Series 65 Unit 13 Communications with customers and prospects

disclosure of capacity by broker-dealers

broker-dealers can act in principal or agency capacity

principal capacity: BD is the contra party, profit from markup or markdown

agency capacity: BD acts as a broker, earns commission

trade confirmation must indicate capacity and disclose commission or markup/markdown if applicable

disclosure of capacity by investment advisers

investment advisers give advice and get compensated, not in the business of executing transactions

advisers may act as principal or agent in rare cases

principal transactions can lead to abuses like price manipulation

agency transactions create conflicts due to additional compensation

full written disclosure and client consent required for principal and agency transactions

consent can be oral or written, obtained before or after execution but before completion

broker-dealers only need to indicate capacity on trade confirmation, no consent required

adviser not "acting as broker" if no additional compensation received

agency cross transactions

adviser acts as agent for both sides of the trade

requires client's written consent in advance

adviser receives commissions from both sides

potential conflict of interest due to divided loyalties

annual statement summarizing transactions and remuneration

arrangement can be terminated at any time

no transaction if adviser recommended to both buyer and seller

adviser must obtain best execution and best price

written trade confirmation includes nature, date/time, and remuneration details

required disclosure would include the following:

state or regulatory proceedings: adviser or management person violated rules/statutes, leading to denial, suspension, or revocation of registration

court proceedings: permanent/temporary injunction against the firm or management person for investment-related activity or any felony

SRO proceedings: adviser or management person caused business to lose registration, or was barred, suspended, expelled, fined over $2,500, or had activity limitations

examples of failures to disclose material information to clients would include the following:

how fees are charged, and negotiability

affiliation with broker-dealer or other securities professionals

financial condition if adviser has discretionary authority, custody, or requires prepayment of fees (over $500 for state-registered, over $1,200 for federal)

average price paid in bunched trades and disclose allocation policy

legal actions promptly to existing clients and within 48 hours to prospective clients (state-registered) or in the brochure (federal covered)

Practice Question

BJS Advisory Service maintains no custody of customer funds or securities, requires no substantial prepayments of fees, and does not have investment discretion over clients' accounts. Which of the following would have to be promptly disclosed to clients?

I. The SEC has entered an order barring the executive vice president of the firm from association with any firm in the investment business.

II. BJS has just been fined $3,500 by the NYSE.

III. A civil suit has just been filed against BJS by one of its clients alleging that BJS made unsuitable recommendations.

A. I and II

B. I and III

C. II and III

D. I, II, and III

Answer: A. Material disciplinary violations must be reported by all investment advisers, regardless of whether they keep custody. The first two answers fit the definition of material actions, but not the third. If the suit goes in favor of the client and the adviser is found guilty, disclosure would need to be made. However, there is something that investment advisers who do not maintain custody or receive substantial prepayments avoid having to do. What is that? They do not have to notify their clients about any financial situation that might impair their ability to meet contractual commitments to clients.

some examples of potential conflicts of interest are:

offering a proprietary product, such as a house fund (a mutual fund where the underwriter or adviser is affiliated with the broker-dealer)

offering a limited partnership offering (DPP) where the sponsor is an affiliate of the broker-dealer

program sponsors, such as investment companies or insurance companies, providing incentives or rewards to agents for selling the sponsors' products

a securities professional having a financial interest in any security being recommended

a broker-dealer going public and placing shares of its own stock into discretionary accounts

a broker-dealer publishing a favorable research report after underwriting the issuer's stock offering

here are some ways that broker-dealers can make the disclosures easier for customers to follow:

fees are typically disclosed when a customer account is opened

if the firm changes the fee schedule, be clear about it, and be sure to use appropriate methods to give advance notification of the changes to the customer

minimize the fine print, or at least make the fees and charges clear

whether using a table, a chart, or a list, make sure it is easy for customers to determine what the fees and charges are and how they are computed

use standardized and uncomplicated terms to describe service and maintenance fees in order to help clients compare fees between different firms

examples of the more common fees that might be charged by a broker-dealer include the following:

issuance of stock certificate: charge for physical delivery

transferring account: charge for administrative expenses

wiring funds: charge similar to bank fees

margin account interest: disclosed interest rate on borrowed funds

account maintenance fees: annual fee, often for small accounts

safekeeping of funds/securities: custody charge, usually waived for large accounts

late settlement fee: fee for late or insufficient payment

postage and handling: charge for express or overnight delivery

a firm's regulation best interest/relationship summary tells retail investors about:

the types of services a firm offers

the fees and costs they will have to pay for those services

conflicts of interest a broker or adviser has

the required standard of conduct associated with the services a firm offers

whether a firm and its financial professionals have reportable legal or disciplinary history

key questions (conversation starters) to ask the financial professional

links or other references to more detailed information

any broker-dealer or agent making a recommendation must exercise reasonable diligence, care, skill, and prudence, and they must:

acknowledge the potential risks, rewards, and costs associated with a recommendation

act in the best interest of a particular customer based on that retail customer's personalized investment profile

believe that a series of recommendations is in the customer's best interest when viewed in isolation and is not excessive and unsuitable for the customer when taken together as a whole

identify conflicts of interest and disclose and mitigate or eliminate them

misrepresenting a securities professional's registration

cannot say the administrator has approved you or your registration

representing registration as approval of qualifications is prohibited

can state you are a registered agent of ABC broker-dealer or registered investment adviser representative of XYZ investment adviser

cannot misrepresent the nature of services provided

misrepresenting a security's registration

cannot imply that registration of a security means approval by the administrator or regulatory body

prospectus must include a disclaimer stating the security has not been approved or disapproved

any representation to the contrary is a criminal offense

Practice Question

LMN Securities, a broker-dealer registered with the SEC in more than a dozen states, has just become a member firm of the New York Stock Exchange. It would be permitted for LMN to tell its customers that

A. the membership in the NYSE is a testimony to the integrity of the firm.

B. they are now members of the NYSE.

C. they are now federal covered and will no longer have to register in those states where they do not maintain a place of business.

D. this adds one more level of approval of the firm's business.

Answer: B. When it comes to the registration of any securities professional, any statement relating to approval or something similar is prohibited. There is no such thing as a federal covered broker-dealer, and becoming a member of a national stock exchange has no impact on the state registration of a broker-dealer.

guaranteed security

third party guarantees payment of principal and interest (debt) or dividend (equity)

no guarantee on investment performance

gains cannot be part of the guarantee

guarantee against loss

performance guarantees are prohibited actions

examples: promising specific returns or buying back investments at a guaranteed price

NASAA model rule prohibits guaranteeing specific results (gain or no loss)

under state law and federal law the contract must disclose:

the services to be provided, including custody if appropriate

the term of the contract (contracts can be of any length, not necessarily annual, but all renewals under state law, just as with initial contracts, must be in writing)

the amount of the advisory fee or the formula for computing the fee

the amount or manner of calculation of the amount of any prepaid fee to be returned in the event of contract termination

whether the contract grants discretionary power to the adviser or its representatives

that no assignment of the contract may be made by the adviser without the consent of the other party to the contract (the client)

that, if the adviser is organized as a partnership, any change to a minority interest in the firm will be communicated to the other party to the advisory contract (the clients) within a reasonable period of time

a change to a majority of the partnership interests would be considered an assignment

Practice Question

ABC Investment Advisers, organized as a partnership, has seven equal partners. At ABC's annual partnership meeting, one of the partners announces their retirement, while another is leaving to become a partner in another firm. As a result, ABC must notify

A. the Administrator of the change in partners within a reasonable period of time.

B. the other party to the contract of the change in partners within a reasonable period of time.

C. the SEC of the change in partners within a reasonable period of time.

D. its advisory clients of the change prior to the renewal date of the firm's registration.

Answer: B. When a minority interest changes in an IA structured as a partnership, notification to the firm's advisory clients (the other party to the advisory contract) must be made within a reasonable period of time.

Practice Question

The Investment Advisers Act of 1940 would permit investment advisory contracts to provide for

I. assignment without the client's consent.

II. changes to be made in a partnership with notification to clients within a reasonable period of time.

III. compensation based on average assets under management over a particular time period.

A. I and II

B. I and III

C. II and III

D. I, II, and III

Answer: C. A client's contracts, whether written or oral (technically, the Investment Advisers Act of 1940 does not require written contracts), may not be assigned without the client's consent under any circumstances. If the adviser is a partnership, notice must be made to clients of any changes in the membership of the partnership within a reasonable time period. It is always permitted to charge a fee based on the average value of assets under management.

summary of notice and consent

partnerships: notify clients of changes involving a minority of partners

corporations: no need to notify clients of changes to shareholders

client permission required to assign contracts

assignment: change to majority of partners or majority of stock pledged as collateral

narrative format

part 2 of form ADV requires narrative responses

18 items on form ADV part 2a (19 for state-registered advisers)

items include advisory services, fees, methods of analysis, disciplinary info, broker-dealer selection, custody practices, investment discretion

plain english

brochure and supplements must be written in plain english

should be concise and direct

discuss conflicts of interest and practices

disclosure obligations as a fiduciary

IAS must make full disclosure of all material facts

avoid conflicts of interest or fully disclose them

full and truthful disclosure

all information must be true and not omit material facts

filing

file brochure(s) and amendments through IARD system

federal covered IAS: no need to file supplements, but must preserve copies

state-registered IAS: file brochure supplement for each supervised person in that state

cover page

identifying the supervised person (or persons) covered by the supplement as well as the advisory firm

educational background and business experience

including disclosing if the supervised person has no high school education, no formal education after high school, or no business background

disciplinary information

about material events within the past 10 years, although the SEC says that even if more than 10 years have passed since the date of the event, you must disclose the event if it is so serious that it remains currently material to a client's or prospective client's evaluation

other business activities

including disclosing if the supervised person receives commissions, bonuses, or other compensation based on the sale of securities or other investment products, including as a broker-dealer or registered representative (agent), and including distribution or service (trail) fees from the sale of mutual funds

additional compensation

beyond that paid by the client (such as a sales award or other prizes)

supervision

including providing the name, title, and telephone number of the individual responsible for supervising the supervised person's advisory activities on behalf of the firm

balance sheet requirement for federal covered advisers

include audited balance sheet with ADV part 2a if substantial prepayment of fees

balance sheet requirements for state-registered advisers

include audited balance sheet with ADV part 2a if substantial prepayment of fees

include audited balance sheet if maintaining custody of client funds/securities

include audited balance sheet if custodian is related broker-dealer

file balance sheet (not audited) within 90 days if exercising discretionary authority but not maintaining custody

wrap fee program

charges specified fee for advisory services and transaction execution

use part 2a appendix 1 instead of normal brochure

deliver wrap fee program brochure to clients

wrap free program required disclosures include:

statement on cover page

wrap fee amount

negotiability

services provided

cost comparison

additional fees

compensation for recommending program

account requirements

portfolio manager selection and review

conflicts of interest

client contact restrictions

relationships with issuers

delivery requirements for SEC registered advisers

firm brochure must be delivered to each client

given before or at the time of entering advisory agreement

annually, within 120 days of fiscal year end, deliver updated brochure or summary of material changes

delivery requirements for state-registered advisers

state-registered advisers must deliver brochure at least 48 hours before or at contract signing

client can terminate contract without penalty within five business days

setup fee refunded if brochure not delivered 48 hours before agreement

pro rata charge allowed for services during five-day period

there are three categories of clients to whom the IA is not required to deliver supplements:

no brochure or supplement for clients receiving impersonal investment advice or firm executives/employees involved in investment activities

impersonal advice clients example: those paying $500+ per year for a subscription

firm executives/employees: must have been performing investment-related duties for at least 12 months

there are two exemptions under both state and federal law from the delivery requirements of the rule.

contracts with registered investment companies are exempt

impersonal advisory services contracts are exempt, but brochure delivery must be offered if annual charge is $500 or more

the brochure must be updated:

each year at the time of filing the annual updating amendment

promptly whenever any information in the brochure becomes materially inaccurate

federal covered advisers file brochure amendments through IARD, but not required to file brochure supplement amendments with SEC (must maintain copies)

state-registered advisers file brochure and brochure supplement amendments with state securities authorities through IARD

Practice Question

Many students get confused over the 90-day and 120-day requirements. This example should help:

Which two of the following statements accurately describe the time limits for investment adviser documents?

I. Filing of the annual updating amendment to Form ADV with the appropriate regulatory body is within 90 days of the end of the adviser's fiscal year.

II. Filing of the annual updating amendment to Form ADV with the appropriate regulatory body is within 120 days of the end of the adviser's fiscal year.

III. Delivery of the investment adviser's brochure to the customer is due within 90 days of the end of the adviser's fiscal year.

IV. Delivery of the investment adviser's brochure to the customer is due within 120 days of the end of the adviser's fiscal year.

A. I and III

B. I and IV

C. II and III

D. II and IV

Answer: B. Some logic here might help. The investment adviser must get its paperwork into the state (or SEC) prior to the end of the 90-day period. Then, the IA has another 30 days to get the information into the brochure to be sent to the clients.

social media

integrates technology, social interaction, and content creation

includes blogs, microblogs, wikis, photo/video sharing, podcasts, social networking, virtual worlds

terms social media, social media sites, sites, and social networking sites are used interchangeably

investor concerns regarding social media

traditional communication: written correspondence, print, TV, radio

modern communication: email, texting, websites, social networks

NASAA's concern: alerting investors to social media risks

securities professionals: protect clients from social media scams

con artists: build trust quickly, access personal info, target victims

scams spread rapidly through social networks

online red flags for investors include:

promises of high returns with no risk are too good to be true

offshore operations make it hard to recover funds

e-currency sites may be unregulated and used to hide money trails

recruiting friends often involves bonuses for bringing in new investors

professional websites may lack detailed information about the company

no written information provided about investment risks and withdrawal procedures

testimonials from group members may indicate a ponzi scheme or affinity fraud

Practice Question

One of your clients approaches you to get your evaluation of an investment opportunity that was received through a Facebook post sent by a friend. The investment promises a monthly return in excess of 1% and claims that it is registered with an offshore regulatory body. You should explain to your client that

A. these are reasonable expectations based on the investment and the location of the issuer.

B. your firm does not sell that security and, as a result, you cannot make any comments about the issue.

C. it is important to check with the friend to find out more about the deal.

D. these are red flags and are a clear warning to stay away from this investment.

Answer: D. Unreasonably high returns and not being registered in the United States are two items on the list of red flag warnings to investors published by NASAA.

regulatory concerns about social media

SEC and FINRA policies guide disciplinary actions for broker-dealers and investment advisers

FINRA guidance covers email, instant messaging, chat rooms, blogs, bulletin boards, websites, social media

content determines compliance, not technology or platform

same rules apply to electronic and face-to-face communications

agents must follow firm policies on electronic communications

inappropriate use of email/social media can lead to fines, loss of business, fraud

agents must follow rules even in personal time if identifiable as firm representatives

electronic communications include email, instant messaging, text messaging

websites treated as advertisements, original and revised designs kept for three years

according to NASAA an example of deceptive or misleading advertising or sales presentations may include:

a distribution of any nonfactual data

any material or presentation based on conjecture

exaggerated or unrealistic claims in any brochure, flyer, or display by words, pictures, or graphs

anything otherwise designed to supplement, detract from, supersede, or defeat the purpose or effect of any prospectus or disclosure

broker-dealer advertising

broker-dealers must comply with FINRA and NASAA policies on advertising

recommendations through social media must meet suitability requirements

non-recommendations: research pages, search engines, research tools, general alerts

recommendations: targeted communications, sector-specific emails, personalized portfolio analysis, data-mining-based suggestions

testimonials allowed for broker-dealers, not for investment advisers (until new rule)

broker-dealers must analyze communications to determine if they are recommendations and fulfill suitability obligations

investment adviser advertising

communications offering advisory services to clients or private fund investors

endorsements or testimonials with compensation

third-party information endorsed or prepared by adviser

communications to private fund investors

live written communications like texts or chats

no untrue or misleading statements

must substantiate material statements

fair and balanced treatment of benefits and risks

no misleading implications or inferences

no false claims of free services

no misleading performance results

no claims of SEC or administrator approval

testimonials

testimonials and endorsements allowed if disclosures are met

disclose if promoter is a client

disclose if compensation was provided

disclose material conflicts of interest

solicitors may be considered promoters

written agreement with promoters required unless de minimis compensation or affiliate

specifically, the marketing rule prohibits including in any advertisement:

gross performance unless the ad also includes net (after fees) performance

any performance results, unless they are provided for specific time periods (the most recent one-, five-, and ten-year periods to the extent applicable)

"cherry-picking" by showing only the best performing portfolios

hypothetical performance unless the adviser adopts and implements policies and procedures reasonably designed to ensure that the performance is relevant to the intended audience

predecessor performance, unless there is appropriate similarity with regard to the personnel and accounts at the predecessor adviser and the personnel and accounts at the advertising adviser

social media issues related to agents

personal devices used for client communication are covered by rules

prior approval may be required depending on the media

Twitter: unscripted participation generally doesn't need prior approval

LinkedIn: likely requires preapproval

content determines approval and recordkeeping, not the device or technology

Twitter posts easy to monitor, Facebook poses challenges

initial tweet needs preapproval, subsequent tweets do not

LinkedIn: business networking site, job info can be unmonitored

testimonials or recommendations on LinkedIn make it a business site requiring firm responsibility

Practice Question

The regulatory bodies are concerned about agents using social media to communicate with clients when they are using their

I. office desktop computers.

II. tablets supplied by the firm.

III. smartphones.

IV. personal laptops while on vacation.

A. I and II

B. I and IV

C. II, III, and IV

D. I, II, III, and IV

Answer: D. The format is not what counts; it is the content that matters.

Practice Question

Which of the following is not a factor when a communication to be distributed to the public is either being reviewed or approved by the investment adviser?

A. Whether statements of benefits are balanced with statements of potential risks

B. The nature of the audience to which the communication is intended to be distributed

C. Whether the piece will be distributed in written form or on the firm's website

D. Whether the communication is targeting existing customers or prospective ones

Answer: C. The format is not what counts; it is the content that matters.