ETF`s - PassThe6

Series 6 Update – Pass the Test©
Perhaps you have heard of “ETF’s” or seen advertisements for the well-known
varieties called “Spiders,” “Diamonds” and “QQQ.” An “ETF” is an exchange-traded
fund. Why did they name it that? Because it is a fund that trades on an exchange and this
is not an industry brimming with creative types.
Trade like Shares of Stock
An ETF is just a closed-end index fund. That means that if an investor wants to
do as well as a particular index, she can track that index with an exchange traded fund
(ETF). To track the S&P 500, she can buy the “Spider,” which is so named because it is
an “SPDR” or “Standard & Poor’s Depository Receipt.” Of course, she could already
have been doing that with Vanguard’s S&P500 open-end index fund. But, that is a
boring old open-end fund, and how does an investor buy or sell those shares? Directly
from the open-end fund. No matter what time of day, if we put in a redemption order, we
all receive the same NAV at the next calculated price—forward pricing. So, if the S&P
500 drops 80 points in the morning and rises 150 points by mid-afternoon, there is no
way for us to buy low and then sell high.
But with the ETF version investors can buy and sell their shares as often as they
want to. They can try to buy when the index drops and sell when it rises. Unlike the
open-end versions, these ETF’s can be bought on margin and can be sold short for those
who enjoy high-risk investment strategies. The test might say that ETF’s facilitate “intraday trading,” which just means that you can buy and sell these things as many times as
you want throughout the day.
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Cost comparisons
So, are the closed-end ETF’s cheaper than the open-end index fund versions?
Depends how you do it. If you were only going to invest $500, the open-end fund
by Vanguard would be cheaper. By the way, I don’t work for Vanguard. I’m just using
them because they have a low expense ratio, and their S&P 500 index fund is the biggest
fund in America. Anyway, you wouldn’t pay a sales charge and the expenses are only
.18% (18 basis points) at the time of this writing. The ETF has an expense ratio of only
.11% (11 basis points). But, since the ETF version (Spider) is a stock, you would pay a
commission to buy it, just as you would pay to buy shares of GE, Wal-Mart, etc. So, if
you invested $500 into the ETF and paid a $10 commission, that commission would work
out to be 2% (200 basis points), which is much higher, and that’s before we factor in the
expenses. On the other hand, if you’re investing a larger amount, such as $100,000, the
same $10 commission is now 1 basis point (.0001) versus the 18 basis points (.0018) for
the open-end index fund’s operating expenses. So, I think it’s safe to say that for a small
amount of money—as usual—the open-end mutual fund is a great option. For larger
amounts of money, though, the ETF might be cheaper, assuming the investor is paying
low commissions.
As with the open-end index funds, ETF’s offer diversification. For a rather small
amount of money, an investor can own a little piece of, say, 500 different stocks with the
SPDR, or 100 stocks with the QQQ. It is also easy to implement asset allocation
strategies with ETF’s. An investor can find ETF’s that track all kinds of different indexes
(small cap, value, growth, blue chip, long-term bonds, etc.). If an investor wanted to be
80% long-term bonds and 20% small-cap stock, that goal could be achieved with just two
low-cost ETF’s. This point is not necessarily a comparison to the open-end index funds,
which would offer the same advantage. Rather, it is a comparison to purchasing
individual bonds or small cap stocks. In order to spread the risk among many bonds and
small cap stocks, an investor would have to spend large sums of money. With an ETF (as
with the open-end index funds) diversification can be achieved immediately with a much
smaller investment.
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The main testable points concerning ETF’s would seem to be:
Closed-end index funds
Trade like shares of stock, intra-day
Investors pay a commission rather than a sales charge
Shares can be bought on margin, sold short
ETF’s have low expense ratios
ETF’s are convenient for investors seeking diversification/asset allocation
ETF’s are very low-cost when purchased in larger quantities
Indexes include small-cap, mid-cap, large-cap, growth, value, S&P500, Dow
Jones, NASDAQ, even fixed income
Quantitative Risk Management
Apparently, they must have eliminated some positions from the Series 65 and 66
exam committees and placed those folks on the Series 6 exam committee. In any case,
you may now see some terms that used to be reserved for the even more painful Series 65
and Series 66 exams.
How sensitive is that bond you just bought to a small change in interest rates? If
it’s a long-term bond, it is more susceptible to a spike in interest rates, right? Don’t 30year T-bonds have more interest rate risk than 2-year T-notes?
Well, so far we’ve been focusing just on that concept; now the Series 6 decides it
wants to raise the ante a little bit and use the word “duration.” Duration simply measures
how much interest rate risk a bond presents. A duration of “10” would imply that for
every 1% rise in interest rates, the bond’s price would drop 10%. A duration of “20”
means that a 1% jump in interest rates would push the bond’s price down 20%. Imagine
how ticked you’d be if interest rates rose just 1%, pushing the bond you just paid $1,000
for down to $800 on the secondary market.
High durations = high market risk.
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In general, long-term bonds have high durations. Bonds that pay low nominal
rates have high durations, too. And, if the question says it’s a bond with both qualities
(long-term, low coupon rates), then its duration would be very high.
See, when a bond is kicking out fat interest payments, that cash flow offsets the
risk you’re taking by letting the issuer play with the $1,000 you loaned him a few
decades ago. So, if the bond is paying low interest to you—say 2% or $20 a year—it’s
going to take a heck of a long time before that $20 in interest per year begins to offset the
$1,000 you paid for the bond. On the other hand, if the bond pays generous coupons of,
say, 10%, now you’re collecting $100 per year. And, if the principal is going to be
returned in two years, as opposed to wondering what can happen over the next 30 years,
the duration will be lower.
The main testable points on duration would seem to be:
Duration quantifies/measures interest rate risk
Long-term bonds with low coupon rates have high durations
Zero coupon bonds have even higher duration than interest-paying bonds of
the same term to maturity (no cash flow to offset the risk on a zero coupon).
A 10-year STRIP, therefore, has a higher duration than a 10-year T-note.
People with too much time on their hands often track the up and down movement
of a particular stock and then compare that to the up and down movement of the “overall
market” as measured by the S & P 500. They call the number they arrive at “beta” or
“beta coefficient.” The idea is that if a stock tends to jump up higher and fall down lower
than the overall market, it could be a bit too risky for some investors. What’s kind of
funny, though, is that if the beta is “1,” the stock or overall portfolio is “only” as volatile
as the overall stock market. Oh, cool. Not like the S&P could ever drop 30% in a year.
Anyway, a “high beta” means that the stock is even more volatile than the overall stock
market, which is pretty freaking volatile. A beta of less than 1 implies that the
investment doesn’t go up or down as dramatically as the overall market. Maybe the test
writers will want you to say something stiff such as, “An investment with a beta of more
than 1 would tend to outperform a bull market and underperform a bear market.” That
way the language itself could scare you away from the right answer.
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And, in case the exam is feeling really mean, a “negative beta” would imply that
the stock moves this much in the opposite direction of the overall market. So, a beta of
negative-point-five (-.5) means that this stock goes down half as far as the overall market
goes up, and vice versa.
The most likely testable points would seem to be:
A beta of more than 1 suggests a volatile stock
A beta of less than 1 suggests the investment is less volatile than the overall
A beta of 1 implies the stock moves in lock-step with the overall market
High beta and high risk go together
The “overall market” used to compare against the stock is the S&P 500
Hedge Funds
Mutual funds are open to the average investor, not just to the big, sophisticated
individuals and institutional investors that include pension funds, insurance companies,
university endowments, etc. Since the mutual fund is open to the average Joe and JoAnn,
they can’t focus on extremely risky investment strategies. It would be sort of rude to take
the average Joe and JoAnn’s retirement nest egg and lose it all on a couple of ill-placed
foreign currency bets or ill-timed short sales. But, when the investors are all rich folks
and institutions, the regulators can relax a little bit.
This is where hedge funds come in. In general, hedge funds are only open to
institutions and to individuals called “accredited investors.” We’ll look at these
“accredited investors” when we discuss another fascinating topic called “Reg D private
placements under the Securities Act of 1933.” There, too, the well-moneyed accredited
investor can do things the average Joe and JoAnn can not, but we’ll save that excitement
for another section. An accredited investor has over $1 million in net worth and makes >
$200,000 per year. If it’s a married couple, the assets held jointly count toward that $1
million figure, and the annual income needs to be > $300,000, just to make sure you have
even more numbers to learn for your exam.
Why does the investor need to be rich? Because these hedge funds use some very
high-risk strategies including short selling, currency bets, risky options plays, etc. If
you’re an average Joe and JoAnn, it wouldn’t be cool to let you risk all of your
investment capital on such high-risk investing. On the other hand, if you’re a rich
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individual or a big institution, chances are your hedge fund investment is just a
percentage of the capital you invest. So, if you lose $1 million, chances are you have
several more million where that came from.
A typical arrangement for a hedge fund is to have a limited number of investors
form a private investment partnership. Once you buy, there’s a good chance you will not
be able to sell your investment for at least one year, even if it sucks. Rather than trying to
beat an index such as the DJIA, hedge funds generally go for “absolute positive
investment performance”—usually 8% or so—regardless of what the overall market is
Now, just to keep everything nice and simple, although a non-accredited investor
can not invest directly in a hedge fund, there are mutual funds called “funds of hedge
funds,” which she can invest in. As the name implies, these mutual funds would have
investments in several different hedge funds. In most cases, the investor would not be
able to redeem her investment, since hedge funds are illiquid (they don’t trade among
investors). Also, these investments would involve high expenses, since there would be
the usual expenses of the mutual fund, on top of the high expenses of the hedge funds the
mutual fund invests in.
So, other than the fact that they’re really expensive, very risky, and make it really
tough for the investor to liquidate her position, they’re a great investment. The main
testable points on hedge funds would seem to be:
Open to sophisticated, accredited investors with high net worth
Illiquid—usually can’t be sold for at least 1 year
Employ riskier, more diverse strategies
Charge high management fees and usually 20% of all gains
Non-accredited investors can buy mutual funds that invest in hedge funds
Liquefied Home Equity
For me, Sunday afternoon usually involves turning on the AM radio and listening
to Bob Brinker’s “Money Talk.” With home prices skyrocketing the past few years, I’ve
heard many callers suggest that they should borrow from a home equity line of credit and
put that money into the stock or bond market. Suppressing a laugh, Mr. Brinker usually
helps the guy (it’s always a guy) run the numbers. Let’s see, Bob will say, what’s the
rate you’ll pay on the home equity line?
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Caller: Five percent.
Bob: So, you’ll need to get a few percentage points higher than that on your
investment, right?
Caller: Exactly.
Bob: And, where will you get that?
Caller: I don’t know, that’s why I’m asking.
At that point Mr. Brinker explains that Treasury notes and bonds are actually
yielding less than 5%. If they were yielding more than 5%, the caller wouldn’t be able to
get the home equity line so cheap.
Caller: So, I’ll put it in the stock market—my buddy is up 200% on Google.
To which Mr. Brinker asks if the caller understands that the NASDAQ 100 is
down, say, 50% the past few years. Does it really make sense to put his home up as
collateral and then stick the money into the stock market, where absolutely anything can
happen? In other words, is it worth losing your house trying to make a few percentage
points in the stock market?
Since using home equity lines to borrow money for the stock or bond markets is
just a little risky, the NASD would like you and your firm to provide all kinds of risk
disclosure to the people thinking of embarking on such a strategy. For example, they
might lose their house.
Currency Exchange Rates
This concept was already on the NASD outline, but I believe the topic requires a
little more depth. So, here goes. The value of the US Dollar versus other currencies can
either help or hurt an investor. If the investor purchases global, international, or
emerging market funds, that means that currency exchange risk will be disclosed in the
prospectus, and a registered representative needs to point this risk out. If a company
receives payment in a foreign currency, that foreign currency won’t translate to very
many dollars if the dollar is strong. Also, if a US company has to pay for things in a
foreign currency, it will take more dollars to do that when the dollar is weak.
A question could pop up about ADR’s. Know the following, just in case:
A strong dollar hurts the holder of an ADR
A weak dollar helps the holder of an ADR
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Securities Act of 1933
As I like to say in class, all securities have to be registered, except for all the
securities that don’t have to be registered. As you already know, Treasury securities,
municipal securities, bank securities, and others are excused or “exempt” from the
registration requirements of the Act of ’33. Well, the Act of ’33 also offers certain
transactions that qualify for an exemption and very cleverly calls these “exempt
Private Placements
See, the federal government requires most securities to be registered in order to
protect the average Joe and JoAnn from excessively risky investments. If the investors
are all sophisticated and well funded, the regulators can ease up a bit. While the
Securities Act of 1933 would require a company doing a general offering of stock to
provide a standard registration statement and prospectus, the Act also offers companies
the ability to do a much easier “private placement.” A private placement is sold to
sophisticated, well-funded investors, and because these investors are so incredibly
sophisticated the stock does not even have to be registered. That’s right, if you purchase
a private placement, that stock has not even been registered. Of course, if no one has
ever called to interest you in one of these private placements, don’t feel bad. You’d have
to find yourself on the following list before expecting a phone call:
Bank, savings & loan, other similar institution
Insurance company
Registered investment company, business development company, small
business investment company
Employee benefit plans with > $5,000,000 in assets (includes government,
ERISA, and 501c3 plans)
Any trust with assets > $5,000,000
Any director, executive officer, or general partner of the issuer of the
securities being offered or sold
Any natural person whose individual net worth, or joint net worth with that
person's spouse, at the time of his purchase exceeds $1,000,000;
Any natural person who had an individual income in excess of $200,000 in
each of the two most recent years or joint income with that person's spouse in
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excess of $300,000 in each of those years and has a reasonable expectation of
reaching the same income level in the current year
Any entity in which all of the equity owners are accredited investors
If you didn’t see yourself on that list, you could still get in on one of these private
placements, as they allow the issuer to sell to no more than 35 non-accredited investors.
The issuer/underwriters would have to be reasonably sure that you and the other nonaccredited investors are sophisticated enough to get in on a private placement.
Since the shares are unregistered, a legend needs to be printed on the certificates
reminding the investor that the transfer/sale of the shares is restricted. Therefore, since
everything needs at least three names in this industry, private placement securities are
also referred to as “legend stock” or “restricted stock.” They need to be held fully paid
for 1 year before the investor sells them.
Purchaser Representatives
Since a private placement may be sold to 35 unsophisticated, non-accredited
investors, the regulators decided to provide some protection to those folks. So, a nonaccredited investor who lacks sufficient knowledge of financial matters must have a
purchaser representative to help evaluate the risks/suitability of the investment. The
purchaser representative is simply someone who can help act as a mentor to the investor,
explaining the merits and potential risks of the investment. The purchaser representative
can not be some guy who steps out of an office at the issuer’s headquarters volunteering
his time to the buyer. The purchaser representative can not be affiliated with the issuer
unless they also happen to be a relative of the buyer. So, if the guy stepping out of the
office happens to be the buyer’s father-in-law, that’s a different story.
Finally, note that variable life insurance is sometimes sold through a private
placement to sophisticated, wealthy investors who want more sophisticated investment
options than those offered from conventional variable products.
Definitions Under Securities Act of 1933
The Series 6 may want you to know the definitions for the following terms:
Issuer: every person who issues or proposes to issue any security
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The term "sale" or "sell" shall include every contract of sale or disposition of a
security or interest in a security, for value.
The term "offer to sell", "offer for sale", or "offer" shall include every attempt
or offer to dispose of, or solicitation of an offer to buy, a security or interest in
a security, for value
Underwriter: any person who has purchased from an issuer with a view to, or
offers or sells for an issuer in connection with, the distribution of any security,
or participates or has a direct or indirect participation in any such undertaking,
or participates or has a participation in the direct or indirect underwriting of
any such undertaking
And, boy, that sure clears things up, doesn’t it? In English, what that means is that
an issuer is considered an issuer as soon as they propose to issue a security. In other
words, once you declare your intentions by filing a registration statement, you are an
issuer and are subject to all the rules that issuers must follow. You can’t take money
from investors, for example, until the securities have been declared effective for sale.
The definition of sale is exactly what you’ll see on your Series 63. You might think it
would have been easier if they’d used the word “money,” but that would have left a
loophole big enough to drive a Hummer through. By using the word “value,” the
regulators cast a wider net. This way, if you give me some stock in exchange for a
Porsche, a Rolex, or for buying my house at 30% below market value, you have made a
“sale.” And, every time you attempt to interest me in exchanging a security for value,
you have made an offer. Since you can’t offer or sell securities without following the
requirements of the Securities Act of 1933, these definitions are important to know.
Securities Act of 1933 and Investment Companies
The exam may ask some questions about specific rules of this act as they relate to
investment companies, so here goes.
Generic Advertising
Generic advertising is defined as any type of notice that does not specifically refer
by name to the securities of a particular investment company or to the investment
company itself. Generic advertising would include communications that:
relate to securities of investment companies generally or to the nature of
investment companies, or to services offered in connection with the ownership
of such securities
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mention or explain different types of funds, for example—growth, value,
blend, bond, no-load, variable annuities, etc.
invite the reader to inquire further
Generic advertising needs to contain the name and address of a registered broker
or dealer or other person sponsoring the communication. What this all means is that
generic advertising is not considered an offer for sale and, therefore, falls under different
rules from, say, a prospectus or advertisement for a specific mutual fund.
Sales Literature Must Not Be Misleading
As always, it would be a real bad idea to say or write anything misleading in
connection with the offer or sale of any security. The Securities Act of 1933 specifically
mentions that sales literature for investment company shares must not be misleading,
either by making untrue statements of material fact or omitting material facts that need to
be included to avoid misleading the heck out of investors. For example, if the aggressive
growth technology fund wants to brag about a 20% total return, they need to compare that
to the appropriate technology index. If a technology fund is up 20% when the NASDAQ
100 is up 35%, the investor needs the whole story, right? And, of course, whenever past
returns are mentioned, the sales literature needs to also point out that this does not imply
that future results are somehow implied or predicted. We just thought, you know, you’d
like to hear about our past returns. Not that we want you to draw any conclusions or
anything. Also, inappropriate comparisons among funds are prohibited. For example, if
an aggressive growth fund tries to compare its 5% return to the 2% return on a money
market fund, that would be just a bit misleading. See, the money market fund is about
1,000 times safer than the aggressive growth fund. So, the literature should take great
pains to compare the aggressive growth fund to other aggressive growth funds and an
appropriate index—not to bank CD’s, T-bills, money market funds, or even growth &
income funds.
Benefits of investing in securities and, particularly, the securities of the fund
being promoted can be listed. This is, after all, sales literature. It’s just that whenever a
benefit is mentioned, a statement of risk can’t be far behind. The prospectus I’m looking
at tells the reader:
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Your investment in the fund is not a bank deposit and is not insured
or guaranteed by the FDIC or any other government agency.
In case that didn’t make the point, the next statement is:
You may lose money by investing in the fund. The likelihood of loss is
greater if you invest for a shorter period of time.
So, I guess mutual funds don’t just go up once you buy them?
Sales charges and 12b1 fees cover distribution costs, which include the costs of
advertising the fund. In other words, those slick, full-color ads you see in Businessweek
and Forbes aren’t cheap. When an investment company advertises its “products,” they
need to follow Rule 482 under the Securities Act of 1933.
An advertisement must include a statement that advises an investor to consider the
investment objectives, risks, and charges and expenses of the investment company
carefully before investing. The ad also needs to explain that the prospectus contains this
and other information about the investment company, and it needs to identify a source
from which an investor may obtain a prospectus. If it’s a radio ad, these are the
statements that the person reads as if the recording studio is on fire.
An advertisement containing performance data must include a legend disclosing
the following:
the performance data quoted represents past performance
past performance does not guarantee future results
the investment return and principal value of an investment will fluctuate so
that an investor's shares, when redeemed, may be worth more or less than their
original cost
current performance may be lower or higher than the performance data
The legend should also identify a toll-free telephone number or a website where
an investor may obtain performance data current to the most recent month-end. If a sales
load or any other nonrecurring fee is charged by the fund, the advertisement must
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disclose the maximum sales charge, and it must be clear whether the performance figures
cited are including the deduction of sales loads. If they aren’t including that, there must
be a statement pointing out that returns would be reduced if we actually decided to factor
in the sales loads.
An advertisement for a money market fund that presents itself as maintaining a
“stable value” must include the following statement:
An investment in the Fund is not insured or guaranteed by the
Federal Deposit Insurance Corporation or any other government
agency. Although the Fund seeks to preserve the value of your
investment at $1.00 per share, it is possible to lose money by investing
in the Fund.
Of course, if you end up losing money on a money market fund please stop
investing immediately and go, instead, to the nearest casino, where you, apparently, stand
an equal chance of coming out ahead.
Oh yeah, and just in case the exam hasn’t met its quota of trivial information,
remember that a money market fund that does not present itself as “stable value,” would
not have to include the bold-letter disclaimer above.
Securities Exchange Act of 1934
Many securities are exempt from the registration requirements of the Securities
Act of 1933. That means they don’t have to register the way other securities have to, and
that is all that it means. See, whether a security has to be registered is one consideration.
A much more important consideration is that if the thing fits the definition of a
“security,” it would be a real bad idea to sell it using deceptive, misleading, or fraudulent
tactics. In other words, if you tell me that a Treasury bond leaves me with no chance of
sustaining a loss, you’re in big trouble. Treasury bonds have interest rate risk (high
durations), so if I buy one from you at par, the market price could plummet if interest
rates go up. The fact that the T-bond escaped the registration hassles under the Act of ’33
has nothing to do with nothing.
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Anti-Fraud Provisions
Why? Because the Securities Exchange Act of 1934 has anti-fraud provisions.
The anti-fraud provisions apply to any person and any security. As the Act of ’34 makes
It shall be unlawful for any person:
 To employ any device, scheme, or artifice to defraud,
To make any untrue statement of a material fact or to omit to state a material fact
necessary in order to make the statements made, in the light of the circumstances
under which they were made, not misleading, or
To engage in any act, practice, or course of business which operates or would operate
as a fraud or deceit upon any person, in connection with the purchase or sale of any
What is a Security?
So, what the heck is a “security”? Well, the Act of ’34 supplies us with a very
long and tedious list:
The term "security" means any note, stock, treasury stock, security future, bond,
debenture, certificate of interest or participation in any profit-sharing agreement or in any
oil, gas, or other mineral royalty or lease, any collateral-trust certificate, preorganization
certificate or subscription, transferable share, investment contract, voting-trust certificate,
certificate of deposit for a security, any put, call, straddle, option, or privilege on any
security, certificate of deposit, or group or index of securities (including any interest
therein or based on the value thereof), or any put, call, straddle, option, or privilege
entered into on a national securities exchange relating to foreign currency, or in general,
any instrument commonly known as a "security"; or any certificate of interest or
participation in, temporary or interim certificate for, receipt for, or warrant or right to
subscribe to or purchase, any of the foregoing; but shall not include currency or any note,
draft, bill of exchange, or banker's acceptance which has a maturity at the time of
issuance of not exceeding nine months, exclusive of days of grace, or any renewal thereof
the maturity of which is likewise limited.
You may have noticed that “investment contract” is listed above as an example of
a security. Since attorneys often tried to argue that what their client was offering/selling
was not even a security, the regulators went around and around until we finally reached
the Supreme Court’s “Howey Decision.” The Howey Decision defined an “investment
contract” as:
An investment of money in a common enterprise
With an expectation of profits derived through the efforts of others.
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And that casts a pretty wide net doesn’t it? Of course, it clearly describes stock in,
say, Microsoft. When I purchase 1,000 shares of MSFT, that’s an investment of money
in a common enterprise whereby I hope to benefit solely through the efforts of others,
since I couldn’t write a line of Visual Basic or C++ if my life depended on it.
But, the definition would also include some things you might not think of right
off. For example, if a local farmer needed to raise $500,000 to expand his operations,
maybe he prints up 10 pieces of paper at Kinko’s. Each one costs $50,000 and gives the
owner a 4% ownership stake in the farming operation. That’s an investment of money in
a common enterprise whereby each investor’s fortunes are bound together with other
investors and the promoter, and whereby the investor hopes to benefit solely through the
efforts of others—the farmer. The investors sure as heck aren’t getting up at 5 AM on a
cold, February morning to feed the livestock, right?
What they just bought was an “investment contract,” and that’s one example of a
“security” as listed in the Securities Exchange Act of 1934. So, if the farmer gives them
all offering documents with inflated profits or exaggerated crop yields, he has probably
committed a fraud. Fraud can carry criminal penalties and civil liabilities to the
investors. Which means, if it were really a serious offense, he could get fined and thrown
in jail. And, he could be forced to return the investors’ money plus interest.
So, I guess everything is a security, right?
Yes, expect for everything that isn’t. The following investments are not
Fixed annuities
Whole life, term life
Bank CD’s up to $100,000 (fully insured)
Commodities/futures contracts
But, if those aren’t securities, who the heck is going to regulate them to make sure
investors don’t get burned? Luckily, we already have insurance regulators for the
insurance products, bank regulators for the bank CD’s, and commodities regulators for
the commodities futures. The securities regulators only want to regulate securities.
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So, why is a fixed annuity not a security when a variable annuity is? Same reason
that whole life is not a “security” while “variable life insurance” is—a security involves
some sort of risk that the value could fluctuate or drop. A fixed annuity or whole/term
life policy is just an insurance contract guaranteed by an insurance company’s general
account. Money is not really at risk when you buy a whole life policy or a fixed
annuity—the insurance company guarantees a certain rate of return and has to live up to
the guarantee. But, once they start tying contract values to the wild ups and downs of the
stock and bond markets—look out. Anything can happen. Since the investor’s money is
no longer secure, we make sure and call the investment a “security.”
Yes, unfortunately, if your money is secure, it’s not a security. It’s only a security
when you’re money isn’t secure. A fixed annuity, whole life policy, or FDIC-insured
bank CD is way too secure to be a security. When your money is no longer secure in a
variable annuity or variable life policy, now we’re talking about a “security.”
So, the most important concept in securities regulations is that if the thing fits the
definition of a “security,” and this security is “offered” and/or “sold” through any
deceptive or manipulative device, that constitutes a “fraud,” and the regulators simply
will not tolerate that sort of nonsense. In order to protect investors, the regulators make
securities issuers all fill out registration statements and pay fees before anybody does
Securities and Exchange Commission
The Securities Exchange Act of 1934 established the SEC as the ultimate
securities regulator. Remember, these folks aren’t just an SRO such as the NASD or
NYSE. These folks comprise a government entity. They’re real close pals with the
Attorney General’s office, so if the SEC isn’t satisfied with ruining your career and
extracting vast sums of money from you in the form of civil penalties, they might just
turn you over to the Attorney General for criminal prosecution.
Of course, you’d have to be going out of your way to get in that much trouble, but
it’s still something to keep in mind.
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Registration of Securities Associations
Section 15A of the Securities Exchange Act of 1934 requires national securities
associations to register with the SEC. That means that exchanges and associations such
as the NYSE, NASD, MSRB, etc. have to register. When the SRO’s (self-regulatory
organizations) want to change a rule, it has to be signed off on by the SEC as well. These
SRO’s may not allow members to join the association unless the members are registered.
And, they don’t necessarily let everybody who wants in, in. Section 15A talks about
“statutory disqualification,” which means that, by statute, the NASD/NYSE, etc. can
deny membership to a firm if it lacks financial strength or has engaged in “acts or
practices inconsistent with just and equitable principles of trade.” As you may have
noticed, the NASD and other SRO’s can deny membership if a firm or associate of the
firm fails to meet “standards of training, experience, and competence as are prescribed by
the rules of the association.”
Let’s see what the Act of 1934 says the whole SEC thing is all about:
The rules of the association are designed to prevent fraudulent and manipulative acts and
practices, to promote just and equitable principles of trade, to foster cooperation and
coordination with persons engaged in regulating, clearing, settling, processing
information with respect to, and facilitating transactions in securities, to remove
impediments to and perfect the mechanism of a free and open market and a national
market system, and, in general, to protect investors and the public interest;
Rule 17f-2 of the Securities Exchange Act of 1934 requires officers and certain
employees of member firms to submit fingerprints. As the Act says in its rather awkward
. . . every member of a national securities exchange, broker, dealer, registered transfer
agent and registered clearing agency shall require that each of its partners, directors,
officers and employees be fingerprinted and shall submit, or cause to be submitted, the
fingerprints of such persons to the Attorney General of the United States or its designee
for identification and appropriate processing.
But, of course, not everybody has to submit fingerprints. Persons who fit the
following descriptions are exempt from the fingerprinting rule:
 Is not engaged in the sale of securities;
 Does not regularly have access to the keeping, handling or processing of:
1. securities,
2. monies, or
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3. the original books and records relating to the securities or the monies; and
Does not have direct supervisory responsibility over persons engaged in the
activities referred to in paragraphs (a)(1)(i)(A) and (B) of this section.
Also, the following verbiage exempts those firms who fit this description:
Is engaged exclusively in the sale of shares of registered open-end
management investment companies, variable contracts, or interests in limited
partnerships, unit investment trusts or real estate investment trusts; Provided,
that those securities ordinarily are not evidenced by certificates
Insider Trading
If you had dinner last night with your sister-in-law, who told you that her
company was going to be purchased by GE, that would be some pretty interesting news,
right? If the announcement hadn’t come out yet, you could pretty well bet that GE’s stock
will drop and your sister-in-law’s company’s stock will shoot up when that
announcement is made in the Wall Street Journal, CNBC, Bloomberg, etc. So, it would
be lots of fun to buy a bunch of calls on your sister-in-law’s company’s stock and maybe
a few puts on GE for good measure, too.
Unfortunately, it would also be unethical, illegal, and extremely painful if you got
caught. See, like the other Acts, the Securities Exchange Act of 1934 is frequently
amended and updated, just like the Series 6 exam. In 1988 Congress passed the Insider
Trading and Securities Fraud Enforcement Act, which amended the Securities Exchange
Act of 1934. The Act of ’34 had already prohibited insider trading, but the legislation in
1988 raised the penalties a bit. Even if the person doesn’t end up in prison, the SEC can
sue him in civil court and extract the following penalties:
For the individual who passed out the inside information or was dumb enough
to use it the court can impose a civil penalty of three times the profit gained or
loss avoided as a result of such unlawful purchase, sale, or communication.
If that person happened to be “controlled” by somebody else (a boss, the
broker-dealer who hired the agent, for example) that “controlling person”
could receive a civil penalty of the greater of $1,000,000, or three times the
amount of the profit gained or loss avoided as a result of the controlled
person's violation
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A person caught trading on inside information can also be held liable to
“contemporaneous traders.” That means that if you profit big time from your little putcall play, I might have to sue you and show how your actions caused me to lose money.
How much would you have to pay me for “pain and suffering”?
You wouldn’t. The maximum under this statue is the profit you made or the loss
you avoided by trading on inside information.
How would anybody find out about you? Check this out—the SEC offers bounties
to people who might want to narc you out. The bounties paid to those who drop a dime
can not exceed 10% of the penalty they extract out of the inside trader.
NASD Rules
Looks like the exam intends to get even more regulatory than it already was. Oh
well, the good news here is that rules & regulations can be memorized. They are what
they are.
NASD Rule 2210. Communications with the Public.
We already know that communications with the public have to be approved or at
least monitored by a principal and that the material must be kept in a separate file at the
firm for 3 years. As Rule 2210 makes clear, “Members must maintain all advertisements,
sales literature, and independently prepared reprints in a separate file for a period of three
years from the date of last use. The file must include the name of the registered principal
who approved each [item] and the date that approval was given.” Also, since these
communications are regulated so tightly, it’s important that each firm have sufficient
written supervisory procedures governing the whole process. One of the more frequent
violations that firms get nailed for is inadequate written supervisory procedure. It’s like a
special bonus violation—they get busted for whatever happened, then they also get
busted for not having adequate written supervisory procedures in place that might have
prevented what happened from happening.
Anyway, the exam has expanded the list of definitions for communications:
Advertisement: anything published in the media, including a magazine ad, a
Web site, a radio or TV spot. The message is broadcast, rather than sending
somebody a flyer in the mail.
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Sales Literature: these are messages directed to prospects or customers,
including research reports, performance reports. With sales literature, the firm
controls who receives the communication. Seminar texts, cold calling scripts,
computer slideshows at a seminar . . . all examples of sales literature.
 Correspondence: any written letter or electronic mail message distributed by a
member to:
(A) one or more of its existing retail customers; and
(B) fewer than 25 prospective retail customers within any 30 calendar-day period.
NOTE: Correspondence need not be approved by a registered principal prior
to use, but is subject to supervision and review requirements. Also note, that
if the “letter” goes to 25 prospects or more, it is now “sales literature.”
Institutional Sales Material: any communication that is distributed or made
available only to institutional investors. NOTE: Institutional Investors
include: a bank, savings and loan association, insurance company, registered
investment company, registered investment adviser, any other entity (whether
a natural person, corporation, partnership, trust, or otherwise) with total assets
of at least $50 million, a governmental entity or subdivision thereof, a 403(b)
or Section 457 plan that has at least 100 participants, a qualified plan that has
at least 100 participants, an NASD member or registered associated person of
such a member, and a person acting solely on behalf of any such institutional
Public Appearance: participation in a seminar, forum (including an interactive
electronic forum), radio or television interview, or other public appearance or
public speaking activity. NOTE: this would include a registered
representative participating in a chat room!
Independently Prepared Reprint: any reprint or excerpt of any article issued by
a publisher, provided that the publisher is not an affiliate of the member using
the reprint or any underwriter or issuer of a security mentioned in the reprint
or excerpt and that the member is promoting. An “independently prepared
reprint” is also any report concerning an investment company, provided that
the report is prepared by an entity that is independent of the investment
company, its affiliates, and the member using the report (the "research firm")
No matter how we define the communications with the public, it all comes down
to this idea:
All member communications with the public shall be based on principles of fair dealing
and good faith, must be fair and balanced, and must provide a sound basis for evaluating
the facts in regard to any particular security or type of security, industry, or service. No
member may omit any material fact or qualification if the omission, in the light of the
context of the material presented, would cause the communications to be misleading.
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As you already know, if the material concerns investment companies, established
firms file a copy with the NASD within 10 days of first use. But, new firms would prefile these materials during their first year. After that, they’re established.
NASD Rule 2212. Telemarketing.
So, you’d like to spend your day smiling and dialing, huh?
As you may have noticed, there has been a major backlash against telemarketing
in general, and the NASD has codified how the smile-and-dial process needs to be
approached. Let’s bring up a few quick facts:
Don’t call the residence of any person before 8AM or after 9PM in the
prospect’s local time zone, unless that person has given express written/signed
permission, is an established customer of your firm, or is a broker-dealer
Check your firm’s specific do-not-call list. If the prospect is on that list,
should you go ahead and dial them anyway? Only if you’re planning an early
Check the Federal Trade Commission’s national do-not-call-list and do-notcall anyone on that list.
A member or person associated with a member making a call for
telemarketing purposes must provide the called party with the name of the
individual caller, the name of the member, an address or telephone number at
which the member may be contacted, and that the purpose of the call is to
solicit the purchase of securities or related service. The telephone number
provided may not be a 900 number or any other number for which charges
exceed local or long distance transmission charges
The provisions set forth in this rule are applicable to members telemarketing
or making telephone solicitations calls to wireless telephone numbers.
If a member uses another entity to perform telemarketing services on its
behalf, the member remains responsible for ensuring compliance with all
provisions contained in this rule
What does it mean to “have a business relationship” with your firm? Basically,
the person has either made a transaction with your firm in the past 18 months, currently
holds a security position with your firm, or is the broker-dealer of record for an account
of the person you’re pestering.
Prior to engaging in telemarketing activities, the firm needs to:
Create a written policy for maintaining a do-not-call list
Train personnel who will be smiling and dialing
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If anyone requests to be put on your firm-specific do-not-call list, put ‘em on
the list
Identify all callers—who you are, who you work for, the fact that you are
trying to interest them in securities
Tape-Recording Rule
Obviously, this whole do-not-call stuff is a major pain in the neck. For some
firms, the pain is even greater. If certain sales representatives have an employment
history that includes working at a “disciplined firm,” the firm is going to have to start
tape-recording all telephone conversations between the member's registered persons and
both existing and potential customers. The firm will have to establish procedures for
reviewing the tape recordings and will have to maintain the recordings for three years. At
the end of each calendar quarter, such firms have to report to the NASD on their
supervision of the telemarketing activities. The reporting is due within 30 days of the end
of each quarter.
What is a disciplined firm? Basically, any firm that has been busted by the SEC,
any SRO, or the Commodity Futures Trading Commission. So, if a certain number of
registered rep’s used to work at disciplined firms, break out the tape recorder and start
NASD Rule 2820. Variable Contracts.
This rule tells member firms that when they accept payment from a customer for a
variable contract, the price at which the money is invested is the price next computed
when the payment is accepted by the insurance company. Just an obvious restatement of
the “forward pricing” concept you already know for mutual funds, which are the same
thing as variable annuities minus the tax-deferral and death benefit. The member firm
has to transmit the application and payment promptly to the insurance company. No
member who is a principal underwriter may sell variable contracts through another
broker/dealer unless the broker-dealer is a member, and there is a sales agreement in
effect between the parties. The agreement must also provide that the sales commission
be returned to the insurance company if the purchaser terminates the contract within
seven business days. Sorry, that rule doesn’t favor you very much, but it is what it is.
Also, member firms can only sell variable annuities if the annuity/insurance company
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promptly pays out when clients surrender their contracts. In other words, if the insurance
company is lame, the member firm can’t just keep shrugging their shoulders and going,
“Hey—what are ya’ gonna do—we just sell the darn things.”
Associated persons (you) may not accept compensation from anyone other than
the member firm. The only exception here is if there is an arrangement between you and
the other party that your member firm agrees to, and your firm deals with a bunch of
other requirements. Associated persons (you) may not accept securities from somebody
else in exchange for selling variable contracts. The only non-cash compensation that can
be offered or accepted would be:
gifts that do not exceed an annual amount per person fixed periodically by the
Association and are not preconditioned on achievement of a sales target. The
gift limit is still $100, by the way.
an occasional meal, a ticket to a sporting event or the theater, or comparable
entertainment which is neither so frequent nor so extensive as to raise any
question of propriety and is not preconditioned on achievement of a sales
Payment or reimbursement by offerors in connection with meetings held by an
offeror or by a member for the purpose of training or education of associated
persons of a member
For that last bullet, remember that the associated person (you) would have to get
your firm’s permission to attend and that your attendance and reimbursement of expenses
can not be preconditioned on your meeting a sales target. Only you—not your guest—
can have your expenses reimbursed, which is a rule just begging to be bent like a freakin’
pretzel but let’s keep moving. The location of the meeting has to be appropriate, too,
meaning if the offeror’s office is in Minneapolis, it looks real suspicious when the
meeting is held in Montego Bay, mon. And—as always—the record keeping
requirements are tougher than we’d like. As the rule states, your “member firm shall
maintain records of all compensation received by the member or its associated persons
from offerors. The records shall include the names of the offerors, the names of the
associated persons, the amount of cash, the nature and, if known, the value of non-cash
compensation received.”
Your firm can give you non-cash compensation for selling variable contracts, but
they can’t compensate you more for selling one variable contract than for another. This
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rule states that the non-cash compensation arrangement requires that the credit received
for each variable contract security is equally weighted.
NASD Rule 2830. Investment Company Securities
Mutual funds and variable annuities are both investment companies covered under
the Investment Company Act of 1940. Since they are so similar, it’s not surprising that
this NASD rule on investment company securities is very similar to the one we just
looked at on variable contracts. Like the previous rule, this one tells member firms who
act as underwriters/distributors of investment companies that they need to have a written
sales agreement between themselves and other dealers. If the other dealer is not an
NASD member, they would have to pay the full public offering price, which would make
it real tough for them to make a profit. As before, member firms need to transmit
payment from customers to the mutual fund companies promptly.
Excessive Charges
This rule also tells member firms not to offer or sell shares of investment
companies if the sales charges are excessive. What makes the sales charges excessive?
Well, you already know that 8.5% of the public offering price is the maximum sales
charge. Also note that if the fund does not offer breakpoints and rights of accumulation
that satisfy the NASD, the fund can not charge 8.5%. As you already know, it would be a
violation to describe a mutual fund as being "no load" or as having "no sales charge" if
the investment company has a front-end (A shares) or deferred (B shares) sales charge, or
whose 12b1 fees exceed .25 of 1%.
Withhold Orders
Although I would have thought this truth were self-evident, this NASD rule states
that, “No member shall withhold placing customers' orders for any investment company
security so as to profit himself as a result of such withholding.” Another part of this rule
says that member firms can only purchase investment company shares either for their
own account or to fill existing customer orders—they can’t just pick up a batch of shares
and then see if anybody wants them, in other words.
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No More Pay-to-Play
This next thing seems highly testable to me. Broker-dealers can not decide to sell
particular investment company shares based on how much trading business the
investment company does or would consider doing through the firm. The ole’ “pay to
play” method is a big no-no, in other words. Be very broad in your understanding of this
rule—if it looks at all as if a member firm is tying the promotion of particular funds to the
amount of trading commissions they receive when the fund places trades through them,
it’s not passing the smell test. This would also apply to a member firm offering to
compensate their branch managers and rep’s more for selling the shares of those
investment companies who execute transactions through the firm, generating fat
So, I just told you that a broker-dealer (member firm) can not sell mutual fund
shares if the mutual fund trades through the broker-dealer, generating commissions for
the member firm, right?
No. What I’m saying is that the firm can’t tie the promotion/sale of the mutual
fund to the level of trading the fund does or intends to do through the firm. Similarly,
firms definitely compensate their branch managers and representatives for selling mutual
fund shares; they simply can’t compensate them more for selling the shares of the funds
willing to “pay to play.”
Interestingly, as I look at the NASD’s website this morning, I see that the
regulators just fined a firm over $12 million for placing mutual funds on a “preferred list”
in exchange for those funds doing lots of lucrative trading business through the firm. The
news release calls it a “shelf space program,” which is a great name for it. See, in the
supermarket, all the products you see are required to pay just to get on the shelf. Well,
that’s okay for cookies and crackers, but not for mutual funds.
This all boils down to the fact that a broker-dealer should recommend a mutual
fund because it’s the best investment for a particular client, not because the broker-dealer
will make money from the mutual fund when it executes its trades through the firm.
If a transaction involves the purchase of shares of an investment company that
imposes a deferred sales charge when the investor redeems the shares some day, the
written confirmation must also include the following legend: "On selling your shares, you
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may pay a sales charge. For the charge and other fees, see the prospectus." The legend
must appear on the front of a confirmation and in, at least, 8-point type.
I am not making that up. 8-point type. What’s more, I understand that the
members of the rowdy 9-point-font faction of the rules committee had to be forcibly
restrained several times before finally bowing to the demands of their relentless, 8-pointfont-favoring colleagues.
Finally, everything I told you about NASD Rule 2820 concerning receipt of
payment from other sources, including non-cash compensation, holds true here, too. So,
assuming you haven’t fallen asleep or died of boredom yet, you might want to do a quick
review of that section.
NASD Rule 2790
If the underwriters have set the public offering price (POP) of a stock at $10, what
happens if the stock shoots up to $20 on the secondary market, while they're still selling
shares at $10? Wouldn't it be tempting to hold all the shares for their own account and let
the price rise even further?
Might be tempting, but it's not allowed by the NASD. These public offerings have
to be bona fide (good and true) distributions. That means that if your firm is an
underwriter, it has to sell all the shares it is allotted, no matter how tempting it might be
to keep most of them for its own account.
Restricted persons
Your firm also has to watch whom they sell the new issue to. A person who may
not purchase a new issue of common stock is called a “restricted person.” Restricted
persons include:
Member firms
Broker-Dealer personnel
Finders and fiduciaries (finders, accountants, consultants, attorneys, etc.)
Portfolio managers for institutions (banks, S&L’s, insurance companies, etc.)
Of course, it would be fun to help your immediate family members profit from a
wildly successful IPO such as the one pulled off by Google not so long ago.
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Unfortunately, NASD Rule 2790 prohibits the offering of new issues to immediate family
members, defined as:
mother-in-law or father-in-law
spouse, brother or sister
brother-in-law or sister-in-law
son-in-law or daughter-in-law
any other individual to whom the person provides material support
The last bullet point above mentions “material support,” which the NASD is kind
enough to define for us:
"Material support" means directly or indirectly providing more than
25% of a person's income in the prior calendar year. Members of the
immediate family living in the same household are deemed to be
providing each other with material support.
Rule 2790 also requires that before selling a new issue to any account, a member
firm must in good faith have obtained within the twelve months prior to the sale, a
representation that the account is eligible to purchase new issues in compliance with this
NASD Rule 3110. Books and Records.
As you know, a broker-dealer (member firm) has to deal with customer
complaints. That means that they have to maintain a file of all the written complaints and
the action taken. Of course, complaints could lead to a customer threatening to sue,
which is why the broker-dealer likes to get all customers to sign a “pre-dispute
arbitration agreement.” Remember that once the customer signs an arbitration
agreement, they’ll have to take their claim to the arbitrators, where they’ll get just one
chance. Also, the arbitrators don’t have to explain their decision, and some of them come
from the securities industry, which might make them lean toward the side of the firm the
customer is ticked at. Trouble is, a lot of firms thought it would be cool to insert a clause
in the customer agreement that few customers noticed, let alone understood. So the
NASD now requires member firms to use specific language pointing out to the customer
that with her signature she is, in fact, agreeing to use arbitration (not civil court) and what
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the heck that actually means. Within 30 days of signing the agreement, the customer
must be given a copy of what the heck she just signed. And, any time a customer
requests a copy of the pre-dispute agreement, the firm must provide it within 10 business
In case you didn’t already have enough numbers to memorize.
NASD Rule 2330. Customers' Securities or Funds.
This rule is basically telling member firms to watch what they do with the funds
and securities they hold on behalf of customers. Since some of the customers might not
pay close attention to their account statements, it might be tempting to, like, borrow a few
grand here and there, as long as you put it back, right?
Tempting, sure. And real stupid, especially if you get caught. The firm can not
lend out customer securities to themselves or others who might want to sell them short,
unless the customer has authorized that in writing. Also, the firm has to segregate
(separate) customer securities that have been fully paid from the firm’s own securities. In
other words, they need to keep a really tight set of books of who owns what.
I’m sure it’s tempting to tell a skeptical customer that, “Even if you lose money
on this stock transaction—don’t worry. We’ll guarantee you and give you your money
back.” I have recently seen many real-world examples of registered rep’s dropping the
ball on customer accounts and then trying to appease the angry investor with a personal
Don’t do that. Firms may not offer guarantees against loss, nor would they really
want to. You make a suitable recommendation and help your customer manage risk, but
when he buys a stock, anything can happen.
We’ve already covered the rule on sharing in the profits/losses of a customer
account, but let’s do a quick review:
The word “sharing” is a red-flag word
If a rep wants to share in the account of a customer, they will need the
customer’s written authorization, the firm’s written authorization, and they
have to share only in proportion to their investment in the account
The exception to the proportional sharing requirement is if the customer
happens to be a member of the rep’s immediate family (parents, mother-inlaw or father-in-law, husband or wife, children or any relative to whose
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support the member or person associated with a member otherwise contributes
directly or indirectly)
NASD Rule 2370. Borrowing From or Lending to Customers.
A registered representative may never borrow money from or lend money to a
customer. Except when he can. As this NASD rule makes clear: No person associated
with a member in any registered capacity may borrow money from or lend money to any
customer unless the member has written procedures allowing the borrowing and lending
of money between such registered persons and customers of the member and the lending
or borrowing arrangement meets one of the following conditions.”
Here are the conditions that would allow a registered rep to borrow from/lend to a
the customer is a member of such person's immediate family
the customer is a financial institution regularly engaged in the business of
providing credit, financing, or loans, or other entity or person that regularly
arranges or extends credit in the ordinary course of business
the lending arrangement is based on a personal relationship with the customer,
such that the loan would not have been solicited, offered, or given had the
customer and the associated person not maintained a relationship outside of
the broker/customer relationship
the lending arrangement is based on a business relationship outside of the
broker-customer relationship.
the customer and the registered person are both registered persons of the same
member firm
How does the NASD define “immediate family”? Very broadly:
parents, grandparents, mother-in-law or father-in-law, husband or wife,
brother or sister, brother-in-law or sister-in-law, son-in law or daughter-inlaw, children, grandchildren, cousin, aunt or uncle, or niece or nephew, and
shall also include any other person whom the registered person supports,
directly or indirectly, to a material extent.
Also note that the member firm would always have to pre-approve the
borrowing/lending arrangement, except when they wouldn’t. If it’s an arrangement with
a lending institution or an immediate family member, the firm can write their policy in a
way that does not require notification. But the arrangement between a fellow registered
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rep or somebody with whom you have a business relationship—that would have to be
Just to keep everything nice and simple.
NASD Rule 2420. Dealing with Non-Members.
In their typically lucid prose, the NASD writes, “No member shall deal with any
non-member broker or dealer except at the same prices, for the same commissions or
fees, and on the same terms and conditions as are by such member accorded to the
general public.” And then I step in and translate it back to English. What they’re saying
is that member firms can’t treat broker-dealers who don’t belong to the NASD or other
registered securities association any differently from how they treat any other public
customer. The Securities Exchange Act of 1934’s Section 15A calls for registration of
securities associations, such as the NASD, NYSE, MSRB, etc. So, if the broker or dealer
is not registered under that Act, the member firm can’t share commissions with them, or
participate in a syndicate with them, or trade securities with them at special prices not
available to a schmuck like me.
The rule would allow an NASD member firm to do business on more favorable
terms with a member of a different securities association—as long as it’s registered under
Section 15A of the Securities Exchange Act of 1934.
And you thought this Series 6 stuff was going to be boring!
Types of Mutual Funds
We already took a fascinating look at hedge funds and the new “funds of hedge
funds” that allow investors to take on huge risk, pay big expenses, and end up with shares
they usually can’t redeem. The Series 6 is also now threatening to talk about some
mutual funds that you may not be sufficiently familiar with.
So, let’s talk.
Growth vs. Value
You’ve probably heard of growth stocks and value stocks. A growth investor is
interested in buying hot companies expected to grow much faster than their competitors
and the overall market. Trouble is, there is a lot of hope and speculation built into these
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stocks, so the price is usually very high compared to the earnings/profits of the company.
In fact, many investors will buy stocks in companies who still haven’t made a profit.
But, the investor figures that everything will work out just as soon as those profits that
inconveniently haven’t shown up yet start to materialize. If you’re buying stock in
AMZN or PCLN, you’re paying a lot compared to the earnings of the company.
A value investor likes to buy stocks in companies who are struggling. As I write
this, General Motors is struggling, and its stock and bond prices have dropped
accordingly. Oh well. A value investor might decide that the company will soon get its
act together. Therefore, since the stock can be purchased right now on the cheap, let’s
snap up some shares and simply wait for the turnaround. What if you buy a value stock
cheap and then it gets a whole lot cheaper?
Hate it when that happens.
Rather than picking individual “growth” or “value” stocks, many investors prefer
to buy growth funds or value funds and let the portfolio manager choose the actual
ingredients of the fund. Of course, they pay sales charges, 12b1 fees, and other expenses,
but nothing comes for free. If you want to avoid those expenses, pick your own darned
The exam might say that growth stocks tend to trade at “high multiples” while
value stocks trade at “lower multiples.” The “multiple” is just the P/E ratio. Sounds
fancy, but the P/E ratio just compares the market price (P) to the earnings of the company
(E). See, the only reason to buy a share of stock is to share in the earnings/profits of a
company. Increased earnings make the stock price rise, and, someday the company will
probably start sharing those profits in the form of fat dividend checks. The question is,
how much are you willing to pay for those earnings? If the company earns $1 per share
and the stock trades today for $25, that is a P (price) E (earnings) ratio of 25. A P/E ratio
of 25 means the Price is 25 times the Earnings. The companies who assemble growth
and value indexes simply use a numerical cut-off point: if the P/E is this high, the stock is
in our growth index. If the P/E drops down to this point, we put it in our value index.
That explains why Krispy Kreme was once a “growth stock” and is now a “value stock.”
So, if you like to buy companies expected to grow and you’re willing to pay high
price-to-earnings multiples, buy a growth fund. If you prefer buying stocks at what you
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think are low P/E ratios, usually because the company is going through a tough spot, buy
value funds.
Compared to growth funds, value funds tend to invest in companies that are more
mature and that pay higher dividend yields. Why do they pay higher yields? Two
reasons. One, they are mature companies, and, two, their share prices are low.
Remember, if the dividend stays the same as the stock price drops, dividend yield
increases. Finally, value funds are generally less volatile than growth funds.
Blend Funds
What if you wanted to invest in both growth stocks and value stocks—would you
have to buy two separate funds? Not necessarily. A “blend fund” might invest in both
growth and value at the same time. Or, maybe you’d like some blue-chip stocks (GE,
Wal-Mart, MSFT, Citigroup) as well as some aggressive growth stocks. No problem,
chances are there is a blend fund that invests in some of each. Some blend funds will
invest in a mix of stock and fixed income securities. How I could possibly differentiate
that from a balanced fund, I have no idea. But when the Series 6 says something, I
usually just smile and agree, no matter how silly it is.
Some investors prefer to buy just one fund that uses different objectives, rather
than purchasing several different funds, each with its own objective. Might even be a
cheaper way to go, unless it isn’t. See, you’d have to pay close attention to the sales
charges and expenses of a blend fund. It might be cheaper to buy a single blend fund
versus a growth fund and a value fund.
Or not.
Principal protected Funds
Would you believe that principal-protected funds focus on protecting investors’
principal? Why these people can’t just buy T-bills, T-notes, and T-bonds, I do not know.
Perhaps they prefer paying expenses to getting the principal guarantee for free and
avoiding the lock-up period. These funds take a lot of steps to keep the principal invested
stable, but those steps usually cost something—buying puts on indexes or individual
stocks, for example, carries a cost. So, these funds can be rather expensive. In exchange
for the guaranteed principal, the fund also might limit the upside that the investor can
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make. Reminds me of an “indexed annuity,” but let’s not get into that right now.
Principal-protected funds would be suitable for a very conservative investor who needs a
lump sum at a fixed point in the future. These are not for income investors, as there will
be no income for a long while. Generally, the investor has to deal with a lock-up period
of 5 to 10 years, during which no redemptions can be taken and all dividends/capital
gains must be reinvested. The guaranteed principal begins after this lock-up period.
Statement of Additional Information (SAI)
When you sell a mutual fund, you provide the prospect with a prospectus.
Technically, that’s a “summary prospectus.” It discloses the investment objectives, risks,
fees & expenses, dividend and capital gains policy, etc. If an investor would like a
statement of additional information, they can get a document named, ironically, a
“statement of additional information.” In this document, they would find more
information than what’s in the summary prospectus, including the fund’s consolidated
financial statements (balance sheet, income sheet, statement of operations). There would
also be a list of the portfolio’s securities holdings as of the date of writing.
To obtain this “SAI,” an investor simply makes a request to the investment
company, free of charge, visits the website, or contacts the SEC.
Expanded Retirement Plan Focus
Bonus annuities
As if annuities weren’t complicated enough already, the exam may expect you to
know something about “bonus annuities.” With a “bonus annuity” the Annuity Company
may offer to enhance the buyer’s premium by contributing an additional 1 to 5% of what
he/she puts in. Of course, this comes with a price. First, there are fees attached and,
second, the surrender period is longer. Third, if the investor surrenders the contract early,
the bonus disappears. Remember that an investor will get penalized by the annuity
company with a “surrender charge” if they pull all their money out early. For “bonus
annuities” that period where the investor could get penalized is longer.
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Bonus annuities are not suitable for everyone. Variable annuities in general are
not good for short-term investment goals, since the surrender charge will be applied
during the first 7 years or so. Should you switch a customer into a bonus annuity?
Maybe. But, remember, even though the annuitant can avoid taxes through a 1035
exchange, when she exchanges the annuity, her surrender period starts all over again.
And, yes, the NASD will bust you if it looks like you did the switch just to make a nice
commission, forcing the investor to start the surrender period all over again. In general,
investors should maximize their 401k and other retirement plans before considering
annuities. Annuities are ideal for those who have maxed out those plans, since the
annuity allows investors to contribute as much as they would like.
72 (t) and Substantially Equal Periodic Payments
Speaking of early withdrawal penalties, remember that annuities are by nature
retirement plans and are subject to the 10% penalty for withdrawals made before age 59
½ or made without a good excuse. One good excuse is to utilize IRS rule “72(t).” As
with an IRA, an individual can avoid the 10% penalty if the withdrawal qualifies for an
exemption. For example, if the individual has become disabled and can’t work, or has
certain medical expenses, money can be taken out penalty-free. Notice how I didn’t say
Basically, a reference to “72t” has to do with an individual taking a series of
substantially equal periodic payments. Of course, the industry quickly turned that phrase
into the acronym “SEPP.” The IRS won’t penalize the early withdrawal if the individual
sets up a rigid schedule whereby they withdraw the money by any of several IRSapproved methods. Once you start your little SEPP program, stay on it. See, the IRS
requires you to continue the SEPP program for five years or until you are the age of 59 ½,
whichever comes last. So, if the individual is 45, she’ll have to keep taking periodic
payments until she’s 59 ½. If the individual is 56 when she starts, she’ll still have to
continue for 5 years. Either that, or cut the IRS a check for the very penalties she was
trying to avoid.
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Section 457 Plan
One of the most confusing concepts in this industry is the difference between a
“qualified” and a “non-qualified” plan. Many people think the distinction comes down to
“pre-tax” versus “after-tax” contributions. If the plan is funded with pre-tax (taxdeductible) contributions, they’ll call it a “qualified plan.” And, if the money goes in
after-tax (non-deductible), they’ll call it a non-qualified plan.
Unfortunately, watch how quickly the logic would break down. A Keogh Plan is
funded with pre-tax dollars and is used by sole proprietors. A sole proprietor could also
use a SEP-IRA or SIMPLE IRA, which are also funded with pre-tax contributions.
So, they’re all qualified plans, then, right?
Actually, no. The words “qualified plan” have to do with those plans that require
IRS approval and that have to cover all eligible employees. Qualified plans include
401(k), 403(b), defined benefit pension, Keogh, profit sharing. If the plan can exclude
certain employees, it is now a “non-qualified plan,” which would include: deferred
compensation, SEP-IRA, SIMPLE IRA, payroll deduction, and the 457 Plan I’m getting
ready to tell you about.
Notice how in those “non-qualified plans” such as the SEP or SIMPLE IRA, the
contributions are still made pre-tax. If you make a $5,000 contribution to your SIMPLE
or SEP-IRA, that reduces your taxable income by $5,000. You’ll pay tax on everything
when it comes out at your ordinary income rate, just as you do on the 401(k). But, the
401(k) is a qualified plan because it has to cover all eligible employees and receive IRS
approval before getting started.
Anyway a Section 457 plan is a deferred compensation plan for state and local
government workers. Employees can contribute part of their salary to reduce their tax
burden now, and let the earnings grow tax-deferred. Of course, whenever you do this,
you end up paying ordinary income tax on everything that comes out. But that’s okay.
Most people plan on being in a lower tax bracket when they retire, and their money
grows faster when it isn’t being depleted every year by cutting a check to the IRS.
A Section 457 plan is a non-qualified plan, and the maximum contribution is the
same as it is for the 401(k).
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Roth 401(k) Plans
What do you get when you combine the higher contribution limits and matching
features of a 401(k) plan with the after-tax contributions and tax-free distributions of a
Roth? Would you believe, a “Roth 401(k)”? Why would somebody prefer this option?
Well, a Roth only offers tax-free withdrawals after the individual is at least 59 ½ years
old and has had the account for five years. With the Roth 401(k), you just need to be 59
½. Also, people with high incomes are phased out of being able to contribute to a Roth
IRA—not so with the 401(k) version. Just to keep things nice and simple, when the
employer matches the individual’s contributions, the employer contributions go into a
traditional 401(k). The individual, essentially, has a pre-tax and an after-tax account
going. The individual can contribute to either one, but she can’t transfer money among
the two. Also, unlike the Roth IRA, this account requires the individual to start taking
money out by age 70 ½.
Self-Employed 401(k) Plans
Self-Employed 401(k) plans are for the owner and spouse of a small business, as
well as any part-time employees. The plans are flexible in terms of funding requirements
and are available to basically any business structure: sole proprietor, C Corporation, S
Corporation, limited partnership, or LLC.
Although the federal government should probably be prohibited from ever using
the word “simple” in any plan they come up with, they still came up with something
called a “SIMPLE IRA.” Actually, the “SIMPLE” thing is pure coincidence. It stands
for “Savings Incentive Match Plans for Employees.” The SIMPLE IRA is for businesses
with no more than 100 employees that have no other retirement plan in place. The
employees make pre-tax contributions up to the current maximum ($10,000 for 2005).
The employer generally makes matching contributions of 1-3% of the employees’
compensation. The SIMPLE is often attractive to an employer because it is much easier
to establish than a traditional 401(k). Remember—the 401(k) is qualified, so it requires
IRS approval.
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The SIMPLE IRA would be good for a company where the employees don’t
make huge salaries. For high earners, the SEP IRA allows for higher contributions. If a
high earner has a SEP, she can put in up to $42,000 for 2005. But, since the SEP is based
on 25% of compensation, her compensation would have to be pretty big before that
percentage got up to $42,000. With a SIMPLE IRA, the employees can “simply” put in
whatever they want up to the current maximum.
Also note that when a business starts a SEP or SIMPLE IRA, the employees are
“immediately vested.” That means that it’s their money, and if they want to take it out
and pay penalties, that’s completely their business. If you want to control your
employees’ ability to withdraw money, set up a pension plan, 401(k), etc.
Money Purchase Plan
This is simply a defined contribution retirement plan where the employer
contributes a fixed percentage of the employee’s salary, regardless of the company’s
profitability. That means the company has to make contributions or pay a penalty, so
these are not appropriate for all businesses. The employer may deduct the contributions
it makes on behalf of workers up to a maximum of 25% of compensation. The current
limit is $42,000, rising to $44,000 for 2006.
Rollover vs. Transfer
I’m not sure why, but some people will take a “rollover” from an IRA and then
plan to send the money to a new IRA custodian within 60 days. Remember that a
rollover must be completed within 60 days, and an individual can only do one per year
without IRS hassles. What the exam calls a “rollover” is a situation where the individual
has the current IRA custodian cut her a check in her name. I guess she’s planning a
shopping spree, but she’ll notice that her check is short by 20%, which is the
“withholding” that the custodian will keep for their friends at the IRS. The individual
would then need to make up the 20% shortfall when she cuts her check to the new
custodian. Either that, or the IRS will treat the 20% shortfall as an early distribution
subject to ordinary income tax and the 10% penalty.
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So, most people would do a direct transfer of funds from one IRA or 401(k)
custodian to the next. There are no limits here, since the individual does not cash a
check, play with the money a while, and then roll it over into a new IRA.
This situation is very common when someone leaves a job where they have a
401(k) account balance. Same thing here—transfers are no problem, but a true “rollover”
will have all the hassles we just described.
Now, in the so-called “real world,” we can do a “direct rollover,” in which the
current custodian cuts a check in the name of the new custodian “F.B.O.” the individual.
The “FBO” means “for benefit of.” This is really a third-party check that the individual
can’t cash, so there will be no hassles in this situation, either. When I did this recently,
the check was cut to “Ameritrade Holding, Inc. F.B.O. Robert Walker.” So, I just sent
the check to Ameritrade along with my little IRA deposit slip, and, suddenly, my IRA
was a whole lot larger. Just as important, there was no withholding, and no IRS hassles.
Basically, if you leave your job and want to move the 401(k) balance to your own
IRA, you can have the custodian cut a check to the new IRA custodian and send the funds
directly. That’s a transfer. Or, you could have the 401(k) custodian cut a check in the
name of the custodian “F.B.O. Your Name,” and that would avoid hassles, too.
But, if you have the custodian just cut you a check in your name, and then you
start procrastinating about establishing the new IRA, now you’re doing what the exam
calls a “rollover.” You can do one rollover per year. You must complete it in 60 days.
And, there will be the 20% withholding hassle.
Distributions from an IRA after the owner’s death
When an individual dies, her IRA does not pass to the estate. Instead, it passes to
the named beneficiaries. The beneficiaries, then, must decide how to receive the money.
One option is to simply take a lump sum. There is no 10% penalty, but ordinary income
tax must be paid on the amount received. Why? Because the individual has not paid
taxes on the account yet. Somebody has to pay taxes on the IRA. That’s the deal we take
in exchange for the tax deferral and current tax deductions for the contribution. Another
option is to roll the money into the beneficiary’s own IRA. This way, taxes won’t be due
until the beneficiary begins to take it out.
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If the individual dies before starting to take the required minimum distributions,
then there are two ways for the beneficiary to take the money out:
Withdraw the funds over a 5-year period
Withdraw the funds based on the beneficiary’s life expectancy
Just to keep things nice and simple, if the individual had already begin to take the
required minimum distributions (which start at age 70 ½), then the money must be taken
out based on the life expectancy of the deceased owner.
No, the life expectancy of a deceased person is not “zero,” and, please let me do
the smart-aleck jokes if you don’t mind. The life expectancy of the deceased person is
simply the table the IRS was using to force him/her to begin the RMD (required
minimum distribution) while still alive.
Now, if the beneficiary is the spouse of the individual, things are different.
Surviving spouses have more flexibility. As before, the surviving spouse can simply take
a lump sum distribution and pay ordinary income taxes on it. The spouse can also treat
the IRA as if it were his/her own. They need to start the RMD based on their own life
expectancy and pay the same taxes that the deceased individual would have paid.
Education Savings Plans
529 Plans
These are not retirement plans, but we usually talk about them when discussing
retirement plans because of the tax deferral.
529 Savings Plan
The 529 Savings plan allows investors to save/invest for education. Usually, it
would be a family member socking away money for a nephew’s or grandchild’s
education, but, actually, the donor and the beneficiary do not need to be related. The
beneficiary also does not have to be a child. The person who opens the account is the
owner; the beneficiary is the person who will use the money for education. Lots of
flexibility in these plans. The donor can contribute up to the gift tax exclusion ($11,000
currently, $12,000 for 2006) without incurring gift taxes and can even do a lump sum
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contribution for the first five years ($55,000 now, $60,000 in 2006) without incurring gift
tax hassles. A married couple—grandpa and grandma, for example—could double that
amount and contribute $110,000. These numbers will rise in 2006 to $12,000 per year or
$60,000 for the first five ($120,000 for a married couple for the first five years). Note
that if somebody uses the five-year-up-front method, they can’t make any more gifts to
the beneficiary for the next five years without dealing with gift taxes. We’re talking
about avoiding gift taxes—the states would actually set the maximum that may be
contributed on behalf of a beneficiary.
Contributions are made after-tax, and the withdrawals used for qualified
education expenses are tax-free at the federal level. A qualified withdrawal would be
taken to cover tuition, room & board, books and no more than 7 pitchers of beer per
week. Kidding with the last item—the expenses do need to be directly related to
education; otherwise, you’ll get hit just like you do for an early IRA distribution (10%
penalty plus ordinary income tax). Once per year, the account can be transferred to a
different 529 Savings plan without tax hassles. Also, if the beneficiary decides he
doesn’t need the money, the account can name a second beneficiary without tax
problems, as long as the second beneficiary is related to the first.
The plans are state-specific, so some states may actually allow the donors who are
residents to deduct their contributions for purposes of state income taxes. Or, maybe
they’ll tax the withdrawals if little junior decides he’s too good for any of the little
colleges in his little old home state.
Prepaid Tuition
If you’re pretty sure that junior won’t be too good for any of the colleges in your
state, you might want to lock him in as a future Boilermaker, Hoosier, or Sycamore
through a plan whereby you pay for his tuition credits now for any state school in the fine
state of Indiana. I didn’t say you were locking him into being accepted at Purdue or IU,
but he would get to go to a state school with a certain number of credits already paid for.
What if he decided he wanted to be a Buckeye or Hawkeye, instead?
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The financial penalties could be nasty in that case, which is why we need to be
reasonably sure that the kid will end up going to school in-state. Also note that these
credits cover tuition only—not room and board, or books, lab fees, etc.
Anti-Money Laundering
The Bank Secrecy Act (BSA) authorizes the US Treasury Department to require
financial institutions such as banks and broker-dealers to maintain records of personal
financial transactions that "have a high degree of usefulness in criminal, tax and
regulatory investigations and proceedings." It also authorizes the Treasury Department to
require any financial institution to report any "suspicious transaction relevant to a
possible violation of law or regulation." These reports, called "Suspicious Activity
Reports" are filed with the Treasury Department's Financial Crimes Enforcement
Network ("FinCEN").
This is done secretly (thus the law’s middle name), without the consent or
knowledge of bank customers, any time a financial institution determines that a
transaction is suspicious. The reports are made available electronically to every U.S.
Attorney's Office and to 59 law enforcement agencies, including the FBI, Secret Service,
and Customs Service.
Recently, the US Treasury Department used the Bank Secrecy Act (BSA) to
require that for transmittals of funds of $3,000 or more, broker-dealers are required to
obtain and keep certain specified information concerning the parties sending and
receiving those funds. In addition, broker-dealers must include this information on the
actual transmittal order. Also, any cash transactions over $10,000 require the same type
of uptight record keeping. For these, broker-dealers must file a Currency Transaction
Report with FinCEN.
Why? Because terrorist organizations fund their operations through money
laundering. Since broker-dealers are financial institutions, they’re lumped in with banks
and required to do all kinds of record keeping to help the government prevent these
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With the passage of the “USA Patriot Act” broker-dealers and other financial
institutions have to help the government monitor suspicious activity that could be tied to
money laundering. Broker-dealers now have to report any transaction that involves at
least $5,000 if the broker-dealer knows, suspects, or has reason to suspect that it doesn’t
pass the smell test. The NASD spells out four specific characteristics that would make a
broker-dealer file a “suspicious activity report” (SAR). A SAR would be filed if the
transaction falls within one of four classes:
(1)the transaction involves funds derived from illegal activity or is intended or
conducted to hide or disguise funds or assets derived from illegal activity;
(2) the transaction is designed to evade the requirements of the Bank Secrecy
(3) the transaction appears to serve no business or apparent lawful purpose or
is not the sort of transaction in which the particular customer would be
expected to engage and for which the broker/dealer knows of no reasonable
explanation after examining the available facts; or
(4) the transaction involves the use of the broker/dealer to facilitate criminal
Broker-dealers now have to have a “customer identification program” whereby
they require more information to open an account. They now have to get the customer’s
date of birth. If the customer is not a U.S. citizen, the firm will need:
taxpayer ID number
passport number and country of issuance
alien ID card
other government-issued photo ID card
Even the US citizen may need to show a photo ID, just as you do when you go
take your Series 6 exam.
Finally, the federal government now maintains an Office of Foreign Asset Control
(OFAC) designed to protect against the threat of terrorism. This office maintains a list of
individuals and organizations viewed as a threat to the U.S. Broker-dealers and other
financial institutions now need to make sure they aren’t setting up accounts for these
folks, or—if they are—they need to block/freeze the assets.
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Regulation S-P
Sharing customer information with law enforcement officials is one thing.
Providing it to telemarketers is quite another. To fight identity theft and to protect
consumers from having too much of their information shared with people they’ve never
met, the SEC enacted Regulation S-P to put into place a requirement from the GrammLeach-Bliley Act. Basically, “a financial institution must provide its customers with a
notice of its privacy policies and practices, and must not disclose nonpublic personal
information about a consumer to nonaffiliated third parties unless the institution provides
certain information to the consumer and the consumer has not elected to opt out of the
disclosure.” Broker-dealers now have to deliver initial and annual notices to customers
about their privacy policies and practices, and about the opportunity and methods to opt
out of their institution's sharing of their nonpublic personal information with nonaffiliated
third parties. The initial notice must be provided no later than when the firm establishes a
customer relationship with the individual.
Broker-dealers and financial advisers also need to have written supervisory
procedures dealing with the disposal of consumer credit report information. Since firms
typically look at a client’s credit history when opening accounts—especially margin
accounts—selling annuities, or providing financial planning services, the firms need to
safely dispose of the information rather than just setting it all in a big box out back.
Investment Advisers
A “broker-dealer” makes money through transactions in securities. The Uniform
Securities Act (Series 63 is all about this one) defines a broker-dealer as:
A broker-dealer is any person engaged in the
business of effecting transactions in securities
for the account of others or for its own account.
So, of course, the investment in question would have to be a “security” as defined
by law, not a fixed annuity, bank CD, etc. But if any “person” is effecting transactions
for the accounts of others in “securities,” they fit the definition of “broker-dealer.”
An “investment adviser,” on the other hand, does not necessarily make money
because somebody is buying or selling securities. Would you believe that an investment
adviser is compensated for providing investment advice? If I draw up a detailed financial
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plan for you and charge you $3,000, I just got compensated for investment advice. If I
tell you to buy five stocks and you decide not to, oh well—I’m getting compensated just
for advising you.
The Uniform Securities Act defines an investment adviser the same way that the
Investment Advisers Act of 1940 does:
. . . any person who, for compensation, engages
in the business of advising others, either
directly or through publications or writings, as
to the value of securities or as to the
advisability of investing in, purchasing, or
selling securities, or who, for compensation and
as part of a regular business, issues or
promulgates analyses or reports concerning
And, boy, that sure clears things up, huh? What the law is trying to say is that if
you get compensated for advising others on securities, you are acting as an investment
adviser. What if you’re advising them on fixed annuities or bank CD’s? Those aren’t
securities, so you wouldn’t be an investment adviser. If you did something stupid, you’d
have to be busted under insurance or banking laws.
Types of Advisers
The term “investment adviser” is a legal term that encompasses many different
types of financial professionals. The term would include a financial planner helping
someone determine insurance, estate, investment, and retirement strategies. Many
advisers are portfolio managers with discretion over the account—just professional
investors, basically, trading other people’s accounts. Some help pension funds determine
strategies or decide which portfolio managers to hire. Some sell reports to institutional
investors. In any case, if they get compensated for advising others on securities, they
probably fit the definition of “investment adviser” and probably have to register.
Investment Adviser Representatives
When investment advisers hire people to sell the services of the firm or manage
customer accounts, those people have to be registered, too. These folks would be
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considered to represent the investment adviser, so the creative types in this industry
decided to get a little crazy and call them “investment adviser representatives.” The
investment adviser registers either with the SEC or particular states. When they do so,
they use Form ADV and indicate whether they’re registering with the federal regulators
or the state regulators. They submit U-4 applications to the states where their investment
adviser representatives need to be registered, too. The exam might say that employees of
an investment advisory firm would be considered representatives if they:
manage accounts
sell the services of the firm
determine recommendations for clients
make recommendations to clients
supervise those who do any of the above
So, the receptionist or IT guy would not have to pass the 65/66 and get licensed,
in other words. The regulators might call the folks who don’t have to register
“ministerial personnel” in order to scare you away from a perfectly good answer. Just
use common sense—they want to regulate anybody meeting with clients or having any
say over their investment account at the firm whatsoever. The guy still promising to take
a look at your printer, he doesn’t have to register.
The SEC excuses the following advisers from having to register:
any investment adviser whose clients are all residents of the State where the
investment adviser maintains its principal office and place of business, and
who does not furnish advice with respect to securities listed any national
securities exchange;
any investment adviser whose only clients are insurance companies;
any investment adviser who during the course of the preceding twelve months
has had fewer than fifteen clients and who neither holds himself out generally
to the public as an investment adviser nor acts as an investment adviser to any
investment company registered under title I of this Act
So, the SEC gives those advisers an excuse known as an “exemption” from
registration. If the SEC decided that certain advisers should register exclusively with
them, those advisers would be covered at the federal level, right? So, they got all creative
and named these advisers “federal covered advisers.”
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Too much excitement?
I’ll slow it down a little.
Federal Covered Advisers
Under the Investment Advisers Act of 1940, the SEC wants the following “federal
covered advisers” to register with “the Commission”:
Adviser with > $30 million of assets under management (advisers with $25
million + may register with the SEC)
Adviser to a registered investment company
Adviser doing business in 30+ states
NRSRO’s (Nationally Recognized Statistical Rating Organizations, i.e.
Moody’s and S & P)
Pension consultants providing advice to employee benefit plans with assets of
at least $50 million
Affiliates of federally registered IA’s if the principal office and place of
business of the affiliate is the same as that of the SEC-registered adviser
Newly formed advisers that reasonably believe that they will become eligible
for federal registration within 120 days
The Act of 1940 also spells out a thing or two about state regulation of advisers.
Rather than take away from the power of state regulators, the Investment Advisers Act of
1940 says, paraphrased: “Nothing in this Act prevents the state regulators from hassling
somebody over any security or any person as long as it doesn’t conflict with what we’re
saying here.” So, that speaks to the federal versus state issue. The Act also says
something about state versus state authority. According to the Act of 1940, if an adviser
is registered in Arkansas and also does business in Missouri, Missouri can not require the
adviser to maintain any books or records in addition to those required under the laws of
the State in which it maintains its principal place of business, which would be Arkansas.
Well, it says that’s the case as long as the firm is properly registered in Arkansas and is in
compliance with the books and records required by that state, where they have their
principal place of business. Also, the Act of 1940 says that the states can not make an
adviser register in their state if the adviser:
does not have a place of business located within the State; and
during the preceding 12-month period, has had fewer than 6 clients who are
residents of that State
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Notice how the word “residents” would imply individuals. That means that when
the clients are institutional investors such as big pension funds, big trust funds, insurance
companies, banks, other advisers, etc., the adviser also will not have to register in that
state. The adviser would either register in the state where it has its principal place of
business, or if its assets under management were over $30 million, it would register with
the SEC as a “federal covered adviser.” Would the firm have to register in any other
Maybe. If it’s a federal covered firm, it would not actually register with any of
the states. Instead, it would provide a “notice filing,” which basically means a copy of
the Form ADV they file with the SEC. Just a filing of paperwork, maybe a fee, and
definitely the U-4 form for all the representatives doing business in the state. But, if the
adviser has an office in, say, Kansas, and the assets under management are only, say, $15
million, and none of the clients is a registered investment adviser, then that firm will
register in the state of Kansas, where it has its principal place of business. Would it
register in other states?
Maybe. If it wants to manage accounts for more than five individuals residing in
another state, that state can make them register.
So, some advisers are excused/exempted from having to register with the SEC,
and some advisers are exempted from having to register with the states. There are also
some entities that simply do not meet the definition of “investment adviser” to begin
with. A bank or similar institution (savings & loan, building & loan, credit union, thrift,
etc.) is not an investment adviser, just as I am not a point guard for the Chicago Bulls.
So, the NBA training requirements would affect me as much as the registration
requirements for investment advisers affect those who don’t fit the definition of
“investment adviser.”
What if the question says, “a bank or other financial institution that advises clients
to sign up for low-yielding checking accounts”? It’s messing with you. The advice has to
be connected to securities—this is a checking account. This is a bank. This is not an
investment adviser.
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Lawyers, Accountants, Teachers, and Engineers might be talking about securities
as part of their regular course of business. That doesn’t necessarily make them an
adviser. If a lawyer is establishing an estate, he may ask if the estate holds any stocks or
bonds—that doesn’t make him an investment adviser. If your accountant asks if you’ve
made your maximum 401(k) contribution to reduce your tax burden, she’s just acting as
your accountant. Notice that we have a convenient little acronym here “LATE.” Just
don’t assume they’re all immune from having to register. If they also start advising
people on securities for compensation, they will fit the definition of “investment adviser”
and will have to register.
Release IA-1092
See, there’s often some confusion over whether the professional is, in fact, an
investment adviser and will, in fact, soon be studying for some goofy test even harder
than the one you’re studying for. Many financial planners would really prefer to skip the
whole Series 65 and 63 thing altogether. Same for a lot of pension fund consultants.
Well, as much as the SEC and state regulators feel their pain, they usually prefer that
these people go ahead and study for some really tricky exams, pay some fees, and
maintain their registrations so that the regulators can keep tabs on them in order to protect
SEC Release IA-1092 came up with a 3-pronged test. If the answer to the
following three questions is “yes,” then the professional probably is an adviser and
probably will have to register:
Does the professional provide investment advice?
Is he/she in the business of providing advice?
Do they receive compensation for this advice?
The advice in this case doesn’t have to be on a specific security. If a financial
planner or sports agent is helping clients pick investments in securities as an alternative to
an investment in real estate or other assets, then he/she IS an investment adviser.
Pension consultants who help pension plans decide on either which securities to
invest in or whether to invest in securities over some other asset are advisers. The
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consultants who help the funds determine which investment advisers to hire or retain are
Sorry about that. Gotta register.
So what does it mean to “be in the business of providing advice”? The SEC and
NASAA determined that the person is in the business of providing advice if he or she
gives advice on a regular basis and that advice “constitutes a business activity conducted
with some regularity.” The frequency is a factor, but it’s not the only factor in
determining if the person is “in the business” or not. Providing advice doesn’t have to be
the main activity of the person, either. If the person “holds himself out to the public” as
one who provides investment advice—business cards, Yellow Page® ads, etc.—then
he/she is in the business and is an adviser.
Lots of financial planners represent broker-dealers or insurance companies and
make commissions selling variable annuities, variable life insurance, mutual funds, or
specific issues of stocks, bonds, etc. Many of these planners are clever enough to figure
that they can just issue the advice for free and get paid off the commissions to avoid
being defined as IA’s. Unfortunately, Release IA-1092 says they’re still advisers,
because they receive an economic benefit for providing advice.
Some folks would like to think they’re not advisers because they don’t receive
money for their advice. But regulators wouldn’t leave a loophole that big—they use the
broader term “compensation” to determine who is and isn’t an IA. Compensation is any
economic benefit, not necessarily money. Compensation can come in the form of “soft
dollars,” such as receiving goodies from broker-dealers when you direct clients to put
trades through the firm. Goodies such as research reports, custodial and clearing (trade
processing) services, and special software aiding in research represent compensation, so
if you receive it, you’re probably an adviser. See, otherwise, a smart financial planner
would give the advice to a handful of clients, having them buy securities through the
broker-dealer, who only provides services or software that the planner can use with all of
her clients, and that way she escapes having to register as an adviser.
Sorry. This Release IA-1092 is pulling her into the fold. These soft dollar
compensations are allowable, but they must be disclosed to clients. If the professional is
telling people to trade through a broker-dealer that compensates the professional, clearly
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the clients should know about the arrangement. But the regulators won’t let anybody
receive the following soft dollar compensation arrangements: furniture and office
equipment, salaries or overhead, vacations, cell phones . . . you know, the stuff you might
actually want.
Research reports
Custodial and clearing (trade processing) services
Special software aiding in research
Furniture and office equipment
Salaries or overhead
Cell phones
Surprisingly, even if the compensation is paid by someone other than the client,
you’re still an investment adviser. For example, if you advise Coca-Cola’s employees on
how to allocate their 401K investment dollars, and you bill the company, you’re still an
adviser. And if you’d like to share some of that account with me . . .
Anyway, because of Release IA-1092 advisers must take great care to disclose
conflicts of interest. If the IA advises, say, technology stocks, he/she/they will have to
disclose the fact that his wife/husband just happens to be on the boards of many
technology companies that will be recommended for purchase. If an agent of a brokerdealer (like you, for example) also does some financial planning/advising business on the
side, she must inform clients that these services are performed outside the scope of her
employment at the broker-dealer. Wouldn’t be fair for a brand new rep of some major
Wall Street firm to set up shop as an adviser on the side and imply that the advice is
being given under the umbrella of, say, Goldman Sachs or Merrill Lynch, right? Many
IA’s and planners make commissions from broker-dealers when they place or tell
customers to place trades through them. That needs to be disclosed to clients. And the
IA needs to tell clients they don’t have to use the particular broker-dealer in cahoots with
the adviser—they might be able to get lower commissions using somebody else. If the
planner only recommends products offered by his/her employer, that needs to be
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disclosed. Wouldn’t you feel better getting a recommendation for a mutual fund based
on its performance rather than on the fact it’s the only one the planner can recommend or
the one that pays the best commission?
Suitability of Fee-Based Compensation
Finally, since many firms are both broker-dealers and investment advisers, the
NASD published a rule reminding firms not to stick clients into a fee-based account
simply because it generates, you know, fees. The firm has to determine that the billing
structure is suitable for the client. Some clients might have a pretty good idea of what
they want to buy and when they want to buy and sell it. If they pay a few commissions
here and there, it might be cheaper to just have them pay commissions when they trade,
rather than an ongoing fee that takes a percentage of the assets. But, if it’s a large
account where the person prefers to let a portfolio manager trade the account, maybe the
fee-based structure makes more sense. Not long ago at the NASD website, I was reading
a notice that the regulators had come down hard on a firm for sticking clients into feebased accounts simply because they enjoyed charging the fees.
No. That’s not conduct consistent with just and equitable principles of trade, now
is it?
Practice Questions
1. A client’s 62-year-old mother passes away. The client was named the beneficiary of
the IRA account. If the mother had not begun distributions, the client may:
A. receive the proceeds only after five years
B. receive half the proceeds per year for five years
C. receive the proceeds over the life expectancy of his mother
D. receive the proceeds over his life expectancy
2. Your client’s 73-year-old mother passes away, with your client named as beneficiary
on the IRA account. Your client may receive the proceeds:
A. tax-free
B. over the life expectancy of his mother
C. over his own life expectancy
D. when he reaches the age of 70 ½
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3. One of your clients is 74 years old, earning $17,000 in retirement benefits from a
local car manufacturer. He also earns $2,500 selling hand-made furniture and $1,000
in dividends from three blue chip stocks. Therefore, your client’s Roth IRA
A. may not be made due to the client’s age
B. may be as high as $4,500 for tax year 2005
C. must be based on the $2,500 of earned income
D. may be based on income of $35,500
4. One of your clients is a widowed grandmother looking to contribute to her
granddaughter’s education. Which of the following represent accurate statements
concerning a Coverdell Savings Account?
maximum contribution is $4,000 per donor
maximum contribution is expressed per-child, not per donor
if the funds are not used for education, they may be withdrawn tax-free as part of
the donor’s retirement savings
contributions from the grandmother must stop when the child reaches age 18
A. I only
B. I, III only
C. II only
D. II, IV only
5. Which of the following statements are accurate concerning a Coverdell Savings
A. maximum contribution is currently $2,000 per child
B. the donor does not have to be a member of the child’s immediate family
C. contributions are made after-tax and distributions are tax-free if used for education of
the child
D. all of the choices listed
6. Which of the following statements accurately compare(s) the Coverdell Savings
Account with a 529 Savings Plan?
A. the 529 plan allows for significantly higher contributions
B. the 529 plan contribution limits are expressed per-donor, while the contribution limits
for the Coverdell Savings Account are expressed per-child
C. if the child does not use the funds for education, the Coverdell Savings Account will
subject the earnings to ordinary income tax rates
D. all of the choices listed
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7. Which of the following statement(s) is/are accurate concerning 529 Savings Plans?
A. the assets may be transferred without taxation or penalties to a second beneficiary if
not used by the primary beneficiary, provided the second beneficiary is a member of
the primary beneficiary’s immediate family
B. contributions may be made up to the current gift tax exclusion, with 5 years
aggregated as a lump sum
C. if the lump sum method is used, no further gifts may be made during the next five
years without subjecting them to gift taxes
D. all of the choices listed
8. Which of the following represent true statements concerning the Simplified Employee
Pension (SEP-IRA) plan?
A. the employer does not have to make annual contributions
B. both the employer and employee may make contributions on a pre-tax basis
C. the employee is immediately vested
D. all of the choices listed
9. Which of the following plans is available to a company with no more than 100
employees that offers no other retirement plan?
B. Money Purchase
C. Keogh
10. A bonus annuity typically involves all of the following EXCEPT:
A. minimum guaranteed return
B. longer surrender period
C. credit equal to 1-5% of the initial investment
D. withdrawals above cost basis subject to ordinary income taxes
11. Section 457 Plans are established by
A. any company with 100 or fewer employees
B. any federal government agency
C. a state or municipality
D. a closely-held corporation with fewer than 275 employees
12. Compared to other annuities, the bonus annuity typically offers
A. shorter surrender period
B. higher guaranteed rate of return
C. tax-deferral
D. a credit equal to 1-5% of the initial investment
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13. Which of the following clients would be the most suitable for the purchase of a bonus
A. a mother saving for the education of her 15-year-old daughter
B. a father saving for the education of his 14-year-old son
C. a 32-year-old advertising executive who has made his maximum 401(k) contribution
D. a couple in their late sixties planning to retire early next year
14. Barbara is 52 years old. She has recently left a position that she held for 17 years and
is planning to roll her 401(k) balance into a Traditional IRA. Which of the following
represents the most suitable recommendation if Barbara plans to retire at age 69?
A. money market mutual funds
B. bonus annuity
C. large cap value fund
D. T-bills
15. The portfolio manager for which of the following funds would focus primarily on
purchasing stocks trading below their estimated intrinsic value?
A. growth
C. value
D. short-term
16. One of ABC’s equity funds focuses on investing in stocks with solid fundamentals
operating in sectors currently out of favor with investors. This fund is a(an)
A. growth fund
B. value fund
C. exchange-traded fund
D. sector fund
17. Which of the following types of mutual funds invests in companies whose sales and
earnings are expected to increase greatly over the next 7 – 10 years?
A. value
B. growth
C. index
D. balanced
18. Which of the following is a type of mutual fund that invests primarily in established
companies likely to pay dividends but operating in an industry currently out of favor?
A. turnaround funds
B. value funds
C. growth funds
D. balanced funds
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19. Which of the following statement(s) is/are true concerning hedge funds?
A. private investment pools for wealthy, sophisticated investors
B. generally illiquid investments
C. charge high fees
D. all of the choices listed
20. Which of the following likely represent(s) a “blend fund”?
A. a fund investing in both growth and value stocks
B. a fund investing in both equities and long-term bonds
C. either choice listed
D. neither choice listed
21. Which of the following investors is most suitable for a principal protected mutual
A. any investor with a short time horizon
B. any investor with a long time horizon
C. an investor with a short time horizon looking for a lump sum at a future date
D. a conservative investor with a long time horizon requiring a lump sum at a future date
22. Which of the following statement(s) is/are accurate concerning exchange-traded
A. They are most suitable for investors making purchases of $300 or less
B. They offer the ability to track a particular stock or bond index, unlike open-end index
C. They are cost-effective when purchased in larger amounts
D. They carrier much higher expense ratios than open-end index funds
23. Under Regulation S-P a customer must be provided with a broker-dealer’s statement
of privacy policy
A. at the time the customer establishes a business relationship with the firm
B. within 30 days of the third transaction with the firm
C. either choice listed
D. neither choice listed
24. In which of the following cases must a member firm file a currency transaction report
to FinCEN?
A. a customer deposits $2,000 in cash
B. a customer deposits $50,000 in bearer bonds
C. a customer purchases $12,000 of stock with cash
D. a customer writes a check for $12,000 to a mutual fund company
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25. A client deposits $6,000 at 10 AM. If the client deposits $5,000 at 5:00 PM, your
firm would file
A. no report at this time
B. a currency transaction report
C. a suspicious activity report
D. a Reg T extension request
26. A suspicious activity report (SAR) should be filed with FinCEN:
A. only if the broker-dealer has actual knowledge of criminal activity
B. only after receiving a court order
C. only if the parties are on the OFAC list
D. for most types of suspicious activity, depending on the facts/circumstances
27. As a registered representative of Abel Broker-Dealers, you notice that a client has
executed a series of transactions that are inconsistent with his objectives. If you
suspect that the trading is linked to criminal activity, your firm must file an SAR
when the transactions equal or exceed
A. $10,000
B. $5,000
C. $2,500
D. $1,000
28. One of your clients owns a local coffee shop and frequently deposits a few hundred
dollars with your firm for her investment account. Which of the following would
make you suspicious of her activity?
the client begins selling ETF’s short
the client begins daytrading exchange-traded funds
the client makes a wire transfer to a foreign bank
the client begins making deposits in much larger denominations
I only
II only
I, II, III only
III, IV only
29. What must a firm do if it discovers that one of its clients is on the OFAC list of
suspected terrorists?
A. notify the SEC
B. notify the NASD
C. notify federal law enforcement authorities immediately
D. initiate an internal investigation forthwith
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30. For purposes of private placements under Reg D of the Securities Act of 1933, an
“accredited investor” would include:
A. CFO of the issuing corporation
B. Chairman of the Board of Directors for the issuing corporation
C. Individual with $2.5 million liquid net worth
D. All of the choices listed
31. Which of the following represent true statements concerning a private placement
under Reg D?
the maximum number of non-accredited investors is 35
there is no maximum number of non-accredited investors
the maximum number of accredited investors is 35
the CFO of the issuer is an accredited investor
I only
I, III only
I, IV only
II, III only
32. Which of the following represent accredited investors for purposes of a Reg D private
A. an individual with over $1 million net worth
B. an individual earning in excess of $200,000 the past two years
C. a married couple holding jointly assets worth in excess of $1 million on net
D. all of the choices listed
33. What is required for a non-accredited investor to purchase a private placement
variable life insurance policy?
A. an attorney
B. blood relation to an officer/director of the issuer
C. a purchaser’s representative*
D. an investment adviser
34. Ronald purchases high-quality long-term corporate bonds through a conservative
bond mutual fund. According to the fund’s prospectus, no less than 70% of the bonds
are rated A or higher by S&P and Moody’s. The average duration of the portfolio is
5. Which of the following probably represents the main investment risk?
A. default
B. credit
C. interest rate
D. inflation
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35. Which of the following bonds has the highest duration?
A. 5% nominal yield, matures ’17
B. 3 ½ nominal yield, matures ‘21
C. 4% nominal yield, matures ’19
D. 5% nominal yield, matures ’19
36. Which of the following most likely represents a suitable recommendation?
A. advising a 72-year-old teacher planning to retire next May to purchase a single
premium deferred annuity
B. advising an investor to purchase a deferred annuity inside a Traditional IRA
C. recommending that a 61-year-old client invest 50% of her capital in a blue chip fund
and 50% in an intermediate-term corporate bond fund
D. recommending Treasury notes to a 27-year-old investing for retirement
37. All of the following are true of both open-end index funds and ETF’s except:
A. neither typically charges a sales charge
B. operating expenses are typically very low
C. shares may be purchased on margin and sold short
D. active portfolio management is not utilized by the investment adviser of the fund
38. An advertisement for a mutual fund containing performance data must include a
legend disclosing which of the following?
the performance data quoted represents past performance
past performance does not guarantee future results
the investment return and principal value of an investment will fluctuate so that an
investor's shares, when redeemed, may be worth more or less than their original
current performance may be lower or higher than the performance data quoted.
I only
I, II only
III only
39. You notice that the exchange rate between the dollar and the Yen has fluctuated
recently. If the dollar has appreciated versus the Yen, which of the following
statements is/are accurate?
A. American exports to Japan will suffer
B. Imports from Japan to America will be more attractive to Americans
C. Holders of Toyota’s ADR will receive lower dividends upon conversion
D. All of the choices listed
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40. Four portfolios have been assigned beta coefficients. The portfolios are those of the
following mutual funds: sector, balanced, value, blue chip. Which of the following
betas most likely belongs to the sector fund?
A. .5
B. .7
C. 1.1
D. 1.5
41. A prospectus showing total return data for 1, 5, and 10-year periods would likely
compare the performance to the S&P 500 for all of the following mutual funds
A. growth
B. growth & income
C. intermediate fixed income
D. value
42. Which of the following represent true statements concerning money market mutual
A. share price is typically maintained at $1.00
B. share price is not guaranteed to remain at $1.00
C. the funds may charge a 12b1 fee not to exceed .25% of average net assets
D. all of the choices listed
43. A magazine advertisement for the Oakwood Partner’s Conservative Income Fund lists
performance data for 1, 5, and 10-year periods. Which of the following represent true
statements concerning such advertising?
A. If a sales load or any other nonrecurring fee is charged by the fund, the advertisement
must disclose the maximum sales charge
B. It must be clear whether the performance figures cited are including the deduction of
sales loads
C. A disclaimer that past performance does not guarantee future results must be
D. All of the choices listed
44. Which of the following represent accurate statements concerning securities?
A. only non-exempt securities are subject to anti-fraud regulations
B. fraud is a violation under federal, not state, law
C. if the investment fits the definition of a “security,” it is subject to anti-fraud
regulations and is subject to registration requirements
D. both fixed and variable annuities are defined as securities
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45. All of the following represent sales literature except:
A. Research report
B. Market letter
C. Letter sent to 35 retail prospects in a 90-day period
D. Letter sent to fewer than 25 retail prospects in a 90-day period
46. Which of the following represent sales literature?
A. computer slide shows
B. letter sent to more than 25 retail prospects
C. handouts and invitations connected to a seminar on securities products
D. all of the choices listed
47. Which of the following represent accurate statements concerning NASD rules on
A. some firms must tape record all calls between registered representatives and both
prospects and existing customers
B. the caller must identify him/herself, identify the member firm, provide an address or
telephone number at which the firm may be contacted, and explain that the purpose of
the call is to interest the party in purchasing securities or related services
C. callers must first check the firm-specific do-not-call list, then check the national
registry and refrain from calling any name on either list
D. all of the choices listed
48. Which of the following represent violations of NASD rules concerning investment
company securities?
A. a member firm acts as a distributor with a non-member firm
B. a member firm acts as a distributor with a member firm without a formal sales
agreement in place
C. a member firm offers to promote a mutual fund provided the fund increase its trading
volume through the firm’s trading department
D. all of the choices listed
49. An NASD member firm acts as a distributor for variable annuity contracts. The
member, who is headquartered in Des Moines, Iowa, would like to provide a training
seminar for registered representatives. According to NASD Rule 2820, what is true
of this situation?
A. as long as the attending registered representatives are limited to those meeting a
specific sales target, this would be acceptable
B. as long as the attending registered representatives achieved at least $1 million in
sales, this would be acceptable
C. the member may reimburse registered representatives and one guest for all seminarrelated expenses
D. the member may reimburse the registered representative for his/her expenses only and
may not precondition attendance on achieving a specific sales target.
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50. Under NASD Rule 2790, certain persons are defined as “restricted persons” who may
not purchase initial public offerings through member firms. Which of the following
represent restricted persons for purposes of this rule?
A. receptionist for a member firm not involved in the sales or trading operations of the
B. portfolio manager for a large insurance company
C. sister-in-law of a registered representative of a member firm
D. all of the choices listed
51. Under NASD Rule 2790, certain persons are defined as “restricted persons” who may
not purchase initial public offerings through member firms. Which of the following
represent restricted persons for purposes of this rule?
A. A roommate of a registered representative living rent-free for one final semester of
B. mother-in-law of a sales supervisor of a member firm
C. receptionist of a member firm
D. all of the choices listed
52. Kelly, a registered representative of a member firm, services her mother-in-law’s
investment account held at the firm. Recently, Kelly’s mother-in-law offered to lend
Kelly $5,000 toward the purchase of a townhouse. Which statement most accurately
addresses this situation?
A. it is always a violation for a registered representative to borrow money from a client
of a member firm
B. since Kelly’s mother-in-law is a member of the immediate family, the member firm
may not set policy on such loans
C. the member firm must have written policy addressing loans of this nature and may
decide that notification is not required concerning loans from or to immediate family
D. the firm must file a suspicious activity report to FinCEN
53. Which of the following professionals least likely meets the definition of an
“investment adviser”?
A. an individual providing advice on variable annuities for compensation
B. an individual providing advice on variable life insurance for compensation
C. an individual providing advice on fixed annuities for compensation
D. an individual providing advice on convertible debentures for compensation
54. Which of the following are federal covered investment advisers?:
A. investment adviser with an office in the state with $42 million in assets under
B. an investment adviser with an office in the state providing portfolio management
services to a registered investment company headquartered in another state
C. an investment adviser with an office in the state with $32 million in assets under
D. all of the choices listed
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55. All of the following represent criteria from the so-called “three-pronged approach”
provided by SEC Release IA-1092 except:
A. Does the professional provide investment advice?
B. Is the person compensated for providing investment advice?
C. Is the person in the business of providing investment advice with some regularity?
D. Is the person registered as an investment adviser?
56. Which of the following likely represent securities subject to anti-fraud statutes and
registration requirements?
A. a certificate representing a 10% ownership stake in a prize-winning thoroughbred
B. a certificate representing a 40% revenue interest in three ATM machines owned by a
third party
C. a variable annuity
D. all of the choices listed
57. Which of the following represents a security?
A. fixed annuity
B. universal life insurance policy
C. $50,000 bank certificate of deposit
D. American Depository Receipt
58. A common stock with which of the following beta coefficients would be expected to
outperform a bull market but underperform a bear market?
A. .5
B. .75
C. 1.0
D. 1.5
59. Which of the following debt securities would be expected to have the highest
A. 5-year Treasury note
B. 7-year general obligation bond
C. 30-year Treasury bond
D. 30-year STRIP
60. Which of the following represent true statements concerning offers and sales?
A. if an agent calls a prospect and fails to sell a variable annuity, a security has been
offered for sale
B. an exempt security may be offered and sold without registration
C. it is fraudulent to offer and sell any security, including an exempt security
D. all of the choices listed
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61. In which of the following cases has a sale of securities been effected?
A. an investment representative sells a variable annuity to a high-net-worth client
B. an individual exchanges 100 shares of a local printing company for the privilege of
purchasing the contra party’s home for 35% below market value
C. a soybean farmer sells 5% ownership stakes in his farm to 10 investors
D. all of the choices listed
62. Under Rule 17f-2 of the Securities Exchange Act, all of the following persons
associated with a member firm must submit fingerprints to the Attorney General of
the United States except
A. a registered representative
B. a principal who supervises sales activities
C. an agent who sells mutual funds and variable annuities issued in book-entry form
D. head of the cashiering department of a member firm
63. Under NASD Rule 2210 “Communications with the Public,” a registered
representative participating in a chat room about securities products would be defined
A. sales literature
B. advertising
C. public appearance
D. institutional sales literature
64. An American investor holding an American Depository Receipt is probably least
effected by which of the following investment risks?
A. purchasing power
B. business
C. currency exchange
D. non-systematic
65. Armanov Broker-Dealers has found that complying with NASD Rule 2212
“Telemarketing” is time-consuming and expensive. Therefore, the firm instructs its
registered representatives to provide prospects with a 900-number should they wish to
contact the firm for purposes of being placed on the firm’s do-not-call list. The
charges are minimal and deemed reasonable by the firm’s chief compliance officer.
Also, in order to reduce phone charges, the firm has instructed registered
representatives to direct prospects to the 900-number if they would like the full name
and title of the caller as well as the firm. What is true of this situation?
A. the firm has violated the rule by providing a toll number
B. the firm has violated the rule by instructing agents not to provide their name and the
name of the firm they represent
C. the calling representatives must also identify that the purpose of their call is to interest
the prospect in securities or related services
D. all of the choices listed
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66. Which of the following persons may a registered representative call at a primary
residence before 8 AM?
A. an investor who has held an IRA account with the firm for two years
B. an investor who has expressed interest in completing a transfer of funds from a 401(k)
plan to an IRA at the firm
C. neither choice listed
D. either choice listed
67. A member firm has entered into an informal agreement with a growth & income
mutual fund whereby the portfolio manager of the fund will trade exclusively through
the member when the member’s sales of the growth & income fund to retail clients
exceeds a specified target. What is true of this situation?
A. it represents common, acceptable arrangements between member firms and mutual
B. it would not violate NASD rules if the agreement were in writing
C. as long as a compliance offer at the member firm approves the arrangement in
writing, no rules have been violated
D. the NASD forbids member firms from offering to promote a particular mutual fund
based on the trading business executed on behalf of the fund
68. In which of the following retirement plans is the employee immediately vested?
A. Defined benefit
C. 401(k)
D. Profit Sharing
69. Which of the following represent(s) methods of penalty-free withdrawals from an
IRA even if the account owner is younger than 59 ½?
A. first time home purchase of a primary residence to $10,000
B. permanent disability
C. series of substantially equal periodic payments under IRS Rule 72(t)
D. all of the choices listed
70. Which of the following would be associated with a 50% insufficient withdrawal
A. Internal Rate of Return
B. Required Minimum Distribution
C. Substantially Equal Periodic Payments
D. Non-qualified premature distribution
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71. Which of the following represent true statements concerning the tax implications of
Section 529 Savings Plans?
A. an individual may currently contribute $11,000 without incurring gift tax liability, an
amount set to rise to $12,000 for Tax Year 2006
B. a married couple could contribute $22,000 without incurring gift tax liability
C. the money contributed is removed from the donor’s estate
D. all of the choices listed
72. A client is asking for an explanation of Section 529 Savings Plans. You would tell
her that:
A. earnings are taxable to the account owner annually
B. earnings are taxable to the account holder only upon withdrawal
C. earnings grow tax-deferred and are taxed at the beneficiary’s ordinary income rate at
the time that withdrawals begin
D. earnings grow tax-deferred and are tax-exempt at the federal level if used for
qualified education expenses
73. Which of the following retirement plans would be the easiest to implement for a small
business owner?
A. Defined benefit
B. Keogh
C. 401(k)
74. Your clients are a married couple looking to build retirement savings and also utilize
current tax deductions. You would recommend a
A. Roth IRA
B. Section 529 Savings Plan
C. Coverdell Savings Account
D. Traditional IRA
75. Which of the following classes of mutual fund shares would be least appropriate for
an investor planning to invest for a 10-year period?
A. A-shares
B. B-shares
C. C-shares
D. All would be equally inappropriate
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COMMENT: if the mother had begun distributions, the account would need to be
withdrawn over her life expectancy.
COMMENT: assume that a 73-year-old has begun taking distributions from the IRA,
since RMD’s (required minimum distributions) must begin at age 70 ½.
COMMENT: both the Roth and Traditional IRA are based on earned income only.
COMMENT: if the funds aren’t used for education, they will be subject to tax and a
10% penalty.
COMMENT: use a question like this simply to learn three testable points.
COMMENT: use a question like this simply to learn three testable points.
COMMENT: use a question like this simply to learn three testable points.
COMMENT: use a question like this simply to learn three testable points.
COMMENT: just something to associate with the SIMPLE IRA.
COMMENT: variable annuities don’t offer minimum guaranteed returns—as opposed
to fixed annuities.
COMMENT: most of these questions are just designed to teach you testable points.
COMMENT: the surrender period is longer. Nothing different about the tax deferral,
which all annuities offer. And, variable annuities don’t offer guaranteed rates of
return. That’s why they named them “variable” rather than “fixed.”
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COMMENT: since the period during which the annuity company will penalize early
surrenders is longer on the bonus annuity, we need someone with a long time horizon,
especially someone who has already maxed out his other retirement plans.
COMMENT: she has a long time horizon, so let’s put her into the stock market,
especially an equity fund based on established, large-cap companies. The short-term
debt securities don’t yield enough to grow her capital over 17 years, and, please, do
not place an annuity into a tax-deferred account. That’s redundant.
COMMENT: the value investor says the stock is worth $15. The market says it’s worth
only $12. The value investor sees a buying opportunity.
COMMENT: a growth stock would be very much “in favor,” which is why it would cost
a lot (high P/E ratio).
COMMENT: that describes a “growth fund” that seeks out companies expected to grow
rapidly in the near future. Of course, you know what can happen when we expect too
COMMENT: there are many ways to describe a “value fund,” so I’m going out of my
way to describe them in different ways. You’re welcome.
COMMENT: just three testable points about hedge funds.
COMMENT: a blend fund has a blend of assets or investing styles. Go figure.
COMMENT: you have to stay “locked up” for a long period of time. An investor with a
long time horizon could have all kinds of goals—often growth/capital appreciation.
COMMENT: ETF’s charge low expenses and are cost-effective when bought in large
quantities. Since you pay a commission to buy them, you need to make sure that the
commission represents only a small percentage of what you’re investing. Then, you
go forward with low expenses. The ETF does track a particular index, but so does the
open-end index fund.
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COMMENT: just something more to memorize, in case it shows up on your exam.
COMMENT: transactions over $10,000 in cash must be reported.
COMMENT: that’s over $10,000 in a single day—report the transaction. We’re not
saying she’s guilty of anything. We just might want to watch her a little closer.
COMMENT: seems like a likely question to me.
COMMENT: something more to memorize, just in case.
COMMENT: sure hope we don’t have to start turning in all the daytraders and shortsellers. Just the ones doing things with cash and wire transfers that don’t necessarily
pass the smell test.
COMMENT: it is what it is.
COMMENT: just a question to teach three things about accredited investors.
COMMENT: there is no maximum number for accredited investors.
COMMENT: just a question to teach three things about accredited investors.
COMMENT: if the investor is not accredited, we need a mentor called a “purchaser’s
representative” to make sure the investor understands the risks of having to hold a
stock for one year, no matter what, or taking on riskier investments in the VLI policy.
COMMENT: there’s really no way to protect against inflation/purchasing power risk if
you’re settling for a fixed income stream. But, since the maturities are fairly short
and the credit ratings fairly high, interest rate risk and default/credit risk have been
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COMMENT: bonds with low coupons and long maturities have high durations. Why?
Long-term bonds always have high interest-rate risk, and if the bond is paying a small
coupon payment, the interest rate and default risk are not being balanced out with a
generous stream of income.
COMMENT: try to use process of elimination whenever you can. Regulators generally
don’t like agents selling deferred annuities to senior citizens. The surrender period is
usually 7+ years, and a 72-year-old might need to make a sudden withdrawal long
before that period ends. Annuities already carry plenty of fees (mortality & expense
risk fee, administrative fee, sales charge, management fee, etc.), so it would be very
harsh if the investor also got nailed with a 7% surrender fee when she needed to cover
a hip replacement or replace a water heater. The IRA is already tax-deferred, so why
pay all the fees involved with annuities? Treasuries are excellent for capital
preservation, but not effective for the long-term growth that a 27-year-old needs in
order to retire someday.
COMMENT: only ETF’s trade like shares of stock. Stock can be bought on margin and
sold short. Mutual funds are simply redeemed at the next calculated NAV.
COMMENT: lifted right out of the NASD rule that you can read yourself at (NASD MANUAL).
COMMENT: think of it this way—everything we make is priced in dollars. Everything
they make is priced in Yen. How much stuff will our dollar buy if their stuff is
suddenly priced in a cheap currency? And, how much of our expensive stuff can they
buy if our stuff is suddenly priced in an expensive currency?
COMMENT: very typical Series 6-style question. You have to put at least two concepts
together. High beta = high risk. Sector funds are high beta because industry sectors,
such as pharmaceuticals, telecommunications, or e-commerce, are very up-and-down.
COMMENT: the S&P 500 is a stock index—an intermediate fixed income fund would
compare its returns to a bond index, i.e. Lehman Brothers
COMMENT: good, testable points.
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COMMENT: lifted straight from the NASD conduct rules, available under “NASD
Manual” at
COMMENT: there are fraud statutes under federal securities law such as the Securities
Exchange Act of 1934 and state laws modeled on the Uniform Securities Act. If the
investment is a “security,” it is subject to securities fraud statutes. Whether it’s
exempt or non-exempt is another matter. A fixed annuity, however, is not a security.
Neither is a whole life policy, bank CD, or commodities futures contract.
COMMENT: if it’s fewer than 25, it’s correspondence. If it’s 25+, it’s sales literature.
Sales literature has to be pre-approved. Correspondence has to be
COMMENT: if they’re targeting a select audience, it’s sales literature. If they’re
broadcasting a message, it’s advertising. Both have to be approved and filed by a
principal, who needs to make sure there is nothing misleading in these
COMMENT: just three testable points concerning NASD telemarketing rules.
COMMENT: three testable points concerning NASD Rule 2830.
COMMENT: it needs to be a seminar, not a reward for achieving a sales target. See,
investments should be sold because they’re good for the client, not because the
registered rep can win a nice vacation disguised as a seminar.
COMMENT: three testable points concerning NASD Rule 2790.
COMMENT: looks like the roommate is receiving “material support” from the
registered rep. Employees of member firms are restricted, not just registered persons.
COMMENT: there has to be a written policy, and the policy may state that notification
is not required if the loan is between members of the immediate family. Of course, if
the customer were a bank or savings & loan, the firm might also write in their policy
that notification is not required. But, there has to be a policy—the NASD insists.
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COMMENT: you’re an investment adviser only if the advice is on “securities.” A fixed
annuity is outside the scope of securities, just like clipping is outside the scope of
baseball and icing outside the scope of football.
COMMENT: three common examples of federal covered investment advisers.
COMMENT: if that were a criteria, the regulators would be in an awful catch-22. Well,
we’d make you register except, apparently, you’re not registered, so we can’t make
you register.
COMMENT: the first two fit the definition of “investment contract,” which is a
security. And a variable annuity is, of course, a security, since your money is not
COMMENT: ADR’s are shares of stock. If you buy Toyota, symbol TM, that’s an
ADR that trades on the NYSE.
COMMENT: a high beta stock shoots way up and also way down.
COMMENT: a zero coupon bond such as a STRIP pays no income stream to offset risks
such as interest rate and inflation risk.
COMMENT: an exempt security does not have to be registered, but all securities are
subject to anti-fraud regulations. The regulators hate it when investors get ripped off
through misleading sales tactics.
COMMENT: all three investments are securities and they have been disposed of for
COMMENT: if there are no certificates issued, there’s no need to worry about
COMMENT: it’s a public appearance, and he needs to watch what he “says.”
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COMMENT: common stock is the best investment versus inflation. Any stock is
subject to business and non-systematic risk. An ADR is also subject to currency
exchange risk. With a strong dollar, the ADR isn’t worth as much, and neither are the
COMMENT: three testable points about NASD telemarketing rules.
COMMENT: existing customers and people who have provided a signed, written
invitation to please, please cold call them about securities may be called outside the
8AM – 9PM requirement.
COMMENT: very recently a firm was fined over $12 million for doing this sort of “one
hand washes the other” method of selling mutual fund shares. The NASD really
prefers that you sell mutual fund shares based on which ones are good for you clients,
not on which ones are connected to funds paying large commissions when they trade
through the firm.
COMMENT: if it says “IRA,” the individual is immediately vested. That means that if
the business owner doesn’t want the employee to do an early distribution and cash out
the account, there’s really nothing he/she could do to stop the employee from being
COMMENT: three testable points.
COMMENT: when the individual turns 70 ½, he/she has until April 1st of the following
year to take a required minimum distribution from the IRA or other plan funded with
tax-deductible dollars.
COMMENT: three testable points on 529 Savings Plans.
COMMENT: this choice describes the advantage of the plan—the money grows taxdeferred and is tax-free at the federal level when used for education.
COMMENT: the SEP-IRA is not a true qualified plan, so it wouldn’t require the IRS
approval that the others would. Simplified Employee Pension (SEP).
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COMMENT: only the Traditional IRA would offer pre-tax contributions that would
reduce their current taxable income. Note that if the couple were covered by an
employer plan and/or made what the IRS deems too darned much money, they would
lose some or all of their ability to deduct their IRA contributions. But, those
contributions could still be made. People do make after-tax contributions to their
Traditional IRA’s, and then keep track of their cost basis. Too messy for my tastes,
but it does happen.
COMMENT: B-shares would not be the best either, especially if the client had enough
money to get a breakpoint on the A-shares and then go forward with a much lower
12b-1 fee, saving maybe 75 basis points + each year over the B shares. But, at least
the B-shares will convert to A-shares when the contingent deferred sales charge
finally goes away, usually after about 7 years. The C-shares do not convert. They
would just keep nailing the investor with the 1% 12b-1 fee that gives the shares their
“level load” nickname. Recently, a firm was fined serious dollars by the NASD for
sticking people into B- and C-shares even when they had lots of money to invest and
a long time horizon. Those people should have been put in A-shares. A large
investment knocks down the front-end sales charge, and then the 12b-1 fee is often 75
basis points lower than what the B- and C-shares charge each year in operating
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