Series 24 Exam Questions & Answers (SIA Instructor Verified)

This question is definitely targeting the carve out procedure. Under FINRA’s freeridding and withholding rules broker dealers who engage in the sale of IPOs must make a full and complete offering of all shares. Firms may not withhold the shares for their own account nor for the accounts of employees or those financially dependent on their employees. Series 7 registered persons (and their financial dependents) are known as restricted persons and are prohibited from purchasing shares of IPOS. These rules are in effect for initial public offerings, but they are especially prevalent when dealing with a hot issue. A hot issue is one that trades at an immediate premium to its offering price in the secondary market. A broker dealer may not free ride by withholding securities for its own account or for the accounts of those listed above. FINRA Rule 5130 covers initial offerings of common stock only. Exempt from the rule are offerings of additional issues, bonds, and preferred shares. These offerings may be purchased by registered persons. FINRA Rule 5130 requires that a broker dealer (not the Rep) obtain an eligibility statement from all account owners who purchase a new issue of stock within 12 months prior to the purchase. This eligibility statement attests to the fact that the person is not restricted from purchasing new issues. If a member of the syndicate or selling group receives an order for a new issue from a financial intermediary such as a bank or an investment adviser, the member selling the securities to the customer of the financial intermediary may rely on the financial intermediary’s representation that their client is not restricted from purchasing new issues. Some people may purchase hot issues so long as the amount is not substantial and they have a history of purchasing new issues. These conditionally approved people are:

• Employees of financial institutions not able to direct the securities business of the institution.

• Non-supported family members.

• Accounts where the restricted persons’ interest is limited to 10 percent or

less or where a maximum of 10 percent of the allocation of new issue is for the benefit of such persons. This is known as the carve out procedure Let's look at the carve out procedure more closely. To ensure you know how to handle this on your exam. Let's say a representative has an institutional account for a hedge fund and that the fund has $100 million of investable assets. The account is seeking an allocation of 10,000 shares of a IPO. If $8 million of the fund’s assets were obtained from restricted people, the fund would be allowed to purchase shares of an IPO without any restrictions or requirements. However, if $50 million of the fund’s assets were received from restricted people, the fund would be subject to the carveout procedure to ensure that no more than 10 percent of the allocation would benefit restricted people. In this case 1,000 of the shares could be allocated to restricted people and the remaining 9,000 shares would have to be for the benefit of the non restricted capital contributors

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.