An effort to stay one step ahead of regulators. The reps would leave the firm just prior to FINRA expelling their broker dealer. The expelled or barred broker dealer becomes known as a sanctioned or disciplined firm. These representatives often engaged in high pressure sales tactics usually involving low priced penny stocks. Questionable broker dealers would higher these reps to continue the abusive sales practices. In an effort to combat this practice FINRA established the Taping Rule. A firm that is subject to the taping rule must implement special written procedures and begin taping the conversations of its registered personnel and customers within 60 days of being notified by FINRA that the firm has become subject to the taping rule. The firm also must implement written procedures to retain, review, and classify the recordings. Firms that fall into the following categories must tape their employees:

• Has more than five but fewer than 10 registered representatives and 40 percent or more have come from disciplinary firms within the last three years.
• Has at least 10 but fewer than 20 registered representatives and four or more have come from disciplinary firms within the last three years.
• Has 20 or more employees and at least 20 percent have come from disciplinary firms within the last three years.

A broker dealer that has been notified by FINRA that it is subject to the taping rule has a one- time option to reduce its number of registered representatives. If the firm elects to reduce a portion of the subject agents to eliminate the taping requirement, the firm may not rehire the subject agents who were eliminated for 180 days. Also, the firm may not hire additional agents to dilute the percentage of agents with disciplinary histories to avoid the taping requirement. All calls between Registered employees and customers or potential customers must be recorded. Exempt from the rule are internal calls and calls from employees who are not talking to customers.

FINRA definitely wants you to know a lot about CMO advertising, disclosures and suitability. A collateralized mortgage obligation (CMO) is a mortgage-backed security issued by Government- sponsored entities (such as Fannie Mae and Freddie Mac), broker-dealers and private finance companies . The securities are structured much like a pass-through certificate and the terms are set into different maturity schedules, known as tranches. Pools of mortgages on one to four- family homes collateralize CMOs. Investors in most CMOs receive monthly interest and principal payments based on the mortgage payments made by the homeowners. CMOs issued by Fannie Mae and Freddie Mac have largely had their credit risk offset through government guarantees. However, private label CMOS issued by broker-dealers carry the credit risk of the issuing entity even if all of the mortgages in the pool have been insured by government entities. Changing interest rates will impact the price of the CMO and the cash flow received by the investor. As interest rates change, homeowners tend to refinance homes based on the prevailing market rates. If interest rates rise, refinancing activity slows and in times of falling rates, refinancing activity accelerates. As a result the expected life and the ultimate yield for the CMO is subject to change. All retail communications relating to collateralized mortgage obligations must clearly disclose this fact to investors. Specifically, the communications must contain statements advising the client that the information regarding the yield and life of the CMO is based on certain prepayment assumptions and that those assumptions may or may not be met. To ensure that these required disclosures are included in print advertisements FINRA has created a standard CMO advertising template for use by member firms. Broker-dealers are free to use this template or to create their own provided that all of the required disclosures detailed in FINRA’S template are included. Television and radio advertisements are required to contain the same disclosures that appear in the template. Further, broker-dealers are required to provide retail investors with educational material covering the performance and risk characteristics of CMOs. This material must detail the impact changing interest rates have on CMOS, an explanation of the various tranches and a glossary detailing the relevant terms used. Because of the unique characteristics of CMOS, CMOS may not be compared to other interest-bearing investments such as bonds or other debt securities. Additionally, there are specific disclosures which must be made on a customer’s confirmation. The nominal face value, nominal yield, anticipated average life and yield, final maturity date, the specific tranche, CUSIP number if assigned and underlying securities must be disclosed on a customer’s confirmation.

The personal trading of analysts is highly regulated and closely supervised by the firm and by regulators. Many analysts are very influential. Their opinions and research reports can dramatically impact the price of a stock. In order to ensure that analysts who issue research reports do not profit by trading the security just before or after they issue the report, the following rules have been enacted:

• Analysts may not trade against their recommendations.
• An analyst who is working on a research report may not trade the security that is the subject of the report until such time as the intended recipients of the report have had an opportunity to act on the report.
• Analysts may not receive pre-IPO shares from a company in a sector the analyst covers.

The personal trading rules apply to accounts owned by the analyst or under the control of the analyst or any member of the analyst’s household. Exceptions would be made for hardship or emergency sales by analysts. Each exemption would have to be approved by the firm’s legal or compliance department. It’s important to note that a hardship exemption would not allow the analyst to trade against their own recommendation to cover expenses they knew were coming up, such as college tuition. Analysts may invest in mutual funds without restriction so long as the analyst does not own 1 percent or more of the fund and the fund does not invest more than 20 percent of its assets in a sector covered by the analyst. A broker dealer may prohibit analysts from owning securities issued by the companies or in the sector covered by the analyst. Should a broker dealer hire an analyst or assign a company to an analyst who already owns the stock in the company or sector they are now going to cover, the broker dealer must handle the sale of the securities in line with its policy of not allowing an analyst to own such securities.

A free writing prospectus is any form of written communication published or broadcast by an issuer which contains information about the securities offered for sale that does not meet the definition of a statutory prospectus. Common examples of a free writing prospectus include:

• Marketing materials
• Graphs
• Term sheets
• Emails
• Press releases

The free writing prospectus should include a legend recommending that the individual read the statutory prospectus to obtain more information relating to the securities being offered. A hyperlink will be used in many cases to direct the reader to the statutory prospectus. If the free writing prospectus has been erroneously distributed without a legend, the broker dealer should amend the free writing prospectus to include the legend and resend to recipients as soon as practical. An issuer who meets the definition of a well-known seasoned issuer may use an FWP at any time before or after the filing of a registration statement. A seasoned issuer may only use an FWP after the filing of the registration statement with the SEC. An unseasoned or non- reporting issuer may use a free writing prospectus only after a registration statement is filed with the SEC and must either send a statutory prospectus with FWP or must include a hyperlink to a statutory prospectus. Issuers who use free writing prospectuses will file them with the SEC over the SEC’s website.

These types of bonds are not bonds in the traditional sense like the ones investors purchase to earn interest income. Fidelity and surety bonds are more line insurance policies designed to protect against certain events. FINRA member firms are required to obtain a fidelity bond that covers the firm’s officers and employees. The purpose of the fidelity bond is to protect the firm’s customers from:

• Fraudulent acts
• Loss of securities
• Check forgery
• Securities forgery

The fidelity bond does not cover broker dealer bankruptcy or losses incurred as a result of errors or omissions. The required amount of the fidelity bond is based on the firm’s net capital. The minimum required fidelity bond coverage is 120 percent of the firm’s net capital for firms whose required net capital is less than $600,000 with a $25,000 minimum. The minimum fidelity bond requirement is based on 120 percent of the firm’s highest net capital requirement during the preceding 12 months. All firms must review their fidelity bond coverage annually and must make any required changes to the coverage within 60 days of the anniversary date of the bond’s issuance. For firms whose minimum required net capital is greater than $600,000, the minimum required fidelity bond coverage is $750,000. The minimum required coverage increases to a maximum of $5,000,000 for a firm whose minimum required net capital is greater than $12,000,000. If a broker-dealer makes a substantial change to its blanket fidelity bond or if the coverage is terminated, the broker-dealer must immediately notify FINRA in writing. Exchange members such as designated market makers and floor brokers who do not conduct business with the general public are exempt from the fidelity bond requirements.

A surety bond on the other hand primarily ensures a broker dealer’s financial solvency. It is used to guarantee that a broker dealer can meet its financial obligations. Many states require broker dealers to post a surety bond as a condition of state registration. On the series 24 exam you are most likely to encounter questions about fidelity bonds. The key test points are covered above.

A broker dealer’s net capital requirement is based on its business activities and the relationship of aggregate indebtedness to its net capital.. The question you refer to is frequently seen on the series 24 exam. First you need to know that a broker dealer’s minimum capital requirement to qualify as a market maker is $100,000. Its maximum capital requirement based solely on its market making activities is capped at $1,000,000. With that said the question often centers around the number of securities the firm is making markets in. The capital requirement for each security is as follows:

• $2,500 for each stock with a bid price of $5 or more
• $1,000 for each stock with a bid price of less than $5

A typical series 24 question will provide you with the number of securities the firm makes markets in and information on the price of the securities. The question will be laid out as follows:

ABC broker dealers is an active market maker. The firm makes markets in 350 equity securities. 250 of these are trading with a bid of $5 or more. What is the firm’s capital requirement based on its market making activities ? the math is easy enough 250 securities x $5 = $125,000. The question implies that the remaining 100 securities are priced below $5 per share and are therefore subject to $1,000 requirement. 100 X $1,000 = $100,000. As a result ABC broker dealers has a capital requirement of $225,000 based solely on the market making activity.

Most series 24 test takers will see an application style question on this very subject. A haircut is a deduction taken from the market value of securities in inventory for the purpose of determining net capital. A haircut is taken to allow for the volatility in securities prices and to reflect the fact that positions held in inventory may be off set at prices that are somewhat different from current market prices. Haircut deductions are 15 percent of the net long or short positions for securities traded on an exchange and regulation T OTC marginable securities and OTC securities with 3 or more market makers excluding the market maker doing the capital computation. Haircut deductions on other stocks with a limited market (one or two independent market makers) are 40 percent on both the long and short positions.Unregistered securities under the Securities Act of 1933 or those with no ready market receive a 100 percent haircut (no value given in computation of fi rm’s net capital). An additional haircut of 15 percent is applied to proprietary positions of a broker dealer on the market value of a stock in excess of 10 percent of its tentative net capital if the concentration limit is held for more than 11 business days. Th is is known as undue concentration. Tentative net capital is the broker dealer’s net capital prior to haircut deductions. The additional 15 percent haircut is applied only to the amount of securities in excess of 10 percent of the tentative net capital.

A riskless principal transaction for regulatory purposes is treated as if the transaction was executed on an agency basis. If a brokerage firm receives a customer order to buy or sell a security and the firm does not have an inventory position in the security, the firm may still elect to execute the order on a principal basis. If the firm elects to execute the order on a principal basis, it is known as a riskless principal transaction. Because the dealer is only taking a position in the security to fill the customer’s order, the dealer is not taking on any risk. As a result, the markup or markdown on riskless transactions will be based on the dealer’s actual cost, not on the inside market. Let’s look at an example: Let’;s say the market for ABC is $10 X $10.20. A client gives the firm an order to purchase 1,000 shares of ABCD at the market. The trader goes into the market and is able to purchase the stock for the firm’s account at $10.10. The firm immediately uses the stock in its inventory account to fill the customer’s market order. The customer’s markup will be based on the firm’s actual or contemporaneous cost of $10.10. The rationale behind this is clear. The firm did not take on any risk and therefore is not entitled to earn any extra profit on the transaction.

The NASDAQ market systems are heavily tested on the series 24 exam. This section tends to be the most challenging and in many cases the most frustrating for students. Most series 24 test takers are not sitting on trading desks. In fact most have never even seen one. In order to pass the series 24 exam you have to be a master of this information and demonstrate a level of understanding equivalent to a seasoned NASDAQ trader. The easiest way to differentiate ACT from TRF is to explain the concept using an every day scenario. Lets say you need to place an order on Amazon to buy a few household products. Once the products are in your cart you fill out the order form. You enter your name, shipping address, email address and payment information. You press the order button and the information is transmitted to Amazon. The next step takes place in the backend where Amazon’s merchant account charges your credit card and processes the order to ship you your products Simple, right? The TRF and ACT system function in exactly the same way. Instead of ordering products from Amazon and entering your details on a check out form, the TRF is an on screen “form” where traders can report the details of a trade. I.e bought 1,000 shares of XYZ at 42.15 from JP Morgan. When the trader hits the submit button the information is transmitted to the ACT system. In the backend the ACT system functions in a similar fashion to Amazon’s merchant account. ACT facilitates the clearing of the transaction. It facilitates the exchange of cash and securities between the buyer. Any transaction executed electronically is automatically reported to the ACT system ACT reports trades to the tape, matches and clears. ACT only plays a role after a trade is executed. It does not display, route or execute orders.

All broker dealers are required to report their financial status to the SEC and to FINRA. Firms file the report of their financial status on a Financial Operational Combined Uniform Single Report, more commonly referred to as a FOCUS report. It sometimes helps students better understand the concept if they think of how and when individuals file tax returns. A young person just out of school who does not have a lot of deductions or writeoffs will file a simple tax return on form 1040 EZ. An older, more established person whose income and deductions are more complex will file a long form 1040 to file his / her tax return. It is similar to the way firms file FOCUS reports. Introducing broker dealers who do not have custody of customer assets have a much less complex business than a general securities broker dealer. As a result, the introducing or correspondent broker dealer will file FOCUS 2A quarterly. The general securities broker dealer is required to file more frequently and to submit more detailed financial information. . Here is a breakdown of when the FOCUS reports are filed.

• FOCUS Part I is a summary of key financial ratios and numbers that is filed monthly within 10 business days after the end of the month by broker dealers that carry customer accounts.
• FOCUS Part II is a balance sheet, income statement, and net capital computation that is filed quarterly. Broker dealers that clear or carry customer accounts must file Part II within 17 business days from the end of each calendar quarter.
• FOCUS Part II-A is a less comprehensive version than Part II that is filed quarterly. Broker dealers that do not carry or clear customer accounts must only file FOCUS Part II-A within 17 business days after the end of each calendar quarter.

A variable life insurance contract is both an insurance policy and a security because of the way the insurance company invests the cash reserves. A variable life policy is a fixed-premium plan that offers the contract holder a minimum death benefit. The holder of a variable life insurance policy may choose how the cash reserves are invested. A variable life policy typically offers stocks, bonds, mutual funds, and other portfolios as investment options. Although the performance of these investments may tend to outperform more conservative alternatives, the cash value of the policy is not guaranteed. The cash and securities held by the insurance company are invested in the insurance company’s separate account and are kept segregated from the insurance company’s general account. The separate account is required to register as either an open-end investment or as a UIT under The Investment Company Act of 1940. Representatives who sell these policies must have both a securities license and an insurance license. The insured is covered from the date of issuance to the date of death as long as the premiums are paid.

A variable universal life policy gives the policyholder the ability to determine when premiums are paid and to decide how large those payments are. The net premium is invested in the insurance company’s separate account, and the policy’s cash value and variable death benefit are determined by the investment experience of the separate account. A variable universal life insurance policy will remain in effect as long as there is enough cash value in the policy to support the cost of insurance. A variable universal life insurance policy may have a minimum guaranteed death benefit, but it does not have to. A representative who sells variable universal life policies must have both insurance and securities licenses.

Most of us have seen the commercials on TV. A happy couple in their 60s talking about how they have a life insurance policy they no longer need. In these situations the owner of a life insurance policy may elect to sell his or her interest in the policy to a third party in exchange for a lump sum payment during the insured’s lifetime. The sale of the life insurance policy is known as a life settlement.

If a policyholder is suffering from a terminal illness and has a life expectancy of 2 years or less, the individual may enter into a contract known as viatical settlement. The sale of a variable life insurance policy is considered to be the sale of a security and is regulated by both FINRA and the SEC. The buyer of the policy agrees to make all future premium payments and will be entitled to receive the payment of the death benefit upon the death of the insured.

The market for life insurance policies is illiquid, and pricing of policies can vary greatly. FINRA requires any firm that assists in the selling of client policies obtain multiple bids for the policy to ensure that the client receives a fair price. The firm may not enter into any arrangement that would require the firm to sell all or substantially all of its client life insurance policies to any one buyer. FINRA requires agents assisting in the sale of life settlements, as well as the supervisors of the agents, to receive training relating to life settlements. FINRA further requires that the training be documented for each agent and supervisor.

First lets start with defining what volatility is. Volatility is the speed at which the price of an investment changes over time. Independent agencies and third parties often publish bond mutual fund volatility ratings. The purpose of these ratings is to provide information to investors about the sensitivity of the net asset value of a bond mutual fund to a change in interest rates and economic conditions. The volatility rating will be based on a review of the debt instruments owned by the mutual fund. A review of the credit quality, the fund’s performance and risk will also be used to evaluate the portfolio. Specific risks such as interest rate, prepayment and currency risks will all be taken into consideration. When registered persons or the member distribute bond mutual fund ratings as part of its retail communication the following must be disclosed:

• The name of the entity providing rating
• A statement that the rating does not identify or describe volatility as a risk rating
• The most current rating
• Information that at a minimum is current to the most recent quarter’s end
• A link to a website or toll free number providing rating information, methodologies and criteria
• A narrative description containing a statement that there is no standard method for assigning ratings
• The type of risks measured by the rating and time frame i.e. short or long term
• A statement regarding any compensation received for issuing the rating
• A statement that there is no guarantee that the fund will continue to have same rating or performance

If the above disclosures and requirements are not satisfied, the member may not distribute retail communications containing bond volatility ratings.

A broker dealer who includes investment company rankings in its retail communication may only provide ranking information created by a ranking entity, investment company or investment company affiliate. A ranking entity is any entity that is independent from the investment company and who in the normal course of business, provides general information about investment companies to the public. The member using the ranking must include a headline or prominent disclosure stating:

• The fund category (i.e. growth, income etc)
• The number of funds or fund families in the category
• The name of the ranking entity
• If the investment company or affiliate created the category or subcategory of funds included in the ranking
• The length of time measured from the starting date through the ending date
• The ranking criteria (i.e. total return, risk adjusted return)

All communications must include a statement that past performance is no guarantee of future results. Additionally, the communication must disclose whether or not the ranking includes the impact of front end sales loads. If rankings are provided for multiple share classes (A, B or C shares) representing ownership in the same portfolio, a prominent disclosure must be included detailing the different expense structures. All retail communication must be based on the rankings for the most recent quarter’s end. If these rankings are not available, the member may use the most recent rankings available providing that doing so would not be misleading. If the rankings are based on a symbol system such as “star rankings” a detailed explanation as to the meaning of such rankings must be disclosed. Rankings that are based on total return must be based on a time period of at least 1 year.

Rankings for funds that have been in existence for a substantial period of time must be based on total return for the fund for 1, 5 and 10 years. If the fund has been in existence for at least 5 years, the total return must be based on 1 and 5 years. If rankings for 5 and 10 years are not or were not published by the ranking entity, the entity must publish rankings for “short, medium and long” term. Retail communication may not include ranking information that is based on a time frame of less than 1 year unless the ranking is based on the fund’s yield.

Every broker dealer is required to ensure that it has backup systems to ensure the firm may continue to operate in the event one or more its offices become inaccessible. FINRA requires member firms to develop and maintain plans and backup facilities to ensure that the firm can meet its obligations to its customers and counterparties in the event that its main facilities are damaged, destroyed,or are inaccessible.

The plan must provide for alternative means of communication between the firm, its employees, customers, and regulators, as well as a data backup. The plan must provide for data backup in both hard copy and electronic format. All mission critical functions including financial and operational systems and regulatory reporting must be addressed in the plan.The plan must be approved and reviewed annually by a senior member of the firm’s management team and provide plans to ensure that customers have access to their funds. The plan must be provided to FINRA upon request. Should the firm’s business materially change, the business continuity plan should be updated promptly to reflect the change in the member’s business. The plan must identify two members of senior management as emergency contacts, one of whom must be a registered principal with the firm. Should one of the contact people change, FINRA must be notified within 30 days.

Customers of the firm must be advised of the business continuity plan at the time the account is open and in writing upon request. The plan must also be posted on the firm’s website. Small firms with one office should provide a contact number to the clearing firm. Each member firm is required to evaluate its potential vulnerabilities as well as any areas of weakness that may arise from its relationships with other firms and service providers. The A firm's business continuity plan must adequately address each of these issues. A significant business disruption event may require the firm to go out of business temporarily or permanently and customers must be informed of this fact. The firm must inform customers how they will have access to their assets in such an event.

The Securities and Exchange Act of 1934 dictates that broker dealers maintain certain minimum levels of net capital. In order to obtain the required funds firms will often borrow the money from outside sources. A subordinated loan is used by broker dealers to borrow the needed capital. Satisfactory subordination agreements are instruments that allow an individual to loan cash or securities to a broker dealer in return for interest paid to the lender (this is debt for the broker dealer).

Subordinated lenders are not considered to be customers of the broker dealer and are not provided SIPC coverage in the event of the broker dealer’s failure. Under SEC Rule 17a-11, a violation is deemed to occur if the principal amount of satisfactory subordination agreements exceeds 70% of the broker dealer’s debt plus equity total for a period in excess of 90 days. This means that subordinated debt can be considered part of the broker dealer’s net capital, but only if it is through a satisfactory subordination agreement. In order for the loan to be satisfactory, it must meet the following requirements:

• The agreement must be in writing.
• The agreement must be for a specific dollar amount, even if securities are pledged.
• The agreement must subordinate any right of the lender to receive payment to the claims of all present and future creditors of the broker dealer.
• Proceeds of the loan may be used by the broker dealer for any general business purpose.
• The agreement must have a maturity of at least 1 year.
• The agreement may not be subject to cancellation by either party.

The special reserve account is all about protecting the customers’ assets. The Customer Protection Rule ensures that customer funds held by a broker dealer are maintained in safe areas of the business related to servicing its customers or are deposited in a special reserve bank account. The broker dealer must make the following monthly computation to determine the amount required to be on deposit in its special reserve bank account for the exclusive benefit of its customers:

(credit items − debit items) × 105% = the amount to be deposited in the special reserve account If the broker dealer computes weekly rather than monthly, only 100% of the credit excess must be deposited in the reserve account. A broker dealer must compute weekly if at any time its aggregate indebtedness exceeds 800% of its net capital or if its aggregate funds owed to customers exceeds $1 million. The deposit must be made by 10AM 2 business days after the calculation has been made.

The bank holding the special reserve account must acknowledge in writing that the account is the exclusive property of the customers of the broker dealer. As such the bank is not allowed to use those funds to meet the obligations of the broker dealer and the funds may not be used to secure a loan for the firm. If the amount of money customers owe the firm exceeds the sum owed to customers no deposit is required to be made into the separate account.

This is definitely something you want to know as it appears on many real series exams. Broker dealers who meet the $25,000 Capital requirement are allowed to conduct mutual fund business on a wire basis. This allows the firm to accept customer funds and transmit them to the investment company for the purchase of mutual fund shares. Conducting mutual fund business in this way is far superior to the old subscription based model. Customers who purchase mutual fund shares on a subscription basis must fill out a subscription form and forward it to the mutual fund company with a check

Broker dealers who exclusively conduct mutual fund business on a subscription basis are subject to a minimum net capital of $5,000. These types of firms are known as “nickel BDs” Here is the important test point for your exam. Broker dealers who are subject to the $25,000 requirement are allowed to accept a customer’s stock certificate ( ie IBM, Amazon, Apple) and sell the shares for the customer, so long as the proceeds are immediately transmitted to the mutual fund to purchase shares.

The difference between a branch and an OSJ is significant. An office of supervisory jurisdiction or OSJ is empowered to engage in any business activity the member firm is authorized to perform. This includes market making, investment banking and approval of retail communications. A member firm must inform FINRA which offices it has identified as being an office of supervisory jurisdiction (OSJ). An OSJ is any office that conducts one or more of the following activities at that location:

• Has custody of customer funds or securities.
• Has final approval for retail communications.
• Has final approval of customer accounts.
• Reviews and approves customer orders.
• Executes orders or makes markets in securities.
• Forms or structures offerings.
• Supervises employees at other branch offices.

At least one resident principal must manage the OSJ. The resident principal must enforce the policies and procedures of the firm, review all customer activity, and inspect the branch offices within his or her jurisdiction. Each OSJ should have one resident onsite principal who is assigned to the office and who maintains a consistent physical presence at the office. FINRA’s guidelines assume that each principal will have supervisory reasonability for only one OSJ. However, if a member’s business requires it to assign the supervisory responsibilities for more than one OSJ to a principal, the member must document the supervisory arrangement in its written supervisory procedures manual. FINRA would not be required to approve the arrangement but the member should give special consideration to the experience level of the principal, the geographic location of the offices, the number of representatives and if the principal is a producing agent. An office that solely has final approval over the issuance of research reports need not be classified as an OSJ so long as it does not engage in the activities of an OSJ detailed above.

A branch office is any location that is identified to the public as being a place where the member conducts business but does not engage in any of the activities that would require it to be considered an OSJ. Branch offices are inspected by an OSJ. A branch office may operate without a resident principal. A registered representative may act as the branch manager. The supervisory responsibility is with the OSJ.

Understanding the difference between a market maker and an ECN is critically important. Each plays an important role in the NASDAQ market. However, their roles and responsibilities are extremely different. Because there are no DMMs for the NASDAQ markets, bids and offers are displayed by broker dealers known as market makers. A market maker is a firm that is required to display a two-sided market. A two-sided market consists of a simultaneous bid and offer for the security quoted through the Nasdaq workstation.The market maker must be willing to buy the security at the bid price, which is displayed, as well as be willing to sell the security at the offering price, which also is displayed. These are known as firm quotes. There is no centralized location for the Nasdaq market; it is simply a network of computers that connects broker dealers throughout the world. Market makers purchase the security at the bid price and sell the security at the offering price. Their profit is the difference between the bid and the offer, which is known as the spread. Rule changes and new trading systems known as electronic communication networks, or ECNs, have narrowed the spreads on stocks significantly in recent years. Firms that act as market makers must continuously display two-sided quotes during normal business hours. Firms may remain open for extended hours trading but are not required to display quotes after the close of the market at 4:00 p.m. EST. During extended hours trading the market has greater volatility, lower liquidity, and fewer market participants than trading during the regular session. As a result, there are wider spreads and the risk of poor executions.

Electronic communication networks / ECNs are subscriber networks whose role is to match and pair off orders routed to them by broker dealers and institutions. When the ECN has an order imbalance it is allowed to display and execute third-party orders in the NASDAQ market center ECNs are widely used by both broker dealers and institutional investors to display and execute orders. ECN quotes are included in the Nasdaq quote system, but the ECN is not required to maintain a two-sided market like a market maker, and ECNs do not take positions in the security. ECNs may:

• Display 1 sided quotes.
• Enter and accept directed and nondirected orders.
• Accept automatic executions.
• Send orders for automatic execution through the NMCES

The key series 57 test points to remember are

1. Market makers must display a continuous 2 sided market. ECNs are allowed to display a bid or offer only based on customer interest.
2. Market makers may not pull their quotes. ECNS may enter and exit the market as needed.
3. Market makers take on risk and trade in a principal capacity. ECNs never take positions or risk in the security and only act as an agent.

This information will definitely be tested on your series 57 exam.

The alternative display facility or ADF was created in order to provide broker dealers with an opportunity to quote securities in a venue other than the NASDAQ. It was developed many years ago before we had countless market centers to ensure that the NASDAQ was not deemed to be a monopoly. FINRA operates the Alternative Display Facility (ADF) from 8:00 a.m. to 6:30 p.m. EST. The ADF allows market makers and unlinked ECN participants to enter and match quotes and to report trades. The quotes entered in the ADF will not appear in the NMCES. However, if the quote entered in the ADF would improve the inside market, the quote will be displayed as part of the inside market. The ADF does not provide execution capabilities. All ADF participants are required to provide direct or indirect electronic access to their quotes. Direct electronic access will allow other market participants to execute an order electronically against the firm’s quote. Indirect electronic access will allow another market participant to execute an order against the firm’s quote through the firm’s broker dealer customer. Both direct and indirect electronic access requires:

• No voice communication.
• Equivalent speed, reliability, and availability as offered to participants’ customers.
• Equivalent costs as offered to participants’ customers.
• A two-second turnaround for accepting or declining an order.
• A three-second or less turnaround for communication between market participants.

Each ADF participant must certify that it has the ability to display automated quotations during times of peak volume. Each participant is also required to display a marketable quote on each side of the market at least once every 30 days in order to meet certification standards. A firm that is unable to meet the certification standards or who experiences three unexcused outages over 5 consecutive business days will be suspended from quoting all securities in the ADF for 20 business days.

The first thing to keep in mind is that a market maker never has to file form 211 when requesting to quote a NASDAQ stock. An approved market maker who wishes to quote a NASDAQ stock will simply electronically request permission to quote the stock and will receive same day approval to enter their initial quote. If a firm wants to quote an inactive unlisted OTC stock, FINRA wants to know why. SEC Rule 15C2-11 (as amended) sets the standards for non listed companies to develop a public market and for broker dealers to publish quotations for the securities. SEC 15c2-11 requires issues to be current when reporting and disclosing financial and other information. The OTC Markets Group acts as a qualified interdealer quotation service (IDQS) and monitors issuers compliance on an ongoing basis to ensure that issuers are current with their disclosures. A broker dealer wishing to quote an OTC security will be able to rely on the current information designation made by the IDQS in lieu of submitting Form 211 with FINRA. In order for an issuer to maintain its designation as being current, SEC reporting issuers must continuously make timely filings of all reports. Companies listed on the OTCQX, OTCQB and PINK Current are subject to this rule. If companies fail to meet this continuing reporting requirement, the security will be deemed ineligible for public quotes. During market hours quotes for these ineligible securities will be shown as zero (0). However, last sale data for the stock will be available at the end of the day. If the security is deemed to be inactive The issue must work with the broker dealer to file form 211 with FINRA. Rule 15c2-11 permits additional time (180 days) for Exchange Act reporting companies to continue to be eligible for public broker-dealer quotes. Accordingly, companies that make their annual or quarterly reports publicly available (via EDGAR) within 180 days of the end of the reporting period will still be eligible for broker-dealer proprietary quotes, but will be designated as “Limited Information”. Companies who have no information available may be traded on either the OTC Expert market or be forced into the Gray market. The OTC Expert market is where broker dealers may publish unsolicited quotes based on customer limit orders to obtain the best possible execution for the customer. Quotes in the Expert Market are restricted from public view. The Gray market is not an electronic market. The stock of issuers whose securities have been delisted or who are no information companies will be traded over the phone between broker dealers. The Gray market lacks the price discovery made available in electronic markets. Investors should be extremely cautious when considering purchasing securities in either the Expert or Gray market.

Market makers who take on risk in liquid securities base the mark up on the inside market for that security. Meaning the firm’s inventory cost for the security is irrelevant. For example, Let’s assume the market for a stock is: $25 bid and offered $25.20. A market maker who accumulated the stock over a number of days has an average cost of $22. If the firm receives a customer market order to buy the stock, it would base the mark up on the best offer of $25.20. The fact that the firm owns the stock at $22 per share is not considered. Nor would it matter if the firm had an average cost of $28 per share. Some small OTC securities do not have active and competitive markets because of lack of national interest in the company. As a result, the market for these securities can be dominated or controlled by one market maker. Market makers who dominate or control the market for a security must base the markup charged to the customer on their contemporaneous cost, not on the inside market for the security. All markups will be based on the price the market maker paid for the stock when it was purchased for their inventory account. On your exam if the question notes that the firm is responsible for 70 percent of the volume in the stock, this is letting you know that the firm in question is dominating the market. As a result the firm must base the mark up on their inventory cost.

When broker dealers act as underwriters and as market makers there are inherent conflicts of interest. Regulation M Rule 103 was designed specifically to address these situations. Rule 103 regulates the activity of market makers participating in a distribution. Market makers that are participating in a distribution may only act as passive market makers during the restricted period. Passive market makers may not enter a bid for their own account or buy the security at a price that exceeds the highest bid entered by an independent party. If the highest independent bid entered by a nonparticipant drops below the bid of the passive market maker, the passive market maker may remain as the highest bid until it purchases an amount equal to the lesser of its volume restriction or 2 times the minimum quote size for the security. Once this volume restriction is reached, the passive market maker must lower its bid to a price no higher than the current independent bid. If there are no independent market makers, passive market making will not be allowed. The syndicate manager must apply for passive market making status on behalf of all syndicate members by filing part of the Underwriting Activity Form no later than one business day prior to the first full trading day of the restricted period.

If a broker dealer accepts customer limit orders it is required to protect the order and may not trade for its own account at prices that would satisfy the customer’s limit order. The order protection rule is also known as the Manning rule. The Manning rule states that a firm may not compete with a customer’s limit order by executing an order for its own account at a price that would satisfy the customer’s limit. If the firm executes an order for its own account at a price that would satisfy the customer’s limit order, the firm must execute the customer’s order at the same price and for the same number of shares within 60 seconds.Broker dealers that route orders to ECNs or other firms to be displayed must still protect the customer’s limit order and are not relieved of their obligations under the Manning Rule. If the market-making desk is holding a customer’s limit order that is subject to the Manning Rule, no trading desk anywhere within the firm may knowingly execute a proprietary order that would compete with the customer’s order. If the firm has sufficient barriers between its trading desks and the other desk does not have knowledge of the customer’s order, the other desks are not bound by the Manning Rule.

This is definitely a testable question on the Series 57 exam. The timely reporting of transactions is critical for market integrity. All transactions are required to be reported as soon as practicable, but not later than 10 seconds after execution . If a transaction is executed and later cancelled under FINRA trade reporting rules the firm is required to report the transaction promptly. The trader is then required to use the ACT trade scan to cancel the transaction. The trade cancellation report should be made on the same day as the trade was reported provided the trade reporting facility is still open. This rule is in effect for transactions executed during normal business hours as well as for those trades executed during extended hours trading.

A discretionary range order gives the trader the ability to execute a customer’s limit order within an acceptable range of prices. Discretionary range orders provide flexibility to the trader to adjust the order to current market conditions. Providing a range of acceptable limit prices rather than 1 firm fixed limit price increases the chances that the customer’s order will be executed. It is important to remember that a customer’s limit order may never be executed at an inferior price. For example If a customer placed an order to sell 5,000 shares of TRY at $42, the firm would not be able to execute that order at a price less than the stated limit price. This is true even if the trader feels that doing so would be in the best interest of the client. A discretionary range order would provide the trader with the ability to execute the order within a range of prices which are inferior to the desired limit price. If in our example the customer who wants to sell the TRY at $42 provided the trader with discretionary trading range of 25 cents, the trader would be allowed to execute the order at any price of $41.75 or higher. The trader may enter the discretionary range order as a limit order. It will be displayed at the limit price of $42. When entering the order in the NASDAQ system, the trader will append the discretionary range of 25 cents to the order. If a contra bid shows up within the range of acceptable prices the NASDAQ system will execute the order. Using our example, if a bid of $41.80 appeared in the market place the order would be executed at that price.

The operation of the CATS system is definitely an area you want to have down cold. CATS plays a vital role in market surveillance and it is heavily tested on the series 57 exam. In order to ensure that customer orders are transmitted to the marketplace in a timely manner, FINRA developed the Consolidated Audit Trail system (CATS). CATS tracks an order through each stage of its life, from receipt to execution or cancellation. The CATS system has replaced the Order Audit Trail or OATS system previously used to track customer order information. The CATS system is often still referred to as OATS in the industry and may appear as OATS on your exam. Each firm is required to synchronize clocks used for electronic order events to within 50 milliseconds of the National Institute of Standardized Time’s atomic clock. These clocks must display and record military time in hours, minutes, seconds and milliseconds. Each clock used solely for manual order events may be synchronized to a tolerance within 1 second of the NIST clock. Each member may record and submit manual order events and allocation reports to the Central Repository in increments of 1 second. Firms are only requested to collect and submit data in nanoseconds if the firm collects the data. Firms are required to submit daily electronic CATS reports to FINRA’s Central Repository. The business day for CATS is 4:150:00:01 p.m. to 4:15 p.m. the following business day. CATS reports must be made by 8 a.m. on T+1 on the business day following the trade date. For trades executed on Friday, CATS reports may be submitted on Saturday but must be submitted by 8 a.m. Monday morning. Daily CATS reports must be made for each order and include the following information:

• Customer name, account number, date of birth, address and tax ID.
• Date and time of receipt.
• Order ID.
• Terms of the order (i.e. buy, sell, long, short, security, price, shares, account type and handling instructions).
• If the order was received manually or electronically.
• If the order was routed manually or electronically
• Where the order was routed for execution.
• Any modifications to the order, including the date and time of any modifications.
• Execution information, including partial executions, price, date, time, and capacity in which the firm acted in the trade.

The NASDAQ and the OTC markets have multiple venues for executing orders. Each of these require trades to be reported using the proper “input screen". These are user interfaces. It will help you to think of the TRF, ORF and TRACS as nothing more complicated than the order screen you use when placing an order online. The vast majority of transactions will be reported using the Trade Reporting Facility or TRF. The FINRA/Nasdaq Trade Reporting Facility (TRF) is a trade comparison service operated on the ACT platform. It has been designed to greatly reduce questionable trades and trades that one party does not know (DKs). The TRF facilitates the reporting and clearing of trades in Nasdaq and the NYSE listed stocks executed off the floor in the third market. Trades executed on the exchanges do not get reported using the TRF and are NOT reported to the ACT system.

The order reporting facility (ORF) is used to report trades in OTC MKT, OTC PINK and trades in restricted stock under Rule 144A to the NSCC. The “O” in the ORF is a great way to remember the ORF is used for OTC non nasdaq transactions.

The Trade Reporting and Comparison Service (TRACS) collects trade information for market participants who use the ADF. FINRA established TRACS to assist in the reporting of trades for ADF market participants who are not eligible to use the Nasdaq Market Center Trade Reporting Service or ACT. ADF market participants who are also market makers may choose to report trades executed through the ADF either through ACT or the TRACS systems. The TRACS system works in much the same way as ACT. However, the TRACS system will allow ADF market participants to report a three-party trade to assist in the reporting of riskless principal trades. The TRACS system reports trades to the Depository Trust Clearing Corporation (DTCC) and reports the trade to the appropriate securities information processor for public dissemination. FINRA may terminate the TRACS service upon notice to members who fail to abide by the rules of FINRA or the TRACS service.

As you say, unlike the prospectus/summary prospectus, the Statement of Additional Information shows the fund’s income statement and its balance sheet. An open-end fund is a large portfolio of securities. Bonds generate regular interest payments to the fund. Many common stocks generate regular dividend payments.  That represents the portfolio’s gross income. Next, operating expenses are deducted: management fee, transfer agent fees, custodial fees, etc. What is left is the net investment income, and most of this is distributed as dividend payments to the shareholders on a schedule established by the Board of Directors. The balance sheet shows the assets of the fund—the portfolio securities. Against that, the fund may have some liabilities—perhaps they borrow money to pay out redemptions to shareholders. The difference between the assets and liabilities equals the net assets of the fund.

Open-end and closed-end bond funds are large bond portfolios managed by a registered investment adviser. Investors buy shares of common stock in that bond portfolio. On a regular schedule, shareholders receive the net income derived from bond interest as income dividends. Once a year, shareholders receive their share of any capital gains realized through the trading of the portfolio by the investment adviser. Closed-end funds typically use leverage, so even within their equity portfolios they frequently issue senior securities in the form of preferred stock and, even, bonds. Open-end funds do not issue debt securities to their investors.

All withdrawals from a Traditional IRA are taxable as ordinary income. The reference to age 59 ½ has to do with the 10% early withdrawal penalty. If withdrawing funds before age 59 ½, IRA owners pay a 10% penalty on top of the ordinary income tax due on the withdrawal. So, for example, a withdrawal of $20,000 would involve a $2,000 penalty plus taxes on $20,000 of income, which could easily be anywhere between $5,000 and $8,000.

After settling with the IRS, the individual might be left with just over half the amount withdrawn, an extremely inefficient movement of funds that also leaves the account owner less prepared for retirement.

However, the following are qualifying exemptions to the 10% penalty. Although the withdrawal is taxable, the 10% penalty is waived for withdrawals before age 59 ½ made pursuant to the following:

• Death
• Permanent disability
• First home purchase for residential purposes
• A series of substantially equal periodic payments under IRS Rule 72-t
• Medical expenses
• Higher education expenses 

A withdrawal pursuant to death means the IRA owner has died before reaching age 59 ½, and someone else is receiving the account balance as a named beneficiary. In this case, the beneficiary will be taxed but will not be penalized. Unlike a taxable account, which may or may not name a beneficiary, IRAs and other retirement accounts are presumed to name one or more beneficiaries.

Shares of closed-end funds do trade throughout the day, but the buying/selling interest determines the market price for the shares, not their NAV. Open-end and closed-end funds calculate the NAV at the end of the trading session. For both, the NAV is the difference between the fund assets and liabilities, divided by the outstanding shares. For open-end funds, shares are then redeemed at that price or sold at a price based on the NAV. For closed-end funds, the market price for the shares could be above or below that NAV during a trading session. Or, it could trade for exactly the NAV.

We approach things as if suitability/investment recommendations will be an important part of the exam. As a registered representative, a Series 6 licensee explains investment options to customers and helps them determine suitability. Broker-dealers provide training, of course, but the license exam wants to see if candidates are able to rule out poor investment options in favor of more suitable approaches. Some questions on the exam involve basic math. Some involve remembering what a particular term or securities law is associated with. But, as you correctly state, suitability questions seem inherently unfamiliar and confusing. Then again, it’s a multiple choice exam. Therefore, the only way a suitability question can work is if three of the answer choices are eliminated by the facts presented in the question. There cannot be one or two “pretty good” answers and then one “really good” one. Rather, three of the answer choices are to be eliminated based on the information provided. For example, if the question says the recent retiree already has a defined benefit pension plan, you can probably eliminate redundant investments such as money market mutual funds or Treasury notes. If the question says the investor is concerned about inflation, that is a signal that common stock is a requirement, for at least a percentage of the portfolio. If there is no mention of the investor’s tax bracket, the option containing municipal bonds can probably be eliminated. Once you find fault with three of the answer choices, you are left with the correct answer. Suitability questions—and many others on the exam—must be solved carefully as opposed to answered through memorization or simple arithmetic.

Form U4 requires the applicant to disclose any felony charge and any felony conviction regardless of the date of occurrence. The form also requires disclosure of misdemeanors related to the securities business, e.g., theft, perjury, counterfeiting, forgery, and fraud, etc. Assuming the DUI conviction was a misdemeanor, you not only can take the exam and/or get licensed, but also you will not be required to disclose it via Form U4. It is a misdemeanor that does not relate to a financial services career.

There are two ways capital gains come into play for mutual funds. If the investment adviser realizes more gains than losses by trading portfolio securities, the fund realizes a net capital gain for the year. They can either distribute this to the shareholders or not. Either way, investors are taxed on their proportional share of this capital gains distribution. No matter how recently they bought into the fund, all investors are taxed at their long-term capital gains rate. The holding period is based on the mutual fund’s holding period, not the shareholders of the fund. The other way capital gains come into play is when the shareholder sells/redeems shares. If the holding period is at least 12 months plus 1 day, the gains/losses are long-term. If not, they are short-term.

Some open-end funds impose a sales charge when the investor purchases shares. For example, an investment of $10,000 in a small-cap growth fund might involve a sales charge of 5%, or $500, meaning that only $9,500 is invested, with the rest going to the distributor of the fund and members of the sales network. Some funds charge a redemption fee if shares are sold back to the fund within a stated time frame—maybe 18 months.

These fees are charged one-time only and depend on the decisions of the individual investor, who can invest a larger amount and avoid short-term redemptions to reduce or even avoid the fees.

Many funds do not have sales charges, but all funds charge investors for their operating expenses. The management fee to the investment adviser is typically the largest annual expense for an open- or closed-end fund. Other expenses include legal and accounting services, transfer agent fees, custodian charges, and board of director salaries. These expenses are taken from the dividend and/or interest income generated by the portfolio, with the net income then distributed to shareholders in the form of dividends at a frequency determined by the fund’s Board of Directors.

With a Series 6 license, the representative is qualified to sell open-end funds, and to sell closed-end funds during the primary offer period.  Whether open-end or closed-end, some investment company portfolios establish covered calls to enhance the funds’ overall return. For example, there is a closed-end fund trading under the symbol BXMX, which is an S&P 500 index fund that also engages in covered calls. Back when that fund was first sold to investors, a registered representative with a Series 6 license could have offered and sold shares to customers. And, of course, with a Series 6, the agent is licensed to sell any open-end fund that may engage in options trading in addition to managing the core portfolio of common stock.

The practice question likely gives the following four answer choices: diversified open-end fund, diversified closed-end fund, non-diversified open-end fund, and non-diversified closed-end fund. Assuming the portfolios are the same, we can determine which of the four is most aggressive and which is most conservative. First, closed-end funds typically use leverage, increasing their risk to investors. Second, diversification reduces many investment risks, making a non-diversified fund riskier than a diversified fund. Therefore, the most aggressive of the four is the non-diversified closed-end fund. The most conservative is the diversified, open-end fund.

It is never okay to sell something fraudulently. Some state criminal codes refer to this as “theft by deception,” which would include, for example, rolling back the odometer on a used car before selling it or trading it in to a dealer. The point of such an exam question is to point out that only securities are subject to the Uniform Securities Act. That includes securities that are exempt from registration, too, such as T-notes or municipal bonds. A fixed annuity, however, is an example of an investment of money that is not a security. It is an insurance product. Therefore, it is outside the scope of the Uniform Securities Act, even the anti-fraud statute.

You are correct that many well-known banks are also in the brokerage and investment advisory businesses. The point of these exam questions is that the bank is a separate entity from either the related broker-dealer or investment adviser.  Typically, well-known banks are bank holding companies, with stock trading on the secondary market. Under the bank holding company, we find a bank, a broker-dealer, and a wealth manager/investment adviser. The three entities are related yet separate. Therefore, a bank is not a broker-dealer or an investment adviser, even when related to them under a common parent company.

We know candidates taking the Series 63 will have to understand registration of securities professionals to this level of detail. First, the state where the individual lives is irrelevant. What matters to the State Securities Administrator is, first, where the individual maintains a place of business. That is State B in your hypothetical, so the IAR must register with the Administrator of State B. If all clients in State C are institutional clients, no registration is required there. But if the IAR serves more than 5 retail investors residing in State C, the IAR must register there, as well.

This assumes that the agent is working for a state registered investment adviser. If the agent worked for a federally covered adviser the agent would only register where he / she works.

The word “cancellation” has a serious and final connotation to it, which is what makes it a good false answer to such a question. A cancellation order, like a withdrawal order, is not a punitive order.  The Administrator cancels a registration if the registrant dies, is declared mentally incompetent, or cannot be located. The most severe punitive order the Administrator issues is an order of revocation.

When the broker-dealer files Form BD with the regulators, the three owners will provide their disclosure information at that time. When a brokder-dealer files for registration in a state at least 1 officer must also register as an agent of the broker-dealer. As all 3 of the owners of the broker-dealer will be selling securities. All of the owners in this case will be required to register. 

The risk faced by an investor holding U.S Treasury securities is, certainly, low, but there are a few risks. First, these securities pay relatively low yields, making them more subject to purchasing power/inflation risk than other investments. Also, although the interest and principal payments are guaranteed by the United States Treasury, the securities have market prices, which fluctuate. An investment of $1 million into T-Bonds could drop to, say, a market value of just $800,000 if interest rates rise suddenly, for example. If that investor sells, he/she loses money. And, if the investor holds, their account value has dropped. Either way, an investment in U.S. Treasuries is low-risk, but no securities investment is “zero risk” or ensures the investor “can’t lose money.”

A fixed annuity does not meet the definition of a “security” under the Uniform Securities Act. It is, rather, an insurance product. An exempt security is a security that is not subject to registration requirements, for example a U.S. Treasury note or a municipal bond. Exempt securities are subject to the Uniform Securities Act’s anti-fraud statute, while a fixed annuity is outside the scope of the Uniform Securities Act, as is a whole life insurance policy. State insurance laws regulate these products. 

The Uniform Securities Act defines an “issuer” as, “any person who issues or proposes to issue any security.” The word “person” includes individuals and entities such as corporations, partnerships, and estates.

Securities agents and investment adviser representatives are individuals—natural persons—who receive compensation while representing a broker-dealer or an investment adviser. A broker-dealer or investment adviser could be owned as a corporation, a partnership, or an LLC. Or the firm could be owned as a sole proprietorship. If owned as a sole proprietorship, the broker-dealer or investment adviser would be indistinguishable from the individual who owned it. In that case, the broker-dealer or investment adviser would be a natural person, rather than a legal person such as a C-corporation.

Broker-dealers perform many different activities, from investment banking to providing custody for both retail and institutional investors. Investment advisers provide two main services: financial planning, or portfolio management. A mutual fund involves the services of a broker-dealer and an investment adviser. Sometimes, the two firms are affiliated. Sometimes, they are not. Either way, the investment adviser manages the portfolio of securities for compensation, while the broker-dealer acts as the sponsor of the fund. That means the broker-dealer markets the mutual funds and lines up broker-dealers to promote and sell the shares.

The better the investment results achieved by the investment adviser, the easier it is for the broker-dealers to sell the fund shares to investors. In a fictitious example, for the ABC Funds, ABC Distributors is a broker-dealer, while ABC Capital Management is the registered investment adviser to the fund. The broker-dealer markets and sells the investment to investors, while the investment adviser manages the portfolios for the various funds within the family.

Investment advisers providing portfolio management services to high net worth individuals and institutions typically have unaffiliated broker-dealers act as custodians for client assets. Broker-dealers are good at this kind of recordkeeping, while RIAs specialize in managing securities portfolios.

Open-end and closed-end funds have more similarities than differences. In either case, a registered investment adviser manages a portfolio of securities, with ownership of that portfolio then subdivided into the shares owned by investors. Each trading day, the NAV of the fund rises or falls based on market prices of portfolio securities and any dividend or interest income generated by the stocks and bonds in the portfolio. The registered investment adviser has a contract with the Board of Directors for the fund and is paid a percent of portfolio assets under management plus bonuses for hitting or exceeding certain benchmarks.

The differences include, first, how the shares of the fund are bought and sold by investors. Open-end fund shares are sold from the fund to investors and repurchased from investors who want to redeem/sell them. Closed-end fund shares, on the other hand, trade on the secondary market. Therefore, a closed-end fund such as BXMX is bought and sold just like shares of MSFT or MCD are—among investors. For that reason, the market price of a closed-end fund may be higher or lower than the NAV. Open-end fund shares do not have market prices. They are redeemed for the next-calculated NAV and purchased based on the next-calculated NAV—sometimes with a sales charge added.

The other difference is that closed-end funds typically use leverage. That means some investors are preferred stockholders and some may hold bonds. Both types of investors have higher claims on the income generated by the portfolio than do owners of the common shares. This is what makes closed-end funds as a class more aggressive than open-end funds, even if the portfolios hold similar securities.

FINRA's guidance on this point is clear. As you may know, Form U4 asks if the applicant has ever been charged with any felony, and whether convicted of any felony. Some exam candidates confuse the “ever” with a 10-year period looking back from the date of application. They mistakenly think if a felony conviction occurred 12 years ago, the applicant can answer “No” to these questions/items. Turns out, any felony charge and any felony conviction must be disclosed, no matter how long ago it took place. Failing to disclose the information is a game-over for any state regulator, the SEC, or FINRA, too.

What about a pardon? An individual pardoned was, first, convicted of the crime. And, he/she was, also, formally charged with the crime. So, as nice as it must be to get out of prison sooner than expected, the pardon does not change either answer on Form U4. Yes, the pardoned individual was both charged and convicted of a felony offense.

Exam candidates know that closed-end fund shares trade among investors on the secondary market. Does that mean for closed-end funds the imbalance of buying and selling interest does determine the NAV?

No. The Net Asset Value for either an open-end or closed-end fund is the difference between the assets of the securities portfolio, minus any liabilities, divided by the outstanding shares. Open-end funds don’t borrow a lot of money, so their liabilities are minimal. At the end of each market session, the value of all stocks and bonds in the portfolio are revalued. Those, plus all the cash the portfolio has generated, are the assets. The liabilities are the amounts borrowed short-term, perhaps to pay investors who redeem shares. Take the assets, minus the liabilities, and divide those net assets by the number of outstanding shares.

That is the new NAV for the fund.

Only now are shares redeemed at that price or sold to investors at a price based on this new NAV. The transfer agent is merely turning cash into shares, or shares into cash, based on this new Net Asset Value per share. Investors’ shares are not being traded among investors.

The NAV is calculated the same way, and only once a day, for a closed-end fund. The shares trade throughout the day, at a market price that could be above or below the NAV.

Many exam candidates struggle with the difference between stop and limit orders. However, they are quite different. When an investor enters a limit order to buy or sell, the investor is ready to buy or sell the security. He simply wants to buy or sell it at a specific price—or not at all. And, logically, the price he wants to buy or sell the security at is better than the current bid or ask for the security. If ABC can be purchased for $50.12 now, a buy-limit order would be placed at a better price than that—a lower price. Maybe the investor places an order to buy 300 ABC @$50, limit.

That is a buy-limit at $50 order. Only if the Ask price drops to $50 or lower—and there are 300 shares available at the time—will that purchase order be filled.

Other investors may hold shares of ABC. Those interested in selling, say, 400 shares may also choose to name a price for execution. If the Bid is currently $50.10, maybe one investor decides she is willing to sell 400 shares of ABC if she can get at least $50.25 per share. If so, she enters an order to sell 400 ABC @50.25, limit. Only if the Bid rises to at least $50.25 will that order be executed.

Notice in both cases the price for execution is more important than getting the order filled. If an exam question asks which type of order to use when the investor wants to make sure the order is filled, the answer is a “market order.” Market orders are filled at either the best available Bid (sell orders) or Ask (buy orders) prices.

Stop orders come from a much different perspective than limit orders. Limit orders are placed by investors who want a particular price—or better—and are willing to forego the transaction altogether if that price is unobtainable. Stop orders are used to protect a stock position, especially if a small “paper gain” has already occurred. For example, maybe an exam question says an investor purchased $8,000 of XYZ common stock, which now trades for $10,000…which type of order can protect this “paper gain”?

We are not saying he is ready to sell XYZ common stock.  But he has a 25% gain on his hands. Maybe he owns 100 shares of XYZ, now trading at $100 per share. If so, he could place a sell-stop order with an activation price below the current market price. Maybe he places an order to sell 100  XYZ @99.10, stop.

Best case, the stock stays at $100 or rises a few dollars per share. If so, he can cancel that stop order and place a new one, at a higher activation price. But, as long as that sell-stop order is there, just below the current market price, the investor can focus on other things, knowing the next time he checks his account, he will either still hold 100 shares of XYZ—at a favorable market price—or, he will have about $9,910 in cash, as a result of that sell-stop order being triggered and filled.

With a sell-limit order, the investor would simply sell XYZ for a little more than the current market/ask price. With a sell-stop order, he can ride out the position, knowing the worst case is an automatic sale, which often represents a profit. In our example, he bought the stock for $80 a share; therefore, if it is triggered and sold for about $99.10, that represents a pretty good outcome. Even better would be for XYZ common stock to rise to $110, then $120, then…who knows?

The state securities Administrator regulates all investment adviser representatives in the state and all state-registered investment advisory firms. If an IAR or RIA is found to be harming investors and violating securities regulations, the individual or firm receives a notice from the Administrator announcing the alleged violations, explaining the rules/laws allegedly violated, and announcing the upcoming hearing—or how the respondent may request a hearing. After a disciplinary hearing is held, an order to suspend or revoke the license of an IAR or RIA may be issued.

On the other hand, if an individual or business outside the advisory business is, for example, issuing promissory notes to investors in the state and failing to honor the terms of the securities, the Administrator has no license to threaten to suspend or revoke. In these cases, a cease and desist order is typically issued. 

Only a judge/court of law has the authority to issue an injunction. If an injunction is issued against any person (individual or firm), the Administrator can use that to deny, suspend, or revoke an application or registration. So, the individual issuing bogus promissory notes is still not facing dire consequences, although his ability to work as an agent, IAR, etc. in the future is doubtful. And, if a court of law were to issue a restraining order/injunction against an individual selling promissory notes in a way that violates the law and the individual disregards the order, criminal penalties are a possible outcome.

There are two types of investment risk. Systematic risks affect securities system-wide, whereas unsystematic risks affect only certain market sectors or companies at any given time. Diversification spreads unsystematic risks among many issuers and industry groups. It has no effect on the first type, systematic risk.

For example, market risk is a type of systematic risk that affects securities across the board. Market risk is the risk that an investment will lose value due to an overall market decline. No one can predict the next war, pandemic, or banking crisis, but when events like that take place, they can have a devastating effect on the overall market for stocks and bonds. 

Whether they panic because of war, weather, or whatever, when investors panic, securities prices drop. So, even if an investor holds shares in several solid companies, when securities holders all try to sell at the same time, the market prices of securities across the board drop. 

Unfortunately, diversification does not help in this case. If the overall market is going down, it does not matter how many different stocks or bonds we own. They are all going down. That is why we would have to bet against the overall market to protect against market risk. The S&P 500 index is generally used to represent the overall stock market. Therefore, investors use options, futures, and ETFs based on such indexes to bet the overall market will drop. 

Beta measures market risk. A beta of 1.3 indicates the stock is more volatile than the S&P 500—1.3 times as much, and the S&P 500 is already volatile. A beta of .8 indicates the stock is less volatile than the S&P 500—only 80% as volatile. The higher the beta of a stock, the greater the market risk faced by an investor in that security. Investors following modern portfolio theory and its related tenets believe this is the only type of risk an investor should expect to be compensated for taking. 

Why? Because unsystematic risks can be diversified and thereby reduced. This type of systematic risk is “non-diversifiable,” and so the more of it one faces, the higher the potential return.

Most investors purchase securities, hoping they increase in value. Short sellers, on the other hand, bet that a security’s price is about to drop and profit if they are correct.

It works sort of like this. You go to your friend’s house and see that she has a new mountain bike that she paid too much money for. Mind if I borrow your mountain bike, you ask, to which your friend agrees. On the way home you run into another friend, who admires the bike so much that she offers you two thousand dollars for it.

Sold! You take the $2,000 and put it in your pocket.

Wait a minute, that wasn’t even your mountain bike! No problem. A few days later you go to the bike store to replace the borrowed bike, and—as predicted—the price has fallen to just $1,000. Perfect! 

You sold the bike for $2,000 and you can get out of your position by paying only $1,000, keeping the $1,000 difference as your profit. Buy the bike for $1,000, wheel it over to your friend to cover the one you borrowed, and everyone is happy. 

Notice that you made money when the price went down. Therefore, you were "bearish" on the price of mountain bikes.

Short sellers do not sell bikes or software companies short, but they can sell the stock of companies who make bikes or software short. If investors think Apple or Alpha common stock is overpriced and headed for a drop, they can borrow the shares from their broker-dealers and sell them at what they feel is the top. 

However, many people tried that after Facebook went public at $38. When it got to $50, many were convinced the stock would only go down from there, so they sold it short at $50. Expecting to buy it back or “cover their short positions” for less than $50, these traders must have been embarrassed to see the stock soon climb to nearly $200 per-share.

Selling for $50 and buying for $200 is not a good trade. It is no different from buying for $200 and then selling for $50. It is just more dangerous. When we buy, we have already lost all we could ever lose. But when we sell stock short, there is no limit to how much we will have to spend to get out of the position.

Short sellers profit when the price of the stock goes down, but they have limited upside and unlimited risk. If an investor sells a stock short for $5,000, $5,000 is the maximum gain, and only if the stock went to zero. On the other hand, the potential loss is unlimited, since no one can say for sure how high the stock could rise, representing the purchase price.

Stock is not the only thing that can be sold short. Treasury securities are frequently sold short, as are corporate bonds, ETFs (exchange-traded funds), and closed-end funds. Writers of options are “short the option” and complete the trade when they buy it back to close.

In cash accounts, customers pay for securities purchases in full, no later than settlement. On the other hand, margin accounts allow customers to purchase securities on credit. These customers then pledge the securities they are purchasing on credit as collateral to the lender, the broker-dealer. If the market value of the securities drops, the broker-dealer can sell the securities to recover the money it lent the customer. 

The fact that the broker-dealer has collateral backing the loan to the customer allows them to charge a lower interest rate than that typically paid on a credit card. Moreover, this interest is tax-deductible, helping offset portfolio income for that year.

The use of borrowed money to earn potentially outsized returns is a form of leverage. Like bonds, private equity, and closed-end funds, margin accounts are associated with use of leverage. Investing on margin is a high-risk strategy that involves buying securities on credit in hopes of making more on the securities positions than the broker-dealer charges in interest on the margin loans. By using leverage in a margin account, investors double their potential gains, but also double their potential losses.

The term “equity” is often used in relation to real estate. Let’s say a homeowner buys a property for $200,000 and borrows $100,000 to do so. The mortgage account starts out looking like this:

Equity is ownership and equals the difference between what someone owns (assets) and owes (liabilities). As with a margin account, the initial equity is the investor’s down payment. Assume that this home’s value then increases 5% annually for three years running, and the homeowner also pays down some principal. At this point, the account looks like this:

The equity is just a number, but the customer can decide to borrow against that amount, either all at once or going forward as needed.

In a margin account, investors buy stocks and bonds on credit. If their market value rises, they win. What if their market value drops? Then, they have a problem. 

Buying securities on margin increases both potential gains and losses to the investor.

Growth stocks trade at high P/E and price-to-book ratios. When a stock is trading at 35 or 50 times the earnings, every earnings announcement can move the stock's price dramatically. A growth investor must have a long time horizon and the ability to withstand large fluctuations in the market price of the investments. A growth investor is not seeking dividend income.

Value investors buy stocks trading at low price-to-earnings and price-to-book ratios. A value investor often purchases stocks in out-of-favor corporations trading for less than they should be. For example, when the company’s CEO is testifying before Congress over badly handled recalls, many traders dump shares of the stock, while value investors might buy shares at currently depressed prices. 

Value stocks that pay dividends typically have high dividend yields. The board of directors does not usually cut or suspend the dividend paid to common stockholders, so the decreasing market price raises the yield. 

A value stock could trade at a low multiple for many reasons. It could be the company has recently stumbled, or has lost the media buzz it once had, or that the industry sector is currently out of favor or in a period of contraction. In general, large, established companies trade at lower P/E ratios. Younger companies are associated with stock trading at high P/E ratios, as the future is a blank slate supported by a very short history of financial results and much conjecture.

The goal for both growth and value investors is the same. They both want the market price of their stock to rise. The difference is in the price points at which they make their purchases. Growth investors buy expensive stocks expected to rise even more in the future, while value investors buy stocks they are convinced are worth more than the market realizes. 

If the two groups invested in real estate, growth investors would buy new properties in the hot part of town, while value investors would favor fixer-uppers that can be rented for a few years and then sold at a profit.

Investment advisers managing portfolios typically receive a flat fee. Maybe they charge 1% of the assets, which provides incentive for the adviser. One percent of $150,000 is nice, but one percent of $200,000 is even nicer. So, the percentage stays flat, and the adviser’s compensation only grows if the customer’s assets grow.

Some advisers would prefer to take a share of the paper gains or the profits made from trading the account. Every time the adviser buys at $10 and sells at $18, the adviser gets a piece of that capital gain. What about the rest of the stocks?

That is the problem. If a client were to pay an adviser with a share of capital gains, the adviser could make a profit on one lucky stock pick even if the rest of the account goes down to zero. Say a client invested $100,000 with an investment adviser who said they were not going to charge any ongoing fees. Rather, they would just take half of any “trading profits.”

Let’s say the investment adviser puts the client into 10 stocks with $10,000 invested in each. One stock goes up from $10,000 to $18,000, and the adviser sells it for an 80% profit. The client makes a short-term capital gain of $8,000, and the adviser takes $4,000.

Now, the adviser tells the client to be patient, just wait until those 9 other stocks go up. Only, they never do. The account drops from $90,000 to $60,000 in a hurry, then slowly drifts down to $36,000, at which point the client tells the adviser to sell everything and send a check for what’s left.

So, how did the client do in this case? After putting down $100,000 the client is left with $36,000 plus a pre-tax profit of just $8,000. How did the adviser do? They made a fast profit of $4,000 with no risk to the firm.

Ouch. Or, maybe dependable, blue-chip stocks are suitable for a client’s portfolio. Unfortunately, if the investment adviser is paid on a share of capital gains/appreciation, why bother with the slow-and-steady stocks that might not go anywhere for a while? Regardless of the client’s risk tolerance, why not pick 20 of the most speculative stocks trading through the non-NASDA OTC?

Offering to share the gains or capital appreciation with an investment adviser entices the adviser to take on bigger risks and often puts the adviser’s interests in conflict with those of the client.

That is why advisers cannot be compensated as a share of capital gains or “paper gains” as a general rule. Advisers managing a portfolio, typically, are compensated as a percentage of assets over a specified period.

The Uniform Securities Act then clarifies that this rule, “does not prohibit an investment advisory contract which provides for compensation based upon the total value of a fund averaged over a definite period, or as of definite dates or taken as of a definite date.” That means that while an adviser cannot share the gains on individual stocks or take a percentage of the amount that the account “went up,” the firm can bill the client based on the average account balance over a certain period or bill a percentage of assets as of, say, the end of each financial quarter, or on the last day the market is open for the calendar year.

As we said, this is the general rule for compensation. However, if the adviser has a contract with a qualified client, performance-based compensation is allowed. A qualified client includes certain institutional clients and individuals with either $2 million of net worth (excluding the value/equity of the primary residence) or—more typically—at least $1 million of assets under the adviser’s management. Advisers to mutual and pension fund portfolios typically earn performance bonuses based on matching or beating an index that represents the portfolio’s makeup.

So, although performance-based compensation, or compensation based on the capital gains/appreciation of the account, are generally not allowed, the Uniform Securities Act includes the caveat, “Except as may be permitted by rule or order of the Administrator.”

The U.S. Supreme Court’s Howey Decision says that an “investment contract” is an:

• investment of money due to
• an expectation of profits arising from
• a common enterprise
• which depends solely on the efforts of a promoter or third party

The SEC and state securities regulators use the Supreme Court’s four-pronged approach under the Howey case to determine if an investment is an investment contract and, therefore, a security. The, “depends solely on the efforts of a promoter or third party” above means this person is providing money, not labor or management, to the enterprise. The fact that the seller had no pre-existing relationship with the buyer would factor in, as well. For example, if you have been a trusted ranch hand for many years and the owners then sell you a part-ownership of the cattle ranch, you could just be a managing member of the LLC.

But, if a farmer is offering investors the chance to provide money in exchange for a share of the farm’s profits, that is an offer of a security. It is an investment of money in a common enterprise in which the investors expect to profit through the efforts of others.

Since the investment being offered is a “security,” the farmer could end up committing securities fraud if important facts were omitted or misstated. Since this investment fits the definition of a security, the offer must be registered. A registration statement allows the state securities Administrator to perform a background check on the issuer and requires the issuer to provide full disclosure of all risks and other material information to investors.

Sometimes the owners of an LLC forget that when the business offers shares of the LLC to non-managing members, this typically meets the definition of an offer of securities, subject to, at least, antifraud regulations and, maybe, registration requirements. Full disclosure must be provided, even if this disclosure is only for a few potential investors.

Since it is not always clear if a professional meets the definition of “investment adviser,” the SEC issued a release in 1987 that attempts to explain their thought process when determining if someone is or is not an investment adviser. This release made clear that the “three-pronged” test to determine if someone is an investment adviser involves the following:

• Does the professional provide investment advice?
• Is he/she in the business of providing advice?
• Do they receive compensation for this advice?

If the answer to all three questions is “yes,” the person is an investment adviser and must register unless they can claim an exemption.

So, first, does the professional provide investment advice? This is the most difficult of the three prongs to determine. Generally, if someone helps someone decide whether to invest in securities based on the client’s needs, that person is providing investment advice. The specificity of the advice is not a determining factor. For example, if a sports agent helps clients pick investments in securities in general as an alternative to an investment in real estate or insurance-based products, then that professional is acting as an investment adviser.

In fact, if they tell clients to avoid investing in securities/to invest elsewhere, they are acting as investment advisers.

Pension consultants who help pension plans decide either which securities to invest in or whether to invest in securities over some other asset are investment advisers. The consultants who help the funds determine which investment advisers to hire or retain are as well.

What does it mean to “be in the business of providing advice”? The SEC and NASAA determined that a 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 not the only factor in determining if the person is “in the business” or not.

In other words, the regulators take it case-by-case.

Providing advice does not have to be the main activity of the person, either. The person could be a CPA doing tax planning work and only providing investment advice if a client asks for it. That is close enough. If the person “holds himself out to the public” as one who provides investment advice—via business cards, billboards, letterhead, office signage, etc.—then he is in the business and is considered to be an investment adviser.

What about the compensation question, the third prong? Some would like to think they are not advisers because they do not receive money for their advice. But regulators use the broader term “compensation” to determine who is and is not an investment adviser. Compensation is any economic benefit, not necessarily money.

Even if someone other than the client pays the compensation, the person is an investment adviser. For example, if a firm advises Coca-Cola’s employees on how to allocate their 401(k) investment dollars, and bills the company, they meet the definition of an investment adviser.

Some securities agents with a Series 6 or 7 function as financial planners, even if they do not call themselves that. Many of these planners assume they can put together a financial plan for free and only get paid off any resulting commissions to avoid being defined as investment advisers.

Unfortunately, Release IA-1092 says they would likely be considered investment advisers because they receive an economic benefit because of their advice. The compensation might come directly or indirectly as the result of providing investment advice to clients. However it comes, the regulators will probably require such people to get registered.

It does not matter whether the compensation is called a “commission” or a “fee.” The compensation does not have to be listed as a separate item. The regulators, as always, look at how things function. If it were based on terminology, those who wanted to escape registration could just use different terms and function in a way that threatens investors.

Let’s distinguish an “exclusion” from an “exemption.” Some institutions and individuals are excluded from the definition of “investment adviser.” This includes banks and savings institutions. They are simply not investment advisers. A broker-dealer or securities agent who provides some investment advice but is compensated only as a broker-dealer or agent also escape the definition of “investment adviser.” That is also true of certain professionals—lawyer, accountant, teacher, or engineer—whose advice is incidental to their profession. For example, if a CPA tells a tax planning client that opening a SIMPLE IRA would provide tax advantages, the CPA is not acting as an investment adviser. However, if the CPA goes too far and tells the business owner that mutual funds are “better” than other investment vehicles, now the CPA is acting as an investment adviser—probably an unregistered one, at that.

So, if these professionals refrain from offering investment advice, they are excluded from the definition of “investment adviser.” An exemption implies an investment adviser or IAR are not subject to registration in a particular jurisdiction—but, they are, still investment advisers or IARs.

Offers of exempt securities are not required to be registered with the Administrator. Also, securities offered through exempt transactions are either not required to be registered with the Administrator or are subject to scaled-down requirements. If a company in the state offers 40% of its stock to a venture capital firm, this is an exempt transaction. The company files a notice with the Administrator after the fact. Very little disclosure of the transaction or the parties involved is provided/required.

Exempt securities, such as Treasury and municipal securities, are not subject to any registration requirement by the Administrator.

So, an offer of municipal securities is an offer of exempt securities rather than an offer of non-exempt securities being done through an exempt transaction. Exempt securities offerings are “good to go” by their nature. Only securities without exemptions require transactional exemptions, including private placements and offerings to institutional investors, if the issuer wants to avoid the typical registration process with the Administrator.

Under the Uniform Securities Act, a party who is harmed through, say, a fraudulent offer of securities, may file a civil action if it is filed within 2 years of discovery or 3 years from the event, whichever comes first. Therefore, if the party has known about the illegal nature of the sale for more than 2 years, it is too late to sue. Or, if the sale took place more than 3 years ago, it is also too late to take civil action.

Not many criminal cases arise out of state securities law, but those that do must be filed by the State within 5 years of occurrence, which is how it works for most crimes other than homicide/manslaughter and a few others.

It is not that the investment advice must be specific or highly detailed for it to be deemed “investment advice.” If the advice involves investing—or not investing—in securities, the key is whether the person providing such advice knows the investment situation of the person receiving the advice. A sports agent who knows his client’s financial situation is providing investment advice even if he says something vague, such as, “If I were you, I would put that signing bonus into real estate. Stay away from stocks and bonds.”

The sports agent receives compensation from the client. He knows his financial situation. And he just provided investment advice. If he is registered as an investment adviser, no problem. If not, he probably should be registered. Or he should stick to his area of expertise and refer his client to an investment adviser or broker-dealer who can help him.

 When an agent terminates employment with the current broker-dealer, the firm completes and files Form U5. When that is finished, the agent and the new broker-dealer complete and file Form U4. Therefore, the answer to an exam question is that the agent and both broker-dealers must/will notify the Administrator of the change of association.

Some individuals and small firms solicit new business on behalf of an investment adviser. The regulators call such persons solicitors. To use a solicitor, the adviser must be registered; there can be no outstanding order suspending, limiting, or barring the solicitor’s activities; and there must be a written agreement between the solicitor and the adviser. Also, the following conditions must be met:

• The agreement between the adviser and the solicitor must describe the solicitation activities and the compensation arrangement.
• The solicitor must provide the client with the adviser’s disclosure brochure and a separate solicitor disclosure document.
• The adviser must receive a signed acknowledgment from the client that he/she received both the
• RIA’s and the solicitor’s disclosure documents

The adviser must obtain a signed acknowledgment from the client that both disclosure brochures were received. Also, if the solicitor were some shady character, the adviser would not be able to stand back shrugging off responsibility to the regulators. The adviser is expected to do due diligence on the solicitors they use, and if an adviser knew the individual was a convicted felon and hired the solicitor anyway, the adviser would face regulatory action.

Is the solicitor required to be registered? Not by the SEC and not by all the state securities Administrators. The important point is that the adviser must be registered, must oversee the solicitor, and the solicitor cannot be someone ineligible for registration because of criminal or regulatory events.

Most states call a “solicitor” an “investment adviser representative” and make him—or them—register as such. But not all states feel that way.

Before issuing a punitive order to deny, suspend, or revoke an application or registration, the Administrator must provide prior notice, written findings of fact/conclusions of law, and an opportunity for a hearing. The Administrator can take two specific actions without first giving notice and an opportunity for a hearing. The cease & desist order can be issued without prior notice, because sometimes the thing that someone is doing or is planning to do is so outrageous the State needs to stop it immediately. Also, the Administrator can, “summarily suspend a registration pending final determination” of the matter. That means until the hearing has been held and the decision has been reached, the license is “summarily suspended.” Some states refer to a summary suspension as a “show-cause order.”

The balance sheet is often described as a “snapshot of the company’s financial condition,” which is a great way to define it. A balance sheet shows assets and liabilities as of the time the report is compiled. The higher the value of assets relative to the liabilities, the higher the net worth/stockholders’ equity the company has. The balance sheet does not show what happened over a reporting period. For that, we look to the income statement, which shows revenue—the top line—minus all expenses to arrive at the bottom line—net income after tax. To see if a business was profitable over a financial quarter or fiscal year, the income statement is consulted by fundamental analysts. The income statement is where profits and profit margins are expressed.

Systematic risks affect securities system-wide, whereas unsystematic risks affect only certain market sectors or companies at any given time. Diversification spreads unsystematic risks among many issuers and industry groups. It has no effect on the first type, systematic risk. Market risk is a type of systematic risk that affects securities across the board. Market risk is the risk that an investment will lose value due to an overall market decline. No one can predict the next war, pandemic, or banking crisis, but when events like that take place, they can have a devastating effect on the overall market for stocks and bonds. 

Whether they panic because of war, weather, or whatever, when investors panic, securities prices drop. So, even if an investor holds shares in several solid companies, when securities holders all try to sell at the same time, the market prices of securities across the board drop. 

Unfortunately, diversification does not help in this case. If the overall market is going down, it does not matter how many different stocks or bonds we own. They are all going down. That is why we would have to bet against the overall market to protect against market risk. The S&P 500 index is generally used to represent the overall stock market. Therefore, investors use options, futures, and ETFs based on such indexes to bet the overall market will drop. 

While diversification does not reduce the systematic risks we just examined, it does reduce the unsystematic risks we will look at now. Unlike systematic risk, unsystematic risk applies to a specific issuer or industry space as opposed to the overall market. For instance, the risk that the EPA will increase regulations on the automobile industry is not system-wide. Rather, it affects only a few issuers and industries and therefore represents an unsystematic risk. 

Diversifying a portfolio reduces these specific risks by spreading them among stocks of different issuers operating in different sectors. A diversified stock portfolio holds securities in different issuers that operate in different industry spaces. Microsoft, Toyota, Starbucks, and Wells Fargo operate in unrelated industries. Therefore, the portfolio containing them is more diversified than a portfolio holding positions in Starbucks, McDonald’s, Cheesecake Factory, and Dunkin’ Donuts. These four companies are all in the same industry space—the restaurant space, and so, if the restaurant group declined, the portfolio made up of these would likely drop more than a diversified portfolio would.

When completing Form U4, the applicant must disclose any felony conviction and any charge of a felony violation, no matter how long ago it occurred. No matter how minor—or serious—the felony may seem, it is treated as a felony, whether for theft, burglary, rape, or homicide. After 10 years, an individual with a homicide conviction would not be precluded from associating with a member firm under FINRA rules based solely on that. Would a broker-dealer hire the individual? That is a different question, of course, and not one that can be answered across-the-board. Some firms may view a homicide conviction with less concern than they would view a conviction for armed robbery or embezzlement. Others may choose not to hire convicted felons, period.

If the investor owns no long position in ABC, this represents a “naked call.” As with someone who sells stock short, this investor profits if the market price of ABC drops and loses if the market price rises. Because the maximum market price is unlimited, so is the potential loss. The investor in the question you cite collects $300 to take on the obligation to sell 100 shares of ABC common stock for $55 a share. How much will the investor pay for those 100 shares when/if the contract is exercised?

That is unknown/unlimited, as it is for a short seller who may have to buy the stock in a hurry at whatever the market price happens to be. Remember that writing naked calls and selling stock short both lead to limited gains and unlimited losses. Buying calls and buying stock, on the other hand, are associated with limited losses and unlimited gains.

If the investor owned the underlying stock as you suggest the investor’s maximum loss would be calculated as the difference between what the investor paid to purchase the shares of ABC minus the premium received for selling the 55 call. IF the investor purchased ABC at $52 and sold the 55 call for a premium of $3 the investor’s maximum loss would be $49, calculated as follows: $52-$3 =$49. The investor only received partial protection by employing a covered call strategy. ABC could fall to zero and the investor would suffer their maximum loss of $49 per share. Our videos have entire sections dedicated to showing students how to master option hedging. We provide step by step instructions detailing exactly how to set up these questions so they are very easy to understand.

The Securities Act of 1933 focuses on the offering of securities to public investors, requiring issuers to register their offerings with the SEC before even trying to sell their securities to the public. Because of this law investors must be provided with full disclosure of everything they might need to know about the company issuing the securities. A typical path for a technology company is to raise various rounds of venture capital investments, which are exempt transactions under the Securities Act of 1933. If the company hits its financial targets, it may choose to go public. At that point, it will contract with an underwriter and register the IPO with the Securities and Exchange Commission.

When the offering is completed, the stock starts trading on the secondary market, and the company becomes a reporting company under the Securities Exchange Act of 1934. That means at a minimum the issuer will file three quarterly and one annual report with the SEC going forward. The quarterly reports are known as 10Qs and the annual report is known as the 10K. 

Keep in mind that The Securities Act of 1933 regulates the primary market. This consists exclusively of issuer to investor transactions. It is only concerned with full and fair disclosure. 

The Securities and Exchange Act of 1934 regulates the secondary market. Everything that takes place after the stock has become public. It regulates investor to investor transactions. And of course It created the Securities and Exchange Commission as the ultimate securities industry regulator. 

Once the number of annuity units has been determined, that number is fixed and, so, for example, every month an annuitant would be paid the value of 101 annuity units.

What is the monthly value of an annuity unit? That depends on the investment performance of the subaccounts compared to the expectation of performance known as AIR, or assumed interest rate.

If the returns are higher than the assumed rate, the units increase in value. If the account returns are exactly as expected, the unit value remains the same. And, if the account returns are lower than expected, the unit value drops from that it held in the previous month. 

It is all based on the assumed interest rate (AIR) —typically 3, 4, or 5%. If the AIR is set at 5%, the subaccount investments are expected to grow each month at an annualized rate of 5%. If the account has a 6% annualized rate of return one month, the payout increases. If the account grows at the anticipated 5% rate of return during the next month, that month’s payout remains the same. And, if the account has only a 4% rate of return during the next month, the payout will decrease.

If the AIR is 5%, here is how it might work:

When the account receives a 7% return, the account increases. Then, when it has only a 6% return in the following month, that is 6% of a larger account and is 1% more than expected. 

Thus, if the actual return is larger, so is the monthly payout. If it is smaller, so is the payout. If the actual return is the same as the AIR, the payout stays the same.

Yield represents the income an investor receives as a percentage of either market value or of the purchase price of the investor’s shares. For example, if an investor buys $10,000 worth of the ABC equity income fund and receives dividend distributions of $500, that investor’s yield is 5%.

Whereas yield is always a positive number, total return can be positive or negative. Total return includes both the income received by the investor and the increase or decrease in market value the investment experiences. For example, if the investor in the ABC equity income fund also receives a capital gains distribution of $200, that is factored into the total return, as is the increase or decrease in market value of the investor’s investment. If the investment has dropped to $9,200, the total return is negative. We add $500 to $200 but subtract $800 for the market decline. The investor is down $100 on a $10,000 investment, resulting in a total return of -1%.

Securities regulators insist that agents do not try to conceal a fund’s negative total performance by quoting only its yield. Yield is always a positive number, as some amount of money is received by investors, which is then divided by the NAV. Total return, on the other hand, can be positive or negative. Therefore, securities agents must not quote yield without also quoting total return to an investor and clearly explaining the difference.

Broker dealers have an affirmative obligation to obtain the best possible prices for clients. When customers are buying stock broker dealers must execute the customer’s order at the best ( lowest ) offer price available at the time. Alternatively, when customers are selling stock, the firm must execute the customer’s order at the best  ( highest ) bid price available at the time. Provided the prices available meet any limit prices on the customer’s order. It is a violation of industry standards to execute a customer’s order at any price deemed to be inferior to the best price. The inside market for a stock consists of the Highest Bid and Lowest Offer displayed by any firm or in any market.. A broker dealer may never place a third party in between the customer and the best market. This is known as Interpositioning. The placing of another broker dealer in between the customer and the best marke.is prohibited unless it can be demonstrated that the customer received a better price because of it.. Here is an example of interpositioning.

A customer gives Broker an order to buy 3,000 shares of ABCD when the stock is quoted $3.75 X $4.25. Instead of buying the stock for their customer Broker A sends the order to Broker B who buys the stock at $4.10, Broker B then sells the stock to Broker A at $.4.15 and Broker A then sells the stock to the client at $4.25 plus a mark up. As a result both Broker A and B made money and the customer paid more than he / she should for the stock.

Bond yields can be a sticking point for many SIE candidates. Understanding the inverse relationship between price and yield is only the first step to mastering this content. Knowing how the nominal yield, current yield, yield to maturity and in some cases how yield to call relate to one another are essential. The bond see saw is a time tested way to ensure you can handle these questions on your SIE Exam. Practice drawing it out for each possible scenario. This will make these questions visual and in most cases simple. All you have to do is look at the drawing and you will be able to quickly answer the questions on your actual SIE exam. Create the seesaw with bonds at a discount, when purchasing bonds at par and when bonds are purchased at a premium and you will be in good shape. It is important to note that the nominal yield never changes. It is printed in ink on the bond certificate . Your current yield is a relationship between the annual interest payments and the price the investor pays for the bond. Once the investor purchases the bond he /she has locked in their current yield The formula is always Annual Income / Current Market Price. An investor’s yield to maturity is the overall return for purchasing the bond; it takes into account the Annual interest payments with the assumption that they are reinvested at the same rate ( not spent by the owner of the bond) and any gain or loss at maturity. For bonds purchased at a discount the investor will have a gain. For a bond purchased at a premium the investor will  have a loss. Don’t worry you will not have to calculate the yield to maturity. If a bond is callable the yield to call will be the highest yield for a bond purchased at a discount and the lowest for a bond purchased at a premium.

Both front running and trading ahead are violations. Both are based on trading using advanced knowledge and the violations are often confused as a result. Front running is the entering of an order for the account of an agent or firm prior to the entering of a large customer order. For example, let's say that a representative received an order from an institutional investor to purchase 500,000 shares of DEF. Prior to entering the order to purchase the large amount of stock, the representative enters an order to purchase 1,000 shares of DEF. for themselves.. After purchasing the share for their own account the representative enters the order to buy 500,000 shares of DEF for the institutional customer. This large order drives the stock price up and the rep sells their shares at a profit.

Trading ahead is the entering of an order for a security based on the prior knowledge of a soon to be released research report. Research reports can have a substantial impact on the price of the stock covered in the report. This is particularly true when the analyst has a large following. It is not uncommon for the price of a stock to move up or down by 10 percent or more on the day the report is released. Questions on the exam often provide scenarios where a rep walks into an elevator and overhears a conversation between two analysts about a report they are going to release with a price target on a stock significantly higher than its current market price. The rep then returns to his or her desk and buys the stock for clients and themselves.. This is a classic example of trading ahead.

The level of interest rates are determined by a number of factors. Including:

• The level of economic activity.
• The supply and demand for capital
• The level of risk perceived to be in the market.

The money supply is controlled by the Federal Reserve Board largely through open market operations. Open market operations consist of the FRB buying and selling Treasury and mortgage backed securities in the secondary market. When the Fed buys securities it increases the money supply and lowers rates. This has a stimulating effect on the economy. When the FRB is a net seller of securities it is removing money from the banking system and interest rates will increase as a result. The discount rate is the interest rate that the Federal Reserve Board charges member banks on loans made directly by the FRB. The Federal Funds rate on the other hand is the rate banks charge each other for short term loans. These loans are typically overnight or for short periods of time. The Federal funds rate is NOT controlled by the Federal; Reserve Board.  The actual rate is determined by the marketplace. The Fed does set a range or target for what it thinks the fed funds rate should be. However, the borrowing and lending banks ultimately determine the rate.

Accumulation units and annuity units both  represent an investor’s ownership in the separate account. However, the units are owned during different phases of the annuity contract. An accumulation unit represents the investor’s proportionate ownership in the separate account’s portfolio during the accumulation or deferred stage of the contract. The value of the accumulation unit will fluctuate as the value of the securities in the separate account’s portfolio changes. As the investor makes contributions to the account or as distributions are reinvested, the number of accumulation units will vary. An investor will only own accumulation units during the accumulation stage, when money is being paid into the contract or when receipt of payments is being deferred by the investor, such as with a single-payment deferred annuity. When an investor changes from the pay-in or deferred stage of the contract to the payout phase, the investor is said to have annuitized the contract. At this point, the investor trades in the accumulation units for annuity units.

The number of annuity units is fixed and represents the investor’s proportional ownership of the separate accounts portfolio during the payout phase. The number of annuity units that the investor receives upon annuitizing a contract is based on the payout option selected, the annuitant’s age and sex, the value of the account, and the assumed interest rate.

A lot of people get tripped up on this very point. The difference between the 5 and 10 percent rule is an important difference. The goal of diversification is to reduce risk by spreading investments over many different holdings. Mutual funds are designed to help investors achieve diversifications through a single investment in the fund. Mutual funds that market themselves as diversified funds must adhere to the 75-5-10 rule.  the requirements are as follows:

• 75%: Seventy-five percent of the fund’s assets must be invested in securities of other issuers. Cash and cash equivalents are counted as part of the 75 percent. A cash equivalent may be a Treasury bill or a money market instrument.
• 5%: The investment company may not invest more than 5 percent of its assets in any one company.
• 10%: The investment company may not own more than 10 percent of any company’s outstanding voting stock.

Let's look at an example to help you understand this concept better:
XYZ fund markets itself as a diversified mutual fund. It has $10,000,000,000 in net assets. The fund’s investment adviser thinks that the ABC Company would be a great company to acquire for $300,000,000. Because XYZ markets itself as a diversified mutual fund, it would not be allowed to purchase the company, even though the price of $300,000,000 would be less than 5 percent of the fund’s assets. The investment company must meet both the diversification requirements of 5 percent of assets and 10 percent of ownership in order to continue to market itself as a diversified mutual fund.

This can be a bit confusing for test takers. While mutual funds and UITs are both types of investment companies and both are registered under the Investment Company Act of 1940 a UIT is NOT a mutual fund. A Unit Investment Trust is a non managed pooled investment. A unit investment trust (UIT) will invest either in a fixed portfolio of securities or a nonfixed portfolio of securities. A fixed UIT will traditionally invest in a large block of government or municipal debt. The bonds will be held until maturity, and the proceeds will be distributed to investors in the UIT. Once the proceeds have been distributed to the investors, the UIT will have achieved its objective and will cease to exist. A nonfixed UIT will purchase mutual fund shares in order to reach a stated objective. A nonfixed UIT is also known as a contractual plan. Both types of UITs are organized as a trust and operate as a holding company for the portfolio. UITs are not actively managed, and they do not have a board of directors or investment advisers. Both types of UITs issue units or shares of beneficial interest to investors, which represent an undivided interest in the underlying portfolio of securities. UITs must maintain a secondary market in the units or shares to offer some liquidity to investors.

Every transaction in the market consists of 2 parties: a buyer and a seller. No one would be able to buy a stock, bond or option if another party was not willing to sell it to them. The purchaser of the put is absolutely bearish and is betting that the stock price is going to fall. The put buyer pays the premium to acquire the right to sell the stock at the strike price. The premium is paid to the seller of the put contract. In exchange for the premium, the seller takes on an obligation to purchase the stock. Because the seller is now obligated to purchase the stock, the seller is considered to be bullish on the price of that stock. If the seller was bearish and thought the stock price was likely to decline they would not want to buy the stock and would not sell a put. Commit this to memory, the right to sell is bearish and an obligation to buy is bullish.

Most Bonds are designed to provide investors with regular interest payments and are most suitable for investors who have an income investment objective. Matching the particular type of bond to the investor’s profile is the key to answering the questions correctly. In the question there will be keys that help you identify which bond is the most appropriate and therefore correct choice. Key factors include such things as are they looking for maximum income or safety of principal. If they are seeking maximum income corporate bonds are going to be the best choice. Investors who are seeking safety of principal should be placed in the highest rated bond choice in the question. Treasury securities are often the correct choice here. Keep in that shorter term investments carry less interest rate risk. For the most risk adverse investors a money market fund may be the correct choice. There is no market risk and the money market fund will provide some level of income. Treasury bills are not the correct choice for investors seeing income. Remember that Treasury bills are issued at a discount and mature at the par value. Municipal bonds are best for investors who have an income objective but who do not want to incur additional tax obligations. Investors in higher tax brackets benefit the most from investments in municipal bonds. Investors who are in lower tax brackets will be better off investing in corporate bonds of equal quality.

Corporations declare forward and reverse stock splits for very different reasons. When the price of a stock increases to the point where the price makes it too high for many retail investors to purchase a round lot ( typically 100 shares) corporations will often declare a forward stock split. The impact of the forward stock split reduces the market price of the stock making it more attractive to individual investors. For example, let's assume XYZ is tracking in the market at $100 per share and the company declares a  2 for 1 split. As a result of the split XYZ will now be priced at $50 per share. Making it more attractive to individual investors. An investor who owned 100 shares of XYZ before the split value at $100 per share would now own 200 shares of XYZ valued at $50 each. The value of their holdings would not change. Their ownership would be valued at $10,000 before and after the split. To calculate the ownership take the number of shares and multiply it by the split as a fraction 2/1 and you multiply the share price by the reciprocal of the split as a fraction ½. If they are going to test you on an uneven split it will probably be a  3:2 split. Reverse splits on the other hand are effected to increase the price of a stock to make the stock more attractive to institutional investors. Many institutions do not want to purchase shares of stock trading below $5 or $10 per share. In these cases the reverse stock split reduces the number of shares and increases the market price of the stock For example, If ABC was trading in the market at $4 per share and ABC declared a 1 for 10 reverse split ABC would now be trading in the market at $40 per share. An investor who owned 1,000 shares at $4 per share before the split would now own 100 shares at $40 each. The value of the investor’s holdings remained unchained. Their ownership is $4,000 before and after the split.