Series 26 Exam Questions & Answers (SIA Instructor Verified)

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.