Unit 7: Ethics Flashcards
“The client agrees to waive rule violations by the IA (or other securities professional)” the answer is the one that states
“waivers are never permitted.”
Hedge clauses may not be used to
disclaim statements that are inherently misleading.
What hedge clause would generally be acceptable to the Admin?
A hedge clause that limits the investment adviser’s liability for losses caused by conditions and events beyond its control, such as war, strikes, and natural disasters.
Compensation details must
always be disclosed
Performance-based compensation is prohibited under all circumstances unless there is a qualifying exception.
Exceptions:
- A natural person or company that immediately after entering into the contract has at least $1 mil AUM of the IA
- A natural person of company that the IA has reason to believe that immediately prior to entering into the contract has a net worth exclusive of the primary residence in excess of $2.1 mil
- A natural person who is an offer or director of the IA or IAR who have been employed in the industry at least 12 months
A fee based on the average amount of money under management over a particular period is
not considered to be a performance fee.
The most common type of performance fee is known
fulcrum fee.
The fee is averaged over a specified period with an increase or decrease in proportion to the investment performance in relation to the performance of a specified index.
In regard to performance-based compensation:
The advisor must use net performance (consider both gains and losses).
The Admin has the power to authorize this type of fee even when the client doesn’t meet the financial requirements
The Investment Advisers Act of 1940 permits payment of cash referral fees to solicitors, providing the below conditions are met:
The IA is registered under the Advisers Act
Cannot be subject to a statutory disqualification
Fees are to be paid pursuant to a written agreement to which the investment adviser is a party
HOWEVER, even if the above are all met, cash referral fees are prohibited unless they are made in one of these circumstances:
Payments are for the provision of impersonal advisory services
The adviser pays a referral fee to a person affiliated with the adviser
Fees may be paid involving 3rd party solicitors who are not persons affiliated with the adviser
Contents of the solicitor’s brochure:
- Name of solicitor
- Name of IA
- Nature of the relationship between the solicitor and IA
- Fact that the solicitor will receive compensation
When a lawyer, accountant, or insurance agent refers a client to an IA, it would be permitted for the IA to offer
a nominal fee (in the range of several hundred dollars) as a thank you.
What would be prohibited is to have the size of the fee based on the size of the client account or the fees generated by managing that account.
To make cash payments to solicitors, the agreement must:
- Be in writing
- Provide for disclosure of any affiliations between the advisor and the solicitor
- Provide that no one subject to statutory disqualification be compensated
- Follow a script approved by the adviser
- A solicitor brochure be delivered as well (3rd party)
To make cash payments to solicitors, the agreement must:
- Be in writing
- Provide for disclosure of any affiliations between the advisor and the solicitor
- Provide that no one subject to statutory disqualification be compensated
- Follow a script approved by the adviser
- A solicitor brochure be delivered as well (3rd party)
Safe harbor
compensation to an investment adviser from a BD that will generally not be considered unethical
The practice of allocating certain of these dollars to pay for the research component has come to be called
soft dollars
The SEC has defined soft dollar practices as
arrangements under which products or services other than execution of securities transactions are obtained by an investment adviser from or through a BD in exchange for the direction by the IA of client brokerage transactions to the BD, frequently referred to as directed transactions.
Soft dollar compensation is when an IA
derives an economic benefit from the use of a client’s commission dollars.
The following items that, if received as soft dollar compensation, would likely fall under 28(E)’s safe harbor:
- Research reports analyzing the performance of a particular company or stock
- Financial newsletter and trade journals could be eligible research if they relate with appropriate specificity
- Quantitative analytical software
- Seminars or conferences with appropriate content
- Effecting and clearing securities trades
On the other hand, likely to fall out of the safe harbor would be:
- Telephone lines
- Office furniture (including computer hardware)
- Travel expenses associated with attending seminars
- Rent
- Any softwares that does not relate directly to analysis of securities
- Payment for training courses for this exam
- Internet service
Directed brokerage
the practice of asking or permitting clients to a spend trades to a specific BD for execution
Trade aggregation and allocation
the practice of bundling (sometimes called bunching) trades to obtain volume discounts on execution costs
Qualified custodian is a:
- bank or savings association that has deposits insured by the FDIC under the Federal Deposit Insurance Act
- registered BD holding the client assets in customer accounts
- foreign financial institution that customarily holds financial assets for its customers, provided that the foreign financial institution keeps the advisory clients’ assets in customer account segregated from its proprietary assets
Most investment advisors do not
take custody and are unable to accept direct delivery of customer securities or funds exempt under the limited conditions described in this section
There are two major benefits to an investment adviser using a qualified custodian:
- Because the custodian is sending the quarterly reports to the client, that administrative burden is lifted from the investment adviser
- There is no requirement for a surprise annual audit by an independent accountant
Taking custody is considered to be of such significance that it requires
prompt notification to the Admin by the IA by updating the Form ADV.
Using a qualified custodian still constitutes
a form of custody and requires notification to the Admin.
Whether custody is maintained by the IA itself or by a qualified custodian, statements must be sent at least
quarterly
3rd party checks must be
forwarded
Under the USA, custody indicates that the adviser
has physical possession over its clients’ certificates and monies.
Although the general rule is that state-registered IA having custody must maintain a minimum net worth of $35,000 (or equivalent surety bond), the net worth/bond requirements are waived in two cases:
- Advisers having custody solely due to direct fee deduction and who keep the required records and make the required notifications to clients
- Advisers having custody solely due to advising pooled investment vehicles and who keep the required records and make the required notifications to clients
Form ADV-E is used as a
cover page for a certificate of accounting of securities and funds of which the IA has custody.
Filing of the form ADV-E is required only when the IA,
rather than a qualified custodian, maintains custody of customer funds/securities.
Discretionary account
account set up with preapproved authority for a securities professional to make transactions without having to ask for a specific approval.
An order is discretionary if any of the 3 As are missing:
Activity
Amount
Asset
What is not discretionary?
time or price
“Buy 100 shares of ABC for my account whenever you think the price is right” is NOT a discretionary order.
Discretion for Investment Advisers
permits oral discretionary authority to be used for transactions in a customer’s account during the first 10 business days after the date of the first discretionary transaction.
After that time, if the written authorization has not been received, no further discretionary activity can take place.
The greatest concern of regulators when it comes to discretionary accounts is the possibility
of the account being churned
What is churning?
rading in a discretionary account that are excess in size or frequency
3rd Party Trading Authorization
can be done with a written 3rd-party trading authorization on file
Customer’s “free” securities are those which have
no lien against them.
Securities pledged as collateral in a margin account have a lien against them.
Current Transaction Report (CTRs)
The Bank Secrecy Act requires every financial institution to electronically file through the Department of the U.S. Treasury, a currency transaction report (CTR) on FinCEN form 112 for each cash transaction that exceeds $10,000 within 15 days.
Structuring
deposits designed to fall under the $10,000 radar (prohibited activity)
An unethical business practice is making blanket recommendations. That is when
the investment adviser recommends the same security to most or all clients without regard to individual suitability
What do you do when a client is unhappy with a recommendation due to lack of understanding?
The first attempt is to impart some education. However, the client is the one who has to make the final decision.
Free Lunch Seminars
if not clearly presented, NASAA will consider the delivery of the seminar a prohibited business practice
Withholding Shares of a public offering
Failing to make a bona fide public offering of all of the securities allotted to a BD for distribution
A complaint received by electronic means (email) is considered
a written complaint.
Any written complaint must be brought to the attention of the agent’s supervisor without hesitation.
Written complaints must be kept on file by broker-dealers for 3 years and by IA for 5 years.
Front running
placing a personal order ahead of a previously received customer order (trading ahead)
Backdating records
all records and documents must reflect their actual dates
Engaging is the practice of
ending or borrowing money or securities from a customer
Which clients can you borrow from?
- Bank/financial institution in the business of making loans
- BD in a margin account
- Person affiliated with your firm
Which client CAN’T you borrow from?
- Employee at the lending institution who process/approves your loan
- Agent at the BD who services your margin account
- Mortgage broker
- Family member
Fictitious Accounts
account containing fictitious information such as “beefing up” a client’s net worth to enable him to engage in margin or options trading
Agents cannot share in the profits or losses of client accounts unless
the client and the BD supply prior written approval.
Only who can share in the profits or losses in their client’s accounts?
ONLY AGENTS
An agent and a customer can have a
joint account
Dividing or splitting the agent’s commissions, profits, or other compensation with any person that is not registered for the same BD is allowed UNLESS
it increases the transaction cost to the client
If an IA provides a report to a client that is prepared by a 3rd party, the advisor has a responsibility to
disclose that fact to the client.
SEC Release IA-1092 warns against
effecting transactions in which the advisor has a personal interest in a manner that could result in preferring his own interest to that of his advisory clients.
Material nonpublic inside information (MNPI) under securities law is
any information about a company that has not been communicated to the general public and that would likely affect the value of a security.
Even if you acquire the information “accidentally,” you cannot use it until it becomes public.
Treble damage means that
the guilty party could be fined up to 3 times any ill-gotten gains or up to 3 times any losses avoided by using inside information to get out before a market drop.
If the SEC should elect to pursue criminal action, penalties would include potential jail time with a max sentence of
20 years
Chinese Wall Doctrine
It is a violation of the law only when
you use the MNPI for trading.
Selling Away
effecting securities transactions not recorded on the regular books or records of the BD which the agent represents, unless the transactions are authorized in writing by the BD prior to execution of the transaction.
The exam may refer to selling away as
a trade made off the books
Instead of churning, the exam may refer to it as
excessive trading
Matched orders occur when
when an order to buy or sell securities is entered with knowledge that a matching order on the opposite side of the transaction has been or wil be entered.
A wash trade is
an order to buy or sell securities wrestling in no change of beneficial ownership.
This is typically done by an investor buying in one brokerage account and simultaneously selling through another.
Arbitrage
the simultaneous buying and selling of the same security in different markets to take advantage of different prices - this is NOT a form of market manipulation.
I think this is permitted.
Section 13(f) of the Securities Exchange Act of 1934 requires
that any institutional investment manager that exercises investment discretion over an equity portfolio with a market value in any of the preceding 12 months of $100 mil or more in 13(f) securities file a Form 13F with the SEC.
Form 13F must be filed
quarterly, within 45 days of the end of each quarter.
Access Person
any of the advisor’s supervised persons
As an access person, any personal securities transactions must be
reported on a quarterly basis.
Political Contributions by Investment Advisers (Pay to Play Rule)
Prohibits investment advisers from receiving compensation for advisory services to a government entity for 2 years after the firm or any covered employee makes a political contribution.
De Minimis Exception
allows covered employees to make contributions up to $350 per official per election or $150 for other elections
New Hire Exception
political contributions made by the new hire more than 6 months before coming on board do not trigger the ban. However, if the new hire’s role is soliciting, this exception does not apply - there would be a 2 year “look back.”
Returned Contributions Exceptions
an IA can be expected from the prohibition if the contribution is returned under certain conditions
- IA discovered the contribution within 4 months
- The contribution be returned within 60 calendar days
Identity theft means
a fraud committed or attempted using the identifying information of another person without authority.
Red flag means
a pattern, practice, or specific activity that indicated the possible existence of identity theft.
The term covered account is defined as:
- An account that a financial institution offers or maintains that involved or is designed to permit multiple payments or transactions
- Any other account that the financial institution offers or maintains for which there is a reasonably foreseeable risk to customer or to the safety and soundness of the financial institution from identity theft
Examples of a covered account is
a margin account
a brokerage account with a BD
an account maintained by a mutual fund (or its agent) that permits wire transfers or other payments to 3rd parties
Single-factor authentication
ID/password
Dual-factor authentication
key fobs/secure IDs
Adaptive-factor authentication
challenge questions
Biometric authentication
fingerprint scan
BDs and IAs backing up client data should make sure
it is encrypted
Regulation S-P
requires
that firms take identity theft seriously and have adequate safeguards in the form of privacy policies to protect nonpublic personal information from authorized access or use.
Regulation S-P permits
firms to disclose nonpublic personal information to unaffiliated 3rd parties unless the customer has elected to opt out of the disclosure.
Customers are given 30 days to opt out.
Consumer
an individual who obtains a financial product or service from a firm and has no further contact with the firm
Customer
an individual who has an ongoing relationship with a firm
Protection of customer confidential information is an obligation of
the agent servicing the customer’s account
BD maintaining the account
CUSTOMER
IA in an advisory account.
