive any compensation to first receive permission from their firm.
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Sharing in Customer Accounts
A registered rep and customer can share in the profits and losses in an account only with permission of the firm and customer. The sharing must be proportionate to each person’s financial contribution to the account.
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Continuing Commissions
A retired registered rep who had a continuing commissions arrangement as part of their retirement can continue to receive commissions for legacy clients even after the rep’s retirement.
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Gifts and Entertainment
Under FINRA and MSRB rules, gifts to a client or potential client are limited to $100 per client per year. However, entertainment expenses – events where the rep attends – are not considered gifts. For example, if a rep takes a client to dinner and the bill is $250, this is permitted. Likewise, attending a baseball game where the tickets cost more than $100 is permitted provided the rep attends.
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Borrowing from or Lending to Members:
Registered reps are generally prohibited from personally lending money to clients unless the firm has written procedures in place allowing for the activity. Assuming that is the case, a registered rep is allowed to lend or borrow money from a client with no notice or permission required if the client is a bank or family member. Firm permission is required if the loan is based on an outside business or personal relationship with the client or if the client is a registered person at the same firm.
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Customer Complaints
Under FINRA and MSRB rules, all written complaints must be forwarded to a supervisor. Note, that verbal complaints do not need to be reported.
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Heightened Supervision
A firm would likely heighten its supervision over a registered representative who had a history of notable events on their Form U4 (e.g. customer complaints).
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Political Contributions
The MSRB has strict political contribution rules to prevent pay-to-play, which is the practice of municipal firms and their representatives making contributions to candidates in exchange for receiving business opportunities. These rules apply to municipal finance professionals (MFPs), which is any rep involved with municipal securities business except for those limited to retail sales. Specifically, an MFP can give a maximum contribution of $250 per election to a candidate they are eligible to vote for. If a violation occurs, the firm is prohibited from doing any negotiated business with that municipality for two years. Note that contributions made by spouses of MFPs are not subject to the $250 limit unless the contribution was directed by the MFP.
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Annual Compliance Meeting:
To ensure that a firm’s supervisory procedures and all FINRA rules are being adhered to, all registered employees of a firm must attend an annual compliance meeting conducted by the firm’s chief compliance officer. The meeting may be conducted electronically (e.g. by video conference), but all participants must have the opportunity to ask questions and receive immediate feedback.
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Retail Communications
Retail communications include any written or electronic communication distributed to more than 25 retail investors within a 30-calendar-day period. Because these communications are seen by individuals, they require principal approval before first use and are highly regulated. For example, retail communications cannot predict or project the performance of a security, imply that past performance forecasts future results, or include exaggerated claims. Take note that the following activities would be permitted:
I. A hypothetical illustration of mathematical principles, as long as it does not specifically predict or project the performance of an investment or investment strategy, and
II. A price target, but only if contained in a research report.
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Communications through Personal Email & Social Media:
registered representative is allowed to communicate with clients through a personal email address and personal social media account as long as they receive prior permission from their supervisor and the firm appropriately monitors the communications. Supervision is required for contacts with both current and prospective investors.
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Business Continuity Plans
All firms must have a written business continuity plan to address emergencies and business disruption. Customer must receive a summary of the plan at account opening and it must be on the firm’s website. Customers must also be mailed a summary of the plan upon request.
