Unit 2 Obtain Necessary Suitability Information & Approvals Flashcards
1
Q
Getting to Know a Client - Financial Information
A
- Financial investment consideration can be express as a sum of money
- Financial questions have answers that show up on a customer’s personal balance sheet or income statement
2
Q
Customer Balance Sheet
A
- Snapshot of the individual’s financial condition @ a point in time
- Ask questions like - value of CDs, savings accounts, home, car, collectibles, securities you own; have you established long-term investment accounts; what are your liabilities - owe on mortgage and how large is your credit card debt
- From this info it can determine the net worth and how much of it is liquid
3
Q
Customer’s Net Worth
A
- ASSETS minus LIABILITIES
- Assets do not include income
- Liabilities do not include expenses
- Net worth is relevant in determining an individual’s investment objective (for example - have credit card debt - objective could be debt reduction)
4
Q
Customer Income Statement
A
- Info about customer’s marital status, financial responsibilities, projected inheritances & pending job changes
- Ask questions like - total gross income/family income; pay in monthly expenses; net spendable income after expenses; secure is your employment
5
Q
Using Customer Balance Sheet & Customer Income Statement
A
- Client is able to make a lump-sum investment (balance sheet shows a large amount of net assets available)
- Client is able to make periodic investments (income statement reveals a positive cash flow - there is money at the end of the month)
6
Q
Noninvestment Considerations
A
- Cannot be expressed as a sum of money or a numerical cash flow
- Often carry more weight than the financial considerations
- Include - age, marital status, # and ages of dependents, employment of you and family members, current & future education and health needs for you & family, risk tolerance, tax status & attitudes towards investing
7
Q
Customer’s Attitude for Investments
A
- No matter how much an analysis of a customer’s financial status tells the registered rep about the ability to invest, it is the customer’s emotional acceptance of investing & motivation to invest, which molds the portfolio
8
Q
Customer Attitude Questions
A
- What kind of risk can you afford to take?
- How liquid must your investments be?
- Are you seeking long-term or short-term investments?
- Can you tolerate market fluctuations?
- How stable is your income?
- How would you react to a loss of 5% or your principal? 10%? 50%
- What level of return do you consider good? Poor? Excellent?
9
Q
Customer Risk Tolerance
A
- Certainly shades of gray when defining
- Makes it even more critical that the rep and customer are on the same page when it come to the risk tolerance
10
Q
If you see low risk …
A
- Conservative
11
Q
If you see some risk …
A
- Moderate
12
Q
If you see more than average risk …
A
- Moderately agressive
13
Q
If you see high risk …
A
- Aggressive
14
Q
Client contacts rep wanting to purchase securities the rep feels is not suitable for the client …
A
- Rep has a responsibility to tell the customer that the trade is not suitable
- If customer insists, rep should place the order & mark the trade unsolicited
15
Q
How is all the info necessary to complete the customer profile obtained?
A
- No universal method
- Client completes a detail questionnaire
- Personal interview b/t prospect & registered rep
- Data gathering techniques involve asking prospects to bring in account statements, insurance policies, 401k plan options & maybe tax returns
16
Q
Why collect statements and/or financial documents?
A
- Obtaining the info is critical when one needs to measure the sophistication of the investor
- Viewing the types of securities currently or previously owned can provide a clue
17
Q
Who is an accredited investor?
A
- Any individual with a net worth in excess of $1M, not including their primary residence OR
- Any individual who had an income in excess of $200K in each of the 2 most recent years or joint income with that person’s spouse in excess of $300K in each of those years & has a reasonable expectation of reaching the same income level in the current year
18
Q
FINRA believes that each member should take reasonable steps to verify accredited investor status by …
A
- Tax returns or W2s for the previous 2 years
- Obtaining written representation from the purchaser/investor that he has a reasonable expectation of reaching the income level necessary
- Bank or brokerage account statements
- A credit report
- Obtain written confirmation from: registered BD, investment advisor registered with SEC, a licensed attorney in good standing in client’s jurisdiction or a certified public accountant
19
Q
Investment Goals
A
- A goal is where you want to be (end game)
- Common examples: planning for college, retirement, saving for future purchase, philanthropy, capital to start a biz, leaving a legacy
20
Q
Investment Objectives
A
- Are the tools used to reach the investment goals
21
Q
Three Primary Investment Objectives
A
- Growth
- Income
- Stability (capital preservation)
22
Q
Three Broad Classes of Investment Objectives with Many Shades In-between
A
- Growth (can be aggressive, moderate and even conservative)
- Income (can be current, future, or high risk)
- Preservation of Capital (safety)
23
Q
Concept of Investment Objectives
A
- Picture an equilateral triangle with 3 equal sides (leg) and each point being an objective - Growth, Income & Safety
- It is true that the closer you move on the leg to one of these points (objective), the farther you move from the others
- For example if you wish to maximize your growth, you go all the way to the G and move farther away from the I and the S
- The role of the rep is determine where the customer’s objectives lie
24
Q
It is important to to understand with investment objectives …
A
- You can’t maximize all three (growth, income & safety) - something has to give
25
Q
Investment Constraints
A
- Limitations or restrictions that are specific to your client
- “We’d like to buy this, but we can’t.”
- Examples: liquidity needs, time horizon & personal ethical choices
26
Q
Preservation of Capital Objective
A
- Many people want to avoid any drop in value of their investment but these investors are specifically seeking SAFETY
- There is a trade-off with reducing risk, the investor is sacrificing the opportunity for higher income
- Exposed to inflation (purchasing power) risk
27
Q
Income Objective
A
- Primary factor is the amount of risk the investor is willing and/or able to take
- The risk/reward principle is quite clear - the more risk, the greater the potential reward and vice versa
- Example of income & safety would be US Treasury securities
- Example of income & growth would be investing in high-yield (junk) bonds
28
Q
Growth (Capital Appreciation) Objective
A
- The term growth refers to a broad spectrum of objectives
- Some are very high risk tolerance and want their portfolio to be solidly on G while others are quite conservative and are closer to S while still on the “leg” of G
29
Q
Speculation Objective
A
- Although a subcategory of growth, speculation is often listed as specific objective
- Try to earn much higher-than-average returns in exchange for higher-than-average risks
- Use margin, sell short & trade in options or penny stocks
30
Q
Time Horizon
A
- Investment constraint
- Time horizon & liquidity needs will determine the level of volatility the client should assume
- 20 to 30 year time frame, dramatic volatility (changes in prices of a security/commodity) is acceptable
- 3 to 5 year time frame should be invested for safety & liquidity
- Particularly important constraint when planning for college or retirement
31
Q
Liquidity
A
- Investment constraint
- A need for a certain sum or might just like the idea that they can get their money literally at a moments notice
- Product is liquid if a customer can sell it quickly at face amount (or very close to it) or at fair market price
- Liquid investments does NOT mean you won’t lose money on your investment
32
Q
Liquid Investment Examples
A
- Securities listed on an exchange or Nasdaq
- Mutual funds
- Exchange-traded funds
- Most real estate investment trusts
33
Q
Illiquid Investment Examples
A
- Annuities (when initially purchased and/or when the annuitant is under age 59 1/2)
- Real estate
- Securities purchased in a private placement
- DPPs
- Hedge funds
34
Q
Two Ways to Reduce Taxes
A
- Tax deferral
- Tax-free income
- Taxes are an investment constraint
35
Q
Tax Deferral
A
- Certain contributions (IRA or TSA) may be tax deductible & and are not taxed until withdrawn
- Two benefits to investor: investments made with pretax money and no taxes on the income & growth UNTIL the money is paid out
36
Q
Tax-free Income
A
- Municipal bonds pay interest that is free from federal taxation (some cases where it is taxed at state level)
- Depending on the investor’s tax bracket, tax-free income may result in higher returns on an after-tax basis
37
Q
Laws & Regulations Investment Constraints
A
- Example would be the case of the accredited investor - perfect security to meet objective but can’t make the purchase bc of lack of accredited status
- Example is the desired security is not registered for sale in the client’s state of residence
- Certain investments that are illegal or inappropriate for an IRA
38
Q
Unique Circumstances and/or Preference Investment Constraints
A
- Some of the same goals keep coming up so it is important to understand that these are all unique individuals with their own needs & wants
- Desire to avoid investing in certain industries like ESG (Environment, Social & Governance) Investing - strong feeling about environmental issues and won’t invest in companies considered polluters or create health issues or investor has parent die of lung cancer won’t invest in tobacco companies
- Unique cases like receiving a large inheritance or multi-million dollar lottery win could change objectives pretty quickly
39
Q
Suitability
A
- FINRA’s suitability rules have always been based on a fundamental requirement to deal fairly with customers
- Firms and their associated persons must have a reasonable basis to believe that recommended transaction or investment strategy involving securities is suitable for the customer
- The more info a registered rep has about a customer’s income, current investment portfolio, retirement plan, net worth, customer’s financial situation the better the recommendation
- The more a customer knows about the risks & rewards of each type of investment, the better the decisions
40
Q
Rule 2111
A
- Effective in 2011 (proposed in 2009 by FINRA)
- Three main obligations: reasonable-basis, customer-specific and quantitative suitability
41
Q
Reasonable-Basis Suitability
A
- Registered rep has a reasonable basis to believe that a recommendation is suitable for at least SOME investors
- Rep must recognize the potential risks & rewards associated
- If the rep can’t explain risks, they are violating the rule
42
Q
Customer-Specific Suitability
A
- Registered rep has a reasonable basis to believe that the recommendation is suitable for a SPECIFIC customer
- Recommendations would be based on that customer’s investment profile
43
Q
Quantitative Suitability
A
- Registered rep has a reasonable basis for believing that a series of recommended transactions, even if suitable when viewed in isolation, are NOT excessive & UNsuitable for the customer when taken together
- Commissions generated, profits-to-cost ratio & the use of in-and-out trading in a customer’s account may provide a basis for a finding that there’s been a violation
44
Q
An investor opens an account but only provides minimum info. What are the responsibilities of the rep?
A
- The rep is limited to what can be recommended to the customer based on the info that was provided
- The rep is making recommendations that they believe are suitable based on the info they have
- It is when a customer insists on making a trade that is considered unsuitable that the order be marked unsolicited
45
Q
Options Accounts
A
- Trading options generally involves a higher degree of risk than stocks, bonds or mutual funds
- Higher risk requires that a designated supervisory person w/ knowledge about options must approve the account opening
- Special options disclosure document (ODD) that must be provided to any prospective options customer
46
Q
To get a customer’s account approved for options trading …
A
- Member firm or registered rep with the BD must exercise due dilligence
- Learn the essential facts relative to the customer such as investment experience and knowledge - # of years of trading & the size of the trade, frequency & type of transactions for options, stocks and bonds, commodities
- Designated supervisor uses this info to approve or disapprove the account
47
Q
Options Account Approval Will Indicate
A
- Date the ODD is furnished to customer
- Nature & types of transactions for which the account is approved (buying, covered writing, uncovered writing, spreading, discretionary transactions)
- Name of the registered rep assigned
- Name of the supervisor approving
- Date of approval
- Dates of verification of currency of account info
48
Q
Special Options Account Agreement
A
- Describes the risks of options trading & the rules the customer must follow
- Must be signed & returned to the firm/rep within 15 days after the account has been approved
- Customer agrees to advise the firm of any changes that occur to their financial situation, investment objectives, etc
49
Q
Order of Steps in Opening An Options Account
A
- Obtain essential facts about the customer
- Give the customer an options disclosure document (ODD)
- Have the manager approve the account
- Enter the initial order
- Have the customer sign & return the options agreement within 15 days
50
Q
Margin Accounts
A
- Requires more documentation than opening a regular cash account
- Includes 3 documents: credit agreement (mandatory), the hypothecation agreement (mandatory), a loan consent (optional)
- FINRA rules require that the client sign the margin documents no later than the first trade in the account
51
Q
Margin Credit Agreement
A
- Discloses the terms of the credit extended by the BD
- Includes the method of interest computation & situations under which interest rates may change
- Must be signed
52
Q
Margin Hypothecation Agreement
A
- In a margin account, the collateral is the security purchased on margin
- This gives the BD a lien on the customer’s margin securities
- Must be signed
53
Q
Margin Loan Consent Form
A
- Gives permission to the firm to loan the customer’s margin securities to other customers or BDs - usually for short sales
- Optional
54
Q
Margin Risk Disclosure
A
- BD must provide to margin customers on an annual basis
- Discusses the risks associated with margin trading like:
- Customer are not entitled to choose which securities can be sold if a maintenance call is not met
- Customers can lose more money than initially deposited
- Customers are not entitled to an extension of time to meet a margin call
- Firms can increase their in-house margin requirements w/o advance notice
55
Q
Discretionary Accounts
A
- Customer has authorized the BD or RR to make the investment decisions in the account
- Normally an order to buy or sell a security is at the direction of the client but many clients prefer the convenience of letting their securities professional “call the shots”
- Being able to determine the trading activity presents a potential conflict of interest as BDs/agent’s compensation is transaction-based (the more trading in the account = more income)
56
Q
Discretion
A
- Is defined as the authority to decide: which security, the # of shares or units OR whether to buy or sell
57
Q
An order is discretionary if any one of the three A’s are missing …
A
- Activity/action
- Amount
- Asset
58
Q
FINRA rules prohibit the exercise of any discretionary power by a BD/agent in a customer’s account unless …
A
- Customer has given PRIOR WRITTEN authorization (power of attorney) to a stated individual(s)
- Account has been accepted by the brokerage firm, as evidenced in writing by the firm and until the document is on file, no discretionary transactions can take place
- Customers may also continue to enter orders on their own if they wish
59
Q
Discretion - Time or Place
A
- Exception to the discretionary rule
- An oral grant of time or price discretion is limited to the end of the biz day on which the customer grants it
- If the order is to be good longer, the customer must state it in writing
- Any exercise of time or price discretion must be reflected on the order ticket (as is the case w/ regular discretion)
- FOR EXAMPLE: “Buy 100 shares of ABC for my account whenever you think the price is right.” is not a discretionary order bc the client has specified the action (buy), the amount (100 shares) and the asset (ABC) - time or price are not considered discretion
60
Q
Discretionary Account Are Subject to Rules
A
- Each discretionary order must be identified as such when entered
- An officer or partner of the brokerage house must approve each order promptly and in writing (not necessarily before order entry)
- Record must be kept of all transactions
- No excessive trading or churning may occur
- Account must be checked regularly
61
Q
Fiduciary Accounts
A
- Requires evidence of the individual’s appointment & authority which usually comes from the court
- No documentation is required for an individual to open an UGMA or UTMA
- Discretion authority usually makes one a fiduciary
62
Q
Fiduciary
A
- One who has the legal power to act on behalf of another person
- Examples: trustee named on a trust, executor designated in a decedent’s will, admin appointed by the court to liquidate the estate of a person who died (w/o a will), guardian designated by the courts to handle a minor’s affairs, receiver of a bankruptcy or a conservator
63
Q
Corporate Accounts
A
- Must establish:
- The biz’s legal rights to pen an investment account
- Indication of any limitations that the owners, the stockholders, a court or any other entity has placed on the securities in which the biz can invest
- Who will represent the biz in transactions
- Must obtain a copy of the corporate charter & corporate resolution
64
Q
Corporate Charter
A
- Is proof that the corporation does exist
65
Q
Corporate Resolution
A
- Authorizes both the opening of the account & the officers designated to enter orders
66
Q
Partnership Accounts
A
- Partnerships frequently open cash, margin, retirement & other types of investment accounts for biz purposes
- Must complete a partnership agreement stating which of the partners can make transactions and well as any investment limitations (if any)
- Amended partnership agreement must be obtained each year if changes have been made
67
Q
Sole Prop Accounts
A
- Is opened like an individual account
68
Q
Numbered Accounts
A
- Customer’s account may only be identified by only a multi-digit number or symbol
- Customer must sign a form certifying the they own the account(s) identified by the number or symbols
- Tax reporting is done the same as any other account
- Example: celebrities for privacy
