Series 6

Qualification Exam
Investment Company Representative Examination
Study Manual – 42nd Edition

The Final Exams are a critical part of your training.

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T119
 TABLE OF CONTENTS
INTRODUCTION
CHAPTER 1 Building an Investor Profile
Developing a Customer Profile.................................................................... 1-1
Financial Considerations ............................................................................. 1-1
Occupation ............................................................................................ 1-1
Income .................................................................................................. 1-1
Taxation ................................................................................................ 1-2
Capital Gains and Capital Losses .......................................................... 1-6
Filing Tax Returns ................................................................................. 1-7
Taxation – Series 6 Application ............................................................. 1-7
Personal Balance Sheet ........................................................................ 1-7
Non-Financial Considerations ..................................................................... 1-10
Financial Goals and Investment Objectives ................................................ 1-12
Regulation of Customer Interactions ........................................................... 1-14
Know Your Customer and Suitability ..................................................... 1-14
Conclusion............................................................................................. 1-16

CHAPTER 2 Customer Accounts

New Account Documentation ...................................................................... 2-1
New Account Form...................................................................................... 2-2
Required and Requested Information .................................................... 2-3
Account Registration–Forms of Account Ownership .............................. 2-4
Client Authorizations Permitting Third Parties to Trade ............................... 2-7
Trading Authorizations........................................................................... 2-7
Discretionary Accounts .......................................................................... 2-7
Special Client Arrangements ....................................................................... 2-9
Account Registration Changes and Internal Transfers ................................ 2-10
Customer Screening ................................................................................... 2-10
Verification of Client Information ................................................................. 2-12
Account Information............................................................................... 2-12
SEC Regulation SP ............................................................................... 2-12

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 TABLE OF CONTENTS
Chapter 2 (Cont.)

Accounts at Other Broker-Dealers and Financial Institutions ................. 2-14

Approving Customer Accounts .............................................................. 2-15
Account Restrictions .............................................................................. 2-15
Conclusion............................................................................................. 2-15

CHAPTER 3 Customer Communications

Communication Standards .......................................................................... 3-1
FINRA’s Communication Rules ................................................................... 3-1
Communications–Internal Review Procedures ............................................ 3-3
FINRA Filing and Review Requirements ..................................................... 3-3
Exclusions from the Filing Requirements ............................................... 3-5
Communications Regarding Investment Companies ................................... 3-5
SEC Rule 156–Investment Company Sales Literature .......................... 3-7
Use of Investment Companies’ Rankings in Retail Communications ..... 3-9
Bond Mutual Fund Volatility Ratings ...................................................... 3-10
Communications Regarding Variable Products ........................................... 3-10
MSRB Rules–Communications ................................................................... 3-12
Advertising............................................................................................. 3-12
SEC Rule 15c2-12: Municipal Securities Disclosure ................................... 3-12
Advertisements for Municipal Fund Securities ....................................... 3-13
Performance Indicators ......................................................................... 3-13
Conclusion............................................................................................. 3-14

CHAPTER 4 Offerings
Capital Formation ........................................................................................ 4-1
Public versus Private Placement Offerings ............................................ 4-1
The Role of an Underwriter/Investment Banker........................................... 4-1
Underwriting Commitments ................................................................... 4-2
Distribution of Securities ........................................................................ 4-2

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 TABLE OF CONTENTS
Chapter 4 (Cont.)

Securities Act of 1933 ................................................................................. 4-3

The Registration Process ............................................................................ 4-3
The Preregistration (Prefiling) Period..................................................... 4-4
The Cooling-Off Period .......................................................................... 4-4
The Post-Effective Period ...................................................................... 4-6
Exempt Securities ....................................................................................... 4-6
Exempt Offerings ................................................................................... 4-7
Rule 147 and Rule 147A ....................................................................... 4-7
Regulation D.......................................................................................... 4-8
The Primary Market for Municipal Bonds .................................................... 4-9
Conclusion............................................................................................. 4-10

CHAPTER 5 Overview of Securities and Tax Considerations

The Corporation–Equity Securities .............................................................. 5-1
Corporate Organization ......................................................................... 5-1
Raising Capital–Financing the Corporation ........................................... 5-1
Different Types of Equity Securities ....................................................... 5-2
Common versus Preferred Stock........................................................... 5-2
Corporate Bonds ......................................................................................... 5-3
Types of Corporate Bonds ..................................................................... 5-3
Unsecured Bonds .................................................................................. 5-4
The Money-Market ...................................................................................... 5-5
Types of Money-Market Securities ........................................................ 5-5
Treasury Securities ..................................................................................... 5-7
Types of Treasury Securities ................................................................. 5-7
Non-Interest-Bearing Securities ............................................................. 5-8
Stripped Securities ................................................................................ 5-9
Agency Securities ....................................................................................... 5-9
Federal Agencies .................................................................................. 5-9

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 TABLE OF CONTENTS
Chapter 5 (Cont.)

Government-Sponsored Enterprises ..................................................... 5-9

Mortgage-Backed Securities ....................................................................... 5-10
Options ....................................................................................................... 5-12
Equity Options–Terminology ....................................................................... 5-12
Buyers and Sellers ................................................................................ 5-12
Types of Options ................................................................................... 5-12
Speculation versus Hedging .................................................................. 5-13
Tax Considerations ..................................................................................... 5-13
Dividends–Cash Dividends .................................................................... 5-13
Taxation of Bond Interest ...................................................................... 5-14
Cost Basis of Securities......................................................................... 5-14
Capital Gains and Losses ...................................................................... 5-15
Conclusion............................................................................................. 5-16

CHAPTER 6 Investment Companies

Types of Investment Companies ................................................................. 6-1
Open-End Management Companies (Mutual Funds)............................. 6-1
Additional Disclosure: The Statement of Additional Information (SAI).... 6-4
The Organization of a Mutual Fund ....................................................... 6-4
Types of Mutual Funds................................................................................ 6-6
High Risk Category................................................................................ 6-6
Moderate Risk Category ........................................................................ 6-6
Low Risk Category ................................................................................ 6-8
Buying and Selling Mutual Fund Shares ..................................................... 6-10
Net Asset Value ..................................................................................... 6-10
Fees and Charges ................................................................................. 6-12
Classes of Shares ................................................................................. 6-13
Methods of Reducing Sales Charges .................................................... 6-14
Dollar Cost Averaging (DCA) ................................................................. 6-17

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 TABLE OF CONTENTS
Chapter 6 (Cont.)

Redeeming Shares ................................................................................ 6-18

Systematic Withdrawal Plans ................................................................ 6-18
Prohibited Sales Practices .......................................................................... 6-19
Breakpoint Sales ................................................................................... 6-19
Selling Dividends ................................................................................... 6-19
Switching ............................................................................................... 6-19
Purchasing Large Quantities of Class B Shares .................................... 6-19
Mutual Fund Taxation ................................................................................. 6-19
Cost Basis ............................................................................................. 6-20
Income .................................................................................................. 6-20
Capital Gains and Losses ...................................................................... 6-20
Other Types of Investment Companies ....................................................... 6-21
Face-Amount Certificate Company ........................................................ 6-21
Unit Investment Trust ............................................................................ 6-21
Closed-End Investment Companies ...................................................... 6-22
Exchange-Traded Funds (ETFs) ........................................................... 6-23
Conclusion............................................................................................. 6-24

CHAPTER 7 Variable Products and Municipal Fund Securities

Annuities ..................................................................................................... 7-1
Fixed versus Variable Annuities .................................................................. 7-1
Fixed Annuities ...................................................................................... 7-2
Variable Annuities.................................................................................. 7-2
How Deferred Annuities Work ..................................................................... 7-4
Accumulation Period.............................................................................. 7-4
Annuity Charges and Expenses ............................................................ 7-5
Annuity Period ....................................................................................... 7-6
Factors Used to Determine the Number of Annuity units ....................... 7-6
Taxation of Variable Annuities..................................................................... 7-9

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 TABLE OF CONTENTS
Chapter 7 (Cont.)

During the Accumulation Period ............................................................ 7-9

During the Annuity Period ...................................................................... 7-9
Death Benefit Taxation .......................................................................... 7-10
Variable Product Regulation........................................................................ 7-10
Variable Annuities–Suitability and Compliance Issues........................... 7-11
Variable Life Insurance ............................................................................... 7-13
Variable Universal Life Insurance .......................................................... 7-14
Taxation of Life Insurance Policies ........................................................ 7-14
Voting Rights ......................................................................................... 7-14
Municipal Fund Securities ........................................................................... 7-15
Section 529 College Savings Plans ....................................................... 7-15
529 ABLE Plans .................................................................................... 7-16
Local Government Investment Pools (LGIPs) ........................................ 7-16
Conclusion............................................................................................. 7-16

CHAPTER 8 Retirement Plans

The Employee Retirement Income Security Act (ERISA) ............................ 8-1
Employer-Sponsored Retirement Plans–Qualified Plans ............................ 8-3
Profit-Sharing Plans............................................................................... 8-3
Money Purchase Plans.......................................................................... 8-4
401(k) Plans .......................................................................................... 8-4
403(b) Plans .......................................................................................... 8-5
Taxation of Retirement Plans ................................................................ 8-5
Employer-Sponsored Retirement Plans–Non-Qualified Plans ..................... 8-6
Types of Non-Qualified Plans ................................................................ 8-6
Conclusion............................................................................................. 8-7

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 TABLE OF CONTENTS
CHAPTER 9 Investment Risks, Returns and Disclosures
Required Disclosures .................................................................................. 9-1
Disclosures Made Prior to Execution ..................................................... 9-1
Compensation and Disclosure on Equity Trades ................................... 9-1
Compensation and Disclosure on Mutual Funds ................................... 9-1
Compensation and Disclosure on Variable Products ............................. 9-2
Soft-Dollar Arrangements............................................................................ 9-2
Client Notifications ...................................................................................... 9-3
Account Statements and Other Notifications ......................................... 9-3
Broker-Dealer Financial Information ...................................................... 9-3
Confirmations Statements ..................................................................... 9-3
Updating Account Information ............................................................... 9-4
Books and Records ..................................................................................... 9-5
Recordkeeping Formats ........................................................................ 9-5
Financial Exploitation of Specified Adults–FINRA Rule 2165 ...................... 9-5
ACATS–Transferring Accounts ................................................................... 9-7
Investment Risks......................................................................................... 9-9
Systematic (Non-Diversifiable) Risk....................................................... 9-9
Unsystematic (Diversifiable) Risk .......................................................... 9-10
Investment Returns ..................................................................................... 9-12
Calculating Current Yield (Dividend Yield) ............................................. 9-12
Calculating Bond Yields ......................................................................... 9-13
Taxable Equivalent Yield ....................................................................... 9-14
Cost Basis, Capital Events, and Return of Capital ...................................... 9-14
Cost Basis of Inherited Securities .......................................................... 9-14
Cost Basis of Gifted Securities .............................................................. 9-15
Additional Tax Considerations ............................................................... 9-15
Conclusion............................................................................................. 9-15

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 TABLE OF CONTENTS
CHAPTER 10 Investment Strategies and Portfolio Analysis
Suitability and a Customer’s Financial Objectives ....................................... 10-1
Know Your Customer and Suitability ..................................................... 10-2
Asset Allocation .......................................................................................... 10-2
Forms of Analysis ....................................................................................... 10-9
Growth Analysis .................................................................................... 10-9
Value Analysis ....................................................................................... 10-9
Top-Down Analysis................................................................................ 10-10
Bottom-up Analysis................................................................................ 10-10
Momentum Investing ............................................................................. 10-10
Indexing ................................................................................................. 10-10
Modern Portfolio Theory.............................................................................. 10-10
Indexes and Averages ........................................................................... 10-12
Capital Asset Pricing Model (CAPM) ..................................................... 10-13
Fundamental Analysis ................................................................................. 10-14
The Balance Sheet ................................................................................ 10-14
Components of the Balance Sheet–Assets ........................................... 10-16
The Liabilities Section............................................................................ 10-16
The Stockholders’ Equity Section .......................................................... 10-17
Conclusion............................................................................................. 10-17

CHAPTER 11 Orders and Trade Execution

Trading Overview ........................................................................................ 11-1
Secondary Market Trading–From Order Entry to Settlement ...................... 11-1
Capacity of the Firm .............................................................................. 11-1
NYSE and Other Traditional Exchanges ..................................................... 11-3
The Role of the Designated Market Maker (DMM) ................................ 11-3
Dealer-to-Dealer Markets ............................................................................ 11-4
Nasdaq Trading ..................................................................................... 11-4
Market Maker Requirements ................................................................. 11-5
Components of an Order Ticket .................................................................. 11-5

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 TABLE OF CONTENTS
Chapter 11 (Cont.)

Trade Routing........................................................................................ 11-6

Types of Transactions ................................................................................. 11-6
Prohibited Trading Practices ....................................................................... 11-7
Settlement Dates ................................................................................... 11-8
Customer Payment versus Settlement .................................................. 11-9
Delivery of Physical Securities .................................................................... 11-10
Paper Settlement ................................................................................... 11-10
Death of an Account Owner................................................................... 11-11
Conclusion............................................................................................. 11-11

CHAPTER 12 Resolving Disputes and Suitability

Errors .......................................................................................................... 12-1
Execution Errors .................................................................................... 12-1
Error Account ........................................................................................ 12-1
Cancel and Rebill .................................................................................. 12-1
Trade Reporting Errors .......................................................................... 12-1
Clearly Erroneous Transactions ............................................................ 12-2
Resolving Problems .................................................................................... 12-4
Complaints ............................................................................................ 12-4
Code of Procedure ................................................................................ 12-4
Dispute Resolution–Code of Arbitration ................................................. 12-6
Mediation ............................................................................................... 12-7
Disclosures Under Code of Arbitration–Updating Form U4 ......................... 12-8
Suitability .................................................................................................... 12-11
Conclusion............................................................................................. 12-28

INDEX

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 INTRODUCTION

About the Series 6 Examination

The Series 6 Examination is the Investment Company and Variable Contracts Products
Representative Examination. Any person who successfully passes the examination is permitted to
transact business in the following:
 Redeemable securities of registered investment companies
 New issues of registered closed-end investment companies
 Variable contracts and insurance premium funding programs
 Other insurance contracts which are not exempt under the Securities Act of 1933

The Series 6 is comprised of 50 multiple-choice questions which must be completed in one hour
and 30 minutes and the minimum required passing score is 70%. The questions are divided into the
following four major job functions:

Job Function: Number of Questions:

Seeks Business for the Broker-dealer from Customers and Potential Customers 12
Opens Accounts After Obtaining and Evaluating Customers’ Financial Profile and
8
Investment Objectives
Provides Customers with Information About Investments, Makes Suitable
25
Recommendations, Transfers Assets and Maintains Appropriate Records
Obtains and Verifies Customers’ Purchase and Sales Instructions; Processes,
5
Completes and Confirms Transactions
Total: 50

Note: Each examination will include five additional pretest questions that don’t influence a
person’s score. These five unidentified questions are randomly distributed throughout the exam.

Taking the Exam

In order to take an exam, you will need to make a test appointment. Please use the following
information to schedule an appointment and/or to learn more about the examination center:
Prometric Exam Centers
www.prometric.com/finra/
800.578.6273

The website will provide you with the most up-to-date information regarding “Test Center Security”
and “Test Break Policies.” At the testing facility, you will be provided with:
 A four-function calculator
 Two dry-erase boards
 Dry-erase pen

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INTRODUCTION

For more information about scheduling an exam and what to expect on the day of your exam and
after your exam, please use the following link which provides information from FINRA:
www.finra.org/sites/default/files/external_apps/proctor_tutorial.swf.html

About the Training Program

Securities Training Corporation’s Series 6 Training Program is designed to assist students in passing
FINRA’s Series 6 Examination regardless of their prior experience or educational level. The program
consists of the following material:
1. 12-chapter study manual
2. Online final examinations with detailed explanations
‒ Instructions regarding access to the final examinations will be sent to each
candidate via e-mail.

Study Manual
The Series 6 study manual represents the first phase of a student’s preparation. The 12 chapters are
designed to be reader friendly with content that follows FINRA’s Series 6 Exam Outline. After reading
each chapter, STC strongly suggests that students go to their my.stcinteractive.com dashboard and
create a 10-question Custom Exam that contains only questions pertaining to the chapter just
completed.

The Custom Exam may be taken with or without the explanations shown after each question is
answered. Students shouldn’t proceed to the next chapter until they fully understand the
explanation for any questions that were answered incorrectly.

Since examination content is subject to change, we recommend that students visit our website at
www.stcusa.com to see if there have been any exam updates or supplemental materials created.

Final Examinations
The final examinations and explanations represent the most important part of a person’s exam
preparation. These examinations will assist students in applying the information that was learned
in the study manual to questions that are posed in the multiple-choice format used on the Series 6
Examination. Students are not truly ready to sit for the Series 6 Examination until they have
thoroughly studied and practiced these final examinations.

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 INTRODUCTION

How to Study the Final Examinations

An examination should first be taken with the SHOW EXPLANATIONS turned on. As you read a
question, try to answer it. However, whether your answer is correct or incorrect, read the entire
explanation. You may find it helpful to highlight or take notes on any facts you didn’t know for use
in future studying.

Studying each explanation is a crucial step to passing the Series 6 Examination for two reasons.
First, there’s some information contained in the final exams that may not have been covered in the
lessons. Second, by concentrating on only the correct response and disregarding the explanation, a
student runs the risk of memorizing answers without fully understanding the underlying concepts.

After completing all of the examinations with SHOW EXPLANATIONS switched on, and if time permits
based on the calendar you’re following, begin the process over again by retaking each examination
without the explanations shown. If taking the test for the second time, you should strive to achieve a
score of 85% or better to show maximum retention of the material.

Standardized Test-Taking Tips

As with any standardized test, students may be able to increase their score by employing good test-
taking techniques. An efficient technique will ensure that students have an overall understanding of
the question while also helping them avoid careless errors. The following list is a step-by-step
approach that may work well.

Step 1: Read the question the first time through without trying to answer it. At this point, merely
form an understanding of the substance of the question.
Step 2: Carefully read the four choices. Remember, since a multiple-choice examination actually
gives a student the answer, his job is to recognize the correct choice from among the other
distractors. If a student keeps these choices in mind when he rereads the question, he will be able to
efficiently pinpoint the important information and filter out any extraneous material.
Step 3: Reread the question slowly and stop at the end of each sentence and absorb the
information. A student may need to exaggerate this in the beginning as he gets used to applying the
intense concentration required to assure that he recognizes all of the important facts and catch
misleading words or phrases (e.g., not, except, etc.).
Step 4: Make sure to fully understand what the question is asking. A student cannot possibly
answer a question correctly before he knows what it’s asking. Students may need to look back to the
question for additional facts before they are ready to actually choose an answer.
Step 5: Read each choice a second time. As each choice is being read, decide whether it’is a possible
answer. If a student is able to eliminate three of the four choices, he has his answer. However, if he
is only able to eliminate one or two, it will help him narrow it down to the best choices. Reconsider
the remaining choices by comparing their differences and decide which answer is more correct.
Once a final decision has been made, DON’T LOOK BACK!

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INTRODUCTION

NOTE: For Roman numeral questions, do any elimination before trying to answer the question.

It’s important for students to practice their technique so that they become proficient by the time
they sit for their examination. The best place to practice is on the simulated final examinations. Not
only will this practice build a student’s technique, it will also help him to identify any problem areas.

Study Calendars
Following this Introduction, STC has included sample study calendars. These study calendars are
designed to help students in organizing their time and allowing for a manageable amount of daily
study. View each calendar and choose the one that best fits your needs. Remember, these calendars
are simply suggestions for how you may plan your studies. Feel free to make any modifications that
you deem appropriate.

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Securities Training Corporation

Series 6 Top-Off 2-Week Training

MONDAY TUESDAY WEDNESDAY THURSDAY FRIDAY
To complete each chapter: Complete Chapters 3-4 Complete Chapter 5-6 Complete Chapters 7-8 Complete Chapters 9-10
1. Watch the On Demand (Approx. 5 hours)
Lecture for the chapter (Approx. 5 hours)
Take Progress Exams Take Progress Exams
2. Read the chapter in the
1 A and B 2 A and B
study manual
3. Build a 10-question (Approx. 6 hours) (Approx. 6 hours)
custom exam for the
chapter *
4. Create a custom

WEEK 1
flashcard deck for the
chapter
Complete Chapters 1-2

(Approx. 5 hours)

Complete Chapter 11-12 Take Greenlight 1 Take Final Exam 3 Take Final Exam 6 Take Final Exam 8

Take Final Exam 1 Take Final Exam 4 Take Final Exam 7 Take Greenlight 2
Take Progress Exams
3 A and B Take Final Exam 2 Take Final Exam 5 (Approx. 3 hours) (Approx. 3 hours)

(Approx. 6 hours)

WEEK 2
(Approx. 4.5 hours) (Approx. 4.5 hours)

* To create a Custom Exam:

 Log in to my.stcusa.com. From your Dashboard, select Exam Center, select Final Exams, then scroll down and select Create a Custom Exam. Now, select the
appropriate chapter number and, at the bottom of the screen, enter 10 in the Number of Questions box, and then select Build Exam. You can choose whether or
not to have the explanation appear after each question is answered.

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Series 6 Top-Off 3-Week Training

MONDAY TUESDAY WEDNESDAY THURSDAY FRIDAY
To complete each chapter: Complete Chapters 3-4 Take Progress Exams Complete Chapters 6-7 Complete Chapters 8
1 A and B
1. Watch the On Demand (Approx. 5 hours) (Approx. 5 hours) Take Progress Exams
Lecture for the chapter
Complete Chapters 5 2 A and B
2. Read the chapter in the
study manual
(Approx. 3.5 hours) (Approx. 5 hours)
3. Build a 10-question
custom exam for the
chapter *

WEEK 1
4. Create a custom
flashcard deck for the
chapter

Complete Chapters 1-2

(Approx. 5 hours)

Complete Chapter 9-10 Complete Chapter 11-12 Take Progress Exams Take Final Exam 1 Take Final Exam 3
3 A and B
(Approx. 5 hours) (Approx. 5 hours) Take Final Exam 2 Take Final Exam 4
Take Greenlight Exam 1
(Approx. 3 hours) (Approx. 3 hours)

WEEK 2
(Approx. 2.5 hours)

Take Final Exam 5 Take Final Exam 6 Take Final Exam 7 Take Final Exam 8 Take Greenlight Exam 2

(Approx. 1.5 hours) (Approx. 1.5 hours) (Approx. 1.5 hours) (Approx. 1.5 hours) (Approx. 1.5 hours)

WEEK 3
* To create a Custom Exam:
 Log in to my.stcusa.com. From your Dashboard, select Exam Center, select Final Exams, then scroll down and select Create a Custom Exam. Now, select the
appropriate chapter number and, at the bottom of the screen, enter 10 in the Number of Questions box, and then select Build Exam. You can choose whether or
not to have the explanation appear after each question is answered.

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Securities Training Corporation

Series 6 Top-Off 4-Week Training

MONDAY TUESDAY WEDNESDAY THURSDAY FRIDAY
To complete each chapter: Complete Chapters 3-4 Take Progress Exams Complete Chapters 6 Complete Chapters 7
1 A and B
1. Watch the On Demand (Approx. 5 hours) (Approx. 2.5 hours) (Approx. 2.5 hours)
Lecture for the chapter
Complete Chapters 5
2. Read the chapter in the
study manual
(Approx. 3.5 hours)
3. Build a 10-question custom
exam for the chapter *

WEEK 1
4. Create a custom flashcard
deck for the chapter

Complete Chapters 1-2

(Approx. 5 hours)

Complete Chapter 8 Complete Chapter 9 Complete Chapter 10 Complete Chapter 11 Complete Chapter 12

Take Progress Exams (Approx. 2.5 hours) (Approx. 2.5 hours) (Approx. 2.5 hours) Take Progress Exams
2 A and B 3 A and B

WEEK 2
(Approx. 3.5 hours) (Approx. 3.5 hours)

Take Greenlight Exam 1 Take Final Exam 1 Take Final Exam 2 Take Final Exam 3 Take Final Exam 4
(Approx. 1.5 hours) (Approx. 1.5 hours) (Approx. 1.5 hours) (Approx. 1.5 hours) (Approx. 1.5 hours)

WEEK 3
Take Final Exam 5 Take Final Exam 6 Take Final Exam 7 Take Final Exam 8 Take Greenlight Exam 2

(Approx. 1.5 hours) (Approx. 1.5 hours) (Approx. 1.5 hours) (Approx. 1.5 hours) (Approx. 1.5 hours)

WEEK 4
* To create a Custom Exam:
 Log in to my.stcusa.com. From your Dashboard, select Exam Center, select Final Exams, then scroll down and select Create a Custom Exam. Now, select the
appropriate chapter number and, at the bottom of the screen, enter 10 in the Number of Questions box, and then select Build Exam. You can choose whether or
not to have the explanation appear after each question is answered.
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 CHAPTER 1

Building an
Investor Profile

Key Topics:

 Financial Factors

 Personal Characteristics

 Financial Objectives and Goals

 Know Your Customer

 CHAPTER 1 – BUILDING AN INVESTOR PROFILE

Prior to initiating trades with a prospective customer, an RR must collect detailed

information about the customer in order to comply with both federal laws and SRO rules.
Also, since each customer is unique, an RR must develop a customer profile prior to any
recommendation(s) being made. This profile must be updated regularly due to any changes
in a customer’s circumstances and needs. RRs have a responsibility to their customers to
make recommendations that are suitable in terms of type, size, and frequency. The
recommended investments must be appropriate in relation to the customer’s needs,
financial circumstances, and investment objectives.

This chapter describes how an RR develops a customer profile and addresses some of the
common customer investment objectives and concerns. Subsequent chapters will connect
these objectives to the appropriate products and/or investment strategies that best meet the
customers’ needs. Ultimately, the ability to match a customer’s objective with the most
suitable product(s) is a critical component of passing the Series 6 Examination.

Developing a Customer Profile

For RRs, the first step in creating a profile is to determine the type of customer with whom they are
working. In some cases, an RR may be dealing with the same person who is acting in more than one
capacity. For example, a customer may be a business owner using an RR to manage the business
account as well as the owner’s personal cash management account.

Another potential scenario involves an RR managing the assets of an elderly customer. Some of the
customer’s assets are intended to fund his retirement, while he intends to bequeath the remainder
of the assets to his grandchildren. Although the RR may be dealing with the same person, the
investment recommendations would differ for the assets the customer intends to use to fund his
retirement versus the assets he intends to bequeath.

While the exam may include questions about many different types of customers—including large
institutions—the primary focus will be on the RR’s relationships with individual (retail) customers.
Prior to establishing a customer relationship, an important initial step is to determine the current
state of the prospect’s finances. Without this financial profile, an RR is unable to determine whether
her advice and recommendations are suitable.

Some customers may be reluctant to disclose all of their financial information. If a customer refuses
to provide certain information, the RR may not make assumptions about the customer’s finances.
Instead, an RR may only make recommendations based on information that has been disclosed by
the customer. In some cases, a firm may decide not to open an account based on a customer’s
unwillingness to provide sufficient background information.

In order to obtain the required background information, asking customers the right questions is
critical. For financial professionals, both financial and non-financial considerations are important
when constructing appropriate investment strategies.

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Financial Considerations
Most RRs initiate a profiling process by gathering financial information about their customers. This
information includes the following:

Occupation
The wide range of customer occupations will affect how RRs will deal with customers. Some
customers may have a stable job that provides a steady, reliable income. Others may have a job with
fluctuating income that’s volatile and unpredictable which may require the customer to establish a
sizable cash reserve in order to survive periods of little or no work.

In certain cases, a customer’s occupation may trigger additional regulatory obligations. For
example, if a client is employed by another FINRA member firm or a publicly traded company,
special reporting rules apply.

Income
A customer’s income includes salary, wages, alimony, investment income, and qualified
withdrawals from retirement plans. As a general rule, the greater a person’s income, the more
investment risk he is able to tolerate; and, the lower the income, the more conservative the
investment strategy should be. However, the source and reliability of the income are also
important. For example, a teacher’s income is considered steady, while the income of a
commission-based salesperson may fluctuate significantly.

As part of the overall profiling process, an RR may need to assist a potential customer in creating an
income statement to determine the customer’s cash flow. Cash flow refers to the movement of cash
into and out of an account or business. Once the customer’s cash flow has been determined, an RR
is then able to calculate the customer’s discretionary or net income by adding up the total income
and subtracting all taxes and required payments (bills).

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The following is an example of a personal income statement:

AN INVESTOR’S PERSONAL INCOME STATEMENT

MONTHLY INCOME
Salary $8,000
Investment Income 500
Other Income 1,000

TOTAL MONTHLY INCOME $9,500

MONTHLY EXPENDITURES
Taxes $3,100
Mortgage Payments 2,000
Loan Payments 1,000
Living Expenses 2,000
Insurance Premiums 200
Entertainment and Travel 400
Other Expenses 300

TOTAL MONTHLY EXPENDITURES $9,000

DISCRETIONARY OR NET INCOME $500

This statement is useful for several reasons. First, it shows the sources from which the person’s
income is derived. Second, it provides details regarding the customer’s lifestyle—how much money he
spends and the items on which he spends it. Finally, subtracting a customer’s monthly expenditures
from his gross income results in the customer’s discretionary income—in other words, the amount of
money he has left each month after essential expenses are met. Generally, persons with a greater
amount of discretionary income may adopt more aggressive investment strategies.

Now let’s take a closer look at four basic forms of income.

Earned or Ordinary Income Earned income is compensation a person receives for providing
goods or services and includes salaries, commissions, and wages earned through employment
(including self-employment). Earned income is taxed at what is often referred to as the customer’s
tax bracket. In technical terms, this tax bracket is considered the customer’s marginal tax rate.

Marginal Tax Rate A person’s marginal rate represents the tax rate that would apply to any
additional dollars of taxable income earned. Since the U.S. income tax system is progressive, a
person’s tax rate rises as his taxable income rises through two or more tax brackets.

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A person’s marginal tax rate is the rate he pays on the taxable income that falls into the highest
bracket reached (e.g., 10%, 12%, 22%, 24%, 32%, 35% and 37%).

For instance, if a person has taxable income that falls into three brackets, he would pay at the 10%
rate on the first portion, the 12% rate on the next portion, and the 22% federal tax rate on only the
third portion. Therefore, his marginal tax rate would be 22%.

Passive Income This category of income is derived from a business venture in which an investor
does not have an active role. Income received from a limited partnership (a type of direct participation
program) is an example of passive income. Passive income is taxed in the same manner as both
earned and investment income. The difference is that passive losses may only be used to offset
other passive income or gains, but may not be used to offset earned income or portfolio
(investment) income.

Investment Income Investment income is the income derived from owning various types of
investments. Of particular importance is the understanding of the local, state, and federal tax
consequences of each type of investment income. Although a brief overview of each form of
investment income will be provided, the details of each form will be covered in the subsequent
chapters that are devoted to specific products.

Dividend Income This form of investment income is paid to owners of equity securities. Since
dividends may be paid in cash or in additional shares of stock, each form of payment is treated
differently for tax purposes.
 A cash dividend is typically paid out quarterly or semiannually. These payments are taxable in
the year of receipt.
 A stock dividend is paid in the form of additional shares. These payments are not taxable at the
time of receipt. Rather than declaring the additional shares as income, the stockholder must
adjust the cost basis per share of her position in the stock.

Interest Income This form of investment income is derived from the ownership of certain debt
securities (bonds). The tax treatment of interest that’s received by investors differs according to the
bond’s issuer. Although the tax treatment of each type of bond will be covered more thoroughly in
later chapters, the following is a summary of three of the more popular types of bond investments:

Issuer Federal Taxation State and Local Taxation

Corporations YES YES

U.S. Government YES NO

Dependent on issuer and the

Municipalities NO
customer’s state of residency

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Deferred Income Deferred income is the earned income in an account which requires that taxes
be paid at a later date. The earnings derived from retirement plans and annuities, such as IRA,
Keogh, and 401(k) plans, or other retirement accounts, are not currently taxed. Instead, taxes are
deferred until withdrawals are taken from the account. These withdrawals are taxed as ordinary
income at the individual’s current tax bracket.

Taxation
Tax implications must be taken into account when making recommendations to customers.
Frequently, customers will ask registered representatives to recommend specific investments that will
suit their tax status. Although taxation is an important consideration, it should not be the sole factor in
the recommendations being made.

Types of Taxes Taxes may be classified as either progressive (graduated) or regressive (flat).
Progressive tax is a system in which a person with a higher income will pay taxes at a higher
percentage of her income than a person with a lower income. Progressive examples include income
tax, gift tax, or estate tax. On the other hand, a regressive tax has the same rate regardless of the
amount of income which means that it hits lower-income individuals harder. Regressive examples
include sales tax, excise tax, or Social Security tax.

The laws concerning U.S. taxation are complex and constantly changing. In addition to paying taxes
to the U.S. government (federal taxes), individuals may also need to pay taxes to the state, county,
and/or city in which they live. The remainder of this section will focus primarily on those areas of the
tax code that affect securities and securities transactions.

Taxation of Investment Income The manner in which income is taxed is often a function of the
source of that income. Most earned, passive, deferred, and investment (portfolio) income is taxed
as ordinary income which is based on an individual’s tax bracket.

Special Tax Treatment for Qualifying Cash Dividends A qualified dividend is a type of dividend
that’s taxed at the same rate as long-term capital gains, rather than at an investor’s ordinary rate.
Generally, most regular dividends from U.S. companies that have normal company structures (i.e.,
corporations) are qualified. However, dividends that are received from a real estate investment trust
(REIT) are still taxed at ordinary income rates since an REIT does not pay corporate income tax if it
distributes a minimum percentage of its income.

Alternative Minimum Tax The Alternative Minimum Tax (AMT) was introduced as a method of
calculating tax liability to ensure that wealthy individuals who derived income from certain types of
investments pay at least a specified minimum amount of taxes. By applying the AMT, investors are
not able to avoid paying taxes altogether.

For purposes of calculating the AMT, some taxpayers are required to adjust their taxable income
based on their investment in assets that produce certain tax-preference items. Tax-preference items
may include interest on certain municipal bonds, various depreciation expenses, and a variety of
events that result from owning limited partnership interests.

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Under AMT rules, these taxpayers must compute their income taxes twice. They must first calculate
their taxes using the standard method, and then they must recalculate their tax liability using the
AMT method. The taxes due will be the greater of the two calculations.

Estate and Gift Taxes Individuals may transfer assets or give a gift of up to $15,000 per year to
any number of persons (related or unrelated) without incurring gift taxes. A married couple may
combine their individual gifts for a total of $30,000 per recipient. For gifts over $15,000 per person,
per year, the donor is required to file a gift tax return. If the value of a person’s estate exceeds a
certain amount, an estate tax return is required to be filed and a tax may be assessed.
A married couple with a significant net worth is interested in providing gifts to their 10
grandchildren. In order to not be subject to gift tax or be required to file a gift tax return,
how much may be given to each grandchild?

The couple may give each of their grandchildren $30,000 per year without being subject to
gift tax or being required to file a gift tax return. Therefore, with 10 grandchildren, a total of
$300,000 per year may be given.

The marital deduction allows a husband and wife to give each other an unlimited amount of
property without incurring gift taxes. The spouse who dies first may also leave an unlimited amount
to the survivor without incurring estate taxes.

Capital Gains and Capital Losses

If appreciated assets are later sold, there may be a resulting taxable event. For profits on sales, the
length of time the asset was held will determine the amount of tax that must be paid.

Capital Gains Capital gains are generated when an investment is sold for a greater value than its
cost basis. If the investment had been held for one year or less at the time of the sale, the gain is
considered short-term and is taxed at the same rate as ordinary income. However, if the investment
had been held for more than one year, the gain is considered long-term and is taxed at a maximum
rate of 20%.

Capital Losses Capital losses are generated when an investment is sold for less value than its cost
basis. As with capital gains, if an investment had been held for one year or less at the time of the
sale, the loss is considered short-term. If the asset had been held for more than one year, the loss is
considered long-term.

Capital losses are not taxed; instead, the IRS requires capital losses and capital gains to be netted.
The netting of capital losses against capital gains may be done with no maximum dollar limitation.
The result will be a net capital gain (taxable) or a net capital loss. Greater detail on the treatment of
gains and losses will be covered later.

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Filing Tax Returns

Unmarried taxpayers may file a tax return marked single or, if they maintain a household for their
dependents, they may file a return marked head of household. Head of household filing qualifies the
individual for lower rates and a higher standard deduction.

Married couples may either file a return marked jointly or as married filing separately. Since filing
jointly provides more tax benefits, this is usually the best option for married couples. A person’s
filing status is dependent on her marital situation on December 31 in the year for which the return
is being filed. Therefore, if a couple is divorced as of December 31, 20XX, each person is considered
unmarried for the entire year.

Taxation—Series 6 Application
The exam may include customer profile questions that contain limited information. For example, if
the customer is a doctor who is seeking bond interest to supplement his earned income, a person
must be able to tie together the ideas that the doctor is likely in a high tax bracket and that a tax-free
bond may be the most desirable. Conversely, if the customer is a conservative retiree who is seeking
bond income, the best choice may be a U.S. Treasury security. The reasoning for this choice is the
assumption that the retiree’s tax bracket is lower and safety of principal is likely a primary concern.
Keep in mind, U.S. Treasury securities are considered to have very low credit risk.

Personal Balance Sheet

Of course, income and its potential taxation is only one part of an individual’s financial picture. An
RR should also document what a customer owns (total assets) and what she owes (total liabilities). By
listing the customer’s total assets and subtracting her total liabilities, the RR can create a personal
balance sheet and calculate the customer’s net worth.

Simply put, Total Assets – Total Liabilities = Net Worth.

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The following is an example of a balance sheet:

AN INVESTOR’S PERSONAL BALANCE SHEET

ASSETS
Tangible Property
House $500,000
Automobiles 40,000
Furniture and Jewelry 20,000

Investments
Stocks and Bonds $200,000
401(k) Plan 50,000
Pension Plan 100,000

Savings
Checking Account $2,000
Savings Account 3,000
Total Assets: $915,000

LIABILITIES
Home Mortgage $350,000
Car Loans 20,000
Credit Cards 5,000
Total Liabilities: $375,000

NET WORTH $540,000

Assets The asset component of the net worth equation represents what a customer owns and
includes:
 Primary residence and other real estate
 Automobiles
 Personal possessions (e.g., furniture, jewelry, and clothing)
 Government and corporate bonds
 Stocks
 Mutual funds and annuities
 Pension plans and 401(k) plans
 Individual retirement accounts
 Money-market funds and CDs
 Savings accounts
 Cash in checking accounts

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In order to analyze a customer’s financial portfolio more effectively, there are a variety of ways to
list a customer’s personal assets. For example, assets may be classified as:
 Tangible assets (e.g., real estate and personal possessions)
 Investments (e.g., stocks, bonds, and retirement plans)
 Savings (e.g., money-market funds, checking and savings accounts)

By asking a customer to list her assets, an RR is able to determine her current holdings and
investment strategies. Knowing the composition of a customer’s current portfolio is as important as
knowing her net worth. Without this information, it’s difficult for the RR to recommend
investments and adequately diversify the customer’s portfolio.

There are several ways in which an RR’s recommendations may be affected by the customer’s
current portfolio. For instance, a significant portion of a customer’s liquid net worth may be
concentrated in the stock of his employer. This is a common situation for customers who have
worked for the same corporation for a number of years and whose compensation has included
stock options. In these circumstances, an RR may recommend that the customer sell a portion of
the shares in her company’s stock and diversify her portfolio by purchasing other securities.

Liabilities The liabilities component of the net worth formula represents what a customer owes to
her creditors and includes:
 Mortgages and home equity loans
 Automobile loans
 Credit card balances
 Student loans
 Debit balances used to buy stock on margin

Net Worth A customer’s wealth is usually equated to her net worth. As illustrated on the personal
balance sheet, the customer’s net worth is the difference between what she owns and what she owes.
A person’s wealth is difficult to determine without her full financial profile. A person with a high
income is not necessarily wealthy since she may also be carrying a large amount of debt. Another person
with modest income may have accumulated a significant amount of money over her lifetime because
she made wise investment decisions, saved a substantial part of her income, or had little or no debt.

As a general rule, the greater a person’s net worth, the more investment risk she is able to tolerate.
And conversely, the lower the net worth, the more conservative the investment strategy should be.

Liquid Net Worth It’s important to remember that the net worth figure represents everything a
person owns. However, a more realistic assessment of a person’s worth may be her liquid net worth.

Liquid net worth excludes assets that are not readily convertible into cash such as real estate,
limited partnership interests, and stock in small companies. When analyzing a customer’s financial
profile, RRs must consider her liquid net worth (e.g., stocks, bonds, mutual funds, and savings
accounts) to accurately evaluate her financial position.

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Non-Financial Considerations
Developing a comprehensive picture of a customer’s financial circumstances and investment goals
is a very important role for an RR. However, there are other personal characteristics of the customer
that are also relevant.

Age In general, investors who are farther from the typical retirement age are able to tolerate more
risk in their portfolios than those closer to retirement. A person who is just starting his career has
many years left to earn additional money and more years to replace potential losses. However,
investors who are in the latter part of their careers are generally at their peak earning potential.
These customers may be nearing retirement and will have fewer opportunities to replace losses.
Some long-term investments (e.g., equities) are generally not appropriate for aging investors who
will likely not outlive the benefit. One general approach that’s used by many professionals is to
subtract a client’s age from 100 to determine the percentage of assets that should be invested in
stocks. The assumption is that the older the client, the less the risk tolerance, and therefore the less
money that should be invested in equities.

Time Horizon Time horizon represents the amount of time that a customer has available to
achieve his financial goals. In general, the longer an investor’s time horizon, the more volatility
(fluctuation) the portfolio can tolerate. Investors with short time horizons usually require more
stable, conservative investments since they will need their money sooner.

For example, a 35-year-old investor who is planning for retirement will normally have a time
horizon of 25 to 30 years, while a 55-year-old investor will usually have a much shorter period
before retirement. Also, the parents of an infant may have nearly 18 years to save for college, while
the parents of a teenager will have far less time.
Frankie and Larry are colleagues at an advertising agency who are both interested in
planning for retirement. Frankie is single, is in his mid-20s, and has an annual salary of
$75,000. Larry, is married with two children in college, is in his mid-50s, and is a senior
vice president earning $250,000. Based on the information provided, which person would
have the shorter time horizon?

Without additional information, the assumption is that Larry would have a shorter time
horizon since he is in his mid-50s and closer to retirement. Based on the number of years he
has left before he retires, his portfolio will typically be more conservative than Frankie’s.

Investment Experience (Sophistication) Previous investment experience provides

insight about a customer’s ability to understand an RR’s investment recommendations and
the accompanying risks. An experienced investor is more likely to be able to understand the
reason for certain recommendations being made. Also, an investor who has purchased
specific products in the past is likely able to comprehend the risks and benefits of the
recommendations of similar investments.

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Risk Risk is defined as the chance taken that an investment’s actual return may be different from
its expected return. Customers will react differently to the concept of risk. The fact that a customer
is able to afford losses does not mean that an investment is suitable. Regulatory agencies and courts
have made it extremely clear that, given all of the circumstances, suitability is dependent on
whether the investment was appropriate for the customer, not simply on whether the customer is
able to afford the losses.

Risk Tolerance The ability of customers to tolerate risk is not based solely on their financial resources;
it also considers their values and attitudes. Two customers with the same financial resources could
perceive risk differently. An RR needs to pay careful attention to what investors say about their tolerance
for risk, since an investment that goes against a customer’s expressed wishes is never suitable.
Doug is a 28-year-old single lawyer who studies the market on his own. He enjoys finding
and researching high-risk investments for his portfolio. Is Doug’s desire for aggressive
investments appropriate?

Since Doug is at the early stage of his career and has no wife or children, he obviously
feels that he can assume greater risks in his portfolio. However, if Doug’s entire portfolio
is composed of aggressive investments, there’s a significant potential for loss. Doug’s RR
should try to convince him that placing all of his money in risky, long-term investments is
not appropriate.
Susan is a 28-year-old doctor who just opened her own practice. In an interview with an
RR, Susan makes it clear that she is disturbed by the thought of taking risks with her
money. Since Susan does not have a high tolerance for risk, should she pursue an
aggressive investment strategy?

Although Susan and Doug are the same age, the RR should recommend a conservative
program for Susan that’s based on her specific risk tolerance.

Unfortunately, some customers may have uncertainty about their attitude toward risk, especially if
they are new to investing. In these situation, some RRs use questionnaires to help the customers
understand their risk preferences. The customer’s answers are then compiled to form a psychological
profile regarding risk tolerance.

Social Values In addition to financial return, many investors are concerned about the social and
environmental impacts of the companies in their investment portfolios. Companies’ policies and
practices with respect to issues such as human rights, global warming, and ethical labor standards
are among the many elements that customers prioritize. Investors may request that the RR follow
socially responsible investment strategies. However, an RR should explain that this may require the
exclusion of some investments and strategies. Based on these restrictions, an RR may not be able to
take advantage of the same market trends or opportunities that would otherwise be available with
other strategies.

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Financial Goals and Investment Objectives

In addition to understanding the current financial profile of his customers, an RR needs to determine
their financial goals. While certain customers may have a wide range of unique goals, there are a
large number of common goals. The financial services industry usually classifies customer goals
into broad categories of investment objectives.

Capital Reserve As a general rule, most persons should commit to establishing a cash reserve
that’s equal to at least three months’ living expenses. In situations where a customer’s income is
unpredictable, it may be wise to maintain a larger cash reserve. Capital reserves should be kept in a
safe, liquid investment such as a money-market fund.

Preservation of Capital Investors who are concerned with the potential loss of capital will invest in
securities that provide safety. Although achieving a return on their investment is desired, they are
more concerned with preservation of capital. In other words, they don’t want to put their principal
at great risk. Customers with this objective often invest in U.S. government securities, insured
certificates of deposit, or money-market funds.

Liquidity Some investors have a significant need to be able to access their funds within a short
period—in other words, they desire liquidity. While money-market mutual funds and T-bills provide
a lower return than other investments, these products are relatively safe and allow investors to have
ready access to their capital.

Current Income Investors whose primary investment goal is current income are interested in
investments that produce a steady, reliable stream of cash. Investors typically need this income to
defray daily living expenses, particularly during retirement. Some examples of income-producing
investments include most bonds, preferred stocks, and fixed annuities. The downside to income
investments is that they usually produce little, if any, growth of the original amount invested. This may
be a problem over time, since inflation erodes the purchasing power of the income.

Growth Customers whose main objective is growth want their capital to appreciate. These
customers usually expect that the capital will grow at a higher rate than other investments,
ultimately outpacing the rate of inflation. Growth investments are often used to increase assets in the
long term for some future use, such as retirement or college expenses. However, these investments
involve a greater risk to principal than income-oriented investments. Common stocks and equity
mutual funds are examples of growth investments.

College Funding Many customers begin an investment program to provide for their children’s
college education. Parents (and grandparents) have some flexibility in their investment choices.
Funds may be invested in Uniform Gifts/Uniform Transfers to Minors Act (UGMA/UTMA) accounts
to be used for education expenses; however, other options include Coverdell Education Savings
Accounts and college savings programs, such as 529 Plans.

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Retirement Funding Today, since life expectancy has increased, a significant goal for many investors
is to have money available for retirement. Investors who plan to retire in their mid-60s will need a
retirement portfolio that will last 20 years or more. When a person is planning for retirement, he
should avoid constructing a portfolio that’s so focused on income and preservation of capital that
he risks having inflation seriously erode the purchasing power of his retirement income over time.
In other words, a client who is focusing on his retirement goals needs to be careful about avoiding
one risk (loss of principal) only to be faced with another (inflation).

The RR should also determine whether the investor is taking advantage of available retirement plans.
Usually, the best strategy for investors is to maximize their contributions to a tax-deferred retirement
plan, such as a 401(k), before they consider investing retirement assets elsewhere.

The goal of saving enough money to live comfortably during retirement is complicated by two
factors—first, income ceases once people retire, and second, even modest inflation may have a
significant impact on the long-term purchasing power of their retirement assets.

Although this is a generalization, most people will need an income that’s equivalent to 70% of their
current pre-tax income when they retire. Keep in mind that individual circumstances may make this
number higher or lower.

In order to help customers achieve their retirement goals, the government has passed legislation creating a
number of different retirement plans that allow investors to save money for retirement on a tax-deductible
and/or tax-deferred basis. These retirement plans will be addressed in a later chapter.

Speculation Investors who indicate speculation as an investment objective are seeking investments
that have the potential for above-average returns. RRs are responsible for disclosing to a customer
that investments offering greater profit potential also carry a higher degree of risk. With these
investments, it’s possible for a customer to lose his entire principal. Some of the speculative activities
may involve day trading in margin accounts or investing in asset classes such as derivatives, hedge
funds, and small- or micro-cap stocks.

RRs should be cautious when recommending speculative investments to customers. The RR must make
certain that customers (1) have sufficient financial resources to bear the loss, (2) understand the
risks involved, and 3) have portfolios that are diversified with less risky investments.

Tax Relief As previously described, some investors have substantial incomes that are subject to
tax at high marginal rates. These customers often search for investments that will provide them with tax
relief. Some investments, such as municipal bonds, produce income that’s tax-exempt (i.e., the
investor is not required to pay federal taxes on the interest). Other investments, such as annuities,
traditional IRAs, and employer-sponsored retirement plans, are tax-deferred (i.e., the investor is not
required to pay taxes on the income that’s produced until a later date).

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Another potential advantage offered by a small number of investments (e.g., limited partnerships)
is that they may provide the customer with tax credits or deductions. A tax credit provides a dollar-
for-dollar reduction of the investor’s tax liability, while a deduction simply reduces an investor’s
taxable income.

Meeting Fiduciary Obligations At times, assets are being invested for the benefit of a third party,
such as a child or incapacitated relative. In these cases, the RR must look at the profile and objective
of the beneficiary, not the person making the ultimate investment decisions.

Regulation of Customer Interactions

Once a customer’s objectives have been established, it’s imperative that the account be handled in
a manner that conforms to accepted industry practices and the rules and regulations of the various
regulatory bodies. The purpose and objectives of these rules are to accomplish the following goals:
 Promotion and enforcement of just and equitable principles of trade and business
 Maintenance of high standards of commercial honor and integrity by member firm personnel
 Prevention of fraudulent and manipulative activities and procedures
 Prevention of unreasonable profits, commissions, or other charges
 Protection of investors and the public interest
 Collaboration with governmental and other agencies to promote fair practices and eliminate
fraud and, in general, to carry out the purpose of FINRA and other registered securities
organizations

Know Your Customer and Suitability

Once an RR has collected all of the background information on his customers, he may begin to
formulate his recommendations. Under industry rules, all recommendations must be suitable based
on the facts disclosed by the customers regarding their other securities holdings, financial situation,
and needs. Remember, the determinant of fair dealings with customers is suitability, not profitability.
A recommendation that results in a significant profit may still be viewed by regulators as unsuitable.
Conversely, a recommendation that results in a significant loss may, in fact, have been suitable.

A broker-dealer must use reasonable diligence to learn the important facts regarding every customer.
This obligation also extends to any person who is authorized to act on behalf of a customer,
including an RR who has been given the authority to enter orders in a customer’s account. Only
after a registered representative understands the financial needs of his customers may the proper
investment recommendations be made.

Suitability Broker-dealers have a suitability obligation to each of their customers. For non-institutional
(retail) customers, broker-dealers and their registered persons must have a reasonable basis for
recommending a transaction or investment strategy. These recommendations must be based on the
information obtained from the customers which is then used to identify their investment profile.

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As a review, a customer’s investment profile includes the following items:

 Age
 Other investments
 Financial situation and needs
 Tax status
 Investment objectives and experience
 Investment time horizon
 Liquidity needs
 Risk tolerance
 Any other information obtained from the customer

While information pertaining to a customer’s investment expertise and prior experience are important
in determining suitability, information regarding a customer’s educational background is not.

The suitability requirements apply to both any recommended transaction (e.g., the purchase of a
specific security) and any investment strategy (e.g., day trading or margin trading). An investment
recommendation should be in the customer’s best interest. Simply receiving the customer’s
acceptance of a recommendation does not relieve the firm of its suitability obligation. This
prohibits RRs from placing their own interests ahead of their customers’ interests. Some examples
of potential suitability violations include:
 An RR whose motivation for recommending one product over another is to receive a large
commission
 An RR whose mutual fund recommendations are designed to maximize commissions, rather
than establishing a portfolio for his customers
 An RR attempting to increase his commissions by recommending the use of margin
 An RR recommending a new issue that’s being heavily promoted by his firm in an effort to keep
his job

FINRA’s suitability rule has the following three main obligations:

1. The reasonable-basis obligation—which requires a member firm and its RRs to have a
reasonable basis to believe that a recommendation is suitable for at least some investors. If the
firm or its RRs don’t understand a product, it shouldn’t be recommended to customers.
2. The customer-specific obligation—which requires a member firm and its RRs to have a
reasonable basis to believe that a recommendation is suitable for a particular customer based
on the customer’s investment profile.
3. The quantitative obligation—which requires a member firm and its RRs to have a reasonable
basis to believe that a series of recommended transactions, even if suitable for a customer, are
not excessive when the customer’s investment profile is taken into consideration.

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Institutional Suitability When dealing with institutional customers, the suitability obligations
may vary based on the nature of the institution. Some of these customers are sophisticated and
manage billions of dollars, while others may be relative novices in the investment process. For a
broker-dealer to determine the extent of its suitability obligations to an institutional customer, it must
consider the following two guidelines:
1. The firm and the RRs servicing the account must have a reasonable basis to believe that the
institutional customer is capable of evaluating investment risks independently, both in regard to
the specific securities and the different investment strategies.
2. The institutional customer must affirmatively state that it’s exercising independent judgment in
evaluating the recommendations.

When conducting business with institutional customers, the reasonable basis and quantitative
obligations standards still apply, but the customer-specific obligation standard does not.

Verification of Investor Accreditation of Sophistication Certain investments require investors to

have a minimum net worth or level of earnings, as well as an understanding of the level of risk and
reward. Investors who satisfy these standards are deemed accredited and sophisticated. Broker-
dealers must verify that customers meet these standards before recommending and allowing them
to invest. Many of these investments generally fall under the guidelines of the SEC’s Regulation D.

Using a principal-based approach, the SEC provides issuers and any broker-dealers that act on
behalf of the issuers with a number of factors to consider when determining the status of the
investor. Some of these factors include the nature of the purchaser and the type of accredited
investor it claims to be, the amount and type of information that the issuer has about the purchaser,
and the nature of the offering (e.g., the minimum investment amount).

The SEC has created the following suggested methods to use when verifying an investor’s accredited
status:
 To review previously filed IRS tax forms and other tax forms (e.g., Form W-2 and Schedule K-1)
in order to determine the investor’s income
 To review bank and brokerage account statements and other statements of assets for the prior
three months to determine the investor’s net worth
 To obtain written confirmation of the investor’s accredited status from broker-dealers,
registered investment advisers, attorneys, and accountants (CPAs)

The SEC does not stipulate that any one of these methods must be used; instead, the requirement is
to take reasonable steps to ensure that the persons to whom the solicitations are being directed are
accredited investors.

Conclusion
This concludes the chapter on the profiling of prospective customers to determine their objectives
and to ensure that all subsequent recommendations are suitable. The next chapter will proceed to
an examination of the documentation requirements to be followed when opening customer accounts
and the various additional issues that impact existing customer relationships.

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 CHAPTER 2

Customer Accounts

Key Topics:

 Customer Account Registrations

 Account Types and Characteristics

 Account Changes and Required Documents

 Account Approval and Restrictions

 CHAPTER 2 – CUSTOMER ACCOUNTS

Chapter 1 described the need for RRs to profile potential customers properly in order to
better understand their needs and desires regarding potential investments. Remember,
under the industry’s Know Your Customer rules, RRs cannot make recommendations prior
to having a solid understanding of their customers’ financial status, investment experience,
investment objectives, and attitudes toward risk. This chapter will cover the documentation
process involved in both the onboarding of new clients to the firm and the different accounts
that may be established.

New Account Documentation

For a registered representative, compliance with securities industry requirements often begins with
collecting and documenting customer information—both when opening and maintaining an
account. Proper record-keeping protects the interests of the customer, the firm, and the registered
representative. When opening a new account, certain information regarding the products a
customer may purchase must be obtained to comply with industry regulations. Also, the USA
PATRIOT Act (discussed later in this chapter) imposes requirements on firms that relate to both the
verification of potential clients’ identities and subsequent monitoring to ensure compliance with
anti-money laundering regulations.

Customer information is collected on a new account form to satisfy regulatory requirements, but
also to help the registered representative and the firm in understanding the client’s investment
objectives and to ensure that suitability concerns are addressed. Industry rules include the know
your customer (KYC) standards that RRs must follow prior to making any recommendations.

It’s to be expected that every firm’s new account form will be slightly different, but all broker-
dealers must collect certain minimum information in order to meet industry standards. As a general
rule, the more an RR is able to determine about a client, the more likely she and the firm will be able
to avoid charges of unsuitable recommendations.

Traditionally, clients open cash accounts in which all trades are paid for in full. If a client wishes to
trade on credit, he will need to open a margin account. Depending on the account being opened
(e.g., a margin account), there may be additional documentation required. Also, depending on the
products being purchased, there may be additional approval or documentation procedures
required (e.g., options or certain low-priced securities).

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Following is an example of a new account form:

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Required and Requested Information

When opening a new account for a customer, FINRA requires the following information to be
obtained:
 The customer’s name and residence
− Although an account may not be opened with a P.O. box as the address, correspondence
may be sent there if a written request is received from the customer
 Whether the customer is of legal age
 The name of the registered representative who is responsible for the account. If multiple RRs
are responsible for the account, a record indicating the scope of each person’s responsibilities
is required. (This provision does not apply to an institutional account.)
 If the customer is a corporation, partnership, or other legal entity, the names of any persons
authorized to transact business on its behalf
 The signature of the partner, officer, or manager (principal) denoting acceptance of the account

Prior to the settlement date of the initial transaction, a registered representative must also make a
reasonable effort (a request must be made) to obtain the following information:
 Social Security number or taxpayer identification number (TIN)
 Customer’s occupation and the employer’s name and address
 Whether the customer is associated with another member firm
 Financial information, such as annual income and net worth
 Investment objectives

The above section (requested information) does not apply to institutional accounts and accounts in
which the transactions are limited to non-recommended investment company shares (e.g., mutual
fund shares). An institutional account is defined as an account of a bank, savings and loan
association, insurance company, registered investment company, a registered investment adviser,
or any person with total assets of at least $50 million.

For discretionary accounts, a firm is also required to maintain a record of the manual signature of
each named natural person and the date on which the person was authorized to exercise discretion.

In practice, FINRA generally considers all of the previous information to be necessary prior to
opening a customer account. However, if a prospective customer refuses to supply any of the
requested information, the RR should (as a matter of good business practice) document the fact
that an effort was made to obtain the data by writing “refused” in the appropriate space. Principals
may decide not to approve an account if they feel a prospect has supplied insufficient information
for their firm to adequately assess a client’s investment objectives and/or suitability issues.

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Required Signatures For standard brokerage cash accounts, only the approving principal must
sign a new account form. Although many broker-dealers have internal house rules that require
customers’ signatures, industry rules do not require clients to sign a new account form when
opening a cash account. However, for clients who intend to open either an option or margin
account, their signatures are required.

Predispute Arbitration Clause Today, many new account forms contain a clause that obligates
customers to submit all disputes with their RR or their firm to binding arbitration. If arbitration clauses
are included in the form, industry rules require them to appear in a certain format with specific
wording. If a firm elects to include a predispute arbitration clause in its new account form, it must
be highlighted and must be preceded by the following disclosures:
 Arbitration is final and binding on the parties.
 The parties are waiving their right to seek remedies in court, including the right to a jury trial.
 Prearbitration discovery is generally more limited than, and different from, court proceedings.
 It’s not required that the arbitrators’ award include factual findings or legal reasoning, and any
party’s right to appeal or seek modification of rulings by the arbitrators is strictly limited.
 Typically, the panel of arbitrators includes a minority of arbitrators who were or are affiliated with
the securities industry.

Immediately before the signature line, there must be a highlighted statement that the agreement
contains a predispute arbitration clause. A copy of the agreement must be given to the customer
and the customer must acknowledge its receipt either directly on the agreement or on a separate
document.

Numbered and Nominee Accounts In order to protect privacy, clients are permitted to trade
under nominee names or use an account number in lieu of their name. However, firms are required
to maintain records regarding the beneficial owners of all such accounts.

Recordkeeping Requirements Both the SEC and FINRA require member firms to retain a record
of any customer account information that’s subsequently updated for at least six years after the
update is made. Firms must preserve a record of the last update to any customer account
information, or the original information if no updates have been made, for at least six years after the
date the account was closed.

Account Registration—Forms of Account Ownership

During the process of a broker-dealer collecting all necessary information, a client must specify the
type of account to be opened. Some of the different forms of account ownership require documentation
that goes beyond the new account form.

Individual Accounts An individual account is opened by and for one person. That person is the only
one who may direct activity in the account unless a third party has been authorized. For example, if a
married person opens an individual account, his spouse is not authorized to execute trades in the
account unless he has granted third-party trading authorization to the spouse.

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Joint Accounts Joint accounts have more than one owner of record. In most cases, any joint owner
may initiate activity in the account. However, when signatures are required (e.g., to transfer
securities), all owners are normally required to sign and any check made payable to the account
may only be drawn in joint names (as the account is titled). New account information should be
obtained for each account owner, not solely for the person filling out the application.

State law generally dictates the forms of joint ownership available, such as:
 Joint Tenancy with Right of Survivorship (JTWROS)
 Tenancy in Common (TEN COM)
 Community Property

Joint Tenancy with Right of Survivorship and Tenancy in Common are the most common forms of
joint ownership. JTWROS accounts are owned by at least two people, where all tenants have an
equal right to the account’s assets and are afforded survivorship rights in the event of the death of
another account holder (often created by spouses). Therefore, if one tenant dies, the ownership of
the account will pass to the remaining tenant without being subject to probate. In a TEN COM
account, each owner has a percentage of ownership and, at the time of death, the deceased
person’s interest passes to his estate.

Community Property Accounts are essentially the same as accounts that are established as JTWROS,
but are only permitted between legally married couples. A Community Property Document must be
completed and these accounts are subject to the laws of the state in which the couple resides.

Be aware that although background information is collected on each owner, all tax reporting data is
listed under one designated tax ID number that belongs to only one of the account owners.

Corporate Accounts For a corporate account to be opened, a registered representative must be

assured that the person opening the account is authorized to do so. This is evidenced by means of a
corporate resolution. The resolution is a document created by the board of directors which appoints
one or more persons to operate the account. (Note: the customer is the corporation, not the person
opening the account.)

If a corporation intends to open a margin or options account, a copy of the corporate charter must
also be obtained. The charter is the document that certifies whether the corporation is authorized
to have such an account.

Activity Corporate Resolution Corporate Charter

Cash Account Trading Yes No
Margin Trading Yes Yes
Options Trading Yes Yes

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Unincorporated Association Accounts These accounts are opened in the name of the owner,
which can be a business name. The ownership of the account is subject to creditors’ claims.

Sole Proprietorship Accounts Sole proprietorships are businesses that are often opened under the
name of the individual owner, although they may in a different business name. Regardless of the
naming, the account is held by the individual and vulnerable to the owner’s personal creditors.

Partnership Accounts To open an account for a partnership, a member firm must collect certain
information from each general (managing) partner. This information includes their name, address,
citizenship, and tax identification number. A partnership agreement must be created which will
specify the partners who are authorized to execute transactions on behalf of the partnership. For
record-keeping purposes, member firms are required to maintain a copy of the partnership
agreement in the account file.

Fiduciary Accounts A fiduciary is defined as a person who acts on behalf of, and for the benefit
of, another person. Examples include executors or administrators of estates, trustees, guardians,
receivers in bankruptcy, committees or conservators for incompetents, and custodians for minors.
In most cases, fiduciaries are required to provide documentation of their authority.

In the past, fiduciaries were obligated to follow either the Prudent Person Standard or legal lists that
states created to identify acceptable investments. Much of the focus of these previous approaches
was on what investments a prudent person of discretion and intelligence would choose for income
and preservation of capital. Today, the Uniform Prudent Investor Act (UPIA) acknowledges that
there should be no categorical restrictions on investments and, instead, it focuses on identifying
investors’ objectives and appropriately diversifying their portfolios.

Trusts In a trust, one person (the trustee) is put in charge of managing the assets for the benefit of
another (the beneficiary). The trustee has legal control of the trust assets, but must manage it in the
interest of the beneficiary. To open a trust account, an RR must obtain the following:
 Evidence of the trustee’s authority to transact business in the account
 A copy of the trust agreement—the legal document that establishes the trust account

The level of control that the individual (creator) has over the assets in the trust is determined by the
type of trust – whether it’s revocable or irrevocable.
 Revocable – Also referred to as a living or inter vivos trust, the individual has the ability to make
any changes in the trust, even cancelling it. The assets don’t transfer until death. This type of
trust does not reduce taxes, but does avoid probate when funded prior to the grantor’s death.
 Irrevocable – Once assets are deposited into the account, the grantor is no longer able to modify
or cancel the trust. This type of trust reduces the donor’s estate taxes and avoids probate.

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 CHAPTER 2 – CUSTOMER ACCOUNTS

Client Authorizations Permitting Third Parties to Trade

There are several other items that may appear on either the new account form itself or in a separate
document.

Trading Authorizations
For another person to be permitted to execute trades in an account (other than the account owner),
additional information and documentation are required. This type of situation may arise if a client
wants to assign a third party to have trading authority.

Examples of third parties frequently include:

 Family members, such as spouses or adult children
 Attorneys
 Investment advisers
 Registered representatives

Trading authorization is a power of attorney (POA) that allows the authorized person to trade the
account. The customer may decide to offer this person either full or limited authorization.

Limited versus Full POA A limited trading authorization permits the authorized person only to
place orders for the account, but not to make withdrawals. With full trading authorization, in
addition to placing buy and sell orders, the authorized person is able to withdraw money and
securities from the account. In either case, the broker-dealer must receive written trading
authorization that’s signed by the account owner prior to permitting the authorized person to trade
the account. The firm should also obtain the signature of each authorized person and the date that
the trading authority was granted.

Durable POA Regular (non-durable) power of attorney terminates if the grantor becomes
incapacitated; however, with durable power of attorney, the third party’s power to manage another
person’s financial affairs continues even if that person becomes incapacitated. Ultimately, if an
account owner becomes incapacitated by a mental or physical ailment, it’s durable power of
attorney that must be in place for another person to be able to exercise discretion in the account.
However, either type of POA is terminated in the event of the grantor’s death.

Discretionary Accounts
When a registered representative is the authorized third party, the account is generally referred to as
a discretionary account. Some firms don’t permit registered representatives to accept discretionary
authority, while most others will permit the RR to accept only limited trading authorization. If the
firm permits discretionary accounts, a principal must accept the discretionary authorization in
writing before it becomes effective. Each discretionary order must be approved by a principal
promptly (i.e., on the day of the trade) and the account’s activity must be reviewed frequently.

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One area of concern in discretionary accounts is excessive trading—also referred to as churning.

When investigating allegations of excessive trading, the most important element in the process is to
examine the investment objectives of the customer, followed by the number and size of
transactions. A customer’s investment objectives are instrumental in guiding a registered
representative’s decisions and should always be considered prior to making recommendations.
Frequent trading may be acceptable in the account of a day trader, but inappropriate for many
other investors. Remember, to determine if there is evidence of churning it’s the frequency of
trading that matters, not whether the client lost money.

With discretionary accounts, the authorized third party generally is not required to obtain the
account holder’s permission prior to executing any transactions. However, if a member firm is
selling its own stock to the public and it wishes to place some of the stock in the account of a
customer for whom the member firm holds discretionary authorization, it must obtain prior written
consent from the customer to execute the trade.

Time/Price Exception In some cases, a registered representative may accept a customer’s verbal
authorization to make certain decisions without it being considered discretionary. If a customer
indicates (1) the specific security (asset), (2) whether it’s to be bought or sold (action), and (3) the
number of shares or other units to be bought or sold (amount), but leaves discretion only as to the
time and/or price of execution, this is not considered a discretionary order and written authorization is
not required. Remember, if a customer specifies the three order details that start with the letter “A”
(asset, action, and amount), the order is not considered discretionary.

These orders that provide time and/or price discretion, often referred to as not-held orders, are limited
to the trading day for which the order was placed and must be noted on the order ticket. A client must
give her RR written instructions if the not-held order is to remain in effect for more than one day.

Authorized Activities Document Required

Trades Only Limited POA

Trading, deposits, and/or

Full POA
withdrawals of funds

Not-Held Orders (for one day) None

In addition to the previously described industry rules that pertain to the opening of a new account,
federal law has obligations and procedures with which firms are expected to comply. These
requirements will be covered later in this chapter.

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 CHAPTER 2 – CUSTOMER ACCOUNTS

Special Client Arrangements

Prime Brokerage Accounts One service that may be offered by some brokerage firms is the prime
brokerage arrangement. This prime brokerage service involves a clearing firm offering a bundled
package of services to sophisticated clients. The clearing firm acts as a centralized location for
holding the customer’s securities positions that are created by several executing firms through
which the client trades.

Prime brokerage clients include hedge funds, institutions, and high net worth individual clients.
Prior to prime brokerage, these clients were required to open separate accounts at each executing
broker-dealer that they used. For all trades that were executed, the broker-dealers would then
provide confirmations and statements to the client. The client would ultimately be required to
combine the information it received from its various accounts to understand its overall position.

In a prime brokerage arrangement, a client selects one firm as its prime broker to essentially
consolidate the bookkeeping process. The client still uses several broker-dealers for reasons such as
their execution capabilities, research services, and access to IPOs, but all trades are ultimately
handled through an account that’s maintained with its prime broker.

The following picture provides a simplified example of the prime brokerage relationship:

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Benefits Prime brokerage provides several benefits to large, active customers. It enables clients to
centralize their clearing and custodial services, and allows them to receive one set of comprehensive
reports regarding their portfolios. For those customers who use margin accounts, the concentration
of margin positions in one single account lowers the client’s cost of funds.

Investment Adviser Accounts Most investment advisers are registered with the SEC or at least
one state and are often referred to as registered investment advisers (RIAs). Investment advisers that
provide portfolio management services often buy and sell securities for their clients on a
discretionary basis. An RIA may open one account with a broker-dealer that contains all of its
advisory clients’ assets or it may have each client establish a separate account with a broker-dealer
and have the client provide the adviser with third-party trading authorization. In either case, the
client must provide written authorization for the adviser to transact business in the account.

Wrap Accounts The term wrap account refers to an account in which one fee—usually ranging
from 1 to 3% annually—is charged by a broker-dealer for a number of services being provided. The
fee is used to cover administrative, portfolio management, and transaction costs. A wrap account is
usually offered by a broker-dealer, but managed by an investment adviser. The appropriate client
for a wrap account is a person who is interested in trading frequently.

Account Registration Changes and Internal Transfers

Account Registration Changes Situations may require a change to the registration of an account.
This could be the result of death, divorce, or simply the transfer of securities to another individual.
Changes may require the following:
 Changes resulting from a marriage or divorce require a marriage certificate, divorce decree, or
court document. Driver’s licenses are usually not acceptable due to the risk of fraud.
 In order to add or remove a person from an account, the birth date, social security number, and
contact information for the person being added is required. In addition, both parties must sign
and submit the appropriate forms.
 A principal must approve and document all changes before any transactions are executed in the
account.

Internal Transfers There are times when customers may want to transfer securities to another
individual’s account. When doing so, a stock transfer must be completed and all parties on the
account must approve of the transfer.

Customer Screening
The Bank Secrecy Act (BSA) is the primary U.S. anti-money laundering (AML) law and has been
amended to include certain provisions of the USA PATRIOT Act to detect, deter, and disrupt
terrorist financing networks. The Act imposes a number of new regulatory obligations on broker-
dealers including verifying the identity of individuals who intend to open accounts.

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Customer Identification Program (CIP) As a part of their AML compliance program, broker-
dealers must create a customer identification program in order to verify the identity of any person
who seeks to open an account. Firms must also maintain records of information that’s used to
verify a person’s identity and determine whether the person is listed as a known or suspected
terrorist or an affiliated organization.

Individuals on Governmental Lists Firms and their representatives must make certain that they
are not doing business with anyone on a list that’s maintained by the Treasury Department Office
of Foreign Assets Control (OFAC). The OFAC List identifies known and suspected terrorists, other
criminals, as well as pariah nations. Doing business with any of these individuals or entities is
prohibited. If a firm discovers that one of its clients is on the OFAC List, it must block all
transactions immediately and inform the federal law enforcement authorities.

Broker-dealers are required to exercise special due diligence when opening private banking
accounts for foreign nationals. They are also prohibited from maintaining correspondent accounts
for foreign shell banks (i.e., banks with no physical presence in any country).

Customer Verification A broker-dealer must verify a customer’s identity within a reasonable

period either before or after the customer’s account is opened. Under the new regulations, the
following minimum information is required to be obtained from a customer (the information is
slightly different from what FINRA requires):
 Name
 Date of birth (for an individual, not a business)
 Address (For an individual this must be a residential or street address. For other corporate
accounts, it must be a principal place of business or local office.)
 An identification number:
− For U.S. citizens: taxpayer ID number (e.g., Social Security number or employer
identification number)
− For non-U.S. citizens: taxpayer ID number, passport number and country of issuance,
alien identification card number, or government-issued identification showing
nationality, residence, and photograph

A broker-dealer may use documentary or non-documentary methods in order to verify the identity
of a customer.

Taxpayer ID Exception A broker-dealer that receives an application to open an account may

waive the obligation of obtaining a taxpayer ID number provided the person has applied for, but
not yet received, the number. However, in lieu of the number, the broker-dealer must retain a copy
of the person’s taxpayer identification application.

Record Retention A broker-dealer must maintain records of the methods it used to verify a
customer’s identity for five years following the closing of the account.

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Verification of Client Information

Account Information
To ensure that an RR has characterized a client’s profile and investment objective properly, copies of the
account record or documentation of the information collected must be sent to the customer either within
30 days of opening the account or at the time the client’s next statement is sent. Periodic updates of
account information must be sent to the customer at least every 36 months thereafter. Definitions of any
terms that are used to describe investment objectives should also be included in these mailings.

Tax Information Securities industry rules state that a registered representative must request a
client’s Social Security or tax ID number. However, if a client fails to provide this number, he may
be subject to backup withholding. Many firms have their own house rules that prohibit the opening
of an account without this number.

Interestingly, customers are typically asked to sign a W-9 certification which may be a separate document
or a part of the new account form. This certification attests to the fact that the Social Security or tax
ID number being provided is accurate and that the customer is not subject to backup withholding.
Under IRS rules, any customers who are subject to backup withholding are responsible for informing
the broker-dealer of this fact. Non-resident aliens and foreign entities that are not subject to backup
withholding must complete IRS Form W-8 (Certificate of Foreign Status).

SEC Regulation SP
Privacy of Consumer Financial Information In November 1999, the Gramm-Leach-Bliley Act was
enacted to require institutions that are engaged in certain financial-related activities to (1) establish
privacy policies with regard to information they collect regarding customers, (2) notify customers of
those privacy policies, and (3) give customers the right to opt-out of any disclosures of their
non-public personal information to certain third parties (i.e., customers may instruct the financial
institution that their information may not be disclosed to unaffiliated third parties). The SEC
adopted rules to implement these privacy requirements under Regulation SP which applies to all
broker-dealers, investment companies, and SEC-registered investment advisers.

Scope of Information That Must Be Protected Remember, Regulation SP is protecting a

customer’s non-public, personal information which includes information obtained from the
customer or from customer lists that are created from personally identifiable information (i.e.,
personal financial and account information). However, disclosure of a customer’s publicly available
information is not restricted under the regulation. Publicly available information includes that
which is lawfully available to the general public from official public records, information from
widely distributed news media (e.g., generally accessible websites or newspapers), and information
that’s required to be disclosed to the general public by federal, state, or local law.

Privacy Notice Under Regulation SP, firms must provide their customers with a description of
their privacy policies (a privacy notice). Among other things, these privacy notices must state the
types of personal information that the firm collects and the categories of both affiliated and
unaffiliated third parties to whom the information may potentially be disclosed.

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The timing of the notice depends on the client’s relationship with the firm. Regulation SP divides
clients into two categories—customers and consumers. A customer is a person who has an ongoing
relationship with the firm. A consumer is a person who is in the process of providing information to
the firm in connection with a potential transaction.
For example, if John has a meeting with a financial adviser from ABC Securities about
establishing a financial plan, he is a consumer (a potential customer). However, if John
opens an account with ABC Securities, he is a customer.

Firms must initially provide every customer with a privacy notice at the time the relationship is first
established. Thereafter, they must follow up with an updated version of this notice annually. For
consumers, a firm must provide a privacy notice before it discloses non-public, personal
information to any unaffiliated third party. However, if the firm does not intend to disclose any
consumer information to an unaffiliated third party, then a notice is not required to be provided.

The notice must disclose to customers-consumers that they have the right to opt out of having their
information shared with unaffiliated third parties and the process for opting out. The opt out
method being used by a broker-dealer must be reasonable. Acceptable methods include electronic
responses or a toll-free telephone number for customers to call; however, requiring a customer to
write a letter is unreasonable.

Identity Theft Prevention—FTC Red Flags Rule The Federal Trade Commission’s (FTC) Red
Flags Rule requires many financial institutions, such as banks and broker-dealers, to create and
implement a written Identity Theft Prevention Program. The program must be designed to detect,
prevent, and mitigate identity theft. Each firm must have policies and procedures that address the
appropriate actions to take if identity theft is suspected and/or detected. The intent of the rule is to
assist firms in quickly spotting suspicious activities (red flags) with the goal of preventing the theft
of their clients’ assets. All of the policies and procedures that are found under these programs must
be referenced in a firm’s Written Supervisory Procedures documentation.

Use of Stockholder Information for Solicitation As indicated by Regulation SP and the FTC Rule,
firms and their RRs are responsible for protecting their client’s information. That being said, may a
firm that’s acting as a trustee for a corporation use a shareholder list to cold-call or prospect in
other matters? Generally, this practice is a violation of industry rules. SRO rules don’t allow a trustee
to use stockholder information for solicitation purposes unless the member firm is specifically
directed to do so by, and for the benefit of, the corporation.

Reporting Requirements and Limitations on Insiders

As defined by the Securities Exchange Act of 1934, an insider is any director, officer, or owner of
more than 10% of the voting stock of a corporation and his immediate family members. Within
10 days of becoming an insider, a person is required to report to the SEC on Form 3. An insider is
required to file Form 4 to report any changes in his stock position by the second business day
following the change.

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Trading Limitations Insiders are not permitted to keep short-swing profits in any stock of a
corporation for which they are insiders. A short-swing profit is the result of an insider selling her
stock at a profit within six months of its acquisition. For violations of the rule, the corporation may
sue for recovery of the profit (a process that’s referred to as disgorgement). This restriction also applies
if an insider sells stock that was held longer than six months and then, within six months of the sale,
repurchases it at a lower price than the previous sale price.

Insiders are not permitted to sell short the stock of the company for which they are insiders.
However, on certain occasions, some insiders may use a technique referred to as shorting against
the box (i.e., executing a short sale against a long position that’s held elsewhere) to ensure the timely
delivery of securities that may be in legal transfer.

Insiders may write (sell) covered calls (i.e., selling calls against stock that they already own), but
may not sell calls that are uncovered. On the other hand, corporations may not sell calls on their
own stock under any circumstances.

Accounts at Other Broker-Dealers and Financial Institutions

For supervisory reasons, member firms are required to monitor the personal accounts that their
employees (both clerical and registered persons) open or establish with a firm other than the one at
which they are employed. For example, if a registered person of ABC Brokerage approaches another
financial institution in an attempt to open an outside (away) account to trade securities, both the
employee and the firm must observe special rules prior to the account being opened. For purposes
of this rule, the term financial institution refers to a broker-dealer, investment advisor, bank,
insurance company, trust company, or investment company.

Employee Requirements Employees who intend to open outside accounts in which securities
transactions may be executed are required to obtain the prior written consent of their firm. In
addition, before an outside account is opened, the employees are required to provide written
notification to the executing firm of their association with another member firm.

Related and Other Persons This rule also applies to any account in which securities transactions
can be executed and in which the employee has beneficial interest, including those held by:
 The employee’s spouse
 The employee’s children (provided they reside in the same household as, or are financially
dependent on, the employee)
 Any related person over whose account the employee has control, and
 Any other individual over whose account the employee has control and to whose financial
support the employee materially contributes

Previously Opened Account If an employee had opened an account prior to the time that he
became associated with a broker-dealer, the employee is required to obtain the written consent of
his employer within 30 days of the beginning of his employment in order to maintain the account.
Also, the employee is required to provide written notification to the executing firm of his
employment with another broker-dealer.

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Once an account has been opened for a member firm employee, the executing firm is not required
to obtain the employing firm’s approval prior to the entry of each order. However, the employee’s
activities are subject to any rules or restrictions that have been established by his employing firm.

Executing Broker-Dealer Requirements Upon written request, the executing firm is required to
send duplicate copies of confirmations, statements, or any other transactional information to the
employee’s broker-dealer.

Exemptions The requirements of this rule don’t apply to accounts that are limited to transactions
involving redeemable investment company securities (mutual fund shares), unit investment trusts,
variable contracts, or 529 plans.

Approving Customer Accounts

All new accounts must be approved in writing by a registered principal. The type of securities being
purchased in the account will dictate the principal who approves the account. For example, a General
Securities Principal (Series 24) is responsible for approving accounts in which corporate securities,
mutual funds, and variable annuities are being purchased. In addition, the General Securities Principal
is also responsible for monitoring and enforcing the firm’s written supervisory procedures (WSP).
When municipal securities are being purchased, a Municipal Securities Principal (Series 53) must
approve and monitor the account. For accounts in which options will be purchased, a Registered
Options Principal (Series 4) is responsible for approving and monitoring the activity in the account.

Account Restrictions
In certain situations, restrictions may need to be placed on a customer’s account. This may be due
to conflicts of interest that don’t allow the individual to establish long or short positions in certain
securities. Other circumstances may arise due to the client’s failure to pay or deliver securities on a
timely basis.

The Federal Reserve Board (FRB) requires that payment be made for purchases in a cash and
margin accounts within two business days of settlement (S + 2), which is also considered no more
than four business days after the trade date (T + 4). If a valid reason exists, payment extensions can
be granted by FINRA. However, if no payment is made and no extension granted, the position is
closed on the third business day following settlement. As a result, the account is frozen for 90 days,
during which payment or delivery must be obtained prior to accepting an order.

Conclusion
This ends the chapter on the information required for opening customer accounts, as well as the
different types of accounts. The next chapter will focus on customer communications with an
emphasis on identifying the differences between correspondence, retail communication, and
institutional communication.

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 CHAPTER 3

Customer
Communications

Key Topics:

 Communication Standards

 Types of Communications

 Product Specific Advertisements

 CHAPTER 3 – CUSTOMER COMMUNICATIONS

This chapter will explain the general standards that apply to customer communications, the
different types of communications, as well as the approval and filing requirements. Details
regarding the disclosures related to specific products (e.g., mutual funds and variable
products) will also be reviewed.

Communication Standards
In their efforts to protect the public, regulators have strict rules governing the use of advertising, sales
literature and other means of promoting the products and services of broker-dealers. These include:
 Providing a basis for evaluating investments, being fair and balanced, and being based on fair
dealing and good faith
 Not containing false, exaggerated, or misleading claims
 Being clear and balanced as to the risks and potential benefits
 Being considerate of the audience to which the communication is directed
 Not predicting or projecting performance, or implying that past performance will be repeated

While all securities are subject to the same essential standards, each SRO adopts specific rules that
focus on the securities under its regulations. These will be reviewed these throughout this chapter.

FINRA’s Communication Rules

FINRA divides communications with the public into three major categories—correspondence,
institutional communication, and retail communication. For exam purposes, part of the challenge
is being able to distinguish between the different forms in situational questions.

Correspondence Traditionally, correspondence has been viewed as any communication being

sent to one person. However, FINRA’s current definition is more precise. Correspondence is
defined as written or electronic messages that are sent by a member firm to 25 or fewer retail
investors within any 30-calendar-day period. The 25 or fewer investors may be any type of retail
client (i.e., existing or prospective). The typical delivery methods include physical (paper) written
letters, text messages, and e-mail.

Institutional Communications This category includes any type of written or electronic

communication that’s distributed or made available only to institutional investors, but does not
include a member firm’s internal communications. FINRA defines institutional investors as:
 Banks, savings and loans, insurance companies, registered investment companies, and
registered investment advisers
 Government entities and their subdivisions
 Employee benefit plans, such as 403(b) and 457 plans, and other qualified plans with at least
100 participants

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 Broker-dealers and their registered representatives

 Individuals or entities with total assets of at least $50 million
 Persons acting solely on behalf of these institutional investors

Under FINRA rules, a member firm must establish policies and procedures that are designed to
prevent institutional communications from being forwarded to retail investors. One acceptable
method is placing a legend on the communication stating “For Use by Institutional Investors Only.”
If a member firm becomes aware that an institutional investor (e.g., another broker-dealer) is
making institutional communications available to retail investors, the firm is required to treat
future communications to that institutional investor as retail communications.

Retail Communications This category is defined as written or electronic communications that are
distributed or made available to more than 25 retail investors within a 30-calendar-day period. A retail
investor is considered any person who does not meet the definition of an institutional investor.

Retail communications are the broadest category and include both advertising and sales literature.
All materials that are prepared for the public media in which the ultimate audience is unknown are
considered retail communications including:
 Television, radio, and billboards
 Magazines and newspapers
 Certain websites and online interactive electronic forums, such as chat rooms, blogs, or social
networking sites (assuming retail investors have access to these sites)
 Telemarketing and sales scripts
 Independently prepared reprints (e.g., newspaper or magazine articles) that are sent to more
than 25 retail investors

E-Mail and Instant Messaging A challenging aspect to e-mail and instant messages is that they may
ultimately be considered correspondence, retail communications, or institutional communications.
For example, e-mail that’s sent only to registered investment advisers (i.e., institutional investors) is
considered institutional communication. E-mail that’s sent to 25 or fewer retail investors is
considered correspondence, and finally, e-mail that’s sent to more than 25 retail investors is
considered retail communication.

Social Media Sites Social media sites fall under the requirements of a public appearance and
certain disclosures may be required. Since firms may be unable to monitor their RRs’ activities on
these sites, most firms don’t permit their representatives to use them for communicating with
customers or conducting business.

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Communications—Internal Review Procedures

Internal Review and Retention Rules Correspondence and institutional communications are
required to be supervised and monitored by the member firm, but need not be approved by a
principal prior to use. However, as a general rule, retail communications must be approved by a
qualified principal. This principal approval must be obtained either before the communications are
released to the public or before they are filed with FINRA—whichever event comes first.

Firms are not only required to maintain a file containing all approved communications for three
years after the last date of use, but these communications must also be maintained in an easily
accessible location for the first two years. The file must contain copies of the communications, the
dates of first and last use, the name of the approving principal, and the date on which approval was
given. In the event that a specific form of retail communication is not required to receive principal
preapproval, the name of the person who prepared or distributed the communication must be
maintained by the member firm for three years from the date of last use.

Retail Communications Approval Remember, many retail communications must be approved

prior to first use by an appropriately approved and qualified registered principal (typically a Series 24
or Series 9/10 registered person). A Supervisory Analyst, who is qualified with a Series 16
registration, may approve research reports concerning debt and equity securities as well as other
research-related communications. Certain other forms of retail communications must be approved
by supervisors who have specific registrations. For example, any communication that pertains to
options will require the approval of an options principal (a Series 4 registered person).

In the following circumstances, retail communications don’t require principal pre-approval:

 Another firm has previously filed the communications with FINRA and it has not been materially
altered.
 The communication was posted on an online interactive electronic forum (social media).
 The communication does not make a financial or investment recommendation, it does not
promote the firm’s products or services, and it’s not a research report.

This last exception applies to most routine communications between registered representatives
and their customers and to market letters since they are not considered research reports. Although
they are not required to be pre-approved, firms must still monitor these retail communications in
the same way that they handle correspondence. Generally, if retail communications are not
required to be pre-approved, then they are also not required to be filed with FINRA.

FINRA Filing and Review Requirements

Correspondence and institutional communications are not required to be filed with FINRA, but
they are subject to spot-checking by FINRA. However, more emphasis will be placed on the
handling of retail communication.

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Retail Communications Depending on the content of retail communications, some are required
to be filed with FINRA 10 business days prior to their first use, while others are required to be filed
within 10 business days of their first use. If pre-use filing is required, firms may not use the material
until it’s in a form that’s acceptable to FINRA.

For its first year as a FINRA member, a new brokerage firm is required to file with FINRA all broadly
disseminated retail communications 10 business days prior to their first use. The term broadly
disseminated refers to materials that have been created for generally accessible websites, the print
media, or television or radio. FINRA may also require any firm that has had disciplinary issues to file
some or all of its communications 10 business days prior to use.

Some of the additional forms of retail communications that must be filed with FINRA at least 10
business days prior to their first use include materials that pertain to:
 Registered investment companies that include rankings or comparisons which have been created
by the investment company itself
 Security futures
 Bond mutual funds that include volatility ratings

On the other hand, retail communications that pertain to the following products must be filed with
FINRA within 10 business days of being published:
 Registered investment companies (provided the material does not include fund-created rankings or
comparisons). This category includes mutual funds, closed-end funds, exchange-traded funds, unit
investment trusts, and variable products.
 Publicly traded direct participation programs (DPPs)
 SEC-registered collateralized mortgage obligations (CMOs)
 Any security that’s registered with the SEC and derived from or based on a single security, a basket
of securities, an index, a commodity, a debt issuance, or a foreign currency. This includes publicly
offered structured products (e.g., exchange-traded notes [ETNs]).

Filing of Television or Video Retail Communications If a broker-dealer has previously filed a

draft version or storyboard of a television or video retail communications, it must also file the final
filmed version within 10 business days of first use or broadcast.

Date of First Use and Approval Information With each filing that’s made to FINRA, a member
firm is required to provide the name, title, and Central Registration Depository (CRD) number of
the registered principal who approved the retail communications along with the date on which the
approval was given.

Spot-Check Procedures All of the written and electronic communications that are created by a
member firm may be subject to spot-check procedures. FINRA may request that certain
communications be submitted within a time frame that’s specified by FINRA’s Advertising Department.

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Exclusions from the Filing Requirements

The following types of communications are not required to be filed with FINRA:
 Correspondence and institutional communications
 Retail communications that have been previously filed with FINRA’s Advertising Department
and are being used without material changes
 Retail communications that don’t make a financial or investment recommendation and don’t
promote a product or service of the member firm. This broad category is also exempt from the
principal pre-use approval requirement and includes:
– Recruitment advertising
– Advertising that relates to changes in a broker-dealer’s name, personnel, electronic or
postal address, ownership, office, business structure, officers or partners, or telephone
number
– Advertising that relates to a merger with or acquisition by another member firm
 Retail communications that simply identify a member firm’s national securities exchange
symbol, identify a security for which the member is a registered market maker, or identify that
the member firm offers a specific security at a stated price
 Tombstone advertisements, mutual fund profiles, and prospectuses that have been filed with
the SEC
 Press releases that are made available only to the media
 Any reprint or excerpt of an article or report that’s issued by a publisher, provided the publisher
is not affiliated with the member firm or issuer of the securities that’s being mentioned in the
reprint and neither the member firm nor the issuer of the securities that’s being mentioned in
the reprint has commissioned the reprint
 Communications that simply refer to types of investments as part of a listing of products and
services that are offered by the member firm

Communications Regarding Investment Companies

There are numerous requirements regarding communications with the public that relate to
investment companies. This section details the provisions that are most likely to be encountered by
a Series 6 candidate.

Omitting Prospectuses (Rule 482) Under specific conditions, there are investment company
advertisements that may be published because they technically meet the definition of a prospectus.
These advertisements are referred to as omitting prospectuses. This form of prospectus omits in part
or summarizes the information that’s contained in the statutory prospectus. As was true of
tombstone advertisements, this form of prospectus may not contain an application to invest.
Essentially, Rule 482 is the primary advertising rule for mutual funds and, in particular, mutual fund
performance may be included in the advertisement if specific standards are followed.

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General Required Disclosures A 482 advertisement must disclose:

 That investors must carefully consider the investment objectives, risks, charges, and expenses
of a mutual fund before investing.
 That the prospectus contains these details about the mutual fund.
 That the prospectus should be read carefully before investing.
 The source from which an investor may obtain a prospectus.

Performance Information Disclosures If a 482 advertisement includes performance information, it

must disclose:
 That the performance data being quoted represents past performance and that past
performance does not guarantee future results.
 That an investment’s return and principal value will fluctuate; therefore, when shares are
redeemed, they may be worth more or less than their original cost.
 Either a toll-free phone number or a website from which an investor may obtain performance
data that’s current to the most recent month-end.
 Whether a sales load or other non-recurring fee is charged, the maximum amount of the load or
fee and, if not reflected, that the performance data does not reflect the sales load deduction.

All of the required performance information and fee disclosures must be clearly and prominently
displayed. Also, standardized performance information must be presented in a font size that’s at
least as large as that which is used for non-standardized performance information. For fund
advertisements that show average annual total return, they must present the following time periods:
 One year for investment companies in existence for at least one year
 One and five years for investment companies in existence for at least five years, and
 One, five, and 10 years for investment companies in existence for at least 10 years

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Below is an example of an omitting prospectus:

ACROPOLIS INTERNATIONAL GROWTH FUNDS

Taking a global point of view can help you reach the investing summit.*

1 Year 5 Years 10 Years

22.31% 14.75% 10.57%
Please ask for a prospectus with more complete information, including charges,
expenses, and minimums. Be sure to read it carefully before you invest or send money.

Average annual total returns as of 12/31/14. Past performance is no guarantee of future

results. The performance of the fund may be different than the figures shown due to market
volatility.
Unusually favorable market conditions prevailed during the period shown. The performance
of the fund might not be repeated or consistently achieved in the future. Data represented
reinvestment of all dividends and capital gains distributions. Performance shown is for Class A
shares. For more information about other share classes, consult the prospectus. Investment
returns and principal value will fluctuate, and redemption value may be more or less than
original cost.

For a free prospectus, call * International investments are

1-800-555-1212 or contact subject to special risks such as
your registered representative. currency fluctuations or political
instability.

SEC Rule 156—Investment Company Sales Literature

Once an investment company’s registration is declared effective, it may use written sales materials,
provided the materials are accompanied by, or preceded by, a current prospectus. Any sales
literature that’s used by an investment company must meet the standards of SEC Rule 156.

Under Rule 156, sales literature is defined as any communication that offers to sell or induces the
sale of shares in an investment company. This includes all written materials, as well as anything
prepared for television, radio, or the Internet. Communications between issuers, underwriters, and
dealers may also be considered sales literature if there’s a reasonable expectation that the materials
may be directed to prospective investors, or that the information contained in these
communications may be given to investors in the course of selling the fund’s shares.

Rule 156 states that it’s unlawful for an investment company to sell its shares using sales literature
that’s materially misleading. Sales literature is considered materially misleading if it:
 Contains an untrue statement of a material fact or
 Omits a material fact that’s necessary to prevent the statement from being misleading

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Whether a particular statement is misleading is determined by the context in which it’s made. Sales
literature may be misleading if it fails to properly explain, qualify, or limit the claims that it makes
about the investment, or fails to mention the importance of general economic or financial conditions.
Funds must also ensure that all of their sales literature is current, complete, and accurate.

Past Performance If not properly qualified, representations about a fund’s past or future
performance may easily mislead investors. Providing portrayals of the income that a fund has
generated in the past or of the way its assets have grown may also be misleading. To avoid this
problem, most investment company sales literature discloses that past performance is not
indicative of future returns.

Generally, funds are required to report one-, five-, and 10-year performance figures. However, if a
fund has not been in existence for 10 years, it must show one-year, five-year, and life of the fund
performance figures. Performance figures are always reported after fees are deducted, but before
taxes are paid.

Characteristics and Attributes Statements about the characteristics or attributes of an investment

company may also be misleading. Therefore, positive statements about possible benefits must be
balanced with equally prominent statements about risks or limitations. Funds should not make
exaggerated or unwarranted claims about the skill of their managers or their investment techniques.
Also, they should not make unwarranted or insufficient comparisons between the fund and other
investments or indexes.

Statements about a fund’s investment objectives may lead investors to believe that these goals are
certain to be achieved. For this reason, funds often disclose that there’s no guarantee that their
investment objectives will be met.

Misleading Fund Names The SEC amended the Investment Company Act to prohibit fund names
that were likely to mislead investors. Under these rules, a registered investment company whose name
suggests that it focuses on a particular type of security or industry must invest at least 80% of its assets
in those securities. For example, a fund that’s listed as the ABC Stock Fund must invest 80% of its assets
in stocks, while a fund listed as the XYZ Bond Fund must invest at least 80% of its assets in bonds.

Under normal circumstances, a fund with a name implying that it concentrates on the securities of a
specific country or geographic region must invest at least 80% of its assets in the securities of that
country or region. Also, a fund with a name suggesting that its distributions are tax-exempt must
invest at least 80% of its assets in tax-exempt investments.

Finally, these rules prohibit funds from using names suggesting that they have the guarantee or
approval of the U.S. government. A name that uses the words guaranteed or insured, or anything
similar in conjunction with United States or U.S. government, is considered misleading and deceptive.

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Use of Investment Companies’ Rankings in Retail Communications

Investment companies that receive superior performance rankings relative to their peers may decide
to emphasize this fact in their retail communications. FINRA has created guidelines on the use of
rankings in communications with the public to prevent the misuse of this type of information. If an
investment company uses a ranking symbol rather than a number in its communications, the
symbol must be explained. These rules don’t apply to a reprint or excerpt of an article or report
that’s issued by a publisher, provided the publisher is not affiliated with the member firm or issuer of
the securities mentioned in the reprint and neither the member firm nor the issuer of the securities
mentioned in the reprint has commissioned the reprint (i.e., independently prepared reprints).

Ranking Entity Members firms may not use investment company rankings in retail
communications other than (1) rankings created and published by ranking entities, or (2) rankings
created by an investment company or an investment company affiliate, but based on the
performance measurements of a ranking entity. A ranking entity is defined as an organization that
provides the public with general information about an investment company, is independent of the
investment company and its affiliates, and has not been hired by the investment company or its
affiliates to assign the fund a ranking (e.g., Morningstar).

SEC Standardized Yields For rankings based on yield, the SEC has established two standardized
yields that must be used. Money-market funds are required to use a seven-day standardized yield,
while bond funds are required to use a 30-day standardized yield. In addition, any rankings that are
based on total return must be accompanied by these yield rankings.

Required Disclosures Headlines or other prominent statements in any form of communication are
prohibited from stating that an investment company or investment company family is the best
performer in a category unless it’s actually ranked first in the category. All retail communications
containing an investment company ranking must disclose:
 The name of the category (e.g., growth, asset allocation, balanced)
 The number of investment companies in the category
 The name of the ranking entity
 The length of the period (or the beginning and ending date of the period)
 The criteria (total return or yield) on which the rankings are based
 The fact that past performance is no guarantee of future results
 For investment companies that assess front-end sales loads, whether the ranking takes those loads
into account
 Whether the ranking is based on total return or the current SEC standardized yield
 The publisher of the ranking data (i.e., the name of the magazine), and
 Whether the ranking consists of a symbol (a star system) rather than a number, and if so, an
explanation of the symbol’s meaning must be provided (e.g., a five-star ranking indicates that the
fund is in the top 10% of all investment companies)

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Multiple Class/Two-Tier Funds If investment company rankings are being used for more than
one class of investment with the same portfolio (Class A and B shares), the retail communication
must provide a prominent disclosure of this fact.

Bond Mutual Fund Volatility Ratings

Bond mutual fund volatility ratings are descriptions that are issued by an independent third party
to measure how sensitive a bond fund’s NAV is to changes in economic and market conditions. The
evaluation is based on objective factors, such as the credit quality of the fund’s individual portfolio
holdings, the market price volatility of the portfolio, the funds’ performance, and specific risks (e.g.,
interest-rate risk, prepayment risk, and currency risk).

A firm may only use bond volatility ratings in its supplemental sales literature, but not in
advertisements that are intended for public dissemination. However, the supplemental sales literature
may only be used if a prospectus for the bond mutual fund has been or will be sent to the customer and
if the following conditions are satisfied:
 The rating may not identify or describe volatility as a risk rating
 The supplemental sales literature must incorporate the most recently available ratings
 The criteria and methodology used to determine the rating must be based exclusively on objective
and quantifiable factors
 The entity that issued the rating must provide detailed disclosure on its rating methodology to
investors through a web site or toll-free number

The sales literature must also contain a disclosure statement that includes the following
information:
 The name of the rating entity
 The most current rating and the date of the current rating
 A description of the rating that includes the methodology behind the rating, whether the fund
paid for the rating, and the types of risks the rating measures

The disclosure statement must also indicate that (1) there’s no standard method for determining
bond fund volatility ratings, (2) the fund’s portfolio may have changed since the date of the rating,
and (3) there’s no guarantee that the fund’s rating will remain the same.

Communications Regarding Variable Products

FINRA has established special guidelines for written materials that are used to sell variable products
to the public. Since registered representatives often prepare customized illustrations for customers
who are interested in variable products, these guidelines also apply to individual communications
that are provided to clients such as letters, e-mails, and computer-generated illustrations.

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Identification as an Insurance Product All communications with clients must clearly identify the
product being described as a variable annuity or variable life insurance policy. Many companies use
proprietary names for their products which may inadvertently confuse investors about the product
they are buying. For example, if an insurance company issues a variable life insurance policy and
calls it the “Still Standing Policy,” the company is required to include a statement in its advertising
to clearly identify this product as life insurance. However, if the policy was called the “Still Standing
Variable Life Insurance Policy,” then no additional description is necessary.

Since there are significant differences between variable products and mutual funds, presentations
to customers should never state or imply that variable products are mutual funds.

Liquidity Customers who withdraw funds from variable products after a short period often incur
significant surrender charges and/or tax penalties; therefore, these products should never be
described as short-term, liquid investments. A presentation implying that an investor may easily
access her cash value either through loans or other means must also clearly describe the negative
impact of early withdrawals. For a variable life insurance policy, all disclosures regarding loans and
withdrawals must also include an explanation of the impact that these actions may have on a
policy’s cash value and death benefit.

Guarantees An insurance company that issues a variable product will often guarantee some of its
features. For example, an insurance company may guarantee that a variable life insurance policy
will always have a minimum death benefit if the policyholder continues to pay all the required
premiums. These guarantees should not be overemphasized or exaggerated since they ultimately
depend on the insurance company’s solvency.

Material that’s provided to clients should never represent or imply that these guarantees apply to
the separate account. With the exception of a fixed-account option offered by some companies,
neither the principal value of the separate account nor its investment returns are ever guaranteed.
Similarly, clients should not be told that the ratings given to the insurance company (AAA, BBB,
etc.) apply to the separate account.

Hypothetical Illustrations of Variable Life Insurance Policies FINRA strictly prohibits its
member firms from projecting or predicting investment results. However, life insurance companies
customarily provide their clients with hypothetical illustrations that assume various rates of return
in order to demonstrate how their policies work.

Both the SEC and FINRA allow the use of hypothetical illustrations, provided the following
guidelines are met:
 An assumed rate of return may not exceed 12%.
 One of the assumed rates of return must be 0%.
 The assumed rates of return must be reasonable based on current market conditions.
 The cash values and death benefits must reflect the policy’s maximum mortality and expense
charges for each of the assumed rates of return.

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The illustration must also include a prominent statement explaining that (1) its purpose is to show how
the performance of the underlying subaccounts could affect the policy’s cash values and death benefits,
(2) it’s hypothetical, and (3) it does not project or predict investment results. Generally, the illustration
should not compare the hypothetical returns of a variable life insurance policy to another product.
However, provided certain conditions are met, comparisons with term policies are acceptable.

MSRB Rules—Communications
Advertising
According to the Municipal Securities Rulemaking Board (MSRB), the term advertisement is
defined as any material, other than listings of offerings, published or used in any electronic or other
public media, or any written or electronic promotional literature distributed or made generally
available to customers or the public. Examples include notices, circulars, reports, market letters,
form letters, telemarketing scripts, seminar texts, and press releases concerning the products or
services of the member firm.

Broker-dealers are prohibited from publishing an advertisement that’s false, omits material facts, or
is misleading in content. Any advertisements that are related to municipal securities and municipal
fund securities (529 Plans) must be approved by a Municipal Securities Principal or a General
Securities Principal prior to its initial use.

Official Statement Summary Preliminary and final official statements are not considered
advertising since they are either prepared by or for the issuer. However, a summary/abstract of an
official statement is considered advertising since the official statement has been altered by a
municipal securities firm. As a result of the alteration, the summary of an official statement must be
approved by a Municipal Securities Principal.

SEC Rule 15c2-12: Municipal Securities Disclosure

SEC Rule 15c2-12 assists an underwriter in meeting its obligation to have a reasonable basis when
recommending a municipal security. According to this rule, an underwriter:
 Must obtain and review an official statement prior to bidding for or purchasing the securities.
The official statement must be considered to be in final form by the issuer at that time. Since
the following information might not yet be known, it can be omitted:
– Offering price, interest rate, selling compensation, aggregate principal amount
– Principal amount per maturity, delivery dates, ratings, and identity of the underwriter(s)
 Must send to customers the most recent copy of the preliminary official statement, if any,
within one business day of request (for negotiated offerings)
 Must contract with the issuer to receive sufficient quantities of the final official statement within
seven business days after the agreement to purchase, offer, or sell the securities

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Continuing Disclosure Requirements After the initial issuance of municipal bonds and the obligation
to send clients an official statement is satisfied, what type of additional disclosure is required? Although
municipal issuers are exempt from most SEC rules, SEC Rule 15c2-12 indicates that an issuer or another
obligated person may enter into a contract to provide continuing disclosure information to the MSRB’s
Electronic Municipal Market Access (EMMA) website. An obligated person is defined as any other entity
that has legally agreed to support part or all of the payment of the issue of securities. These disclosures
usually contain financial or operating information and notices of material events. An underwriter is
required to disclose to the MSRB whether the issuer or other obligated persons have agreed to provide
continuing disclosure information under SEC Rule 15c2-12.

Advertisements for Municipal Fund Securities

When preparing advertising related to municipal fund securities (529 plans), certain disclosures
must be provided. Chief among these are statements that:
 Advise the investor to consider the investment objectives, risks, and charges and expenses
associated with municipal fund securities before investing
 Explain that more information about municipal fund securities is available in the issuer’s
official statement
 Identify the firm as an underwriter of one or more of the issues of municipal fund securities if
the firm publishes the advertisement and will supply the official statement
 The official statement should be read carefully before investing

When advertising Section 529 college savings plans, a statement should be included to advise the
investor to consider, before investing, whether the investor’s or designated beneficiary’s home state
offers any state tax or other benefits that are only available for investments in that state.

Performance Indicators
When incorporating performance data in advertising, the following cautionary statement must be
presented:
Past performance does not guarantee future results and investment return will fluctuate.
Therefore, the investor’s shares when redeemed may be worth more or less than their
original cost. Additionally, current performance may be lower or higher than the data
contained in the advertisement.

If the advertisement does not include total return quotations, calculated to the most recent month
and ending within seven business days prior to the date of the advertisement, the firm must include
either a toll-free (or collect) telephone number or a website from which an investor can obtain total
return quotations for the most recent month-end.

If a sales load or non-recurring fee is charged, the maximum amount of the load or fee should be
stated. If the charge is not reflected in the performance data, a statement to that effect must be
included and should also indicate that the performance data would be lower if the load or fee had
been included.

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When calculating tax-equivalent yields or after-tax returns, the firm must assume that any
distributions that are not reinvested will be used in the manner intended in order to qualify for the
federal tax exemption provided by Section 529. The ad should provide a general description of how
federal law addresses such distributions and that yields would be lower if the funds are not used for
their intended purpose.

Generic Advertisements Generic advertisements may not refer to a specific fund by name, but
may describe the general nature of 529 plans as well as the various investment objectives of the
different types of plans. A generic advertisement may contain an invitation for further information,
provided that an official statement is provided.

A blind advertisement does not identify a municipal securities broker or dealer, but may include the
name of the issuer of the municipal security and/or the contact information for the issuer, as well as
the method by which an official statement may be obtained. A logo or trademark of the municipal
fund security may be used.

Conclusion
This ends the chapter on detailing all of the different forms of customer communications. The next
chapter will examine the process by which issuers offer their securities to the public.

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 CHAPTER 4

Offerings

Key Topics:

 Primary Market and Underwriting Commitments

 The Securities Act of 1933

 Exempt Securities and Transactions

 Municipal Offerings
 CHAPTER 4 – OFFERINGS

This chapter will provide an overview of how the different issuers offer their securities to the
public. Some of the exempt offerings and exempt transactions that provide certain issuers
with the ability avoid the basic registration process will also be described. These exemptions
are especially important since they provide issuers with significant savings of both time and
money.

Capital Formation
When a corporation intends to raise capital, it does so by issuing its securities to investors.

Public versus Private Placement Offerings

Securities may be offered or issued in two ways—public offerings and private placements. The main
advantage of a public offering is the large number of investors (both retail and institutional) who
are permitted to participate. The disadvantages include both the costs involved and the length of
time needed to undertake this type of offering due to the requirements of the Securities Act of 1933.

In some cases, institutional investors, (e.g., venture capitalists or private equity investors) provide
start-up capital to new companies. The capital is typically raised through a form of non-public
offering that’s referred to as a private placement. The primary advantage of a private placement is
that it’s faster and less costly than a public offering. However, a disadvantage faced by an issuer
engaged in a private placement is that there are limits related to whom the offering may be directed
and/or the number of investors that may participate.

An Initial Public Offering Versus a Follow-On Offering When an issuer offers securities to the
public for the first time, the process is referred to as its initial public offering (IPO). However, if a
company has already gone public and intends to raise additional capital through a sale of common
stock, it’s conducting a follow-on offering. In a follow-on offering, the company itself is issuing new
shares which dilute the ownership of existing shareholders. Keep in mind, these offerings are still
considered primary distributions since the proceeds of the offering are being directed to the issuer.

The Role of an Underwriter/Investment Banker

An underwriter or investment banker is a broker-dealer that helps corporations or municipalities that are
interested in raising capital through the distribution of their stocks or bonds. When acting as an
underwriter, an investment banker may assume risk by buying the new issue from the issuing
corporation and reselling it to the public. The investment banking function is an extremely important
one since it brings the issuer and potential buyers together. The responsibility of an investment banker is
to ensure that an issuer is able to raise capital under the most advantageous terms. The proceeds of these
offerings may represent new funds to the issuer or they may be used to refinance its capital structure.

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Underwriting Commitments
The sale of a public offering is typically conducted through a group of broker-dealers that’s referred
to as an underwriting syndicate. The responsibilities of the syndicate members are dependent on
the type of underwriting commitment involved. As it relates to securities offerings, the term
syndicate implies that a financial commitment is being made by the underwriters.

Firm-Commitment If a syndicate is acting for its own account and risk by agreeing to purchase the
entire issue and absorb any securities that are not sold, it’s engaging in a firm-commitment
underwriting. Therefore, the syndicate is firmly committing itself to the issuing corporation for the
entire amount of the offering, regardless of whether it’s able to sell the securities. The syndicate is
acting in the capacity of a principal (dealer).
For example, a corporation wants to sell $10,000,000 of stock, but the syndicate is only
able to sell $8,000,000 of it. In a firm commitment, the syndicate members will absorb the
$2,000,000 of unsold stock for their own accounts.

Best-Efforts In a best-efforts underwriting, underwriters agree to sell as much of the new offering as
they are able to, with the stipulation that they can return any unsold securities to the issuer.

In this case, the underwriters are acting in the capacity of an agent for the issuer, rather than
as a principal for their own accounts. The agreement requires that they make a bona fide
effort to sell the entire issue; however, if unsuccessful, they will return the unsold portion to
the issuer without penalty.
For example, a corporation wants to sell $10,000,000 of stock, but the underwriters are
able to sell only $8,000,000 of it. In a best-efforts underwriting, the syndicate would
return the $2,000,000 of unsold stock to the corporation.

Under certain circumstances, a corporation may require a specific minimum amount of capital to
be raised. The issuing corporation may determine that raising a lesser amount will not permit it to
accomplish its objectives. Therefore, if the minimum contingency is not met, the offering will be
cancelled.

Distribution of Securities
A broker-dealer that’s contemplating the possibility of becoming the manager in a distribution of
securities must perform due diligence on both the issuer and the offering. This due diligence
process is completed by examining the issuer’s history, the quality of the company’s management,
labor relations, financial and operational data, legal matters, and comparable companies in the
same field to determine the viability of the distribution and the price at which to market the issue.

Syndicate The managing broker-dealer will then form the syndicate by inviting other broker-
dealers to participate in the distribution and share in liability. The written agreement between the
manager and syndicate members—referred to as the syndicate letter or agreement among
underwriters—is signed by the participants and specifies their rights and obligations.

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Selling Group In some cases, the syndicate will recruit other broker-dealers to assist in the sale of
the offering. These firms are selling group members that don’t assume financial liability for the
offering, but instead act as placement agents. Any shares that are not sold by the selling group are
retained by the syndicate due to the fact that it remains financially liable for any unsold shares. To
join a selling group, a broker-dealer must sign a selling group agreement which describes the
relationship/responsibilities between the selling group and the syndicate manager.

Each firm that participates in a new issue distribution must review its transactions for suitability.
However, the syndicate manager is under no obligation to review trades executed by selling group
members. Additionally, a broker-dealer that’s participating in a distribution of securities (primary or
secondary) may not pay any third party or unregistered person (e.g., an accountant, finder, or
attorney) to solicit another person to purchase the security.

Syndicate Practices Just prior to beginning the selling process, the underwriters will assess the
demand for the issue and determine its public offering price (POP). If the offering price is satisfactory to
the issuing corporation, the new issue distribution will proceed. Syndicate members are required to
maintain the public offering price and, unless they’re released from this commitment by the managing
underwriter, they may not sell the issue at a lower price. Since the syndicate requirements remain in
effect until terminated by the syndicate manager, all investors will pay the same price (the POP).

Securities Act of 1933

The Securities Act of 1933 attempts to prevent fraud in the sale of new issues by requiring that
investors be provided with enough relevant information about the offering to make an informed
investment decision. This information is provided through the registration statement which is a
public document that issuers file with the SEC.

The registration statement is designed to provide full disclosure of all material information about both
the issuer and the offering. Issuers are also required to prepare a prospectus for distribution to potential
purchasers. The prospectus is essentially an abbreviated version of the registration statement.

The SEC simply reviews the information contained in the prospectus; it doesn’t attest to its
accuracy. Since both the issuer and the managing underwriter have liability for any omissions
and/or inaccuracies in the documents it provides to shareholders, the managing underwriter must
review all disclosure documentation. This review process is required as a part of the underwriter’s
due diligence obligation.

The Registration Process

Next, let’s examine the three phases of the registration process for securities:
1. The preregistration period
2. The cooling-off (waiting) period
3. The post-effective period

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The Preregistration (Prefiling) Period

During the preregistration phase, an issuer prepares its registration statement and, once it’s
completed, the issuer files it with the SEC. The date on which it’s filed marks the end of the
preregistration period. An underwriter will often assist the issuer during this process; however, the
underwriter may not yet discuss the new issue with its customers. This is the point at which the due
diligence process begins for the managing underwriter.

Registration Statement Under the Securities Act of 1933, a registration statement must contain
detailed information about the issuer, its business, its owners, and its financial condition. The required
information includes:
 The character of the issuer’s business
 A balance sheet created within 90 days prior to the filing of the registration statement
 Financial statements that show profits and losses for the latest fiscal year and for the two
preceding fiscal years
 The amount of capitalization and use of the proceeds of the sale
 Monies paid to affiliated persons or businesses of the issuer
 Shareholdings of senior officers, directors, and underwriters, and identification of individuals
holding at least 10% of the company’s securities

The Cooling-Off Period

The second phase in the registration process is the 20-day cooling-off or waiting period. During this time,
the SEC reviews the issuer’s registration statement to determine if it’s complete and that it contains no
misleading statements. However, the SEC doesn’t judge the investment merits of the issue or the
appropriateness of the pricing of the issue. The cover of a prospectus will include the SEC’s no-approval
clause to indicate that the SEC neither approves, nor disapproves, of the securities being offered. If the
SEC believes the registration statement to be incomplete or misleading, it sends a deficiency letter to the
issuer. The issuer must then refile an amended registration statement for SEC review.

Red Herring During the cooling-off period, broker-dealers are able to send a condensed form of the
registration statement to potential buyers. This document is referred to as the preliminary
prospectus or red herring. The red herring has a statement on its cover page (in red writing) to
indicate that a registration statement has been filed with the SEC, but has not yet become effective.
Also, the final offering price is not included in the red herring; instead, it may indicate a price range
(e.g., $14 to $17 per share).

During the cooling-off period, underwriters are permitted to:

 Discuss the issue
 Provide the red herring to potential purchasers
 Record the names of persons providing an indication of interest (the indications are non-
binding for either party)

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During this period, underwriters are not permitted to:

 Accept payment for the new issue in advance
 Sell the new issue (since the deal is not effective and has not been priced)

Prospectus Alterations A prospectus is the primary source of information for most retail investors;
however, it cannot be amended or altered in any way, including highlighting and/or underlining
relevant portions of the document, unless the changes are filed with the SEC. Essentially, an RR may
discuss certain portions of the prospectus with the client, but should not make any marks on it.

State or Blue-Sky Laws In addition to satisfying SEC registration requirements, issuers are required
to comply with applicable state registration laws. This process is conducted during the cooling-off
period. State securities laws are established under the Uniform Securities Act (USA) and are often
referred to as Blue-Sky Laws (the name refers to a statement made by a Supreme Court justice in 1917).

The three methods of state securities registration include:

1. Notification (also referred to as filing)—Though not allowed in all states, this method simply
involves submitting an application with the state Administrator requesting approval to offer
securities in the state.
2. Coordination—This form is completed simultaneously with a federal registration and
generally becomes effective at the same time.
3. Qualification—This method involves meeting the specific requirements of one state and
becomes effective at the discretion of the state Administrator.

Along with securities, states also require the registration of both broker-dealers and their agents
(RRs) in each state in which they plan to do business. If broker-dealers and their agents are not
properly registered or if they violate state securities regulations, the state Administrator may take
action against them.

Firms should have systems and procedures in place to ensure that securities are being sold only in
states in which they are registered. Safeguards may include account coding in an effort to prevent
transactions in states where no valid registration exists for the securities.

Due Diligence Just prior to the determination of the effective date, a bring down due diligence
meeting is held. The participants at this meeting include the underwriters, syndicate members, officers
of the issuer, attorneys, and accountants. The purpose of the meeting is to review the different
aspects of the planned underwriting, including certifying that the issuer and its underwriters have
satisfied state and federal laws. If the parties involved don’t exercise due diligence, they could find
themselves as defendants in stockholder lawsuits.

Effective Date The effective date represents the end of the cooling-off period and the beginning
of the post-effective period. Generally, a registration statement’s effective date is 20 days after the
filing or the last amendment in response to a deficiency letter. If a written request is received from the
issuer or its underwriters, the SEC may accelerate this process.

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The Post-Effective Period

By the morning of the effective date, the public offering price (POP) is usually set by the underwriters and
it’s at this point that sales of the offering may begin. Purchasers must be provided with a copy of the
final prospectus which will now include the public offering price. This final prospectus must be
delivered to purchasers no later than the time a sale is confirmed.

Broker-dealers are required to take reasonable steps to fulfill written requests for a prospectus.
During the cooling-off period, the preliminary prospectus is sent; however, after the effective date, a
final prospectus must be supplied. In many cases, a client may request that disclosure documents
be provided in an electronic format. Under SEC rules, providing clients with electronic access
equates to the delivery of the relevant documentation.

Actions by RR After the Effective Date Once an offering is declared effective, a broker-dealer will be
notified of its allocation. The firm’s RRs should then contact all of its clients who received a preliminary
prospectus to determine if they have made a purchase decision. If the client acknowledges his interest
and places an order, the order is binding. All broker-dealers are required to provide a final prospectus
to purchasers in the primary market, even those who already received the preliminary prospectus.

The following graphic is a summary of the typical registration process:

- Prepare registration statement - Extends for 20 days from - Final prospectus issued
- No discussions with customers amendment, unless accelerated - Sales confirmed
- Preliminary prospectus delivered
- Blue-Sky the issue
- Hold due diligence meeting
- Accept indications of interest

If a prospectus is in use for more than nine months, it may be updated to include new information as
long as the information is no more than 16 months old, such as the most recent financial statements.

Exempt Securities
Now that the registration process is complete, it may be obvious that there’s a significant time and cost
savings for issuers that qualify for an exemption from registration. The SEC has determined that the
following securities are exempt from the registration and prospectus requirements of the Act of 1933:
 U.S. government and U.S. government agency securities
 Municipal securities
 Securities issued by non-profit organizations
 Short-term corporate debt instruments that have a maturity not exceeding 270 days
(e.g., commercial paper)
 Securities issued by domestic banks and trust companies
 Securities issued by small business investment companies

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 CHAPTER 4 – OFFERINGS

Although these securities are exempt from the registration and prospectus requirements of the
Securities Act of 1933, they are not exempt from the antifraud provisions of the Act. This means that, in the
event that fraud occurs, the SEC may prosecute offenders regardless of the status of the security sold.

Exempt Offerings
In some cases, it’s the manner in which securities are being offered that provides the exemption
from the registration requirements of the Act. The SEC will only provide an exemption if it feels that
there’s a good reason for doing so. Some examples of exempt offerings are based on (1) issuers limiting
the amount of capital being raised, (2) securities being offered in only one state, and (3) securities being
offered privately.

Rule 147 and Rule 147A

Rule 147 was created as a safe harbor under the statutory intrastate offering exemption which is
provided by the Securities Act of 1933. The rule allows companies to raise capital from their in-state
investors. Typically, companies that are selling new securities are required to register their
securities with the SEC; however, under Rule 147, if a company is conducting an offering and only
selling its securities to its state residents, the offering is exempt from registration. Today, the strict
issuer eligibility requirements and developments in both company business practices and
communications technology have made portions of Rule 147 outdated.

Amendments to the existing Rule 147 and the implementation of a new rule—Rule 147A—became
effective on April 20, 2017. These new rules are designed to update and modernize the existing
intrastate offering framework and permit a company to raise money from investors who reside within
its state without being required to register the offers and sales at the federal level.

Although it’s similar to Rule 147, the new Rule 147A will allow for multi-state offers (not sales), which
means that:

 Issuers will be permitted to use general solicitation and publicly available websites to locate
potential in-state investors. Although offers are able to be made outside of the state, all sales
must still be limited to in-state residents.
 Companies will be able to be incorporated or organized outside of the state in which they
conduct the offering as long as they have their principal place of business in that state. Principal
place of business is defined as the location from which the principal officers, manager, or
partners primarily direct, control, and coordinate the activities of the issuer.
− For example, ABC is incorporated in Delaware, but its principal business is conducted in New
Jersey. Under Rule 147A, ABC will be allowed to sell securities to residents of New Jersey.

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Both the amended Rule 147 and the new Rule 147A include the following provisions:
 For an issuer to sell securities in a state, it must have its principal office (under Rule 147) or
principal place of business (under Rule 147A) in that state and satisfy one of four “doing business”
requirements. By satisfying one of the four new requirements, the issuer can avoid having to
comply with all three of the 80% tests for assets, revenue, and proceeds of the offering.
− If a Rule 147 or 147A issuer subsequently changes its principal place of business after issuing
securities, it will not be able to conduct another intrastate offering under these rules in
another state for a period of six months from the date of last the sale in the previous state.
− An issuer is considered to be “doing business” in a state as long as it meets just one of the
following four new requirements:
1. At least 80% of its consolidated gross revenues are derived from the operation of a
business or of real property that’s located in the state or territory or from the rendering
of services within the state or territory;
2. At least 80% of its consolidated assets are located within the state or territory at the end
of its most recent semi-annual fiscal period prior to the first offer of securities under the
exemption;
3. At least 80% of the net proceeds from the offering are intended to be used by the issuer,
and are in fact used in connection with the operation of a business or of real property,
the purchase of real property located in, or the rendering of services within the state or
territory; or
4. A majority of the issuer’s employees are based in the state or territory (this fourth
requirement was not included in the original Rule 147)
 An issuer must utilize a reasonable belief standard when determining the residency of the
purchaser at the time of the sale of securities. This standard is supported by the requirement
that the issuer obtain a written representation from all purchasers as to their residency.
− If the purchaser is a legal entity (e.g., a corporation, partnership, trust, or other form of
business organization), residency is defined as the location where, at the time of the sale,
the entity has its principal place of business.

 Resales to persons who reside outside of the state in which the offering is conducted are
restricted for a period of six months from the date of the sale by the issuer to the purchaser
(formerly nine months).
− A legend requirement applies in order to notify offerees and purchasers about the resale
restriction.

Regulation D
Regulation D is a safe harbor which permits securities offerings to be sold as private placements
without SEC registration. Many securities professional use the term exempt transactions when
referring to these offerings since their exemption is based primarily on the method being used to offer
these securities, not on the type of securities being offered.

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Under Regulation D, an issuer’s private placement of securities qualifies for an exemption provided
the following conditions are met:
 The issuer must have reason to believe that the buyer is a sophisticated investor (i.e., one who is
experienced enough to evaluate any risks involved)
 The buyer must have access to the same financial information that would normally be included in
a prospectus. This information is provided in a document that’s referred to as a private placement
memorandum.
 The issuer must be assured that the buyer doesn’t intend to make a quick sale of the securities.
This is usually accomplished by means of an investment letter (also called the lock-up agreement).
 The securities are sold to no more than 35 non-accredited investors (non-accredited investors are
those who don’t meet the standards listed below for accredited investors).

Accredited Investor For private placements, there’s no restriction on the number of accredited
investors. An accredited investor includes any of the following:
 Financial institutions (e.g., banks), a large tax-exempt plans, or private business development
companies
 Directors, executive officers, or general partners of the issuer
 Individuals who meet either one of the following criteria:
– Have a net worth of at least $1,000,000 or
– Have gross income of at least $200,000 (or $300,000 combined with a spouse) for each of the
past two years with the anticipation that this level of income will continue

Restricted Securities—Lock-Up Agreements and Legends A lock-up agreement dictates the amount
of time that pre-IPO investors, such as private placement buyers, management, venture capitalists, and
other insiders, must wait to sell their shares once the company has gone public. Although a lock-up
agreement will generally expire six months following the closing of the company’s IPO, there’s no
statutory time limit. The lock-up is designed to prohibit management and venture capitalists that initially
funded the company from immediately liquidating their shares once the issue goes public.

The lock-up period also restricts or limits the supply of shares being sold in the market. Shares subject
to a lock-up agreement will carry a restrictive legend that’s printed across the face of the certificate to
indicate that the securities have not been registered with the SEC and are not eligible for resale unless
the legend is removed. In many cases, the removal of the legend is accomplished under SEC Rule 144.

The Primary Market for Municipal Bonds

As listed earlier, municipal securities are exempt from the registration and prospectus requirements
of the Securities Act of 1933. Although exempt, the underwriting process for municipal securities
follows many of the same guidelines that are used for corporate underwritings. The MSRB, which is
the self-regulatory organization (SRO) for firms that deal in municipal securities, formulates and
interprets the rules and regulations that relate to municipal underwritings. Remember, although
some specific securities are exempt, the antifraud provisions of the Securities Act of 1933 apply to all
securities. Different documents are used when underwriting municipal debt.

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CHAPTER 4 – OFFERINGS

Underwriting Documentation The following list identifies some of the documents that may be
utilized during a primary distribution of municipal bonds.

Notice of Sale When an issuer intends to sell bonds, it will advertise by publishing a Notice of Sale.
The Notice of Sale will usually contain essential information that an underwriter will need in order
to submit a bid such as the size of the offering, its maturity date, the coupon rate, and the details
related to the bidding process.

Official Statement The disclosure document that’s used in municipal offerings is referred to as the
official statement. This document essentially takes the place of a prospectus; however, it’s not
required to be filed with the SEC since municipal issuers are exempt from the Act of 1933.

The official statement contains detailed information about both the issuer and the offering and, if
produced, must be distributed to investors. As is the case with a prospectus, there’s both a
preliminary and final version of the official statement. If an official statement has been prepared,
MSRB rules require that a copy be sent to each purchaser of a new issue.

Conclusion
This ends the chapter on the process that issuers follow to offer securities. This chapter focused on
the primary market and the issues related to underwriting securities, the Securities Act of 1933,
exempt securities and exempt transactions. The next chapter will examine both securities and the
tax implications that relate to different investments.

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 CHAPTER 5

Overview of Securities
and Tax Considerations

Key Topics:

 Types of Securities

 Tax Considerations
 CHAPTER 5 – OVERVIEW OF SECURITIES AND TAX CONSIDERATIONS

The goal of this chapter is to provide a general overview of the different types of securities
and their fundamental characteristics. The securities to be analyzed will be included in the
portfolios of the products that will be described in upcoming chapters, such as investment
companies and variable products. This chapter will conclude with a discussion various tax
considerations involving securities.

The Corporation – Equity Securities

Many businesses are organized as corporations. As a legal entity, a corporation may engage in many
of the activities that a natural person is able to do. For example, it can buy property, obtain loans,
sue, and be sued. Although a corporation is owned by its shareholders, the business is considered a
separate person under the law and, therefore, an individual shareholder is generally not held
personally responsible for the corporation’s debts. If a business fails, the most a shareholder can
lose is her original investment. In other words, shareholders have limited liability.

Corporate Organization
Corporations can vary in both size and complexity—ranging from large international conglomerates
to small family businesses. However, the basic legal structure remains the same. The shareholders of
the company elect a board of directors (BOD) and this board is responsible for overseeing the
company and appointing its senior managers.

Raising Capital – Financing the Corporation

After being formed, it’s inevitable that a corporation may need to raise additional capital (money) to
fund its operations. There are two basic methods that corporations use to raise money—debt
financing and equity financing. An issuer that sells bonds (debt) is borrowing money from the
investors who buy the bonds. The funds are borrowed for a predetermined period and the company
is required to make interest payments to the bondholders over the life of the bond. Bondholders are
not considered owners and therefore they have no voting rights. For bond investors, their returns
are limited to the interest that the corporation pays them for the use of their money.

The other way for a corporation to raise money is to issue stock. Unlike bondholders, investors who
purchase stock become part owners of the corporation. Since the investors are provided with an
ownership interest in the corporation, these securities are referred to as equities. Stockholders
don’t receive guaranteed interest payments and there’s no maturity date on their investments.

So what’s the upside for equity investors? If a company prospers, the shareholders can expect to share in
its profits in the form of cash or stock distributions (dividends) and experience an increase in the value
of their shares. However, if a company fails, the shareholders are more likely than other investors to lose
their entire investment. This is due to the fact that, if the corporation is forced to liquidate its assets at
bankruptcy, bondholders and other creditors have a higher claim to the company’s assets.

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CHAPTER 5 – OVERVIEW OF SECURITIES AND TAX CONSIDERATIONS

Different Types of Equity Securities

Common Stock There are two main types of
stock that a corporation may issue—common
and preferred. Common stock is the traditional
form of equity and common stockholders are the
last to be paid if the corporation declares
bankruptcy. Common stockholders may receive
dividends, but only after the corporation’s
bondholders (if any) have been paid their interest
and the preferred stockholders (if any) have been
paid their stated dividend.

Preferred Stock The second form of equity is

preferred stock. In the capital structure, preferred
stock is considered a senior security above the
common stockholders, but it still ranks below the
bondholders. The name preferred is derived from
the fact that these owners have preference over
common stockholders regarding payment of Investors provide capital and, Investors provide capital and,
dividends. This preference also extends to any in turn, may receive: in turn, receive:
potential liquidation. At liquidation, the  Dividends  Interest
corporation’s secured creditors receive
 Potential capital  Principal at maturity
appreciation  Liquidation preference
consideration first, followed by its unsecured over stockholders
creditors, then its preferred stockholders, and the  Creditor status
last to receive payments are common
stockholders.

Common versus Preferred Stock

Common Stock Preferred Stock
Ownership stake in the company  
More likely to receive regular dividend payments 
Higher priority in the event of bankruptcy 
Greater potential for capital appreciation 
Typically has voting rights 
Issued with a specific dividend rate 

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 CHAPTER 5 – OVERVIEW OF SECURITIES AND TAX CONSIDERATIONS

Corporate Bonds
Corporations that issue bonds use the proceeds from the offering for a variety of purposes—from
building facilities and purchasing equipment to expanding their businesses. The advantage to
issuing bonds over issuing stock is that the corporation is not giving up any control of the company
or any portion of its profits. However, the disadvantage is that the corporation is required to repay
the money that was borrowed plus interest.

If a corporation has common and preferred stock outstanding and issues bonds, it’s required to pay
the interest on its outstanding bonds before it pays dividends to its stockholders. Also, if the
company goes bankrupt, bondholders and other creditors must be satisfied before the stockholders
can make a claim to any of the company’s remaining assets. Although buying corporate bonds puts
an investor’s capital at less risk than purchasing stock of the same company, bonds typically don’t
offer the same potential for capital appreciation as common stocks.

Types of Corporate Bonds

Corporate bonds are divided into two major categories—secured and unsecured. Although all debt
that’s issued by a corporation is backed by the issuer’s full faith and credit, secured bonds are
additionally backed by specific corporate assets.

Secured Bonds With secured bonds, if the issuer falls into bankruptcy, the trustee will take
possession of the assets, liquidate them, and then distribute the proceeds to the bondholders.
Therefore, if the company defaults, secured bondholders have a higher degree of protection. The
following are the different types of secured bonds that companies issue:

Mortgage Bonds Mortgage bonds are secured by a first or second mortgage on real property;
therefore, bondholders are given a lien on the property as additional security for the loan.

Equipment Trust Certificates These are bonds secured by a specific piece of equipment that’s
owned by the company and used in its business. The trustee holds legal title to the equipment until
the bonds are paid off. These bonds are usually issued by transportation companies and backed by
the company’s rolling stock (i.e., assets that move), such as railroad cars, airplanes, and trucks.

Collateral Trust Bonds Collateral trust bonds are secured by third-party securities that are owned
by the issuer. The securities (stocks and/or bonds of other issuers) are placed in escrow as collateral
for the bonds.

Type of Secured Bond Collateral

Mortgage Real Estate

Equipment Trust Equipment

Collateral Trust Stocks or Bonds

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CHAPTER 5 – OVERVIEW OF SECURITIES AND TAX CONSIDERATIONS

Asset-Backed Securities (ABS) Many loans that are held by financial institutions (banks and
finance companies) are not permanently held by the lender; instead, some are securitized and
offered to investors. This securitization is done with credit card receivables, home equity, as well as
automobile and student loans. In the process of securitizing the loans, the lender sells its
receivables to a trust that creates a security which represents an interest in the trust and is backed
by the subject receivables. In many cases, the investor receives a monthly payment that reflects
both interest and principal amortization.

The benefits of investing in these securities includes a higher yield or return as compared U.S.
Treasury securities, high credit quality since they’re secured, and a relatively predictable cash flow.
Asset backed securities are subject to interest-rate risk, credit risk, and prepayment risk due to
being backed by payments that are made to the lender.

Unsecured Bonds
When corporate bonds are backed by only the corporation’s full faith and credit, they’re referred to as
debentures. If the issuer defaults, the owners of these bonds have the same claim on the company’s
assets as any other general creditor (i.e., before stockholders, but after secured bondholders).

Occasionally, companies issue unsecured bonds that have a junior claim on their assets compared
to its other outstanding unsecured bonds. These bonds are referred to as subordinated debentures.
In case of default, the owner’s claims are subordinate to those of the other bondholders. If the
company defaults, the owners of subordinated debentures will be paid after all of the other
bondholders, but still before the stockholders.

Order of Liquidation
1. Wages
2. Taxes
3. Secured creditors, including secured bonds
4. General creditors, including debentures
5. Subordinated creditors, including subordinated debentures
6. Preferred stockholders
7. Common stockholders

High-Yield (Junk) Bonds Corporate bonds that are rated below investment grade (below BBB by
S&P or below Baa by Moody’s) are referred to as high-yield or junk bonds. The lower rating indicates
that bond analysts are uncertain about the issuer’s ability to make timely interest payments and to
repay the principal. In other words, these bonds carry a higher-than-normal credit risk and typically
pay higher coupons in order to compensate investors for the added degree of risk.

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 CHAPTER 5 – OVERVIEW OF SECURITIES AND TAX CONSIDERATIONS

Guaranteed Bonds A guaranteed bond is one that, along with its primary form of collateral, is secured
by a guarantee of another corporation. The other corporation promises that it will pay interest and
principal if necessary. A typical example is a parent company that guarantees a bond that’s issued
by a subsidiary company.

The Money-Market
Debt securities with maturities of more than one year are often referred to as funded debt, while
short-term debt instruments with one year or less to maturity are referred to as money-market
securities. There are a significant number of securities that trade in the money market with issuers
including the U.S. government, government agencies, banks, and corporations. There’s also a
diverse group of participants that utilize the money market, including the Federal Reserve Board,
banks, securities dealers, and corporations.

Money-market transactions provide an avenue for both acquiring money (borrowing) and investing
(lending) excess funds for short periods. Typically, the investment period ranges from overnight to a
few months, but may be as long as one year.

Types of Money-Market Securities

Examples of money-market securities and related instruments include:
 Commercial paper
 Bankers’ acceptances
 Negotiable certificates of deposit
 Federal funds
 Money-market mutual funds
 Repurchase agreements (Repos)

Money-market instruments are a separate asset class and referred to as cash equivalents. Since cash
equivalents are investments of high quality and safety, they’re considered to be nearly the same as cash.

Commercial Paper When corporations need long-term financing, they issue bonds; however, when
they need short-term financing, they issue commercial paper. Commercial paper is short-term,
unsecured corporate debt which typically matures in 270 days or less. Due to its short maturity,
commercial paper is exempt from the registration and prospectus requirements of the Securities
Act of 1933. Similar to T-bills, commercial paper is usually issued at a discount; however, some
issues are interest bearing. The standard minimum denomination is $100,000.

Since commercial paper is typically issued by corporations with high credit ratings, it’s considered
very safe. Standard & Poor’s, Fitch, and Moody’s issue credit ratings for commercial paper. S&P will
assign ratings from A1 (highest) to A3, and Fitch will assign ratings from F1+ (highest) to F3. The
highest rating that Moody’s will assign to commercial paper is P-1 (also called Prime 1) with
intermediate ratings of P-2 and P-3. Speculative commercial paper receives a rating of NP (not prime).

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CHAPTER 5 – OVERVIEW OF SECURITIES AND TAX CONSIDERATIONS

Bankers’ Acceptances (BAs) Bankers’ acceptances are instruments that are used to facilitate
foreign trade. For example, let’s assume that an American food company is importing French snails.
The American company may want to pay for the snails after delivery and, therefore, it issues a time
draft (i.e., a check that’s payable on a future date) which is secured by a letter of credit from a U.S.
bank as payment. The French company that’s exporting the snails is able to hold the draft until its
due date and receive the full amount or may cash it immediately at a bank for a discounted amount.
At that point, the bank has the draft guaranteed by the issuing bank and it becomes a banker’s
acceptance. BAs are actively traded and considered quite safe since they’re secured both by the
issuing bank and by the goods that were originally purchased by the importer.

Repurchase Agreements (Repos) In a repurchase agreement (repo), a dealer sells securities

(usually T-bills) to another dealer and agrees to repurchase them at both a specific time and price.
Essentially, the first dealer is borrowing money from the second dealer and securing the loan with
securities (a collateralized loan). In return for making the loan, the second dealer (the lender)
receives the difference between the purchase price and the resale price of the securities.

If a dealer purchases securities and agrees to sell them back to the other dealer at a specific date
and price, this is referred to as a reverse repo or matched sale. In this situation, the first dealer lends
money (with securities as collateral) to the second dealer and earns the difference in sales prices.
Many corporations, financial institutions, and dealers engage in repos and reverse repos. These
types of transactions are typically short-term, with most being overnight transactions.

Negotiable Certificates of Deposit (CDs) Banks and savings and loans issue certificates of deposit,
which are time deposits that carry fixed rates of interest and mature after a specified period. Although
most CDs mature in one year or less, they essentially have a minimum maturity of seven days with no
maximum maturity. Holders of CDs are penalized if they redeem them prior to their stated maturity.

Negotiable CDs have a minimum denomination of $100,000, but often trade in denominations of
$1,000,000 or more (also referred to as jumbo CDs). There’s an active secondary market in these securities.
CDs of up to $250,000 are currently insured by the Federal Deposit Insurance Corporation (FDIC).

Long-Term CDs Long-term or brokered CDs generally have maturities that range from two to 20
years and are not considered to be money-market securities. These long-term CDs may have
additional risks that are not associated with traditional bank-issued CDs, including:
 Either limited or potentially no liquidity
 The possibility of experiencing a loss of principal if the CD is sold prior to maturity
 The potential existence of call features that limit capital appreciation and subject the investor to
reinvestment risk
 The possibility of no FDIC insurance

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 CHAPTER 5 – OVERVIEW OF SECURITIES AND TAX CONSIDERATIONS

Treasury Securities
According to the Securities Act of 1933, securities that are issued by the U.S. government
(Treasuries) and any government agency are exempt from registration. Treasury securities are
considered the safest type of fixed-income investment and are suitable for the most conservative
investors. Since the securities are backed by the full faith and credit of the U.S. government, they
have virtually no credit risk. This “no default” status is the benchmark against which the credit
ratings of all other issuers are measured.

Types of Treasury Securities

The U.S. government issues securities to finance its operations. The securities may be divided into
two major groups:
1. Marketable (negotiable)
2. Non-marketable (non-negotiable)

Treasury securities are considered marketable securities since they’re traded in the secondary market
after issuance. On the other hand, U.S. savings bonds are considered non-negotiable since they’re
purchased from and redeemed back to the U.S. government. Of the two groups, marketable securities
are much more likely to appear on the Series 6 Examination and include the following:
 Treasury bills
 Treasury notes
 Treasury bonds
 Treasury Separate Trading of Registered Interest and Principal Securities (T-STRIPS)
 Treasury Inflation-Protected Securities (TIPS)
 Treasury Cash Management Bills (CMBs)

From this point on, when the word Treasuries is used, it will refer to marketable/negotiable
securities only. The three most prevalent types of these marketable issues are T-bills, T-notes, and
T-bonds. Let’s begin our discussion with the interest-bearing Treasury securities and then move on
to other instruments that are non-interest-bearing.

Treasury Notes (T-Notes) and Treasury Bonds (T-Bonds) Treasury notes and Treasury bonds
are interest-bearing securities that have all of the attributes of traditional fixed-income
investments. Each pays a fixed rate of interest semiannually and the investors receive the face value at
maturity. Treasury notes have initial maturities that range from 2 to 10 years, while Treasury bonds
are issued with maturities of more than 10 years. T-notes and T-bonds are both issued in book-
entry (electronic) form and in minimum denominations of $100.

Treasury Inflation-Protected Securities (TIPS) One of the primary concerns for bond investors is
inflation. Since a bond investor may often need to wait years for his principal to be returned,
inflation (a rise in prevailing prices) will diminish the purchasing power of the returned funds.

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CHAPTER 5 – OVERVIEW OF SECURITIES AND TAX CONSIDERATIONS

So how is a Treasury investor able to protect herself? One answer may be to acquire protection by
investing in Treasury Inflation-Protected Securities (TIPS). TIPS are interest-bearing, marketable
securities.

The rate of interest on TIPS is fixed; however, the principal amount on which that interest is paid
may vary based on the change in the Consumer Price Index (CPI). During a period of inflation (a
rise in CPI), the principal value will increase. However, if deflation occurs (from a decline in CPI),
the principal value of the instrument will decrease (but not below $1,000). TIPS are issued in book-
entry form in $100 increments and are available in 5-, 10-, and 30-year terms.

Non-Interest-Bearing Securities
T-bonds, T-notes and TIPS are all interest-bearing instruments. This next section will describe the
various forms of Treasuries that are non-interest bearing. These securities are issued at a discount
and mature at face value.

Treasury Bills (T-Bills) Treasury bills are short-term securities that mature in one year or less.
Currently, an investor may purchase T-bills with maturities of one month (4 weeks), three months (13
weeks), six months (26 weeks), and one year (52 weeks). T-bills are issued in book-entry form only
and are sold in minimum denominations of $100 (and in multiples of $100 thereafter).

T-bills are always sold at a discount from their face value and, unlike Treasury bonds and notes,
T-bills don’t make semiannual interest payments. The difference between a T-bill’s purchase
price and its face value at maturity represents the investor’s interest. Consequently, T-bills are
referred to as discount securities or non-interest-bearing securities.

Prices T-bills are quoted on a discounted yield basis, not as a percentage of their par value. The
yield represents the percentage discount from the face value of the security. An example of a T-bill
quotation is shown below:

Bid Asked Ask Yld

1.12 1.11 1.13

Remember, due to the inverse relationship between price and yield, the higher the yield, the lower
the price, and the lower the yield, the higher the price. Therefore, despite the fact that the bid (1.12
discount yield) is numerically higher than the asked (1.11 discount yield), the bid (higher yield) will
actually represent a lower price.

Along with the bid and asked quotation, the column titled asks yield signifies the bond or coupon
equivalent yield. The bond equivalent yield allows investors to compare the yields available on T-bills
with the yields available on notes, bonds, and other interest-bearing securities. The bond equivalent
yield takes into account the fact that the interest being earned is on the amount invested, not on the
face amount. As a result, a T-bill’s bond equivalent yield is always greater than its discount yield.

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 CHAPTER 5 – OVERVIEW OF SECURITIES AND TAX CONSIDERATIONS

Stripped Securities
In the 1980s, several broker-dealers began stripping the interest payments and final principal
payments from Treasury notes and bonds and then repackaging and reselling them as zero-coupon
bonds. Although these stripped securities were not issued by the Treasury, their cash flows were
very secure since the underlying securities are direct obligations of the U.S. government. Thereafter,
a group of dealers began to issue generic stripped securities—referred to as Treasury Receipts (TRs).
An important distinction is that Treasury Receipts are backed by Treasury securities that are owned
by the issuing broker-dealer; they’re not directly backed by the U.S. Treasury.

Treasury STRIPS In order to facilitate the stripping of securities, the Treasury created its Separate
Trading of Registered Interest and Principal Securities (STRIPS) program. Dealers are able to
purchase T-notes and T-bonds and separately resell the coupon and principal payments as zero-
coupons (discounted securities) after requesting this treatment through a federal reserve bank. The
difference between an investor’s purchase price and the bond’s face value is interest. STRIPS are
backed by the full faith and credit of the U.S. Treasury and are quoted on a yield basis, not as a
percentage of their par value.

Agency Securities
Agency securities include debt instruments that are issued and/or guaranteed by federal agencies
and by government-sponsored enterprises (GSEs). Although agency securities are not direct
obligations of the U.S. government, their credit risk is still considered low. Investors are attracted to
agency securities due to their perceived safety and the fact that their yields are slightly higher than
the yields of corresponding U.S. Treasury securities.

The overriding presumption is that since the federal government created these entities, it will not
allow a default on their obligations. Therefore, although unrated, agency debt may be considered to
be AAA rated. Also, as with U.S. Treasury securities, agency debt is issued in book-entry form and
1
quoted in fractions of /32nds of a point.

Federal Agencies
Since federal agencies are direct extensions of the U.S. government, the securities that they issue or
guarantee are backed by the full faith and credit of the U.S. government. This category includes the
Government National Mortgage Association (GNMA or Ginnie Mae).

Government-Sponsored Enterprises
Government-sponsored enterprises (GSEs) are publicly chartered, but privately owned
organizations. Congress allowed for their creation to provide low-cost loans for certain segments of
the population. The enterprise issues securities through a selling group of dealers with the offering’s
proceeds provided to a bank (or other lender). The bank then lends the money to an individual who
is seeking financing (e.g., students, homeowners, or farmers).

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CHAPTER 5 – OVERVIEW OF SECURITIES AND TAX CONSIDERATIONS

Although GSE securities are not backed by the U.S. government, they do have an implicit guarantee
from the U.S. government and are considered to have minimal default risk. Examples of GSEs
include:
 Federal National Mortgage Association (FNMA or Fannie Mae)
 Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac)
– Both FNMA and FHLMC are covered with mortgage-backed securities below
 Federal Farm Credit Banks (FFCBs)
 Federal Home Loan Banks (FHLBs)

Federal Farm Credit Banks (FFCBs) The Federal Farm Credit Banks provide funds for three separate
entities—Banks for Cooperatives, Intermediate Credit Banks, and Federal Land Banks. These
organizations make agricultural loans to farmers. Interest received on these obligations is subject to
federal tax, but is exempt from state and local taxes.

Federal Home Loan Banks (FHLBs) The 12 Federal Home Loan Banks help provide liquidity for
the savings and loan institutions that may need extra funds to meet seasonal demands for money.
As with FFCB debt, interest received on these securities is subject to federal tax, but is exempt from
state and local taxes.

Mortgage-Backed Securities
As the name implies, mortgage-backed securities are debt instruments that are secured by pools of
home mortgages. The agencies that issue these securities include GNMA, FNMA, and FHLMC.

Pass-Through Certificates The most common security that’s issued by government agencies is a
mortgage-backed pass-through certificate. The simplest method of creating a pass-through
certificate is for an agency to purchase a pool of mortgages with similar interest rates and
maturities. Interests in the pool are then sold to investors as pass-through certificates. Each
certificate represents an undivided interest in the pool and the owners are entitled to share in the
cash flow that’s generated by the pooled mortgages.

The picture below provides the basic idea of a mortgage-backed pass-through investment:

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 CHAPTER 5 – OVERVIEW OF SECURITIES AND TAX CONSIDERATIONS

On a monthly basis, the homeowners in the pool make their mortgage payments and, after certain
administrative charges are deducted, the bulk of these payments are passed through to investors
every month. Each payment includes a portion of both interest and principal.

Federal Home Loan Mortgage Corporation The purpose of the Federal Home Loan Mortgage
Corporation, or Freddie Mac, is to provide funds to federally insured savings institutions to finance
new housing. Freddie Mac raises money for its operations by issuing mortgage-backed bonds, pass-
through certificates, and guaranteed mortgage-backed certificates. These securities are not backed
by the U.S. government; instead, they’re backed by other agencies and the mortgages that are
purchased by Freddie Mac. Interest earned on Freddie Mac securities is subject to federal, state,
and local tax (i.e., it’s fully taxable).

Federal National Mortgage Association The Federal National Mortgage Association, or Fannie
Mae, raises money to buy insured Federal Housing Administration (FHA), Veterans Administration
(VA), and conventional residential mortgages from lenders such as banks and savings and loan
associations. Rather than being backed by the U.S. government, FNMA issues are backed by its
authority to borrow from the U.S. Treasury. Interest earned on FNMA securities is subject to
federal, state, and local taxes (i.e., it’s fully taxable).

Government National Mortgage Association Unlike FHLMC and FNMA, the Government
National Mortgage Association, or Ginnie Mae, is part of the Department of Housing and Urban
Development. Since Ginnie Mae is a true government agency, it’s backed by the full faith and credit of
the U.S. Treasury. Ginnie Mae’s purpose is to provide financing for residential housing. Although
Ginnie Mae securities are direct obligations of the U.S. government, any interest earned on the
securities is subject to federal, state, and local taxes.

GNMA issues mortgage-backed securities and participation certificates, but its most popular
securities are modified pass-through certificates. A modified pass-through certificate is backed by a
pool of FHA and/or VA residential mortgages. As the homeowners in the pool make their mortgage
payments (consisting of principal and interest), a portion of those payments is passed through to
the investors who purchased the certificates from GNMA. GNMA guarantees monthly payments to
the owners of the certificates, even if it has not been collected from the homeowners.

The mortgages in the pool have maturities that range from 25 to 30 years. However, due to
prepayments, foreclosures, and refinancings, the average life of the pool tends to be much shorter
especially during periods of declining interest rates and the resulting prepayment risk.

Prepayment Risk In addition to the risks that are inherent in many fixed-income investments (e.g.,
interest-rate, credit, and liquidity risk), mortgage-backed securities are subject to a special type of
risk which is referred to as prepayment risk. This is the risk that’s tied to homeowners paying off their
mortgages early. When interest rates fall, homeowners have an incentive to refinance and pay off
their existing mortgages. This risk, and others, will be described in more detail in Chapter 9.

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Options
Let’s start with answering the question, what’s an option? An option is a derivative security and, in
the simplest terms, is a contract whose value is derived from the movement of an underlying stock,
index, currency, or other asset. These derivatives trade in markets that are very similar to those in
which stocks and bonds trade. The foundation for understanding options is to examine the terms
that are essential to any option discussion.

Equity Options – Terminology

Buyers and Sellers
An option is a contract that’s entered into by two parties. On one side of the contract is the buyer, owner,
or holder of the option who is also considered long the option. The buyer pays the option’s premium (i.e.,
the contract’s market price) and receives the right to exercise the contract. Depending on the type of
contract that’s purchased, the holder has the right to either buy or sell the underlying security.

On the other side of the contract is the seller or writer of the option who is also considered short the
option. The seller receives the option’s premium and assumes an obligation if the contract is
exercised in the future. Depending on the type of contract that’s sold, the writer may be obligated to
either buy or sell the underlying security.

Remember, a buyer pays the premium and receives the right to exercise. However, if the option
expires worthless, the premium paid represents the buyer’s maximum loss.

A seller receives the premium and assumes an obligation if exercised against. However, if the
option expires worthless, the premium received represents the seller’s maximum gain.

Synonymous Terms
Buyer Seller
Owner Writer
Holder Short
Long

Types of Options
The two types of options that may be purchased and/or sold are calls and puts.
 A call option gives the owner the right to buy the underlying security. In other words, a call buyer
is able to call the security away from the writer at a fixed price. The writer of the call has the
corresponding obligation to sell the security at the fixed price if the owner exercises the contract.
– Buyers of calls are bullish (want the underlying asset to rise)
– Sellers of calls are bearish (want the underlying asset to fall)

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 CHAPTER 5 – OVERVIEW OF SECURITIES AND TAX CONSIDERATIONS

 A put option gives the owner the right to sell the underlying security. In other words, a put buyer
is able to put the security to the writer at a fixed price. The writer of the put has the
corresponding obligation to buy the security at the fixed price if the owner exercises the
contract.
– Buyers of puts are bearish (want the underlying asset to fall)
– Sellers of puts are bullish (want the underlying asset to rise)
The following table summarizes the rights or obligations and strategies of the two sides of an
option:

Long Short
Right to Buy Obligation to Sell
Call
(Bullish ) (Bearish )

Right to Sell Obligation to Buy

Put
(Bearish ) (Bullish )

Speculation versus Hedging

Investors purchase and sell options to either speculate on the potential movement of an underlying
instrument or hedge an existing position. Speculation refers to generating a profit based on an
anticipated price change in the value of a security on which the investor has no existing position.
Buying a call in anticipation of an increase in the price/value of an underlying instrument and
buying a put in anticipation of a decrease in the price/value of an underlying instrument are
examples of speculation. Conversely, writers of either calls or puts are simply speculating that their
options will expire worthless.

Hedging refers to purchasing options to protect against the risk of adverse movement in the value of
the underlying instrument. For example, an investor who owns stock can buy a put option to hedge
the risk of the stock declining in value. The put purchase locks in selling price (the strike price) if the
underlying stock falls in value.

Tax Considerations
The final section of this chapter will examine some of the specifics regarding the taxation of various
investments. There are two issues that are of primary concern, (1) the tax status of the payments
received from the securities (i.e., dividends or interest), and (2) the resulting capital event at the
time of resale.

Dividends—Cash Dividends
Dividends may be paid in the form of cash or additional shares of stock. Cash dividends are taxable in
the year in which they’re received by the shareholder. Individuals must pay tax on the full amount of
all cash dividends received, even if those dividends are subsequently reinvested with the issuer.

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Qualifying Cash Dividends A qualified dividend is a type of dividend that’s taxed at the same rate
as long-term capital gains (maximum of 20%), rather than at an investor’s ordinary rate. Generally,
most regular dividends from U.S. companies that have normal company structures (i.e.,
corporations) are considered qualified for tax purposes.

Taxation of Bond Interest

Interest received from bonds is considered income, but whether it’s federally taxable, state/local
taxable, or both is determined by the nature of the issuer as shown below:

Security Federally Taxable State/Local Taxable

Corporate Bonds Yes Yes

U.S. Government Treasuries Yes No

Municipal Bonds No Varies*

Territory/Possession Bonds No No

* In most states, taxpayers don’t pay state and local tax on bonds issued
by municipal entities that are located in the states in which they reside.

Cost Basis of Securities

The cost basis of a security is the total price paid to acquire the security including any transaction
costs (e.g., commissions). For example, if an investor purchased 100 shares of ABC at a cost of $10
per share, her cost basis is $1,000. For tax purposes, an investor’s profit or loss is calculated based
on the difference between the cost basis and the proceeds from the sale.

Identifying Shares Sold Investors who have made multiple purchases of the same stock over time
will generally have a different basis for each purchase. If any portion of the shares are subsequently
sold, the investor may choose to designate which shares are being sold. If specifically designated,
the brokerage firm will mark the confirmation "versus purchase of . . ." and insert the desired
purchase date. However, if a designation is not made, the IRS will automatically assume that the
taxpayer is using the first-in, first-out (FIFO) method to determine the position being sold. For
sales, the use of specific identification or FIFO may have a significant influence over whether the
investor has a resulting gain or loss.
For example, Mr. Jones has executed the following transactions in the same year:
On May 1, he bought 100 shares of XYZ at $60
On September 1, he bought 100 shares of XYZ at $90
On October 15, he sold 100 shares of XYZ at $89

For Mr. Jones to be able to apply the October 15 sale of 100 XYZ at $89 to his September 1
purchase at $90 (creating a $100 loss), the sell order ticket must be marked "versus
purchase of September 1, 20XX." If not designated, the IRS will apply the October 15 sale
to the May 1 purchase (FIFO), thereby creating a $2,900 capital gain.

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 CHAPTER 5 – OVERVIEW OF SECURITIES AND TAX CONSIDERATIONS

Capital Gains and Losses

Securities such as stocks, bonds, and options are considered capital assets. For an investor, any sale
of these assets will likely produce either a capital gain or capital loss. These gains or losses are
typically recognized in the year in which the asset was sold. If a capital asset is sold for more than its
cost, it’s considered a capital gain. On the other hand, if a capital asset is sold for less than its cost,
the result is considered a capital loss. When the holding period for the asset exceeds one year, the
gain or loss is considered long-term. However, if the holding period for the asset is one year or less
prior to its sale, any gain or loss is considered short-term.

Whether a capital gain is classified as short-term or long-term may have significant tax implications
for investors. Long-term capital gains are taxed at a maximum rate of 20%, while short-term capital
gains are taxed at the same rate as ordinary income.

Netting Gains and Losses An investor who has a combination of capital gains and losses
involving securities with short-term and long-term holding periods will need to net those activities
to determine the applicable tax treatment. Netting refers to using capital losses to offset capital
gains on a dollar-for-dollar basis. The process of netting effectively reduces (or possibly eliminates)
the tax liability that normally exists when capital gains are created.

Net short-term capital gains or net long-term capital gains are taxed at the rates previously
specified. However, if an investor has both net long-term gains and net short-term losses, these two
figures must be netted before the 20% tax rate applies.

If gains exceed losses, the tax liability is dependent on the category into which the remaining gains
fall. For example, if an investor has a $12,000 short-term capital gain and a $7,000 long-term capital
loss, the result is a net $5,000 capital gain which will be taxed at the short-term rate. If capital losses
exceed capital gains, a maximum of $3,000 of those losses may be used in the current tax year as a
deduction against ordinary income. Thereafter, any unused losses are able to be carried forward for
use in subsequent years until the excess net losses have been offset by net gains or ordinary income.
For example, an investor with $5,000 in long-term gains and $10,000 in short-term losses
will net these two results and be left with a $5,000 short-term loss ($10,000 – $5,000). The
investor will then deduct $3,000 from their ordinary income and carry forward the
remaining $2,000 loss to the next tax year.

Wash Sale The IRS does not allow an investor to claim a deduction for a capital loss on an
investment if he purchases “substantially the same security” within 30 days of the sale. The period
covered by the wash sale rule is actually 61 days since it includes the date of sale and 30 days both
before and after the date of sale.

If a security is sold for a loss, the seller must wait a minimum of 31 days before repurchasing the
same or similar security. If a wash sale is determined to have occurred, the loss is denied and will be
added to the cost basis of the new purchase.

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For example, an investor bought stock at $24 per share and later sold the stock at $21 per
share—claiming a $3 loss per share. If, 10 days after the sale (within 30 days), the investor
buys the same stock at $23, the $3 loss would be disallowed and his new cost basis will be
$26 ($23 + $3).

For purposes of the wash sale rule, what does the IRS consider to be substantially the same? For
common stock, in addition to the stock itself, convertible bonds, convertible preferred stocks, or
call options of the same company are considered “substantially the same” since they are able to be
converted into the common shares.

For debt securities, bonds of a different issuer, or with a different coupon, or with a different
maturity will not be considered “substantially the same.” However, if a bond is purchased and
subsequently sold with only different accrued interest amounts, this will not be considered a
relevant difference for avoiding the wash sale rule.

Wash Sale Zone

In this zone, any purchase of the
Purchase Purchase
security will trigger a wash sale
allowed allowed
30 days 30 days
Sale at
a loss

Conclusion
This ends the chapter on securities and tax considerations. Keep in mind that equities represent an
investor’s ownership in a corporation and, with ownership, the investor is entitled to certain rights
and privileges. The next chapter will focus on investment companies. This is a significant chapters
since the first part of the Series 6 Exam title is Investment Companies.

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 CHAPTER 6

Investment Companies

Key Topics:

 Types of Investment Companies

 The Organization of a Mutual Fund

 Categories of Mutual Funds

 Buying and Selling Mutual Fund Shares

 Other Types of Investment Companies

 CHAPTER 6 – INVESTMENT COMPANIES

This chapter will examine different investment company products such as mutual funds,
closed-end funds, unit investment trusts (UITs), and exchange-traded funds (ETFs).
Although each of these products has different characteristics, they have one element in
common—they provide investors with an efficient way to quickly buy or sell a group of
underlying stocks and/or bonds. Series 6 candidates should place special emphasis on both
the suitability concerns and tax issues that surround these investments.

Types of Investment Companies

Let’s begin by defining the topic of this chapter—investment companies. An investment company
pools funds from numerous investors and purchases securities that are held in a portfolio for the
benefit of those investors. The method by which investment companies are organized and operated
is governed by the Investment Company Act of 1940. The Act of 1940 identifies three different types
of investment companies—face-amount certificate companies, unit investment trusts, and
management companies. The Act further divides the management companies into closed-end and
open-end companies. Open-end management companies are more commonly referred to as
mutual funds.

Types of
Investment Companies

Face Amount Management Unit Investment

Certificate Companies Companies Trusts (UITs)

Open-End Closed-End

Open-End Management Companies (Mutual Funds)

Open-end management companies are by far the most popular type of investment company. The
basic idea is that, for a cost, a mutual fund provides a means for investors with similar goals (e.g.,
long-term growth) to pool their money and invest in a portfolio of securities. As with other
companies, this investment pool elects a board of directors (BOD). The fund’s BOD will hire an
expert (i.e., an investment adviser) to perform the security selection and trading functions.

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Some of the advantages offered by mutual funds include the following:

Diversification Essentially, the diversification in a mutual fund is exemplified by the adage, “don’t
put all your eggs in one basket.” Diversification allows investors to reduce their risk by spreading
their money among many different investments.

Diversified versus Non-Diversified A management company may be either diversified or non-

diversified. In order to qualify as a diversified company, the portfolio must be invested in the
following specific manner:
1. At least 75% of the assets must be invested.
2. No more than 5% of the invested assets may be invested in any one company.
3. No more than 10% of the voting stock of any one company may be owned.

25%
May be invested
in any manner
75% No more than 5%of the
fund’s total assets in any
Must be diversified one issuer’s securities

A diversified company must meet these standards at the time of initial investment; however,
subsequent market fluctuations or consolidations will not nullify its diversified status.

Professional Management Most retail investors don’t have the time or expertise to manage their
own investments adequately and cannot afford to hire their own professional manager. By
investing in mutual funds, the investors receive the services of professional managers for much less
than they would need to pay individually. These money managers must be registered as investment
advisers under the Investment Advisers Act of 1940.

Liquidity Liquidity is defined as the ability to sell an asset at a reasonable price within a short
period. Mutual funds are highly liquid investments; however, unlike standard stocks, mutual fund
shares are not traded throughout the day. Instead, mutual fund shares are issued and able to be
redeemed at the end of each trading day.

Exchanges at Net Asset Value Another benefit is that shareholders may often exchange their
shares own in one fund for shares of another fund within the fund family at the net asset value (the
fundamental value of the shares). No sales charges will be assessed on the reallocation.

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Convenience A person who wants to invest a fixed sum of money every month may arrange to
have the funds automatically deducted from their checking accounts. Investors are also able to have
their income dividends and capital gains reinvested automatically.

Recordkeeping Mutual funds provide a number of services that make investing easy. The fund
takes care of most of the record-keeping and ensures that shareholders receive regular reports that show
their purchases and redemptions as well as end-of-the-year tax summaries (Form 1099-DIV).
Mutual funds also must send detailed financial reports to their shareholders at least twice per year.
These semiannual and annual reports provide the shareholders with the most current information
about the fund’s finances and holdings as of a particular date.

SEC Registration The Investment Company Act of 1940 requires every investment company that
has more than 100 shareholders to register with the Securities and Exchange Commissions (SEC).
(There’s an exception if all of the shareholders meet certain financial tests that make them
qualified investors.) Also, a fund must have a minimum net worth of $100,000 in order to offer its
shares to the public.

The Prospectus The fund’s prospectus is the primary disclosure document for potential investors.
This document includes the following information about the fund:
 Investment objectives
 Investment policies and restrictions
 Principal risks of investing in the fund
 Performance information (whether the fund made money)
 The fund’s managers
 Operating expenses (the costs that are deducted from the fund’s assets on an ongoing basis)
 Sales charges (what investors pay in commissions when they buy shares in the fund)
 Classes of shares the fund offers
 How the fund’s NAV is calculated
 How investors redeem or purchase shares
 Exchange privileges (whether the investor can exchange shares in one fund for shares of
another fund)

Prospectus Delivery Requirement Any offer to sell a fund’s shares must either be preceded by or
accompanied by the current prospectus. The delivery may be made in physical or electronic form.
Dealers must have systems in place to ensure that clients receive this document before any
purchase orders are processed. Also, RRs are not permitted to alter a prospectus in any way. This
restriction prohibits a salesperson from underlining or highlighting the information he considers to
be the most relevant.

Mutual Fund Terminology Since mutual fund disclosure documents use specialized language, a
list of substitute terms is provided below:
 The sales charge is also referred to as the sales load.

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 The net asset value (NAV) is also referred to as the redemption or bid price.
 The public offering price (POP) is the net asset value plus the sales charge (if any).

Additional Disclosure: The Statement of Additional Information (SAI)

The Statement of Additional Information provides more detailed information than the prospectus
about a fund and its investment policies and risks. Unlike the prospectus, the SAI is not required to
be given to any person who simply expresses an interest in purchasing the fund’s shares. However,
the fund is required to provide a copy of the SAI to anyone who requests it.

Structure of a Mutual Fund

Shareholders The Fund Board of Directors

Investment Custodian Transfer Principal Service

Adviser Bank Agent Underwriter Providers

The Organization of a Mutual Fund

Although most mutual funds are organized as corporations, some are established as trusts. In many
ways, the structure of a mutual fund resembles a regular corporation. It has a board of directors
that’s responsible for administering the fund for the benefit of the shareholders. The shareholders
are the persons who invest money in the mutual fund.

Board of Directors The board of directors of a mutual fund is elected by its shareholders. The
board’s main functions are to protect the shareholders’ interests and to be responsible for:
 Establishing the fund’s investment policy (any fundamental changes in the policy must be
approved by shareholders)
 Determining when the fund will pay dividends and capital gains distributions to shareholders
 Appointing the fund’s principal officers who run the fund on a day-to-day basis (e.g., the
investment adviser that manages the fund’s portfolio)
 Selecting the fund’s custodian, transfer agent, and principal underwriter

Investment Adviser The fund’s investment adviser manages the fund’s portfolio in accordance
with its investment objectives and the policies established by its board of directors. The adviser
researches and analyzes financial and economic trends and then decides which securities the fund
should buy or sell in order to maximize its performance. The adviser is also responsible for ensuring
that the fund’s assets are properly diversified and for tracking the tax status of the fund’s
distributions to its shareholders.

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For these services, the investment adviser is paid a management fee that’s based on the assets
under management, but not on performance. The management fee is the largest expense incurred
by an investment company. Fund advisors are typically prohibited from employing certain
aggressive trading strategies such as short selling and using margin.

Custodian Bank In order to prevent the theft or loss of a fund’s assets, the Investment Company
Act requires the fund to either appoint a qualified bank as its custodian or maintain its assets under
a very strict set of rules. Most funds choose to appoint a bank to act as their custodian.

The custodian is responsible for safeguarding the fund’s cash and securities and collecting dividend and
interest payments from these securities. However, the custodian does not guarantee the fund’s
shareholders against investment losses, nor does it sell shares to the public. A fund’s custodian may also
serve as its transfer agent.

Transfer Agent The fund’s transfer agent performs a number of recordkeeping functions for the
fund, such as issuing new shares and canceling the shares that investors have redeemed. Today, most
of these securities functions are done electronically without physical certificates changing hands. The
transfer agent also distributes capital gains and income dividends to the fund’s shareholders, and
often handles the mailing of required documents such as statements and annual reports. A transfer
agent may be a broker-dealer or have a broker-dealer as a subsidiary. If this is the case, any
information that the broker-dealer or its representatives acquire regarding the fund(s) for which it
serves as a transfer agent may not be used without the permission of, and on behalf of, the fund itself.

Principal Underwriter Most funds use a principal underwriter, also referred to as the sponsor,
wholesaler, or distributor, to sell their shares to the public. An underwriter may sell shares directly
to the public or it may employ intermediaries (dealers) such as a discount or full-service brokerage
firm. Many funds use a network of dealers to market their funds to investors. The dealers are
essentially brokerage firms that have a written contract with the underwriter and are compensated
for selling shares of the fund to investors. A FINRA member firm may not sell fund shares at a
discount to a nonmember firm since only member firms may receive sales charges.

Three Distribution Methods

Dealers
1) Fund Principal Underwriter Dealers Investors
Dealers

2) Fund Principal Underwriter Investors

3) Fund Investors

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CHAPTER 6 – INVESTMENT COMPANIES

Types of Mutual Funds

Now that the technical aspects of mutual funds have been examined, let’s review the different types
of funds and the clients for whom they are suitable. While there are thousands of mutual funds
available in today’s marketplace, the key is finding the fund or funds that best meet a client’s
objective. Not every mutual fund is suitable for every investor. Different mutual funds will be
appropriate for different clients, depending on their investment objectives and risk tolerance.

High Risk Category

Aggressive Growth Funds Aggressive growth funds invest in small companies and often
participate in the initial public offerings of these companies’ shares. The stocks of these companies
can be very volatile, but historically they have also produced high returns for long-term investors.
These funds are best suited for younger, risk-taking investors who can tolerate the swings in value
and the fact that these holdings generally don’t provide income (dividends).

Specialized or Sector Funds Some funds concentrate their investments to stocks in a particular
industry (e.g., high tech stocks or pharmaceuticals) or in a particular geographic location.
Specialized funds invest in companies that are undergoing some type of change, such as
bankruptcy. Although specialized funds are riskier than more diversified funds, they allow fund
managers the opportunity to take advantage of unusual situations. These funds are most
appropriate for investors who are seeking to speculate on a given sector of the economy (e.g., gold,
housing, etc.) For example, precious metal funds invest in companies whose values are connected
to gold, silver, or other precious metals, or may invest directly in the actual metals.

International and Global Funds Mutual funds that focus on foreign securities are often the
easiest way for U.S. investors to invest abroad. International funds invest primarily in the securities
of countries other than the United States. They include funds that invest in a single country and
regional funds that invest in a particular geographic region (e.g., Europe or the Pacific Basin). On
the other hand, global funds invest all around the world, both in the U.S. and abroad.

International funds have more risks than purely domestic funds, but also have the potential to provide
higher returns and allow U.S. investors to diversify their portfolios. One particularly volatile type of
international fund is an emerging markets fund. These funds invest in the stocks and bonds of emerging
market countries that are evolving from an undeveloped agricultural economy to a modern industrial
one (e.g., Brazil), or from a socialist economy to a free market system (e.g., Eastern Europe and Russia).

Moderate Risk Category

Growth Funds Capital appreciation is the main objective of a growth fund. The advisers of these
funds invest in stocks that they believe will show above-average growth in share price. Growth
stocks are more volatile than other securities and are more vulnerable to market risk; however, they
also have a higher potential for long-term appreciation. These funds are most suitable for investors
with long-term investment objectives and those able to tolerate fluctuations in their principal.

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Equity Income Funds Equity income funds invest in companies that pay high dividends in relation
to their market prices. These funds usually hold positions in mature companies that have less
potential for capital appreciation, but are also less likely to decline in value than growth companies.

Growth and Income Funds These funds have both capital appreciation and current income as
their investment objectives. Growth and income funds invest in companies that are expected to
show more growth than a typical equity income stock and higher dividends than most growth
stocks. However, the trade-off is that they usually offer less capital appreciation than pure growth
funds, and lower dividends than income funds.

Bond Funds The main objectives of bond funds are current income and preservation of capital. Since
the portfolio consists of bonds only, many of these funds are susceptible to the same risks as direct
investments in bonds, including credit risk, call risk, reinvestment risk, and some degree of
interest-rate risk.

Bond funds are grouped into subcategories according to the type of bonds that they purchase for
their portfolio. Government bond funds invest in Treasury securities; mortgage-backed bond funds
usually contain mortgage-backed pass-through securities that are issued by government agencies
(e.g., Ginnie Mae or Fannie Mae); and municipal bond funds create portfolios that exclusively
consist of municipal bonds. Actually, some municipal bond funds invest only in the municipal
bonds issued by one state which provides residents of that state with triple-tax-exempt income.

Corporate bond funds invest in bonds from a variety of corporate issuers and, since even highly rated
corporate bonds have more credit risk than government bonds, the yields from these funds are
normally higher. Some corporate bond funds buy investment-grade bonds only, while high-yield bond
funds invest in bonds that are rated below investment grade (also referred to as junk bonds. High-yield
bond funds have the potential to pay higher returns, but also have much greater credit risk.

Convertible Security Funds Convertible security funds invest the majority of their assets in
securities that are convertible into common stock (e.g., convertible bonds and convertible preferred
stock). These can provide a stream of income as well as the ability to protect against interest-rate
risk due to the ability to convert into the underlying stock component.

The funds will pass through the interest payments that they receive from the bonds in their portfolios
to the holders of the bond funds—either monthly, quarterly, or semiannually. One of the major
differences between investing in actual bonds versus a fund that consists of bonds is that the actual
bonds have a maturity date, while the bond funds don’t. Instead, the manager of a fund comprised of
bonds will adjust the portfolio with new bonds as others mature. In order to receive principal in a
bond fund, an investor is required to sell or redeem her shares of the fund. Only by investing in actual
bonds is an investor able to have her principal returned in one lump sum when the bonds mature.

Index Funds Index funds have become increasingly popular in recent years. An index fund
creates a portfolio that mirrors the composition of a particular benchmark stock or bond index,
such as the S&P 500 Index.

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An index fund attempts to produce the same return as the index; therefore, investors cannot expect
the fund’s returns to outperform the relevant benchmark. Nevertheless, index funds have
historically outperformed a large percentage of actively managed funds.

Since index funds don’t require active management, they are considered to be passively managed.
These funds generally have much lower fees than actively managed funds and are often used by
investors who believe markets are efficient and that active management is unlikely to produce
superior returns.

Balanced Funds Balanced funds maintain some percentage of their assets in stocks, bonds, and
money-market instruments (cash equivalents). Although the percentages will vary from time to
time as market conditions change, a portion of the portfolio will always be invested in each type of
security. Balanced funds tend to show less volatility than common stock funds by falling less in
periods of market declines and rising less in periods of market advances.

Asset Allocation Funds Similar to balanced funds, these funds also invest in stocks, bonds, and
money-market instruments. Fund managers determine the percentage of the fund’s assets to invest
in each category based on market conditions. The proper proportion of each asset class is often
determined by a computer model that’s used by the manager. Unlike balanced funds, the
percentage of the portfolio that’s invested in any of the three asset classes may drop to zero for a
period based on the model’s projections.

Life-Cycle Funds These funds are designed for investors who have a specific goal in mind, such
as retirement. Life-cycle funds define the investment time horizon by naming a target date.
Typically, when the investor is younger, the fund is more aggressively invested. As she ages, the
fund periodically switches to a more conservative investment mix. These funds offer investors the
convenience of knowing that once the parameters are set, they will be adjusted automatically.

Interval Funds See description in Closed-End Investment Companies section on Page 23.

Low Risk Category

Money-Market Funds Money-market funds invest in short-term debt (money-market)
instruments that typically have maturities of less than one year. The two principal benefits for
investors in money-market funds are liquidity and safety. Investors are able to withdraw funds at
any time, often by means of receiving a check. These funds are designed to maintain a constant net
asset value of $1 per share; however, this is not guaranteed. Returns vary along with short-term
interest rates, while dividends are typically declared daily with payment made on a monthly basis.

Money-markets funds are often used by investors as a safe haven. If an investor is uncomfortable
with the current state of the stock and/or bond market, he may choose cash equivalents as his
investment. This approach is most likely accomplished through a money-market investment.

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Not all money markets are alike; some hold only U.S. Treasury-backed instruments, others may
hold commercial paper, and still others hold short-term municipal debt. Ensuring that the money
market instruments selected matches the clients’ risk tolerance and tax situation is extremely
important for RRs. High tax bracket clients are typically placed in tax-free funds, while extremely
risk-averse clients may be better served in U.S. government money-market funds.

The table below is a summary of the different types of funds:

Types of Funds
Type Portfolio Suitable For
Growth Funds Common stocks
Long-term investors who are seeking capital
 Conservative Growth Funds Blue-chip, large-cap stocks
appreciation
 Aggressive Growth Funds Small- and mid-cap stocks
Investors who want income along with some
Equity Income Funds Common and preferred stocks
small potential for capital appreciation
Investors who want both capital appreciation
Growth and Income Funds Stocks
and income
Bond Funds Debt securities Investors interested in current income

 U.S. Government Funds Treasury securities Investors who want income and safety

 Municipal Bond Funds Municipal securities Investors who want tax-exempt income

 Corporate Bond Funds Investment-grade corporate bonds Investors who need income
Investors who want high income and are willing
 High-Yield Funds Non-investment-grade (junk) bonds
to accept a high degree of capital risk
Stocks, bonds, and cash equivalents (money-
Investors who are interested in having an
Balanced Funds market instruments). The asset mix adjusts,
investment in all three classes of assets
but will always have some of each asset.
Stocks, bonds, and cash equivalents.
Investors who want to diversify among asset
Asset Allocation Funds The proportions may be changed and the
classes in a single fund
percentage in any class could drop to zero.
Securities that are selected to mirror a Investors who want to pursue a passive
Index Funds particular index investment strategy that offers low fees
Investors who are willing to assume more risk
Specialized or Sector Funds Securities of one industry or geographic area
in exchange for a higher potential return
Investors who are willing to assume extra risk
Foreign Funds Non-U.S. securities and who want to diversify using securities
outside of U.S. markets

 Emerging Markets Funds Securities of emerging market countries Aggressive investors only

Cash equivalents (T-bills, commercial paper, Short-term investors who want liquidity and
Money-Market Funds negotiable CDs, and bankers’ acceptances) safety

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Buying and Selling Mutual Fund Shares

Mutual fund shares are purchased at their public offering price (POP) and redeemed at their
intrinsic net asset value (NAV). The difference between these two values is the sales charge.

Net Asset Value + Sales Charge = Public Offering Price

The equation above is used to determine the purchase price of the shares of a traditional front-end
load fund (Class A shares). In this case, the investor pays an up-front sales charge that’s added to
the NAV at the time of purchase. Fractional shares may be purchased if the amount being deposited
is not sufficient to purchase an even number of whole shares. If a client intends to sell (redeem) his
shares, he receives the next calculated NAV. Other share classes and pricing methods exist and will
be described later in this chapter.

Net Asset Value

The NAV of a mutual fund (or any other investment company) is determined by dividing its total net
assets (securities valued at their current market price, plus cash, minus total liabilities) by the total
number of shares outstanding.

Total Net Assets

Net Asset Value =
Number of Outstanding Shares

The net asset value of a mutual fund must be computed at least once a day. A fund’s prospectus
discloses the cutoff time used for purchases and redemptions of shares and explains how its NAV is
calculated. The net asset value is normally computed daily as of the close of trading on the NYSE.

End of Day Pricing Orders to buy and sell fund shares are based on the next price to be computed.
This is referred to as forward pricing since purchases and redemptions are based on the next calculated
price. For example, if an individual places an order to purchase shares at 11:00 a.m., the purchase price
will not be known until the net asset value is computed after the close of business on that day.

If a client places an order at 4:10 p.m. on Wednesday (after the close), the order will not be executed
until the close of business on Thursday. This end of day pricing is an important distinction between
mutual funds and other types of funds, such as ETFs. ETFs trade throughout the day and use
intraday pricing in a manner that’s identical to individual stocks.

Settlement of Transactions Mutual fund transactions typically settle on the same day as the
purchase/redemption. Unlike stocks, the ex-dividend date for a mutual fund is determined by the
fund or its principal underwriter. Typically, a mutual fund’s ex-dividend date is the business day
following the record date.

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Sales Charges—Front-End Loads When mutual fund shares are purchased with a front-end load
(Class A shares), investors must pay the public offering price which consists of the NAV plus a sales
charge. The maximum sales charge permitted under FINRA rules is 8.5%; however, breakpoints
(reduced sales charges) are often available to investors who purchase a significant amount of Class
A shares. The sales charge of a mutual fund share is stated as a percentage of the POP and the
percentage is calculated using the following formula:

POP – NAV
Sales Charge % =
POP

For example, if the XYZ Fund has an NAV of $17.25 and a POP of $18.40, the sales charge
percentage is 6.25% (the difference in values of $1.15 ÷ $18.40).

Back-End Loads and Contingent Deferred Sales Charges Rather than assessing a sales charge at
the time of purchase, some funds allow an investor to buy shares at the NAV and will then assess a
sales charge when the investor redeems her shares. Usually, the longer the investor owns the
shares, the greater the amount the back-end load will decrease. This is referred to as a contingent
deferred sales charge (CDSC). If the investor holds the shares long enough, it’s possible that there
will be no sales charge imposed at the time of redemption.

The following is a hypothetical example of a contingent deferred sales charge scale:

Years Since the CDSC as a Percentage of

Purchase was Made the Dollar Amount Invested
0–1 4.0%
1–2 3.0%
2–3 2.0%
3–4 1.0%
Greater than 4 None

Confirmation Disclosure For any transaction that involves the purchase of shares of an investment
company that imposes a deferred sales charge on redemption, FINRA’s Conduct Rules require a
written disclosure which includes the following statement: "On selling shares, an investor may pay
a sales charge. For details on the charge and other fees, see the prospectus." Although there’s no
sales charge assessed at the time of purchase, registered representatives may not attempt to sell
Class B shares as no-loads.

No-Load Funds Not all mutual funds assess sales charges. No-load funds sell open-end investment
company shares to the public at simply their net asset value; there’s no added sales charge. Therefore,
with these funds, the net asset value and public offering price are equal. Most no-load funds are
purchased directly from the fund’s distributor without any compensation being paid to salespersons.

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To be marketed as a no load fund, a fund may not assess a front-end load, a deferred sales load, or
a 12b-1 fee (described next) that exceeds .25% of the fund’s average annual net assets.

Fees and Charges

Prior to purchasing mutual fund shares, investors must review the total cost of fund ownership
since, in addition to sales loads, investors usually incur annual fees that are based on the NAV of
their holdings including those listed below.

12b-1 Charges In a 12b-1 arrangement, mutual funds may pay for distribution expenses by
having them deducted from the portfolio’s assets. These deductions are referred to as 12b-1
charges. These fees are used to pay the costs of distributing the fund’s shares to the public and will
cover expenses such as concessions and the costs associated with advertising and the printing of
the prospectus.

Before a mutual fund is able to pay its distribution expenses out of its portfolio, it must have a 12b-1
plan in place. This plan permits the board to enter into a contract with the principal underwriter
that involves payments to the underwriter. The 12b-1 charges are based on an annual rate, but may
be accrued and paid over shorter periods.

A 12b-1 fee is an ongoing asset-based charge that’s deducted from the customer’s account on a
quarterly basis. Typically, 12b-1 fees range between .25% and 1%, but the maximum permissible
12b-1 fee is an annualized 1% of the fund’s assets.

Service Fees Service fees are charges that are deducted under a 12b-1 plan and used to pay for
personal services or the maintenance of shareholder accounts. Trailing commissions (trailers) are
an example of a service fee. When RRs have sold fund shares to customers, they may be entitled to
trailers in the years following the original sale as compensation for continuing to service the clients’
accounts.

Administrative Charges Administrative charges are deducted from the net assets of an
investment company and used to pay various costs that are associated with operating the fund.
These charges include payments made to custodian banks and/or transfer agents. In the front of its
prospectus, a mutual fund is required to disclose all of its fees using a standardized table.

Expense Ratio The expense ratio is defined as the percentage of a fund’s assets used to pay its
operating costs. The ratio is calculated by dividing the fund’s total expenses by the average net
assets in the portfolio. The expense ratio consists of the management fee, administrative fees, and
12b-1 fees, but does not include sales charges.

Total Expenses
Expense Ratio =
Average Net
A t

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If a fund has total expenses of $1 million and average net assets of $100 million, its expense ratio is
1% ($1 million ÷ $100 million = .01 or 1%). Expense ratios typically range between .20% and 2% of a
fund’s average net assets and must be disclosed in the fund’s prospectus. Ultimately, the expense
ratio varies based on the fund and the share class selected by the investor.

Classes of Shares
Today, most funds offer investors the choice of multiple classes of shares, usually referred to as
Class A, Class B, Class C, etc. The differences in classes are the ways in which the sales charges and
distribution charges are assessed. Investors may choose between shares with front-end loads and
varying 12b-1 fees (marketing fees), back-end loads with higher 12b-1 fees, or some other combination.

Although the specifics of the different classes that each fund sells may vary widely, most funds offer
the following classes of shares:

Class A Shares (Front Load) Class A shares usually have front-end loads, but have small or
nonexistent 12b-1 fees. In addition, investors who purchase large amounts of shares within the
same fund family may be able to take advantage of reduced sales charges through the use of
breakpoints or rights of accumulation. The disadvantage of Class A shares is that not all of the
investor’s money is directed into the portfolio. For example, if an investor purchases $1,000 worth of
Class A shares of a common stock fund that has a 5% sales charge, only $950 is actually invested in
the fund. The $50 is deducted as a sales charge and benefits the selling brokers.

Class B Shares (Back Load)) Although Class B shares generally have no up-front sales charges,
higher 12b-1 fees are usually assessed. Investors are subject to contingent deferred sales charges (CDSC)
if the shares are redeemed before a certain period has elapsed. However, once the specified number of
years has passed and the back-end charge is reduced to zero, most funds will convert their Class B
shares to Class A shares. Unlike Class A shares, large purchases of Class B shares don’t qualify for
breakpoint discounts of sales charges.

Class C Shares (Level Load) Class C shares assess an up-front sales charge, which is usually 1%,
plus they have an annual 12b-1 fee or level load that’s typically equal to 1% of the fund’s assets. In
some cases, an investor may also pay a contingent deferred sales charge if the shares are sold within 12
to 18 months after being purchased.

Other Classes Many funds also offer additional classes of shares for employees of broker-dealers,
institutional investors, retirement plans, or other special categories of investors. In its prospectus, a
fund must fully disclose each class of shares it offers and the different sales charges and applicable
12b-1 fees.

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Shares Class Summary

Class A Class B Class C
Contingent deferred sales May have a front-end load, or
Sales Charges: Front-end load charge assessed if held less a contingent deferred sales
than 6 to 8 years charge, or both

Higher than for Class A

Higher than for Class A
12b-1 Fees: Low or none shares, generally the same as
shares
for Class B shares

Often convert to Class A

Breakpoints available for No conversion to Class A
Other: shares after 6 to 8 years; no
large purchases shares
breakpoints available

Appropriate Share Class Recommendations Recommending that a customer should buy one class
of shares instead of another is acceptable provided there’s a reasonable basis for believing that the
recommendation is suitable. The suitability of a share class with a particular sales charge/fee mix is
often based on the length of time the customer intends to hold the investment and the amount of
money the customer intends to invest.

Methods of Reducing Sales Charges

Investors who purchase Class A shares have a variety of different methods to reduce their sales
charges. Typically, these reduced sales charges apply to all purchases made within a fund family.

Fund Families The term fund family or fund complex is used when defining a single investment
company or mutual fund company that offers many different types of mutual funds under its brand
name. The objective is to provide a large number of mutual funds that provide a broad range of
investment options for investors. A customer may be able to invest a large sum of money with one
fund family, receive a sales breakpoint (reduced sales charge), diversify his assets, and be allowed to
exchange between mutual funds.

Breakpoints Mutual fund shares must be quoted at the maximum sales charge percentage that the
fund charges. However, most mutual funds offer sales breakpoints on shares that are purchased with
a front-end load. Breakpoints are dollar levels at which the sales charge is reduced (the mutual fund
industry’s version of a volume discount). The breakpoint is set by the fund’s distributor and cannot be
negotiated by individual broker-dealers. A fund’s breakpoints must be clearly stated in its prospectus.

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The following is an example of a breakpoint table:

Sales Charge As a Percentage

Amount Deposited
of the Offering Price
Less than $25,000 5.0%
$25,000, but less than $50,000 4.25%
$50,000, but less than $100,000 3.75%
$100,000, but less than $250,000 3.25%
$250,000, but less than $500,000 2.75%
$500,000, but less than $1 million 2.0%
$1 million and more 0.0%

For this fund, a person who invests between $100,000 and $250,000 will pay a reduced percentage
sales charge (3.25%). Notice that investors who contribute $1 million or more in a fund family will
not be assessed a sales charge. This is especially important if a client is prepared to make a
purchase of $1 million or more. If the entire amount is invested in shares of the same fund family,
all sales charges are waived. However, if the investment is split into two different fund families,
sales charges will be assessed by both families.

Determining the Offering Price Since breakpoints affect the purchase price of mutual fund shares,
investors should be able to determine a mutual fund’s offering price based on the sales charge
percentage. The POP may be determined by using the following formula:

NAV
POP =
(100% – Sales Charge %)

For example, if the XYZ Fund has an NAV of $10 and a person invests $100,000 into the
fund, it will entitle him to a 3.25% breakpoint. What’s the offering price for the investor?

$10.00 $10.00
POP = = = $10.34
(100% – 3.25%) 96.75%

In this example, with an offering price of $10.34, the investor is able to purchase 9,671.18
shares ($100,000 ÷ 10.34).

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Variations in sales loads are allowed if:

 The fund applies the variations uniformly to all of the potential purchasers of its shares
 Adequate information concerning scheduled variations is given to shareholders and
prospective investors
 The prospectus is revised if schedules are changed
 The company advises its existing shareholders of any new variations within one year

Letter of Intent (LOI) A letter of intent enables an investor to qualify for a discount that’s made
available through breakpoints without initially depositing the entire amount required. The letter
indicates the investor’s intention to deposit the required money over the next 13 months and is able
to be backdated for 90 days. The benefit of backdating is being able to incorporate earlier purchases.

Since letters of intent are non-binding, an investor will not be penalized for failing to make the
additional investments. However, if investors fail to make the additional investments, they are
charged the amount that would equal the higher sales charge that applied to the original purchase.
Basically, if a person fails to invest the amount stated in the LOI, the fund will retroactively collect
the higher fee.

Rights of Accumulation (ROAs) Rights of accumulation give investors the ability to receive
cumulative quantity discounts when purchasing mutual fund shares. The reduced sales charge is
based on the total investment made within a family of funds provided the shares are purchased in the
same class. Rather than using the original purchase price, the current market value of the investment
plus any additional investments is used to determine the applicable sales charge.

Availability of Breakpoints and Rights of Accumulation Breakpoints, letters of intent, and rights
of accumulation may be made available to any of the following:
 An individual purchaser
 A purchaser’s immediate family members (i.e., spouse and dependent children)
 A fiduciary for a single fiduciary account
 A trustee for a single trust account
 Pension and profit-sharing plans that qualify under the Internal Revenue Code guidelines
 Other groups, such as investment clubs, provided they were not formed solely for the purpose
of paying reduced sales charges

Remember, only purchasers of Class A shares are eligible for breakpoints; therefore, large
purchasers of funds should not be placed into Class B shares.

Before mutual fund shares are purchased by a client, an RR must inquire as to whether the client owns
other mutual funds within the same fund family in a related account—even if the account is held by
another broker-dealer. For example, a minor’s account, a joint account, and an IRA could be combined
with an individual account when determining the appropriate breakpoint on a new purchase.

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Letters of Intent Rights of Accumulation

The investor is able to add up all of the purchases

Investors receive the benefit of a breakpoint without made in the same fund complex. Once a breakpoint
immediately depositing all of the required funds. is reached, all future purchases are entitled to the
reduced sales charge.

For a fund to assess the maximum allowable sales charge of 8.5%, it must offer investors both
breakpoints and rights of accumulation. If the fund omits either of these features, the maximum
sales charge it’s permitted to assess is lowered according to a set schedule.

Dividend Reinvestment Most mutual funds make dividends and capital gains distributions to
their shareholders on an annual basis. Once a distribution is made, the investor must then choose
to either take the funds or reinvest them. Most mutual funds allow investors to reinvest dividends
and other distributions at the NAV. However, even if reinvested, the distribution is taxable and will
be added to the client’s cost basis.

Dollar Cost Averaging (DCA)

Dollar cost averaging is a popular method of investing in mutual funds in which a person invests a
fixed-dollar amount at regular intervals, regardless of the market price of the shares. An investor who
uses dollar cost averaging is ultimately buying more shares when the price is low and fewer shares
when the price is high. The result is that the investor’s average cost per share is lower than the
average of the prices at which the investor purchased shares.
For example, an investor commits to purchasing $100 worth of XYZ Fund shares each
month for three months. In month one, the shares are trading at $25 and four shares are
purchased. In month two, the shares are trading at $20 and five shares are purchased.
Finally, in month three, the shares are again trading at $25 and four shares are
purchased. What is the average cost per share and the average price per share?

Finding average cost per share: Finding average price per share:

Amount invested $300 Total of all prices $70

= = $23.08 = = $23.33
Shares acquired 13 Total time period 3 mo.

When discussing dollar cost averaging in reference to a periodic payment plan, the following points
must be made clear:
 At redemption, investors will sustain a loss if the market value of the shares is below the total
cost of the shares.
 Investors must take into account their ability to continue the plan in periods of low prices and
their willingness to continue the plan regardless of price levels.
 The plan does not protect investors against losses in steadily declining markets.

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Dollar cost averaging lessens the risk of investing a significant amount of money at the wrong time and
is considered particularly appropriate for long-term investors, such as those investing for retirement.

Redeeming Shares
An investor who currently owns shares in a mutual fund may redeem (sell) those shares back to the
fund on any business day. Since shares are redeemed at the NAV, a fund must calculate its NAV at
least daily; however, some funds may do the pricing more frequently. The Investment Company Act
of 1940 requires mutual funds to pay the redemption proceeds to their investors within seven
calendar days.

Redemption Fees When mutual fund shares are redeemed, some funds deduct a small
redemption fee from the amount paid to the investor. Redemption fees have a range of .5% to
approximately 2% and are returned to the fund’s portfolio. Ultimately, the fee, which is separate
from any deferred charge that may apply, is designed to discourage investors from redeeming shares
too quickly. Some funds waive redemption fees after the shares have been held for a specific period.

Systematic Withdrawal Plans

Many mutual funds offer investors the opportunity to withdraw their money systematically. If
investors elect to begin a systematic withdrawal plan, they will receive regular payments from their
accounts, typically on a monthly or quarterly basis. To participate in a systematic withdrawal plan,
investors must have a minimum amount in their accounts (generally at least $5,000). Payments are first
made from dividends and then capital gains; however, if these are not sufficient, the fund will redeem
the investor’s shares until the principal in the account is exhausted.

Investors who choose systematic withdrawal plans have three payout options—fixed-dollar, fixed-
percentage, or fixed-time. With fixed-dollar payout plans, investors will receive the same amount of
money with each payment. For example, a person who has $25,000 worth of shares could request
that the fund send her $200 per month until all of the funds are exhausted.

Investors may also request that their fund liquidate a fixed-percentage of their shares at regular
intervals—for example, 1% each month or 3% each quarter (using a fixed-percentage payout plan).
With this payout option, the exact dollar amount to be received by the client will vary based on the
NAV of the shares at the time they are sold.

The third choice for investors is to have their holdings liquidated over a fixed-time (using a fixed-
time payout plan). A client who chooses this method must provide the fund with an exact ending
date. Once the date is set, the fund will liquidate the client’s shares in amounts that will exhaust the
account by the date specified by the client.

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Prohibited Sales Practices

FINRA has established rules that address different violations relating to the sale of investment
company securities. Some of FINRA’s concerns involve RRs who ignore the best interests of their
clients and attempt to maximize their sales commissions by ignoring discounts that may be
available to clients. Below are some of the violations that may be encountered on the Series 6
Examination.

Breakpoint Sales
RRs who induce clients to purchase shares at a level just below the dollar value at which a
breakpoint is available are engaging in a prohibited practice that’s referred to as a breakpoint sale.
Instead, clients should be reminded that LOIs may be used if all of the funds are not currently
available. Also, RRs should avoid allocating a client’s investments into several different fund
families. This practice may result in the client not receiving a breakpoint that would have been
available if all the funds were allocated to a single family.

Selling Dividends
RRs are prohibited from pressuring clients to immediately purchase mutual fund shares in order to
capture an impending dividend. Essentially, there’s no economic benefit for a customer since, once
the dividend is paid, the fund’s NAV will fall. Also, by receiving the dividend, the customer will be
required to pay taxes on the distribution.

Switching
Regulators are always on the lookout for abusive sales practices. When an RR recommends that a
client sell the existing mutual fund shares she owns of one fund family and invest the proceeds into a
fund of another family, a new sales charge will be levied. The concern is that the movement between
different fund families is being recommended by an unscrupulous RR who is seeking to generate
income at the client’s expense. Remember, the movement between funds of the same family is not
typically a sales practice concern since the client is not required to pay an additional sales charge.

Purchasing Large Quantities of Class B Shares

RRs should not recommend buying Class B shares to a client who intends to place a large order. The
client would derive a greater benefit by purchasing Class A shares since only these shares qualify for
breakpoints.

Mutual Fund Taxation

Subchapter M of the IRS Code provides beneficial tax treatment to regulated investment companies
(RICs) that operate on a conduit or pass-through basis by distributing a substantial percentage of
their income to shareholders.

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To qualify as an RIC, an investment company must pass through at least 90% of its net investment
income (defined as dividends, plus interest, minus expenses) to shareholders. If the fund qualifies, it
will only be taxed on the portion of income that it retains. Therefore, the burden of paying taxes on
net investment income is primarily borne by the shareholders. Investment income, whether
reinvested in the fund or received as cash, is taxable to the investor. It’s important to remember that
investors are taxed appropriately based on the type of security that generates the income.

Cost Basis
A mutual fund investor’s cost basis represents his original investment along with all subsequent
reinvestments. When calculating gains and losses on liquidated positions, investors are permitted to use
their average cost basis. Average cost basis is calculated by dividing the total assets invested (including
reinvested dividends) by the total number of shares owned.
For example, by making an initial investment of $20,000 in a high-yield bond fund, an
investor acquires 702 shares. Over the next five years, the customer deposits another
$25,000 and reinvests $14,000 of distributions all of which allows him to acquire an
additional 1,240 shares. If the fund is currently valued at $27.11, what is the customer’s
cost basis if the average cost method is used?
In this example, the investor deposited a total of $59,000 and acquired a total of 1,942
shares. The average cost is $30.38 ($59,000 ÷ 1,942). Coincidentally, the current NAV of
the shares is irrelevant.

Reinvested Dividends and Distributions Many investors choose to reinvest the dividends and
other distributions paid by mutual funds rather than taking the payments in cash. However,
investors must still report these dividends and other distributions as taxable income in the year in
which they are reinvested. The cost basis of shares purchased through reinvestment is equal to the
purchase price at the time of the reinvestment.

Income
Any distribution of taxable bond interest and cash dividends on common stock must be reported as
ordinary income and is taxed at an appropriate rate. Realized short-term capital gains are included with
mutual fund dividends on an investor’s tax return and are taxed as ordinary income.

Capital Gains and Losses

As with other capital assets, capital gains and losses on mutual fund shares are calculated by
subtracting the cost basis of the shares from the sales proceeds received when they are sold
(redeemed). Of course, unrealized gains or losses are not included in this calculation. An investor who
redeems mutual fund shares receives a report of the sales proceeds at the year-end on Form 1099-B.
Using her account records (e.g., confirmations and statements), the investor is responsible for
determining the cost basis of the shares being sold. Whether a gain or loss is deemed to be long-term or
short-term is based on the length of time the investor owned the shares prior to sale (redemption).

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On the other hand, whether a capital gains distribution made by a mutual fund is deemed to be
long-term or short-term is based on the length of time the fund held the securities positions prior to
their sale. Since this situation involves the fund selling shares in its portfolio, the investor’s holding
period is irrelevant.

Exchange of Shares The exchange of shares is considered the sale of one fund’s shares and the
purchase of another. An exchange could result in a gain or loss and will represent a taxable event for
the investor. The capital gain or loss is calculated based on the cost basis of the shares being
redeemed from the first fund.

As it relates to mutual funds, the following events are taxable:

 Receiving dividends

 Reinvesting dividends

 Exchanging shares (within a fund family)

 Switching shares (outside a fund family)

Other Types of Investment Companies

Although mutual funds are by far the most common type of investment company, there are others.
Let’s now examine the other varieties of investment companies.

Face-Amount Certificate Company

This type of investment company is very rare today. A face-amount certificate company issues debt
certificates that pay a predetermined rate of interest. Investors purchase these certificates in either
periodic installments or by depositing a lump sum and then receive a fixed amount if they hold the
certificates until maturity. However, investors who cash in their certificates early will receive a
lesser amount—referred to as a surrender value.

Unit Investment Trust

Unit investment trusts (UITs) are formed under a legal document called an indenture and have
trustees rather than boards of directors. UITs invest in a fixed portfolio of income-producing
securities, such as bonds or preferred stocks.

UITs issue only redeemable securities that are referred to as units or shares of beneficial interest
(SBIs) that are generally sold in minimum denominations of $1,000. Each unit entitles the holder to
an undivided interest in the UIT’s portfolio that’s proportionate to the amount of money invested.

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The portfolio of a UIT generally remains static (fixed) until the trust is dissolved and, for that
reason, there’s no need for an adviser to manage the trust. Since securities are not consistently
being purchased or sold, UITs don’t have an associated management fee. Without management,
there’s no management fee that applies. Because of this structure, UITs are considered to be
supervised—not managed.

Closed-End Investment Companies

Along with open-ends, closed-end investment companies are the other type of management
company. Unlike open-end management companies (mutual funds), closed-end funds usually
issue common shares to the public on a one-time basis. Although they may issue additional shares
later, they don’t continuously issue new shares or stand ready to redeem their shares for cash.
While it’s typical for closed-end funds to issue common shares, some may issue senior securities
(i.e., preferred stock or bonds).

Once a closed-end investment company issues shares, these securities trade in the secondary
market. Therefore, if an investor wants to purchase shares in a closed-end investment company, he
will need to buy them on a traditional exchange (e.g., the NYSE or Nasdaq). There’s no prospectus
delivery requirement that applies to secondary market trades of closed-end funds.

The price that an investor pays for his shares is determined by the market forces of supply and
demand. Unlike mutual funds, closed-end funds may trade at prices that are at a discount or a
premium to their NAV. When closed-end funds are purchased or sold in the secondary market, the
investors are subject to commissions rather than sales charges.

Below is a table that compares open-end to closed-end management companies:

Open-End Funds Closed-End Funds

Continuously issue new shares Issue a fixed number of shares
May issue common shares or senior securities, such as
May issue only common shares
preferred stock and bonds
Price is determined by market forces which result in
Sold at NAV + sales charge (if any) shares selling at discounts or premiums to the NAV
 Commissions are paid on purchases and sales
Fund sponsor stands ready to redeem shares at the next
Fund sponsor does not stand ready to redeem shares
calculated NAV
Shares don’t trade in the secondary market Shares are traded in the secondary market

Prospectus delivery is required No prospectus delivery requirement

Interval Funds Although interval funds are legal classified as closed-end funds, they are quite
different than traditional closed-end funds. One of the concerns when purchasing a closed-end
fund is that the value of these investments often drift from the NAV. An interval fund is a type of
closed-end fund which offers shares that don’t trade on the secondary market.

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 CHAPTER 6 – INVESTMENT COMPANIES

An Interval Fund instead will periodically offer to buy back a portion of the outstanding shares at
net asset value, every three, six, or nine months. This removes the risk of some closed-end funds
that have limited marketability and often trade at deep discounts to their NAV.

Exchange-Traded Funds (ETFs)

ETFs issue shares each of which represent an interest in an underlying basket of securities that
mirror a specific index. Some ETFs may also be linked to indexes that represent the securities of a
particular country or industry.

Some examples of ETFs include:

 SPDRs (Spiders), which tracks the S&P 500 Index
 QQQs (Cubes), which tracks the Nasdaq 100 Index
 DIA (DIAMONDS), which tracks the Dow Jones Industrial Average

Many investors actively trade ETFs because they think they are better able to estimate the overall
direction of the market or a sector, rather than trying to do the same for an individual stock that’s
more susceptible to unexpected news events.

There are a number of ways that ETFs are unlike mutual funds, such as the fact that they are traded
on an exchange, have prices that are determined continuously by the forces of supply and demand,
have lower expenses, may be sold short, and may be purchased on margin. Additionally, rather than
being assessed sales charges, investors pay commissions whenever ETFs are purchased or sold.

An ETF may be an appropriate investment for customers who are investing a lump-sum and are
seeking diversification and low costs. They may also be suitable for investors intending to
implement asset allocation plans.

Lately, specific types of ETFs—inverse and leveraged ETFs—have become popular among investors.
Inverse ETFs attempt to go up when the market drops or go down when the market rises. Leveraged
ETFs seek to provide a multiple of the return on a benchmark index.

Inverse ETFs An inverse ETF is designed to perform as the inverse of the index it’s tracking. This
reverse tracking is accomplished through the use of short selling the underlying investments in the
index and other advanced strategies using futures and derivatives. The goal of the inverse ETF is to
yield performance that’s equivalent to short selling the stocks in the index. For example, if the S&P
500 falls by 1.5% on a given day, the inverse ETF should rise by approximately 1.5%. These products
are often used by long investors to hedge against a bear market.

Inverse ETFs provide investors with a benefit over traditional short selling strategies. When selling
short, an investor is exposed to a potential unlimited loss; however, with an inverse ETF, the
investor is only exposed to a potential loss of the instrument’s purchase price (i.e., ETFs offer
limited liability).

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Leveraged ETFs Leveraged ETFs are products that use debt instruments or financial derivatives
such as swaps, futures, and options to amplify the returns of a specific index. These leveraged
products may be constructed to either track the specified index or an inverse of the index. For
example, a leveraged long ETF may be designed to deliver 2 times or 3 times the performance of the
S&P 500 (referred to as double-long or triple-long ETFs). A leveraged bear ETF may be designed to
deliver the inverse of 2 times or 3 times the performance of the S&P 500 (referred to as double-short or
triple-short ETFs).

Inverse and Leveraged ETFs are Short-Term Investment Products Most inverse and leveraged ETFs
reset their portfolios daily in an effort to meet their objectives. In other words, all price movements
are calculated on a percentage basis for that day only. On the next day, everything will start all over.
For example, an investor pays $100 for one share of an inverse ETF based on an index
with a value of 10,000. On that day, the index falls by 10% and closes at 9,000. As a result,
the investors ETF share increases by 10% to $110. Rather than selling at the end of the
day, the investor stays invested. On the next day, the index opens at 9,000, but rises
during the day to close at 10,000, representing an increase of 11.11% (1,000 ÷ 9,000). The
inverse ETF will decrease by the same percentage and, as a result, the investor’s share goes
down from $110 to $97.78 (11.11% of $110 = a reduction of $12.22). Although the index
ended up exactly where it started, the investor’s ETF is down 2.22% because it was held
over multiple trading sessions.

Due to this daily resetting process, an inverse or leveraged ETF’s performance may not provide true
tracking of the underlying index or benchmark over longer periods. For this reason, leveraged ETFs
and inverse ETFs are best used for short-term trading strategies such as attempting to take
advantage of intraday price swings on a given index.

Comparison of Investment Companies

Secondary Market
Product Portfolio Marginable
Trading
Mutual Fund No Adjustable No
Closed-end Fund Yes Adjustable Yes
ETF Yes Generally Fixed Yes
UIT (redeemable) Yes Fixed No

Conclusion
This concludes the analysis of investment companies and exchange traded funds. The next chapter
will examine variable products and municipal fund securities.

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 CHAPTER 7

Variable Products
and Municipal Fund
Securities
Key Topics:

 Insurance versus Annuities

 Variable Annuities

 Suitability

 Variable Life Insurance

 Municipal Fund Securities

 CHAPTER 7 – VARIABLE PRODUCTS AND MUNICIPAL FUND SECURITIES

This chapter will focus on annuities, variable products and municipal fund securities.
Variable products are issued by insurance companies and are often offered through other
financial intermediaries, such as banks and broker-dealers. Municipal fund securities are
primarily designed for college savings. As with all of the other products introduced in this
manual, Series 6 candidates should become familiar with both the taxation and suitability
issues that surround these products.

Annuities
An annuity is an agreement between a contract owner and an insurance company. The owner gives the
insurance company a specific amount of money and, in return, the company promises to provide a
person (i.e., the annuitant) with income either immediately or at some point in the future. The
contract owner may designate any person as the annuitant; however, the annuitant and the
contract owner are usually the same person. Most annuitants choose to start receiving their income
payments when they retire.

Annuities are typically considered long-term investments which many clients use to supplement
their work-sponsored retirement plans and/or their IRAs. A significant benefit offered by annuities
is that the growth in the accounts is tax-deferred. However, two drawbacks are that purchasers of
these investments often have long holding periods and they may be subject to significant surrender
charges and/or tax liabilities if assets are withdrawn too early. Also, from an investor’s standpoint,
many of these contracts have features that can be confusing.

Tax Issues The majority of annuities are non-qualified, which means that the contract owner
invests money on an after-tax basis. Despite the fact that contributions are non-deductible, the
money will accumulate on a tax-deferred basis. In other words, an annuitant is not required to pay
taxes on the increases on her investment until she begins taking distributions or withdraws funds
from the account. If an annuitant withdraws money from an annuity before the age of 59 1/2, she may
be subject to a penalty and also be taxed on any portion of the withdrawal that represents earnings.

As is the case with retirement plans, these contracts don’t generate capital events. If any portion of
a withdrawal is subject to taxation, it’s taxable at ordinary rates.

Fixed versus Variable Annuities

There are two sub-categories of annuity contracts—fixed and variable. With a fixed contract, the
investment risk is borne by the insurance company; however, with a variable contract, the owner of
the policy assumes all of the investment risk. For this reason, fixed contracts are not considered
securities and are governed under state insurance law only. On the other hand, variable contracts
are considered securities and are subject to SEC, FINRA, and state insurance regulation. As is the
case with all variable products, a prospectus must be delivered prior to completing the sale of any
variable annuity.

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Fixed Annuities
For a fixed annuity, the money being contributed is invested by the insurance company in its
general account. This general account is the portion of an insurance company’s asset base into
which traditional policies such as whole life, term life, and other lower-risk investments are placed.
With fixed annuities, insurance companies guarantee a minimum rate of return and agree, if the
customer chooses, to provide fixed-dollar payments for potentially the rest of the annuitant’s life.

Fixed Contract Suitability Since the insurance company is obligated to pay the annuitant
regardless of how its investments perform, the insurance company assumes all of the investment
risk in a fixed annuity. An annuitant must feel secure in knowing that she will regularly receive the
same amount of money for the remainder of her life (assuming the insurance company remains
financially healthy). These fixed contracts are best suited for conservative investors who are seeking
predictable tax-deferred growth. Again, registered representatives must clearly disclose that an
annuity is a long-term investment since significant surrender fees may be incurred if assets are not
held in the contract for a minimum prescribed period.

A significant disadvantage to a fixed annuity is that the fixed-dollar payments being received by the
annuitant tend to not keep pace with inflation. Income that may seem sufficient today may become
inadequate after 20 to 30 years of rising prices (inflation).

Regulation Since fixed annuities are not securities, these contracts are typically not subject to
regulation by either the SEC or FINRA. However, all annuities are governed by state insurance
regulations. Lastly, there’s no prospectus delivery requirement with fixed annuities and any person
who sells them must have an insurance license, but is not required to obtain a securities registration.

Variable Annuities
Variable annuities are a more complex product. Rather than receiving a fixed interest rate or fixed
dollar amount as offered by fixed contracts, variable annuity investors are able to choose from a
menu of investment options. Contributions are invested in the insurance company’s separate
account with a rate of return that’s not guaranteed. The investor’s motivation for choosing a
variable annuity is the hope that the contract will consistently grow in order to counteract the
effects of inflation during retirement.

The Separate Account The separate account feature is unique to variable products. As the name
implies, the assets in an insurance company’s separate account are segregated from the insurance
company’s general account. A separate account and its underlying subaccounts must be registered
with the SEC as investment companies. All of the income and capital gains that are generated by the
investments are credited to the separate account. Additionally, any capital losses that are incurred
from the investment activity are charged to the separate account. However, the separate account is
not affected by any other losses or gains that the insurance company incurs in its general account.

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 CHAPTER 7 – VARIABLE PRODUCTS AND MUNICIPAL FUND SECURITIES

Separate
Account

Subaccount A Subaccount B Subaccount C Subaccount D

Growth Income Long-Term Bonds Aggressive Growth

Subaccounts In a typical variable annuity, the separate account contains a number of different
underlying portfolios (subaccounts) into which a contract owner may allocate his payments
according to his investment objectives. Also, the contract owner may generally transfer money from
one subaccount to another as his investment goals change. These transfers are not subject to tax
and additional sales charges are not assessed.

The table below provides a summary of the differences between fixed and variable annuities:

Fixed Annuity Variable Annuity

Provides a specified fixed payment for the Provides variable payments at regular
Payments:
contract term intervals for the contract term

Rate of Return: A guaranteed minimum No guaranteed minimum

Risk: Assumed by the insurance company Assumed by the annuitant

Hedge Against
No Yes
Inflation:

Classification: Not considered a security Considered a security

Prospectus Delivery: Not required Required

Types of Variable Annuities A variable annuity may be classified according to the point at which
annuity payments are to begin. The two classifications are immediate annuities and deferred annuities.

Immediate Annuities These annuities begin payments to the annuitant one payment period after a
lump-sum deposit has been made to fund the annuity. If the contract calls for monthly payments,
these payments to the annuitant will begin one month after the date of purchase. If the contract
calls for annual payments, these payments will begin one year after the date of purchase. An
immediate annuity may only be funded with a single premium since the payments will begin
shortly after the contract is purchased.

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Deferred Annuities With deferred annuities, the payments to the annuitant are delayed for an
undetermined period after the date of purchase. The first payment may begin several years after the
money is deposited. A deferred annuity may also be funded with a single premium, but most are
funded with periodic payments. Premiums may be deposited in the annuity monthly, quarterly, semi-
annually, or annually.

For Series 6 Examination purposes, if not specified, it should be assumed that the questions are
referring to non-qualified, deferred contracts which are funded with after-tax dollars.

How Deferred Annuities Work

Most variable annuities consist of two phases—the accumulation period and the annuity period.

Accumulation Period
During the accumulation, funding or pay-in period, the owner makes payments to the insurance
company and the value of the annuity account begins to grow (accumulate) on a tax-deferred basis.
Depending on when the annuity contract was established, the accumulation period could last for a
significant number of years. While mutual fund investors buy shares, customers investing in
variable annuities buy accumulation units. Accumulation units are an accounting measurement
used to determine the annuitant’s ownership interest in the separate account. The value of each
unit is tied to the performance of the separate account. If the separate account performs well, then
the units will increase in value. If performance is poor, the value of the units will decrease.

Accumulation Units Clients buy accumulation units at their net asset value (NAV), but are
normally subject to a deferred sales charge. The NAV of the subaccount units is calculated in the
same manner as the NAV of a mutual fund.

Total Net Assets

NAV Per Unit =
Total Units Issued

The NAV of each unit is calculated at the end of every business day (usually at the close of trading
on the NYSE). As with mutual funds, both liquidations and purchases of annuities use the same
end-of-day forward pricing method. To find the current value of a person’s interest in the separate
account, the number of accumulation units owned is multiplied by the current value of each
accumulation unit.

Tax Treatment Provided an investor doesn’t withdraw money from her annuity, she has no tax
liability from either the dividends or interest generated by the securities positions within the
subaccounts. Also, any switches executed between subaccounts are tax-free.

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 CHAPTER 7 – VARIABLE PRODUCTS AND MUNICIPAL FUND SECURITIES

Cash Surrender Value At any time during the accumulation period, a contract owner may cancel
(surrender) her variable annuity and receive a return of its current value. She may also simply
choose to withdraw a portion of its value (a partial surrender).

Death Benefit Although variable annuities are not life insurance policies, they often provide a
death benefit. The contract owner designates a beneficiary and, if the annuitant dies during the
accumulation period, the beneficiary receives the greater of either (1) the sum of all of the contract
owner’s payments to the annuity or (2) the value of the annuity on the day the annuitant dies.
Because mutual funds lack this feature, this is one reason that clients may prefer to purchase
annuity contracts despite the fact that they are relatively more expensive.

Annuity Charges and Expenses

In an annuity, the entire contribution is not invested since purchases are subject to various sales
charges and fees. Registered representatives must explain each of these costs to their clients prior to
carrying out a sale.

Sales Charges The prospectus for a variable annuity must clearly disclose all of the charges and
expenses that are associated with the annuity. Today, the majority of companies impose a form of
contingent deferred sales charge (also referred to as a surrender charge or withdrawal charge) that’s
similar to what’s assessed on Class B mutual fund shares. Although FINRA rules specify a maximum
sales charge of 8 1/2% for mutual fund sales, there’s no statutory maximum sales charge on variable
products. Instead, sales charges for variable annuities must be reasonable.

Expenses As to be expected, insurance companies that issue variable annuities have expenses. These
expenses are deducted from the investment income that’s generated in the separate account. Expenses
include the costs of contract administration, investment management fees, and mortality risk charges.

Management Fee Each of the subaccounts will usually assess an investment management fee.
This is the fee that the subaccount’s investment adviser receives for managing the assets.

Expense Risk Charges When an insurance company issues a variable annuity, it usually
guarantees that it will not raise its costs for administering the contract beyond a certain level
(referred to as the expense guarantee). The expense risk charge compensates the company if the
expenses incurred for administering the annuity turn out to be more than estimated.

Administrative Expenses Administrative expenses are associated with the costs of issuing and
servicing variable annuity contracts including recordkeeping, providing contract owners with
information, and processing both their payments and requests for surrenders and loans.

Mortality Risk Under this provision, an insurance company guarantees that it will make
payments to the annuitant for the rest of her life. When calculating these payments, the company
considers the annuitant’s expected life span and promises to provide the annuitant with lifetime
income even if she lives longer than expected (referred to as the mortality guarantee).

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CHAPTER 7 – VARIABLE PRODUCTS AND MUNICIPAL FUND SECURITIES

Annuity Period
The annuity, benefit, or pay-out period begins if/when an annuitant elects to receive income payments
from the annuity. Up to this point (during the accumulation period), a contract owner is permitted to
surrender the annuity for its current value or take random withdrawals at any time. However, once the
annuitant initiates the annuity period, he may not surrender the annuity or withdraw money from it.
Instead, he can only receive income payments based on the value of annuity units.

Annuity Units When a contract owner decides to annuitize, the insurance company converts his
accumulation units into a fixed number of annuity units. Annuity units are the accounting
measurement used to determine the amount of each payment to the annuitant. At annuitization,
these units become the property of the insurance company.

At annuitization, a significant concept is that the number of annuity units on which each payment
is based is fixed, but the value of the units will fluctuate. The insurance company calculates the
annuitant’s first payment by considering the following details about the annuitant and the contract:
 Age and gender
 Life expectancy
 Selected settlement (payout) option
 Projected growth rate, referred to as the assumed interest rate (AIR)

Factors Used to Determine the Number of Annuity Units

Age and Life Expectancy Since an annuity typically promises a payment for life, the insurance
company needs to use a person’s current age and gender to estimate how long the payments will need
to be made. For example, on average, it may be assumed that a 65-year-old woman will live for another
20 years. If payments are to be made monthly, it would require 240 monthly payments. Therefore, the
insurance company credits the account with 240 annuity units. The value of those units is then based
on how the funds in the account have accumulated and the manner in which they will be paid out.

On the other hand, if an 80-year-old man decides to annuitize, his remaining life expectancy will be
much shorter. The insurance company may assume he will live for only five years and,
correspondingly, his annuity payments will be much larger than the 65-year-old’s for a given
amount of accumulated assets.

Payout Option There are several methods for receiving payments from an annuity. An annuitant
may choose from any of the following options to receive benefit payments from the contract:

Straight-Life Annuity A straight-life annuity is a contract in which an annuitant receives monthly

payments for as long as she lives, but this method makes no provision for a designated beneficiary.
Therefore, no payments are made after the annuitant’s death, even if only one payment had been
made before the person’s death. Remember, the contract’s death benefit ceases once the holder
makes the decision to annuitize. This payment option carries the most risk, but also provides the
annuitant with the highest payout of all of the options.

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 CHAPTER 7 – VARIABLE PRODUCTS AND MUNICIPAL FUND SECURITIES

Life Annuity with Period Certain A life annuity with period certain is an option that will provide
monthly or other periodic payments to the annuitant for life. However, if the client dies prior to the
end of the specified period, the payments will continue to be made in either a lump-sum or in
installments to a designated beneficiary until the end of the period certain.
For example, an investor chooses a 15-year period certain life annuity, but dies after
receiving payments for five years. The annuity company will continue to pay the named
beneficiary for the remaining 10 years on the contract. However, if the investor had lived for
18 years, the annuity company’s payment obligations would have continued up until his
death. Since his death occurred three years after the end of the period certain, the annuity
company is relieved of the obligation to make any payments to a beneficiary.

Unit Refund Life Annuity Under a unit refund life annuity, periodic payments are made during the
annuitant’s lifetime. If the annuitant dies before an amount equal to the value of the annuity units is
paid out, the remaining units will be paid to a designated beneficiary. This payment may be made
either in a lump-sum or over a given period.

Joint and Last Survivor Life Annuity A joint and last survivor life annuity is an option in which
payments are made to two or more persons. If one person dies, the survivor continues to receive
only her payments. However, upon the death of the last survivor, payments cease.
For example, a grandfather establishes an annuity that will provide lifetime payments to
both his son and grandson. A joint and last survivor life annuity is the best payout option
for the grandfather’s needs because it provides lifetime income to both persons.

The settlement options are summarized in the table below:

Settlement Option Description

 Annuitant receives payments for life
Straight-Life Annuity  Provides the highest possible payout
 Payments stop at annuitant’s death (no beneficiary)
 Annuitant receives payments for life
Life Annuity with  Payments are guaranteed for a certain period
Period Certain  If the annuitant dies before the end of the period, a beneficiary
receives the remaining payments
 Annuitant receives payments for life
Unit Refund Life  Certain amount of payments is guaranteed
Annuity  If the annuitant dies before receiving all of the payments, a beneficiary
receives the balance of the payments
Joint and Last  Annuitants receive payments for life
Survivor Life Annuity  Payments end upon the last person’s death

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Assumed Interest Rate (AIR) Once the insurance company determines its future payout
requirements, it uses an assumed interest rate to project the return over the payout (annuity) period.
The AIR is NOT a minimum or guarantee—it’s simply used as part of the actuarial calculation. The
AIR is the rate of interest that’s stated in the contract and used to determine the first annuity
payment. Going forward, it then becomes the benchmark for determining subsequent payments.

Annuitants are able to choose from various assumed interest rates when annuitizing their
contracts. The maximum AIR is regulated by the state. If a high AIR is chosen, the challenge is that it
will be more difficult to achieve a return that exceeds the AIR. If the AIR exceeds the account’s
actual performance, the annuity payment will decrease.

After the initial payment, the insurance company calculates each subsequent monthly payment by
multiplying the fixed number of annuity units on which the client is receiving payments by the
current value of an annuity unit (a fluctuating value). The actual value of the annuity units will
change based on the performance of the investments in the separate account. The annuitant’s
future payments depend on the relationship between the AIR and the actual performance of the
separate account as summarized below:
 If separate account performance is equal to the AIR, the annuitant’s payment will remain the
same as the previous payment.
 If separate account performance exceeds the AIR, then the payment will be higher than the
previous payment.
 If separate account performance is less than the AIR, the payment will be lower than the
previous payment.

For example, an individual’s contract has an AIR of 5% and the insurance company uses
this rate to determine the first monthly payment of $500. Over time, the separate account
performs at different rates and provides fluctuating payments as shown below:

An individual annuitizes his contract and receives his first monthly payment of $500 based on an AIR of 5%
Separate
Separate Account Performance Monthly Payment Actual Payment
Account
Compared to the AIR: Will Be: (illustration only):
Performance:
Month 2 10% Performance is greater than AIR Greater than previous month $523.81
Month 3 8% Performance is greater than AIR Greater than previous month $538.78
Month 4 5% Performance is equal to AIR The same as previous month $538.78
Month 5 3% Performance is less than AIR Less than previous month $528.16
Month 6 1% Performance is less than AIR Less than previous month $508.04

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 CHAPTER 7 – VARIABLE PRODUCTS AND MUNICIPAL FUND SECURITIES

Taxation of Variable Annuities

For tax purposes, the IRS divides all annuities into two types—qualified and non-qualified.
Qualified plans limit the type of person who can make contributions and the amount that a person
may contribute. On the other hand, any person can purchase a non-qualified annuity and may
contribute an unlimited amount of money because the contributions are made with after-tax
dollars. Any money invested on an after-tax basis will not be taxed again when it’s withdrawn; only
the earnings will be taxed at withdrawal. Therefore, in a non-qualified variable annuity, the
investor’s cost basis represents the total amount of the contributions.

During the Accumulation Period

In a non-qualified contract, any capital gains and dividends earned during the accumulation period
grow on a tax-deferred basis and are used to purchase more accumulation units.

Withdrawals Withdrawals may be taken from the contract and will be taxed in accordance with
how the withdrawal is made. For both initial and subsequent withdrawals, the IRS requires a last-in,
first-out (LIFO) method. This means that any earnings are withdrawn first and are treated as taxable
ordinary income. Ultimately, if all of the earnings have been withdrawn, the additional amounts are
treated as tax-free withdrawals of after-tax contributions.
For example, a customer has made total contributions of $50,000 to a non-qualified
variable annuity. The account currently has a value of $150,000 and the customer
chooses to take a random withdrawal of $20,000. Using the LIFO method, the earnings
come out first; therefore, the entire withdrawal is taxable as ordinary income.

If an investor chooses to take a lump-sum withdrawal of the entire amount, the portion that
represents earnings is taxable, while the amount equal to the investor’s contribution is a non-
taxable return of her cost basis. In other words, if the entire $150,000 is withdrawn, the $100,000
which represents earnings is taxable as ordinary income, while the remaining $50,000 is considered
a non-taxable return of capital.

During the Annuity Period

Annuitizing a Non-Qualified Contract When a non-qualified contract is annuitized, the annuitant
begins to receive periodic payments. For tax purposes, these payments are divided into the
following two parts:
1. An amount that represents the original investment in the annuity
2. The remainder which represents investment income

On each annuity payment, the annuitant is only taxed at her ordinary rate on the amount of the
payment that represents investment income. Once the total amount of non-taxable income
received equals the investor’s cost basis, the entire amount of any future payments is taxable as
ordinary income.

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CHAPTER 7 – VARIABLE PRODUCTS AND MUNICIPAL FUND SECURITIES

Annuitizing a Qualified Contract A qualified annuity is funded with pre-tax contributions that are
deducted from the employee’s paycheck. These funds subsequently grow on a tax-deferred basis.
Therefore, when a qualified contract is annuitized, the entire payment will be taxable as income.
Remember, since the contributions were made pre-tax, the contract holder has a zero cost basis (i.e.,
none of the money has been taxed).

Death Benefit Taxation

If an annuitant (e.g., a husband) dies during the accumulation period, the annuity’s value will be
included in his estate for the purpose of calculating federal estate taxes. The beneficiary (his wife)
will also be required to pay ordinary income taxes on anything she receives in excess of the cost
basis. The death benefit of a variable annuity skips the probate process which is a lengthy legal
process that involves settling an estate according to the terms of a will.

Variable Product Regulation

FINRA rules that govern the sale of variable products are similar to those for investment companies.
As mentioned previously, although variable products are issued by insurance companies, they are
considered securities and are regulated by federal securities laws and must be delivered with a
prospectus. Persons who market these products must hold a valid Series 6 or Series 7 registration as
well as a state insurance license. The separate accounts of variable products are generally required
to be registered as investment companies under the Investment Company Act of 1940.

Selling Agreements FINRA members that are the principal underwriters of variable products
may not sell them through another broker-dealer unless that firm is also a FINRA member. As is the
case with mutual fund trades, there must be a selling agreement in effect between the underwriter and
the broker-dealer. This agreement must state that if a client cancels the contract within seven business
days after the application is accepted, the broker-dealer will return the sales commission to the
insurance company that issued the contract.

Applications and Premium Payments A FINRA member must promptly transmit all applications
for variable life insurance policies or variable annuities to the insurance companies that issue the
contracts. A firm must also promptly send the issuer the portion of a client’s premium (purchase)
payments that are supposed to be credited to the contract.

The exact price (NAV) of the shares of a subaccount being purchased by a policy owner must be
determined after the issuer receives the owner’s premium payment. The NAV calculation must be done
in accordance with the product’s contract, its prospectus, and the Investment Company Act of 1940.

Cash Surrender A FINRA member firm is prohibited from selling variable contracts that are
issued by an insurance company that doesn’t promptly pay clients who surrender (cash in) all or
part of their contracts.

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Variable Annuities—Suitability and Compliance Issues

Since variable contracts don’t provide a known amount of retirement income, these contracts are best
suited for investors who can deal with the fluctuation in value and payment stream and understand the
risks inherent with equity investments. The hope is that the contract will continually grow at an average
rate that’s above the AIR and that the payments will increase to provide a hedge against inflation risk.
Since deferred variable annuities contain both insurance and investment attributes, they are considered
a complex investment option for clients. When a person makes a recommendation regarding the
purchase of a variable annuity contract, FINRA stresses the need for suitability determination.

Generally, variable annuities are not suitable for senior investors; instead, they are appropriate only
for persons with long-term investment goals who don’t anticipate needing access to their money
for at least five to seven years. While variable annuity contracts have features that are similar to
mutual funds, what makes them unique is that they provide tax-deferred growth. However, as
referenced earlier, many annuities impose significant charges on investors who surrender their
contracts early.

Under FINRA rules, prior to making a variable annuity recommendation, salespersons must make
reasonable efforts to obtain certain client-related information including their age, annual income,
financial situation and needs, investment experience, investment objectives, and investment time
horizon (most contracts have CDSCs), the intended use of the deferred variable annuity, existing
assets (including outside investments and life insurance holdings), liquidity needs, liquid net worth,
risk tolerance, and tax status.

Any RR who recommends deferred variable contracts must have a reasonable basis to believe that:
1. The customer has been informed of, and understands, the various features of the contract
such as surrender periods, potential surrender charges and tax penalties for redemptions prior
to age 59 1/2, mortality and expense fees, investment advisory fees, and the features associated
with various riders available with a given policy.
2. The customer will benefit from some feature(s) of the contract (e.g., tax-deferred growth,
annuitization, death benefits, etc.). These potential benefits should be weighed against the
additional costs associated with annuities compared to mutual funds or other investments.
3. The contract has subaccount choices and other features that make it suitable (as a whole)
based on the client’s objectives, tax situation, and age.

Principal Approval Once a registered representative has collected the required information on a
potential deferred variable annuity customer, this complete and correct application package and
the customer’s non-negotiable check (payable to the issuing insurance company) must be promptly
forwarded to the representative’s Office of Supervisory Jurisdiction for approval. Typically, once
received, the approving principal at the OSJ will review the application and determine whether the
proposed transaction is suitable. The broker-dealer has up to seven business days from its receipt of
the application package to make this determination.

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If the proposed transaction is deemed to be suitable, the paperwork and funds are transmitted to the
issuing company. If not, the funds must be returned to the customer. The broker-dealer is required to
maintain a copy of all checks and record the date(s) on which the funds were received. Additionally,
the firm must record the date(s) that the funds were either forwarded to the insurance company for
purchase of the contract or returned to the customer for transactions that were not approved.

Review of 1035 Exchanges While many persons use new funds to contribute to annuities,
registered representatives may also suggest moving client assets from existing contracts. Managers
must be extremely vigilant when examining the validity of a proposed transfer which is typically
accomplished through a 1035 Exchange. Named after IRS Section 1035, this provision permits the
exchange of annuity contracts without creating a taxable event. A principal should determine if the
proposed customer transfer will result in the client incurring a surrender charge, being subject to a
new surrender period, losing existing benefits (e.g., death, living, or other contractual benefits), or
incurring increased fees or charges (e.g., mortality and expense fees, investment advisory fees, or
charges for riders).

The central issue that managers must consider is the cost of the exchange compared to the
benefit(s) being received by the client from the new contract. Firms and their approving principals
must look for patterns of unsuitable transfers and are required to implement surveillance
procedures for determining whether any of their salespersons have excessive rates of deferred
variable annuity exchanges. An exchange is often viewed as inappropriate if the client has made
another 1035 deferred variable annuity transfer within the previous 36 months.

In order to protect against abusive transfers, many individual states and brokerage firms require the
registered representatives who recommend transfers to provide disclosure and acknowledgement
forms to customers. These documents often provide a comparison of the features and costs of an
existing contract to a proposed replacement contract and may highlight the costs of the exchange.
Generally, these acknowledgment/disclosure forms must be signed by both the firm and the client.

FINRA Concerns—Series 6 Application Historically, some RRs have sold annuities to the wrong
investors and/or recommended inappropriate exchanges within contracts. For Series 6 Exam purposes,
it’s possible for candidates to encounter red flag questions concerning inappropriate transfers (1035
exchanges) and/or evaluation scenarios addressing suitability concerns that are based on a client’s
advanced age or tax situation. A person must be prepared for questions concerning variable
annuity recommendations being made to clients who may have less costly alternatives available in
order to save for retirement (e.g., IRAs or qualified work-sponsored plans).

Remember, although not specifically prohibited, recommending the purchase of annuity contracts
within a tax-deferred account (e.g., an IRA) deserves special scrutiny since variable annuity
contracts already grow tax-deferred. Additionally, annuities generally have higher expenses than
similar mutual funds that could instead be placed within a retirement account.

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Individuals saving for retirement should normally exhaust all of their opportunities to contribute to
employer-sponsored retirement plans (e.g., a 401(k) or IRA) before investing in a variable annuity.
The benefit of employer-sponsored plans is that they are funded with deductible (pre-tax)
contributions. Although the earnings in a non-qualified variable annuity grow on a tax-deferred
basis, the contributions are made with after-tax dollars.

Variable Life Insurance

Although the Series 6 Exam will not include a large number of insurance questions, there are some
details that must be examined. Remember, an investment that includes the term variable in its
name is considered a security.

Variable life insurance policies are a form of permanent insurance which requires fixed premiums,
but have death benefits and cash values that may vary based on the performance of the investment
options. Variable life insurance policies are regulated by state and federal securities laws and must
be registered with the SEC under the Securities Act of 1933. Any offers to sell variable life insurance
policies to clients must be accompanied by or preceded by a prospectus.

Only an insurance company that’s licensed and regulated by the state may issue a variable life
insurance policy. The company that sells the policy must be a broker-dealer that’s registered with
the SEC and is a FINRA member. The agents who sell variable life insurance policies are required to
hold both a state insurance license and either Series 6 or Series 7 securities registration.

In a variable life insurance policy, the policy owner, not the insurance company, decides how the
premium payments will be invested. However, an important feature of this type of insurance is that
the death benefit generally may not decrease below a certain guaranteed minimum.

Variable life insurance policies are not appropriate for all clients. A suitable client is one who has a
sufficient level of sophistication and knowledge to understand the available investment options. He
must be able to tolerate the fact that the policy’s cash value may fluctuate greatly.

Variable Life Insurance Characteristics Variable life insurance policyholders make premium
payments to the insurance company that issued the policy. The company first deducts various
charges and expenses, such as sales charges and the cost of the insurance. After these deductions,
the company deposits the remainder (the net premium payments) in its separate account.

Separate Accounts Similar to variable annuities, these insurance policies also utilize separate
accounts and their associated subaccounts. Since each of the subaccounts contains different types
of securities and investment objectives, the policyholders are able to select the account(s) that best
suit their needs.

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Cash Value Variable life policies build cash value by requiring policyholders to pay higher
premiums since part of the premium pays for the death benefit coverage, while the other part goes
toward the policy’s cash value. Policyholders are able to use the cash value as a tax-sheltered
investment (the interest and earnings on the policy are not taxable). Over time, the cash value is
considered a fund from which policyholders may borrow and as a means to pay policy premiums
later in life, or they may pass the funds on to their heirs.

Death Benefit Most variable life insurance policies are sold with a fixed death benefit. However, the
death benefit may increase depending on the performance of the subaccounts in which the policy
owner invests. The death benefit may not fall below a certain minimum—the face value of the policy.

Riders A life insurance rider is an additional feature/benefit added to a life insurance policy.
These could include disability income benefits, waiver of premium, guaranteed insurability, or
accidental death benefits. Each rider adds to the cost of the policy above the standard cost of
insurance. Riders are often selected at time of contract issuance, but some may be added after a
contract has been issued.

Advantages of Variable Life Insurance Policies A significant advantage of variable life insurance
policies is the ability to invest some of the premium payments into subaccounts that contain stocks
or other assets that have historically paid high returns over the long term. These types of
investments give policyholders the potential to grow their cash value and death benefits, and may
help protect policyholders and their beneficiaries from the negative effects of inflation.

Variable Universal Life Insurance

Once insurance companies started to separately issue both universal and variable life policies, the
next progression was the combined variable universal life (VUL) policy.

Variable universal life policies combine the flexibility of universal life policies with the investment
aspect of variable life policies. Policyholders may adjust their premiums and death benefits to meet
their changing circumstances. The owners may also decide how their net premiums are invested
among the subaccounts that the insurance company offers in its separate account.

Taxation of Life Insurance Policies

The death benefit of a life insurance policy passes tax-free to the beneficiary. However, if the
deceased person owned the policy, the death benefit is included in his estate for the purpose of
calculating estate taxes. In order to avoid this problem, many tax advisers recommend that the
insurance policy be placed in the name of the beneficiary or in an irrevocable life insurance trust.

Voting Rights
Variable contracts (both variable annuities and variable life insurance policies) provide contract
owners with the ability to vote on certain issues that affect the separate account. These rights are
similar to the voting rights that are available to mutual fund shareholders.

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For example, the contract owners elect the Board of Managers (similar to the board of directors for
a mutual fund) that administers the separate account and approves any changes in the separate
account’s investment objectives or policies. The board also authorizes the selection of an
independent accountant who audits the separate account.

Municipal Fund Securities

Section 529 College Savings Plans
The Economic Growth and Tax Relief Reconciliation Act of 2001 expanded the federal tax treatment
of state-run 529 plans, which are also referred to as municipal fund securities. Section 529 plans are
not retirement accounts; instead, they are savings vehicles created to meet the expenses of higher
education. The beneficiary, who may include the donor, is able to be changed in the future. Under
federal law, contributions are made with after-tax dollars, but any earnings grow on a tax-deferred
basis. States that offer 529 plans are responsible for determining the specific plan rules such as
allowable contributions, investment options (e.g., mutual funds), and the deductibility of
contributions for state tax purposes.

Qualified Expenses If withdrawals are used to pay for higher education, they are considered
qualified withdrawals and are tax-free. In general, costs required to attend a college, university, or
other eligible post-secondary educational institution are considered qualified higher education
expenses. In other words, funds can be withdrawn from a 529 plan on a tax-free basis to pay these
expenses. Some of the expenses include:
 Tuition and fees  Books and supplies  Room and board

Contribution Limits Although current tax law allows a tax-free gift of up to $15,000 to any one
person in any given tax year, a 529 plan may be front-loaded with an initial gift of $75,000 which is
treated as if it’s being made over a five-year period (five contributions of $15,000 each). Individuals
may contribute these same amounts to 529 plans that are maintained for more than one beneficiary.

In other words, if an individual has five grandchildren, she is able to contribute $75,000 to each
grandchild’s 529 plan without incurring federal gift taxes. These amounts are doubled for a married
couple funding multiple 529 plans. The aggregate amount able to be contributed to a 529 plan is
determined by the state; however, most states use a total that’s sufficient to pay for an
undergraduate degree.

Rollovers Under IRS rules, a rollover of a 529 plan is permitted once every rolling 12 months. In
rolling over funds from this plan, an investor is moving the funds to another state’s 529 plan.
However, a 529 plan cannot be rolled over to a Coverdell ESA.

In a 529 plan, the donor is not permitted to choose the individual securities to own; instead, the donor
chooses among the investment options that are stipulated in the plan. No more than twice per
calendar year, the donor may change the selected investment options in a 529 plan.

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Disclosure Requirement When promoting 529 plans, an RR is required to:

 Disclose the risks and costs (both fees and maximum sales charges) involved with the different
types of plans
 Provide a disclaimer stating that, prior to investing in a plan, customers should read the official
statement (disclosure document)
 Recommend that clients check with their home state to discover if it offers tax benefits for
investing in its plan.

There’s no requirement to provide the name and contact information of the Municipal Securities
Principal who will approve customers’ investments in the plan.

Expanded Use of 529 Plans Beginning in 2108, the new tax law has expanded the use of 529
plans. Although originally intended to accumulate funds to only pay for college educational
expenses, the funds in these plans may now also be used for expenses related to elementary and
secondary schools at public, private, or religious institutions. The new plan allows individuals to
take up to $10,000 in distributions annually from their 529 plans to pay for private school tuition
and books for grades K through 12—in addition to using their account proceeds for college costs.

The assets in plans may be transferred to another family member (a change in beneficiary) if the
original beneficiary doesn’t need or use the funds for qualifying education expenses.

529 ABLE Plans

Section 529 Achieving a Better Life Experience (ABLE) plans are municipal fund securities that can
be purchased to help support individuals with disabilities without jeopardizing their disability
payments received from Social Security, Medicaid, or private insurance. The maximum
contribution is $15,000 per year and front-loading is not permitted. The individual’s other disability
payments will continue if the account’s value does not exceed $100,000. Distributions from the
plans are tax-free if they are used to pay qualified expenses.

Local Government Investment Pools (LGIPs)

LGIPs are investment pools that are created by state and local governments to provide municipal
entities a place to invest funds. Although municipalities are generally prohibited from investing in
money market funds, these pools are structured in a manner that’s similar to money market funds.
The pools provide both liquidity and minimal price volatility, but are not open to the public.

Conclusion
This concludes the chapter on variable products and municipal fund securities. Although these
products are complex, they are becoming more popular with investors. Remember, the primary
attraction to these products for many investors is their tax benefit. The next chapter will focus on
retirement plans.

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 CHAPTER 8

Retirement Plans

Key Topics:

 ERISA

 Taxation and Types of Retirement Plans

 CHAPTER 8 – RETIREMENT PLANS

The previous chapter described the characteristics and benefits of variable products and
municipal fund securities. This chapter will examine the various retirement plans that are
provided through employers for their employees and the regulations that govern their use.

The Employee Retirement Income Security Act (ERISA)

Certain work-sponsored plans are governed by a body of federal law referred to as ERISA. The
purpose of ERISA is to prevent the misuse and mismanagement of pension plan funds, especially by
the managers of these plans. To accomplish this goal, ERISA sets standards of conduct for all persons
who deal with pension plans. In particular, ERISA has established two special categories of persons
that are held to very high standards—parties in interest and fiduciaries. Investment advisers that
provide services to pension plans are usually considered both parties in interest and fiduciaries.

ERISA generally covers all employee benefit plans except government plans, church plans, plans
required under both workers’ compensation and unemployment and disability insurance laws, and
plans established outside the United States for the benefit of non-U.S. citizens. However, ERISA
does not apply to IRAs and other individual retirement plans that are not established or maintained
by an employer.

Fiduciary Responsibility Investment advisers have a fiduciary duty to all of their clients, but this
duty is even greater when the client is a qualified pension plan that’s subject to the provisions of
ERISA. Under ERISA, a fiduciary is any person that exercises discretionary authority or control
involving the management or disposition of plan assets, renders investment advice for
compensation, or has discretionary authority or responsibility for the administration of the plan.
ERISA places many restrictions and obligations on fiduciaries. Consequently, advisers to qualified
pension plans must be careful to not inadvertently violate the provisions of ERISA.

Suitable Investments Based on its fiduciary obligation, the plan manager should seek to
maximize the returns for the plan’s participants. Investments must be chosen carefully, with
conservative investments being considered a priority. Although aggressive derivative strategies
are prohibited, certain conservative option strategies (e.g., covered call writing) are permissible.
Since the plan grows tax-deferred, the manager should avoid including tax-free investments
(e.g., municipal securities) in the plan.

Transfers and Rollovers An investor may transfer funds from one retirement plan to another
retirement plan of the same type. For example, from one 401(k) to a new 401(k) without incurring taxes.
A transfer is a situation in which plan assets move directly from one trustee to another. There’s no
limit to the number of these transactions that may be effected annually.

An investor may also roll over distributions from qualified retirement plans (e.g., a 401(k) plan),
into IRAs without incurring taxes. In order to avoid a tax penalty, the rollover must be completed
within 60 days and may only be done once every rolling 12 months.

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Tax Ramifications A withholding tax of 20% may apply if a person transfers funds from one
retirement account into another and receives a check that’s made payable to her name (this
transfer is considered a rollover). However, withholding tax may be avoided if funds are transferred
directly from one retirement account to another and the check is made payable to the new trustee
(this is considered a trustee-to-trustee transfer).

Combined Withdrawals If an investor maintains a retirement account in which both pre-tax and
after-tax contributions have been made and begins withdrawals, the IRS considers the withdrawals
to come from both sources. Therefore, a portion of the withdrawal is taxable and the other portion
is tax-free.

Early Withdrawals from Retirement Plans An investor who withdraws money from a retirement
plan before reaching the age of 59 1/2 will be required to pay a 10% tax penalty on the amount
withdrawn, in addition to being liable for ordinary income taxes on the withdrawal. The amount of
the early withdrawal will be added to the investor’s taxable income for that year.
For example, a 40-year-old individual who earns $45,000 per year decides to take a $5,000
withdrawal from her retirement plan. She will need to pay a $500 tax penalty (10% of $5,000)
for the early withdrawal and her taxable income for that year will be $50,000. Assuming that
she’s in the 28% tax bracket, this will increase her tax liability by $1,400 (28% of $5,000).

Investors who are under the age of 59 1/2 will not be subject to a tax penalty for early withdrawals
from a retirement plan if any of the following exceptions apply:
 The account owner becomes disabled
 The account owner dies and the money is withdrawn by the beneficiary
 The withdrawals are set up as a series of substantially equal periodic payments that are taken
over the owner’s life expectancy
 The money is used to pay certain medical expenses that are not covered by insurance

For early withdrawals, a tax penalty will not be assessed if the withdrawals are used for:
 Medical insurance premiums when the owner is unemployed
 Expenses related to being a qualified first-time home buyer (limited to $10,000)
 Paying qualified higher education expenses (including tuition, fees, books, and room and board)
for the account holder or a member of her immediate family

Although investors who fall under these exceptions and those who are 59 1/2 or older will avoid a tax
penalty, they will still be required to pay ordinary income taxes on the amounts withdrawn. If an
investor is under the age of 59 1/2 and withdraws money from a retirement plan due to a financial
hardship, she will still be subject to the 10% tax penalty.

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 CHAPTER 8 – RETIREMENT PLANS

Required Minimum Distributions (RMDs) Investors who have not yet begun to take withdrawals
from their retirement plan (e.g., 401(k) plan by the age of 70 1/2 may also incur a tax penalty. The
IRS will levy this penalty if the investor does not start taking withdrawals by April 1 following the
year in which the person reaches the age of 70 1/2. Please note that this RMD provision does not
apply to Roth IRAs (since Roth IRAs are funded after-tax).

Employer-Sponsored Retirement Plans—Qualified Plans

Qualified retirement plans meet both IRS and ERISA requirements and receive favorable tax
treatment. To be qualified, a plan must be established in writing and must adhere to the following
standards:
1. Eligibility Requirements The plan must cover all employees who are age 21 or older and have
worked for the employer for at least one year. For purposes of determining full-time
employment, working 1,000 hours or more during the year equates to full-time.
2. Vesting This is the schedule under which employees’ rights to receive the benefits
contributed to a plan by their employers gradually become guaranteed based on their years of
service. At a minimum, all participants must be either fully vested after five years or 20%
vested after three years with full vesting after seven years of service. However, employees are
always 100% vested in the contribution they have made to a plan on their own behalf.
3. The Investment of Contribution and Determination of Benefits The investment of plan assets,
as well as other plan activities, is governed by strict fiduciary guidelines.

Employers that want to establish qualified retirement plans may seek advance determinations from the
IRS to ensure that the plans meet the required standards. Alternatively, employers may adopt an existing
IRS-approved master or prototype plan provided by a financial institution. The plan must satisfy the
IRS standards both in terms of the way it’s designed and in the way it actually operates.

If established correctly, a qualified plan will provide the following benefits:

 Pre-tax contributions: Employer contributions to a qualified plan are generally able to be made
on a pre-tax basis. In other words, no income tax is paid on the amounts contributed by
employers until the money is withdrawn from the plan. Also, employee contributions are made
on a pre-tax basis.
 Tax-deferred growth: Investment earnings (e.g., dividends and interest) on all contributions are
tax deferred; therefore, income tax is not paid on the earnings until the money is withdrawn
from the plan.
 Payments received at retirement may qualify for special tax treatment.

Profit-Sharing Plans
Profit-sharing plans allow employers to make discretionary contributions. In other words, there’s
no set amount that the law requires employers to contribute. An employer may or may not be able
to afford to make contributions to the plan for a particular year. Actually, an employer’s business is
not required to generate profits in order to make contributions to the plan.

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When a company decides to contribute funds into the plan, it must allocate these funds to its
employees in accordance with a predetermined formula. Generally, all participants receive a
certain percentage of their salary and the money is deposited into a separate account that’s
established on their behalf. For example, if a company decides to contribute 10% of each
employee’s salary in any given year, then an employee who is earning $30,000 will have a $3,000
contribution made to her account by her employer.

Limitations on Contributions Employers are able to deduct the contributions that they make into
the plan, but the maximum annual contribution amount is determined by the IRS (inflation adjusted).

Money Purchase Plans

Money purchase plans are a type of defined contribution plan that operate in a manner that’s
similar to profit sharing plans. However, a significant difference is that, unlike profit sharing plans
in which employers are permitted to make discretionary contributions each year, the employers
have a set mandatory contribution rate and the contributions must be made each year regardless of
the employer’s profits. Failure to make the contribution may result in an IRS penalty. Today, most
money purchase plans have been converted to profit sharing plans in order to provide employers
with more flexibility in determining whether to make contributions from year-to-year. The
maximum annual contribution amount is determined by the IRS (inflation adjusted).

401(k) Plans
A 401(k) plan is a type of qualified plan that depends heavily on employee contributions, rather than
being funded by employer contributions. These plans allow employees to save a portion of their
salary for retirement on a pre-tax basis (i.e., before income tax is deducted from their paychecks)
and the earnings that are generated by their contributions grow on a tax-deferred basis until they
are withdrawn from the plan. Once withdrawn, the funds are entirely taxable as ordinary income
since the employees have a zero cost basis. Employers may also choose to match their employees’
contributions; however, the employers may establish a vesting schedule for those matching
contributions.

Vesting refers to the employees’ percentage of ownership of the money that’s contributed on their
behalf by their employer to which she is entitled if she leaves her employer. Essentially, the longer a
person remains with an employer, the greater her percentage of ownership. It’s important to note
that employees are always fully vested in the contributions that they make on their own behalf.
For example, if an employee has $10,000 of matching contributions in her 401(k) and
then leaves her job, the vesting schedule will determine the amount of money to which
she’s entitled. If she’s only 40% vested when she decides to resign, she’s entitled to all of her
own contributions (and any earnings that are generated by them), but only $4,000 of the
$10,000 of matching contributions made by the employer.

In most plans, the employees decide how they want to allocate their contributions from a menu of
investment options that are selected by their employer. This menu typically includes stock funds,
bond funds, a money-market fund, and occasionally, the employer’s own stock.

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Contribution Limits The maximum annual contribution amount is determined by the IRS
(inflation adjusted). However, for employees who are age 50 and older, there’s a catch-up provision
which allows for an increased contribution amount.

403(b) Plans
403(b) plans are tax-deferred retirement plans that are available to employees of public school
systems as well as employees of tax-exempt, non-profit organizations that are established under
Section 501(c)(3), such as charitable or religious organizations. These plans are also referred to as
tax-deferred annuities (TDAs) or tax-sheltered annuities (TSAs).

While a 403(b) plan is technically not a qualified plan, it resembles a 401(k) plan by allowing the
participants to exclude the contributions that they make from their taxable incomes. As with a
401(k) plan, the maximum annual contribution amount to a 403(b) plan is determined by the IRS
(inflation adjusted). Employers may also make matching contributions for their employees.

Unlike 401(k) plans, which allow participants to invest their contributions in any prudent manner,
the funds in 403(b) plans may only be invested in the following:
 Annuity contracts
 Custodial accounts that hold mutual fund shares
 Retirement income accounts (defined contribution plans that are maintained by churches or
certain church-related organizations)

Taxation of Retirement Plans

There are three distinct phases in each of these plans—contributions, growth of investment, and
distribution. Retirement plans are not subject to preferential, long-term tax rates and any portion of the
distribution that’s taxable will be taxed at the same rate as the person’s ordinary income.

Taxation of Contributions Contributions to these plans are generally made on a pre-tax basis. If the
contribution is made pre-tax, it means that the funds are removed directly from the client’s gross
income and will not count as part of her taxable income. For example, if a client earned gross income of
$100,000 per year, but made pre-tax contributions of $10,000, the IRS will tax her only on the $90,000 of
net income. In effect, the client is avoiding income taxes on the $10,000 in the year in which it’s earned.
On the other hand, if a client makes an after-tax contribution, it means that the funds were taxed prior to
the contribution being made.

The tax implications will differ based on how the contributions have been made. In the pre-tax
scenario, the contributions had not yet been taxed; therefore, these funds will be taxed at the time
of withdrawal. If a plan is funded solely with pre-tax contributions, it’s said to have a zero cost basis.
However, if the contributions are made post-tax, these contributions are considered a part of the
plan’s basis and may be withdrawn without being subject to tax.

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Taxation of Income and Trading Events During the Plan’s Life The plan investments may generate
income in the form of dividends and/or interest. Also, clients may decide to buy and sell various
investments within the plan. From a tax standpoint, none of these events matter since all activity within
these plans is tax-sheltered (tax-deferred).

Taxation of Distributions As described earlier, distributions of pre-tax monies are typically taxable at
ordinary income rates as will all of the income and trading profits that occurred over the life of the plan.
All distributions of post-tax monies will be free from taxation since these funds have already been taxed.

To summarize, the general rule of thumb is that:

1. Post-tax contributions are not taxed upon distribution
2. Pre-tax contributions are taxable at ordinary rates upon distribution
3. All account earnings (i.e., interest, dividends, and trading profits) are taxable at ordinary income
tax rates upon distribution*

* Note: The government may even allow the owners of certain plans, such as Roth IRAs and 529
college savings plans, to avoid taxation altogether. For Roth IRAs, withdrawals are tax-free if funds
are not withdrawn prior to age 59 1/2 and the plan has been in existence for five years. For 529 plans,
distributions are tax-free if the funds are used for the purpose for which they were intended
(educational expenses).

Employer-Sponsored Retirement Plans—Non-Qualified Plans

Non-qualified retirement plans are not required to meet ERISA standards regarding employee
coverage, contribution limits, and vesting. Although employers may not deduct contributions
made, the income contributed to these plans will accumulate on a tax-deferred basis until
withdrawn. Rather than being made available to all employees, non-qualified plans are designed to
meet the specialized retirement needs for key executives and other select employees. These plans
are exempt from the discriminatory and top-heavy requirements which apply to qualified plans.

Types of Non-Qualified Plans

457 Plans A 457 plan is a non-qualified, deferred compensation plan. However, it’s a tax-
advantaged defined contribution plan that may be established by state and local governmental
employers, including state universities and local school districts, as well as certain non-
governmental (non-profit) employers.

As with 401(k) and 403(b) plans, 457 plans allow for pre-tax (deductible) contributions to be made
by employees; however, the maximum annual contribution amount is determined by the IRS
(inflation adjusted). For employees who are age 50 or older, an additional amount may be
contributed annually. Unlike 401(k) and 403(b) plans, the contributions to 457 plans are not
coordinated among the other plans; instead, they may be set up separately.

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Another benefit provided by a 457 plan is that the 10% penalty for withdrawals taken prior to age
59 1/2 does not apply; however, any withdrawal is subject to ordinary income tax.

The following guidelines/restrictions apply to non-governmental 457 plans:

 ERISA states that non-governmental 457 plans must be limited to higher compensation
employees. Although the level of compensation is not specified by ERISA, it must be based on
an ascertainable standard that’s set by the employer. These plans are usually restricted to
specific classes of employees, such as officers and directors, and are occasionally referred to as
Top Hat plans.
 Any money invested in a non-governmental 457 plan may not be rolled over into any other type of
tax-qualified plan. However, governmental 457 plans allow their funds to be rolled over into
other qualified plans, such as 401(k) and 403(b) plans, or even IRAs.
 Any non-vested money that’s contributed to a non-governmental 457 plan must remain as the
property of the employer, not the employee. Unlike the contributions made to 401(k) or 403(b)
plans, these contributions that are made by the employer are not set aside in a trust for the
exclusive benefit of the employee. Therefore, the assets held in these plans are subject to claims
by general creditors of the employer.

Employee Stock Ownership Plans (ESOP) An ESOP is an employee benefit plan in which the
company contributes its stock or money to purchase its stock to the plan. The stock generally
comes from retiring or departed employees. When an individual retires, he doesn’t actually receive
the stock; instead, he receives the cash equivalent of the value of the stock.

Payroll Deduction Plans Payroll deduction plans allow employees to purchase life insurance,
mutual funds, and variable annuities by having after-tax deductions taken from their paychecks.
Although not required, employers may match employee contributions. The sales charges assessed
are often lower than what the employees would pay if they purchase these products individually.

Deferred Compensation Plans Deferred compensation plans are contracts that are entered into
between employers and employees whereby the employers agree to pay a certain amount of
compensation to the employees at a later date. The employees agree to defer the receipt of the funds
until retirement, disability, death, or termination. One advantage of deferred compensation plans is that
income taxes are deferred until a time at which the employee is presumably in a lower tax bracket.

Deferred compensation plans may either be funded or unfunded. In a funded plan, the plan is secured
by specific assets that are protected from the employer’s creditors. An unfunded plan is backed only
by the employer’s promise. Since deferred compensation plans are non-qualified plans, the
employer is able to discriminate and include only selected employees in the plan.

Conclusion
This concludes our discussion of retirement plans. The next chapter will examine the different
disclosures required, as well as various investment risks and returns.

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 CHAPTER 9

Investment Risks,
Returns and Disclosures

Key Topics:

 Account Disclosures

 Account Transfers

 Systematic vs. Unsystematic Risks

 Investment Returns
 CHAPTER 9 – INVESTMENT RISKS, RETURNS, AND DISCLOSURES

Customers must be fully informed of the risks associated with specific securities before any
investments are made. This includes the various fees that are associated with different
investments and the costs incurred when executing transactions. In addition to detailing the
required disclosures, this chapter will address the documents that must be provided to
customers and the process of transferring accounts between broker dealers. Finally, the
chapter will examine the different types of risks and returns related to various investments.

Required Disclosures
Disclosures Made Prior to Execution
When discussing various securities/strategies with clients, it’s imperative that registered representatives
inform them of the risks associated with the investments. As described previously, this includes discussing
risks involving options, penny stocks, junk bonds, etc. Potential conflicts of interest, investment limitations
of the firm, as well as costs and fees that influence the return on the investments must be disclosed. Some
of the costs and fees include the sales charges on different mutual fund share classes, potential redemption
fees, and the additional fees to which clients are subject when investing in annuities. Lastly, careful
consideration is required when determining whether a customer is suitable for non-discretionary, fee-
based accounts (i.e., whether her level of trading is sufficient related to the bee being charged).

Compensation and Disclosure on Equity Trades

Broker-dealers act in different capacities when executing customer trades. However, a firm may act
in only one capacity in a single customer transaction, which includes acting as agent, principal,
riskless principal, or on a net basis. The required disclosures are determined by the firm’s capacity.

Agency Trade An agency transaction occurs when a broker-dealer buys or sells securities in the
marketplace on behalf of its client. The firm charges the client a commission, which is disclosed on the
client’s confirmation.

Principal Trade In a principal transaction, a broker-dealer sells securities out of its inventory or buys
securities into inventory when executing a customer order. The broker-dealer is exposed to risk in its
inventory value. Transaction charges are based on the market price of the security, rather than the
inventory value of the dealer. In the case of a customer purchase, the firm includes a markup above
the market price of the security; however, in the case of a customer sale, the firm marks down the
amount of proceeds the customer will receive.

Compensation and Disclosure on Mutual Funds

For transactions related to investment companies, all costs and fees must be disclosed to customers.
This includes sales charges on different share classes, 12b-1 fees, and surrender charges that may
apply due to early redemption.

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Compensation and Disclosure on Variable Products

Although variable products may have characteristics that are similar to mutual funds, they have
additional benefits such as tax-deferred growth and death benefits. However, these benefits come with
extra costs and issues that need to be disclosed to purchasers. Mortality and expense charges increase
the cost of variable products. Since variable annuities are generally considered retirement vehicles,
cashing out early generally results in premature distribution penalties.

Soft-Dollar Arrangements
Soft-dollars are broadly defined as commission rebates that money managers (investment advisers)
receive for channeling some or all of their trades through certain brokerage firms. When an adviser
uses soft dollars to obtain products or services, its clients are paying for more than simple execution and,
accordingly, using soft dollars may result in clients paying higher commissions on their trades.

Section 28(e) of the Securities Exchange Act of 1934 recognizes soft-dollar arrangements as an
acceptable means of conducting business (safe harbor). However, to rely on the safe harbor, the
following three conditions must be satisfied:
1. The adviser must be exercising investment discretion over the accounts of others.
2. The broker-dealer must provide the adviser with services that assist the adviser in making
investment decisions for client accounts.
3. The adviser must determine that the value of these services is reasonable in relation to the
commissions being charged by the brokerage firm.

The key is that the service(s) received by the adviser as part of a soft-dollar arrangement must
benefit its clients. Provided the investment adviser is using soft dollars to purchase items (e.g.,
research reports) that assist them in the investment process and clients receive full disclosure, the
SEC permits the arrangement.

The following chart provides details regarding the acceptable and unacceptable uses of soft-dollar
arrangements:

Soft-Dollar Arrangements
May be used to acquire: May NOT be used to acquire:

− Traditional research reports and related publications − Payments for advertising and marketing
− Discussions with research analysts − Travel expense reimbursement (including meals and
− Software for analyzing portfolios entertainment)
− Certain types of trading software − Overhead and administrative expenses
− Market and economic data services − Employee salaries
− Coverage of attendance fees for a − Accounting and professional licensing fees
conference/seminar where company executives − Computer terminals
discuss their company’s performance − Correction of trading errors

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For example, a trader solicits an advisory firm to send its securities trades to his broker-
dealer. In exchange for the business, the trader agrees to pay bonuses to the adviser’s
employees using a portion of the commissions. Is this practice acceptable?
No. The practice of using earned commissions to pay bonuses to the IA’s employees
is an unacceptable form of soft-dollar rebating. These actions don’t directly
benefit the advisory client; instead, they benefit the IA and its employees.

Client Notifications
Once an account is opened, broker-dealers are required to provide their clients with information such
as trade confirmations, statements, and other miscellaneous mailings. The SEC mandates the
frequency and timing of the delivery of this information.

Account Statements and Other Notifications

At least quarterly, broker-dealers are required to provide customers with a statement of account.
Also, the typical practice is to provide monthly statements for any account in which activity has
occurred. At a minimum, the account statement must contain:
 A description of all security positions
 All money balances
 All account activity since the last statement

Account activity includes purchases, sales, interest credits or debits, charges or credits, dividend
payments, transfer activity, securities receipts or deliveries, and/or journal entries relating to
securities or funds in the possession or control of the broker-dealer.

Broker-Dealer Financial Information

Additionally, SEC regulations require a brokerage firm to provide a current financial statement (balance
sheet with net capital computation) to a customer on request. The justification for this requirement is
that customers have the right to know the financial condition of the company with which they are doing
business. Financial statements are typically sent to customers annually. Although a balance sheet must
be provided, the firm’s income (or profit and loss) statement is not required.

At times, customer accounts may be transferred internally. An internal transfer may arise when an
RR leaves a firm and his accounts are transferred to another RR of the firm. Account records must be
amended whenever there’s an internal transfer of an account. However, this change doesn’t require the
reapproval of the customer, the completion of a new account form, or the notification of a
regulatory authority.

Confirmations Statements
The SEC requires broker-dealers to provide customers with detailed confirmations for each
purchase or sale that’s executed in their accounts. The confirmation must be given or sent at or
before the completion of any transaction—which is generally the settlement date.

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A confirmation must include the following information:

 The identity and price of the security bought or sold
 The number of shares, units, or principal amount
 The date of the transaction, as well as the time of execution (or a statement that the time will be
furnished on written request)
 The capacity in which the broker-dealer acted, such as:
− Agent for the customer
− Agent for another person
− Agent for both the customer and another person (referred to as an agency cross)
− Principal for its own account
 The dollar price and yield information on debt securities
 Whether a security is callable and a statement that more information will be provided on request
 The settlement date

Even if an RR has discretion over a customer’s account, confirmations for all transactions that are
executed must be sent to the customer. Trade confirms may be sent to an investment adviser or
other third party, but only if the written consent of the customer is obtained.

Updating Account Information

Not only is it important to fill out a new account form correctly, it’s also very important to keep the
information up-to-date. This updating obligation is one of the most overlooked areas of account
documentation. If a customer’s situation changes, the regulatory concern is that unsuitable
transactions may be executed in the account. Although any of the items on the form could change,
there are several items which are of special importance.

Address Changes If a customer’s address changes, it’s important to note whether she now lives in
a different state. In order to conduct business in the new state, both the registered representative and
her firm must be properly registered in the new state. State registration requirements are contained in
a set of rules that are referred to as the Blue-Sky laws.

Also, if a request is made to change a customer’s address, member firms must send notification of
the change to any registered personnel who are responsible for the account and to the previous address
on file (to prevent misdirection of account information).

Financial Background For better or for worse, a customer’s financial picture can change very quickly.
It’s important for representatives to occasionally verify that the customer’s information on file is
accurate. While some customers may keep the firm well-informed of any changes, others may not be as
forthcoming. Changes in the patterns of purchases and sales may indicate a different financial situation.

Updated Objectives Over time, almost all customers will change or modify their investment
objectives. This is especially true as customers grow older, since their investment time horizons, tax
situations, and goals may change. All such changes should be documented.

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FINRA Updating Requirement If a customer provides a broker-dealer with updated account

information (e.g., name change or change to investment objective), the broker-dealer must send a
copy of the revised account record to the customer within 30 days after it received notification of
the change or at the time the next statement is mailed to the customer.

Books and Records

Recordkeeping Formats
Broker-dealers must maintain records for a certain number of years after creation. The SEC allows for
the maintenance of records in forms other than paper. For example, firms may maintain their files on
micrographic media or electronic storage media. Micrographic media includes microfilm, microfiche,
or similar methods, while electronic storage media includes methods of digital storage (e.g., CD-ROM).

If a firm decides to use electronic storage media, it must notify its primary regulator prior to the
beginning of its use. Also, if a firm changes the form of electronic storage media that it’s currently
using, it must notify its regulator at least 90 days prior to using the other method.

When maintaining records using electronic storage media, the firm must:
 Maintain records in non-rewriteable and non-erasable formats
 Automatically confirm the quality and accuracy of the media recording process
 Maintain records in serial form with time and date information that documents the required
retention period for the information stored
 Be able to download the indexes and records maintained to any medium that’s accepted by the SEC
or other SRO of which the firm is a member

In addition to the aforementioned requirements, a firm that uses micrographic or electronic storage
media must establish a location from which the SEC and the firm’s SRO can immediately review
stored files and have duplicates of the files available. All duplicates of the files being maintained
must be kept separate from original records. The records (original and duplicates) must be
accurately organized and indexed. The indexes are required to be duplicated, kept separate from
originals, and made available for examination by regulators if a review is requested.

FINRA and the MSRB also have recordkeeping requirements for any books and records that were
not specifically referenced under SEC Rules. For FINRA, the requirements are found in Rule 4511;
however, for the MSRB, the requirements are found in Rule G-8 (which identifies the records that
must be kept) and Rule G-9 (which identifies how long the records must be kept).

Financial Exploitation of Specified Adults – FINRA Rule 2165

FINRA created a hotline for seniors who have questions or concerns about their brokerage
accounts. One of the major issues that was highlighted by these investors was suspected financial
exploitation. In order to address this issue, FINRA created Rule 2165, which is titled Financial
Exploitation of Specified Adults.

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Specified Adults According to FINRA’s rule, the term specified adult is defined as:
 Any person who is age 65 or older
 Any person who is age 18 or older and who the firm reasonably believes has a mental or
physical impairment that renders the person unable to protect his own interests. This
determination should be based on the facts and circumstances that are observed in the firm’s
business relationship with the person.

To assist these specified adults, FINRA also established a process by which a firm could respond to
situations in which it has a reasonable basis to believe that financial exploitation has occurred, is
occurring, has been attempted, or will be attempted. The process includes the appointment of a
trusted contact person.

Trusted Contact Person If concerns arise, firms may now contact a customer’s designated
trusted contact person and, when appropriate, place a temporary hold on a disbursement of funds
or securities from a customer’s account. A trusted contact person, who must be age 18 or older, is
essential in assisting the firm in protecting the customer’s account and its assets as well as
responding to possible financial exploitation.

The trusted contact person’s name and contact information (mailing address, phone number and
email address) are a part of the customer account information that should be obtained when a
member firm opens or updates an account. Although the trusted person’s contact information is
not required when opening the account, a firm should make a reasonable effort to obtain it.

Financial Exploitation According to FINRA’s rule, financial exploitation includes:

 Wrongful or unauthorized taking, withholding, appropriation, or use of a specified adult’s funds
or securities; or
 Any act or omission taken by a person, including through the use of a power of attorney,
guardianship, or any other authority, regarding a specified adult, to:
‒ Obtain control, through deception, intimidation, or undue influence, over the specified
adult’s money, assets or property; or
‒ Convert the specified adult’s money, assets or property

Temporary Hold The rule permits a firm to place a temporary hold on the disbursement of a
specified adult’s funds or securities, but not to their transactions in securities. Although the hold will
not apply to a customer’s sell orders, if there’s a reasonable belief of the existence of financial
exploitation, it will apply to any request for the proceeds of a sale to be sent to another person. The
temporary hold will apply to both a single disbursement and a transfer of an entire account.
However, if the firm places a hold on an account, it must allow disbursements if there’s no
reasonable belief of financial exploitation (e.g., normal bill paying).

Account Movement Between Accounts at the Same Firm The temporary hold also applies to the transfer
of assets from one account to another account at the same brokerage firm. For example, the temporary
hold applies when a relative or friend of an account owner is attempting financial exploitation and
initiates the transfer of assets to her account which is held at the same brokerage firm.

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Reasons for the Hold If a member firm places a temporary hold, the rule requires the firm to
immediately initiate an internal review of the facts and circumstances that caused it to reasonably
believe that financial exploitation of the specified adult has occurred, is occurring, has been
attempted or will be attempted.

Notification of the Hold By no later than two business days after the date that the member first
placed the temporary hold on the disbursement of funds or securities, the member firm must
provide notification, either orally or in writing (which may be electronic), of the temporary hold and
the reason for the hold. The notification must be provided to:
 All parties who are authorized to transact business in the account, unless a party is unavailable
or the firm reasonably believes that one party has engaged, is engaged, or will engage in the
financial exploitation of the specified adult; and
 The trusted contact person(s), unless this person is unavailable or the firm reasonably believes
that the trusted contact person(s) has engaged, is engaged, or will engage in the financial
exploitation of the specified adult

The intent of the rule is to prohibit a firm from dealing with the person(s) who might be exploiting
the specified adult. For example, if the adult child of a senior investor is the trusted contact person
who might be misappropriating funds, it’s not prudent for this person to be contacted.

Before placing a temporary hold, it’s recommended for the firm to first attempt to resolve the
situation with the customer. However, if the temporary hold is placed, the firm is required to notify
the trusted contact person. Once a temporary hold is initiated, the firm is permitted to terminate it
only after contacting either the customer or the trusted contract person and discussing the situation.
The customer’s objection to the temporary hold or information obtained during the discussion with
the customer or trusted contact person may be used by the firm when determining whether the
hold should be placed or lifted.

Period for the Temporary Hold A temporary hold will expire by no later than 15 business days after
the date that it was first placed on the account, unless it was otherwise terminated or extended by
another authorized regulatory entity. If a member firm’s internal review of the facts and
circumstances supports its reasonable belief that the financial exploitation of the specified adult
has occurred, is occurring, has been attempted or will be attempted, the firm may extend the
temporary hold for an additional 10 business days, unless otherwise terminated or extended by
another authorized regulatory entity.

ACATS—Transferring Accounts
If a customer wants to transfer an account from one member firm (the carrying firm) to another
member firm (the receiving firm), the customer must provide written instructions to the receiving
firm. When both the carrying member and the receiving member are participants in a registered
clearing agency that has automated customer securities account transfer capabilities, they must use
that system.

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An example of such as system is the National Securities Clearing Corporation’s Automated Customer
Account Transfer Service (ACATS). Both member firms are required to coordinate their activities in
order to expedite the transfer.

The receiving firm must submit the transfer request to the carrying firm immediately at the time of
receipt from the customer and, within one business day, the carrying firm must either validate the
instructions or take exception to the transfer.

Protesting a Transfer If the transfer is protested, the carrying and receiving parties must resolve
their differences promptly. A carrying party may take exception to a transfer if:
 It has no record of the account on its books
 The account is flat and contains no assets
 The transfer instructions are incomplete
 The transfer instructions contain an invalid signature

Validating a Transfer When validating transfer instructions, the carrying party must freeze the
account. At this point, all open orders must be cancelled and new orders may no longer be
accepted. Within three days following the validation, the carrying party must complete the transfer
of the account to the receiving party.

Non-Transferable Assets The customer must be informed, either in writing on the transfer
instructions or on a separate document, whether any of the assets in the account cannot be readily
transferred or cannot be transferred within the time frame of the rule. The following situations could
result in customer assets not being transferable from one firm to another:
 The asset is a proprietary product of the carrying member
 The asset is a product of a third party (mutual fund) and the receiving firm doesn’t maintain the
necessary relationship to receive the assets (it has no selling agreement with distributor)
 The asset of a bankrupt issuer is held by the customer and the carrying member doesn’t possess
the proper denominations to complete delivery and no transfer agent is available to reregister
the shares
 The asset is a limited partnership interest

If an asset is non-transferable, the brokerage firm must provide the customer with written
notification and await instructions regarding its disposition, which may include:
 Liquidation
 Retention
 Transfer and delivery to the customer
 Transfer to a third party

If a non-transferable asset is liquidated, distributions must be made within five business days of the
customer’s liquidation instructions.

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Residual Credits Any cash or securities which have been received by the carrying firm that were
not included in the original account transfer request (through ACATS) are referred to as residual
credits. The carrying firm is required to continue to transfer these residual credit balances for a
period of six months from the processing of the original transfer request. These transfers must be
made within 10 business days of any credit balance(s) accruing in the client’s account.

Interfering with the Transfer of Customer Accounts Under FINRA rules, member firms and their
employees are prohibited from interfering with a customer’s account transfer request. Transfer requests
often stem from the departure of an RR to a new member firm. Once the client has given his written
instructions for the transfer of his account, the carrying member firm is prohibited from seeking a
court order to restrict the movement of the customer’s assets.

Investment Risks
When recommending specific securities or financial plans to clients, financial professionals are
required to consider various factors. Among these factors are the client’s financial holdings, risk
tolerance, investment objectives, and related risk factors. This section will outline some of the key risk
factors that registered persons should discuss with clients prior to making recommendations. The
concept of diversification will also be described, which in simple terms means not putting all of your
eggs (investment dollars) in one basket.

One example of utilizing diversification is purchasing shares of a mutual fund that owns a large
collection of stocks, rather than purchasing the stock of one company. To expand on the concept of
diversification, let’s begin a deeper discussion of risk. Investment risk is divided into two major
categories—non-diversifiable and diversifiable.

Systematic (Non-Diversifiable) Risk

Systematic risk is caused by factors that affect the prices of virtually all securities. Interest rates, recession,
and wars all represent sources of systematic risk since they affect all securities markets to some degree
and cannot be avoided through diversification. The following are different types of systematic risk.

Market Risk Market risk represents the day-to-day potential for an investor to experience losses
due to market fluctuations in securities’ prices. Any security being bought and sold can decline as
it’s traded in the market. In a prolonged bear market, most stocks will trade down regardless of the
company’s individual prospects.

Interest-Rate Risk There’s an inverse relationship between the prices of existing bonds and the
movement of market interest-rates. Therefore, interest-rate risk primarily affects existing bondholders,
since the market value of their investments will decline if interest rates rise. If rates do rise, new
potential investors will not be interested in purchasing existing bonds since they know that they can
obtain higher yields by purchasing newly issued bonds with higher coupon rates. For that reason, the
prices of existing bonds will need to be lowered to attract purchasers.

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Diversification A diversified portfolio of bonds from different issuers with different coupon rates,
maturity dates, and geographic locations will provide protection against some risks, but not against
interest-rate risk. In other words, since all bonds have some exposure to interest-rate risk, it’s
considered systematic or non-diversifiable.

Duration Bonds with longer maturities tend to be more vulnerable to interest-rate risk than bonds
with shorter maturities. Also, bonds with lower interest rates are more sensitive to interest-rate risk
than bonds with similar maturities and higher coupon rates. Duration measures the sensitivity of a
bond or portfolio of bonds to a given change in interest rates. Duration is measured in years, but for
practical purposes, a bond’s change in price is based on its duration. For example, if a bond’s
duration is 10 years, a 1% increase in interest rates will cause a 10% decrease in the bond’s price.
Some investors will spread out (ladder) their bond maturities to minimize the impact of interest-
rate risk by having a portion of their holdings in shorter term bonds.

Interest Rates and Equities Stock prices may also be influenced by interest rate changes. For example,
when interest rates are rising, utilities stocks will be adversely affected because these companies are
heavy borrowers (leveraged). However, stocks of cosmetic companies (defensive stocks) are not as
affected by rising interest rates, which is due to the nature of their business and the low cost of their
products. If interest rates rise, preferred stocks will react in a manner that’s similar to debt securities. In
other words, preferred stock prices have an inverse relationship to interest rate changes.

Inflation (Purchasing-Power) Risk Inflation (purchasing-power) risk is experienced by

investments that provide fixed payments (e.g., bonds and fixed annuities). Inflation is the rising
price levels of goods and service as measured by the Consumer Price Index (CPI). Ultimately,
inflation diminishes the real value of a dollar by decreasing its purchasing power.

Historically, equity securities, variable annuities, investments in real estate, or precious metals (e.g.,
gold and silver) have provided the best protection against inflation. Inflation hurts bondholders in
two ways, 1) inflation leads to rising interest rates which causes the market prices of their existing
bonds to fall, and 2) the purchasing power of their interest payments decreases.

Many market professionals measure an investment’s real rate of return (for bond’s, it’s also referred
to as the real interest rate). The formula for calculating real rate of return is an investment’s return
minus the rate of inflation (as measured by CPI). For example, if an investment has an 8% return
and CPI is 3%, the real rate of return is 5%.

Event Risk Event risk is the risk that a significant event will cause a substantial decline in the
market value of all securities (e.g., the 9/11 terrorist attack).

Unsystematic (Diversifiable) Risk

In contrast to systematic risk, unsystematic risk is based on circumstances that are unique to a
specific security and may be managed by diversifying the assets in a portfolio (i.e., by selecting
stocks possessing different risk-return characteristics). The following are different types of
unsystematic risk.

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Business Risk Business risk is the risk that certain circumstances or factors may have a negative
impact on the operation or profitability of a specific company. For example, a company’s prospects
may suffer due to either increased competition or decreased demand for its goods or services.

Beta and Alpha Beta measures how volatile an investment is relative to the market as a whole.
However, alpha measures the risk that’s specific to a particular company. Using beta, investors can
predict a stock’s rate of return. Thereafter, alpha can be calculated by taking what the stock actually
earned and subtracting its expected return. For example, based on its beta, a stock is expected to
earn 5%. If the stock actually earned 8%, then alpha was 3% (8% – 5%). On the other hand, if the
stock only earned 4%, the alpha is -1% (4% – 5%).

Regulatory Risk Regulatory risk is the risk that regulatory changes may have a negative impact on
an investment’s value. For example, an FDA announcement denying approval of a new drug may
cause the price a pharmaceutical company’s stock to decline.

Legislative Risk Legislative risk is the risk that new laws may have a negative impact on an investment’s
value. Changes in the law can occur at any level of government and can potentially affect all sorts of
investments. For example, an increase in the legal drinking age could hurt the sales of a beer producer.

Political Risk Political risk is simply defined as the risk that foreign investors will lose money due to
changes that occur in a country’s government or regulatory environment. This risk is typically
associated with emerging markets countries and may include acts of war, terrorism, and military coups.

Liquidity Risk Liquidity risk is the risk that investors may be unable to dispose of a securities
position quickly and at a price that’s reasonably related to recent transactions. This type of risk tends
to increase as the amount of trading in a particular security decreases. For instance, the shares of large
blue-chip companies are highly liquid, while the stocks of small companies are typically less liquid.
Investments which are not traded in the market, such as hedge funds, private placements, direct
participation programs (limited partnerships), and real estate have a significant lack of liquidity.

Opportunity (Cost) Risk Opportunity cost or opportunity risk represents the possibility that the
return of a selected investment is lower than another investment that was not chosen. For example,
an investor may be planning to hold a bond until maturity and is therefore unconcerned with the
potential decline in its price if interest rates rise.

After all, as long as there’s no issuer default, he will receive the bond’s par value at maturity. Of
course the problem with this approach is that it fails to take into account the higher return that the
investor could have possibly earned from an alternative investment.

Reinvestment Risk Reinvestment risk is the risk that an investor will not be able to reinvest her
principal at the same interest rate after a bond matures or is called. This situation typically occurs
when interest rates have fallen. At this point, the investor typically has two choices, 1) accept a
lower rate of return, or 2) assume a higher degree of risk to keep her returns stable. Reinvestment
risk is also evident if market interest rates have declined and a bond investor is forced to reinvest
her bond’s interest payments at a lower rate.

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Currency (Exchange-Rate) Risk Currency or exchange-rate risk is the possibility that foreign
investments will be worth less in the future due to changes in exchange rates. For example, an
American investor owns a British stock that pays a quarterly dividend. The real value of the
dividend to the investor will decline if the British pound weakens against the U.S. dollar. This is
because the British pounds received will buy fewer American dollars when converted. Foreign
securities, global funds, international funds, and ADRs all have a high degree of exchange-rate risk.

Currency risk may also impact the price of a company that’s based in the U.S. if it earns revenue in a
foreign country. For example, a U.S. company sells its products and services in Europe and earns
revenue in euros. If the U.S. dollar increases or strengthens in value, the euro will decline and cause
the dollar value of this revenue to fall. In addition, if the dollar strengthens, this company’s
products will be less competitive in Europe and result in the company exporting less.

Capital Risk Capital risk is the risk that an investor could lose all or a portion of her investment.
Purchasers of options are significantly impacted by capital risk because, if the options purchased
expire worthless, the investor will lose 100% of his capital. On the other hand, if an investor buys a
stock at $50 and it declined to$40, his loss of capital is 20% (10 point loss ÷ $50 purchase price).

Credit Risk Credit risk or default risk is the risk that a bond issuer will not make payments as
promised. U.S Treasuries are assumed to have virtually no credit (default) risk. Rating companies,
such as Standard & Poor’s (S&P) and Moody’s Investors Service, provide information to market
participants concerning the credit risk of an issuer’s bond offering.

Call Risk Call risk is the risk that an issuer may decide to pay back its bondholders prior to maturity.
Bonds are typically called when interest rates fall; therefore, bondholders receive their money back
early and are unable to earn the same return when searching for a replacement investment.

Prepayment Risk In addition to the risks inherent in all fixed-income investments (e.g., interest-
rate, credit, and liquidity risk), mortgage-backed securities are subject to a special type of risk that’s
referred to as prepayment risk. This risk is tied to homeowners paying off their mortgages early. When
interest rates fall, homeowners have an incentive to refinance and pay off their existing mortgages.

These prepayments are passed through to the pools that hold the old mortgages. At this point, the
pass-through investors will need to reinvest this large amount of principal at a time when interest
rates have declined and will likely have difficulty matching their existing coupon rates and returns
when seeking new investments.

Investment Returns
Calculating Current Yield (Dividend Yield)
For stock, the current yield is its annual return based on its annual dividend and current price (as
opposed to its original price or face value). The formula for calculating a stock’s current yield is its
annualized dividend divided by its current market price.

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 CHAPTER 9 – INVESTMENT RISKS, RETURNS, AND DISCLOSURES

For example, if XYZ stock is trading at $50 per share and the stock has a quarterly dividend
of $0.25, its current yield is 2%. Since dividends are typically paid quarterly, the $0.25
dividend must be multiplied by four to determine the annualized dividend income.

$0.25 x 4 $1.00
= = 2%
$50 $50

Calculating Bond Yields

As with any other investors, bondholders are interested in determining the return or yield of their
investment. There are three different measures for determining a bond’s yield are nominal yield,
current yield, and yield-to-maturity.

Nominal Yield A bond’s nominal yield is the same as its interest rate or coupon rate. If a
bondholder purchases a 6% bond, her nominal yield is 6% regardless of the price she paid. Nominal
yield is the simplest measurement of return; however, since it fails to account for the fact that the
bond may have been purchased at a premium or discount.

Current Yield Current yield essentially measures what a bond investor receives each year based on
her (potential) purchase price. While the nominal yield is based on a bond’s par value, current yield is
based on the bond’s current market price. The only difference between calculating a stock’s current
yield versus a bond’s current yield is that the bond’s annual interest is used as the numerator.

Annual Interest
Current Yield =
Current Market Price

For example, an XYZ corporate bond has a 5 1/2 % coupon and is priced at $975. What is the
bond’s current yield?

$55
= 5.64%
$975

Determining and analyzing a bond’s current yield allows an investor to gain a better understanding
of what she’s earning on the bond. However, current yield fails to take into consideration the
payment at maturity. If an investor buys a bond at a price other than par, the difference between
the price paid (premium or discount) and the par value paid at maturity must be factored in to
determine the bond’s overall yield.

Yield-to-Maturity (YTM) Yield-to-maturity, also referred to as a bond’s basis, takes into account
everything that an investor receives on a bond from the time she purchases it until the bond
ultimately matures. This includes the bond’s interest payments plus the difference between what
the investor paid for the bond and what she receives at maturity (par).

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An investor who purchases a bond at par will get her money back at maturity. An investor who purchases
a bond at a discount will have a profit since she paid less for the bond than its par value. An investor who
purchases a bond at a premium will have a loss since she paid more than the bond’s par value.

Note: The calculation of YTM is complex and not required for exam purposes. Instead, the
goal should be to gain an understanding of the concept.

Taxable Equivalent Yield

Municipal bonds generally provide investors with tax-exempt interest. This allows purchasers to
retain more interest than if the bond was taxable. If a customer is considering the possibility of
purchasing a tax-free bond and wants to calculate what he would need to earn on a taxable issue to
earn an equivalent return, the taxable equivalent yield calculation is used. To determine the taxable
equivalent yield of a tax-exempt investment, the formula is:

Municipal Yield
Taxable Equivalent Yield =
(100% – Tax Bracket %)

For example, an investor is in the 32% tax bracket and own a 4.9% municipal bond.
What must a taxable bond yield to be equivalent to the municipal bond?

4.9 4.9
= = 7.20%
(100% - 32%) 68%

Cost Basis, Capital Events, and Return of Capital

This final section will describe unique situations and how they impact the cost basis of a security.
Additionally, other tax-related issues will be examined.

Cost Basis of Inherited Securities

When securities are inherited, the recipient’s cost basis is equal to the market value of the securities
at the time of the deceased’s death. This is referred to as a step-up in cost basis. Regardless of the
deceased’s actual holding period, the recipient’s holding period will be considered long-term.
For example, on July 30, Joe’s uncle purchased 100 shares of TPA stock at $15, but
subsequently passed away on August 18 when the market value of TPA was $22. If Joe
inherits the TPA stock, he will have a cost basis in the stock of $22 (the market value at
the time of his uncle’s death). Although his uncle only owned the stock for less than one
month, Joe’s holding period is considered long-term.

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Cost Basis of Gifted Securities

When securities are received as a gift, the recipient’s cost basis is the lesser of the security’s market
value or the donor’s cost. If the market value is higher than the donor’s cost, the recipient’s cost
basis is equal to the donor’s cost basis. However, if the market value is less than the donor’s cost,
the recipient’s cost basis is equal to the market value of the securities at the time of the gift. The
holding period of the recipient will be the same as the holding period of the giver.
For example, on May 25, Charles bought 100 shares of STC at $15 and gives the stock to
Bruce on August 14 when the market price is $20. On the day of the gift, since the market
price ($20) is higher than Charles’ cost ($15), Bruce’s cost basis for the stock is $15. On the
other hand, on August 14, if the market price was $12, then Bruce’s cost basis would be $12.

Additional Tax Considerations

Unified Gift and Estate Tax Credit The unified credit is the amount that can be left in an estate
without incurring estate taxes. The lifetime amount is adjusted for inflation. Currently, $15,000 can
be gifted each year to as many individuals as desired without tax to the donor. Amounts that are
gifted in excess of the yearly exclusion reduce the lifetime unified credit. An important note is that
unlimited amounts can be gifted between spouses.

Return of Capital A return of capital occurs when an investor receives a portion of her original
investment back. Since this payment is considered neither income nor a capital gain, it’s not a taxable
event. Any return of capital will lower an investor’s cost basis since she now has less money at risk.

Conclusion
This ends the chapter addressing the importance of keeping client’s informed as to the status of their
accounts, the different risks to which they are exposed, as well as the tax implications on their
investments. The next chapter will discuss the different methods that are used to evaluate the
performance in a portfolio.

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 CHAPTER 10

Investment Strategies
and Portfolio Analysis

Key Topics:

 Investment Selection

 Asset Allocation

 Technical Analysis

 Fundamental Analysis
 CHAPTER 10 – INVESTMENT STRATEGIES AND PORTFOLIO ANALYSIS

This chapter will focus on the factors that influence the selection of investments for a
customer. To learn about constructing optimal portfolios for customers, consideration will be
given as to how different asset classes can be used. Finally, the chapter will review the different
methods that may be used to value investments.

Suitability and a Customer’s Financial Objectives

This chapter begins by examining a challenge that many students face—determining the most
suitable investment(s) for a given customer. Due to the importance of making appropriate
recommendations, this manual has provided information regarding taxation, economics,
suitability, the risks associated with different products, as well as a general understanding of the
dynamic of risk and reward. Using all of those factors, an RR is able to determine the best approach
to investing customers’ assets.

An earlier chapter in this manual examined the process of profiling customers and described the
need to collect a significant amount of financial information by using tools such as personal
balance sheets and income statements; however, this process extends beyond the collection of
these quantitative measurements. Many firms also use questionnaires to better gauge a specific
client’s attitude toward risk and to help define her investment objectives. Ideally, all of this
information would be available prior to making a recommendation, but during the Series 6
Examination, much of this detailed background information may be unavailable.

Candidates may be presented with brief and incomplete client profiles that contain limited
information and will be required to tie together both the obvious facts presented in the client
descriptions (e.g., age, tax bracket, risk tolerance) with clues or inferences that may be less obvious. For
example, if a question introduces a 57-year-old doctor who is seeking a fixed-income investment, the
candidate may be forced to assume that the doctor is in a high tax bracket and would be best served by
federally tax exempt status of municipal bonds.

The challenge being issued by the test writers is that candidates must understand all of the features of a
product (e.g., risk level, tax attributes, liquidity) and be able to match these features to a client’s
investment objective and risk tolerance.

Conversely, if a candidate is presented with the profile of a 60-year-old with a low income, a better
selection is likely a U.S. Treasury or high-grade corporate security. This answer is based on the
assumption that the customer may have a lower tax bracket and is less concerned with the tax
status of the interest payments. Remember, corporate bonds typically provide higher yields than
Treasuries, but their coupons are fully taxable.

Before examining some application questions that are related to investment selection for clients,
let’s review the suitability obligations that RRs must follow.

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Know Your Customer and Suitability

As suggested earlier, only after an RR has collected all of the background information on her client
is she able to make a recommendation. Under industry rules, all of the recommendations that are
provided to customers must be suitable based on the facts which are disclosed by customers
regarding their other securities holdings and their financial situation and needs. Remember, suitability
is the determinant of fair dealings with customers, not profitability. Even if a recommendation
results in a significant profit, it may still be viewed by regulators as unsuitable. Conversely, even if a
recommendation results in a significant loss, it may have actually been suitable.

A broker-dealer must use reasonable diligence to obtain the important facts regarding every
customer. In other words, for firms to provide appropriate services, it’s vital that they follow the
know your customer policy.

Remember, suitability is not based solely on the investment selected; another consideration is how
large the purchase is that’s being recommended. For aggressive accounts, recommending a risky
stock may be suitable; however, recommending that a client place 100% of his assets in a risky stock
is considered unsuitable.

Asset Allocation
Bonds as Part of an Asset Allocation For suitability purposes, the exam may include questions
which ask, what percentage of a client’s portfolio should be allocated to bonds? Given the tradeoff
between risk and reward, the general guideline is that customers should have an amount invested
in debt (as a percentage of their overall portfolio) that’s approximately equal to their age. Or, put
another way, simply subtract a person’s age from 100 to arrive at the percentage that should be
invested in equities. For example, a 30-year-old may have 70% of her portfolio allocated to equities
(100 – 30 = 70) and 30% allocated to bonds.

The following are sample allocations that are based on the age of a customer:
 A 25-year-old may want 25% of his portfolio allocated to fixed-income investments, with 75%
allocated to equity securities
 A 45-year-old may want 45% of his portfolio allocated to fixed-income investments, with 55%
allocated to equity securities
 An 80-year-old may want 80% of his portfolio allocated to fixed-income investments, with 20%
allocated to equity securities

Keep in mind, these percentages may need to be adjusted based on the financial profile and risk
tolerance of an individual customer.

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 CHAPTER 10 – INVESTMENT STRATEGIES AND PORTFOLIO ANALYSIS

25-Year Old 45-Year Old 80-Year Old

(Aggressive) (Moderate) (Conservative)

20%
25% Equities
Bonds 45%
Bonds 55%
75% Equities 80%
Equities Bonds

Note The following section will focus on reviewing customer situations and suggested portfolios.
The potential investments will include different types of mutual funds, annuities, or other
retirement vehicles.

Customer Profile An RR’s clients are a husband and wife who are both in their 20s and have jobs
that pay well. If they are considering several asset allocations to create a long-term retirement savings
portfolio, what’s an appropriate investment mix?

Choice A - An asset allocation of 80% equity funds and 20% bond funds
Choice B - An asset allocation of 100% equity funds

Investment Selection 80% stock and 20% bonds placed into IRAs

Rationale To accumulate the assets that they‘ll need at retirement, the couple should include a
significant allocation of equity funds in their portfolio. Placement of the investments into an IRA
will serve to defer any taxes due. Although a portfolio that’s predominately allocated to bond funds
may be safer, it’s unlikely to produce the required long‐term returns.

Customer Profile During an initial interview with a successful 45-year-old doctor who has her
own practice, she makes it clear to her RR that she is disturbed by the thought of taking risks with
her money, but realizes that the stock market provides the best long-term returns. What should
the RR recommend for this customer?

Choice A - A portfolio consisting of 60% equity funds and 40% fixed-income funds
Choice B - A portfolio primarily consisting of tax-exempt funds with a small to moderate (20
to 25%) allocation of equity funds

Investment Selection A mix that’s weighted heavily toward municipal bond funds and a small
allocation of individual equity funds.

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Rationale Based on the asset allocation approximation rule, the recommended portfolio may appear to
hold too little equity. However, in this case, the increased bond allocation is appropriate given the
customer’s risk aversion. A customer’s ability to tolerate risk is not based solely on her financial resources,
but also on her values and attitudes. Two customers who have the same financial resources may perceive
risk differently. An RR should pay careful attention to what investors say about their tolerance for risk
since an investment recommendation that goes against a client’s expressed wishes is never suitable.

For this client, the majority of the assets are being allocated to a safe investment (municipal bond
fund) since the client is uncomfortable with risk. With the client’s consent, the RR may allocate a
small portion of the client’s portfolio to equity funds in order to provide some growth potential.
Ultimately, this portion may be increased over time if the client becomes more comfortable with
the fluctuations of the stock market and provides permission.

Customer Profile The client is a New York advertising agency executive who is interested in making
a mutual fund investment. The client is 30-years-old, single, has an annual salary of $250,000, and
recently received a sizable bonus to be used as the down payment to purchase a home within the next
year. What’s the most appropriate recommendation?

Choice A - An asset allocation of 70% equity funds and 30% bond funds
Choice B - An asset allocation of 100% money-market funds and/or short-term bond funds

Investment Selection A portfolio of money-market funds and/or short-term bond funds

Rationale It may initially seem as though this client is the perfect candidate for a growth portfolio;
however, his investment time horizon is not long enough.

Before designing an investment program for a customer, an RR must determine the investor’s time
horizon (i.e., the amount of time that a client has available to achieve his financial goals). Generally,
the longer an investor’s time horizon, the more volatility (fluctuation) the portfolio can tolerate.
Investors with short time horizons usually require more stable, conservative investments since they
will need their money sooner. Based on this client’s short time horizon, equity investments are
unsuitable. The client will need liquid assets to purchase his home and cannot afford fluctuations in
value; therefore, a money-market or short-term bond fund is the most suitable.

For example, a 35-year-old investor who is planning for retirement will normally have a
time horizon of 25 to 30 years, while a 55-year-old investor will usually have a much shorter
period before retirement. Also, the parents of an infant will have 18 years to save for college,
while the parents of a teenager will have far less time.

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 CHAPTER 10 – INVESTMENT STRATEGIES AND PORTFOLIO ANALYSIS

Client Profile A 35-year-old small business owner who is single and appears to be doing well
financially informs an RR that he would like to day-trade. Fearing identity theft, the client refuses to
provide the RR with background information beyond what’s required under AML rules (e.g., name,
Social Security number, date of birth). What should the RR recommend for this client?

Choice A - A collection of small capitalization ETFs and some leveraged ETFs

Choice B - Nothing

Investment Selection Nothing

Rationale Some clients may be reluctant to disclose their complete financial information. If a
client refuses to provide certain information, an RR may not make assumptions about the client’s
finances. An RR may only make recommendations that are based on the information that’s been
disclosed by the client. In some cases, a firm may decide not to open an account due to a client’s
unwillingness to provide sufficient background information.

Customer Profile A high-income, high-net-worth investor is seeking income and safety of principal.
What is the appropriate allocation recommendation for this customer?

Choice A - A mix of U.S. Treasury bond funds and high-grade corporate bond funds
Choice B - Investment-grade municipal bond funds

Investment Selection Investment-grade municipal bond funds

Rationale Safety of principal refers to a customer’s desire to be able to preserve or retain the initial
amount of her investment over its life. Many bond funds offer this benefit to investors. The higher
the rating of the debt instrument, the greater the likelihood that investors will achieve the safety of
principal that they desire. Investment‐grade municipal bond funds offer safety of principal and also
offer tax-exempt income to investors who are in a high tax bracket. In this case, although the
Treasury funds and corporate bond funds will provide income, the income is federally taxable.
Remember, since investors who have significant taxable income will typically have a higher
marginal rate of taxation, they’re good candidates for tax-free bond funds.

Customer Profile An RR’s client is an elderly customer who is seeking preservation of his capital.
What investment should an RR recommend to this customer?

Choice A - U.S. Treasury bond funds

Choice B – Money market funds

Investment Selection Money market funds

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Rationale Investors who are concerned about the potential loss of their capital will invest in securities
that provide safety. Although they want to achieve a return on their investment, these investors don’t
want to put their principal at risk. Although T-bond funds are not subject to default risk, they do
expose customers to interest-rate risk. On the other hand, money market funds protect clients against
both default risk and interest-rate risk. Older clients with a preservation of capital objective often
invest in short-term instruments, such as insured certificates of deposit or money-market funds.

Customer Profile An RR’s client is a recent college graduate who has just landed his first full-time job and
has recently moved out of his parents’ home. If the investor wants to allocate 10% of his salary to stock
market investments, what’s an appropriate recommendation?

Choice A - A variable annuity

Choice B - A work-sponsored retirement plan

Investment Selection Prior to investing the client’s assets, the appropriate step is to have the client
investigate whether his employer offers a retirement plan, such as a 401(k) plan.

Rationale Employer-sponsored retirement plans typically grow on a tax-deferred basis and are often
the first choice to consider when making an investment. Generally, these plans permit pre-tax
investments (which reduce current taxable income) and normally offer a wide range of low-cost
investment choices.

Customer Profile An RR’s client is a retired school teacher who is seeking current income and a
portfolio that provides some inflation protection. If she’s willing to accept a moderate level of risk,
what should an RR recommend?

Choice A - A collection of high-grade convertible corporate bond funds

Choice B - A high-yield bond fund

Investment Selection High-grade convertible corporate bond fund

Rationale Investors with a primary investment goal of current income want investments that produce a
steady, reliable stream of cash. These investors typically need this income in order to defray daily
living expenses, especially during retirement years. Some examples of income investments include
most bonds, preferred stocks, and fixed annuities. Often, the downside to income investments is that
they produce little, if any, growth in principal (the original amount invested). Over time, this may
present a problem due to the fact that inflation erodes the purchasing power of the income.

Investment‐grade (highly rated) convertible corporate bond funds offer investors both the safety of
income and the potential for appreciation if the underlying equity increases in value. Although U.S.
Treasury securities are safer, they don’t offer the equity upside potential of a convertible issue.

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 CHAPTER 10 – INVESTMENT STRATEGIES AND PORTFOLIO ANALYSIS

It’s unlikely that the high-yield bond fund is the best choice for this customer. Although these
products provide income, they do so at greater risk and offer no inflation protection.

Customer Profile An RR’s client has been using a 529 plan to save for her child’s college education
and her child will be attending college in a few years. What asset allocation should an RR recommend
to the client?

Choice A - A mix of 80% equities and 20% fixed-income securities

Choice B - A mix of 20% equities and 80% fixed-income securities

Investment Selection 20% equity securities and 80% fixed-income securities

Rationale Although the student is young, she will soon need to access the funds for college. As a child
approaches college age, a suitable investment strategy is to move from growth-oriented securities (e.g.,
equities) to income‐oriented securities (e.g., bonds and money-market funds). Once a child begins to
attend college, most of the funds should be invested in money‐market funds or other types of short‐
term investments that offer liquidity and limited capital risk. In this case, since there are a few years
remaining for the assets to grow, a minimal percentage of the account should be invested in equities.

Customer Profile A registered representative’s customers are a husband and wife who are in their
early 70s and are retired. They live on a small pension from the post office and also collect Social
Security benefits. If the couple has assets of $355,000 to invest and they’re in the lowest tax bracket,
what portfolio allocations are most suitable?

Choice A - A mix of 25% domestic equity funds, 60% bond funds, 10% cash, 5% international equity
funds
Choice B - A mix of 75% high-grade municipal bond funds and 25% equity funds

Investment Selection 25% domestic equity funds, 60% bond funds, 10% cash, 5% international
equity funds

Rationale Considering the customers’ ages and limited incomes, investing a greater portion of
their assets in bond funds will provide additional income, while the assets invested in equity funds
will provide the potential for growth. As explained previously, one approach that’s used by many
professionals is to subtract a client’s age from 100 to determine the percentage of assets that should
be invested in equities. The general assumption is that as clients get older, they have less risk
tolerance and, therefore, less money should be invested in equities. Only a small percentage of a
client’s assets should be allocated to the international marketplace. Remember, clients who are in
the lowest tax bracket are generally not good candidates for tax-free investments.

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CHAPTER 10 – INVESTMENT STRATEGIES AND PORTFOLIO ANALYSIS

Customer Profile A newly married couple in their early 20s is interested in investing a portion of the
money they received as wedding gifts. The couple has very little savings and virtually no investment
experience. If they have just purchased a new home and are eager to begin making money in the stock
market, what’s the appropriate recommendation?

Choice A - A mix of index mutual funds and corporate bond funds

Choice B - Short-term bond funds or money-market securities and a small allocation of equity
funds

Investment Selection Short-term bond funds or money-market securities and a small allocation of
equity funds

Rationale As a general rule, most investors should have a cash reserve equal to at least three months’ living
expenses. In certain circumstances, such as when a client’s income is unpredictable, it may be wise to
maintain a larger cash reserve. These capital reserves should be kept in a safe, liquid investment such as a
money-market fund. Although this couple is ready and willing to invest in the stock market, until they
establish sufficient cash reserves, only a small portion of their assets should be allocated to equity funds.

Customer Profile An RR’s customer is a biotech engineer who believes that biotechnology will be a
leading industry in the 21st century. He wants some exposure to this area of investing that offers high-
risk with the potential for high-reward and is seeking to maximize his returns by utilizing margin.
What investment should be recommended to this customer?

Choice A - A biotechnology sector ETF

Choice B - A biotechnology mutual fund

Investment Selection A biotechnology sector ETF

Rationale Both the biotechnology ETF and the biotechnology mutual fund provide exposure to
this market segment. A sector ETF concentrates its investments in a given industry, such as mining,
biotechnology, or computer technology. While these funds are certainly more risky than other
diversified offerings, they provide exposure to a given industry for any investors who seek it. The
key to this question is that the customer intends to use margin to maximize his returns. Remember,
ETFs are marginable, but mutual funds are not.

Customer Profile The customer is an accredited investor who consistently invests in high-risk
ventures. He is a seasoned stock market investor who enjoys trading both options and leveraged
products. The customer is also the custodian for his 6-year-old niece’s UGMA account. What
investment(s) should be recommended for the UGMA account?

Choice A – Leveraged ETFs, since these products offer the potential for significant returns
Choice B - A broad collection of equity funds

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 CHAPTER 10 – INVESTMENT STRATEGIES AND PORTFOLIO ANALYSIS

Investment Selection A broad-based portfolio of high-quality stock funds

Rationale In some cases, assets are being invested for the benefit of a third party such as a child or
infirmed relative. In these cases, the RR must examine the profile and objective of the beneficiary,
not the person who is making the ultimate investment decisions. In this case, a high-quality equity
fund portfolio is a suitable recommendation for the niece’s account. Leveraged ETFs are
inappropriate for placement in a UGMA account.

As shown by reviewing these customer profile examples, choosing an appropriate investment mix for a
customer can be a difficult process. RRs must weigh the client’s objective, profile, tax situation, and the
current market conditions prior to making a recommendation.

Forms of Analysis
Let’s review some of the different approaches that investors take when allocating assets to their
portfolios.

Growth Analysis
This method of analysis is used by investors who are concerned with a company’s future earnings
potential. The investors are seeking companies with rapidly growing earnings in the hope that this
growth will continue. Growth investors believe that if the company’s earnings are outperforming the
market, the stock’s price will continue to increase. Also, as long as the company controls its costs and
increases sales, the value of the business will increase and the stock price will grow along with
future earnings.

Growth investors usually purchase stocks that have high price-to-earnings (P/E) ratios, a high level of
retained earnings, and low dividend payout ratios. Remember, growth companies tend to retain most
of their earnings to finance expansion of operations rather than paying dividends to shareholders.

Value Analysis
The value analysis method is used by investors (or funds) that are interested in stocks of companies that
are intrinsically undervalued or trading at a discount to their book value. If the market is efficient and the
issuing companies continue to generate profits, these stocks are attractive to long-term investors since
their depressed prices make them a good value. Value stocks are characterized by a low P/E ratio, a
history of profits, a high dividend yield, and a low market-to-book ratio.

Value investors are most concerned with the fundamental value of businesses as opposed to their
current share price and believe that companies that are out of favor and underperforming may be
overlooked. Many of these investors have very long-term time horizons and seek out companies
that are undergoing a fundamental change such as a restructuring or shift in leadership.

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Top-Down Analysis
When following the top-down analysis approach, a broad analysis of the economy is conducted first
and then specific industries are identified that are likely to benefit the most from the anticipated future
economic conditions. Ultimately, particular companies are chosen from within those industries.

Bottom-Up Analysis
The bottom-up analysis focuses on fundamental analysis and the evaluation of companies based on
a number of factors. The goal is to find stable companies that have a history of profits and to determine
whether a company is undervalued relative to its peers. The analysis will also consider the economic
climate to further validate the investment decision.

Momentum Investing
Momentum investors often move rapidly from one sector of the market to another—essentially in an
effort to chase money flows. For example, if gold stocks are in favor, they will overbuy in that area;
however, if auto stocks are subsequently moving higher, they will change focus rapidly. Many of these
investors use sector specific ETFs to accomplish this rapid movement from one sector to another.

Indexing
The index approach basically concedes that most investors don’t outperform the market. The goal
of indexing investors is to find the least expensive and most tax-efficient products that reconcile
with their objectives. These investors often choose to go it alone since they believe registered
representatives or financial advisers lack the knowledge to beat the market. Investment choices
may include index funds and ETFs since both of these products offer a low-cost and tax-efficient
way to gain broad exposure to the market.

Modern Portfolio Theory

Regardless of the method being employed, investors are constantly seeking to construct the perfect
portfolio. But ultimately, how does a person measure perfection? Is it the absolute return or is it
small or non-existent losses? To adequately answer the question, the goal must be reviewed—to
generate the maximum return for a given level of risk.

Prior to the middle of the last century, theories about investing focused mainly on the strengths and
weaknesses of individual securities. According to these approaches, good analysts constructed
portfolios that contained only the strongest performing stocks or other securities. But beginning in
the 1950s, a number of financial analysts revolutionized the approaches to investing. These advances
are grouped under the heading the Modern Portfolio Theory (MPT).

One of the basic assumptions of the Modern Portfolio Theory is that investors are risk-averse. This
essentially means that investors prefer the lowest risk possible to obtain a given level of return. Or,
put another way, investors want the highest return possible given a specific level of risk.

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Constructing Optimal Portfolios MPT shifted investors’ attention away from individual securities and
toward a total portfolio that consists of various classes of assets. For example, a simple portfolio may
contain three basic asset classes in various proportions. One mix may be 60% stocks, 30% bonds, and
10% cash equivalents, while another mix may be 20% stocks, 20% bonds, and 60% cash equivalents.

MPT suggests that there’s actually a whole series of possible mixes that are optimal. An optimal
portfolio is one that provides the greatest return for a given amount of risk. A graph of these optimal
portfolios (shown below) produces a diagram that’s referred to as an efficient frontier.

Efficient
Frontier
B
Same risk,
C but higher return

Same A
return, but
less risk
Return

Risk
(Volatility of Returns)

Any point behind the frontier, such as Point A, represents a portfolio that’s not optimal. There are
portfolios that offer better returns than A for the same level of risk (Portfolio B). Also, there are
portfolios that offer the same return as A, but with less risk (Portfolio C). The lesson is that portfolios
on the efficient frontier are better than those behind it.

A more challenging issue is deciding between Portfolios B and C. Is one better than the other? The
decision depends on an investor’s risk tolerance. If Portfolio B is chosen, the investor expects to
achieve a better return than C, but with more risk. While it’s clear that when given a choice an
investor should not choose Portfolio A, the selection of either between B or C is a matter of investor
preference and risk tolerance.

There are many different methods that may be used to help determine the proper allocation among
different asset classes. Many financial professionals begin by using the investor’s age, while others
use time horizon and risk tolerance. Investors may accomplish proper asset allocation on their own
by investing in mutual funds or exchange-traded funds.

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Below is an asset allocation table that’s posted on FINRA’s website:

Investment Horizon Stocks Bonds Cash

20 to 30 years until retirement 80% 15% 5%

10 to 20 years until retirement 60% 30% 10%

Five years until retirement 40% 40% 20%

At retirement age and beyond 30% or less 40 to 80% 20% or more

Indexes and Averages

Indexes and averages monitor the performance of a group of securities. Some are intended to
reflect the entire market and are referred to as broad-based, while others measure only a market
segment or particular industry and are referred to as narrow-based.

The Dow Jones Averages The Dow Jones Averages are widely quoted measurements of the stock
market. The Dow Jones Composite Average consists of 65 stocks and is broken down into the
following three subaverages:
 Dow Jones Industrial Average – consisting of 30 stocks
 Dow Jones Transportation Average – consisting of 20 stocks
 Dow Jones Utility Average – consisting of 15 stocks

Of the three Dow Jones Averages, the Dow Jones Industrial Average (DJIA) is the most commonly
quoted. The DJIA contains 30 of the leading blue-chip companies that represent the backbone of
industry in the U.S., such as General Electric, AT&T, and IBM.

The Standard & Poor’s 500 Index The S&P 500 Composite Index consists of mainly NYSE stocks,
but also some NYSE American (formerly AMEX) and Nasdaq stocks. This index gives a broader
measure of the market as compared to the Dow Jones Averages. The index is widely considered to
be the best indicator of how large U.S. stocks are performing on a day-to-day basis. The S&P 500
Index consists of approximately:
 400 industrial stocks
 20 transportation stocks
 40 financial stocks
 40 utility stocks

The New York Stock Exchange Composite Index The NYSE Composite Index contains all of the
common stocks that are listed on the New York Stock Exchange. As with the S&P 500 Index, this
index is also divided into four sub-indexes for industrial, transportation, financial, and utility issues.

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The Wilshire Associates Equity Index The Wilshire Associates Equity Index consists of stocks
that trade on the New York Stock Exchange, the NYSE American, and Nasdaq. The index represents
the dollar value of all of the stocks and is considered the broadest of all indexes and averages.

Other Indices Some of the other indices that are widely used include the Major Market Index
which consists of 20 well-known highly capitalized stocks, the Nasdaq Composite Index which
consists of all Nasdaq-listed securities, and the Nasdaq 100 which consists of 100 of the largest
companies listed on Nasdaq. The Morgan Stanley Capital International Europe, Australasia, and Far
East (MSCI EAFE) Index follows the equity performance of the developed markets, but excludes the
U.S. and Canada. Lastly, the FTSE Index mostly follows the stocks of companies that trade on the
London Stock Exchange. (The FTSE acronym is derived from its two parent companies—the
Financial Times and the London Stock Exchange.)

Capital Asset Pricing Model (CAPM)

The original ideas of Modern Portfolio Theory have been extended in a number of directions. One
of these extensions is the Capital Asset Pricing Model (CAPM). CAPM attempts to describe how the
market values (prices) investments and provides insights into the nature of risks.

Types of Risk Although there are a number of ways to categorize investment risks, CAPM
simplifies the analysis of risks by classifying them into two types—diversifiable and non-
diversifiable risk. Since these two types were described in the previous chapter, the following is a
quick review.

Diversifiable Risk This risk, which is also referred to as non-systematic risk, is associated with
owning the securities of specific companies. CAPM suggests that this risk is able to be avoided or
even eliminated by holding a diversified portfolio of securities. Since it’s avoidable, investors are
not compensated for assuming diversifiable risk.

Non-Diversifiable Risk This risk, which is also referred to as market risk or systematic risk, is
associated with the overall movement of the market. Since this risk is not able to be avoided
through diversification, investors are rewarded for assuming it. The greater the non-diversifiable
risk, the greater the potential reward.

Measuring Non-Diversifiable Risk Avoiding diversifiable risk is as simple as constructing a

portfolio of relatively uncorrelated assets; however, non-diversifiable risk must be approached
differently. The reason for this is that the amount of risk being assumed by a portfolio is directly
related to its expected return.

Beta The amount of non-diversifiable risk associated with a particular portfolio or asset is
measured as beta (β). The value of beta describes the risk of a portfolio or asset as compared to the
total market, which is measured as volatility. The total market is assigned a β value of 1; however,
some representation of the total market (usually the S&P 500 Index) is commonly employed.

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For example, if Investment Z has a β of 1.5, this suggests that it’s 50% more volatile than
the market as a whole. Therefore, if the market rises by 10%, Investment Z is expected to
rise by 15% (10% x 1.5). Conversely, if the market declines by 10%, Investment Z is
expected to decline by 15% (10% x 1.5).

An investment with a β of less than 1 is not as volatile as the total market and is expected to fall less in
declining markets than the average security, but also rise less in bull markets. When beta is calculated
for an entire portfolio, the weighted average of the betas of the component parts (securities) is used.

Alpha While a stock’s beta measures its performance related to the overall market, alpha
measures the portion of a stock’s return that’s achieved independent of the market. Alpha is
influenced by factors that are unique to the company and its industry group. As a risk-adjusted
return, alpha represents the difference between an asset’s expected return (as implied by beta) and
its actual return. If a security’s actual return is higher than its beta, the security has a positive alpha;
however, if the return is lower, it has a negative alpha.
Based on the example above, let’s assume that Investment Z has a β of 1.5 and over a
specific period the market is up 5%. During the same period, Investment Z’s actual return
is 9%. What does all of this mean? If the market is up 5% and Investment Z’s beta is 1.5,
the investment’s expected return is 7.5% (5% x 1.5). However, since the actual return is
greater than the expected return, there’s positive alpha of 1.5 (9 – 7.5)

Fundamental Analysis
Securities analysts seek to predict the future performance of marketable securities. Fundamental
analysis focuses on analyzing individual companies and their industry groups. Important items for
a fundamental analyst include a company’s financial statements (e.g., its balance sheet and income
statement), details regarding the company’s product line, the experience and expertise of the
company’s management, and the outlook for the company’s industry. Obviously, the general
condition of the economy will also affect the prospects for a given company.

Conversely, technical analysis focuses on market sentiment or trading trends. Investors who
subscribe to technical analysis tend to be more short-term oriented and may even attempt to time
markets as a security fluctuates in value.

The Balance Sheet

The balance sheet (also called a statement of financial condition) represents the financial picture of
a company as of a specific date. The balance sheet is divided into three major sections—Assets,
Liabilities, and Stockholders’ Equity. The name balance sheet is derived from the fact that the total
assets must always equal the sum of the total liabilities plus the stockholders’ equity. The basic
balance sheet formula is:

Assets = Liabilities + Stockholders’ Equity (Net Worth)

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Assets represent all of the items that are owned by a corporation, while the liabilities section
contains all of the items that are owed by the corporation. The difference between a corporation’s
total assets and its total liabilities is stockholders’ equity (also referred to as net worth).

The exhibit below represents a sample balance sheet:

National Corporation Balance Sheet

For period ending December 31, 20XX

ASSETS LIABILITIES
Current Assets Current Liabilities
Cash $ 43,000 Accounts Payable $188,000
Marketable Securities 62,000 Interest Payable 27,000
Accounts Receivable 270,000 Dividends Payable 40,000
Inventories 330,000 Taxes Payable 72,000

Total Current Assets: $705,000 Total Current Liabilities: $327,000

Fixed Assets Long-Term Liabilities

Land $ 64,000 9% Debentures due 2035 $300,000
Plant and Equipment 630,000
Furniture and Fixtures 280,000 TOTAL LIABILITIES $627,000
Less: Accumulated
Depreciation (220,000)

Total Fixed Assets: $754,000

Intangible Assets STOCKHOLDERS’ EQUITY

Goodwill $ 30,000 6% Preferred Stock,
$100 par value,
500 shares outstanding $ 50,000
Common Stock,
$3.00 par value,
300,000 shares authorized,
200,000 shares outstanding 600,000
Capital Surplus 52,000
Retained Earnings 160,000

Total Stockholders’ Equity: $862,000

TOTAL LIABILITIES AND
TOTAL ASSETS $1,489,000 STOCKHOLDERS’ EQUITY $1,489,000

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Components of the Balance Sheet—Assets

There are three basic subsections to the asset category—current assets, fixed assets, and intangible
assets.

Current Assets Current assets represent cash and other items that may be converted into cash
within a short period (usually one year). The assets that may be converted into cash include
marketable securities, accounts receivable, and inventories.

It’s important to examine the method being used for valuing the inventory. In most cases, either the
LIFO (last-in, first-out) or FIFO (first-in, first-out) method is used. Using LIFO, the cost of the last
item produced is applied to the price of the first item sold from inventory. The FIFO method applies
the cost of the first item produced to the money received from the first item sold.

In a period of rising prices, FIFO results in a greater earnings before interest expense and taxes
(EBIT) because a lower cost basis is used for the units that are being sold. Therefore, the company
would report greater profits and pay a greater amount of taxes. If LIFO is used during an
inflationary period, it results in lower profits and taxes.

Fixed Assets Fixed assets are items that are used by the company in its day-to-day operations to
create its products. This section will list the company’s physical property, such as land, buildings,
equipment, and furniture.

Depreciation With the exception of land, fixed assets lose some of their value each year due to
normal use. The IRS allows a company to claim this wear and tear on assets as a depreciation
deduction against income. On the balance sheet, fixed assets are shown at a value which represents
their original cost less accumulated depreciation.

Intangible Assets Although intangible assets don’t have physical value, they add substantial
value to a company. Some intangible assets differentiate the company from its competitors and are
proprietary such as patents, intellectual property, trademarks, franchises, and copyrights. Goodwill
is another intangible asset that’s created when a company buys or mergers with another company.
It represents the amount that was paid above the fair market value to acquire a company.

The Liabilities Section

The liabilities section identifies the company’s debts. Some of the debts must be paid in a short
period (current liabilities), while others are not required to be repaid for many years (long-term
liabilities).

Current Liabilities Current liabilities are debts that become due in less than one year and are
easily identified by the word payable. Included in this section are accounts payable (the amount a
company owes for goods and services that are purchased on credit), dividends payable, interest
payable, notes payable, and taxes payable.

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Long-term Liabilities Long-term liabilities are debts which are incurred by a corporation that
become payable in one year or more, such as bonds and long-term bank loans.

The Stockholders’ Equity Section

The stockholders’ equity section represents the company’s net worth and also indicates the
shareholders’ ownership interest. The items listed in this section include the different classes of
stock, retained earnings, and capital surplus.

Preferred stock is listed in the balance sheet at the par value of the company’s outstanding shares.
The usual par value for preferred stock is $100. Common stock is listed in the balance sheet based at
a par value that’s arbitrarily set and is used only for bookkeeping purposes. The par value set for
common stock doesn’t influence the market price of the stock.

Capital surplus, or paid-in capital, is the amount of premium above the par value that’s paid by
shareholders for the shares that are sold to the public by the corporation. For example, if a
company’s IPO is priced at $15 per share and the par value is $10 per share, then $5 is added to the
capital surplus in the stockholders’ equity section of its balance sheet. Capital surplus does not
include the funds that the company derives from business profits. Earnings that are generated, but
not distributed, are referred to as retained earnings or earned surplus. The retained earnings entry
represents net profits that have been retained for future use by the corporation. Typically,
dividends that are paid by a corporation come from its retained earnings.

Conclusion
This concludes the chapter on investment strategies and portfolio analysis. The next chapter will
examine different orders and how they’re executed.

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 CHAPTER 11

Orders and Trade

Execution

Key Topics:

 Overview

 Trade Capacity

 Order Tickets and Transactions

 Prohibited Trading Practices

 Settlement and Delivery

 CHAPTER 11 – ORDERS AND TRADE EXECUTION

This chapter will examine the secondary market trading of securities that begins after their
issuance in the primary market. The beginning will detail the mechanics of order placement
and then move on to a comparison of the various trading venues. The final part of the
chapter will focus on how trades are settled and securities are delivered.

Trading Overview
Trading markets are generally broken down into two categories—traditional physical trading
venues, such as the NYSE, and over-the-counter (OTC) marketplaces where trades occur in
dispersed dealer-to-dealer networks that connect participants through phones and/or computers.
Today, although they lack a physical trading floor, many electronic trading venues are classified by
the regulators as exchanges (e.g., Nasdaq). Any equity securities that meet the standards for trading
on a national exchange are referred to as listed securities.

Any equities that are not listed on either a physical or electronic exchange are referred to as OTC equities
or non-exchange-traded securities. These issues trade in non-exchange OTC venues, such as the OTC
Bulletin Board (OTCBB) or on a platform created by the OTC Markets Group (e.g., the Pink Marketplace).
Many other securities, such as U.S. government bonds, some corporate bonds, and certain derivative
products, are also traded in the OTC market through various dealer-to-dealer networks.

Secondary Market Trading—From Order Entry to Settlement

In the secondary market, trades begin with the placement of an order ticket in either a physical or
electronic format. After the order ticket is completed, the Sales Department forwards the order to
the Trading Department. If the order is ultimately executed, the trade is cleared by the broker-
dealer’s Operations Department.
1. Order Entry—The placing of a trade into the system either electronically or using a paper ticket
2. Execution—The occurrence of the trade in the marketplace, such as the NYSE or Nasdaq
3. Clearing—The agreement by executing firms as to the details of a trade

Order Entry An order ticket, also called an order memorandum, is a record of a customer’s
instructions regarding the execution of a buy or sell order. Traditionally, registered representatives
filled out paper order tickets, but today the process is almost exclusively electronic. Essentially,
many firms permit clients to fill out their own tickets through online trading accounts.

Capacity of the Firm

Although the different capacities in which a broker-dealer can act was described in Chapter 9,
this section will provide greater detail of what it means to acts as either a broker or a dealer in a
given transaction.

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Brokers (Agents) Regardless of whether a client wants to buy or sell a security, a firm that acts as a
broker (agent) is attempting to find the other side of the trade on behalf of its client. If a client wants to
buy, a broker will try to find a seller. On the other hand, if a client wants to sell, a broker will attempt to
find a buyer. The firm is not willing to take the other side of the trade (it assumes no risk) since it
doesn’t maintain an inventory of the security. This action is referred to as brokering a trade.

Commissions When a firm acts in a broker (agent) capacity, it earns a commission for its efforts.
However, if a trade is not executed, then no commission is earned.

Agency Cross Occasionally, a broker-dealer may have one client who wants to sell a particular
stock and another client who is seeking to purchase the same security. In this case, the firm may
simply choose to cross the shares internally between the two accounts. This agency cross is often
executed between the bid and offer with both customers paying the firm a commission.

Dealers (Principals) When a firm buys securities for or sells securities from its own inventory, it’s
acting as a dealer (principal). A dealer that always stands ready to buy or sell a specific stock is
referred to as a market maker in that stock and assumes risk by taking the other side of the trade. As
both a buyer and a seller, a market maker provides a two-sided quote—its bid is the price at which
it’s willing to buy stock and its ask (offer) price is the price at which it will sell the stock. For
example, if a dealer (market maker) is quoting a stock at $20.00 – $20.25, it’s willing buy stock at $20
per share and sell it for $20.25 per share to other dealers. The $.25 difference between the bid of
$20.00 and the ask of $20.25 is the spread—a source of profit for the market maker.

Markups/Markdowns When acting in a dealer capacity, a firm will adjust its prices for retail
customers. Using the above quote of $20.00 – $20.25, if a client wants to sell stock to the dealer, the
dealer may pay her $19.95 net per share—a $.05 markdown from the prevailing market price. On
the other hand, if the client wants to buy stock, the dealer may offer to sell her the shares at
$20.31—a $.06 markup. The dealer profits by purchasing securities from customers at one price and
selling those securities to other customers at a higher price.

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 CHAPTER 11 – ORDERS AND TRADE EXECUTION

NYSE and Other Traditional Exchanges

Things have changed significantly since the New York Stock Exchange was founded in 1792. The
NYSE was created to facilitate the orderly trading of selected securities. Traditionally, this trading
was done at a single location utilizing an open outcry auction process by members of the exchange
that held a seat. Today, the NYSE employs hybrid trading methods that include both personal face-
to-face trading on a physical floor as well as electronic linkages.

The Role of the Designated Market Maker (DMM)

On the NYSE, each specific stock is assigned to a designated market maker. The DMM’s role
includes maintaining liquidity, promoting a fair and orderly market, and resolving trade imbalances
that result from a temporary lack of supply or demand in that particular security.

The DMM must stand ready to buy for and sell from its own account (acting as a dealer) to make
the market fair and orderly. In doing so, the DMM must be a buyer when there are no buyers and
be a seller when there are no sellers. The result of these actions is a narrowing of the spread
between transactions.

DMM Acting as Agent The following example describes the DMM’s role as an agent:
An investor gives a registered representative an order to buy 7,000 XYZ at 40.25. The order
is transmitted to the firm’s floor broker, who enters the trading crowd and determines
that the stock’s current quote is 40.50 – 40.75, 50 by 80. This means that the highest bid is
40.50 and the lowest offer is 40.75 with the bid representing 5,000 shares and the offer
representing 8,000 shares. Although the floor broker is able to purchase shares at a price
of 40.75, this will not satisfy the conditions of the customer order. Therefore, the floor
broker may leave the order with the DMM. Later, if the inside offer price drops to 40.25,
the DMM will purchase the stock for the customer.

DMM Acting as Principal In the previous example, the DMM acted as agent for the customer by
matching the customer with a counterparty when market conditions allowed. DMMs also act as
principals by trading their own accounts. The trades that DMMs execute for their own accounts
must always be done with a focus on their responsibility to maintain a fair and orderly market.

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The term fair and orderly market refers to a market in which there’s price continuity and reasonable
depth. To maintain this type of market, the DMM is required to maintain a reasonably small spread
(price difference) between bids and offers.
For example, an orderly market is more likely to have a bid of 40 and an offer of 40.05,
rather than a bid of 40 and an offer of 41. If the spread becomes too wide, DMMs are
expected to enter the market for their own accounts and raise the bid or lower the offer to
narrow the spread. Also, a fair and orderly market is indicated by a series of trades with
small price changes (ticks) such as 40, 40.05, 40.10, 40.15, rather than large changes in
price from trade to trade, such as 40, 42, 40.10, 41.75. The DMM is expected to supply
stock to the market if there’s a large imbalance between supply and demand and may be
required to sell short to accomplish this.

The additional trading by the DMM that occurs during trade imbalances may be the result of a
temporary lack of supply or demand (buyers and sellers) in a particular security. By trading during
imbalances, the DMM is maintaining liquidity in the market for that stock.

Dealer-to-Dealer Markets
In many of the markets that lack a centralized meeting place, transactions are conducted over the
telephone or through a computer network. These dealer-to-dealer markets have come to dominate
modern securities trading. One example of a liquid dealer-to-dealer market is the U.S. Treasury market.

Most debt securities trade in these dealer-to-dealer settings (often referred to as over-the-counter
[OTC] markets), including:
 Corporate bonds
 Municipal securities
 U.S. government and government agency securities

Nasdaq Trading
One of the most well-known dealer-to-dealer trading venues is the National Association of Securities
Dealers Automated Quotation system—or simply referred to as Nasdaq. Non-centralized markets are
considered negotiated markets since broker-dealers that intend to buy or sell a security must negotiate
a price with a market maker. Unlike the NYSE where there’s only one market maker (DMM) per
security, there may be many market makers for Nasdaq equity securities. These dealers stand ready to
buy or sell a minimum number of shares at their two-sided quoted price. The quote size requirement is
dependent on the security’s price and the system in which the market maker displays its quotes.

Broker-dealers are able to select the stocks for which to act as a market maker. Within each broker-
dealer, a position trader is responsible for maintaining the broker-dealer’s inventory as well as
trading the firm’s proprietary account.

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Quotations and Backing Away The stated price at which market makers are willing to buy or sell
securities is considered their firm quote. For example, a market maker’s quote is:

Bid Ask Size

16.20 16.40 10 x 5

It’s a violation of industry rules to provide a firm quote and then fail to fill an order on the basis of
the quotation. Such action constitutes a firm-quote violation that’s referred to as backing away.
Based on the quote shown above, if a market maker receives an order to sell up to 500 shares at
16.20, but doesn’t fill the order, it’s backing away. However, this provision doesn’t preclude a dealer
from changing its quotation during the course of the trading session as market conditions dictate.

Market Maker Requirements

To be a market maker in the Nasdaq system, a dealer must provide regular bids and offers for a
security, meet specific capital requirements, and be registered with FINRA. A registered market maker
that enters a bid and offer in the Nasdaq system must be prepared to buy or sell a minimum unit of
trading (100 shares) at its quoted bid and offer.

Alternative Trading Systems (ATS)

Alternative trading systems are SEC-approved, non-exchange trading systems. An ATS provides an
alternative method to trading on an exchange and enhances the liquidity of securities in the
marketplace. Examples of these systems include a broker-dealer’s internal execution system, electronic
communication networks (ECNs) that choose not to register as an exchange, and trade crossing
networks. An ATS is generally required to register with the SEC and FINRA as a broker-dealer, but is
not required to be registered as an exchange. An ATS doesn’t set rules or discipline its subscribers but,
due to its registration as a broker-dealer, it’s subject to FINRA rules and disciplinary action.

Components of an Order Ticket

Although order tickets that are used by different broker-dealers may vary slightly in appearance, they
have many common elements. Not all of the information on the ticket will be filled in by the registered
representative who deals directly with the customer. Some of the information will be added at the time
of the order’s transmission or execution. The entries on an order ticket include the following items:
 Whether the order was a purchase, a long sale, or a short sale
 Security name (or symbol) and quantity
 Terms and conditions of the order (e.g., market, limit, day order, etc.)
 Account type (e.g., cash or margin)
 Whether discretion was exercised
 Whether the order was solicited or unsolicited
 Special directions to override standing instructions

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 Client identifier
 Trade date
 Registered representative responsible for the account
 Office from which the order originated

Discretionary Order/Discretion Not Exercised If the client has granted discretionary authority to
the registered representative, this should be indicated for each order. It’s important to check off
discretion not exercised if that was the case, since this indicates that the customer consented to that
specific trade. (Note that this is not the same as indicating that the trade was unsolicited.) If an
order was the client’s idea, the ticket should be marked unsolicited.

A firm’s order-entry system may automatically include additional information to the ticket. Much of
this additional information is based on the customer’s account documentation and may include
items such as the RR of record, negotiated commission rates, standing delivery instructions, trading
restrictions, suitability concerns, etc.

Trade Routing
Once the order has been reviewed and released by the Sales Department, the firm must decide how
it will attempt to execute the trade. Depending on where a security trades or the preferences of a firm,
orders may be routed to various locations that include the following:
 An internal trading desk  The OTCBB
 The NYSE  The OTC Link
 Nasdaq  ECNs
 Regional exchanges  Dealer-to-dealer marketplaces
 The third market  An affiliated executing firm (e.g., order-entry firm)

Types of Transactions
As just mentioned, one of the important elements noted on the order ticket is the client’s desired
action or intent, which may include:
 A purchase
 A long sale
 A short sale

When making a purchase, the client must designate whether the trade will be fully paid for or be
purchased with borrowed funds (on margin). Under the SEC’s short selling rules (i.e., Regulation
SHO), a broker-dealer is required to mark all sell order tickets either long or short. This requirement
applies to all sales of equity securities that are traded on an exchange (e.g., NYSE or Nasdaq) or OTC.

What’s the difference between normal selling (a long sale) and short selling? A long sale occurs
when the client owns the securities being sold; however, with a short sale, the client must first
borrow the shares from the firm and then execute a sale.

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Since short sellers anticipate that the price of the shares will fall in value, their investment outlook is
often referred to as bearish. If the securities are purchased at a later time at a lower price, she will
realize a profit. However, if the securities increase in value, the investor may be forced to buy the
securities at a price that’s well above the price at which they were sold short and result in a loss. Since
there’s no limit as to how high a security’s price may increase, the short seller has unlimited risk.

A sell order is marked long if the seller:

 Owns the security being sold and it’s either in the possession or control of the broker-dealer, or
 Owns the security and it’s reasonably expected that the security will be delivered by no later
than the settlement date
 Has exercised a call option or warrant, or has converted a convertible preferred stock or bond

A sell order is marked short if the seller:

 Doesn’t own the security being sold (i.e., she’s effecting a sale by delivering borrowed shares)
 Owns the security being sold, but does not reasonably expect that it will be in the possession or
control of the broker-dealer prior to the settlement date

Prohibited Trading Practices

Interpositioning Interpositioning is generally defined as the insertion of a third party between the
customer and the best market. The practice is specifically prohibited when it’s to the detriment of
the customer.
For example, a broker-dealer receives an order from a customer to buy 100 shares of XYZ
at the market and the best offer of any market maker is 40. Rather than buying directly
from the market maker, the B/D interposes another firm that buys the stock at 40 and
sells them to the member firm at 41. The member firm then ultimately sells the stock to
the customer at 42 and the two firms share the one-point extra markup charged to the
customer. This action is prohibited since the customer received no benefit.

However, the prohibition does not apply if the member firm is able to demonstrate that the
customer received a better price because of the intervention of a third party.

Trading Ahead of Research FINRA’s rule prohibits a member from establishing, increasing,
decreasing, or liquidating an inventory position in a particular security, or derivative of that
security, based on material, non-public, advance knowledge of the content and timing of a research
report in that security.

Without this prohibition, a firm may be tempted to build up a position in a stock right before the
publication of a favorable report or be tempted to sell short an issue just prior to an unfavorable report.

Rumors and Tips Some of the more common forms of market manipulation are the spreading of
tips and rumors and distributing information that misrepresents the facts. It’s also unlawful to omit
material facts, since the absence of these facts may make any other statements misleading.

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If an RR receives unsubstantiated news (possibly through a rumor), he should take no action until
the information becomes public. At that time, the RR would be in a better position to be able to
recommend whether clients should purchase or sell the stock. If an RR receives material, non-
public information on a company, his best course of action is to contact a principal or compliance
person who is associated with his firm.

Front-running This prohibited act involves firms or RRs executing either stock or option trades with
the prior knowledge that other investors are about to execute transactions involving large blocks of
stock that will positively influence their own positions. Another example involves an RR who has a
large position in a stock and recommends the same stock to many of her wealthy clients. Once the
purchases are made and the stock rises, the RR then liquidates the shares for her own personal profit.
Keep in mind, it’s always unethical for an RR to put her needs ahead of her clients’ needs.

Settlement Dates
If all of the parties involved in a trade agree to the details (clearance of the transaction), settlement
is the next step. The date on which the transaction must be completed (settled) between the broker-
dealers representing the buyer and the seller is referred to as the settlement date.

Regular-Way Most securities settle on a regular-way basis, which refers to the normal number of
days to complete the transaction. However, the required number of days is primarily determined by
the securities involved in the trade. For corporate securities (stocks and bonds) and municipal
securities (covered under MSRB Rule G-15), the settlement for regular-way transactions is two business
days after the trade date (i.e., T + 2). For Treasury securities and options transactions, settlement
occurs one business day after the trade date (i.e., T + 1).

Special Settlement If either party seeks to alter the timing of settlement on a trade, the adjusted
period must be agreed to prior to the transaction. For example, if a stock seller is in urgent need of
funds and needs a next-day settlement (rather than T + 2), the buyer must agree to these conditions
prior to the transaction and may be offered a slightly lower price for the shares.

Cash Settlement A cash settlement is completed on the same day as the trade. This option, which
requires the agreement of both parties, can be used for any type of security.

Seller’s Option If trade settlement cannot be completed on a regular-way or for-cash basis, the
seller may request a seller’s option settlement. At the time of the transaction, both parties to the trade
may agree to a seller’s option, which gives the selling firm additional time beyond the normal two
business days to make good delivery. Often, a seller’s option is used when the seller needs additional
time because of legal requirements, such as the removal of a legend from a stock certificate.

When Issued In certain cases, securities may have been authorized, but have not yet been issued
(e.g., new issues, spin-offs, etc.) These transactions will settle when the security becomes available
for delivery.

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Settlement Dates
Corporate or
Second business day following the trade (T + 2)
Municipal Bonds
U.S. Government
Next business day (T + 1)
Securities
Cash
Same day (T)
Trade/Settlement
Negotiated settlement not earlier than two business days after the
Seller’s Option
trade (i.e., additional time is required)

When Issued As determined by the National Uniform Practice Committee

Customer Payment Versus Settlement

Don’t confuse a customer’s payment obligation with the settlement obligations of the firms involved in
a given trade. According to Regulation T, customer payment for purchases that are made in cash and/or
margin accounts must be made promptly, which typically means by no later than two business days
following regular-way settlement (i.e., S + 2).

Remember, trade settlement refers to the timing of payment and delivery between member firms
and is governed by FINRA’s Uniform Practice Code. The date on which customer payment must be
made (Reg. T payment) is set by the Federal Reserve Board (FRB) and this authority was established
under the Securities Exchange Act of 1934.

To keep these two concepts clear, the differences between them are summarized in the following table:

Settlement versus Customer Payment

Security/Trade Settlement Customer Payment
Corporate Securities in a Two business days Four business days
cash or margin account (T + 2) (T + 4 or S + 2)
Two business days Exempt from Reg. T
Municipal Securities
(T + 2) (generally due at settlement)
U.S. Government Next Business Day Exempt from Reg. T
Securities (T + 1) (generally due at settlement)
Next Business Day Four business days
Option Trades
(T + 1) (T + 4)
Cash transactions for any security settle on the same day.

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Delivery of Physical Securities

Paper Settlement
In some cases, physical securities may be delivered for settlement. Reasons for this include a client
who is personally holding the certificates or the security itself is not DTCC-eligible. In either case, the
physical securities must be in proper order and have all of the necessary endorsements before being
delivered to the buyer. If all paperwork is in order, the position is referred to as a good delivery.

FINRA’s Uniform Practice Code establishes the requirements for good deliveries of securities. One
of the purposes of the rule is to ensure that the securities will be acceptable to the transfer agent.
The transfer agent will make the final determination as to whether a security is a good delivery and
may be transferred to the new owner. This section will detail what constitutes good delivery.

CUSIP Numbers One aspect of good delivery is the assurance that the correct security is being
delivered. Many issues have similar features and maturities and may be confused with one another.
CUSIP numbers are similar to bar codes for items in a store and are identifying numbers assigned to
each maturity of an issue. CUSIPs are essential in the identification and clearance of securities.

Endorsements and Assignments A customer who sells a security is required to sign the certificate.
The usual method of endorsing a stock certificate is to sign the certificate on the back and then mail
the certificate to the broker-dealer. In order to safeguard the certificate while it’s in the mail, the
seller could send the certificate by registered mail. An alternate method is for the customer to send
the certificate, unsigned, in one envelope and to send a signed stock power in a separate envelope.
In this way, if the certificate falls into unauthorized hands, it has no value since it’s non-negotiable.

Units of Delivery For certificates to be acceptable for broker-to-broker delivery, they must be in
certain units. If the selling broker delivers units in multiples other than what’s allowed, the buying
broker is not required to accept the certificates.

Stock Transactions On stock transactions, certificates must be delivered in multiples of 100 shares.
For example, on a transaction involving 500 shares, one certificate for 500 shares, or five certificates
for 100 shares each, or two certificates for 200 shares and one certificate for 100 shares are all good
delivery since they’re all in multiples of 100 shares. However, multiples that are not 100 shares, such
as two certificates for 250 shares each or one certificate for 450 shares and one certificate for 50
shares, are not good delivery.

Bond Transactions Registered bonds are good delivery if they’re in $1,000 units or multiples thereof.
Additionally, amounts of $100 or multiples aggregating to $1,000 are acceptable, but with no
denomination larger than $100,000.

In addition to denominations, the form of issuance may be a factor.

 Bearer – This a certificate delivery with no owner name noted and interest coupons are
physically attached

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 Registered to Principal Only – This method provides a physical certificate with the owner’s
name, but interest coupons are physically attached
 Fully Registered – This method offer a certificate with the owner’s name identified and interest
mailed directly to the evidenced owner

Restricted Securities Securities that carry a restrictive legend are not considered to be in good
deliverable form. Generally, these certificates must have the legend removed, which is the
responsibility of the selling firm. Only a transfer agent has the authority to remove a restrictive legend.

However, the transfer agent will not remove the legend unless the client has obtained the consent of the
issuer in the form of an opinion letter that’s created by the issuer’s counsel. The process of cleaning
the certificate (removing the legend) is typically accomplished under Rule 144.

Death of an Account Owner

Regardless of the account type, a customer’s death requires an RR to follow certain guidelines. If
securities or other instruments were registered in the name of the deceased person, they will usually be
transferred by the executor or administrator of the estate to the name of the estate. Certain documents
are required by the transfer agent before the change may be made. The specific documents will
depend on state law, which governs the way a deceased person’s affairs are handled.

These documents may include any or all of the following:

 Notarized copy of the death certificate
 Copy of the will or court appointment (letters testamentary)
 Affidavit of domicile
 State inheritance tax waiver

Remember, if a customer granted a power of attorney to another individual and subsequently dies,
the power of attorney is automatically terminated.

After a customer’s death, an RR may be asked to provide the executor with information regarding
the value of securities for estate tax purposes. If this is the case, the securities are generally valued
as of the date of death or as of an alternative date that’s six months after the date of death.

Conclusion
This chapter described the different methods by which a broker dealer may execute trades and the
importance of documenting the client’s instructions. The different methods of settling a trade and
the manners in which securities may be delivered was also described. The next and final chapter
will focus on how disputes between customers and firms are resolved.

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 CHAPTER 12

Resolving Disputes
and Suitability

Key Topics:

 Erroneous Trades

 Customer Complaints

 Dispute Resolution

 Required Disclosures

 Suitability
 CHAPTER 12 – RESOLVING DISPUTES AND SUITABILITY

Mistakes happen and, at times, RRs and customers disagree. This chapter will cover the
process of trade corrections and will describe the steps that must occur in the event of a
customer complaint. If a complaint cannot be amicably resolved, the dispute resolution
procedures between firms and their customers will be examined.

The last section of this chapter will provide an overview of the suitability of recommendations.
After describing the characteristics of the various products throughout this study manual, it’s
time to connect customers to these products. The focus will be on identifying a customer’s needs
and objectives and then offering her the best available securities product(s).

Errors
Execution Errors
After examining a confirmation, either the customer or the registered representative may detect an
error. For example, the RR may have purchased or sold the wrong security or the wrong quantity of
a given stock. Once the error is discovered, the procedures to be followed depend on the nature of
the error and the firm’s own policies. However, registered representatives are generally not
permitted to make their own decisions as to how to correct the error. Instead, the RR should bring the
mistake to the attention of a supervisor.

Error Account
All broker-dealers are required to record any errors that are made by their RRs and maintain an
error account. This account is used by a broker-dealer when the firm or an RR executes a trade in
error (e.g., the wrong security or the wrong side of the market). These error accounts are maintained
by the firm and not be the RRs themselves. Any adjustments or cancellations that are routed through
the error account must be approved by a principal.

Cancel and Rebill

If a registered representative executes a transaction, but uses the wrong account number, this type of
error can be corrected. The appropriate procedure is to transfer the transaction to the correct account
number with the permission of a registered principal. This transfer process is often referred to as a
cancel and rebill. In some cases, the error is made using the correct account number for the client, but
the wrong account (margin account, rather than an IRA). A similar process is used to correct this error.

If there’s a cancel and rebill, corrected confirmations must be generated. The trade cannot simply
be transferred from one account to another. For example, if a trade was assigned in error to a
client’s cash account and subsequently placed into the client’s Roth IRA, two additional
confirmations must be created. One confirmation that signifies the cancelling of the original trade
in the cash account and a second confirmation placing it into the Roth IRA.

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Trade Reporting Errors

Occasionally, an error may occur while completing the paperwork, rather than in the execution of the
trade. For example, if a client sold 1,000 shares of ABVC at $23.00, but the firm printed a confirmation that
mistakenly reported the execution of the sale at $43.00, the actual trade will stand. In other words,
the client is obligated to accept the actual execution. A corrected confirmation will be generated
and sent to the client.

Clearly Erroneous Transactions

FINRA provides a mechanism for correcting or voiding transactions if one of the terms of the contract
is clearly in error. This rule was created as the result of a complaint from a FINRA member due to the
fact that a trade was executed 10 points away from the inside market (an obvious mistake), but the
contraparty refused to cancel the trade. Prior to the establishment of this rule, FINRA did not have
the authority to adjust such a transaction, even when the error was obvious.

FINRA defines the term clearly erroneous to refer to an obvious error in any term, such as price,
number or shares or other unit of trading, or identification of the security. FINRA will consider the
circumstances at the time of the transaction, the maintenance of a fair and orderly market, and
investor protection. This rule pertains to disruptions and extraordinary market conditions and not
to unauthorized trading or market manipulation.

The determination of a clearly erroneous execution is based on certain thresholds—one for

exchange-listed securities and another for OTC equity securities.

Numerical Threshold for Exchange-Listed Securities

Normal Market Hours (9:30 a.m. to Outside Normal Market Hours
Reference Price: 4:00 p.m. ET) Numerical Guidelines Numerical Guidelines (Subject
Consolidated Last Sale (Subject Transaction’s % Difference Transaction’s % Difference from
from the Consolidated Last Sale) the Consolidated Last Sale)
Greater than $0.00 up to and
10% 20%
including $25.00
Greater than $25.00 up to and
5% 10%
including $50.00
Greater than $50.00 3% 6%
Multistock event – Filings involving
five to 19 securities by the same
10% 10%
member will be aggregated into a
single filing.
Normal market hours numerical Normal market hours numerical
Leveraged ETF/ETN securities guidelines multiplied by the leverage guidelines multiplied by the leverage
multiplier (i.e., 2x) multiplier (i.e., 2x)

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FINRA may also expand the numerical guidelines due to a Multi-Stock Event involving 20 or more
securities whose executions occurred within a five-minute period or less. This would be done to
maintain a fair and orderly market and to protect investors. For both market hours and outside
market hours, FINRA uses a threshold of 30% away from the reference price.

FINRA Rule 11893 governs clearly erroneous determinations involving transactions in OTC equity
securities. Although the rule is structured similarly to FINRA Rule 11892 that governs exchange-
listed issues, it uses different numerical guidelines when determining if a transaction is erroneous.
Many of these potentially erroneous transactions occur in periods of extreme market volatility, or
are the result of system malfunctions and/or disruptions.

Numerical Threshold for OTC Equity Securities

Numerical Guidelines (Subject Transaction’s
Reference Price
Percentage Difference From the Reference Price)
$0.9999 and under 20%
Low end of range, minimum 20%
$1.0000 up to and including $4.9999
High end of range, minimum 10%
$5.0000 up to and including $74.9999 10%
Low end of range, minimum 10%
$75.0000 up to and including $199.9999
High end of range, minimum 5%
$200.0000 up to and including $499.9999 5%
Low end of range, minimum 5%
$500.0000 up to and including $999.9999
High end of range, minimum 3%
$1,000.0000 and above 3%

At times, the determination of whether a given transaction price is erroneous involves more than
simply examining a pricing difference. When making a determination as to whether a given trade
price is fair, while also attempting to maintain fair and orderly markets, FINRA may choose to use
alternative reference prices in unusual circumstances and will examine other factors such as:
1. Whether the security was subject to a stock split or other corporate action,
2. Whether the stock was recently halted or resumed trading, or
3. Whether the security is an IPO

Procedures for Reviewing Transactions A member firm that receives an execution that it believes is
clearly erroneous must submit a written complaint within 30 minutes of the execution time. In the
case of an Outlier Transaction, a request may be made within 60 minutes after the transaction. An
Outlier Transaction is a transaction in the Nasdaq market in which the execution price of the security
is greater than three times the current numerical guidelines. A FINRA officer or Nasdaq official has
the authority to declare a transaction null and void. The officer will generally take action within 30
minutes after becoming aware of a transaction in an exchange-listed security. In the case of an OTC
equity security, the officer will take action as soon as possible, but in all cases, by 3:00 p.m. on the
next trading day.

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Appeal Process Under this rule, a decision of a Nasdaq or FINRA officer can be appealed to the
Market Operations Review Committee (MORC) or the Uniform Practice Committee (UPC). The appeal
must be in writing and must be received within 30 minutes after the person making the appeal is
given notification. For exchange-listed securities, the decision will be made as soon as feasible, but
generally on the same trading day. If the request for an appeal is made after 3:00 p.m., the decision
may not be made later than the next trading day. For OTC equity securities, the decision will be made
as soon as feasible, but not later than two trading days after the execution under review.

Resolving Problems
Even with the best policies and procedures, disputes will still inevitably arise. Often these disputes
begin with the receipt of a customer complaint.

Complaints
FINRA defines a complaint as any written statement that’s made by a customer or any person acting
on behalf of a customer which alleges a grievance involving the activities of any person who is under
the control of a member firm in connection with the solicitation or execution of any transaction or
the disposition of securities or funds of that customer. The complaint may be delivered in any
written format, which includes letters, e-mails, instant messages, and text messages.

Once received, customer complaints must be forwarded to a principal who will review and initial
the complaint. Member firms are required to maintain a separate file of all written complaints in
each office of supervisory jurisdiction (OSJ) for four years. The file must contain a description of the
actions taken by the member as well as any correspondence regarding the complaint. A firm’s
response to a customer’s written complaint may be in either written or oral form. Interestingly,
even if a member has not received complaints, a complaint file (empty) must be maintained by the firm.

Code of Procedure
FINRA’s Code of Procedure describes the disciplinary process used in the event that a member firm
or any of its associated persons violate FINRA rules, SEC rules, or fail to pay dues or assessments.

Disciplinary Proceedings If a rule violation comes to the attention of the Department of

Enforcement and it believes that a member firm or associated person is responsible, the Department
may request authorization from the Office of Disciplinary Affairs to issue a complaint. The firm or
person being named in the complaint is referred to as the respondent. The respondent must file a
response to the complaint within 25 days of receiving it. However, if the respondent fails to answer
within the required time, the Department will issue a second notice. Failing to respond to the second
notice within 14 days may be treated as the respondent’s admission to the allegations in the complaint.

A respondent’s answer to a complaint may be to request a hearing; however, if a hearing is not

requested, the right to one is waived. The requested hearing is held before a Hearing Panel that
consists of a Hearing Officer and two panelists who are appointed by the Chief Hearing Officer.

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The Hearing Officer is an attorney who is employed by FINRA, while the other members of the
panel are persons who are associated with, or retired from, member firms. These panelists have an
expertise in the area under dispute and have served on local and/or national FINRA committees.
For preparation purposes, the Hearing Officer must provide the respondent with 28 days advance
notice of the hearing.

The Hearing Officer may call a prehearing conference to instruct the parties involved and to make the
process more efficient. Documentary evidence is generally submitted prior to the hearing, but the
hearing provides an opportunity for witnesses to give testimony. All witnesses who are under the
jurisdiction of FINRA must testify under oath. Within 60 days after the Hearing Panel has stopped
accepting evidence, a written decision must be rendered that was arrived at by majority vote.

At any time before the hearing has begun, the respondent may propose an offer of settlement to the
Hearing Panel. If accepted by the panel, the respondent waives the right to appeal. However, if the
respondent’s offer is rejected, the hearing will proceed to a conclusion.

Sanctions A Hearing Panel may impose the following penalties:

 Censuring a member firm or an associated person
 Fining a member firm or an associated person
 Suspending the membership of a firm or an associated person for either a definite period or
until specified conditions are met
 Expelling a member firm or cancelling its membership; revoking or cancelling the registration
of an associated person
 Suspending or barring an associated person from association with any member firm
 Imposing any other fitting sanction

If the registration of an associated person is suspended, cancelled, or revoked, that person may not
be associated with a member firm in any capacity—which includes clerical or ministerial positions.

Other than being barred or expelled, a sanction is effective 30 days after the respondent has
received notice of a final disciplinary action. A bar or expulsion is effective as soon as the decision is
served on the respondent. If a broker-dealer is suspended from membership, member firms must
treat the firm in the same manner that they treat non-members.

Appeals A significant component to the Code of Procedure is the ability to appeal decisions. Once
a decision has been rendered by the Hearing Panel, the respondent has 25 days to file an appeal
with FINRA’s National Adjudicatory Council (NAC). For cases in which the decision of the Hearing
Panel is in the favor of the respondent, the Department of Enforcement also has the same right of
appeal to the NAC. Ultimately, the NAC has both appellate and review jurisdiction. The filing of an
appeal halts the decision until the appeal process is exhausted. Upon review, the NAC has the
power to affirm, modify, reverse, increase, or reduce any sanction, or to impose any other fitting
sanction.

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A respondent has the right to appeal the NAC’s decision to the SEC. Finally, if dissatisfied with the
SEC’s decision, the matter may be brought before a federal court.

Appeals Process
Hearing Panel NAC SEC Federal Court

Dispute Resolution—Code of Arbitration

The Code of Arbitration establishes the process that’s used for the settlement of disputes between
members and other members, between members and any clearing corporation, or between
member firms and persons associated with a member, but not for disputes between a member firm
and FINRA. For any disputes that involve statutory discrimination or sexual harassment claims,
using arbitration is not required.

When a representative signs his application for securities industry registration (Form U4), he agrees
to a statement that indicates, “I agree to arbitrate any dispute, claim, or controversy that may arise
between me and my firm, or a customer, or any other person, that is required to be arbitrated under
the rules, constitutions, or by-laws of the SROs indicated...”

If a public customer has a dispute with a member firm or a person associated with a member,
arbitration may also be used if it’s agreed to by the customer (based on the predispute agreement
described below). A customer may initiate arbitration by filing a Submission Agreement of Claim
and paying the required deposit fee. If arbitration is initiated, respondents may file a counterclaim
against the other person. Under the Code of Arbitration, the statute of limitation on filing claims is
six years from the disputed transaction or occurrence.

Predispute Arbitration Clause Many new account forms contain a clause that obligates
customers to submit any disputes that arise with their RR or brokerage firm to binding arbitration.
Industry rules require arbitration clauses to be presented on the form in a certain format and with
specific wording. If a firm elects to include a predispute arbitration clause in its new account form,
it must be highlighted and preceded by the following disclosures:
 Arbitration is final and binding on the parties.
 The parties are waiving their right to seek remedies in court, including the right to a jury trial.
 Prearbitration discovery is generally more limited than, and different from, court proceedings.
 The arbitrator’s award is not required to include factual findings or legal reasoning, and any
party’s right to appeal or seek modification of rulings by the arbitrators is strictly limited.
 Typically, the panel of arbitrators will include a minority of arbitrators who were or are affiliated
with the securities industry.

Immediately before the signature line, there must be a highlighted statement that the agreement
contains a predispute arbitration clause. Also, a copy of the agreement must be given to the customer
and the customer must acknowledge its receipt either on the agreement or on a separate document.

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Depending on the dollar amount of the dispute that arises, the National Arbitration Committee will
appoint a panel of one to three arbitrators to hear the dispute. If a customer is involved, a majority
of the arbitrators must be public arbitrators (those not affiliated with the securities industry) unless
the parties agree otherwise. Once notified of the composition of the panel, the customer has the
right to reject the selection of an arbitrator on a peremptory basis and has an unlimited number of
challenges for cause.

After hearing the evidence, the arbitrators will make their determination and make awards as
deemed appropriate. All awards that are granted by an arbitrator must be paid within 30 days of
determination or penalties may be assessed on late payments. Unless the law directs otherwise, the
findings of the arbitrators are final for both members and customers.

Simplified Arbitration Simplified arbitration procedures are used if the amount in dispute doesn’t
exceed $50,000. In a simplified customer arbitration proceeding, one public arbitrator decides the
case based on written evidence and arguments, unless the public customer demands/consents to a
hearing or the arbitrator calls for a hearing. In a simplified industry arbitration proceeding, one
public arbitrator decides the case without a hearing, unless the demand for a hearing is made by
either of the parties involved.

Mediation
Although arbitration has been favored as the method for resolving securities industry disputes due
to being less costly and time-consuming than litigation, it has actually become a victim of its own
success. As the process began to be used more frequently, there were increasing delays and,
occasionally, a shortage of qualified arbitrators. To address this issue, FINRA launched a mediation
program to help resolve disputes in an alternative form.

Mediation is an informal process in which the two parties to a dispute attempt to reach a mutually
acceptable resolution without resorting to arbitration or litigation. In addition to the two opposing
parties, a mediator participates as a neutral person who is knowledgeable about the securities industry
and attempts to facilitate the discussions and help the parties reach an agreement.

Once the two parties agree to use mediation, they select a mediator who is acceptable to both sides.
Although FINRA may initially suggest a mediator, the parties may also select one from a list that’s
provided by FINRA or they may select their own based on a mutual agreement. Once the mediator
is selected, both parties then provide the mediator with any information that they consider
necessary in order to understand the dispute.

The parties subsequently meet with the mediator in an initial joint session, with each party
presenting his case to the other party and the mediator. Thereafter, the parties meet separately with
the mediator in sessions that are referred to as caucuses. In the caucuses, the mediator’s job is to help
each party examine the strengths and weaknesses of the case, consider the risks involved, and review
the possible settlements or resolutions. Unless authorized to do so, the mediator will not reveal the
content of the discussions in a caucus to the other side since those discussions are confidential.

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The mediation process will continue until:

 The parties resolve the dispute through a written settlement
 The mediator declares an impasse in the belief that continuing would be futile
 Either party or the mediator withdraws from the process in writing

Partial Success Possible Even if a settlement is not reached through mediation, the process may still
be considered beneficial. Often, the opposing sides reach a clearer understanding of the dispute
through the use of mediation, and any further action (e.g., arbitration) is often shorter and more
efficient. Occasionally, only part of a dispute will be settled through mediation, leaving only the
more difficult matters to be settled through arbitration.

The parties are not required to wait until the completion of the mediation process to begin
arbitration; instead, the two processes may run concurrently. Therefore, if mediation is
unsuccessful, the arbitration proceedings continue. As long as an arbitrator has not made a final
decision, the mediation process may even be started after arbitration has begun.

Arbitration versus Mediation

Arbitration Mediation

A hearing process for two parties to present their cases A negotiation process between two parties

Often more expensive and time-consuming than

May be less costly and quicker than arbitration
mediation, but usually cheaper and quicker than litigation

Useful where the position of one or both parties is Parties must be willing to see strengths of the position of
inflexible the other side

A more informal process; in addition to evidence, parties

More formal process—testimony under oath
may consider feelings and look for creative solutions

Parties cannot unilaterally withdraw Either party may withdraw from the process

Mediator attempts to facilitate a resolution, but doesn’t

Arbitrator imposes a binding settlement
impose a settlement

Hearings are private, but the decision is public Process is private and any settlement is confidential

Disclosures Under Code of Arbitration – Updating Form U4

Certain arbitration outcomes must be disclosed on a registered person’s Form U4. Disclosure or
updating a Form U4 is required if a person has been convicted or charged, or pled guilty or no
contest to any felony or misdemeanor involving investments or an investment-related business or
any fraud, false statements or omissions, wrongful taking of property, bribery, perjury, forgery,
counterfeiting, extortion, or a conspiracy to commit any of these offenses.

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A person who has been arrested, but has not yet been charged with a crime, is not required to report
the event on Form U4 or to FINRA. However, most firms require notification if a registered person was
arrested for any offense.

Form U5 After a registered person resigns or is terminated from a member firm, the firm is
required to notify FINRA within 30 days on Form U5 and must provide the applicable details. A
copy of Form U5, which includes the reason the person has left the firm (voluntary or mandatory),
must also be provided to the person. Within 30 days following termination, if answers to certain
questions change, the form must be updated.

If a broker-dealer receives a written customer complaint after an RR has left the firm, it’s still
required to notify FINRA regardless of how long ago the RR had left the firm. However, there’s no
requirement to send a copy of the complaint to the former RR. If an individual wants to return to a
brokerage firm as a registered representative without having to requalify by examination, she is
required to do so within a two-year period.

Form U6 Regulators, states, and/or jurisdictions use Form U6 to report disciplinary actions
against an RR or firm. FINRA also uses Form U6 to report final arbitration awards against RRs and
firms. As is the case with Form U4 and U5, any information that’s processed on this form feeds into
the Central Registration Depository system and some of the content may be available to the public
through FINRA’s BrokerCheck system.

The Central Registration Depository (CRD) The CRD system is an automated database that
contains information concerning the employment and disciplinary histories of registered persons.
This system is also used to process both registration and withdrawal applications for agents and
broker-dealers at the state level. If any information on an individual’s Form U4 changes, an
amendment to the CRD system must be filed promptly.

Release of Disciplinary Information Information about the disciplinary history of a member firm or
registered representative is available to the public through FINRA’s public disclosure program
(BrokerCheck). BrokerCheck provides information on individuals who are currently registered or have been
registered within the last 10 years. The following information is on file with the Central Registration
Depository and can be obtained through a toll-free telephone number or the website of FINRA Regulation:
 The current employing firm, 10 years of employment history, and all approved registrations
 Certain legal and regulatory charges and actions brought against the RR, such as felonies, certain
misdemeanors and civil proceedings, and investment-related violations
 Pending customer-initiated arbitrations and civil proceedings involving investment-related
activities, any arbitrations or civil proceedings that resulted in an award to a customer, and
settlements of $10,000 or more in an arbitration, civil proceeding, or complaint involving
investment-related activities
 Written customer complaints alleging sales practice violations and compensatory damages of
$5,000 or more that were filed within the last 24 months
 Formal investigations involving criminal or regulatory matters
 Terminations of employment after allegations involving violations of investment-related statutes or
rules, fraud, theft, or failure to supervise investment-related activities

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If a person who is currently registered disagrees with any information found on BrokerCheck, he
must file an amended Form U4 with FINRA. If an individual is not currently registered with
FINRA (but was registered within the last 10 years), he may submit a Broker Comment Request
Form with FINRA to provide an update or add context to the information that’s made available
on BrokerCheck.

Investor Education FINRA’s Investor Education and Protection Rule requires member firms, at
least once every calendar year, to provide to each customer with written disclosure of the following:
 FINRA Regulation’s Public Disclosure Program (BrokerCheck) hotline number
 FINRA website address
 A statement regarding the availability of an investor brochure that includes information describing
FINRA BrokerCheck

However, any member that doesn’t carry customer accounts and doesn’t hold customer funds or
securities is exempt from these provisions.

Expungement What happens if information in the CRD system is incorrect? FINRA has
established procedures that arbitrators must follow before the removal (expungement) of customer
dispute-related information in connection to arbitration cases from an RR’s CRD record. This
removal of information from the CRD system is permitted only if:
 The claim, allegation, or information is factually impossible or clearly erroneous.
 The registered person was not involved in the alleged investment-related sales practice violation,
forgery, theft, misappropriation or conversion of funds.
 The claim, allegation, or information is false.

Once information is removed from the CRD system, it’s permanently deleted and is no longer
available to the investing public (through BrokerCheck), regulators, or prospective employers.

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 CHAPTER 12 – RESOLVING DISPUTES AND SUITABILITY

Suitability
This final section is designed to provide students with a process that may be used to break down
and decode suitability questions on the Series 6 exam. For exam purposes, the concept of suitability
can be simplified into two important concepts:
1. Know your customer
2. Know your products

When dealing with suitability questions, students must identify the customer’s investment
objective(s), time frame, and appropriate risk level. Additionally, for each of the given product
choices, students must also analyze their purpose, time frame, and risk level.

To handle suitability questions, we suggest the following step-by-step approach:

 Step 1. Review the table which lists various investment objectives and appropriate products.
 Step 2. Review the tables which provide the details of different investment products.
 Step 3. Work through the examples that are provided.
 Step 4. Work through the remaining questions using a blank worksheet.
 Step 5. After breaking down and solving each question, check your answer and review the
explanation which is provided at the end of the section.

To Determine the Suitability of an Investment, Consider the Customer’s:

Investment Objective
 What does the customer want to accomplish with the investment?
− Common objectives include long-term growth, current income, safety of principal, tax
benefits, speculation, and short-term capital preservation.

Time Frame
 Some investments are more suitable for long-term needs, while others are more suitable for
short-term needs.

Risk Tolerance
 Some investors will accept more risk than others when attempting to meet their objectives.
− Risk tolerance is often affected by time frame:
• If the investment period is long, investors can typically afford to take more risk.
• If the investment period is short, investors will typically take less risk.
Age (which impacts both time frame and risk tolerance)
 Younger investors typically take a long-term approach and can afford to take more risk in
exchange for higher long-term returns.
 Older investors have shorter time horizons and therefore should seek more stable investments.
− Equity securities are considered riskier and more appropriate for long-term growth.
− Bonds are considered safer and more appropriate for current income.

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CHAPTER 12 – RESOLVING DISPUTES AND SUITABILITY

− A common rule for determining asset allocation is (100% – Age) = % of growth or equity
investments (with the remaining % as income or bond investments).
− Tax implications for retirement: 10% penalty for withdrawals before age 59 ½; 50% penalty
for failing to take RMD by age 70 ½; etc.

Investment Objectives and Suitable Investments

Long-Term Growth Short-Term Capital Preservation
Longer time horizon; greater volatility Money-Market Instruments
 Common stock  Money-market mutual funds
 ADRs  T-bill
 Variable annuity (based on subaccount)  Bankers’ acceptances
 Growth fund  Commercial paper
 Stock fund  Brokered CDs
 Index fund
 Stock ETF
 International/Global fund Tax-Advantaged Investments
High Tax Bracket
Growth and Income  Tax-exempt income
Less volatility; reduced earnings − Municipal bonds of funds
 Mix of stocks and bonds  Tax-deferral
 Balanced fund − Annuities
 Convertible bond fund − IRA and retirement plans
 Growth and income fund − Education savings plans
 Variable annuity (based on subaccount)

Income Aggressive Growth or Income

Least volatility High risk, high reward
 Income fund  High-yield bonds of funds
 Bonds and bond funds  Small-cap fund
 Preferred stock or funds  Micro-cap fund
 Utility stock or funds  Regional or country specific fund
 Covered call writing

Safety Speculation
Low Credit Risk Active, short-term speculation
 U.S. Treasury or Treasury funds  Leveraged ETF
 Agency debt or funds  Micro-cap funds
 Investment-grade corporate bonds or  Country specific funds
funds  Sector funds

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PRODUCT CHARACTERISTICS SUITABILITY

− Corporate ownership − Suitable for investors seeking long-term
− May pay dividends growth (capital appreciation) and the
 Large Cap: least volatility/least growth opportunity to outpace inflation
Common potential
Stock  Mid Cap: more volatility/more growth
potential − Unsuitable for short-term investors or those
 Small Cap: most volatility/most growth seeking safety of principal
potential

− Pays fixed dividend, but doesn’t share in − Suitable for investors seeking stable dividend
earnings growth income with returns that are comparable to
Preferred − Receives dividends before common long-term bonds
Stock − Has no voting or preemptive rights
− Subject to inflation (purchasing power) risk and − Unsuitable for investors seeking capital
interest-rate risk appreciation

− Suitable for investors seeking long-term

− More volatile (risky) than most stocks; has a growth and retirement savings; good hedge
Growth high beta against inflation
Stock − Offers little or no dividend income
− Low dividend payout ratio and high P/E ratio − Unsuitable for investors seeking income or
short-term investing due to its greater volatility
− Suitable for investors seeking stable dividend
− Company has stable earnings and the stock is income (e.g., older or retired investors)
Utility
less risky than most stocks (has a low beta)
Stock − Unsuitable for investors seeking a growth
− High dividend payout and low P/E ratio
investment

− A receipt of ownership (equity) in a foreign − Suitable for investors seeking to invest in

American corporation foreign companies (similar to U.S. common
Depositary − Trades in the U.S. market and in U.S. dollars stock)
Receipt − Must be SEC registered, unless exempt − Unsuitable for investors unwilling to take on
(ADR) − Subject to market and exchange-rate risk the risk associated with investing in foreign
− May pay dividends companies (e.g., political risk; exchange risk)
− Provides stable (fixed) interest income − Suitable for older and/or more conservative
− Conservative, less risky than equities investors who want consistent income
− Subject to inflation (purchasing power) risk,
Bond
interest-rate (market) risk, default (credit) risk,
reinvestment risk − Unsuitable for investors seeking a growth
− Longer maturities have more risk investment

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PRODUCT CHARACTERISTICS SUITABILITY

− May be secured or unsecured − Suitable for investors seeking current income

− Price fluctuation is influenced by length of for a specific period
Corporate
maturity and interest rate/coupon − Unsuitable for investors seeking growth or
Bond
− Interest rate is generally fixed and the interest capital appreciation or those who are in a high
is fully taxable tax bracket
− Suitable for investors seeking income with the
− Convertible into a fixed number of common potential for long-term growth (the relative
shares safety of a bond, with the growth potential of
Convertible
− Offers lower interest rate than non-convertibles the underlying stock)
Bond
− For parity purposes, its price is influenced by
the value of the underlying stock − Unsuitable for investors seeking high income
or those with short-term objectives

− Issued at a deep discount, but matures at par − Suitable for investors seeking an investment
value that’s less risky than equities and provides
− Makes no interest payments predictable growth (used for retirement
Zero-Coupon − Basis is accreted and treated as interest income planning or college funding)
Bond − Discount is taxed annually for corporates, and
tax-exempt for municipal (OID) bonds − Unsuitable for investors seeking current
− Has a high degree of interest-rate and inflation income or if the level of inflation or interest
risk, but no reinvestment risk rates are rising
− High risk bond with a speculative rating − Suitable for high-risk, speculative investors
High-Yield Bond
− Offers a higher coupon
(Junk Bond) − Unsuitable for conservative investors
− Includes Income (Adjustment) Bond
− Short-term debt (one year or less to maturity) − Suitable for investors seeking conservative
with very low yields investments for short-term needs; used to hold
− Very safe and liquid investments funds safely until needed or invested for a
Money Market
− Examples include commercial paper (CP), longer term
Instruments
bankers’ acceptance (BA), short-term
negotiable CDs, repurchase agreements − Unsuitable for investors seeking long-term
(REPOs) growth and/or income

− Pays federally tax-exempt interest − Suitable for investors in high tax brackets and
− Price fluctuation is influenced by length of seeking tax-exempt interest income
maturity and interest rate
Municipal
− G.O. bonds typically have less credit risk than − Unsuitable for growth investors or those in
Bond
revenue bonds low tax brackets or with low incomes; should
− Due to tax exemption, pays lower coupon than not be included in an IRA or other tax-deferred
a comparable corporate bond account

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PRODUCT CHARACTERISTICS SUITABILITY

− Low risk of default; low interest payments − Suitable for investors seeking fixed income
− Subject to inflation and interest-rate risk and safety of principal
Treasury Note and − Note maturities are from 2-10 years
Treasury Bond − Bond maturities exceed 10 years
− Interest income is exempt from state and local − Unsuitable for investors seeking growth or
tax (subject to federal) capital appreciation

− Suitable for investors seeking absolute safety

− Short-term and liquid (a money-market of principal who are willing to accept a very low
Treasury instrument) return
Bill − Safe investment with low yield
− Maturities of up to one year − Unsuitable for investors seeking growth or
capital appreciation

− Pass through debt certificates that make

monthly payments of both principal and interest
(fully taxable) which are derived from residential
Government − Suitable for investors seeking safety, monthly
mortgage payments
Agency Mortgage interest income, and a yield that’s slightly higher
− Issued by federal agencies or government-
Backed Securities than U.S. Treasuries
sponsored enterprises; considered AAA rated
− Due to prepayment risk (mortgages being paid
off early), the maturity is uncertain

− Suitable for investors who speculate on short-

− Allows investors to speculate on the price term price fluctuations
Long Options movement of a stock without the capital outlay  Long calls for bullish speculation
(Buying Calls of buying the shares outright  Long puts for bearish speculation
or Puts) − Unlike stock purchases, options are short-term
and may expire worthless − Unsuitable for investors seeking income or
those who cannot afford a total loss of capital

− Option seller accepts potential future obligation − Suitable for sophisticated investors willing to
in exchange for premium income accept substantial risk in exchange for premium
Short Options income
− Income is limited to the premium (if the option
(Selling Calls
expires worthless)
or Puts)
− Potential future loss may be substantial, or − Unsuitable for investors who cannot assume
even unlimited substantial risk

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PRODUCT CHARACTERISTICS SUITABILITY

− Suitable for investors seeking to limit a short-
− A put purchased on a long stock position term loss on the stock position while still
− Used to significantly protect (hedge) the participating in potential gains (gain on stock is
Protective Put downside risk of the stock reduced by premium paid)
− If the stock falls in value, the option position will
gain value − Unsuitable for investors seeking to generate
income

− Suitable for investors seeking a conservative

− A call sold against a long stock position income generating strategy, with risk exposure
− Generates income (the premium) and lowers that’s less than holding the stock without the
the cost of the stock by the premium received option (due to the premium received)
Covered Call
− Upside potential is limited (if the call is
exercised), while the downside risk is still − Unsuitable for investors who believe that the
substantial stock has significant upside potential or those
who want protection

− Offers shares of a portfolio that’s diversified

− Suitable for investors seeking to invest in a
based on the type of fund
diversified portfolio of securities rather than
− Less risky and easier than buying individual
creating their own
securities
Mutual Fund − Priced once per day (forward pricing)
− Fund will redeem shares at NAV; there’s no
− Unsuitable for investors who are interested in
secondary market
speculation or short-term trading due to the
− Suitability varies based on objectives and share
associated transaction costs (sales charges)
class

− Issues a limited number of shares which are

− Suitable for investors seeking to invest in a
Closed End priced and traded in real-time (not redeemable)
diversified portfolio with short-term trading
Fund − Share price is not based on NAV; instead, it’s
capabilities; similar to ETFs
set in market by supply and demand

− Suitability is based on the type of ETF

− Offers shares that track an index and trade in
investment made
the secondary market like common stock
 Traditional ETFs are suitable as a low cost
− Unlike mutual funds, shares are priced and
Exchange Traded and long-term investment (like mutual
traded in real-time on an exchange
Fund (ETF) funds)
− May be sold short and purchased on margin
 Non-traditional ETFs (i.e., leveraged and
− Variations include high risk leveraged and
inverse) are suitable for short-term trading
inverse ETFs
and speculation

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PRODUCT CHARACTERISTICS SUITABILITY

− Best for passive investors who believe in
− Fixed portfolio efficient markets and low-cost investing
Unit Investment
− Fixed life − Due to the way these are sold and regulated,
Trust (UIT)
− Low cost UITs have mostly been replaced by other types
of funds

− A passively managed fund that buys and holds

− Suitable for investors seeking a low-cost
securities that mirror a specific index (e.g., the
Index Fund alternative to more actively managed funds with
S&P 500)
similar objectives
− Low expense ratio

− A managed portfolio that consists of stocks of

Global foreign and U.S. corporations − Suitable for investors seeking exposure to
Stock Fund − Shares are priced in U.S dollars, with dividends both U.S. and international stocks
paid in U.S. dollars

− A managed portfolio that consists of stocks of

International foreign corporations − Suitable for investors seeking to diversify into
Stock Fund − Shares are priced in U.S. dollars, with foreign stocks
dividends paid in U.S. dollars

− A managed portfolio that consists of stocks of − Suitable for investors seeking to diversify into
Country or
corporations from a specific country or region foreign stocks who accept the concentration
Region Fund
− More risk due to geographic concentration risk

− A managed portfolio consisting of common

stocks which have strong upside potential
− Suitable for investors willing to accept the risk
Growth Fund − May pay little or no dividends
associated with long-term growth
− Risk is determined by types of companies
included (large-, mid-, small-cap)

− A managed portfolio that invests in one specific

Specialized/ industry or geographic area − Suitable only for aggressive investors who are
Sector Fund − The least diversified type of fund seeking a higher return
− Higher risk with higher potential returns

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PRODUCT CHARACTERISTICS SUITABILITY

− Invests in very small companies
− Suitable for long-term investors seeking above
Micro-Cap − High volatility
average returns and willing to accept a high-risk
Fund − High risk
investment
− No dividends paid

Balanced or − A diversified and managed portfolio that

− Suitable for conservative investors seeking
Growth and consists of both stocks and bonds
both long-term growth and current income
Income Fund − Provides both growth and current income

− A managed portfolio that primarily consists of

bonds, preferred stocks, and possibly high
Income Fund dividend paying common stocks − Suitable for investors seeking current income
− Price is less volatile than growth funds
− Offers a high dividend yield

− Offers safety of bonds with potential upside of

Convertible equities − Suitable for middle of the road investors who
Bond Fund − Lower interest than traditional bond funds desire income with some growth potential
− May provide an inflation hedge

− Safety of principal
− Risk-free rate of return
U.S. Government
− Default free − Suitable for risk averse investors
Bond Fund
− Income is taxable at federal level, but exempt
from state and local taxation

− Invests in pass-through debt certificates that

make monthly payments of both principal and
interest (fully taxable) which are derived from
residential mortgage payments − Suitable for conservative investors seeking
GNMA Fund
− Issued by federal agencies or government- monthly income.
sponsored enterprises; considered AAA rated
− Due to prepayment risk (mortgages being paid
off early), the maturity is uncertain

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 CHAPTER 12 – RESOLVING DISPUTES AND SUITABILITY

PRODUCT CHARACTERISTICS SUITABILITY

− Conservative income producing portfolio

Municipal − Income is exempt from federal taxation − Suitable for income investors in high marginal
Bond Fund − Income may also be exempt at the state/local tax bracket
level

− May be secured or unsecured − Suitable for investors seeking current income

High-Grade − Price fluctuation is influenced by length of for a specific period
Corporate maturity and interest rate/coupon − Unsuitable for investors seeking growth or
Bond Fund − Interest rate is generally fixed and the interest is capital appreciation or those who are in a high
fully taxable tax bracket

− High risk bond with a speculative rating − Suitable for sophisticated investors seeking
High-Yield Fund
− Offers a higher coupon higher returns in return for accepting more risk

− Creates a custom mix of investments based on − Suitable for investors who want their portfolios
Life Cycle or the investor’s age and risk tolerance. to be automatically adjusted
Target Date Fund − The asset allocation automatically shifts as the − Often used inside of 401(k) and other
client ages and grows nearer to retirement retirement accounts

− Invests in out-of-favor companies

− Long term time horizon − Suitable for equity investors who have long
Value Fund
− Companies are often in the process of time horizon
restructuring

− A type of closed-end fund

− Shares that don’t trade on the secondary
− Suitable for investors who prefer closed-end
market
Interval Fund structure and don’t want to be exposed to NAV
− Fund periodically offers to buy back a
drift
percentage of outstanding shares at net asset
value (NAV)

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CHAPTER 12 – RESOLVING DISPUTES AND SUITABILITY

PRODUCT CHARACTERISTICS SUITABILITY

− An investment contract with an insurance

− Suitable for investors seeking lifetime income
company, risk assumed by ins. company
payments after retirement, with the
Fixed Annuity − May provide fixed payments for life
understanding that the fixed rate of return may
− Income grows tax-deferred until paid out
not keep up with inflation
− The investment return is at a fixed rate

− An investment contract with an insurance − Suitable for investors seeking tax-deferred

company; risk assumed by annuitant retirement savings or the potential for lifetime
− Can provide periodic payments for life payments
− Income grows tax-deferred until paid out
Variable Annuity
− Risk and return are based on the investments
chosen in the separate account (investments − Unsuitable for older investors, those seeking
may be adjusted to suit the investor’s age and fixed payments, or those seeking an
risk profile) immediate tax benefit

− A policyholder purchases contract that may

grow with inflation
Variable Life − Suitable for life insurance buyers seeking an
− VLI policies are securities
Insurance (VLI) inflation hedge
− Guarantees a minimum death benefit, but
doesn’t guarantee a minimum cash value

− A tax deferred investment account; may be − Suitable for persons with earned income who
Individual funded by persons with earned income are saving for retirement
Retirement − Withdrawals are taxed as ordinary income
Account (IRA) − Penalty is assessed for early withdrawal − Unsuitable for persons with no earned income
− RMD applies (e.g., already retired)

− A tax-free investment account available to − Suitable for persons with earned income
persons with earned income (below the limit) who are saving for retirement
− Income limits are imposed on contributors (not and want future tax-free withdrawals
ROTH IRA available for high income persons)
− Qualified withdrawals are tax-free
− Penalty is assessed for early withdrawal − Unsuitable for persons with no earned income
− RMD doesn’t apply (e.g., already retired)

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PRODUCT CHARACTERISTICS SUITABILITY

− A tax-free investment account established to

help pay a child’s education expenses
− Income limits are imposed on contributors
Coverdell − Suitable for investors saving for a child’s
− Withdrawals are tax-free if used for qualified
Education Saving education expenses, including elementary,
education expenses (at any level of education)
Account (CESA) secondary, or higher education
− Penalties and taxes are assessed if the funds
are not used for education
− Change of beneficiary is allowed

− A tax-free investment account established to

help pay higher education expenses − Suitable for investors saving for a child’s
− No income limits are imposed on contributors higher education expenses (college funding)
529 College − Withdrawals are tax-free if the funds are used
Savings Plan for qualified higher education expenses
− Penalties and taxes are assessed if the funds − Unsuitable for investors saving for a child’s
are not used for education elementary or secondary school expenses
− Change of beneficiary is allowed

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CHAPTER 12 – RESOLVING DISPUTES AND SUITABILITY

Breaking Down Suitability Questions

Review the Question
1. An investor is in her mid-30s and is interested in saving for retirement. She has a high risk
tolerance and wants to outpace inflation. Which of the following is the most suitable
investment?
a. U.S. government bond fund
b. A growth fund
c. A fixed annuity
d. A unit investment trust

Question Stem Breakdown

Q. What’s the investor’s main investment objective?
A. Saving for retirement
Q. What’s the time horizon?
A. Long-term since she’s in her 30s
Q. What level of risk / return is appropriate?
A. As stated, she has a high-risk tolerance, a long time horizon, and wants to outpace inflation.

Characteristics of Investment Choices

a. U. S. government bond fund provides current liquidity and safety of principal. Since the
payments are fixed, this investment will not outpace inflation and doesn’t provide for
growth.
b. A growth fund invests primarily is smaller companies that pay little or no dividends and its
objective is to outpace inflation.
c. A fixed annuity provides a fixed and stable cash flow. Since the annuity is fixed, there won’t
be any growth of payments and the investor will be subject to inflationary forces.
d. A unit investment trust contains a portfolio of securities. Since there’s no active
management, fees are lower and the fund generates fewer capital events. This choice may
not achieve the level of growth that a managed fund may provide.

Conclusion
Although both Choices B and D provide for growth, the growth in Choice D is likely limited due
to the lack of active management. For that reason, the best recommendation for the investor is
the growth fund which will provide growth over the investment period.

Answer: B

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 CHAPTER 12 – RESOLVING DISPUTES AND SUITABILITY

Review the Question

2. An investor is disappointed with bank CD yields. How can he best increase his current
retirement income without incurring a high degree of risk?
a. U.S. government bond fund
b. Municipal unit investment trust
c. International stock fund
d. A variable annuity

Question Stem Breakdown

Q. What’s the investor’s objective?
A. Increase of income
Q. What’s the time horizon?
A. Immediate (current)
Q. What’s the risk tolerance?
A. Minimal, as the funds are derived from bank CD investments.

Characteristics of Investment Choices

a. A U.S. government bond fund will provide immediate cash flow with safety against default.
b. A municipal bond investment trust will provide tax-free income (which is not stated as an
objective) and lower returns than a U.S. government or corporate bond fund. The trust will
self-liquidate or end on a specific date and must eventually be replaced.
c. An international stock fund will provide growth and potential income. However, this
investment contains several types of risk, including political risk, currency risk, and
economic risk.
d. A variable annuity provides income which increases based on the superior performance of
the separate account. Not only does the investor assume the market risk, this is the least
liquid of all of the investment choices.

Conclusion
Both Choices C and D provide growth of principal and potential income, but have the greatest
risk. Answer B provides tax-free income, but this isn’t a need for the client. Choice A, the U.S
government fund, will provide the current stable income as well as safety against default. The
client must accept that the purchasing power of his income will remain at risk (which occurs
with bank CDs as well).

Answer: A

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CHAPTER 12 – RESOLVING DISPUTES AND SUITABILITY

Review the Question

3. An investor with high income wants to maximize her retirement savings. She’s already
contributed the maximum allowable amount to her 401(k) and wants to contribute another
$20,000 per year for retirement. Which of the following funding vehicles will BEST suit her
needs?
a. Traditional IRA
b. Variable annuity
c. Roth IRA
d. Fixed annuity

Question Stem Breakdown

Q. What are the investor’s objectives?
A. Retirement savings and tax-deferral
Q. What’s the time horizon?
A. Medium to long-term
Q. What’s the investor’s risk profile?
A. Saving for retirement can be considered a moderate objective, with some risk being
appropriate since there’s an objective to outpace inflation and keep pace with the market.

Characteristics of Investment Choices

a. The Traditional IRA will only allow for a $6,000 contribution per year.
b. The variable annuity provides for the growth of the funds along with tax deferral until
they’re withdrawn.
c. In a Roth IRA, a maximum of $6,000 may be contributed on an after-tax basis, but eligibility
is subject to income limitations. The benefit to the Roth IRA is that the earnings don’t need
to be withdrawn and may be tax-free if withdrawals are qualified.
d. In a fixed annuity, an insurance company makes payments of a fixed amount over the term
of the policy. This allows for tax deferral of the income, which will become taxable upon
withdrawal. The fixed annuity will not allow for growth over the life of the investment.

Conclusion
Since the investor has maximized her company-sponsored retirement plan and wants to invest
an additional $20,000 per year, both Choices A and C are eliminated since they only allow for a
maximum contribution of $6,000 per year. The fixed annuity (Choice D) will not provide for the
growth of the account as the payments are fixed by the insurance company. The variable
annuity (Choice B) provides for the growth of the investment and tax-deferral of the income
which makes it the most suitable choice.

Answer: B

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 CHAPTER 12 – RESOLVING DISPUTES AND SUITABILITY

Review the Question

4. A moderately conservative investor needs funds in 10 years and is concerned about inflation.
He doesn’t want to pay high fees or be involved with a complicated investment. Which
selection is most suitable?
a. A variable annuity
b. U.S. government bond fund
c. A high-grade corporate bond fund
d. A convertible bond fund

Question Stem Breakdown

Q. What are the objectives of the client?
A. Return of capital and inflation protection
Q. What’s the time horizon?
A. Mid-term, 10 years
Q. What’s the risk tolerance?
A. Conservative

Characteristics of Investment Choices

a. A variable annuity is an insurance product that provides a variable payment over time and
is designed to protect against inflation. Unfortunately, there are generally substantial fees
associated with this type of product and its terms may be complicated.
b. The U.S. government bond fund is a conservative choice, but it won’t provide inflation
protection.
c. The high-grade corporate bond fund is another conservative choice that doesn’t provide
inflation protection.
d. A convertible bond fund is a middle of the road investment that’s conservative, but also
offers inflation protection since the bonds are able to be converted if the stocks increase in
value.

Conclusion
Since the investor wants to avoid a complicated or expensive product, Choice A is incorrect.
Neither Choices B nor C will offer inflation protection. Therefore, the convertible bond fund
(Choice D) is the most suitable.

Answer: D

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CHAPTER 12 – RESOLVING DISPUTES AND SUITABILITY

Questions
Use the same approach to complete the following sample questions:
1. A wealthy investor is retired, but is worried about inflation. He recently sold one of his many
rental properties and wants to invest the proceeds in mutual funds. Which of the following
funds is the LEAST suitable recommendation?
a. A growth fund
b. A balanced fund
c. A municipal bond fund
d. A corporate bond fund

2. One of a registered representative’s clients is a part owner of a video game company. The
client is in her early 30s and has a large salary. If the client wants to save for retirement on a
tax-deferred basis, what’s the BEST recommendation?
a. Invest in a Roth IRA.
b. Invest in a variable annuity.
c. Invest in a mutual fund complex, since exchanges are tax-free events.
d. Invest in a municipal bond fund, since the interest is tax-free.

3. An investor is in his 20s and is saving for retirement. Given this limited amount of
information, what’s the BEST recommendation?
a. A money market fund, since adequate information hasn’t been given.
b. An index fund, since it’s suitable for an investor with these parameters.
c. A U.S. government bond fund.
d. A municipal bond fund.

4. A young, aggressive investor is worried about a potential market crash. She plans to invest
consistently over the next 20 years. What’s the BEST recommendation?
a. An international equity fund
b. A growth fund
c. An index fund
d. A bond fund

5. An investor is retired and concerned that he will outlive his savings. Based on his risk averse
nature, which of the following selections is the MOST suitable?
a. A growth fund, since it will grow and provide enough principal to last for the balance of
the client’s life.
b. A variable annuity.
c. A fixed annuity.
d. A monthly withdrawal plan from a balanced fund.

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 CHAPTER 12 – RESOLVING DISPUTES AND SUITABILITY

6. An investor is seeking an inexpensive way to gain the broadest exposure to the stock market.
Which of the following is the MOST suitable?
a. A growth and income fund
b. A balanced fund
c. An S&P 500 Index fund
d. A global equities index fund

Explanations
1. (D) The corporate bond fund is the LEAST SUITABLE choice. Since the investor is
concerned about inflation risk, bond funds are a poor choice. Based on the fact that the
investor is wealthy and owns several rental properties, he’s probably a better candidate for a
municipal bond fund than a corporate bond fund. *Note that this is question asks for the
LEAST suitable choice, not the most suitable choice.

2. (B) Based on the given details, the client’s income may be too high to allow for Roth IRA
contributions. Although no dollar amount of income is provided, a person who is a part
owner of a technology company and “has a large salary” almost certainly surpasses the limit.
Neither one of the fund choices is suitable—a mutual fund complex doesn’t permit tax-free
exchanges and a municipal bond fund is not suitable for a young person who’s intent on
growing her retirement savings.

3. (B) Although limited, the age and objective provided is enough information to choose that
an Index Fund is the most suitable of the choices provided. A money market fund is
considered a “parking place” for funds until an investment decision is made. The other funds
invest in debt securities, which are unsuitable for a younger person’s retirement savings due
to inflation risk.

4. (D) An investor who’s very concerned about a market correction, and possibly wants to
profit off of one, will likely seek a conservative option and attempt to enter into the stock
market at a later date. Occasionally, bonds will gain value if there’s a recession, since interest
rates are usually reduced as a response. All of the other choices are subject to much greater
risk in the event of a market crash.

5. (C) Fixed annuities are ideal for clients who are worried about outliving their savings, since
the insurance company is obligated to pay them in until death. On the other hand, the
payouts from variable annuities may decline if markets decline. Monthly withdrawal plans
from mutual funds are not guaranteed for life; instead, the payments continue until the funds
are exhausted. Lastly, a growth fund is more appropriate for a younger investor who wants to
outperform inflation and is therefore not a suitable choice for this investor.

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CHAPTER 12 – RESOLVING DISPUTES AND SUITABILITY

6. (D) Global funds provide the broadest exposure to the stock market since they invest in
both domestic and overseas companies. Also, index funds typically have lower fees when
compared with actively managed portfolios. By combining a global fund with an index fund
(the global equities index fund), the investor will obtain the broadest exposure and will do so
in the most inexpensive way. Although the S&P 500 index fund may appear like a good choice,
a global fund provides even broader exposure.

Conclusion
This concludes the reading portion of your test preparation. The majority of your remaining study
process should be focused on completing the Final Exams which may be found at
www.my.stcusa.com. These tests will reinforce your understanding of the material and help you to
get ready for the actual test. Best of luck with the remainder of your studies!

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Index
A tax-deferred, 8-5
tax-sheltered, 8-5
ABLE Plans, 7-16 annuitization, 7-6, 7-11
ABS (Asset-Backed Securities), 5-4 annuity contracts, 7-1, 7-4, 7-12, 8-5
ACATS (Automated Customer Account servicing variable, 7-5
Transfer Service), 9-7–9-9 annuity payments, 7-3, 7-6, 7-8–7-9
account information, 2-12, 9-4 first, 7-8
updated, 9-5 annuity period, 7-4, 7-6, 7-9
account transfer request, 9-9 annuity units, 7-6–7-8
accredited investors, 1-16, 4-9, 10-8 fixed number of, 7-6, 7-8
accumulation, 7-4 anti-money laundering (AML), 2-10
rights of, 6-13, 6-16–6-17 arbitration, 2-4, 12-6–12-9
accumulation period, 7-4–7-6, 7-9–7-10 binding, 2-4, 12-6
accumulation units, 7-4, 7-6, 7-9 customer-initiated, 12-9
ADRs, 9-12 simplified, 12-7
advertisements, 3-5–3-6, 3-10, 3-12–3-13 asset allocation, 3-9, 10-2–10-4, 10-7, 10-11
blind, 3-14 asset allocation plans, 6-23
tombstone, 3-5 Asset-Backed Securities (ABS), 5-4
advertising, 3-1–3-2, 3-5, 3-11–3-13, 6-12, asset classes, 1-13, 6-8–6-9, 10-1, 10-11
9-2 assumed interest rate. See AIR
adviser, 2-10, 6-4, 6-6, 6-22, 8-1, 9-2 ATS (Alternative Trading Systems), 11-5
after-tax deductions, 8-7 attorney, 1-16, 2-7, 4-3, 4-5, 12-5
Agency Cross, 11-2 durable power of, 2-7
Agency Trade, 9-1 power of, 2-7, 9-6, 11-11
agents, 4-2, 4-5, 6-4, 7-13, 9-1, 9-4, 11-2– Automated Customer Account Transfer
11-3, 12-9 Service (ACATS), 9-7–9-9
Aggressive Growth Funds, 6-6 average cost method, 6-20
AIR (assumed interest rate), 7-6, 7-8, 7-11 average life, 5-11
alien identification card number, 2-11 average net assets, 6-12–6-13
alpha, 9-11, 10-14 awards, 2-4, 12-7, 12-9
negative, 10-14 arbitrator’s, 12-6
positive, 10-14 final arbitration, 12-9
Alternative Minimum Tax (AMT), 1-5
Alternative Trading Systems. See ATS B
AML rules, 10-5
amortization, principal, 5-4 Back-End Loads and Contingent Deferred
AMT (Alternative Minimum Tax), 1-5–1-6 Sales Charges, 6-11
annuitant, 7-1–7-10 balance sheet, 1-8, 4-4, 9-3, 10-14, 10-16–
annuities, 1-5, 1-8, 1-13, 7-1–7-9, 7-11–7- 10-17
12, 9-1, 10-3 banker’s acceptance, 5-6–5-6
deferred, 7-3–7-4 bankruptcy, 2-6, 5-1–5-3, 6-6
non-qualified, 7-9 Bank Secrecy Act (BSA), 2-10
qualified, 7-10 basis, 2-15–3-1, 5-14, 6-3–6-4, 6-19, 6-22,
straight-life, 7-6–7-7 6-24, 10-12, 11-5
bearer, 11-10 business risk, 9-11
bearish, 5-12–5-13, 11-7
beneficiary, 1-14, 2-6, 7-5, 7-7, 7-10, 7-14– C
7-16, 8-2, 10-9
designated, 7-6–7-7 calls, 2-14, 3-11, 5-12–5-13
beta, 9-11, 10-13–10-14 covered, 2-14
bid, 4-10, 5-8, 11-2–11-5 Capital Asset Pricing Model. See CAPM
blue-chip companies, 10-12 capital events, 5-13, 7-1, 9-14
Blue-Sky Laws, 4-5–4-6, 9-4 capital gains, 1-6, 5-14–5-15, 6-3, 6-18, 6-
bond funds, 3-9, 6-7, 6-9, 8-4, 10-3–10-5, 20–6-21, 7-2, 7-9, 9-15
10-7 long-term, 1-5, 5-14–5-15
convertible corporate, 10-6 offset, 5-15
high-grade municipal, 10-7 short-term, 5-15, 6-20
high-yield, 6-7, 6-20, 10-6–10-7 capital gains distributions, 3-7, 6-4, 6-17, 6-
mortgage-backed, 6-7 21
municipal, 6-7, 10-3–10-5 capitalization, 4-4
short-term, 10-4, 10-8 capital losses, 1-6, 5-15, 7-2, 9-12
tax-free, 10-5 long-term, 5-15
bonds, 1-4, 1-8–1-9, 3-8, 3-10, 4-10–5-1, 5- capital risk, 6-9, 9-12
3–5-5, 5-8–5-9, 5-14–6-1, 6-6–6-9, 6- limited, 10-7
21–6-22, 9-10–9-14, 10-2–10-3, 10-6– capital structure, 4-1, 5-2
10-7, 10-11–10-12, 11-7–11-8 capital surplus, 10-15, 10-17
collateral trust, 5-3 CAPM (Capital Asset Pricing Model), 10-13
convertible, 5-16, 6-7 cash account, 2-4, 12-1
investment-grade, 6-7 cash dividends, 1-4, 5-13–5-14, 6-20
junk, 5-4, 6-7, 9-1 cash equivalents, 5-5, 6-8–6-9, 10-11
outstanding, 5-3 cash flow, 1-2, 5-4, 5-9–5-10
secured, 5-3–5-4 customer’s, 1-2
tax-free, 1-7, 9-14 Cash Management Bills (CMBs), 5-7
term, 9-10 cash settlement, 11-8
zero-coupon, 5-9 Cash Surrender Value, 7-5
bond volatility ratings, 3-10 cash transactions, 11-9
books and records, 9-5 cash value, 3-11, 7-13–7-14
breakpoint discounts, 6-13 policy’s, 3-11–3-12, 7-13–7-14
breakpoints, 6-11, 6-13–6-17, 6-19 CDs (Certificates of Deposit), 1-8, 1-12, 5-
fund’s, 6-14 5–5-6, 10-6
breakpoint sales, 6-19 brokered, 5-6
breakpoint table, 6-15 jumbo, 5-6
broker, 1-16, 11-1–11-2, 11-10, 12-9 long-term, 5-6
prime, 2-9 traditional bank-issued, 5-6
brokerage account statements, 1-16 CDSC. See contingent deferred sales charge
BrokerCheck, 12-9 Censuring, 12-5
BSA (Bank Secrecy Act), 2-10 Central Registration Depository (CRD), 3-4,
bullish, 5-12–5-13 12-9
business days, 2-15, 3-4, 3-12–3-13, 6-10, 6- Certificates of Deposit. See CDs
18, 7-4, 7-10–7-11, 9-7–9-9, 11-8–11-9
charges, 1-14, 2-1, 2-6, 3-6–3-7, 3-11, 3-13, discretionary, 8-3–8-4
6-11–6-12, 7-5, 7-12–7-13, 9-3 employee, 8-3–8-4
administrative, 5-11, 6-12 investor’s, 7-9
asset-based, 6-12 matching, 8-4–8-5
mortality risk, 7-5 maximum, 7-16
regulatory, 12-9 post-tax, 8-6
charter, 2-5 pre-tax, 7-10, 8-3, 8-5–8-6
corporate, 2-5 Convertible Security Funds, 6-7
churning, 2-8 Coordination, 4-5
CIP (Customer Identification Program), 2-11 corporate accounts, 2-5, 2-11
clause, 2-4, 12-6 corporate bond funds, 6-7, 10-5, 10-8
no-approval, 4-4 corporate bonds, 1-8, 5-3–5-4, 5-14, 9-13,
predispute arbitration, 2-4, 12-6 10-1, 11-1, 11-4
closed-end funds, 3-4, 6-1, 6-22–6-24 corporate underwritings, 4-9
traditional, 6-22 correspondence, 2-3, 2-15–3-3, 12-4
CMOs (collateralized mortgage obligations), Correspondence and institutional
3-4 communications, 3-3, 3-5
Code of Arbitration, 12-6, 12-8 cost basis, 1-4, 1-6, 5-14–5-15, 6-20–6-21,
Code of Procedure, 12-4–12-5 7-9–7-10, 9-14
college savings plans, 3-13, 7-15, 8-6 average, 6-20
commercial paper, 4-6, 5-5, 6-9 client’s, 6-17
commissions, 1-3, 1-14–1-15, 5-14, 6-3, 6- customer’s, 6-20
22–6-23, 9-1–9-3, 11-2 donor’s, 9-15
Common and preferred stocks, 6-9 investor’s, 7-9, 9-15
communications, 3-1–3-5, 3-7, 3-9, 3-11–3- lower, 10-16
12 mutual fund investor’s, 6-20
electronic, 3-1–3-2, 3-4 new, 5-16
internal, 3-1 recipient’s, 9-14–9-15
community property, 2-5 zero, 7-10, 8-4–8-5
complaint, 12-1–12-2, 12-4, 12-9 Cost Basis of Gifted Securities, 9-15
complaints Cost Basis of Inherited Securities, 9-14
received, 12-4 Cost Basis of Securities, 5-14
written, 12-3–12-4 coupon, 5-8–5-9, 5-16, 9-13, 10-1
Coverdell Education Savings Accounts, 1-
concessions, 6-12 12
confirmations, 2-9, 2-15, 5-14, 6-20, 9-3–9- Coverdell ESA, 7-15
4, 12-1 CPAs, 1-16
client’s, 9-1 CPI (Consumer Price Index), 5-8, 9-10
corrected, 12-1 CRD (Central Registration Depository), 3-4,
written, 1-16 12-9
Consumer Price Index. See CPI credit balance, 9-9
contingent deferred sales charge (CDSC), 6- credit ratings, 5-7
11, 6-13–6-14, 7-5, 7-11 credit risk, 5-4, 5-7, 5-9, 6-7, 9-12
contributions, 1-13, 7-1–7-2, 7-5, 7-9–7-10, crossing networks, 11-5
7-13, 7-15, 8-3–8-7 Cubes, 6-23
after-tax, 7-9, 8-2, 8-5 currency, 5-12, 9-12
 foreign, 3-4 good, 11-8, 11-10
currency risk, 3-10, 9-12 delivery dates, 3-12
current income, 1-12, 6-7, 6-9, 10-6 delivery methods, 3-1
seeking, 10-6 depreciation, 10-15–10-16
CUSIP Numbers, 11-10 derivatives, 1-13, 6-23
Custodial accounts, 8-5 Designated Market Maker. See DMM
custodian, 2-6, 6-4–6-5, 10-8 DIAMONDS, 6-23
fund’s, 6-4–6-5 digital storage, 9-5
Custodian Bank, 6-5, 6-12 direct participation programs (DPPs), 1-4, 3-
customer account information, 2-4, 9-6 4, 9-11
customer communications, 2-15–3-14 Disciplinary Information, 12-9
customer complaints, 12-1, 12-4 Disciplinary Proceedings, 12-4
Customer Identification Program (CIP), 2- disclosure documents, 4-6, 4-10, 7-16
11 disclosure statement, 3-10
customer’s account transfer request, 9-9 discount securities, 5-8
customer’s address changes, 9-4 discount yield, 5-8
discretionary accounts, 2-3, 2-7–2-8
discretionary authority, 2-7, 8-1
D discretionary authorization, 2-7–2-8
discretionary order, 2-7–2-8
day order, 11-5 disgorgement, 2-14
day-trade, 10-5 Dispute Resolution, 12-6
day trader, 2-8 distributor, 6-5, 9-8
DCA. See Dollar Cost Averaging diversification, 6-2, 9-9–9-10, 10-13
dealer capacity, 11-2 Dividend Income, 1-4
Dealer-to-dealer marketplaces, 11-6 dividend payout ratios, 10-9
death benefits, 3-11–3-12, 7-5, 7-10–7-11, dividend rate, 5-2
7-13–7-14, 9-2 Dividend Reinvestment, 6-17
Death Benefit Taxation, 7-10 Dividends Payable, 10-15
debentures, 5-4, 10-15 Dividend Yield, 9-12
subordinated, 5-4
Debit balances, 1-9 divorce decree, 2-10
debt financing, 5-1 DJIA (Dow Jones Industrial Average), 6-23,
debt instruments, 5-9–5-10, 6-24, 10-5 10-12
short-term, 5-5 DMM (Designated Market Maker), 11-3–
deductions, 1-14, 5-15, 6-12, 7-13 11-4
marital, 1-6 dollar, 1-16, 9-10, 9-12
default risk, 9-12, 10-6 Dollar Cost Averaging (DCA), 6-17–6-18
deferred compensation plans, 8-6–8-7 donor, 1-6, 7-15, 9-15
Deferred Income, 1-5 Dow Jones Averages, 10-12
defined contribution plans, 8-4–8-5 Dow Jones Composite Average, 10-12
tax-advantaged, 8-6 Dow Jones Industrial Average (DJIA), 6-23,
delivery, 2-14–2-15, 4-6, 5-6, 6-3, 9-3, 9-8, 10-12
11-8–11-10 Dow Jones Transportation Average, 10-12
broker-to-broker, 11-10 Dow Jones Utility Average, 10-12
complete, 9-8 downside, 1-12, 10-6
DPPs (direct participation programs), 1-4, 3- investor’s, 6-24
4, 9-11 leveraged long, 6-24
due diligence meeting, 4-5–4-6 sector, 10-8
Durable POA, 2-7 small capitalization, 10-5
duration, 9-10 triple-long, 6-24
triple-short, 6-24
E ETNs, 3-4
exchange privileges, 6-3
EBIT, 10-16 exchange-traded funds. See ETFs
ECNs (electronic communication networks), exchange-traded notes, 3-4
11-5–11-6 excise tax, 1-5
education expenses, 1-12, 7-16 execution, 2-8, 9-1–9-2, 9-4, 11-1, 11-5, 12-
qualified higher, 7-15, 8-2 1–12-4
electronic messages, 3-1 actual, 12-1
Electronic Municipal Market Access erroneous, 12-2
(EMMA), 3-13 executors, 2-6, 11-11
e-mails, 3-1–3-2, 3-10, 12-4 exempt, 3-5, 3-13, 4-6–4-7, 4-9–4-10, 5-5,
employee benefit plans, 3-1, 8-1, 8-7 5-7, 5-10, 8-6, 11-9, 12-9
Employee Retirement Income Security Act. exempt offerings, 4-1, 4-7
See ERISA exempt transactions, 4-1, 4-10
employees, 2-14, 6-13, 8-1, 8-3–8-7, 9-3, 9- expense ratio, 6-12–6-13
Employee Stock Ownership Plans (ESOP), Expense Risk Charges, 7-5
8-7 expungement, 12-9
employer-sponsored plans, 7-13 extensions, 2-15, 10-13
Equipment Trust Certificates, 5-3
equity funds, 10-3–10-4, 10-7–10-8
domestic, 10-7 F
individual, 10-3
international, 10-7 Face-Amount Certificate Company, 6-21
small allocation of, 10-8 fair dealings, 1-14, 10-2
equity income funds, 6-7, 6-9 FDIC (Federal Deposit Insurance
Equity Options, 5-12 Corporation), 5-6
equivalent yield, 5-8 Federal Deposit Insurance Corporation
taxable, 9-14 (FDIC), 5-6
ERISA (Employee Retirement Income federal estate taxes, 7-10
Security Act), 8-1, 8-7 Federal Farm Credit Banks (FFCBs), 5-10
ERISA requirements, 8-3 Federal funds, 5-5
ERISA standards, 8-6 Federal Home Loan Banks (FHLBs), 5-10
error account, 12-1 Federal Home Loan Mortgage Corporation,
ESOP (Employee Stock Ownership Plans), 5-10–5-11
8-7 Federal Housing Administration (FHA), 5-
Estate Tax Credit, 9-15 11
ETFs (exchange-traded funds), 3-4, 6-1, 6- Federal Land Banks, 5-10
10, 6-23–6-24, 10-8, 10-10–10-11 Federal National Mortgage Association, 5-
biotechnology, 10-8 10–5-11
inverse and leveraged, 6-23–6-24
Federal Reserve Board (FRB), 2-15, 5-5, 11- fixed-dollar payout plans, 6-18
9 fixed-income investments, 5-7, 5-11, 9-12,
federal tax consequences, 1-4 10-1–10-2
federal taxes, 1-5, 1-13, 5-10 fixed payment, specified, 7-3
Federal Trade Commission’s (FTC), 2-13 fixed-percentage payout plan, 6-18
fee-based accounts, 9-1 fixed-time payout plan, 6-18
FFCB debt, 5-10 floor broker, 11-3
FFCBs (Federal Farm Credit Banks), 5-10 FNMA, 5-10–5-11
FHA (Federal Housing Administration), 5- Foreign Funds, 6-9
11 foreign nationals, 2-11
FHLBs (Federal Home Loan Banks), 5-10 foreign trade, 5-6
FHLMC, 5-10–5-11 forgery, 12-8–12-9
fiduciaries, 2-6, 6-16, 8-1 Form 1099-DIV, 6-3
Fiduciary Responsibility, 8-1 form letters, 3-12
FIFO (first-in, first-out), 5-14, 10-16 Form U4, 12-6, 12-8–12-9
Financial Exploitation of Specified Adults, amended, 12-9
9-5 registered person’s, 12-8
financial statements, 4-4, 4-6, 9-3, 10-14 Form U5, 12-9
finding average cost, 6-17 Form U6, 12-9
finding average price, 6-17 Form W-2, 1-16
FINRA, 1-14, 2-3–2-4, 2-11, 2-15–3-1, 3-3– forward pricing method, 7-4
3-5, 3-9–3-11, 6-19, 7-1–7-2, 7-12, 9- Fractional shares, 6-10
5–9-6, 11-5, 12-2–12-7, 12-9 fraud, 1-14, 2-10, 4-3, 4-7, 12-8–12-9
FINRA BrokerCheck, 12-9 FRB (Federal Reserve Board), 2-15, 5-5, 11-
FINRA Filing and Review Requirements, 3- 9
3 frontier, 10-11
FINRA Regulation’s Public Disclosure efficient, 10-11
Program, 12-9 Front Load, 6-13
FINRA’s Advertising Department, 3-4–3-5 Front-running, 11-8
FINRA’s Code of Procedure, 12-4 FTC (Federal Trade Commission’s), 2-13
FINRA’s Communication Rules, 3-1 FTSE Index, 10-13
FINRA’s Conduct Rules, 6-11 Full POA, 2-7
FINRA’s Investor Education and Protection Fully Registered, 11-11
Rule, 12-9 fund advertisements, 3-6
FINRA’s National Adjudicatory Council, fund advisors, 6-5
12-5 fund charges, 6-14
FINRA’s suitability rule, 1-15 fund families, 6-2, 6-13–6-16, 6-19, 6-21
FINRA’s Uniform Practice Code, 11-9–11- funds, 1-1, 1-12, 2-8, 2-10, 3-7–3-11, 3-14,
10 5-1, 5-10–5-11, 6-2–6-21, 7-1, 7-3, 7-
FINRA’s website, 10-12 12, 7-14–7-16, 8-4–8-7, 10-7–10-9
FINRA Updating Requirement, 9-5 balanced, 6-8–6-9
FINRA website address, 12-9 borrowed, 11-6
firm’s order-entry system, 11-6 disbursement of, 9-6–9-7
first-in, first-out. See FIFO diversified, 6-6
Fitch, 5-5 domestic, 6-6
fixed annuities, 1-12, 7-2–7-3, 9-10, 10-6 emerging markets, 6-6
 excess, 5-5 government money-market funds, 6-9
exchange-traded, 3-4, 6-1, 6-23, 10-11 Government National Mortgage
extra, 5-10 Association, 5-9, 5-11
first, 6-21 government plans, 8-1
fixed-income, 10-3 government-sponsored enterprises. See
global, 6-6, 9-12 GSEs
hedge, 1-13, 2-9, 9-11 Gramm-Leach-Bliley Act, 2-12
index, 6-7–6-9, 10-10 grantor, 2-6–2-7
international, 6-6, 9-12 Growth Analysis, 10-9
interval, 6-8, 6-22–6-23 Growth and income funds, 6-7
investment company pools, 6-1 growth companies, 6-7, 10-9
managed, 6-8 growth funds, 6-6–6-7, 6-9
misappropriating, 9-7 GSEs (government-sponsored enterprises),
new, 4-1, 7-12 5-9–5-10
no-load, 6-11 Guaranteed Bonds, 5-5
pension plan, 8-1 guardianship, 9-6
person transfers, 8-2
precious metal, 6-6 H
regional, 6-6
required, 6-17 Hearing Panel, 12-4–12-5
returned, 5-7 hearing process, 12-8
single, 6-9 hedge, 5-13, 6-23, 7-3, 7-11
specialized, 6-6 Hedging, 5-13
specified adult’s, 9-6 herring, red, 4-4
tax-exempt, 10-3 Higher priority, 5-2
tax-free, 6-9 High-grade convertible corporate bond fund,
traded, 6-24 10-6
fund sponsor, 6-22 High tax bracket clients, 6-9
futures, 6-23–6-24 High-Yield Funds, 6-9
holding period, 5-15, 6-21, 9-14–9-15
G actual, 9-14
house rules, 2-12
gains, 1-4, 1-6, 5-14–5-15, 6-20–6-21, 7-2, internal, 2-4
9-13–9-14, 10-10 hybrid trading methods, 11-3
long-term, 5-15 Hypothetical Illustrations of Variable Life
unrealized, 6-20 Insurance Policies, 3-11
General Securities Principal, 2-15, 3-12
Generic Advertisements, 3-14 I
Gifted Securities, 9-15
gift tax, 1-5–1-6 identification number, 2-11
GNMA, 5-9–5-11 taxpayer, 2-3
GNMA guarantees, 5-11 Identifying Shares Sold, 5-14
government agencies, 5-5, 5-7, 5-10–5-11, Identity Theft Prevention, 2-13
6-7 income funds, 6-7
government agency securities, 4-6, 11-4 income taxes, 1-5–1-6, 8-3–8-4, 8-7
government bond funds, 6-7 avoiding, 8-5
 corporate, 1-5 investment grade, 5-4, 6-7
ordinary, 7-10, 8-2, 8-7 investment income, 1-2–1-5, 6-20, 7-5, 7-9
indenture, 6-21 investment return, 3-13
indexes and averages, 10-12–10-13 investment risks, 1-2, 1-9, 7-1–7-2, 8-7–9-
Individual retirement accounts, 1-8 15
inflation protection, 10-6–10-7 Investor Accreditation, 1-16
inflation risk, 7-11 investor brochure, 12-9
Inherited Securities, 9-14 Investor Education, 12-9
Initial Public Offering, 4-1, 6-6 IPOs (initial public offering), 2-9, 4-1, 6-6,
insiders, 2-13–2-14, 4-9 12-3
Instant Messaging, 3-2 IRAs, 1-5, 6-16, 7-1, 7-12–7-13, 8-1, 8-7,
institutional communications, 2-15–3-3, 3-5 10-3, 12-1
institutional investors, 3-1–3-2, 4-1, 6-13 traditional, 1-13
Institutional Suitability, 1-16 IRS Code, 6-19
insurability, guaranteed, 7-14 IRS Form W-8, complete, 2-12
insurance, 7-11, 7-13–7-14, 8-2 IRS penalty, 8-4
permanent, 7-13 IRS standards, 8-3
private, 7-16
insurance company guarantees, 7-5 J
insurance license, 7-2
insurance policies, 7-13–7-14 Joint Accounts, 2-5, 6-16
Insurance Premiums, 1-3 Joint Tenancy, 2-5
Interest Income, 1-4 junior claim, 5-4
interest-rate risk, 3-10, 5-4, 6-7, 9-9–9-10,
10-6
Intermediate Credit Banks, 5-10 K
Internal Transfers, 2-10, 9-3
Interpositioning, 11-7 Keogh, 1-5
inter vivos trust, 2-6 key executives, 8-6
intrastate, 4-8 key risk factors, 9-9
existing, 4-7 know your customer (KYC), 1-14, 2-1, 10-2
statutory, 4-7
inventory, 9-1, 10-15–10-16, 11-2
broker-dealer’s, 11-4 L
inverse ETF, 6-23–6-24
Investment Advisers Act, 6-2 legal structure, basic, 5-1
investment advisor, 2-14 legend, 3-2, 4-9, 11-8, 11-11
investment banker, 4-1 restrictive, 4-9, 11-11
Investment Companies’ Rankings in Retail Legislative Risk, 9-11
Communications, 3-9 Letter of Intent (LOIs), 6-16, 6-19
Investment Company Act, 3-8, 6-1, 6-3, 6-5, letters testamentary, 11-11
6-18, 7-10 level load, 6-13
investment company advertisements, 3-5 Leveraged ETFs, 6-23–6-24, 10-8–10-9
investment company rankings, 3-9–3-10 liabilities, current, 10-15–10-16
investment company sales literature, 3-7–3- life annuity, 7-7
8 last survivor, 7-7
 unit refund, 7-7 market sentiment, 10-14
Life-Cycle Funds, 6-8 Markups/Markdowns, 11-2
life insurance companies, 3-11 material events, 3-13
life insurance policies, 7-5, 7-14 maturity date, 4-10–5-1, 6-7, 9-10
lifetime payments, 7-7 mediation, 12-7–12-8
LIFO (last-in, first-out), 7-9, 10-16 Methods of Reducing Sales Charges, 6-14
limited authorization, 2-7 mid-cap stocks, 6-9
limited partnerships, 1-4, 1-14, 9-11 minor’s account, 6-16
Limited POA, 2-8 Modern Portfolio Theory. See MPT
Liquid Net Worth, 1-9, 7-11 Momentum Investing, 10-10
customer’s, 1-9 money-market funds, 1-9, 1-12, 3-9, 6-8–6-
load, 3-6, 3-9, 3-13, 6-13 9, 8-4, 10-4, 10-6–10-8
back-end, 6-11, 6-13 money-market securities, 5-5–5-6, 10-8
front-end, 6-11–6-14 money purchase plans, 8-4
Local Government Investment Pools Moody’s Investors Service, 9-12
(LGIPs), 7-16 Moody’s issue credit ratings for commercial
Lock-Up Agreements and Legends, 4-9 paper, 5-5
London Stock Exchange, 10-13 MORC (Market Operations Review
long-term holding periods, 5-15 Committee), 12-4
long-term liabilities, 10-15–10-17 Morningstar, 3-9
mortality guarantee, 7-5
Mortality Risk, 7-5
M Mortgage Bonds, 5-3
MPT (Modern Portfolio Theory), 10-10–10-
maintenance, 1-14, 6-12, 9-5, 12-2 11, 10-13
Major Market Index, 10-13 MSRB (Municipal Securities Rulemaking
management companies, 6-1–6-2, 6-22 Board), 3-12–3-13, 4-9, 9-5
closed-end, 6-22 MSRB’s Electronic Municipal Market
open-end, 6-1, 6-22 Access, 3-13
management fee, 6-5, 6-12, 6-22, 7-5 Multiple Class/Two-Tier Funds, 3-10
margin, 1-9, 1-15, 2-5, 6-5, 6-23, 10-8, 11- municipal bonds, 1-5, 1-13, 3-13, 4-9–4-10,
5–11-6 5-14, 6-7, 9-14, 10-1, 11-9
margin accounts, 1-13, 2-1, 2-4, 2-10, 2-15, municipal fund securities, 3-12–3-14, 6-24–
11-9, 12-1 8-1
marginal rate, 1-3 municipal offerings, 4-10
margin trading, 1-15, 2-5 municipal securities, 2-15, 3-12, 3-14, 4-6,
Market and economic data services, 9-2 4-9, 8-1, 11-4, 11-8–11-9
municipal securities broker, 3-14
market letters, 3-3, 3-12 Municipal Securities Disclosure, 3-12
market maker, 11-2, 11-4–11-5, 11-7 Municipal Securities Principal, 2-15, 3-12,
designated, 11-3 7-16
registered, 3-5, 11-5 Municipal Securities Rulemaking Board.
market manipulation, 11-7, 12-2 See MSRB
Market Operations Review Committee mutual fund dividends, 6-20
(MORC), 12-4 mutual funds, 1-12, 2-15–3-1, 3-4–3-6, 3-
market risk, 6-6, 9-9, 10-13 10–3-11, 6-1–6-4, 6-6, 6-10–6-12, 6-
 14–6-18, 6-20–6-24, 7-4, 7-11–7-12, 7-
15, 8-7–9-2, 9-8–9-9, 10-8 O
mutual fund share classes, 9-1
Mutual Fund Taxation, 6-19 offering price, 3-12, 4-3, 6-15
mutual fund volatility ratings, 3-10 final, 4-4
public, 4-3, 4-6, 6-4, 6-10–6-11
N Office of Foreign Assets Control (OFAC),
2-11
official statement, 3-12–3-14, 4-10, 7-16
Nasdaq, 6-22–6-23, 10-13, 11-1, 11-4, 11-6, preliminary, 3-12
12-3–12-4 Official Statement Summary, 3-12
Nasdaq Composite Index, 10-13 online trading accounts, 11-1
Nasdaq-listed securities, 10-13 Open-End Funds, 6-22
National Adjudicatory Council (NAC), 12-5 opening customer accounts, 1-16, 2-15
National Arbitration Committee, 12-7 Operating expenses, 6-3
National Securities Clearing Corporation’s optimal portfolios, 10-11
Automated Customer Account Transfer, constructing, 10-1, 10-11
9-8 Options Trading, 2-5
National Uniform Practice Committee, 11-9 option trades, 11-8–11-9
natural person, 2-3, 5-1 Order Entry, 11-1
NAV Order of Liquidation, 5-4
calculated, 6-10, 6-22 order ticket, 2-8, 5-14, 11-1, 11-5–11-6
current, 6-20 ordinary income, 1-3, 1-5–1-6, 5-15, 6-20,
fund’s, 6-3, 6-19 7-9, 8-4–8-5
Negotiable CDs, 5-6, 6-9 taxable, 7-9
Negotiable Certificates, 5-5–5-6 OSJ, 7-11, 12-4
negotiated offerings, 3-12 OTC Bulletin Board (OTCBB), 11-1, 11-6
net assets, 6-12 OTC Equity Securities, 12-2–12-4
annual, 6-12 OTC market, 11-1
fund’s average, 6-13 outcry auction process, open, 11-3
total, 6-10, 7-4 over-the-counter, 11-1, 11-4
Netting Gains and Losses, 5-15
Net Worth, 1-7, 1-9, 10-14 P
new account form, 2-1–2-2, 2-4, 2-7, 2-12,
9-3–9-4, 12-6 Paper Settlement, 11-10
New York Stock Exchange, 10-12–10-13, partners, 2-3, 2-6, 3-5, 4-7
11-3 general, 4-9
New York Stock Exchange Composite partnership, 2-3, 2-6, 4-8
Index, 10-12 Partnership Accounts, 2-6
Nominee Accounts, 2-4 PATRIOT Act, 2-1, 2-10
non-exchange trading systems, 11-5 payout options, 6-18, 7-6
Non-investment-grade, 6-9 Payroll Deduction Plans, 8-7
Non-qualified retirement plans, 8-6 Pension Plan, 1-8, 8-1
Non-Transferable Assets, 9-8 qualified, 8-1
NYSE Composite Index, 10-12 Performance Indicators, 3-13
NYSE stocks, 10-12 Performance Information Disclosures, 3-6
periodic payment plan, 6-17 purchasing power, 1-12–1-13, 5-7, 9-10, 10-
Pink Marketplace, 11-1 6
POA, 2-7–2-8
policyholders, 3-11, 7-13–7-14 Q
variable life insurance, 7-13
Political Risk, 9-11 QQQs, 6-23
POP (public offering price), 4-3, 4-6, 6-4, 6- qualified plans, 3-1, 7-9, 8-3–8-7
10–6-11, 6-15 Qualifying Cash Dividends, 1-5
position trader, 11-4
preferred stocks, 1-12, 5-2–5-3, 6-9, 6-21–6- R
22, 9-10, 10-6, 10-15, 10-17
convertible, 5-16, 6-7, 11-7 ranking entity, 3-9
Prefiling, 4-4 rankings, 3-4, 3-9
pre-tax basis, 8-3–8-5 five-star, 3-9
Previously Opened Account, 2-14 fund-created, 3-4
price-to-earnings, 10-9 record date, 6-10
Prime Brokerage Accounts, 2-9 Recordkeeping Formats, 9-5
principals, 2-3, 5-2, 6-4, 9-4, 11-2–11-3, 11- Record Retention, 2-11
11 redemption fees, 6-18
Principal Trade, 9-1 redemptions, 6-3–6-4, 6-10–6-11, 6-17–6-
Privacy Notice, 2-12 18, 6-20, 7-11
private placement memorandum, 4-9 early, 9-1
private placements, 4-1, 4-8–4-9, 9-11 Red Flags Rule, 2-13
probate, 2-5–2-6 Registered bonds, 11-10
profit-sharing plans, 6-16, 8-3 registered investment advisers (RIAs), 1-16,
Progressive tax, 1-5 2-10, 2-12, 3-1–3-2
Prohibited Sales Practices, 6-19 Registered Options Principal, 2-15
Prohibited Trading Practices, 11-7 registration statement, 4-3–4-6
Proprietorship Accounts, 2-6 amended, 4-4
prospectus, 3-5–3-7, 3-10, 4-3–4-6, 4-9–4- issuer’s, 4-4
10, 6-3–6-4, 6-11–6-14, 6-16, 7-1, 7-5, regressive tax, 1-5
7-10, 7-13 regulated investment companies (RICs), 6-
current, 3-7, 6-3 19–6-20
final, 4-6 Regulation SHO, 11-6
free, 3-7 Regulation SP, 2-12–2-13
fund’s, 6-3, 6-10, 6-13 Regulatory Risk, 9-11
omitting, 3-7 Reinvested Dividends and Distributions, 6-
preliminary, 4-4, 4-6 20
statutory, 3-5 reinvestment risk, 5-6, 6-7, 9-11
Prospectus Alterations, 4-5 REIT (real estate investment trust), 1-5
prospectus delivery, 6-22, 7-3 Repurchase Agreements, 5-5–5-6
prospectus requirements, 4-6–4-7, 4-9, 5-5 Required Minimum Distributions (RMDs),
Prudent Person Standard, 2-6 8-3
public offering price. See POP Requirements and Limitations on Insiders,
public offerings, 4-1 2-13
Purchasers of options, 9-12 residual credit balances, 9-9
respondent, 12-4–12-6 S
Restricted Securities, 4-9, 11-11
retail communications, 2-15–3-5, 3-9–3-10 sales breakpoints, 6-14
video, 3-4 sales charges, 6-2–6-5, 6-10–6-15, 6-17, 6-
retail investors, 3-1–3-2, 4-5, 6-2 22, 7-5, 7-13, 8-7–9-1
retirement plans, 1-2, 1-5, 1-9, 1-13, 6-13, 7- additional, 6-19, 7-3
1, 7-16–8-7, 10-6 applicable, 6-16
employer-sponsored, 1-13, 7-13, 8-3, 8- assessed, 6-23
6, 10-6 deferred, 6-11, 7-4
individual, 8-1 higher, 6-16
qualified, 8-1, 8-3 maximum, 6-11, 6-14, 6-17, 7-5, 7-16
tax-deferred, 1-13, 8-5 new, 6-19
work-sponsored, 7-1, 10-6 paying reduced, 6-16
return, 1-7, 1-12, 4-2, 5-4, 5-6, 6-23, 7-1–7- reduced, 6-11, 6-13–6-14, 6-16–6-17
2, 7-5, 7-8, 7-10, 9-1, 9-10–9-13, 10-6, statutory maximum, 7-5
10-10–10-11, 10-14 up-front, 6-10, 6-13
absolute, 10-10 sales literature, 3-1–3-2, 3-7–3-8, 3-10
expected, 1-11, 9-11, 10-13–10-14 supplemental, 3-10
rate of, 3-11, 7-2–7-3 secondary market, 5-7, 6-22, 6-24, 11-1
real rate of, 9-10 SEC-registered investment advisers, 2-12
risk-adjusted, 10-14 Sector Funds, 6-6, 6-9
RIAs. See registered investment advisers Securities Exchange Act, 2-13, 9-2, 11-9
riders, 7-11–7-12, 7-14 self-regulatory organization (SRO), 3-1, 4-9,
life insurance, 7-14 9-5, 12-6
Rights of Accumulation (ROAs), 6-13, 6- seller’s option, 11-8
16–6-17 Selling Agreements, 7-10, 9-8
risks, 1-10–1-13, 3-6, 3-10, 4-1–4-2, 5-3–5- Selling Dividends, 6-19
4, 5-11, 5-13, 6-6–6-7, 9-1, 9-9–9-12, selling group, 4-3, 5-9
9-15–10-4, 10-6–10-7, 10-11, 10-13, selling group agreement, 4-3
11-2 settlement, 2-15, 6-10, 11-1, 11-8–11-10,
diversifiable, 10-13 12-5–12-9
event, 9-10 binding, 12-8
exchange-rate, 9-12 following, 2-15
non-diversifiable, 10-13 following regular-way, 11-9
non-systematic, 10-13 seller’s option, 11-8
prepayment, 3-10, 5-4, 5-11, 9-12 written, 12-8
systematic, 9-9–9-10, 10-13 settlement date, 2-3, 9-3–9-4, 11-7–11-9
unsystematic, 9-10 sexual harassment claims, 12-6
RMDs (Required Minimum Distributions), share classes, 3-7, 6-10, 6-13–6-14, 9-1
8-3 Shares Class Summary, 6-14
ROAs. See Rights of Accumulation short selling rules, 11-6
rollover, 7-15, 8-1–8-2 Simplified Arbitration, 12-7
Roth IRAs, 8-3, 8-6, 12-1 Social Media Sites, 3-2
Rule G-8, 9-5 Social Security number, 2-3, 2-10–2-11, 10-
Rule G-9, 9-5 5
Soft-dollars, 9-2
SPDRs, 6-23 T
Special Client Arrangements, 2-9
Special Settlement, 11-8 taxable equivalent yield calculation, 9-14
Special Tax Treatment for Qualifying Cash Taxation of Bond Interest, 5-14
Dividends, 1-5 Taxation of Contributions, 8-5
Specified Adults, 9-5–9-6 Taxation of Distributions, 8-6
SRO (self-regulatory organization), 3-1, 4-9, Taxation of Income and Trading Events
9-5, 12-6 During, 8-6
Standard & Poor, 5-5, 9-12, 10-12 Taxation of Investment Income, 1-5
Statement of Additional Information (SAI), Taxation of Life Insurance Policies, 7-14
6-4 Taxation of Retirement Plans, 8-5
state registration requirements, 9-4 Taxation of Variable Annuities, 7-9
state securities registration, 4-5 tax-deferred basis, 1-13, 7-1, 7-4, 7-9–7-10,
statutory discrimination, 12-6 7-13, 7-15, 8-4, 8-6, 10-6
stock certificate, 11-8, 11-10 filed IRS, 1-16
stock dividend, 1-4 taxpayer identification number (TIN), 2-3
stockholders, 1-4, 5-1–5-4, 10-14–10-15, tax rate, 1-3, 5-15
10-17 federal, 1-4
common, 5-2, 5-4 marginal, 1-3–1-4
preferred, 5-2, 5-4 person’s, 1-3
Stockholders’ Equity, 10-14 Tax Relief Reconciliation Act, 7-15
stock options, 1-9 tax-sheltered annuities (TSAs), 8-5
stocks, 1-8–1-10, 2-8, 2-14, 4-1–4-2, 5-2–5- TDAs (tax-deferred annuities), 8-5
3, 5-12–5-16, 6-6, 6-8–6-10, 8-7, 9-9– telemarketing scripts, 3-12
9-15, 10-2–10-3, 10-11–10-13, 10-17, Temporary Hold, 9-6–9-7
11-2–11-4, 11-7–11-8 term life, 7-2
stock split, 12-3 term policies, 3-12
stock transfer, 2-10 Territory/Possession Bonds, 5-14
subaccounts, 7-3–7-5, 7-10, 7-13–7-14 third party, 1-14, 2-4, 2-7, 2-12, 4-3, 9-4, 9-
associated, 7-13 8, 10-9, 11-7
underlying, 3-12, 7-2 authorized, 2-7–2-8
Subordinated creditors, 5-4 independent, 3-10
suitability, 1-11, 1-14–1-15, 2-1, 4-3, 6-1, 6- unaffiliated, 2-12–2-13
14, 10-1–10-2, 11-6 time horizon, 1-10, 10-4, 10-11
summary/abstract, 3-12 investor’s, 1-10, 10-4
surrender charges, 7-5, 7-12, 9-1 Time/Price Exception, 2-8
potential, 7-11 TIN (taxpayer identification number), 2-3
significant, 3-11, 7-1 Top-Down Analysis, 10-10
Survivor Life Annuity, 7-7 Total Current Assets, 10-15
Switching shares, 6-21 Total Current Liabilities, 10-15
syndicate, 4-2–4-3 total liabilities, 1-7–1-8, 6-10, 10-14–10-15
underwriting, 4-2 trade confirmations, 9-3
syndicate letter, 4-2 trade corrections, 12-1
syndicate manager, 4-3 trade date, 2-15, 11-6, 11-8
syndicate members, 4-2–4-3, 4-5 Trade Reporting Errors, 12-1
Trade/Settlement, 11-9
Trading Ahead, 11-7 managing, 4-3–4-4
Trading Authorizations, 2-7 best-efforts, 4-2
granted third-party, 2-4 Underwriting Commitments, 4-2
limited, 2-7 Underwriting Documentation, 4-10
third-party, 2-10 unexpected news events, 6-23
written, 2-7 Uniform Gifts/Uniform Transfers, 1-12
trading venues, 11-1 Uniform Practice Committee (UPC), 12-4
dealer-to-dealer, 11-4 Uniform Prudent Investor Act (UPIA), 2-6
electronic, 11-1 Uniform Securities Act, 4-5
traditional physical, 11-1 Unincorporated Association Accounts, 2-6
Trailing commissions, 6-12 unit investment trusts. See UITs
transaction costs, 2-10, 5-14 Unit Refund Life, 7-7
transfer agent, 6-4–6-5, 6-12, 9-8, 11-10–11- unsecured bonds, 5-4
11 UPC (Uniform Practice Committee), 12-4
Transfer of Customer Accounts, 9-9 Updating Account Information, 9-4
Treasury Bills, 5-7–5-8 Updating Form U4, 12-8
Treasury Bonds, 5-7–5-8 UPIA (Uniform Prudent Investor Act), 2-6
Treasury Cash Management Bills, 5-7
Treasury Department Office of Foreign
Assets Control, 2-11 V
Treasury Inflation-Protected Securities, 5-7–
5-8 value analysis method, 10-9
Treasury securities, 1-7, 5-4, 5-7, 5-9, 6-7, variable annuities, 2-15, 3-11, 7-1–7-5, 7-9–
10-6 7-11, 7-13–7-14, 8-7, 9-2, 9-10, 10-6
interest-bearing, 5-7 deferred, 7-11
Treasury STRIPS, 5-9 non-qualified, 7-9, 7-13
trust, 2-6, 4-8, 5-4, 6-4, 6-22, 8-7 variable life insurance policies, 3-11–3-12,
irrevocable life insurance, 7-14 7-10, 7-13–7-14
real estate investment, 1-5 variable universal life (VUL), 7-14
unit investment, 2-15, 3-4, 6-1, 6-21 Verification of Client Information, 2-12
trust account, 2-6 Verification of Investor Accreditation of
trusted contact person, 9-6–9-7 Sophistication, 1-16
trustee, 2-6, 2-13, 5-3, 6-16, 6-21, 8-1 vesting, 8-3–8-4, 8-6
TSAs (tax-sheltered annuities), 8-5 volatility ratings, 3-4
T-STRIPS, 5-7 bond fund, 3-10
two-sided quote, 11-2 VUL (variable universal life), 7-14

W
U
wash sale rule, 5-15–5-16
UGMA account, 10-8–10-9 weighted average, 10-14
UITs (unit investment trusts), 2-15, 3-4, 6-1, willing, 6-9, 10-6, 10-8, 11-2, 11-5, 12-8
6-21–6-22 Wilshire Associates Equity Index, 10-13
Underwriter/Investment Banker, 3-7, 3-12– withdrawals, 1-5, 2-7–2-8, 3-11, 7-1, 7-9, 7-
3-13, 4-1–4-6, 4-10, 6-4–6-5, 6-12, 7- 15, 8-2–8-3, 8-5–8-7
10 early, 3-11, 8-2
 lump-sum, 7-9
qualified, 1-2, 7-15
random, 7-6, 7-9
subsequent, 7-9
tax-free, 7-9
work-sponsored plans, 8-1
qualified, 7-12
Writer Short, 5-12
written consent, 2-14, 9-4
prior, 2-8, 2-14
Written customer complaints, 12-9
WSP (written supervisory procedures), 2-13,
2-15

yield, 3-9, 5-8, 9-13

bond’s, 9-13
current, 9-12–9-13
high dividend, 10-9
higher, 5-4, 5-8
nominal, 9-13
standardized, 3-9
taxable bond, 9-14
Yield-to-Maturity (YTM), 9-13–9-14