Security Industry Essentials (SIE) Exam Study Guide

Section 1: Knowledge of Capital Markets

This section covers the foundations of the financial services industry. It will address information about regulatory entities, types of economic markets, factors that can impact these markets, and securities offerings. At the end of this section, the goal is to have a greater understanding of the securities industry and its regulations.

1: Regulatory Entities & Agencies

Securities and Exchange Commission (SEC)

• • Established in 1934 during the Great Depression.
  • Purpose: To protect market participants (investors) and ensure fair and efficient markets in the United States.
  • Responsibilities: Enforcing securities laws and regulations, overseeing self-regulatory agencies, state regulators, and Congress.
  • Key Legislation overseen by the SEC:
    • The Securities Act of 1933: Regulates securities offerings and requires issuers to disclose material information to protect investors from fraud.
    • The Securities Exchange Act of 1934: Regulates securities trading on the secondary market and requires certain issuers to file periodic reports with the SEC.
    • The Investment Advisers Act of 1940: Regulates investment advisers' advertising practices and defines "accredited investor" and "qualified client."
    • The Investment Company Act of 1940: Regulates investment companies, such as mutual funds and unit investment trusts.

Self-Regulatory Organizations (SROs)

• • SROs exist to protect investors and establish industry procedures and compliance.
  • Examples of SROs:
    • New York Stock Exchange (NYSE): The largest stock exchange in the world, listing companies that meet rigorous requirements.
    • Chicago Board Options Exchange (CBOE): The largest options exchange, allowing trading in put and call options on various securities.
    • Financial Industry Regulatory Authority (FINRA): Not-for-profit organization supervising U.S. broker-dealers, writing and enforcing rules, and educating investors.
    • Municipal Securities Regulatory Board (MSRB): Regulates investment firms and banks selling municipal bonds and securities.

Other Regulators and Agencies

• • United States Treasury: Oversees government revenue and agencies like the Internal Revenue Service (IRS) and Financial Crimes Enforcement Network (FinCEN).
  • Internal Revenue Service (IRS): Collects taxes and administers U.S. tax law.
  • The Federal Reserve (The Fed): Central bank of the United States with responsibilities like regulating banks and maintaining financial stability.
  • State Regulators: Protect investors through education and market transparency, and each state has its own securities regulator.
  • Federal Deposit Insurance Corporation (FDIC): Provides deposit insurance to U.S. bank depositors.
  • Securities Investor Protection Corporation (SIPC): Restores trust in the securities industry by insuring eligible investors for up to $250,000 in cash in brokerage accounts.
  • Foreign Country Regulators: Most countries have their own government regulatory agencies overseeing securities markets, e.g., Financial Conduct Authority (FCA) in the UK.

2: Market Participants & Roles

Investors

• • Retail Investors: Individual investors who buy and sell public debt and equity securities for personal goals like retirement or saving for a house. Securities regulations aim to protect retail investors.
  • Accredited Investors: Individuals or entities meeting specific requirements related to net worth or income. They can trade in private securities not registered with the SEC.
  • Institutional Investors: Legal entities (e.g., pension funds, hedge funds) trading in securities on behalf of clients or shareholders, considered sophisticated investors.

Broker-Dealers

• • Introducing Brokers: Receive orders for securities but contract with clearing firms to process them.
  • Clearing Firms: Hold customer accounts and facilitate trade clearing and settlement.
  • Prime Brokers: Service large financial institutions by providing various activities like trade clearing and risk analysis.

Investment Advisers

• • Registered individuals or companies providing advice on securities investments or managing investment portfolios.
  • Act as fiduciaries, legally obligated to act in the best interests of their clients.

Municipal Advisors

• • Firms providing advice on municipal financial products or securities issuance to municipal entities or obligated persons.
  • Required to register with both the SEC and MSRB.

Issuers and Underwriters

• • Issuers: Legal entities funding their operations by selling securities to investors.
  • Underwriters: Facilitate the sale and distribution of issuer securities by pricing, purchasing, and selling to investors.

Traders and Market Makers

• • Brokerage firms providing availability for public investors to buy or sell stocks and bonds.
  • Market makers trade securities of specific companies, ensuring liquidity in the market.

Custodians and Trustees

• • Trustees: Govern trusts and manage assets on behalf of trust beneficiaries.
  • Custodians: Hold assets for safekeeping, typically banks or brokerage firms.

Transfer Agents

• • Act as intermediaries between securities issuers and holders.
  • Maintain security holder records and distribute dividends on behalf of issuing companies.

Depository Trust & Clearing Corporation (DTCC)

• • Manages clearing and settlement processes for most U.S. securities transactions.

3: Market Structure

Types of Markets

• • Primary Market: Deals with newly created debt and equity securities, like IPOs.
  • Secondary Market: Facilitates trading of publicly traded securities between investors on stock exchanges.
  • Third Market: Enables OTC trading of exchange-listed securities between institutional investors and broker-dealers.
  • Fourth Market: Allows direct trading of large blocks of securities between institutional investors through ECN, after hours.
  • Foreign Markets: Provide access to international securities, including ADRs and Regulation S Offerings.

4: Economics

Monetary vs. Fiscal Policy

• Monetary Policy: Actions taken by the Federal Reserve (The Fed) to maintain or promote the health of the U.S. economy. Includes changes in the federal funds rate to influence interest rates and stimulate or slow down the economy.
• Fiscal Policy: Actions taken by Congress and the President in setting tax rates and policies to impact government spending and taxation.

Open Market Activities & Impact on Economy

• The Fed can stimulate economic activity by increasing available lendable money supply, leading to lower interest rates and increased consumer spending.
• To slow down the economy and discourage excessive consumer spending, the Fed reduces lendable money supply, leading to higher interest rates.

Different Rates

• Prime Rate: Base interest rate offered by commercial banks for consumer loans, influenced by the discount rate.
• Discount Rate: Rate offered to member banks borrowing money from the Fed to maintain reserves.
• Federal Funds Rate: Target rate set by the Fed to control inflation.

Business Economic Factors: Financial Statements

• Balance Sheet: Details a company's assets, liabilities, and shareholders' equity at a specific time, aiding analysts in assessing the company's health.
• Income Statement: Presents a company's revenues and expenses over a period, determining its profitability (net income).
• Cash Flow Statement: Shows a company's cash inflows and outflows from operating, investing, and financing activities.
• Shareholder Equity Statement: Reflects changes in a company's equity accounts over a period, including common stock, retained earnings, etc.

The Business Cycle

• Expansion: Growing economy with healthy GDP growth (2-3%).
• Peak: Overheated economy, prices at their highest, and economic indicators stop growing.
• Contraction (Recession): Economic growth weakens, GDP growth falls below 2%, and layoffs increase.
• Trough: Lowest point before the economy transitions from contraction to recovery.
• Recovery: Low prices foster demand, employment and production rise, and lenders are more willing to lend.

Economic Indicators

• Leading: Indicate short-term economic direction (e.g., stock market returns, building permits).
• Lagging: Reveal trends after major economic events (e.g., unemployment rate, corporate profits).
• Coincident: Show current economic status (e.g., GDP, personal income).

Inflation

• Occurs when the purchasing power of money declines, leading to higher prices and stock price volatility.

Effects on Bond & Equity Markets

• Cyclical: Businesses that follow the standard business cycle, doing well in good economies (e.g., leisure, luxury industries).
• Defensive: Businesses providing daily necessities not significantly impacted by economic fluctuations (e.g., utilities, basic consumer goods).
• Growth: Industries expected to grow faster than the overall economy (e.g., technology, healthcare).

Principal Economic Theories

• Keynesian: Government interventions through spending and tax changes can prevent or repair recessions.
• Monetarist: Control money supply, let the market work, and minimal government intervention for a healthy economy.

International Economic Factors

• Balance of Payments: Net transactions between one country's entities and those of outside countries.
• Gross Domestic Product (GDP): Total value of all goods and services produced within a country.
• Gross National Product (GNP): Total value of all goods and services produced by a country's citizens, regardless of location.
• Exchange Rates: Rates at which one currency is exchanged for another, influenced by spot exchange rates.

5: Offerings

Public Offerings

• Public Offering: Occurs when an issuer sells its securities to the general investing public, often through an initial public offering (IPO) or a follow-on offering (APO).
• Initial Public Offering (IPO): First time a company offers its shares to the public, requiring a registration statement filed with the SEC.
• Follow-On Offering / Additional Public Offering (APO): Subsequent offering of shares to the public after the IPO, subject to SEC registration requirements.

Private Offerings

• Private Offering: Issuer sells securities to a narrowly defined group of investors who meet strict wealth and sophistication requirements, referred to as private placements.
• SEC Regulation D (Reg D): Contains rules for exemptions from SEC registration for private offerings.

Restricted and Control Securities - Rule 144

• Restricted Securities: Securities acquired in private, unregistered sales by an issuer or an affiliate of the issuer.
• Control Securities: Securities held by an issuer's officers, directors, and investors owning 10% or more of the voting stock of the issuer.
• Rule 144: Allows shareholders to sell restricted and control securities in the public marketplace if certain conditions are met, including holding the securities for a minimum length of time (holding period).

Company Buy-Back Programs

• Stock Buyback / Share Repurchase: Occurs when a company buys back its shares from the market using company funds, leading to reduced outstanding shares and increased relative ownership percentage for shareholders.
• SEC Rule 10B-18: Prohibits share repurchases during the last 30 minutes of the trading day (10 minutes for companies with higher average daily trading volumes) and imposes price restrictions.

Methods of Distribution

• Firm Commitment: Investment bank commits to purchase all securities from the issuer and resell them to the public.
• Best Efforts: Investment bank agrees to use its best efforts to market and sell the issuer's securities, returning any unsold shares to the issuer.
• All or None: If all shares don't sell, the entire offering is nullified, and shares are returned to the issuer.
• Minimum-Maximum (Mini-Max): Similar to all or none, but a lesser minimum percentage must be sold for the deal to proceed.

Roles of Participants

• Initial Public Offering (IPO): Underwriting syndicate with lead underwriter and syndicate members, selling group, and potential non-syndicate member brokers.
• Municipal Bond Offering: Negotiated sale or competitive sale with underwriters and investors placing bids.

Shelf Registrations and Distributions

• Shelf Registration: Allows issuers to register the offer and sale of securities on a delayed or continuous basis, enabling them to offer securities quickly when market conditions are favorable.

Offering Documents and Delivery Requirements

• Prospectus: Filed with the SEC for public securities offerings, discloses relevant information about the issuer and the investment.
• Private Placement Memorandum (PPM): Provided to potential investors in a private placement, discloses relevant issuer information and offering details.
• Official Statement: Prepared for municipal bond offerings, containing bond details and information.
• Program Disclosure Document: Contains information about 529 plans.

Regulatory Filing Requirements and Exemptions

• Exempt Securities: Securities not required to be registered with the SEC.
• Exempt Offerings: Offerings not required to register with the SEC, subject to antifraud provisions of federal securities laws.
• Blue Sky Laws: State securities laws that may require registration unless an exemption is available.

Section 2: Understanding Products and their Risks

This section covers the various types of securities offered to investors along with their respective investment risks. It will address information about equity securities, debt instruments, options, direct participation programs, and other products. At the end of this section, the goal is to have a greater understanding of the numerous investment products that form the backbone of the securities industry.

1: Equity Securities

Type of Equities

1. Common: Represents ownership in a corporation with voting rights on corporate policies and board of directors' elections. Common shareholders may receive dividends and have limited liability. In liquidation, they are entitled to company assets after creditors, bondholders, and preferred shareholders.
2. Common Stock Equivalents: Securities convertible into common stock, such as convertible bonds, convertible preferred stock, options, warrants, and some bonds. Employee stock option plans (ESOPs) often offer common stock equivalents as compensation.
3. Preferred: Holders have fixed cumulative dividends and priority in liquidation over common shareholders.
4. Pre-emptive Rights: Existing shareholders have the right of first refusal to purchase new shares before the general public during a capital raise.
5. Warrants: Certificates giving the holder the right to buy common shares from a corporation at a fixed exercise price until the warrant expires.
6. Stock Options: Similar to warrants, stock options give the holder the right to buy common shares at a set price until the options expire. Often used as employee compensation.
7. Repurchase Agreement (Repo): Agreement to repurchase securities at a slightly higher price after a certain period, used for short-term loans and regulated by the Fed.
8. American Depository Receipts (ADRs): Certificates representing shares of a foreign company's stock, traded on U.S. exchanges in USD.

Shareholder Rights

1. Voting: Common shareholders have voting rights for the Board of Directors. Voting can be under a statutory system (equal votes for each open position) or a cumulative system (votes allocated disproportionately).
2. Freely-Tradeable vs. Restricted and Control Stock: Shareholders can freely trade their stock, but restrictions apply to unregistered securities acquired through private sales and control securities held by affiliates.

Risks of Equity Securities

1. Market Risk: Stocks may drop in value during a declining market.
2. Business Risk/Sector Risk: Poor business results or sector decline can affect stock value.

Order of Payment in Liquidation

1. Domestic support obligations and allowable administrative claims are paid first.
2. Assets used to pay off debt.
3. Equity shareholders, with preferred shareholders paid before common shareholders.

2: Debt Instruments

Treasury Securities

The United States government borrows money through various Treasury Securities:

1. Treasury Bills (T-Bills): Short-term borrowings with a maturity of one year or less. Interest is paid at maturity, and they are sold at a discount from their face value.
2. Treasury Notes: Intermediate-term borrowings with maturities ranging from 2 to 10 years. Interest is paid semi-annually and is exempt from state tax.
3. Treasury Bonds: Long-term borrowings with maturities of up to 30 years. Interest is paid semi-annually and is exempt from state tax.

Bill Auctions: The U.S. Treasury holds weekly public auctions of T-Bills, where investors bid either competitively or non-competitively for the offerings.

Ginnie Mae/Fannie Mae/Freddie Mac: Entities facilitating the mortgage market for residential housing and issuing short-term or long-term debt securities for funding purposes.

Municipal Securities

Municipalities borrow money through various securities:

1. General Obligation Bonds: Used to finance capital asset projects related to infrastructure, buildings, etc. Repayment is backed by the municipality's total tax and operating revenue.
2. Revenue Bonds: Funding public projects with repayment from the income generated by the specific project being funded.
3. Special Tax Bonds: Issued to fund public projects, where a specific tax increase is implemented to repay the bondholders.
4. Authority Bonds: Issued to finance income-producing facilities like toll bridges or airports, with repayment from business operations.
5. Taxable Bonds: Fixed-income municipal securities for projects not subsidized by the federal government.
6. Municipal Notes: Short-term debt securities maturing in one year or less, exempt from federal income tax.

Corporate Bonds

Corporations raise money by issuing bonds with fixed interest paid to investors, typically semi-annually. Other types include zero-coupon bonds and convertible bonds.

Money Market Instruments

Short-term fixed-income debt instruments with maturities up to 270 days:

• Certificates of Deposit (CD): Savings accounts with fixed interest for a fixed period. Can be traditional or brokered CDs.
• Banker’s Acceptances: Trade on secondary money markets, representing guaranteed payments from banks for 30 to 180 days, used in international transactions.
• Commercial Papers: Unsecured interest-paying securities issued by corporations with high credit ratings to cover short-term obligations.

Par Value: The initial loan amount of a bond.

Interest Rate: The fixed percentage of interest paid to bondholders, typically semi-annually.

Length to Maturity: Time between the issue date and maturity date when interest payments are made.

Accrued Interest: Interest earned but not yet paid, calculated based on days since last coupon payment.

Yields

Rate of return on investments.

• Current Yield: Expected annual rate of return, calculated by dividing the annual interest by the current market price.
• Yield to Maturity (YTM): Overall expected yield if held until maturity.
• Yield to Call (YTC): Yield if the bond were called by the issuer before maturity.

Bond Features

• Callable: Allows the issuer to pay off bonds before maturity.
• Puttable: Allows the bondholder to redeem the principal before maturity.
• Zero-Coupon: Bonds that don't pay interest, sold below face value and redeemed at full value at maturity.
• Convertible: Gives the issuer the option to repay the loan with common stock.

Bond Rating Agencies: Organizations evaluating the credit risk of debt securities and issuers, assigning ratings from AAA (highest quality) to lower ratings indicating higher risk.

Priority in Liquidation: Bonds ranked by priority of payment, with senior secured debt having the top priority.

Relationship between Price and Interest Rate: Inverse relationship between interest rates and bond market prices.

Risks of Debt Securities

• Interest Rate Risk: Value of the bond may decrease due to fluctuations in interest rates.
• Inflation Risk: Inflation may decrease the bond's expected return.
• Credit Risk: Risk of issuer defaulting on loan payments.
• Liquidity Risk: Few buyers available when selling the security quickly.
• Political Risk: Political challenges impacting the issuer leading to default or debt downgrade.

Municipal Bond Offerings: Negotiated vs. Competitive

• Competitive: Bonds sold through competitive bids, offering lower interest rates.
• Negotiated: Issuers directly negotiate terms with underwriters, considering indications of interest from investors.

3: Options

Types of Options

1. Call Options: Give the owner the right (but not the obligation) to buy an underlying asset or security on or before the expiration date of the contract.
2. Put Options: Give the owner the right (but not the obligation) to sell an underlying asset or security on or before the expiration date of the contract.

In options contracts, there are buyers and sellers:

• Selling vs. Buying: The seller (writer) receives a premium in exchange for giving the buyer the right to buy or sell an underlying asset at a specific price by the expiration date. The writer has a legal obligation to deliver or purchase the underlying asset if the option is exercised.

Options Terminology

• Premium: The market price paid for an option contract. Buyers pay the premium, and sellers receive it.
• Underlying Assets: The value of an option depends on the value of its underlying asset, such as stocks, foreign currency, market indices, debt securities, etc.
• Strike Price: The agreed-upon price at which a call or put option can be exercised (also called the exercise price).
• Expiration Date: The date at which an options contract expires, ranging from a week to several years. Longer-term options are typically more expensive.
• Intrinsic Value: The value of an option that is in the money (when the option can be exercised profitably) and has a positive value.
  • In the Money: Call option if the current price is higher than the strike price, and put option if the current price is lower than the strike price.
  • Out of the Money: Option contracts that do not have intrinsic value.
  • At the Money: When the current price equals the strike price, there is no intrinsic value.

Options Strategies

• Risk Mitigation/Hedging: Options are used to reduce investment losses (hedging) by taking a position in another investment. Common strategies include:
  • Covered Call Writing: Writing a call option on stock owned to receive a premium and protect against downside risk.
  • Protective Put Buying: Buying a put option on stock owned to lock in a selling price and protect against potential declines.
• Capital Gains: Options can generate substantial upside profits (capital gains) when buying calls if the stock rises or buying puts if the stock falls.
• Buy to Cover: Borrowing shares from a broker, selling them at the current market price, and buying them back at a lower price to return the borrowed shares.

Options Knowledge

• Options Clearing Corporation (OCC): Located in Chicago, the OCC clears put and call option transactions under the supervision of the Commodities Futures Trading Commission (CFTC) and the SEC.
• Options Disclosure Document (ODD): A document provided by brokerage firms to clients when opening an options account, educating them about options, potential risks, and rules.

4: Packaged Products

Mutual Funds

• Definition: Mutual funds are open-ended investment companies that offer shares of a portfolio of stocks and/or bonds to the investing public. They are actively managed by portfolio managers.
• Share Classes: Mutual funds may offer different share classes (Class A, B, C, D), each with different fee structures. Class A shares have a front-end fee, while Class B shares have a back-end fee, and Class C shares have level loads.
• Expenses: Mutual funds have various expenses, such as sales loads, redemption fees, management fees, etc., listed in their prospectus.
• Categories: Mutual funds can be classified into money market funds, bond funds, stock funds (equity funds), and target date funds, each with specific objectives and risks.

Index Funds

• Definition: Index funds are passively managed funds that aim to replicate the performance of a specific stock market index, such as the S&P 500.
• Advantages: Index funds have lower expenses compared to traditional mutual funds, and they are popular for diversification and lower tax implications.

Closed-End Funds (CEFs)

• Definition: Closed-end funds issue a fixed number of shares through an IPO and then trade on stock exchanges like regular stocks.
• Trading: CEF shares trade on the secondary market, and their price may be higher or lower than the NAV, resulting in a premium or discount.
• Leverage: CEFs can use debt or preferred shares to leverage their net assets, potentially increasing distributions but also increasing NAV volatility.

Unit Investment Trusts (UITs)

• Definition: UITs maintain a fixed portfolio of securities and have a mandatory termination date. They may trade on the secondary market.
• Management: UITs are not actively managed and maintain the same portfolio of securities throughout the life of the trust.

Other Investment Companies

• Variable Life Insurance: A type of permanent life insurance policy with cash value invested in a portfolio of securities, offering potential upside potential.
• Variable Annuities: Annuities with separate accounts maintained by insurance companies, where investors' money is invested in securities for tax-deferred purposes.
• Municipal Fund Securities (529 College Savings Plans): Savings plans sponsored by states to save for qualified postsecondary educational expenses.

Packaged Products Terminology

• Investment Objective: The purpose or goal of a fund, such as growth, income, or capital preservation.
• Surrender Charge: The penalty for early withdrawal from certain products like insurance policies, annuities, or mutual funds.
• Load Funds: Mutual funds that charge a commission fee known as a sales charge or load.
• Breakpoint: The dollar level at which an investor receives a sales charge discount in mutual funds.

Mutual funds, index funds, closed-end funds, unit investment trusts, and other investment companies offer diverse investment opportunities with varying objectives and risks. Investors should carefully consider the specific features and expenses of each type of packaged product before making investment decisions.

5: Municipal Fund Securities

Registration and Regulation of Municipal Advisory Services and Municipal Securities Business

• Firms providing municipal advisory services or engaging in municipal securities business must register with both the SEC and the Municipal Securities Rulemaking Board (MSRB). Their representatives must also pass appropriate qualifying examinations.
• Municipal securities broker-dealers are subject to SEC and MSRB rules, including fair dealing, suitability, disclosures, pricing, supervision, and more.

529 College Savings Plans

• 529 college savings plans are municipal securities created and sponsored by each state to help families save for qualified postsecondary educational expenses.
• Plans can be advisor-sold or direct-sold. Advisor-sold plans are offered through registered broker-dealers or RIAs and offer better portfolio flexibility but higher fees. Direct-sold plans are offered directly by the state, have fixed portfolios, and lower fees.
• Tax Benefits: Earnings in 529 plans grow federally tax-free and withdrawals for qualified educational expenses are tax-free. Many states also offer tax deductions or credits for 529 plan contributions.

Achieving a Better Life Experience (ABLE) Accounts

• ABLE accounts, also known as 529 A accounts, are municipal fund securities that allow individuals with disabilities to save up to $15,000 annually for disability-related expenses.
• Similar to 529 plans, ABLE accounts are created by states and offer different investment options, such as mutual funds or money market funds.
• Withdrawals for qualified disability-related expenses are tax-free.
• Eligibility: Individuals must either receive Supplemental Security Income (SSI) and/or Social Security Disability Insurance (SSDI) or have a documented disability diagnosis before age 26.

Local Government Investment Pools (LGIPs)

• LGIPs are investment vehicles established by state governments to pool resources from local governmental entities for short-term investments.
• LGIPs aim to achieve objectives like liquidity or return on investment and are exempt from SEC registration.
• LGIPs can be sponsored by a state or local government or multiple cities and counties under a joint power agreement, depending on state laws.

Municipal fund securities, including 529 college savings plans, ABLE accounts, and LGIPs, offer specific benefits and features tailored to different financial goals and needs. Individuals should carefully review the options and consult with financial advisors to make informed decisions about investing in these municipal fund securities.

6: Direct Participation Programs (DPPs)

DPP Overview

• Direct Participation Programs (DPPs) are often organized as limited liability corporations (LLCs), real estate investment trusts (REITs), or limited partnerships. Investors become limited partners by buying into the program, and a general partner manages and invests the pooled money into various businesses.
• DPPs offer tax advantages, as profits are taxed only once at the investor level through pass-through taxation. Investors report the profits as income on their individual tax returns.
• Liquidity and Marketability: DPP ownership units are not listed or traded on stock exchanges, making them illiquid investments. Limited partners may find it difficult to sell their units, so DPPs are suitable for investors who don't need easily sellable investments.
• Suitability: DPPs are not suitable for all investors. They are typically sold to accredited investors who meet specific income and/or net worth requirements and can handle the illiquid nature of these investments.
• Limited Liability: Investors' maximum possible loss in the event of legal or financial troubles is capped at the amount they invested.

Tenants in Common (TIC)

• TIC investments allow investors to obtain fractional ownership interests in real estate. Investors pool their money together to acquire a larger real property asset than they could individually.
• TIC investments are illiquid and tax-deferred securities, typically structured as DPPs.
• Brokers must conduct due diligence and suitability assessments, including "reasonable-basis" and "customer-specific" suitability, before recommending TIC investments to clients.

Direct Participation Programs provide unique investment opportunities, particularly in real estate and other businesses. However, potential investors should carefully assess the risks, consider their financial goals and needs, and consult with financial professionals to determine if DPPs, including TIC investments, align with their overall investment strategies.

7: Real Estate Investment Trusts (REITs)

Overview of REITs

• Real Estate Investment Trusts (REITs) are companies that pool money from investors and invest in income-producing real estate and real estate assets, such as apartments, resorts, office buildings, mortgages, etc.
• By investing in REITs, individuals can participate in commercial real estate earnings without the need to directly buy or own properties.
• REITs operate similarly to other packaged portfolio products, but they primarily consist of real estate and real estate-related investments instead of securities.
• REITs are subject to a pass-through taxation model, which means the income and tax benefits pass through to the investors.

Types of REITs

1. Publicly Traded REITs: Registered with the SEC and trade on national securities exchanges, offering higher liquidity. Investors can buy them through brokerage accounts.
2. Public Non-listed REITs: Registered with the SEC but do not trade on stock exchanges. They are generally less liquid and can be purchased through brokers participating in such offerings.
3. Private REITs: Generally exempt from SEC registration and are purchased through private placement offerings. They have fewer disclosure requirements, making them harder to value and carry additional risks.

Suitability

• FINRA suggests that REITs should be sold to investors who understand the volatility of the real estate market and the potential for substantial losses in invested principal.
• Private REITs are typically sold to accredited investors.

Equity vs. Mortgage (Debt) REITs

1. Equity REITs: The majority of the REIT market. They acquire and manage commercial real estate properties and generate revenue from rent collected from tenants and businesses. At least 90 percent of their income is paid out to shareholders as dividends.
2. Mortgage REITs: Make up less than 10 percent of the REIT market. They lend money to real estate buyers and generate revenue from interest collected on the debt instruments. Like equity REITs, they are required to pay out at least 90 percent of their annual taxable income to shareholders. Unlike equity REITs, they do not own physical real estate and do not benefit from property price appreciation.

REITs offer investors the opportunity to diversify their investment portfolio with exposure to the real estate market. However, investors should carefully assess their risk tolerance and investment objectives before considering REIT investments. Consulting with a financial professional can help determine if REITs align with their overall financial strategy.

8: Hedge Funds

Overview of Hedge Funds

• Hedge funds pool money from sophisticated investors, typically accredited or institutional investors, with the aim of generating large returns quickly.
• They are considered high-risk portfolios and have less liquidity compared to mutual funds.

Structure

• Most U.S. hedge funds are structured as limited partnerships, with fund managers acting as general partners (GPs) and investors as limited partners (LPs).
• General partners have unlimited liability, while limited partners are liable only up to the amounts they invest.
• Many hedge fund general partners are LLC entities, providing limited personal liability to the fund managers.
• Like mutual funds and DPPs, hedge funds offer pass-through tax treatment, with profits taxed only once at the investor level.

Leverage

• Hedge funds often use leverage, or borrowed money, to increase investment returns.
• They can buy securities on margin, meaning borrowing money from a broker to purchase a larger number of securities, or use credit lines from third-party lenders.
• While leverage can boost gains, it also amplifies losses if investments decline in value.

Suitability

• Hedge funds are generally illiquid, with a lock-up period requiring investors to keep their money invested for at least one year before making withdrawals.
• Investors typically need to be accredited, meeting certain income or net worth requirements, to invest in hedge funds.

Fees

• Hedge funds usually require a minimum investment of $100,000 to $2 million and have higher fees than mutual funds or ETFs.
• The standard compensation structure is "two and twenty," which means an annual asset management fee of around 2% of invested amounts and a performance fee of around 20% of the fund's profits above the hurdle rate.

Private Equity Funds

• Private equity funds differ from hedge funds in their investment strategies and goals.
• Private equity funds focus on long-term returns and invest directly in companies, purchasing private companies or acquiring controlling interests in publicly traded companies.
• They have longer lock-up periods but are considered to carry less risk than hedge funds.

9: Exchange-Traded Products

Overview of Exchange-Traded Products (ETPs)

• ETPs are bought and sold on exchanges like individual stocks.
• They track underlying securities, indices, or other financial instruments, and their prices are derived from these underlying instruments.
• Most ETPs are structured as Unit Investment Trusts (UITs) or exchange-traded funds (ETFs) and can be passively or actively managed.

Exchange-Traded Funds (ETFs)

• ETFs are packaged portfolios with a finite number of available shares.
• They offer real-time pricing, allowing investors to buy and sell throughout the trading day.
• ETFs have lower investment minimums and brokerage commissions compared to mutual funds.
• They come in various types, such as stock ETFs, bond ETFs, and real estate ETFs, each with different investment strategies.
• When investors trade ETFs on an exchange, they are buying or selling shares of the fund itself, not its underlying assets.

ETF Tax Treatment

• Stock ETFs are considered more tax-efficient than mutual funds as they typically make fewer capital gain distributions.
• Taxable events occur when investors sell shares for a profit or receive dividends, with different tax rates for qualified and nonqualified dividends.
• Bond ETFs have similar tax treatment to stock ETFs but may make capital gains distributions more frequently due to bond maturities.

Exchange-Traded Notes (ETNs)

• ETNs are senior, unsecured debt obligations issued by financial institutions, tracking a benchmark index.
• They do not hold a portfolio of assets; instead, the issuer promises to pay the holder a return based on the index's performance minus fees.
• ETNs do not make periodic interest payments and do not promise to repay the principal amount invested.
• They carry various risks, including credit risk of the issuer, market risk, and liquidity risk. They are not suitable for all investors.

10: Investment Risk

Types of Investment Risks

1. Market Risk - Systematic Risk: Risk that affects the entire market or market segment. For example, a stock market crash can lead to a decline in the market price of most stocks.
2. Business Risk - Non-Systematic Risk: Risk specific to a particular company or industry. Investing in only one company can lead to significant losses if the company experiences a downturn or bankruptcy.
3. Inflationary/Purchasing Power Risk: Risk that an increase in inflation will erode the purchasing power of investment returns, especially in fixed-income investments.
4. Interest Rate/Reinvestment Risk: Risk that cash flows received from investments may not generate the same returns when reinvested, particularly affecting fixed-income investments in declining interest rate environments.
5. Credit Risk: Risk that a borrower will fail to make payments on a loan, affecting bonds and debt instruments.
6. Foreign Currency Risk: Risk of losses due to fluctuations in foreign currencies when investing in non-U.S. corporations.
7. Liquidity Risk: Risk that an investment cannot be quickly bought or sold at fair market prices, especially in illiquid investments.
8. Prepayment Risk: Risk that the principal amount of a debt investment is paid back prematurely, affecting investments like mortgage-backed securities.
9. Political Risk: Risk that investment returns decline due to political changes or uncertainty in foreign countries.

Strategies for Risk Mitigation

1. Diversification: Spread investments across various products and industries to reduce exposure to a single risk.
2. Alternative (Non-Securities) Investments: Consider investments like art, collectibles, certificates of deposit, or real estate, which may have different risk profiles.
3. Hedging: Use derivative products like options or future contracts to provide protection against adverse market movements.
4. Portfolio Rebalancing: Regularly adjust the asset allocation of a portfolio to maintain a balanced risk exposure.
5. Sector Rotation: Shift investments among different business sectors based on the phases of the business cycle to capitalize on performing industries during specific economic conditions.

Section 3: Understanding Trading, Customer Accounts and Prohibited Activities

This section covers the types of customer accounts available to investors and the compliance protocols associated with those accounts. It will address information about trade orders and settlement, corporate actions, and prohibited activities of registered representatives. At the end of this section, the goal is to have a greater understanding of investors’ roles in the industry and the regulations that are in place to protect them.

1: Trading, Settlement, and Corporate Actions

Types of Orders

• Market Order: An order to buy or sell a security at its current market price.
• Limit Order: An order to buy at a specified maximum price or sell at a specified minimum price.
• Stop Order: An order to sell a stock if it declines below a specific stop price, used to protect profits.
• Good-til-Canceled Order (GTC): An order that remains on the books until filled or canceled by the investor.
• Discretionary vs. Non-Discretionary Order: Discretionary accounts allow the RR to make trading decisions without prior client approval, while non-discretionary accounts require client approval for every trade.
• Solicited vs. Unsolicited Order: Solicited orders result from a broker's recommendation, while unsolicited orders are initiated by the client.

Trade Capacity

• Broker-dealers act as brokers when executing orders on behalf of clients and as dealers when buying or selling from their own inventory.
• Bid Price: The price at which an investor is willing to buy a security.
• Ask (Offer) Price: The price at which an investor is willing to sell a security.
• Bid-Ask Spread: The difference between the bid and ask prices.

Types of Strategies

• Long-Short Equity: Investing in stocks expected to rise (long positions) and selling short stocks expected to decline.
• Naked Options: Selling options without owning the underlying security (naked call or put writing).
• Covered Options: Selling options while owning the underlying security (covered call or put writing).
• Bearish: Expecting prices to decline.
• Bullish: Expecting prices to rise.

Trade Settlement

• Securities transactions must settle within two business days (T+2) of the transaction date.
• Settlement can be via book entry or physical delivery.
• Transfer agents maintain the corporate record of shareholders.

Investment Returns

• Bond Interest: Investors earn a stated rate of interest until bond maturity.
• Dividends: Investors earn cash dividends from company profits.
• Capital Gains: Realized gains occur when an investor sells a security at a higher price than purchase, while unrealized gains are increases in value without selling.
• Stepped-up Basis: Inherited mutual funds may receive a new basis at the benefactor's time of death.

Corporate Actions

• Buybacks: Companies repurchase their shares from the market.
• Tender Offers: Acquirers offer to buy shares directly from target company shareholders.
• Exchange Offers: Shareholders exchange one security for another, often with a discount.
• Rights Offerings: Existing shareholders have the right to buy additional new shares at a discount.
• Mergers & Acquisitions (M&A): Companies combine or one acquires the other.
• Stock Splits: Companies reduce or increase shares outstanding, adjusting prices accordingly.

2: Customer Accounts & Compliance Considerations

Account Types and Characteristics

• Cash Account: All transactions paid in full with available cash.
• Margin Account: Borrow up to 50% of security cost to buy on margin.
• Options Account: Requires approval and knowledge assessment.
• Educational Accounts: 529 college savings plans for tax benefits.

Customer Account Registrations

• Individual Account: Owned by one person.
• Joint Account: Owned by two or more people with different rights.
• Corporate/Institutional Account: Owned by corporations or institutions.
• Trust Account: Transfer assets to beneficiaries upon death.
• Custodial Account: Gifts for minors managed by a custodian.
• Partnership Account: Owned by business partners.
• Retirement Account: Various types with different rules.

Anti-Money Laundering (AML)

• Bank Secrecy Act (BSA): Detect and prevent money laundering.
• Suspicious Activity Report (SAR): Report suspicious transactions.
• Currency Transaction Report (CTR): Report large cash transactions.
• Office of Foreign Asset Control (OFAC): Enforces sanctions against threats to national security.

Books and Records and Privacy Requirements

• Recordkeeping Rules: Maintain accurate and complete records for specified periods.
• Form CRS: Relationship summary provided to retail investors.
• Business Continuity Plan (BCP): Plan for emergencies and disruptions.
• Segregation of Customer Assets: Protect and deliver customer assets.
• Regulation S-P: Protect customer information and provide privacy notices.

Communications with the Public and Telemarketing

• FINRA Rule 2210: Guidelines for public communications.
• Cold Calling: Outbound phone calls with time restrictions.
• National Do-Not-Call List: Prohibits calls to registered numbers.

Best Interest Obligations and Suitability Requirements

• Regulation Best Interest (Reg BI): Follow best interest standard for retail customers.
• FINRA Rule 2111: Reasonable basis, customer-specific, and quantitative suitability.
• Know-Your-Customer (KYC): Understand customer's investment profile.

3: Prohibited Activities

Market Manipulation

Market manipulation involves artificially changing stock prices for personal gain through illegal means. Examples include:

1. Market Rumors: Spreading false rumors to drive up stock prices and sell for profit.
2. 'Pump and Dump' Schemes: Creating demand for a stock, selling at a peak, and causing losses to clients.
3. Front Running: Trading ahead of a client's order to profit from anticipated price movements.
4. Excessive Trading (Churning): Trading excessively in a client's account to generate higher commissions.
5. Marking the Open/Close: Manipulating stock prices before market open/close to profit from price changes.
6. Freeriding: Buying and selling a security without paying for it, violating Regulation T.
7. Backing Away: A market maker fails to honor quoted bid and ask prices.

Insider Trading

Insider trading involves trading on material non-public information. Examples include:

1. Possession of Material Nonpublic Information: Using non-public information for personal gain.
2. Impending Mergers and Acquisitions: Trading on non-public information about a company's acquisition.
3. Legal Proceedings: Trading based on non-public legal information.
4. Loan Defaults: Trading on non-public information about loan defaults.
5. Development of Patents: Trading based on non-public information about patent developments.

Penalties for insider trading:

• Individuals: Up to 20 years imprisonment and/or fines up to $5 million.
• Business Entities (Corporations): Fines up to $25 million.

Other Prohibited Activities

1. Purchasing Initial Public Offerings (IPOs): Registered reps are prohibited from buying IPOs.
2. Use of Manipulative, Deceptive, or Fraudulent Devices: Prohibited means for transaction effecting.
3. Improper Use of Customers’ Securities or Funds: Includes theft, borrowing, and sharing in customer accounts.
4. Financial Exploitation of Seniors: Placing holds on funds or securities in cases of suspected exploitation.
5. Activities of Unregistered Persons: Paying compensation or soliciting without registration is prohibited.
6. Falsifying or Withholding Documents: Prohibited actions related to signatures and regulatory requests.
7. Prohibited Activities Related to Maintenance of Books and Records: Falsifying or improper maintenance of records.
8. Unsuitable Recommendations: Making recommendations that do not match client's investment goals.
9. Commingling: Mixing client assets with registered rep or firm assets.
10. Theft/Embezzlement/Similar Criminal Behavior: Stealing from clients is illegal and unethical.

Section 4: Overview of the Regulatory Framework

This section covers the regulatory requirements for registered representatives. It will address information about registration and continuing education, employee conduct rules, and reportable events that may require public disclosure. At the end of this section, the goal is to have a greater understanding of the regulations that govern the activities of securities industry professionals.

1: Registration & Continuing Education

SRO Qualification and Registration Requirements

• Persons and firms engaged in securities business with the public must register with FINRA.
• Registered representatives or associated persons, including salespersons, partners, and directors, must pass qualification exams before conducting securities business.
• Permitted activities depend on the qualification exam passed; e.g., Series 79 qualifies for debt and equity offerings, mergers, acquisitions, and financial restructurings.
• Certain individuals, referred to as non-registered persons, are exempt from FINRA registration, such as clerical or ministerial roles.
• Failure to register an associated person who should be registered can result in disciplinary action.

Securities Registration Process

• Background Check: Member firms must investigate prospective associated persons before submitting their applications for registration.
• Form U4: Prospective associated persons fill out the Form U4, reviewed and edited by the member firm before submission to FINRA.
• Fingerprinting: Associated persons submit fingerprints to FINRA for a criminal background check within 30 days of filing the Form U4. Results are available to regulators and the employing member.

Disqualifications

• Statutory Disqualifications: Include felony convictions within the past 10 years and certain misdemeanors involving money or securities within the past 10 years.
• Persons subject to disqualification are generally ineligible for FINRA membership or association.

State Registration Requirements (Blue-Sky Laws)

• Most states require Series 63 (along with an appropriate qualification exam) to sell securities in that state.
• Each state has its own unique securities laws and regulations, known as blue-sky laws.
• Series 63 not required by Colorado, District of Columbia, Florida, Louisiana, Maryland, or Puerto Rico.

Continuing Education

• Securities industry continuing education (CE) program includes two elements: Firm Element and Regulatory Element.
• Completion of both elements is necessary to maintain an approved status with FINRA.
• Failure to complete will lead to a CE Inactive status during which a registered representative cannot conduct any securities business.
• Firm Element: Member firms administer an annual formal training session to keep registered representatives updated on current laws and regulations.
• Regulatory Element: FINRA administers a training session due within 120 days of the second anniversary of a registered representative’s initial registration date, and every three years thereafter.

2: Employee Conduct & Reportable Events

Employee Conduct

• Form U4 and Form U5: Registered representatives must keep their Form U4s up to date, promptly amending any changes in information. When a representative leaves their employer, a Form U5 is filed, detailing the reasons for the departure.
• Customer Complaints: Customer complaints alleging fraud or rule violations trigger specific procedures. Complaints may lead to hearings in front of FINRA-appointed arbitrators, whose rulings are final and binding.
• Misleading or Omitted Information: Filing false, misleading, or inaccurate Form U4 or U5 forms may result in monetary fines, suspensions, or other enforcement actions under FINRA Rules 2010 and 1122.

Reportable Events

• FINRA Rule 4530: Associated persons must promptly report events, such as customer complaints, securities law violations, or Form U4 updates, to their firms. The firms may then report the events to FINRA.
• Outside Business Activities (OBAs) — FINRA Rule 3270: Registered representatives must disclose any business activities outside their member firm's scope and provide written notice before engaging in new OBAs.
• Disclosures on Form U4: Reportable items include felonies, financial-related misdemeanors, liens, and bankruptcies. Severity may disqualify an individual from registration.
• Private Securities Transactions — FINRA Rule 3280: Registered representatives must obtain written approval from their firms before conducting securities transactions outside the firm's offerings.
• Political Contributions: Covered associates of covered members can make contributions within specified limits, and firms must maintain records to demonstrate compliance.
• Gifts and Gratuities: Firms and associated persons are prohibited from giving customers anything of value exceeding $100 annually. Gifts and gratuities records must be kept separately.
• Non-cash Compensation: Member firms and associated persons are prohibited from directly or indirectly accepting or making non-cash compensation payments, except for specific exceptions like occasional meals or entertainment tickets not tied to sales targets.