The Securities and Exchange Commission

The Securities and Exchange Commission, or SEC, is the major watchdog of the securities industry. Congress created the SEC to regulate the market and to protect investors from fraudulent and manipulative practices. All broker-dealers who transact business with investors and other broker-dealers must register with the SEC. And that registration means something: All broker-dealers have to comply with SEC rules or face censure (an official reprimand), limits on activity, suspension or suspension of one or more associated persons (such as a registered rep or principal), a fine, and/or having their registration revoked.

SEC investigations may lead to a civil (financial) complaint being filed in a federal court. The SEC may seek disgorgement (taking away) of ill-gotten gains, civil money penalties, and injunctive relief (a cease-and-desist order from the court). If the matter is criminal in nature, the investigation is conducted by the U.S. Attorney’s Office and the grand jury.

Among its other numerous functions, you need to be aware that besides The Securities Act of 1933, The Securities Exchange Act of 1934, and The Trust Indenture Act of 1939, which were covered in Chapter 5, the SEC also enforces The Investment Company Act of 1940 and the Investment Advisers Act of 1940:

• The Investment Company Act of 1940: This act regulates the registration requirements and the activities of investment companies.
• The Investment Advisers Act of 1940: This act requires the registration of certain investment advisers with the SEC. An investment adviser is a person who receives a fee for giving investment advice. Any investment adviser with at least $25 million of assets under management or anyone who advises an investment company must register with the SEC. All other investment advisers have to register on the state level. The Investment Advisers Act of 1940 regulates
  • Record-keeping responsibilities
  • Advisory contracts
  • Advertising rules
  • Custody of customers’ assets and funds

Self-regulatory organizations

As you can imagine, due to the unscrupulous nature of some investors and registered representatives, the SEC’s job is overwhelming. Fortunately, a few self-regulatory organizations (SROs) are there to take some of the burden off of the SEC’s shoulders. Although membership isn’t mandatory, most broker-dealers are members of one or more SROs. SRO rules are usually stricter than those of the SEC.

The four types of SROs you need to know for the Series 7 are FINRA, MSRB, NYSE, and CBOE:

• The FINRA (Financial Industry Regulatory Authority): FINRA is a self-regulatory organization that’s responsible for the operation and regulation of the over-the-counter market, investment banking (the underwriting of securities), New York Stock Exchange (NYSE) trades, investment companies, limited partnerships, and so on. FINRA was created in 2007 and is a consolidation of the NASD (National Association of Securities Dealers) and the regulation and enforcement portions of the NYSE (New York Stock Exchange). FINRA is responsible for making sure that its members not only follow FINRA rules but also the rules set forth by the SEC. Additionally, FINRA is responsible for the handling of complaints against member firms and may take disciplinary action, if necessary. FINRA is also responsible for administering securities exams such as the SIE (now you know who to blame). FINRA has strict rules (as the other SROs do, I suspect) regarding filing of misleading, incomplete, or inaccurate information as to membership or registration regarding the firm’s registration or registration of member associates.

• The Municipal Securities Rulemaking Board: The MSRB was established to develop rules that banks and securities firms have to follow when underwriting, selling, buying, and recommending municipal securities (check out Chapter 8 for info on municipal bonds). The MSRB is subject to SEC oversight but does not enforce SEC rules.

  The MSRB makes rules for firms (and representatives) who sell municipal bonds but doesn’t enforce them — it leaves that up to FINRA.

• The New York Stock Exchange: The NYSE is the oldest and largest stock exchange in the United States. The NYSE is responsible for listing securities, setting exchange policies, and supervising the exchange and member firms. The NYSE has the power to take disciplinary action against member firms.
• The Chicago Board Options Exchange: The CBOE is an exchange that makes and enforces option exchange rules.

Although SROs may be independent, they do work together creating and enforcing rules. FINRA and NYSE can fine, suspend, censure (reprimand), and expel members. However, FINRA and the NYSE can’t imprison members who violate the rules and regulations.

Look at questions with the words guarantee or approve in them very carefully. FINRA, SEC, NYSE, and so on do not approve or guarantee securities. Any statement that says that they do is false. In addition, because a firm is registered with (or didn’t have its registration revoked by) an SRO, it does not mean that the SRO approves of the firm, its financial standing, its business, its conduct, and so on. So member firms and their associates may not claim that they’ve been approved by the SEC or any SRO.

Filing the facts on the new account form

When you’re opening any new account for a customer, the new account form needs some basic information. Broker-dealers may, in accordance with the Patriot Act, require a customer to provide proof of identification. Getting this information is your responsibility (or the responsibility of the broker-dealer). Here’s a list of the items that need to be on the new account form:

• The name(s) and address(es) of the individual(s) who’ll have access to the account as well as a trusted contact person age 18 or older (especially if the person opening the account is 65 or older).
• The customer’s phone number.
• Some government issued identification information (driver’s license number, passport number, military ID number, and so on).
• The customer’s date of birth (the customer must be of legal age to open an account).
• The type of account the customer is opening (cash, margin, retirement, day trading, prime brokerage, DVP/RVP, advisory or fee-based, discretionary, options, and so on).
• The customer’s Social Security number (if the customer is an individual) or tax ID number (if the customer is a business). For non-U.S. citizens: passport ID number, taxpayer ID number, alien identification card number, foreign government issued ID, residence, and photograph.
• The customer’s occupation, employer, and type of business (certain limitations are placed on customers who work for banks, broker-dealers, insurance companies, SROs, and so on).
• Domestic or foreign residency and/or citizenship.
• Bank references and the customer’s net worth and annual income. To be considered accredited (sophisticated), an individual investor must be able to prove that he or she had an annual income of $200,000 ($300,000 combined income if married) or more for the previous two years and is expected to make at least $200,000 in the current year or have a net worth of at least $1 million excluding primary residence. Note: Accredited investors may also be banks, partnerships, corporations, nonprofit organizations, trusts, and so on.
• Whether the customer is an insider of a company.
• Investment objectives (see Chapter 13).
• The signatures of the registered representative and a principal.

All the items listed should be on the new account form and you should make an effort to determine the customer's investment objectives. However, sometimes new customers may not want to provide all the information. At a bare minimum, to be able to open the account, you need the customer's name, date of birth (for individuals, not businesses), street address (not a P.O. box), and an identification number (Social Security number, tax ID number, and so on). The more information you get from the customer, the better. Besides, it helps you get to know your client better and will help you make more suitable recommendations. If anything changes (for example, a customer’s address, investment objectives, place of employment, marital status, and so on), the account records need to be updated. A copy of the new account form must be sent to the client within 30 days of the account opening. The customer should review the new account form to make sure everything is accurate, including the investor's investment objectives. Account records must be updated at least every 3 years. Additionally, only individuals who are legally competent may open accounts.

The following question tests your ability to answer a question about opening a new account.

Closing customer accounts

In general, the customer or brokerage firm may close an account at any time. The account closure procedures are usually found in the brokerage account agreement. Included in the account agreement are terms and conditions stating how the brokerage firm may close the account at its own discretion.

Selecting the appropriate type of account

Investors can open many different types of accounts through a broker-dealer. Besides knowing a customer’s investment profile (see Chapter 13), you need a basic understanding of the types of accounts for the Series 7 exam. Fortunately, most of them are pretty straightforward.

• Pattern day traders: Pattern day traders are investors who try to take advantage of price movements of securities that take place during the day. Specifically, pattern day traders are investors who execute 4 or more day trades within a 5-business-day period. For customers to open a day trading account, they must deposit a minimum of $25,000. In addition, they must have at least $25,000 in equity in the account on any day where the customer executes a trade. Because of the additional risk involved, firms must provide a day-trading risk disclosure statement prior to the customer opening the day trading account and the customer must be approved for day trading by a principal (manager) of the firm. Part of the approval process includes a determination that this is an appropriate strategy for the customer (does it fit his or her investment objectives, trading experience, financial situation, and so on) and a signed agreement from the customer.

  Note: A day-trading risk disclosure statement should include information such as the following: Day trading is extremely risky; being cautious of claims of large day-trading profits; understanding securities markets; how firms operate; day trading will generate high commission costs; and day trading on margin may result in losses beyond the investment.

• Prime brokerage: This type of account is ideal for large retail or institutional accounts that use the services of several different broker-dealers. The customer may choose one brokerage firm (the prime broker) to combine all the information from all the accounts into one statement. Prime brokerage customers must have a minimum of $500,000 in all the accounts combined to be eligible. However, customers who also have an investment advisory account may choose to use the investment adviser as their prime broker and in that case will only need to have $100,000 invested total in all accounts.
• Delivery verses payment/receive verses payment (DVP/RVP): DVP and RVP accounts are typically used for institutional clients. These transactions are settled cash on delivery (COD). In this case, securities are or cash is delivered to a bank or depository as pre-arranged by the customer. The customer or broker-dealer is responsible for contacting the bank or depository regarding each purchase or sale. The bank or depository is responsible for exchanging the cash for securities or vice versa. After the exchange, the bank forwards the money or securities to the client's broker-dealer.
• Fee-based accounts: For certain investors it might be more beneficial for them to set up a fee-based account. Many firms offer fee-based accounts in which investors are charged fixed fees or a percentage of assets under management instead of charging commissions for brokerage services. Prior to recommending a fee-based account, you should take into consideration whether it is right for the customer or not considering the services provided, the cost, customer preferences, the amount of trading the customer does, and so on. These fee-based accounts may be set up for traditional brokerage accounts or accounts with investment advisory services (wrap accounts).
• Wrap accounts: These accounts are investment advisory accounts where broker-dealers provide clients with a host of services for a single fee. These services include asset allocation, portfolio management, trade execution, and administration.
• Advisory accounts: This type of account allows the investor to pay a fee (a percentage of the value of the customer's portfolio, an hourly fee, a fixed fee, and so on) for receiving investment advice. In order for you to open up an account as an investment adviser, you must be a registered investment adviser (RIA). You can become an investment adviser by passing the Series 65 or Series 66 exams along with whatever other exams your taking like the Series 7. Depending on the amount of client assets under management, investment advisers may have to register with the SEC as well as the states where they do business. Investment advisers with a smaller amount of client assets under management may only have to register with the state securities agency where they have their principal place of business.

Account registration types

Investors can open many different types of accounts through a broker-dealer. Besides knowing a customer’s investment profile (see Chapter 13), you need a basic understanding of the types of accounts for the Series 7 exam. Fortunately, most of them are pretty straightforward.

Standards and required approvals of public communications

To make sure that member firms communications with the public are fair, balanced, and not misleading, FINRA has an Advertising Regulation Department. This department is there to ensure that broker-dealers are in compliance with the advertising rules of FINRA, the SEC, the MSRB, and SIPC. The department reviews public communications submitted by firms (voluntarily or as required). In turn, the department will provide the firms with a written review for every communication submitted.

Financial exploitation of specified adults

With people living longer and the number of seniors increasing, FINRA has recently created rules to help curb or handle cases of financial exploitations of specified adults (seniors — natural persons aged 65 or older — and natural persons aged 18 or older who have mental or physical impairments that render them unable to protect their own interests). In the event that a member believes that the financial exploitation of specified adults has or may be taking place, Rule 2165 allows the member to place a temporary hold on the specified adult’s funds or securities.

The Series 7 and other FINRA exams cover topics related to protecting seniors, including

• Firms’ marketing and communications to investors aged 65 and older
• Information required when opening an account for a senior
• Any disclosures provided to senior investors
• Complaints filed by senior investors as well as how the firm handles the complaints
• Supervision of registered reps as they communicate with senior investors
• The suitability and types of securities marketed and sold to senior investors
• The training of a firm’s representatives as to how they are to handle the accounts of specified adults

FINRA recently created a helpline for seniors to provide support and assistance.

Regulation S-P

Broker-dealers, investment companies, and investment advisers must “adopt written policies and procedures that address administrative, technical, and physical safeguards for the protection of customer records and information.” What this means is that members must provide a way for securing customers' non-public information. This includes things like Social Security numbers, bank account numbers, or any other personally identifiable financial information. Members must provide customers with a notice of their privacy policies. Members may disclose a customer's nonpublic information to unaffiliated third parties unless the customer opts out and chooses not to have his or her information shared. Members must make every effort to safeguard customers' information, including securing computers, encrypting emails, and so on. Broker-dealers must send customers a description of their privacy policies at the time the account is open and at least once a year thereafter.

Reporting requirements

Under FINRA Rule 4530, member firms must report specified events, including quarterly statistical and summary information regarding customer complaints, and copies of certain civil and criminal actions. Members must report promptly (no later than 30 days after the member knows or should’ve known about the event) if the member or associated person of the member

• Has been found to have violated any securities-related or non-securities-related investment laws or standards of conduct by a U.S. or foreign regulatory organization
• Is the subject of a written customer complaint involving allegations of theft or misappropriation of funds or securities
• Is the subject of a written customer complaint involving allegations of forgery
• Has been named as a defendant or respondent in a proceeding brought by a U.S. or foreign regulatory body alleging a violation of rules
• Has been denied registration, suspended, expelled, or disciplined by a U.S. or foreign regulatory organization
• Is indicted, convicted of, or pleads guilty to any felony or certain misdemeanors in or outside of the U.S.

The preceding list includes firm reporting requirements under Rule 4530, but firms are required to report certain other events too. These include

• Outside business activities (covered in the following section).
• Private securities transactions, which are transactions outside the broker-dealer’s normal business. For argument’s sake, say that an associate of a firm has a client who wants to trade options, but his firm doesn’t trade options because it doesn’t have an options principal. In this case, with permission of his firm, he can accept the order from his client and do the trade through another firm.
• Political contributions and consequences for exceeding dollar contribution thresholds. (See “Other violations” later in the chapter.)
• Felonies, financial-related misdemeanors, liens, bankruptcies.

Filling out an order ticket

When you’re working as a registered rep, completing documents such as order tickets will become second nature because you’ll have them in front of you. When you’re taking the Series 7, you don’t have that luxury, but you still need to know the particulars about what to fill out.

Getting the particulars on paper (or in binary form)

When your customer places an order, you have to fill out an order ticket. Order tickets may be on paper or entered electronically. Regardless of how you enter the order, it needs to contain the following information:

• The registered rep’s identification number
• The customer’s account number
• The customer’s name or designation of the account
• The description of the security (stocks, bonds, symbol, and so on)
• The number of shares or bonds that are being purchased or sold
• Whether the registered rep has discretionary authority over the account
• Whether the customer is buying, selling long (selling securities that are owned), or selling short (selling borrowed securities — see Chapter 9)
• For option tickets, whether the customer is buying or writing (selling), is covered or uncovered, and is opening or closing (see Chapter 12 for info on options)
• Whether it’s a market order, good-till-canceled (GTC) order, day order, and so on
• Whether the trade is executed in a cash or margin account
• Whether the trade was solicited or unsolicited
• The time of the order
• The execution price

Figure 16-1 shows you what standard paper order tickets may look like.

The customer's name or designation of the account cannot be changed unless authorized by a principal of the firm. If approved, the reason for the change must be documented in writing and kept on file.

Checking your calendar: Payment and settlement dates

Securities that investors purchase have different payment and settlement dates. Here’s what you need to know:

• Trade date: The day the trade is executed. An investor who buys a security owns the security as soon as the trade is executed, whether or not he has paid for the trade.
• Settlement date: The day the issuer updates its records and the certificates are delivered to the buyer’s brokerage firm.
• Payment date: The day the buyer of the securities must pay for the trade.

Unless the question specifically asks you to follow FINRA or NYSE rules (which I doubt it will), assume the Fed regular way settlement and payment dates as they appear in Table 16-1. The FINRA and NYSE rules both require payment for securities to be made no later than the settlement date, but the Federal Reserve Board states that the payment date for corporate securities is five business days after the trade date.

Cash trades (which are same-day settlements) require payment for the securities and delivery of the securities on the same day as the trade date for all securities.

In certain cases, securities may not be able to be delivered as in the preceding chart. In these cases, the seller may specify that there’s going to be a delayed delivery. This is also known as a seller's option contract. There can also be a mutually agreed upon date in which the buyer and seller agree on a delayed delivery date prior to or at the time of the transaction.

The when, as, and if issued (when-issued transaction) method of delivery is used for a securities issue that has been authorized and sold to investors before the certificates are ready for delivery. This method is typically used for stock splits, new issues of municipal bonds, and Treasury securities (U.S. government securities). The confirmation for when-issued securities must include a description of the security, the contract price or yield, and the trade date. The settlement date for when-issued securities can be any of the following:

• A date to be assigned
• Three business days after the securities are ready for delivery
• On the date determined by FINRA

Confirming a trade

A trade confirmation (receipt of trade) is the document you send to a customer after a trade has taken place. You have to send out trade confirmations after each trade, at or before the completion of the transaction (the settlement date). Here’s a list of information included in the confirmation:

• The customer’s account number
• The registered rep’s ID number
• The trade date
• Whether the customer bought (BOT), sold (SLD), or sold short
• A description of the security purchased or sold along with its symbol
• The number of shares of stock or the par value of bonds purchased or sold
• The yield (if bonds) and type of yield (yield to maturity, yield to call, or current)
• The Committee on Uniform Security Identification Procedures (CUSIP) number, a security ID number
• The price of the security
• The total amount paid or received, not including commission or any fees
• The commission, which is added on purchases and subtracted on sales (if the broker-dealer purchased for or sold from its own inventory, the markdown or markup doesn’t have to be disclosed)
• The net amount, or the amount the customer paid or received after adding or subtracting the commission (if the investor purchased or sold bonds, the accrued interest is added or subtracted during this calculation)
• Whether the trade was executed on a principal or agency basis (the capacity)

Note: Trade confirmations for money-market funds (see Chapter 10) are not required, but certain transaction information should be included in the monthly account statement (such as purchases, sales, dividends, or distributions during the period; the date of the transaction; the identity, number and price of securities being purchased or sold; the total number of shares of such securities in the customer's account; and any remuneration [money] received or to be received in connection with the transaction).

You should recognize the items listed in this section are required for most securities trades, including municipal bonds. However, check out the “Confirmations” section in Chapter 8 for more specific rules relating to municipal securities confirmations. Trade confirmations must be sent to the client after each trade even if you have discretionary authority over the account. Confirmations may be sent to a third party, such as an investment adviser, with written consent of the client.

Meeting the requirements for good delivery

In the securities industry, good delivery doesn’t mean “in 30 minutes or it’s free” (even the pizza delivery places don’t promise that anymore). To constitute good delivery of certificates, the securities have to be in a certain form. The transfer agent is responsible for good delivery. Here are the general requirements:

• They must be in good physical condition (not mutilated). Mutilated certificates must be validated by a transfer agent or other acceptable official of the issuer to be considered good delivery. Mutilated coupons must be endorsed by the issuer or commercial bank to be considered good delivery.
• They must be endorsed by the owner whose name is registered on the certificate(s). Certificates registered in more than one name must be endorsed by all owners. As an alternative to signing on the back of the certificate(s), owners may sign a stock or bond power. A stock or bond power (security power) is a legal document that investors can sign instead of signing on the back of all certificates. The stock or bond power is used for the investors to transfer ownership to another person. Stock or bond powers are often easier for people to sign and also add another degree of safety because they can be sent separately from the unsigned certificates. Signing one stock or bond power represents a signature of all like securities (that is, all ABC common stock, all DEF 7% corporate bonds maturing on the same date, and so on). However, if the investor is selling more than one security, he must sign a stock or bond power for each one.
• All customer signatures must be guaranteed by a notary or some other person acceptable to the transfer agent. The signature must exactly match the name registered on the face of the security.
• For certificates in the names of a fiduciary, the fiduciary must provide a copy of the trust agreement or court appointment. For corporate accounts, the person signing must provide a copy of the corporate resolution giving him the authority to execute trades for the corporation.
• For securities in the name of a deceased person, the executor or administrator of the deceased person's estate must endorse the certificate or provide a stock or bond power and have the securities transferred to the name of the estate prior to selling.
• The exact number of shares or bonds must be delivered. Overdeliveries or underdeliveries are not good delivery.
• The correct denomination of the certificates must be delivered.
• If the bonds being traded have been called, they must be identified as being called when traded.
• For municipal securities, the legal opinion must be attached unless marked “ex-legal.”

And here are the requirements for good delivery of specific securities:

• Bearer (coupon) bonds: These unregistered bonds must be in $1,000 or $5,000 denominations only.

  For a bearer bond to be in good delivery form, it must be delivered with all unpaid coupons (representing interest payments) attached in proper order. See Chapter 7 for more info on bonds.

• Fully registered bonds: These bonds must be in multiples of $1,000 par value with a maximum par value on one certificate of $100,000.
• Stock: Because the most easily traded unit of stock is 100 shares (a round lot), stock certificates must be in denominations of one of the following:
  • Multiples of 100 shares — 100, 200, 300, 400, and so on
  • Divisors of 100 shares — 1, 2, 4, 5, 10, 20, 25, 50, or 100
  • Units that add up to 100 shares — 40 shares + 60 shares, 91 + 9, 80 + 15 + 5, and so on

Odd lot trades (trades of less than 100 shares) or odd lot portions of orders are exempt from the good delivery rule.

The following question tests your ability to answer a good delivery question.

Always look at the shares first to determine whether you have good delivery. I see a lot of students look at the number of certificates before they check the number of shares per certificate. The Series 7 designers want to know more about your understanding of concepts than your multiplication and addition skills, so you probably won’t have to figure out the total number of shares in each answer choice — they should all add up to the number of shares in the order (in the preceding example, 560).

Following up with account statements

An account statement gives the customer information about his holdings in the account along with the market value at the time the statement was issued. Customers are supposed to receive account statements on a regular basis. The timing for issuing account statements should be pretty easy for you to remember. Here’s how often you have to send out statements, from most to least often (remember the acronym AIM):

• Active accounts: If any trading was executed within the month, the customer must receive an account statement for that month.
• Inactive accounts: If the customer is not actively trading his account and is just holding a position, an account statement must be sent out at least quarterly (every three months).
• Mutual funds: No matter how much (or little) trading was done, a customer needs to receive an account statement semiannually (every six months).

The account statement must contain at least a description of all the client's security positions, any cash balance, and all account activity since the previous account statement.

Account activity includes purchases or sales, interest credited to or debited to the account, any miscellaneous charges or credits to the account, dividend payments received, any transfers of securities, and so on.

Penny stocks (see Chapter 6) are risky securities, and it is often difficult for customers to find out current prices for certain penny stocks. Therefore, customers who own penny stocks must receive account statements monthly whether a penny stock trade was made during the month or not.

Keeping your dividend dates straight

When customers are purchasing securities of a company that’s in the process of declaring or paying a dividend, you need to be able to tell those customers whether they’re entitled to receive the dividend. Because stock transactions settle in three business days, the customers are entitled to the dividend if they purchase the securities at least three days prior to the record date. Here’s a list of the four need-to-know dates for the Series 7 exam:

• Declaration date: The day that the corporation officially announces that a dividend will be paid to shareholders.

• Ex-dividend date: The first day that the stock trades without dividends. An investor purchasing the stock on the ex-dividend date isn’t entitled to receive the dividend; because stock transactions take two business days to settle, the ex-dividend date is automatically one business day before the record date.

  The ex-dividend date is the day that the price of the stock is reduced by the dividend amount. (Chapter 6 tells you more about dividends and related calculations.) When a stock is purchased ex-dividend (on or after the ex-dividend date), the seller is entitled to the dividend, not the buyer. Because the dividend may not be paid for up to a month, the buyer is required to sign a due bill indicating that the dividend belongs to the seller. In the case of a cash dividend, the due bill is in the form of a due bill check, which is payable on the date the dividend is paid by the issuer. In addition, if an investor buys a stock on time to receive a dividend but for some reason will not receive the certificates on time (by the record date), the seller must send a due bill to the buyer. A due bill states that the buyer is entitled to the rights of ownership even though he’s not yet receiving the certificates.

• Record date: The day the corporation inspects its records to see who gets the dividend. To receive the dividend, the investor must be listed as a stockholder in company records.
• Payment (payable) date: The day that the corporation pays the dividend.

As you can see from the diagram, the buyer receives the dividend if he purchases the stock before the ex-dividend date. If the stock is purchased on or after the ex-dividend date, the seller receives the dividend.

© John Wiley & Sons, Inc.

To help you remember the sequence of dates, use the phrase Don’t Eat Rubber Pickles. I know it sounds ridiculous, but the more ridiculous, the easier it is to remember.

The board of directors must announce three dates: the declaration date, the record date, and the payment date. The ex-dividend date doesn’t need to be announced because it’s automatically one business day before the record date. However, mutual funds have to announce all four dates because they may set their ex-dividend date at any time (even on the record date).

The following question tests your ability to answer a dividend question.

Wedgie Corp. has just announced a $0.50 cash dividend. If the record date is Tuesday, March 9, when is the last day an investor can purchase the stock and receive the dividend?

(A) March 4

(B) March 5

(C) March 7

(D) March 8

The answer you’re looking for is Choice (B). In order for an investor to purchase the stock and receive a previously declared dividend, he must purchase the stock at least one business day before the ex-dividend date. This question is a little more difficult because you have a weekend to take into consideration.

The ex-dividend date is March 8, which is one business day prior to the record date. This investor has to buy the stock before the ex-dividend date in order to receive the dividend, so he has to buy it March 5 or before (because the 6th and 7th are Saturday and Sunday). The last day an investor can purchase the stock and receive the dividend is March 5.

© John Wiley & Sons, Inc.

If a stock is sold short (if the investor is selling a borrowed security), the lender of the stock sold short is entitled to receive the dividend. (See Chapter 9 for details on margin accounts.) Also, the trades in the example problems are regular way settlement (two business days after the trade date); remember that cash transactions settle on the same day as the trade date. In the case of dividends, if an investor purchases stock for cash, he receives the dividend if he purchases the stock anytime up to and including the record date.

Handling complaints

It’s bound to happen sooner or later, no matter how awesome you are as a registered rep: One of your customers is going to complain about something (like unauthorized trades, guarantees, and so on). Complaints aren’t considered official unless they’re in writing. If necessary, FINRA wants you to follow the proper procedure for handling complaints. The following sections cover formal and informal proceedings.

Transferring accounts

If a customer wants to transfer an account, in whole or part, from one broker-dealer (the “carrying member”) to another (the “receiving member”), the customer has to fill out and sign (a provable electronic signature is fine) an account transfer form with the receiving member listing the securities held at the carrying member firm. Transfer instructions are then sent from the receiving member to the carrying member. Account transfers are often executed through the ACATS (Automated Customer Account Transfer Service). For members to use the ACATS service, they have to be members of the National Securities Clearing Corporation (NSCC).

Upon receipt from the customer an authorized broker-to-broker transfer instruction form (TIF), the receiving member must immediately submit the instructions to the carrying member (done through ACATS); the carrying broker-dealer has one business days to either validate or take exception (for an invalid account number, wrong Social Security number, and so on) to the transfer instructions sent from the receiving member. Any exceptions must be quickly rectified by the carrying member and receiving member. After the carrying member validates the account, that dealer has three business days to transfer the account to the receiving member.

Most account transfers are executed using the ACAT service. However customers may, for whatever reason, choose to have the firms not use the ACAT service. Whether the ACAT service is used or not, both firms must expedite all account transfers.

The Telephone Act of 1991

To make sure that certain standards are used when calling potential customers (such as not calling them at midnight), the Telephone Act of 1991 was created. When you’re dealing with potential customers on the phone, you need to know these rules:

• You can’t make calls before 8 a.m. or after 9 p.m. local time of the potential customer.
• You have to give your name, company name, company address, and phone number.
• If you get a potential customer who’s tired of being called, you should place that person on a do not call list. Each firm must maintain its own do not call list and have the U.S. Government’s National Do Not Call List available.
• You may not send unsolicited ads by fax machine.

The Telephone Act of 1991 does not apply to existing customers (customers who have executed a trade or had a security in the firm’s account in the previous 18 months) or calls from nonprofit organizations. Existing customers who want to be placed on the “do not call” list after opening an account cannot be solicited but can be updated on the status of their account.

The 5 percent markup policy

The 5 percent policy (FINRA 5 Percent Markup Policy) is more of a guideline than a rule. The policy was enacted to make sure that investors receive fair treatment and aren’t charged excessively for broker-dealer services in the over-the-counter (OTC) market. The guideline says that brokerage firms shouldn’t charge commissions, markups, or markdowns of more than 5 percent for standard trades.

The following trades are subject to the 5 percent markup policy:

• Principal (dealer) transactions: A firm buys securities for or sells securities from its own inventory and charges a markdown or markup.
• Agency (broker) transactions: A firm acts as a middleman (broker) and charges a commission.

• Riskless (simultaneous) transactions: A firm buys a security for its own inventory for immediate resale to the customer (riskless to the firm). The idea is that it is a transaction that is riskless to the dealer because she already has an order to fill. In this case, the firm is buying the security at a particular price and selling it to the customer at the same price plus a markup. The firm must disclose its capacity in the transaction. In this case, the markup charged must be disclosed.

  If the securities transaction was executed on a net basis (one in which the firm purchased the security and sold it to a customer at a different price [not including a markup]), the member must provide disclosure and obtain consent from the customer.

• Proceeds transactions: A firm sells a security and uses the money to immediately buy another security. You must treat this transaction as one trade (you can’t charge on the way out and on the way in).

The 5 percent markup policy covers over-the-counter trades of outstanding (not new securities, which require a prospectus), nonexempt securities with public customers. If securities are exempt from SEC registration, such as municipal bonds, they’re exempt from the 5 percent policy. Additionally, if a dealer pays $20 per share to have a security in inventory (dealer cost) and the market price is $8 per share, the dealer can’t charge customers $20 per share so that it doesn’t take a loss.

Under extenuating circumstances, the brokerage firm may charge more. Justifiable reasons for charging more (or less) than 5 percent include

• Experiencing difficulty buying or selling the security because the market price is too low or too high
• Handling a small trade — for example, if a customer was to place an order for $100 worth of securities, you’d lose your shirt if you were to charge only 5 percent ($5); in this case, you wouldn’t be out of line if you were to charge 100 percent (by the same token, if a customer was to purchase $1 million worth of securities, 5 percent [$50,000] would be considered excessive)
• Encountering difficulty locating and purchasing a specific security
• Incurring additional expenses involved in executing the trade
• Dealing with odd lot trades (for details, see “Meeting the requirements for good delivery,” earlier in this chapter)
• Trading nonliquid securities
• Executing transactions on foreign markets

Other violations

You need to be aware of some violations not only for the Series 7 exam but also so you stay out of trouble. Some of the violations are more connected with broker-dealers, some with registered reps, and some with investment advisers:

• Commingling of funds: Combining a customer’s fully paid and margined securities or combining a firm’s securities with customer securities.
• Interpositioning: Having two securities dealers act as agents for the same exact trade so that two commissions are earned on one trade.
• Giving (or receiving) gifts: Giving or receiving a gift of more than $100 per customer per year. Business expenses (lunch, dinner, hotel rooms, and so on) are exempt from this MSRB rule (see “Self-regulatory organizations,” earlier in this chapter).
• Making political contributions (paying to play): Under the Investment Advisers Act of 1940, investment advisers are prohibited from providing investment advisory services for a fee to a government client for two years after a contribution is made. This rule applies not only to the adviser, executives, and employees making contributions to certain elected officials, but also to candidates who may later be elected. In addition, investment advisers are prohibited from soliciting contributions for elected officials or candidates if the investment adviser is seeking or providing government business.
• Freeriding: Allowing a customer to buy or sell securities without paying for the purchase.
• Backing away: Failure on the part of a securities dealer to honor a firm quote.
• Churning: A violation whereby a registered rep excessively trades a customer’s account for the sole purpose of generating commission.
• Matching orders: Illegally manipulating the price of a security to make the trading volume appear larger than it really is, such as two brokerage firms working in concert by trading the same security back and forth.
• Painting the tape: Creating the illusion of trading activity due to misleading reports on the consolidated tape — for example, reporting a trade of 10,000 shares of stock as two separate trades for 5,000 shares each.
• Frontrunning: A violation in which a registered rep executes a trade for himself, his firm, or a discretionary account based on knowledge of a block trade (10,000 shares or more) before the trade is reported on the ticker tape.
• Prearranging trades: A prearranged trade is an illegal agreement between a registered rep and a customer to buy back a security at a fixed price.
• Marking the close/marking the open: Executing a series of trades within minutes of the open or close of the market to manipulate the price of a security.
• Paying the media: A violation in which brokerage firms or affiliated persons pay an employee of the media to affect the price of a security; for example, paying a TV stock expert to recommend a security that the firm has in its inventory.
• Spreading market rumors: Members are prohibited from spreading false market rumors that may prompt others to either buy or sell a security. This is another form of market manipulation.
• Paying for referrals: Members or persons associated with a member (for example, registered reps) are prohibited from paying cash or noncash compensation to any person except those registered with the member firm or other FINRA members. A violation occurs in the event that compensation is paid to a nonmember for locating, introducing, or referring a client.

Regulation FD

The “FD” in Regulation FD stands for fair disclosure. Regulation FD is an SEC rule that covers the issuer releasing material, nonpublic information. Typically, issuers will want to release certain nonpublic information to certain individuals or entities such as securities market professionals, analysts, holders of the issuer's securities, and so on. Regulation FD requires the issuer to make that information available to the public at the same time to keep persons from being able to trade on insider information. The aim of Regulation FD is to promote full and fair disclosure.

Record-keeping

As you can imagine, member firms must keep certain records on file. Depending on which records they are, there are certain SEC retention requirements. The records do not necessarily need to be kept in written format; they can be kept digitally as long as they are in a non-erasable format.

Corporate or partnership documents of the member firm must be kept for the lifetime of the firm. The documents must contain the list of officers, partners, and/or directors of the firm. Additionally, U-4 forms of all active employees must be kept as long as the firm is in business.

The following records must be kept for a minimum of six years:

• Blotters: Records of all trades executed by the brokerage firm for clients and for their own inventory.
• Ledgers: Customer account statements, which include trade settlement dates, interest and dividends received, securities borrowed and loaned, moneys borrowed and loaned, all short and long positions, and so on.
• General ledgers: A firm’s financial statements, which must be updated monthly. A general ledger includes the firm’s assets, liabilities, and net worth.
• Position record: A record of all the securities owned by the firm and its location.
• Account record: Terms and conditions of margin accounts and cash accounts.
• Closed accounts: Firms must keep records of customers who’ve closed accounts for a minimum of six years after the account has been closed.

Note: Like FINRA rules, MSRB rules require blotters, ledgers, closed accounts, and position records to be kept for six years. However, MSRB also requires records relating to the underwriting of municipal securities, complaints (FINRA, four years), supervisory records, and gift records to be kept for six years.

The following records must be kept for a minimum of three years:

• U-4 forms, U-5 forms, and fingerprints of former employees
• Trade confirmations
• Order tickets
• Advertisements
• Sales literature
• Dividends and interest received in each account
• Powers of attorney
• Speeches/public appearances
• Compliance procedure manuals
• Gifts
• Compensation records of associates

Note: MSRB rules require members to maintain certain records for four years. These include subsidiary ledgers, trades, confirmations, terms and conditions of customer accounts, checkbooks and cancelled checks, delivery of official statements, public communications, and so on.

Whether the records have to be kept for three years, six years, or whatever, they have to be easily accessible for two years (FINRA and MSRB).

As you can imagine, there are strict penalties for falsification, improper maintenance, or improper retention of records. FINRA reserves the right to inspect the books, records, and accounts of all member firms and their associates. All regulatory requests by FINRA for specified books, records, or accounts should be supplied by the member firm promptly.

Negotiable instruments drawn from a customer's account

Members shall not submit a client's payment of a check, draft, or other form of negotiable paper drawn on a client's checking account, savings account, or similar type of account without the client's expressed written authorization. If, however, a client sends you a check with her signature on it, that is considered written authorization. In the case where a client sets up where payment for trades, services, and so on can be withdrawn from one of her accounts, you need to keep the her written authorization on file for a period of three years following the date the authorization expires.

Disclosure of control relationships

Any member controlled by or that has controlling interest in the issuer of a security must disclose that fact to a customer prior to entering into a contract with the customer who wants to purchase or sell the security. If the disclosure is not made in writing prior to the transaction, it must be sent with to the customer at or prior to the completion of the transaction.

Customer protection rule

Under the Securities Exchange Act of 1934's Customer Protection Rule (Rule 15c3-3), broker-dealers must segregate customer securities and cash from the broker-dealers' securities and cash. Quite often, broker-dealers use their own securities and/or cash to execute trades. By forcing broker-dealers to segregate customers' cash and securities from the broker-dealers transactions, the likelihood that customers' securities and cash will remain readily available to return to customers in the event of broker-dealer failure.

Networking arrangements

Members who conduct broker-dealer business on the premises of a financial institution shall

• Be clearly identified as the person conducting the broker-dealer services and shall distinguish its services from the services of the financial institution
• Conduct its business in an area that displays the member's name
• If possible, conduct its broker-dealer services in a location that is separate from the financial institution's retail deposit-taking activity
• At the time of opening a customer's account, disclose in writing that the services are being provided by the broker-dealer, not the financial institution, as well as other disclosures such as the securities are not FDIC insured, the deposits are not guaranteed by the financial institution, the account is subject to investment risk, and so on

Uniform Practice Code (UPC)

All over-the-counter securities transactions by members, except for transactions involving exempt securities, are subject to the UPC. The UPC was designed to provide a set of standards for members regarding things like trade terms, delivery of securities, payments, dividends, rights, interest, assignments, computation of interest, due bills, transfer fees, “when, as and if issued” trading, and so on. It was designed to facilitate trading and to minimize the number of disputes between member firms.

Supervision

Each member firm must establish and maintain a system to supervise each associated person in order to make sure all those persons maintain compliance with securities laws and regulations. The member firm is responsible for maintaining proper supervision of its employees. The supervision system must be written and the firm must have appropriately qualified registered principals to carry out the supervision of employees. The written procedures must also spell out procedures for reviewing the investment banking and securities business of the firm, reviewing correspondence and internal communications, reviewing customer complaints, and so on.