CHAPTER 11: Regulation of Securities - Introduction

Look Out!The term "security" is vitally important to theUSA; therefore, you

will find the exactdefinition from the USA below. You arestrongly encouraged to memorize this definition for the exam.

Definition: Stock

As defined by the Uniform Securities Act, asecurity is any of the following:

a note;

stock;

treasury stock;

security future;

bond;

debenture;

evidence of indebtedness;

certificate of interest or

participation in a profit-sharing agreement;

collateral trust certificate;

pre-organization certificate or subscription;

transferable share;

investment contract;

voting trust certificate;

certificate of deposit for a security;

fractional undivided interest in oil, gas, or other mineral rights;

put, call, straddle, option, or privilege on a security,

certificate of deposit, or

group or index of securities, including an interest therein or based

on the value thereof; put, call, straddle, option, or

privilege entered into on a national securities exchange relating to

foreign currency; or, in general,

an interest or instrument commonly known as a "security"; or

a certificate of interest or participation in,

temporary or interim certificate for, receipt for, guarantee of, or

warrant or right to subscribe to or purchase any of the foregoing.

Regulation of Securities - Stock Term Specifics

includes both certified and uncertified securities; 

does not include an insurance or endowment policy or fixed annuity

contract; 

does not include an interest in a contributory or noncontributory

pension or welfare plan subject to the Employee Retirement Income

Security Act of 1974; 

includes an investment in a common enterprise with the

expectation of profits to be derived primarily from the efforts of a

person other than the investor and a "common enterprise" -

meaning an enterprise in which the fortunes of the investor are

interwoven with those of either the person offering the investment,

a third party, or other investors; and 

includes, as an "investment contract", an interest in a limited

partnership and a limited liability company and, an investment in a

viatical settlement or similar agreement. o Viatical Settlement  is an arrangement in which someone with a

terminal disease sells his or her life insurance policy at a discount from its face value for ready cash. The buyer cashes in the full amount of the policy when the original owner dies.

Look Out!The factor that determines if something is a security is whether the item is some sort of venture that could possibly return additional

income. For example, if you were to purchase a portion of a contractual interest related to buying homes - in which you were not the direct owner of the home - you would have purchased a

security. If you owned a collection of stamps, you would not have a security. However, if you owned a salable or tradable interest in

the stamps, but not the stamps themselves, you would have a security. Lastly, domestic currency is not a security.

Example

Bob owns a fancy set of ties, which he considers extremely valuable. He

decides to sell the ties on eBay™, putting them up for auction starting at

$10,000. Has he created a security by initiating an electronic auction?

Answer

No, because the purchaser of the ties will receive them directly, and as far

as we know, no third party benefited from the transaction - eBay™ only

benefited bycharging a fee, which does not qualify it as a broker-dealer.

Regulation of Securities - Definition: Sale and Offer to Sell

The USA defines a sale and an offer to sell as follows:

Sale includes: 

every contract of sale,

contract to sell, or

disposition of, a security or

interest in a security for value.

Offer to sell includes:

every attempt, or

offer to dispose of, or

solicitation of an offer to purchase, a security or

interest in a security for value.

Both terms include:

a security given or delivered with, or as a bonus on account of, a

purchase of securities or any other thing constituting part of the

subject of the purchase and having been offered and sold for value; 

a gift of assessable stock involving an offer and sale; and 

a sale/offer of a warrant/right to purchase/subscribe to another

security of the same or another issuer, and a sale/offer of a security

that gives the holder a present or future right or privilege to convert

the security into another security of the same or another issuer,

including an offer of the other security.

Regulation of Securities - Other Definitions

The USA also defines the following terms:

A non-issuer transaction or non-issuer distribution is a

transaction or distribution that is not directly or indirectly for the

benefit of the issuer. 

The term guaranteed means guaranteed as to payment of all principal and

all interest.

Exam Tips and TricksThe following is a list of additional securities-related information,

mostly pertaining to issuers. Much of this will be on the test, so make sure you do not skip this section!

Unlawful sale - The USA clearly mentions that it is "unlawful for a

person to offer or sell a security" in a state unless: 

o "the security is a federal covered security".

o "the security, transaction, or offer is exempted from

registration".

o "the security is registered under" the USA. 

Initial registration - Before an offer to sell a security can be

made, a registrant(the issuer, insider or broker-dealer) must file a

registration with the state Administrator. 

Filing fees - Issuers are required to pay filing fees at both initial

registration and annual re-registration. Filing fees fluctuate from

state to state. If a filing fee is not paid (or an issuer fails to comply

with a notice), the Administrator may issue a stop order

"suspending the offer and sale of a federal covered security". 

General filings - The registrant must supply general information

regarding the securities to the Administrator, including the

following:

o The states where the securities will be solicited/offered

o Amount of securities that will be issued

o Any guidelines/judgments required by the SEC or other

administrative or judicial entity 

Registration records - The USA specifically states that, along with

the initial registration statement, offerings must be accompanied by

these: 

o A copy of the latest form of prospectus filed under the

Securities Act of 1933

o A copy of the articles of incorporation and bylaws, or their

substantial equivalents currently in effect

o A copy of any agreement with or among underwriters

o A copy of any indenture or other instrument governing the

issuance of the security to be registered

o Copies of any other information or any other records filed by

the issuer under the Securities Act of 1933 requested by the

Administrator 

Effective date  - Once an offering is accepted by the Administrator,

it is valid for one year after the date of approval (the effective

date). Offerings may be renewed the following year, if the entire

issue was not sold. 

Effectiveness of registration statement - The USA states: "If

the federal registration statement becomes effective before each of

the conditions is satisfied or is waived by the Administrator, the

registration statement is automatically effective ..." The conditions

are those of registration records, above. 

Periodic reports - Issuers may be required to file reports "to keep

the information or other record in the registration statement

reasonably current and to disclose the progress of the offering." The

Administrator cannot require the reports to be filed more often than

quarterly. 

Post-effective amendments - A "registration statement may be

amended after the effective date" to alter information, or to

increase the number of securities to be offered. Of course, on

amendment, an issuer may be required to pay a registration fee. 

Form of subscription - It may be required that an offering "be

sold only on a specified form of subscription or sale contract and

that a signed or confirmed copy of each contract be filed" with the

Administrator. 

Escrow and impoundment - 

o Escrow  may be required if the offering:

is issued within the last five years;

is "to be issued to a promoter for a consideration

substantially less than the public offering price"; or

is to be issued "to a person for a consideration other

than cash". 

o Impoundment simply means that proceeds from the sale

must be put in escrow until "the issuer receives a specified

amount from the sale of the security". 

Offering outstanding - "Unless the Administrator determines

otherwise, a registration statement cannot be withdrawn until one

year after its effective date if any securities of the same class are

outstanding ..."

Regulation of Securities - Registration of Securities

Under the Uniform Securities Act, all securities sold in a particular state

must be registered in that state, unless they meet one of the following

exemptions:

Certain issuers - The securities associated with the following

issuers are exempt from state registration: government and

municipal issuers, issuers regulated under other laws (banks, credit

unions, insurance companies, railroads, public utilities), and non-

profit organizations such as cooperatives and employer benefit

plans.

Federal covered security - This includes investment company

shares, IPOs and exchange-listed securities.

Exempt transactions - These are transactions that do not involve

the public, including the following:

Fiduciary transactions

Unsolicited transactions

Real estate transactions secured by a mortgage

Isolated non-issuer transactions

Transactions between issuers and underwriters

Transactions with financial or institutional investors

Private placements

Sales where no commissions or fees are involved

Non-issuer transactions in outstanding securities registered under

either the Securities Act of 1934 or the Investment Company Act of

1940

Each of these issues is covered in more detail in the sections below.

Notice Filing 

If an issuer deals in federally exempt securities, the person/entity is only

required to file the federal forms with the state Administrator. This

method is used by established companies who are permitted to use the

prospectus filed with the SEC under the Securities Act of 1933 as the filing

document for the state. Of course, all fees must be paid.

Notice filing may be referred to on the exam as "registration by filing".

The article "A New Uniform Securities Act" by Richard B. Smith defines

notice filing as follows.

"Notice filing under the 2002 Uniform Act is for federal covered securities

other than listed securities. This filing consists of a consent to service of

process, a filing fee, and (depending on the state securities

administrator's requirements) can include copies of material filed with the

SEC. The 2002 Uniform Act provides a platform for eventually effectuating

one-stop filing, whereby documents filed with the SEC can be

electronically filed with states within which offerings are to be made."

Regulation of Securities - Registration by Coordination

In the article "A New Uniform Securities Act" by Richard B. Smith,

registration by coordination is outlined as follows:

"The objective of coordination is the simultaneous registration of

the offering at the SEC and in the states where the offering is to

be made. In order to facilitate coordinated registration, the state

securities administrators association has implemented a system

for coordinated review of these offerings by the states."

Under the USA, registration by coordination is for securities that

are registered with the SEC but are not federal covered

securities. 

Securities that may fall into this category include those that do

not meet the listing standards of exchanges and/or are

upgrading. 

Look Out!The term "coordination" describes registration, as the securities

are to be registered with the SEC and with individual states where they will be offered and/or sold.

Under registration by coordination, the issuer, offeror or broker-dealer of

the security generally needs to supply the Administrator with a long

laundry list of items regarding the security.

The USA states that registration by coordination is for a "security for

which a registration statement has been filed under the Securities Act of

1933 in connection with the same offering". Along with a registration

application, the USA states that issuers must also file the following:

A copy of the latest form of prospectus filed under the Securities Act

of 1933

A copy of the articles of incorporation and bylaws or their

substantial equivalents currently in effect

A copy of any agreement with or among underwriters

A copy of any indenture or other instrument governing the issuance

of the security to be registered

A specimen, copy or description of the security

Copies of any other information or any other records filed by the

issuer under the Securities Act of 1933 and requested by the

Administrator

An undertaking to forward each amendment to the federal

prospectus, other than an amendment that delays the effective

date of the registration statement, promptly after it is filed with the

Securities and Exchange Commission

A registration becomes effective subsequent to the federal

registration if:

a stop order or proceeding is not pending.

the registration statement has been on file for at least 20 days, (or

less, depending on the rule adopted or order issued under the USA.)

If federal registration is met (before all the aforementioned conditions are

met), the issuer is obligated to notify the Administrator immediately.

Regulation of Securities - Registration by Qualification

Registration by qualification pertains to all other offerings (that are not

federally exempt) that are made within a state. Examples of such include

offerings that are intrastate and/or are SEC exempt, based on their

smaller size.

The registration period is usually one year, and all persons registering a

security must pay the applicable fee. 

In the resources portion of the text, you will find a link for a sample

registration by qualification application for the state of Utah. Utah was

chosen randomly and does not constitute what you will see in all states.

However, on the front page of the application website, the site mentions: 

"Any security may be registered by qualification. Securities should be

registered by qualification when no other method is available."

While this point is not specifically highlighted in the USA, it is important to

recognize. Registration by qualification is generally the final method of

registration if a security cannot be registered another way.

Qualification entails submitting the following information to the

Administrator:

With respect to the issuer and any significant subsidiary:o The issuer's name, address and form of organization

o The State or foreign jurisdiction and date of its organization

o The general character and location of its business

o A description of its physical properties and equipment

o A statement of the general competitive conditions in the

industry or business in which it is or will be engaged 

With respect to each director and officer of the issuer,

and other person having a similar status or performing similar

functions: o The person's name, address and principal occupation for the

previous five years 

o The amount of securities of the issuer held by the person as

of the 30th day before the filing of the registration statement o The amount of the securities covered by the registration

statement to which the person has indicated an intention to

subscribe o A description of any material interest of the person in any

material transaction with the issuer or a significant subsidiary

effected within the previous three years or proposed to be

effected o The aggregate sum of the remuneration paid to those

persons during the previous 12 months and estimated to be

paid during the next 12 months, directly or indirectly, by the

issuer and all predecessors, parents, subsidiaries and

affiliates of the issuer. o All above information for a person owning on record or

owning beneficially, if known, 10% or more of the outstanding

shares of any class of equity security of the issuer o With respect to a promoter, if the issuer was organized within

the previous three years, all information listed in the first five

bullet points above and any amount paid to the promoter

within that period, or intended to be paid to the promoter,

and the consideration for the payment

Summary

Generally speaking, an issuer must provide the following:

Basic information: name, address, type of business and description

Records of officers, directors and owners with a stake of 10% (or

more)

Description of issuer's long-term debt and capitalization

Type and amount of securities to be offered

Any/all stock options to be created in regards to the offering

Estimated proceeds

Copy of all red herrings, investment circulars or pamphlets for the

offering

Sample copy of the security

Audited balance sheet of the issuer as of a date within four months

before the filing of the registration statement

An income statement and statement of cash flows for three years

prior to the balance sheet

A signed or confirmed copy of an opinion of counsel concerning the

legality of the security being registered

Regulation of Securities - Exempt Securities

First, it is important to make this clear: there are two different types of

exemptions, according to the USA. They aresecurities exempt from

registration and transactionsexempt from registration. This may get a

little confusing, as there can be both securities and transactions that are

exempt, or either can be exempt individually. 

A security that is non-exempt must be registered. Furthermore, all

transactions that are exempt are generally known to be exempt before

the transaction ever takes place. 

Securities

Section 201 of the USA lists nine types of exempt securities. As a

general rule, any security backed by or insured by a government, or

government institution, is usually exempt. Though it is important to

remember the following nine items, if you retain nothing else, just

remember that anything that has some sort of federal or municipal

tax-exempt status is probably exempt. 

The following nine items are specified as "exempt" by the USA:o Government securities  - Any securities that are

guaranteed by the U.S.government, a state or "a political

subdivision of a state" o Legitimate foreign governments - Any security issued by

a foreign government - with which the U.S. maintains a

diplomatic relationship o Banks and depository institutions - A security that will

represent an interest in, or a direct obligation of, or

guaranteed by:

an international banking institution.

a depository institution that is a member of the Federal

Reserve system, or organized in relation to the state in

question.

any other depository institution, unless specified

as not exempt by the Administrator. o Insurance  - A security issued/representing (guaranteed by)

an insurance company authorized to do business in the state o Railroads and public utility securities - A security issued,

or guaranteed by a railroad, other common carrier, public

utility, or other public holding company that is:

regulated in respect to the issuance or guarantee,

and/or rates, and charged of the security by the United

States, a State, Canada, or a Canadian, or

a public utility holding company registered under the

Public Utility Holding Company Act of 1935. o Options  or warrants - A put or a call option contract; a

warrant; a subscription right on or with respect to such

securities; or an option or similar derivative security on a

security or an index of securities of foreign currencies issued

by a clearing agency registered under the Securities

Exchange Act of 1934 and listed or designated for trading on

a national securities exchange o Nonprofits - A security issued by a person organized and

operated exclusively for religious, educational, benevolent,

fraternal, charitable, social, athletic or reformatory purposes,

or as a chamber of commerce, and not for profit o Employee benefit plans - Securities sold to employees of a

company in connection to stock, savings or pension plans o Equipment trust certificates - An equipment trust

certificate with respect to equipment leased or conditionally

sold to a person - i.e. equipment lease financing through

leveraged leases, conditional sales and other devices

Regulation of Securities - Exempt Transactions

The USA exempts certain transactions from registration - usually

transactions in securities that are already registered on a federal level,

have some sort of federal association, or in some way are not transacted

among the public at large. After you read the following list, the best bet

for the test is simply to try to use common sense. If an issuer is effecting a

transaction for an average person or purchasing the security for his or her

portfolio, the transaction is most likely not exempt. 

The Administrator has the power to exempt any transaction he or she

deems not necessary of registration. The Administrator can also deny an

exemption, if he or she deems that state registration is necessary. If an

Administrator feels that an exempt security falls under a state provision

(like anti-fraud), he or she may require that thefederally exempt security

be registered with the state.According to the USA, exempt transactions

include the following:

Isolated non-issuer transactions - An isolated non-issuer

transaction, whether or not it is affected by or through a broker-

dealer. 

Non-issuer transactions - A non-issuer transaction by or through

a broker-dealer registered (or exempt from registration), in a

security of a class that has been outstanding in the hands of the

public for at least 90 days, if, at the date of the transaction: o the issuer of the security is engaged in business, is not in

bankruptcy, and is not in any type of merger and the security

is:

sold at a reasonable price.

not representative of an unsold allotment of the

underwriter.

nationally recognized. 

Transaction in a security of a foreign issuer - A non-issuer

transaction by or through a broker-dealer registered or exempt

from registration under this [Act] in a security of a foreign issuer

that is a margin security. 

Non-issuer transaction involving the SEC - A transaction where

the issuer of the security files a report with the Securities and

Exchange Commission. 

Non-issuer transaction by or through a broker-dealer

It is vitally important that these transactions are exempt only if they

are by or through a broker-dealer registered or exempt from

registration in a security that: o is rated at the time of the transaction by a nationally

recognized statistical rating organization in one of its four

highest rating categories 

o has a fixed maturity or a fixed interest or dividend, if: 

a default has not occurred during the current fiscal year

or within the three previous fiscal years or during the

existence of the issuer; 

the issuer is engaged in business, is not in the

organizational stage or in bankruptcy or receivership,

and is not and has not been within the previous 12

months a blank check, blind pool, or shell company that

has no specific business plan or purpose. 

Non-issuer unsolicited - A non-issuer transaction by or through a

broker-dealer registered or exempt from registration affecting an

unsolicited order or offer to purchase. 

Non-issuer transaction through pledge - A non-issuer

transaction executed by a bona fide pledgee without the purpose of

evading the USA. 

Non-issuer transaction by a federal covered investment

advisor - A non-issuer transaction by a federal covered investment

advisor with investments under management in excess of

$100,000,000 acting in the exercise of discretionary authority. 

Security exchange - A transaction where no cash, or partial cash,

is exchanged - this type of transaction is only valid after a hearing

with and approval from the Administrator. 

Transaction between Issuer and Underwriter 

Secured transactions - Transactions secured by a note, bond,

mortgage or security agreement, if:o a general solicitation of the transaction is not made.

o a commission or other remuneration is not made. 

Fiduciary transactions - A transaction by an executor,

administrator of an estate, sheriff, marshal, receiver, trustee in

bankruptcy, guardian or conservator 

Sale or offer of sale to:o an institutional investor

o federally covered investment advisor

o any other exempt person 

Sale by or on behalf of an issuer if:o no more than 25 people purchase the security in the state

registered, in a 12-month period

o a general advertisement or solicitation is not made in

connection to the offero commission is not paid

o the issuer believes that purchasers' interest is purely for

investment 

Transaction to existing owners 

Offer to sell, but not a sale:o Of a security that is not exempt from registration under the

Securities Act of 1933

a registration has not been filed with the state, but is

effective at a federal level

a solicitation of interest is provided

a stop order has not been issued by the Administrator 

Rescission offers - Offers of rescission are defined under civil

liabilities. 

Offer of sale to a person from another state 

Transactions of employee stock plans including:o stock purchase, savings, option, profit-sharing, pension, or

other benefit plans for:

directors, general partners, trustees, officers,

consultants and advisors

family members who acquire securities though gifts or

domestic relations orders

former employees, who were providing services when

the securities were offered

insurance agents, who are the exclusive agent of the

issuer 

Transactions involving:o a stock dividend

o a judicially approved reorganization

Exam Tips and TricksA common "trick" question on the exam involves the "certain issuers" exemption from securities registration. Some of the

incorrect options may include securities issued by bank holding companies (only banks themselves are exempt) and airlines (only

railroads are exempt).

Regulation of Securities - Federal Covered Securities

Federal covered securities are exempt from state registration.

The USA defines a federal covered security as follows:

"A security that is, or upon completion of a transaction will be, a covered

security under Section 18(b) of the Securities Act of 1933 (15 U.S.C.

Section 77r(b)) or rules or regulations adopted pursuant to that

provision." 

More specifically, a federal covered security, also known as a "covered

security", is defined as follows:

Securities issued by an open-end mutual fund, closed-end mutual

fund, unit investment trust, or face amount certificate company,

that is registered under the Investment Company Act of 1940

Securities offered pursuant to the provisions of Rule 506 of

Regulation D under the Securities Act of 1933 

Securities offered by a municipal/governmental issuer, unless the

issuer is located in the state in which the securities are being

offered 

Securities offered by an issuer exclusively to its existing security

holders where no commission or other remuneration is paid directly

or indirectly for soliciting the exchange

Federal covered securities include:

Securities either listed, or authorized for listing, on the New York

Stock Exchange, Nasdaq National Market System, American Stock

Exchange, Chicago Board Options Exchange, Tier 1 of the Pacific

Exchange, and Tier 1 of the Philadelphia Stock Exchange, or any

other national exchange determined by the SEC to have proper

listing standards 

Securities issued by an investment company registered under the

Investment Company Act of 1940 

Securities "offered or sold pursuant to most exemptions contained in the Securities Act of 1933, intrastate exemptions, non-profit exemptions, and any/all municipal/government securities sold in the state where the issuer is located".

Exam Tips and TricksPlease note that Nasdaq small-cap securities are not federal covered securities. This could easily show up on the exam.

Exam Tips and TricksQuestions about securities registration tend to be very

straightforward. Remember that only two questions involving securities registration are scheduled to be on the exam. Here are

two likely questions on the topic of exempt securities or transactions:

1. ABC Corporation has never previously issued securities

registered by the SEC. It can register in the State by which

method(s)?

I. Registration by filing

II. Registration by coordination

III. Registration by qualification

IV. Registration by administration

a. I only

b. II only

c. II & III

d. I, III & IV

The correct answer is "c": registration by filing is only available to

companies that have previously registered securities with the SEC, and

registration by administration is not a valid registration method.

2. Which of the following securities are not exempt under the

Uniform Securities Act?

a. Limited partnerships

b. Convertible bonds of a NYSE-listed company

c. U.S. Treasury bonds

d. Stock issued by a non-profit organization

The answer is "a", since all the other options listed are specifically

exempted.

CHAPTER 12: Remedies and Administrative Procedures - Introduction

Each state has an Administrator, who has certain jurisdiction and powers

related to the offer and sale of securities in his or her state. Generally, an

Administrator will simply issue a cease and desist order if he or she finds a

problem. However, the Administrator can also have a court order an

injunction or deny, revoke or suspend registration. The following section

outlines an Administrator's ability to regulate - that is, the enforcement

aspect of the USA.

Remedies and Administrative Procedures - Administrator Authority

Investigate

At any time, the Administrator can conduct public or private

investigations, within or outside of a state, which the Administrator

considers necessary or appropriate to determine whether a person

has violated, is violating, or is about to violate a rule, or to aid in the

enforcement of regulations of the USA. 

o In conducting an investigation, the Administrator can at any

time require (or permit) a person to testify, file a statement,

or produce a record regarding facts or circumstances of a

situation. o The Administrator can also publish a record that is of direct

concern to an action, proceeding, or investigation.

In general, the Administrator has the ability to inspect records within (and

outside of) his or her state. The Administrator can also require those being

investigated to provide written statements under oath.

Issue Subpoenas

At any time, the Administrator may issue a subpoena for

investigation-related information, if he or she has jurisdiction over

the transaction or security in question. 

Other Provisions

In addition to those already listed, the Administrator has the

following powers:o To cooperate in SEC investigations

o To publish information concerning a violation

o To compel testimony regarding a violation, even if such

testimony might incriminate the individual

Jurisdiction

Jurisdiction comes down to where a securities transaction was made and

whether a state Administrator has the authority to regulate the activity. 

Jurisdiction includes any offer, or offer to sell that:o originates or takes place in the state.

o is directed to the state and received "at the place which it is

directed".o is accepted in a state:

if the offeree reasonably believes the offeror to be

present in the state.

and has not been previously communicated to the

offeror outside the state. 

Jurisdiction as applied to publications or radio

An Administrator does not have jurisdiction over the following:o a publication that is a bona fide newspaper or other print

media - if the publication has two-thirds of its circulation

outside of the state in which it is published, or is circulated

outside of the publication state.o a television or radio broadcast that is syndicated from outside

the state.o any electronic communication originating from outside the

state.o any electronic communication that comes from within the

state, but is not intended for distribution within the state. 

Jurisdiction as applied to investment advice and

misrepresentation

The Administrator has jurisdiction if an individual/entity attempts to

commit fraud in the Administrator's state, whether or not the

individual/entity in question is in the state or not. 

Jurisdiction as applied to securities

When it comes to exempt securities transactions, the Administrator is permitted to deny or revoke any specific transaction or security exemption, but cannot enter the order to do so unless prior notice is given to all parties, an opportunity is given for a hearing, and written findings are provided. If the Administrator issues a summary order to deny or revoke pending final determination, he or she must notify all interested parties of the reasons for entering the order and inform them that a hearing will be granted within 15 days of a written request.

Exam Tips and TricksAn Administrator generally has jurisdiction if a transaction is originated or accepted in his/her state, or if it is directed to the

state.

Remedies and Administrative Procedures - Administrative Actions

The Administrator has the power to deny, revoke or suspend registrations

or licenses at any time, if the Administrator feels he or she is acting for

the benefit of the public. Moreover, the Administrator has an obligation to

not misuse his or her powers for personal gain. 

The USA gives the Administrator very broad powers and applies to offers

made either verbally or in writing. The powers apply to broker-dealers,

agents, investment advisors and investment advisor representatives. 

The Administrator can deny, suspend, or revoke registration if it is in the

public interestand if the registrant:

files a materially false, incomplete or misleading application.

willfully violates any provision of the Uniform Securities Act.

is prohibited by court order from engaging in the securities industry.

becomes insolvent.

fails to pay required fees.

is convicted of any felony, or any misdemeanor involving the

securities industry.

engages in unethical or dishonest business practices.

is unqualified due to lack of experience, training or knowledge.

fails to properly supervise employees.

However, the Administrator cannot deny, suspend or revoke a registration solely based on a lack of

experience if the applicant is otherwise qualified by training or knowledge.

Look Out!While this list of potential reasons to deny a registration

application includes the item "is unqualified due to lack of experience, training or knowledge", note that the paragraph that

follows states that the Administrator cannot deny or revoke a registration based on "lack of experience if otherwise qualified by

training or knowledge". You\'re likely to be tested on that distinction, so watch for answers such as "the Administrator can deny registration if it is in the public interest and an Investment Advisor (IA) has a degree in finance but no investment advisory experience". That answer would be incorrect, since the IA does

have training or knowledge.

Exam Tips and TricksIf, for any reason, an Administrator decides to take any one of the following three actions (denial, revocation or suspension), he/she must expressly detail the reasoning behind the injunctive act and

give the person/entity in question a chance for appeal.

Remedies and Administrative Procedures - Additional Administrative Powers

In addition to the following items (initiated by the Administrator), a

broker-dealer may withdraw its own registration at any time, and this

withdrawal is effective 30 days after an initial withdrawal application is

filed. Lastly, if a broker-dealer withdraws its registration, and then (within

one year) the Administrator finds a wrongdoing, the Administrator may

still commence disciplinary proceedings.

Denial

The Administrator may deny an application if: 

o it is incomplete, contains any misleading information or omits

vital facts. 

o within the last 10 years, the applicant was convicted of a

securities-related misdemeanor or any felony whatsoever -

regardless of whether or not it was securities related. o another Administrator already denied registration, or another

suspension or revocation order is already in effect. o the Administrator finds that the applicant is not financially

solvent and/or is in a state of bankruptcy. o a court order exists barring the registrant from working in the

securities industry. o the Administrator deems that the registrant is not qualified

for the type of business he or she intends to

pursue. However, an Administrator cannot suspend

registration if the registrant can give material proof that he or

she is qualified. 

Revocationo An Administrator may revoke registration at any time, if any

one of the above six items listed under Denial is found to be

true. o In addition, the Administrator may revoke the registration of

an officer or partner of a firm without crippling the entire firm,

although such action could also be grounds for revoking the

registration of the firm as a larger entity. o Registration may be revoked from an agent without being

revoked from the broker-dealer, if it is found that the broker-

dealer was competently supervising the agent but was

nevertheless unable to prevent the agent from committing

some sort of fraudulent activity. However, if the agent's

fraudulent activity was the direct result of a broker-dealer's

incompetent supervision, then the broker-dealer's registration

is at risk as well. 

Suspension

Suspension can occur for the same reasons as Denial, though

registration may be reinstated pending a hearing. Hearings are

usually held within 15 days of the initial request. 

Cancellationo An Administrator may cancel an agent's registration if the

agent is found to be deceased, or not able to perform his or

her duties. In short, if for any reason the agent becomes

incompetent, the Administrator may cancel registration. o If an agent disappears and cannot be found after a

reasonable search (e.g. Jane's lounging on an exotic beach

somewhere and her firm can't find her for a month), the

Administrator may revoke registration. 

Cease and Desist

The Administrator may issue a cease and desist order, if it has

determined that a particular action is in violation of the USA. If the

cease and desist order is ignored, the Administrator may have a

court intervene and issue an injunction against the party in

question.

Remedies and Administrative Procedures - Other Penalties and Liabilities: Civil

Civil liabilities arise when a violation of the USA has occurred and the

person harmed wishes to recover any losses incurred. 

All securities professionals are liable for civil penalties if the USA is

violated. Where there is an infraction of the USA, purchasers of securities

can sue for recovery of losses.

When a client can sue:

A direct violation of the USA occurred, where a securities

transaction ensued.

An agent, broker-dealer or investment advisor sold securities in

violation of a direct rule of the Administrator.

Securities were sold by an unregistered person.

Misleading statements, or omitted facts, led to the sale of a

security.

The securities sold were either misrepresented as being approved

(recommended) by the Administrator or another governing body, or

misrepresented as being listed (or to be listed) on an exchange,

when in fact the information was false.

There was a violation of the state's sales literature requirements.

If a violation occurs, a purchaser can then sue for damages. The formula relating to recovery is fairly

simple. Purchasers can sue for:

Reasonable attorney fees, and other costs

+ Interest

+   The purchase price of the securities

-   Any income (dividend or interest) received

= Damages

Exam Tips and TricksYou will notice that this formula can be summed up by the

acronym RITA. When you write the test, it may be helpful to think, "RITA\'s a little upset with her broker, and she\'s ready to sue!" Although civil penalties are no laughing matter in real life,

the humor should help you remember the damages formula for the exam.

Example

Bob's broker lied to him about a stock, telling him the state

Administrator had approved (and recommended) the stock for

purchase. Bob's broker further suggested that Bob should buy

the stock, since the Administrator's listing endorsement made it a

sure thing. Consequently, Bob bought $1,000 of the stock. Three

weeks after his investment, he received a dividend payment for

$15, which pleased him greatly. Shortly after, the company

released a negative press release. This triggered a sharp sell-off,

and the stock's price was cut in half. Bob sold the stock to retain

$500 of his initial investment. Soon after, Bob decided to sue his

broker, even though the legal costs would be around $300. What

can Bob sue his broker for?

Answer

Reasonable attorney fees, and other costs $300

+ Interest $0.00

+   The purchase price of the securities $500

-   Any income (dividend, or interest) received $15.00

= Damages $775

*The original purchase price is $500 because Bob sold the investment -

holding on to $500 (half) of his original investment.

Remedies and Administrative Procedures - Other Penalties and Liabilities: Investment Advice and Rescission

Investment Advice

Any investment advice in violation of the USA is also liable for

civil penalties, as long as the advice was dispensed for a fee. 

Those subject to fraudulent investment advice can sue for:

+ Cost of the advice

+ Loss resulting from the advice

+ Attorney fees (reasonable), and other costs

+ Interest____________________ _

- Money (dividend or interest) received

= Damages

Exam Tips and TricksIn this case, remember the acronym CLAIM. If investment advice was in violation of theUSA and was dispensed for a fee, an investor

can CLAIM damages.

Statute of Limitations

Once a person discovers a violation of the USA, he or she has two years to

sue, or three years from the date of the initial transaction.

Rescission 

If an agent/person discovers a violation of the USA, a letter of rescission -

containing an offer to buy back the security in question - may be

tendered. Of course, the letter of rescission must also take into

consideration (and make an offer for) any interest potentially gained or

lost. In short, the formulas given for civil losses apply equally for a letter

of rescission - with the exception that the party issuing the letter of

rescission is generally trying to avoid legal fees. Furthermore, it is

important to note that once a rescission offer is tendered, the buyer of the

securities must respond within 30 days, or he or she gives up all rights to

take legal action at a later date.

Example

Billy, an agent of Bad Boy Brokers, Inc, discovers that he has violated

the USA by misquoting dividend information which led to the purchase of

a security by a customer. Though Billy's firm has had a few run-ins with

the Administrator in the past, he's trying to reestablish the firm's

reputation as a reliable business. He realizes that his client invested

$1,000, expecting a 10% dividend. Billy immediately writes a letter of

rescission, offering to repurchase the securities. In the time it takes for

Billy to send the letter and for his client to agree to sell the securities

(three days), the stock appreciates $5. Billy's client sells the securities to

Billy for a $5 profit (assuming, hypothetically, that no commissions are

paid). What is the total amount Billy owes his client? 

Answer

First, Billy owes his client $995, as the client already received $5 in capital

appreciation. 

Second, Billy rescinded the offer in three days, but had guaranteed 10%,

which would equate to $3.65 a day. So, Billy also owes his client $10.95 in

interest. Billy's total tally is $995 + $10.95, working out to $1,005.95

(assuming the client already received an additional $5).

Remedies and Administrative Procedures - Other Penalties and Liabilities: Criminal

Criminal penalties arise when a person or an entity is proven

guilty of consciously and willingly conducting a fraudulent

securities transaction (in violation of the USA). 

Look Out!The key word in criminal liabilities is "fraudulent", meaning the

violation was deliberate.

Once the Administrator makes an order (which can lead to fines

and/or imprisonment), the person or entity affected may retort

with a written petition of appeal within 60 days. 

At the same time, the affected member (agent or broker-dealer)

must serve the Administrator as well. Following this, the

Administrator is obligated to provide the appropriate court with

all evidence. 

Unlike the normal judicial process, once the Administrator makes

an order, it remains in effect until a court of law overturns it.

Whatever the court decides in appeal is final, and the court has

the right to change any part of the order. 

Conviction

If the offender is convicted, he or she may not be imprisoned for

more than three years, or pay more than $5,000 in fines (per

violation). 

Statute of Limitations

The statute of limitations for criminal penalties is five years. 

Exam Tips and TricksIt is crucial to remember that there can be no prison time if a

person can prove that he or she had no knowledge that the USA was being violated.

Exam Tips and TricksYou should be very familiar with the specific powers of the

Administrator and the differences between civil and criminal penalties. Here are two questions that could come up on the exam:

1. Of the following statements regarding the state

Administrator's powers, which are TRUE?

I. The Administrator may revoke a registration for the

sole reason that it is "for the public good".

II. If an IA's registration is suspended, any IARs who work

for the IA will have their licenses suspended as well.

III. If an IAR's registration is suspended, the license of the

IA he/she works for is suspended as well.

IV. IAs, but not IARs, may have their registration revoked

for failing to properly supervise employees.

a. I & II only

b. I & IV only

c. I, II & III only

d. II & IV only

The correct answer is "d": if the IA license is suspended, there can be no

active IAR registrations, and IAs are responsible for supervising employees

(IARs have no such responsibilities).

2. A state Administrator can do all of the following EXCEPT:

a. require a witness to testify at a hearing.

b. inspect a broker-dealer who does business in the state, even

if the broker-dealer is located in another state.

c. suspend the constitutional privilege against self-incrimination.

d. coordinate inspections with the SEC.

The correct answer is "c": while the Administrator can compel

incriminating testimony, the privilege against self-incrimination is a

constitutional one, and federal law must supercede state laws.

Remedies and Administrative Procedures - Other Provisions

The Uniform Securities Act states that an Administrator may require a firm

to "require the filing of any prospectus, pamphlet, circular, form letter,

advertisement, or other sales literature or advertising communication

addressed or intended for distribution to prospective investors, including

clients or prospective clients of an investment adviser, unless the security

or transaction is exempted."

Exempted securities include the following:

Federal covered securities

Any security issued or guaranteed by Canada

Any security issued or guaranteed by a bank, savings institution or

trust company

Any security issued or guaranteed by any federal credit union or

any credit union

Any security issued or guaranteed by any railroad or other common

carrier, public utility, or holding company

Securities issued or guaranteed by non-profits

Any investment contract issued in connection with an employees' stock purchase, savings, pension, profit-sharing or similar benefit plan

Exam Tips and TricksYou can expect a question on the test regarding the Telephone Consumer Protection Act of 1991, which states that organizations must do the following:

Maintain do-not-call lists. When a prospective recipient of a call asks to be put on the list, the firm must keep his or her name on record for 10 years. 

Make sure that reps understand how to use the list and immediately record any names and phone numbers of people who wish to be on the do-not-call list. 

Only call homes of prospective clients between the hours of 8:00 AM and 9:00 PM in the customer\'s time zone.

CHAPTER 13: Client Communication and Compensation Issues - Introduction

Disclosure - The Brochure Rule

Investment advisors must disclose the nature of the relationship between

the client and the IA. IAs cannot participate in, nor be compensated by,

any percentage gains of a client's portfolio. These terms must be included

within the investment advisor's contract. 

The most important rule regarding disclosure is the brochure rule, which

requires an IA to provide a written disclosure document to each

investment advisory client or potential client. The IA can simply provide a

copy of the Form ADV Part II, or create a brochure with substantially the

same content. The document must include all of the following information:

Background information of the IA and any IARs 

Services available and the fees for those services 

Disclosure of any compensation received from third parties (such as

commissions or referral fees) 

Whether the IA exercises discretion over client funds 

Types of clients for whom advisory services are provided, including

any minimum dollar amount for assets to be managed 

Disclosure of any affiliation with a broker-dealer 

Any material legal or disciplinary action that occurred within the last

10 years 

Any financial condition of the IA (such as bankruptcy) that might

impair its ability to meet client commitments must also be disclosed

if the IA:o has discretion over client accounts.

o has custody of client monies or securities.

o requires prepayment of more than $500 in fees, more than

six months in advance.

The brochure must be provided at least 48 hours before entering into an advisory contract, or at the

time of entering into a contract, if the client has the right to terminate the contract without penalty

within five business days. Each year, the IA must deliver (or offer to deliver) its disclosure document

to existing clients. Failure to meet disclosure requirements is considered fraudulent behavior.

Look Out!It is crucial for you to know when the brochure must be given; the

timing of this disclosure is frequently tested on the exam. Remember, it is not true that a brochure must be provided prior to

entering into the contract; however, the contract must then explicitly offer the right to terminate without penalty within five

business days. If this offer is not part of the contract, the brochure maynot be provided at the time of signing the contract. Watch for answers such as "...if the IA states he/she has a right to terminate

within five business days..." - this is incorrect, since a verbal statement is not sufficient.

Under the USA, an additional disclosure is required if the IA acts as

principal for its own account or as broker for both an advisory client and

another person on any securities transaction. In these instances, the IA

must disclose (prior to completion of the transaction) in what capacity it is

acting, and it must receive the client's written consent.

Wrap fee (or wrap   account)  programs require a special disclosure form

instead of the Form ADV Part II. For these purposes, the SEC definition of

wrap accounts does not include:

Managed account programs  - Traditional portfolio management

services offered by money managers 

Mutual fund asset allocation programs - Bundled programs

that charge a percentage of assets fee to manage a portfolio of no-

load (or load-waived) mutual funds

The wrap fee disclosure must include the following information (where

applicable):

The amount of the wrap fee, the services that are included, and

whether the fees are negotiable

Any additional fees that might be required

What methods are used to select portfolio managers

What compensation is paid to the person who recommended the program 

Exam Tips and TricksBe prepared to answer a number of questions on the

"brochure rule", and be familiar with what must be included on Form ADV Part II. Here are two questions you might

encounter on the exam:

1. The brochure rule applies to:

a. only discretionary advisory contracts.

b. only written advisory contracts.

c. only oral advisory contracts.

d. both oral and written advisory contracts.

The correct answer is "d". The brochure rule applies to all investment

advisory contracts.

2. Under the brochure rule, the IA clients (or potential clients)

must receive a copy of the brochure:

a. at least 48 hours prior to entering into an advisory contract.

b. within 24 hours of entering into an advisory contract.

c. at the time of entering into an advisory contract, as long as

the client can terminate the contract without penalty within

three days.

d. within five days of entering into an advisory contract.

The correct answer is "a". "c" is wrong because this provision only applies

if the client can terminate within five days.

Client Communication and Compensation Issues - Investment Advisor Contracts

While state laws require that contracts between state registered

IAs and clients be in writing, the Investment Advisers Act of 1940

does not.

Exam Tips and TricksAlthough the NASAA Model Rule on Unethical Business Practices does state that written contracts are required, the questions on the

exam do reference oral contracts.

However, most IAs put their contracts in writing to avoid

misunderstandings. Also, SECrules do impose the following conditions

on a written investment advisory contract:

Performance-based fees are generally prohibited (learn more in the

next section). 

Contract language must not lead clients to believe they have

waived rights to take legal action against the advisor. 

There must be no provisions that force the client to waive

compliance with any of the rights or rules within the Investment

Advisers Act of 1940. 

Contract must prohibit the IA from assigning the contract without

the client's consent.

Under the USA, IA contracts must:

disclose all material information regarding the services to be

provided and the fees to be charged. 

disclose conditions under which the contract may be assigned to

another party. 

require client consent prior to the IA assigning the contract. 

require the IA (if a partnership) to notify the client of any change in

the membership of the partnership. 

not permit the IA to be compensated on the basis of sharing in

capital gains or capital appreciation of the client's accounts

(however, fees based on the total value of the account, such as an

assets under management fee, are allowed).

Performance Guarantees

Performance guarantees are generally considered a conflict of interest. The hallmark of an

investment advisor is objectivity, so there must be no personal interest in the outcome of any specific

investment recommendation. Also, guaranteeing a client's account against loss is specifically cited as

an unethical business practice under the USA.

Look Out!Guaranteeing a client\'s account against loss is a type of

performance guarantee. The Series 66 exam is not likely to test you on any distinction between these two concepts.

If any change within a partnership firm is made (i.e. change in partners),

clients must be made aware of the change in reasonable time. It is

important to note that this act of notification only applies to partnerships,

not corporations.

Client Communication and Compensation Issues - Advertising

The Investment Advisers Act of 1940 defines advertising as any letter,

notice, circular or other written communication addressed to more than

one person, as well as any notice in a publication or by radio or TV that

contains the following:

Graphs, charts, formulas or other devices used to determine how to

choose a security or when to buy or sell a security

Information that offers analysis, reports, or publications concerning

securities or when to buy or sell a security

Any other investment advisory service that relates to securities

The following media have also been identified by the SEC as forms of

advertising:

Form letters and other mass mailings

Press releases

Newsletters

Marketing brochures

Telemarketing scripts

Slides or audio/videotapes used in marketing presentations

E-mail messages sent to more than one person

Advertising standards

IA advertising is not permitted to:

refer (directly or indirectly) to testimonials about the advisor. 

refer to specific past recommendations that were profitable.

However, an IA may advertise a list of all recommendations made

within the immediate past year (or longer), as long as all pertinent

information is included (date of recommendations, market price at

time of buy, sell, and current), along with a disclaimer on the first

page stating: "It should not be assumed that recommendations

made in the future will be profitable or will equal the performance

of the securities in this list." 

advertise that any report, analysis or other service is free of charge

if that is not completely true - there must be no obligation or

condition of any kind. 

represent that a graph, chart, formula or other device can (by itself)

be used to determine which securities to buy or sell, without

disclosing the limitations in doing so.

Performance advertising 

In a guidance statement called the Clover Capital letter, the SEC clarified

that advertising of actual performance data would be prohibited if the

advertising:

included results that didn't reflect the impact of brokerage

commissions, advisory fees and other client-paid expenses. 

failed to disclose the effect that market or economic conditions had

on the results. 

failed to disclose whether or not the results shown reflected

reinvestment of dividends and capital gains. 

made claims about the future potential for profit without also

mentioning the possibility of loss. 

failed to disclose (if applicable) that performance results related

only to a select group of the IA's clients. 

compared results to an index without disclosing all material facts

relevant to the comparison. 

failed to disclose any material conditions, objectives or investment strategies used to obtain the results.

Exam Tips and TricksOne question you can expect to see involves

performance advertising. In particular, one type of answer that appears to be correct is "IAs cannot use

performance advertising that promotes results received by only a small group of the portfolios under management." But the

requirements listed above state that it is only prohibited to not disclose that only asmall group was used, so the answer above

isactually incorrect.

Client Communication and Compensation Issues - Solicitation

The Investment Advisers Act of 1940 permits an IA to pay a fee to a

person who solicits advisory clients only if these two conditions are met:

The IA is registered with the SEC. 

The solicitor has never been suspended, expelled, limited or barred

from associating with an investment advisor by the SEC.

If solicitation is permitted, the following rules apply:

There must be a written agreement between the IA and the

solicitor, which must require compliance with the Investment

Advisers Act of 1940. 

The solicitor must provide a copy of the IA's disclosure document to

the potential client at the time of solicitation. 

The solicitor must provide a separate disclosure document to the

potential client that spells out the names of the solicitor and the IA,

the nature of the relationship between the two, a statement that

the IA will pay the solicitor, and the amount above the regular

advisory fee that the client will be charged due to the use of the

solicitor. 

The IA must obtain a signed and dated acknowledgement from the client stating that he or she has received both the IA's and the solicitor's disclosure documents by the time the advisory contract is entered into.

Exam Tips and TricksIt is important to know the rules for both general advertising and

performance advertising. You can expect fewer questions on advisory contracts and solicitations. Here is a question you might

encounter on the exam:

1. Which of the following statements about IA advertising is

FALSE under the Investment Advisers Act of 1940?

a. A performance record may only be used if it contains a

disclaimer on the first page that states there is no assurance

that future results will be as good as the reported results.

b. The IA may not advertise a formula without a disclaimer that

refers to the limitations and difficulties of relying on any one

formula or system.

c. Testimonials may be used only if written consent has been

obtained from the client and the testimonial is not misleading

in any way.

d. A performance record may be used only if the results are for

at least one year.

The correct answer is "c": testimonials may not be used in IA advertising.

Client Communication and Compensation Issues - Compensation

There are few specific restrictions on fees within either the Investment

Advisers Act of 1940 or the USA. The advisory fee must not be

"unreasonable", which means that it should be in line with what other

advisors charge. Under the USA, the following types of fee arrangements

are permitted:

Fees based on a percentage of assets under management

Flat annual dollar amount for services agreed upon

Brokerage fees on trades made for clients

Wrap fees that cover all services (asset management and transactional fees) in one single annual fee

Look OutThere are a few exceptional cases in which an investment advisor can benefit from portfolio gains. Advisors can participate in capital gains (receive a performance-based fee) if the client:

1. is an institutional investor. 2. is a private client with a minimum net worth of $1.5

million. 

3. is a private client with a minimum of $750,000 invested with the IA.

As mentioned above, performance-based fees are generally prohibited.

Only two types of clients may be charged such a fee:

Registered investment companies (mutual funds) 

An individual with an account value in excess of $1 million (Uniform

Securities Act), OR 

An individual with an account value in excess of $750,000 and a net

worth of at least $1,500,000 (Investment Adviser Act)

In these cases, a performance-based fee known as a "fulcrum fee" is permitted. A fulcrum fee

provides for a base fee to be paid to the advisor, with additional fees permitted for performance

above a specific benchmark. However, this is allowed only if the base fee would be reduced equally

for inferior performance beneath the benchmark.

Look Out!Don\'t confuse performance-based fees with performance

guarantees - read the exam questions carefully. Remember that performance guarantees are alwaysprohibited, while performance-based fees aregenerally prohibited, with the exceptions discussed

above.

Exam Tips and TricksHere is a question you might encounter on the exam:

1. IAs may enter into advisory contracts that allow

compensation:

a. based on the level of trading activity.

b. based on a percentage of the value of all assets under

management.

c. based on a percentage of capital gains or losses in the

account.

d. based on any of the above

The correct answer is "b": options "a" and "c" are specifically prohibited.

CHAPTER 14: Handling Client Funds - Introduction

Custody

Custody is defined as having physical possession of funds or securities.

Funds and securities can be placed in custodian accounts, though an

Administrator may require that an advisor post a bond for such. 

Investment advisors that have the ability to withdraw money from a

client's account are considered to have custody of these funds. In that

case, the Investment Advisers Act of 1940 requires the IA to do the

following:

Keep each client's securities segregated and held in safekeeping

Not commingle client funds with the IA's funds

Maintain client funds in accounts that name the IA as trustee or

agent

Keep records showing deposits and withdrawals for each client

account

Notify clients in writing of how the funds are maintained and when

accounts are changed

Send a quarterly (or more frequent) itemized statement to each

client

Arrange an annual unannounced visit from an independent public

accountant, who must then file a report with the SEC verifying the

amount of client funds and securities

These rules do not apply if the IA is also a broker-dealer, since broker-

dealers are subject to similar rules at the federal level.

Under the USA, IAs must notify the Administrator if they currently have

custody of client funds and securities (or plan to in the future). Otherwise,

the custody requirements are the same as those stated by the Investment

Advisors Act of 1940 (except that the state Administrator receives the

annual accountant report, rather than the SEC).

Handling Client Funds - Discretion

As is the case with registered representatives of broker-dealers,

an IA must not exercise discretionary power over securities

transactions without first obtaining the proper discretionary

authority from the client. Only oral discretionary orders are

required in the 10 days following the first transaction in a client

account. Thereafter, specific written discretionary authority is

required. As with registered representatives of broker-dealers, an

IA may use discretion as to time and price of an execution

without having discretionary authority.

Look Out!The time and price question is sure to be tested and is easy to

recognize. But expect additional questions on discretionary powers, particularly regarding situations where a client is unavailable and the client\'s spouse may want to place orders or give approval to an IA\'s suggestion of a buy or sell

order. If the spouse has not been given written power of attorney on the account, it is always incorrect to choose an answer involving

the spouse. In particular, watch out for an answer stating the spouse can give approval as long as the client signs a power of

attorney within 10 days following the trade: the 10-day rule only applies following the first transaction to occur in a new

account.

Exam Tips and TricksCustody questions tend to focus on the Investment Advisers Act

standards. Consider this sample question:

1. The following statements about IAs that take custody of

client funds are true, EXCEPT:

a. each client must receive a statement of transactions in the

account at least quarterly.

b. the IA must be audited at least annually.

c. each client's funds must be segregated from other client's

funds.

d. client funds must not be commingled with the IA's funds.

The correct answer is "c" - while the funds must not be commingled with

the IA's funds, there is no requirement that they not be commingled with

other client's funds.

Handling Client Funds - Suitability

If at any time you knowingly recommend an unsuitable

investment to a client, with the intention to defraud, you are

liable for both civil and criminal penalties. Suitability is defined in

many ways, a few of which will be discussed here.

Look Out!The SEC specifically defines suitability as follows:

When your broker recommends that you buy or sell a particular security, your broker must have a reasonable basis for believing that the recommendation is suitable for you. In making this assessment,

your broker must consider your risk tolerance, other security holdings, financial situation (income and net worth), financial needs, and

investment objectives.

The USA requires IAs to determine the suitability of investment

recommendations given each client's circumstances. Failure to do so is

considered an unethical business practice and is subject to penalties.

The following practices are examples of violations of the suitability rules:

Recommending securities without having a reasonable basis for the

recommendation

Recommending securities without taking the client's financial

situation, needs and objectives into account

Recommending the same security to all clients

Failing to describe important facts and risks about the security to

each client

Making trades of excessive size in a client's account

Churning in a client account (making trades too frequently)

Providing services that are not appropriate to the client's situation

and needs

Failing to inquire into client's tax situation, risk tolerance and other

assets

The Investment Advisers Act of 1940 also defines failure to meet

suitability standards as an unethical practice. An IA who does not make

reasonable inquiry, or suitable recommendations given the information

from such an inquiry, is guilty of violating the suitability requirements.

Handling Client Funds - Prudent Investor Standards

For many years, the "Prudent Person Rule" stood as a guide for

fiduciary investing. While it was designed to limit unsuitable

investing by third parties, it basically placed a higher emphasis

on preservation of capital than on income or growth.

Furthermore, the rule required looking at each investment to see

if it was suitable. 

In 1994, the Uniform Prudent Investor Act was created as a model

law for states to enact. It essentially updated the old "prudent

investing" standards to take modern portfolio theory into

account. As a result, fiduciary investors can take advantage of

diversification and risk-reward tradeoffs and can manage a

portfolio as a whole. 

Look Out!While the Uniform Prudent Investor Act permits an IA to include

growth investments if they are appropriate to the needs of the client, remember that the client\'s specific situation is the key consideration. Look out for questions that imply that, under the Act, stocks would be appropriate for any client account.

While the fiduciary role of IAs and IARs was discussed earlier in

the section, it is important to understand that all topics discussed

in this section must be considered in all dealings with the client,

from investment recommendations to choice of trustees (for

retirement accounts and other trusts) and investment managers.

Exam Tips and TricksSuitability is one of the primary concerns of an IA. Questions

could focus on either the practices that violate suitability standards or the consequences of such violations. Consider this sample

question:

1. An IA is working with a new advisory client who is anxious

to get a large sum of cash invested. When the IA tries to

take the time to understand the client's financial objectives

and other assets, the client tells her, "We'll do that later,

just get my account invested first." Which of the following

statements is TRUE?

a. The IA should explain that it is unethical to make investment

recommendations without first obtaining this information.

b. The IA can make investment recommendations as long as the

financial objectives are obtained within 10 days of investing

the funds.

c. The IA must cancel the client's advisory contract.

d. The IA can make investment recommendations once she

receives the client's other investment account statements.

The correct answer is "a". The IA must not invest the client's money until

sufficient information is gathered to make suitable recommendations, and

she should explain to the client why failure to follow this rule is unethical

and inappropriate.

CHAPTER 15: Conflicts of Interest - Introduction

Both the Investment Advisers Act of 1940 and the Uniform Securities Act

spell out a number of potential conflicts of interest and unethical

behaviors.

Conflicts of Interest - Excessive Trading and Insider Trading

Excessive Trading

Excessive trading has already been mentioned in the"Suitability" section.

By definition, excessive trading is also a conflict of interest, since in most

cases an IA who engages in this behavior also receives commissions from

such trades. This is a clear case of conflict of interest, since an IA must

always put his or her client's interests first. Any time you trade (on a

discretionary basis), or recommend trading excessively in or for a client's

account, for the sake of generating commissions, you are committing

fraud. Legally, the term associated with this action is known as churning.

The SEC defines churning as follows:

Churning refers to excessive buying and selling in your account by your

broker. For churning to occur, your broker must exercise control over the

investment decisions in your account, either through a formal written

discretionary agreement or otherwise, and must engage in excessive

trading in light of the financial resources and character of the account for

the purpose of generating commissions.

Insider Trading

As the SEC site makes clear; there are actually two types of insider trading, the legal kind and the illegal kind. This clarification is needed because many people associate the term with solely illegal activities. According to the SEC, legal insider trading occurs when insiders (officers, directors and employees) trade their own securities and report any/all transactions to the SEC. 

Look Out!According to the SEC, illegal insider trading occurs when insiders buy or sell securities"in breach of a fiduciary duty or other relationship of

trust and confidence, while in possession of material, nonpublic information about the security. Insider trading violations may also

include \'tipping\' such information, securities trading by the person \'tipped,\' and securities trading by those who misappropriate

such information."

Examples of insider trading listed by the SEC include:

corporate officers, directors and employees who traded the

corporation's securities after learning of significant, confidential

corporate developments; 

friends, business associates, family members and other "tippers" of

such officers, directors and employees, who traded the securities

after receiving such information; 

employees of law, banking, brokerage and printing firms who were

given such information to provide services to the corporation whose

securities they traded.

Examples of insiders listed by the SEC include:

government employees who learned of such information because of

their employment by the government; and

other persons who misappropriated, and took advantage of,

confidential information from their employers.

Conflicts of Interest - Selling Away, Client Loans and Confidentiality

Selling Away

When a broker solicits you to purchase securities not held or offered by the brokerage firm. As a rule, such activities are a violation of securities regulations. Typically, when a broker is selling away, the investments are in the form of private placements or other non-public investments.

Look Out!The basic idea here is that if you are selling away, as a broker, you are attempting to sell something that you do not have rights to, or have not

been authorized to sell. Such activity is considered fraudulent.

Client Loans

It is usually considered unethical to borrow money from or loan money to

a client. Since the advisory relationship allows the IA to know confidential

information about the client's income and assets, it is a breach of

confidentiality (see below) to borrow money from the client. Furthermore,

loaning money in either direction is likely to influence the advice given,

thus making it almost impossible for the IA to give objective advice.

Exceptional circumstances in which it would be allowable for an IA to

borrow money from a client are these: 

if the client is in the business of lending money

if the client is an affiliate of the investment advisor

if the client is a broker-dealer.

Exceptional circumstances in which it would be allowable for an IA to lend

money to a client are these: 

if the IA is a financial institution that normally engages in lending

money

if the client is affiliated with the IA, such as an employee of the IA.

Look Out!Remember, it is OK to borrow from or lend to someone who is an affiliate of the investment advisor or broker-dealer. On the exam,

this is usually referred to simply as "an affiliate". his can be confusing, but these answers are considered correct.

Confidentiality

Confidentiality is required for all aspects of client information, unless the

client specifically authorizes disclosure of information in writing.

Confidentiality rules cover information on the client's:

identity;

investments;

transactions;

trust arrangements;

legal affairs;

tax information.

However, disclosure that may be required by governmental authorities (e.g. SEC, IRS, FINRA) is

permitted, since the disclosure is required under law.

Exam Tips and TricksYou are sure to be tested on the topic of "arm\'s length"

transactions such as borrowing money from or loaning money to a client. Consider this sample question:

1. An investment advisor cannot borrow money from:

a. an affiliated investment advisor.

b. an affiliated broker-dealer.

c. an accredited investor.

d. an unaffiliated bank.

The correct answer is "c": an IA cannot borrow money from an advisory

client.

Conflicts of Interest - Antifraud Provisions and Market Manipulation

Antifraud Provisions

Complaints and Your Compliance Officer

If a customer brings forth a formal complaint, you must bring the

complaint to the attention of your compliance officer, and/or broker-

dealer.

Guarantees

It is considered fraudulent to guarantee any returns to any client.

Commingling funds

It is considered fraudulent to commingle funds in an account,

unless:o written authorization is granted by the firm.

o an agent contributes equally (monetarily) to the account.

Profit sharing

It is considered fraudulent to share in the profits of a client's

account - unless the account is dually owned with proportionate

funds. Furthermore, if an account is proportionately owned, written

notice must be supplied (and approved) by the broker-dealer.

Antifraud is always hot topic with the FINRA, especially with regards to

Anti-money laundering. exam.

Market Manipulation

Front running

Front running is an unethical practice that occurs when a

broker trades equity based on information from the analyst

department before his or her clients have been given the

information. 

Tailgating

Tailgating occurs when a broker or advisor is purchasing or selling a

security for his or her client(s), and then immediately making the

same transaction in his or her own account. 

Painting the tape

Painting the tape is an illegal action that occurs when a group of

market manipulators are buying and/or selling a security among

themselves to create artificial trading activity, which, when reported

on the ticker tape, lures unsuspecting investors as they perceive an

unusual volume.This behavior is similar to matching orders.

Conflicts of Interest - Fiduciary Duties

A fiduciary is required to act in the best interests of the person

he or she is working with. Fiduciaries have been legally appointed

and authorized to hold assets in trust for another person. The

fiduciary manages the assets for the benefit of the other person

rather than for his or her own profits. Trustees,

pension administrators, custodians and

investmentadvisors are all prohibited from engaging in any

fraudulent, deceptive or manipulative behaviors when working

with beneficiaries or clients. 

All securities professionals have fiduciary responsibility to handle

client funds and advice in a professional, ethical and responsible

manner. If you are a securities professional, you are a fiduciary.

This means you are held to a higher standard of ethical

responsibility than the average person is.

Simply put, fiduciaries must put the interests of their clients

above their own. Fiduciary duty covers agents, investment

advisors, investment advisor assistants, issuers and broker-

dealers. 

Look Out!It is very important to know that under no circumstances can an agent ask a client to sign an affidavit of liability waiver - better

known as an Exculpatory Clause - which says that the agent is not responsible for any losses that may occur in the account.

When it comes to working with clients, investment advisors and

investment advisor representatives have a much stronger fiduciary

responsibility than broker-dealers and their registered representatives.

Under the Investment Advisers Act of 1940, the IA's obligations in the role

of fiduciary include the following:

The duty to be loyal to the client

The duty to have a reasonable and objective basis for investment

recommendations

The duty to make sure that any investment recommendations are

appropriate considering the client's financial objectives, needs and

situation

The duty to ensure best execution for securities transactions, if the IA can direct such transactions

Look Out!The IA\'s primary fiduciary obligation is to put the client\'s (or the

beneficiary\'s) needs before his or her own. When faced with an exam question on this topic, answers such as "ensuring the account

does not lose money" or "investing in a fund desired by the trustee" are incorrect, since performance guarantees are

prohibited, and the IA\'s obligation is to the beneficiary, not the trustee.

Conflicts of Interest - Other Prohibited Behaviors

Actions that are considered either unethical behavior or conflicts of

interest include the following:

Misrepresentations - IA cannot misrepresent his/her qualifications,

services or fees to clients or potential clients 

Third-party research - IA cannot use or rely on third-party research

for investment recommendations or reports without disclosing this

fact to the client 

Advertisements - IA cannot use an advertisement that does not

comply with the guidelines of the Investment Advisers Act of 1940 

Failure to state important facts - for example, failing to state the tax

implication of a transaction 

Failure to follow a client's instructions 

Making misleading or untrue statements, including the following:o Stating or implying that either the state Administrator or the

SEC approves or endorses the IAo Making exaggerated claims about investment performance

o Stating or implying that either the Administrator or the SEC

approves of a specific investmento Making inaccurate statement regarding commissions or

markupso Giving inaccurate market quotations

o Misrepresenting the client's account status

Exam Tips and TricksThe exam is likely to contain a number of questions on prohibited behaviors such as misleading statements and misrepresentations.

Consider this sample question:

1. All of the following are unethical behaviors prohibited under

the Uniform Securities Act EXCEPT:

a. deliberately failing to follow a client's instructions.

b. executing a trade the IA believes to be unsuitable at the

client's orders.

c. telling a client that the IA is a Registered Investment Advisor

and has therefore been approved by the state Administrator.

d. failing to tell a client that making trades recommended by the

IA will subject the client to a large tax liability.

The correct answer is "b": the IA must follow client orders. It would be

unethical only if the IA recommended the inappropriate trade.