Unit 2:  Obtain Necessary Suitability Information and Approvals

Question 1

Before making a recommendation for a new customer, a registered representative must try to find out as much as possible about that person’s financial and nonfinancial situation. In general, the best way to get the proper information is by completing a (____). This profile should contain financial and nonfinancial information.

Answer 1

Customer Profile

Question 2

A customer’s (____) is calculated as:

Assets - Liabilities

Answer 2

Net worth

Question 3

• What is the value of any cash, CDs, and savings accounts (usually looked at as an emergency fund, generally considered to be a primary requirement for investing in securities).
• What are the values of tangible assets? Home? Car? Collectibles? Jewelry?
• What are the values of securities you currently own?
• Have you established long-term investment accounts, and what are the values of those accounts? Do you have an IRA, corporate pension, or profit-sharing plan, and what are the values of those plans?
• What is the cash value of your life insurance?
• What are your liabilities? How much do you owe on your mortgage? Car? Outstanding loans?
• Are there any loans against insurance cash value?- How large is your credit card debt?

From this information, we can determine the net worth and how much of it is liquid.

Answer 3

Representatives determine the status of a customer’s personal balance sheet by asking such questions.

Question 4

To make appropriate investment recommendations, reps must know the customer’s income situation.

They gather this info by asking the Qs similar to:

Answer 4

• What is your total gross income? Total family income?
• How much do you pay in monthly expenses?
• What is your net spendable income after expenses? How much of this is available for
  investment?
• How secure is your employment?

Question 5

Before recommending any investment to a customer, a registered representative must, at a minimum, make a reasonable effort to obtain information concerning the customer’s financial status, tax status, and investment objectives.

TAKE NOTE

Answer 5

Taking into consideration all of this information indicates to the securities professional the extent to which the client is able to make a lump-sum investment (the balance sheet shows a large amount of net assets available), and/or periodic investments (the income statement reveals a positive cash flow—there is “money left at the end of the month”). |

Question 6

A family balance sheet only includes assets and liabilities, not income like salary, dividends, or interest, or amounts paid for expenses.

TEST TOPIC ALERT

Question 7

An individual’s net worth is

A. the difference between the individual’s assets and the individual’s liabilities.
B. best determined by examining the individual’s personal income statement.
C. largely irrelevant in identifying the individual’s investment objectives.
D. another term for discretionary income.

PRACTICE QUESTION

Answer 7

An individual’s net worth is the difference between the individual’s assets and the individual’s liabilities. It is determined from the personal balance sheet rather than from the personal income statement. Net worth is relevant in determining an individual’s investment objectives. Clients with a negative net worth might find it preferable to reduce their debt level before beginning an investment program.

Answer: A.

Question 8

Nonfinancial considerations often carry more weight than the financial considerations and include the following:

• Age
• Marital status
• Number and ages of dependents
• Employment
• Employment of family members
• Current and future family educational needs
• Current and future family health care needs
• risk tolerance
• Attitudes and values, such as ESG investing
• Tax status

Answer 8

Once registered representatives have an idea of the customer’s financial status, they gather information on the nonfinancial status. A nonfinancial investment consideration is one that cannot be expressed as a sum of money or a numerical cash flow (risk tolerance, or tax bracket, for example).

Question 9

• What kind of risks can you afford to take
• How liquid must your investments be?
• How important are tax considerations?
• Are you seeking long-term or short-term investments?
• What is your investment experience?
• What types of investments do you currently hold?
• How would you react to a loss of 5% of your principal? 10%? 50%?
• What level of return do you consider good? Poor? Excellent?
• What combination of risks and returns do you feel comfortable with?
• What is your investment temperament?
• Do you get bored with stable investments
• Can you tolerate market fluctuations?
• How stable is your income?
• Do you anticipate any financial changes in the future?

To understand a customer’s attitude for investment, the representative should ask questions similar to the following:

Question 10

There certainly are shades of gray when defining a customer’s risk tolerance. This makes it even more critical that you and the customer are on the same page when it comes to risk tolerance. For test purposes, you can usually get the correct answer by identifying the key word.

Answer 10

• If you see low risk-conservative
• If you see some risk—moderate
• If you see more than average risk—moderately aggressive
• If you see high risk—aggressive

If you key on the right word, you’ll get the correct answer

Question 11

A registered reps job is to assist customers in meeting their financial objectives. Responsivle reps must learn all about the customer’s financial situations.

Securities laws prohibit unsuitable recommendations

Take Note

Question 12

If a customer contacts a registered representative and wants to purchase securities that the rep feels are not suitable for the client, the registered representative

Answer 12

has a responsibility to tell the customer that she feels the trade is not suitable. If the customer insists on the purchase, the registered representative should place the order and mark the trade unsolicited.

Question 13

Who is an Accredited Investor?

Answer 13

• Any individual with net worth in excess of $1 million, exclusive of the equity in a primary residence
• any individual who had an income in excess of $200,000 in each of the two most recent years or
• joint income in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year.

Question 14

Although the legal obligation for determining accredited investor status is that of the issuer, FINRA believes that each member should take reasonable steps to verify that status where applicable. Here are some of the recommended steps:

• Tax returns or W-2s for the previous two years
• Obtaining a written representation from the purchaser that he has a reasonable expectation of reaching the income level necessary to qualify as an accredited investor during the current year
• If the purchaser is an accredited investor on the basis of the $1 million net worth, reviewing one or more of the following types of documentation dated within the prior three months:
  
  • Bank or brokerage account statements
  • A credit report from at least one of the nationwide consumer reporting agencies

Answer 14

Alternatively, the member firm can comply by doing the following:

• Obtaining a written confirmation from one of the following persons or entities that such person or entity has taken reasonable steps to verify that the purchaser is an accredited investor within the prior three months and has determined that such purchaser is an accredited investor
  
  • A registered broker-dealer
  • An investment adviser registered with the Securities and Exchange Commission
    - A licensed attorney who is in good standing under the laws of the jurisdictions in which she is admitted to practice law
    - A certified public accountant who is duly registered and in good standing under the laws of the place of her residence or principal office

Question 15

Using the information gathered about a client’s circumstances and financial resources, the registered representative and client should establish financial goals. Many investors confuse goals and objectives. A goal is where you want to be (the “end game”), while objectives are the steps taken along the way to reach the goal. Some commonly specified goals include

Answer 15

■ planning for college education;
■ retirement;
■ saving for a future purchase, such as a home;
■ philanthropy;
■ capital to start a business; and
■ leaving a legacy.

Question 16

________, _______, and _______ are three essential components of an investment strategy that can help an investor meet their financial goals. Each component serves a specific purpose and contributes to a balanced and diversified portfolio that aligns with the investor’s risk tolerance, time horizon, and overall objectives.

Answer 16

Growth, income, and stability are three essential components of an investment strategy that can help an investor meet their financial goals. Each component serves a specific purpose and contributes to a balanced and diversified portfolio that aligns with the investor’s risk tolerance, time horizon, and overall objectives.

Question 17

are factors or limitations that restrict or influence an investor’s ability to construct and manage an investment portfolio to meet their financial goals.

Answer 17

Investment Constraints

Question 18

is a specific term used to refer to an objective that can be either to maximize income or maximize growth without regard to stability

Answer 18

speculation

Question 19

Which of the following is properly referred to as an investment goal rather than objective?

A. Current income
B. Endowing a scholarship at your alma mater
C. Conservative growth
D. Speculation

PRACTICE QUESTION

Answer 19

Goals are what you hope to have the money for. Objectives are the way to get there. Remember the triangle for G, I, and S. The S is for stability. The opposite of stability is speculation, and that is another one of the objectives. For some investors, that is the route they choose to take.

Answer: B.

Question 20

are the steps taken by investors to help them reach their stated goals.

Answer 20

investment objectives

Question 21

are limitations or restrictions that are specific to your client.

include - among others:

• liquidity needs
• time horizon
• personal ethical choices (no tabacco or acohol stocks)

Answer 21

Investment constraints

Question 22

bank insured CDs meet the preservation of capital objective for those investors seeking to avoid any drop in the value of their investments,

however, what are some of the trade-offs?

Answer 22

• by reducing risk, the investor is missing out on the opportunity for higher income
• as fixed-income investments, they are exposed to inflation (purchasing power risk)

Question 23

is an example of a security suitable for an investor who wants both income & stability is one issued by the (____).

on the other hand, one wanting to maximize income would do so at the risk of safety (remember the equalatoral triangle with the three sides; G, I, & S) by investing in (____).

Answer 23

the U.S. Treasury

&

high-yield (junk) bonds

Question 24

• margin
• selling short
• options trading
• penny stocks

are all examples of what type of investments

Answer 24

Speculative

meaning they are seeking higher rewards at the cost of higher risks

Question 25

An investor’s (____) and liquidity needs will determine the level of volatility the client should assume.

Over a 20- or 30-year time frame, dramatic short-term volatility is acceptable, even to those who are risk averse.

Money that will be needed within three to five years should be invested for safety and liquidity. (____) is a particularly important investment constraint when planning for college education and for retirement.

Answer 25

Time Horizon

Question 26

Liquid investments include:

Answer 26

• securities listed on an exchange or Nasdaq,
• mutual funds,
• exchange-traded funds, and
• most real estate investment trusts (REITs).

Question 27

Illiquid investments include:

Answer 27

• annuities, when initially purchased and/or when the annuitant is under age
• real estate;
• securities purchased in a private placement;
• DPPs; and
• hedge funds.

Question 28

For exam purposes, there are 2 ways to reduce taxes

Answer 28

• Tax deferral. Contributions to an IRA, a qualified retirement plan, or a TSA may be tax deductible and are not taxed until withdrawn. This gives two benefits to the investor. Firstly, the investments are made with pretax money. Secondly, there are no taxes on the income and growth until the money is paid out. That is the power of deferring taxes. Tax-free income.
• Municipal bonds pay interest that is free from federal taxation. There are cases where the income would be taxed on the state level; that will be covered in Unit 6. Municipal bonds generally pay interest at a lower rate than taxable bonds. That is because the interest is tax-free. Depending on the investor’s tax bracket, the municipal bond may result in higher returns on an after-tax basis. As covered in Unit 1, it is also possible to generate tax-free income using a Roth IRA and the Coverdell ESA. In Unit 6, we will discuss the Section 529 plan—another way to provide tax-free income.

Question 29

became effective in 2011, is composed of three main obligations. Those three are

• reasonable-basis suitability,
• customer-specific suitability, and
• quantitative suitability.

Answer 29

FINRA Rule 2111

proposed in 2009 - became effective in 2011

Question 30

You must recognize the potential risks and rewards associated with the recommended security or strategy. If you can’t explain the risks when recommending a security or strategy, you are violating the (__________) rule.

Answer 30

Reasonable-basis suitability

Question 31

The registered representative, having control over a customer account, has to have a reasonable basis for believing that a series of recommended transactions, even if suitable when viewed in isolation, are not excessive and unsuitable for the customer when taken together.

No single test defines excessive activity; however, factors such as the commissions generated, the profits-to-cost ratio, and the use of in-and-out trading in a customer’s account may provide a basis for a finding that a member or registered representative has violated the (_____) obligation.

Answer 31

Quantitative suitability

Question 32

Before making a recommendation to a client, a registered representative is
I. required to perform a reasonable-basis suitability analysis.
II. not required to perform a reasonable-basis suitability analysis.
III. required to perform a customer-specific suitability analysis.
IV. not required to perform a customer-specific suitability analysis.

A. I and III
B. I and IV
C. II and III
D. II and IV

PRACTICE QUESTIONS

Answer 32

FINRA requires members and their registered representative who wish to make recommendations to perform both a reasonable-basis suitability analysis and a customer-specific suitability analysis. A reasonable-basis suitability analysis is necessary to ensure that an investment is suitable for some investors as opposed to a customer-specific suitability analysis, which is undertaken on a customer-by- customer basis.

Answer: A.

Question 33

A retail investor opens an account at your firm but only provides minimum information. She wants to invest for retirement in 20 years and is willing to take moderate risk. Which of the following statements best describes the responsibilities of the registered representative handling the account?

A. Recommendations cannot be made because the customer refuses to provide income information, personal assets and liabilities, or how much can be
invested.
B. The account cannot be opened without financial and nonfinancial
information.
C. Only unsolicited trades can be made in this account.
D. The representative is limited to what can be recommended to the customer based on the information that was provided.

Answer 33

When limited information is provided for the account, the registered representative will be limited to making recommendations that she believes are suitable based on the information she has. She is missing customer-specific suitability. It is when the customer insists on making a trade that is considered unsuitable that the order must be marked unsolicited.

Answer: D.

Question 34

• generally involves a higher degree of risk than stocks, bonds, or mutual funds.
• designated supervisory person with knowledge about options must approve the account opening.
• a special options disclosure document (ODD) that must be provided to any prospective customer
• investment experience and knowledge required

Answer 34

Options

Question 35

The account approval will indicate:
- the date the ODD is furnished to the customer;
- the nature and types of transactions for which the account is approved (e.g., buying, covered writing, uncovered writing, spreading, discretionary transactions);
- the name of the registered rep assigned to the account;
- the name of the supervisor approving the account;
- the date of approval; and
- the dates of verification of currency of account information.

Answer 35

Options account

Question 36

An options account agreement must be returned signed to the member firm within (____) days after the account has been approved.

Answer 36

15

If not returned by then, any positions in the account purchased during the review period must be sold

Question 37

When a registered representative opens a new options account for a client, in which
order must the following actions take place?
I. Obtain approval from a qualified supervisor.
II. Obtain essential facts from the customer.
III. Obtain a signed options agreement.
IV. Enter the initial order.

A. I, II, III, IV
B.I, II, IV, III
C. II, I, IV, III
D. II, I, III, IV

PRACTICE QUESTION

Answer 37

The steps in opening an options account occur in the following order:

obtain essential facts about the customer, give the customer an options disclosure document (ODD), have the manager approve the account, enter the initial order, and have the customer sign and return the options agreement within 15 days.

Answer: C.

Question 38

This type of account requires the following 3 documents

• the credit agreement (mandatory),
• the hypothecation agreement (mandatory), and
• a loan consent (optional).

Answer 38

Margin Account

FINRA rules require that the client sign the margin documents no later than the first trade in the account.

Question 39

discloses the terms of the credit extended by the broker-dealer. These include the method of interest computation and situations under which interest rates may change. As stated earlier, this must be signed.

Answer 39

Credit Agreement

Question 40

Margin loans are backed by collateral. In that way, they are similar to a home mortgage or a car loan. In the case of a mortgage, the house is pledged as collateral for the loan. In the case of the car, the title shows a lien to the lender. In a margin account, the collateral is the security purchased on margin. In essence, the (____) gives the broker-dealer a lien on the customer’s margin securities. And, as with the credit agreement, this must be signed by the customer.

Answer 40

Hypothecation Agreement

Question 41

When an investor signs a ____________, they acknowledge and agree that the broker may lend the securities in the margin account to other parties, such as short sellers, who need to borrow securities to cover their short positions. The broker earns interest income from these securities lending transactions and may share a portion of that income with the investor.

Answer 41

Loan Consent Form

Question 42

It is mandatory that the customer sign the credit agreement and hypothecation agreement. The loan consent form is optional.

TAKE NOTE

Question 43

In addition to the customer agreements, the member firm must make a special disclosure. Before opening a margin account, a broker-dealer must provide customers with a (____) document. This information must also be provided to margin customers on an annual basis. The document discusses the risks associated with margin trading, some of which follow:

• Customers 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 without advance notice.

Answer 43

Risk Disclosure

Question 44

When opening a margin account, it is mandatory that the customer sign

A. the credit agreement and the loan consent agreement.
B. the credit agreement and hypothecation agreement.
C. the hypothecation agreement and the loan consent agreement.
D. the credit agreement only.

PRACTICE QUESTION

Answer 44

The two documents that must be signed are the credit agreement and the hypothecation agreement. The loan consent agreement is optional.

Answer: B

Question 45

the customer has authorized the broker-dealer or registered representative to make the investment decisions in the account.

Answer 45

Discretionary Accounts

Question 46

is defined as the authority to decide

• which security,
• the number of shares or units, or
• whether to buy or sell.

Answer 46

Discretion

Normally, an order to buy or sell a security is at the direction of the client, generally via a telephone call or online. Many clients prefer the convenience of letting their securities professional “call the shots.” Being able to determine the trading activity in a client’s account presents a potential conflict of interest. In the case of broker-dealers and agents, their compensation is transaction-based. The more trading in the account, the more income.

Question 47

To identify a discretionary order, try this method: an order is discretionary if any one of the three As is missing.

The three As are:

• action,
• amount, and
• asset.

TEST TOPIC ALERT

Question 48

FINRA rules prohibit the exercise of any discretionary power by a broker-dealer or agent in a customer’s account unless

Answer 48

• the customer has given prior written authorization (a power of attorney) to a stated individual or individuals; and
• the account has been accepted by the brokerage firm, as evidenced in writing by the firm.

No discretionary transactions can take place without this document on file. Once authorization is given, the firm is legally empowered to make trading decisions for the account, although the customer may also continue to enter orders on his own if he wishes.

Question 49

There is an exception to the requirement that applies to the exercise of () or () discretion. This is discretion orally granted by the customer to purchase or sell a specific amount of a particular security (e.g., “Buy 100 shares of ABCD and get the best price you can”).

Answer 49

Time or Price discretion

Note: Any exercise of time or price discretion must be reflected on the order ticket (as is the case with regular discretion).

An oral grant of time or price discretion is limited to the end of the business day on which the customer grants it. If the order is to be good from longer than that day, the customer must state it in writing.

Question 50

Discretion does not apply to decisions regarding the timing of an investment r the price at which it is acquired.

Take Note

Answer 50

An order from a customer worded “Buy 100 shares of ABC for my account whenever you think the price is right” is not a discretionary order because the client has specified the action (buy), the amount (100 shares) and the asset (ABC). Time or price are not considered discretion.

EXAMPLE

Question 51

In addition to requiring the proper documentation, discretionary accounts are subject to the following rules:

Answer 51

• Each discretionary order must be identified as such when it is entered for execution.
• An officer or a partner of the brokerage house must approve each order promptly and in writing, but not necessarily before order entry.
• A record must be kept of all transactions.
• No excessive trading or churning may occur in the account relative to the size of the account and the customer’s investment objectives.
• The account must be checked regularly.

Question 52

• a trustee named to administer a trust,
• an executor designated in a decedent’s will to manage the affairs of the estate,
• an administrator appointed by the courts to liquidate the estate of a person who died intestate (without a will),
• a guardian designated by the courts to handle a minor’s affairs until the minor reaches the age of majority or to handle an incompetent person’s affairs,
• a custodian of a Uniform Gift to Minors Account (UGMA) or a Uniform Transfer to Minors Account (UTMA),
• a receiver in a bankruptcy, and
• a conservator for an incompetent person.

Are examples of what type of accounts

Answer 52

Fiduciary Accounts

Discrentionary authority usually makes one a fiduciary

Question 53

This might not be on the exam, but you should know that fiduciaries are obligated to follow the Uniform Prudent Investor Act (UPIA). UPIA currently appears on some other exams so it may soon appear on the Series 7 Top-Off Exam.

TAKE NOTE

Question 54

Which of the following accounts could be opened without any legal documents?

A. UTMA
B. Trust
C. Estate
D. Pension plan

PRACTICE QUESTION

Answer 54

Fiduciary accounts require legal documentation establishing the power of the fiduciary. There is an exception for UTMA and UGMA accounts.

Answer: A.

Question 55

A registered representative who opens a corporate account must establish

Answer 55

• the business’s legal right to open an investment account;
• an indication of any limitations that the owners, the stockholders, a court, or any other entity has placed on the securities in which the business can invest; and
• who will represent the business in transactions involving the account.

Question 56

When opening an account for a corporation, a firm must obtain a copy of the (________),
as well as a (____).

Answer 56

Corporate Charter

&

Corporate Resolution

Question 57

is proof that the corporation does exist, and the resolution authorizes both the opening of the account and the officers designated to enter orders.

Answer 57

The Charter

Question 58

• frequently open cash, margin, retirement, and other types of accounts necessary for business purposes.
• must complete a partnership agreement stating which of the partners can make transactions for the account.
• If the partnership opens a margin account, the partnership must disclose any investment limitations.
• An amended partnership agreement must be obtained each year if changes have been made.

Answer 58

Partnership Account

Question 59

If Alpha Enterprises, Inc., wants to open a cash account, a firm must have all of the following documents on file except

A. a hypothecation agreement.
B. a new account form.
C. a copy of the corporate charter.
D. a copy of the corporate resolution.

PRACTICE QUESTION

Answer 59

A hypothecation agreement is only needed to open a margin account. Any cash account must have a new account form on file. For corporate account, the corporation’s charter must be provided as proof that the corporation exists. In addition, a corporate resolution is needed to designate the officer(s) authorized to enter orders.

Answer: A.