Securities Industry

Essentials (SIE)
General Knowledge Examination
Study Manual – 1st Edition

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 Table of Contents

INTRODUCTION
CHAPTER 1 OVERVIEW OF MARKET PARTICIPANTS AND MARKET STRUCTURE
Market Participants ................................................................................1-1
What’s an Issuer? .............................................................................1-1
What’s a Broker-Dealer? ..................................................................1-2
What’s a Market Maker? ...................................................................1-3
What’s a Trader? ..............................................................................1-3
What’s an Investment Adviser? ........................................................1-3
Types of Investors..................................................................................1-4
Retail Investors.................................................................................1-4
Accredited Investors .........................................................................1-4
Institutional Investors ........................................................................1-5
Market Structure ....................................................................................1-5
Primary Market .................................................................................1-5
Secondary Market ............................................................................1-6
Other Execution Methods and Venues .............................................1-7
Clearing and Settlement–An Overview...................................................1-8
The Depository Trust & Clearing Corporation (DTCC) ......................1-8
Processing the Trade – Clearing and Introducing Firms ...................1-8
Introducing Firms – Fully Disclosed Versus Omnibus Accounts .......1-9
Other Customers of Clearing Firms ..................................................1-10
Clearing Options Contracts...............................................................1-11
Other Entities that Keep Markets Running Smoothly .............................1-12
Conclusion........................................................................................1-12

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CHAPTER 2 OVERVIEW OF REGULATION

Regulation ..............................................................................................2-1
Federal Regulation ...........................................................................2-1
Other Federal Regulators .................................................................2-1
SRO Regulation ...............................................................................2-2
State (Blue-Sky) Regulation .............................................................2-2
Firm (In-House) Rules ......................................................................2-3
Why Take the SIE Exam? ................................................................2-3
Federal Regulation – The Acts ...............................................................2-4
The Securities Act of 1933................................................................2-4
The Securities Exchange Act of 1934 ...............................................2-4
The Maloney Act of 1938 ..................................................................2-4
The Investment Company Act of 1940..............................................2-5
The Investment Advisers Act of 1940 ...............................................2-5
The Securities Investor Protection Act of 1970 (SIPA)......................2-5
The Employee Retirement Income Security Act of 1974 (ERISA).....2-7
The Securities Acts Amendments of 1975 ........................................2-7
The Insider Trading and
Securities Fraud Enforcement Act of 1988 .....................................2-7
The Penny Stock Reform Act of 1990...............................................2-7
The Federal Telephone Consumer Protection Act of 1991 ...............2-8
The USA PATRIOT Act of 2001 .......................................................2-8
Self-Regulatory Organizations ...............................................................2-10
FINRA ..............................................................................................2-10
The Municipal Securities Rulemaking Board (MSRB) .......................2-10
Firm Specific Rules ................................................................................2-11
Internal Compliance..........................................................................2-11
The Importance of Understanding Regulation ..................................2-12
Conclusion........................................................................................2-12

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CHAPTER 3 EQUITY SECURITIES

The Corporation – Equity Securities .......................................................3-1
Corporate Organization ....................................................................3-1
Raising Capital – Financing the Corporation.....................................3-1
Different Types of Equity Securities ..................................................3-2
Common Stock ......................................................................................3-2
Rights of Common Shareholders ......................................................3-3
Rule 144 ...........................................................................................3-5
Classification of Stocks ..........................................................................3-6
Blue-Chip Stocks ..............................................................................3-6
Growth Stocks ..................................................................................3-6
Defensive Stocks ..............................................................................3-6
Income Stocks ..................................................................................3-6
Cyclical Stocks .................................................................................3-6
American Depository Receipts (ADRs) .............................................3-7
Preferred Stock ......................................................................................3-7
Cumulative Preferred Stock ..............................................................3-7
Non-Cumulative Preferred Stock ......................................................3-8
Participating Preferred Stock ............................................................3-8
Callable Preferred Stock ...................................................................3-9
Convertible Preferred Stock..............................................................3-9
Rights and Warrants – Derivatives Securities ........................................3-10
Preemptive Rights ............................................................................3-10
Warrants ...........................................................................................3-10
Miscellaneous Equity Rules ...................................................................3-11
FINRA Rule 2261 – Disclosure of Financial Condition ......................3-11
FINRA Rule 2262 – Disclosure of Control Relationship with Issuer ..3-11
SEC Rule 10b-18 – Purchase of Certain Equity
Securities by the Issuer ..................................................................3-12

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Conclusion........................................................................................3-12

CHAPTER 4 INTRODUCTION TO DEBT INSTRUMENTS

Introduction to Debt Instruments ............................................................4-1
Basic Bond Characteristics ...............................................................4-1
Why Bond Prices Fluctuate from Par .....................................................4-3
Discounts and Premiums .......................................................................4-4
Bond Pricing...........................................................................................4-5
Prices and Yields: An Inverse Relationship ............................................4-6
Calculating Bond Yields ....................................................................4-7
Redeeming Bonds Prior to Maturity .......................................................4-7
Call Provisions ..................................................................................4-7
Convertible Bonds ............................................................................4-8
Conclusion........................................................................................4-11

CHAPTER 5 TYPES OF DEBT INSTRUMENTS

Types of Debt Instruments .....................................................................5-1
Treasury Securities...........................................................................5-1
Treasury Notes (T-Notes) and Treasury Bonds (T-Bonds) ...............5-1
Treasury Inflation – Protected Securities (TIPS) ...............................5-2
Non-Interest-Bearing Securities .............................................................5-2
Treasury Bills (T-Bills) ......................................................................5-2
Stripped Securities .................................................................................5-3
Treasury STRIPS .............................................................................5-3
Cash Management Bills (CMBs).......................................................5-3
U.S. Treasury Securities Auctions – The Primary Market.......................5-4
Agency Securities ..................................................................................5-4
Federal Agencies .............................................................................5-5
Government-Sponsored Enterprises ................................................5-5
Mortgage-Backed Securities ..................................................................5-5

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Pass-Through Certificates ................................................................5-5

Federal Home Loan Mortgage Corporation (FHLMC) .......................5-6
Federal National Mortgage Association (FNMA)...............................5-6
Government National Mortgage Association (GNMA).......................5-6
Municipal Bonds .....................................................................................5-7
Types of Municipal Bonds ......................................................................5-7
General Obligation (GO) Bonds........................................................5-7
Revenue Bonds ................................................................................5-8
Types of Revenue Bonds .................................................................5-8
Municipal Notes ................................................................................5-10
Ratings for Municipal Notes ..............................................................5-11
Other Municipal Securities .....................................................................5-11
Auction Rate Securities ....................................................................5-11
Variable Rate Demand Obligations (VRDOs) ...................................5-12
The Primary Market for Municipal Bonds ...............................................5-12
Issuing GO Bonds ............................................................................5-12
Issuing Revenue Bonds ....................................................................5-12
New Issue Underwritings ..................................................................5-13
Forming a Municipal Syndicate.........................................................5-13
Corporate Bonds ....................................................................................5-14
Types of Corporate Bonds .....................................................................5-14
Secured Bonds .................................................................................5-14
Unsecured Bonds .............................................................................5-15
Other Types of Corporate Bonds ...........................................................5-16
Income Bonds ..................................................................................5-16
Eurodollar Bonds, Yankee Bonds, and Eurobonds ...........................5-16
The Money-Market .................................................................................5-16
Types of Money-Market Securities ...................................................5-17
Bond Taxation Summary ..................................................................5-19
Conclusion........................................................................................5-19

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CHAPTER 6 INVESTMENT RETURNS

Return on Equity Investments ................................................................6-1
Dividends..........................................................................................6-1
Calculating Current Yield (Dividend Yield) ........................................6-3
Return on Bond Investments ............................................................6-3
Prices and Yields – An Inverse Relationship ..........................................6-4
Calculating Bond Yields ....................................................................6-4
Call Provisions ..................................................................................6-7
Cost Basis, Capital Events, and Return of Capital .................................6-8
Measuring Return ..................................................................................6-9
Total Return......................................................................................6-9
Average and Indexes........................................................................6-10
Conclusion........................................................................................6-11

CHAPTER 7 PACKAGED PRODUCTS

Types of Investment Companies ............................................................7-1
Open-End Management Companies (Mutual Funds)........................7-1
Additional Disclosure: The Statement of
Additional Information (SAI) ............................................................7-3
The Organization of a Mutual Fund ..................................................7-4
Categories of Mutual Funds..............................................................7-5
Buying and Selling Mutual Fund Shares ................................................7-6
Net Asset Value ................................................................................7-7
Fees and Charges ............................................................................7-8
Classes of Shares ............................................................................7-9
Methods of Reducing Sales Charges ...............................................7-10
Dollar Cost Averaging (DCA) ............................................................7-13
Redeeming Shares ...........................................................................7-13
Systematic Withdrawal Plans ...........................................................7-13
Prohibited Sales Practices ................................................................7-14
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Other Types of Investment Companies ..................................................7-15

Face-Amount Certificate Companies ................................................7-15
Unit Investment Trusts......................................................................7-15
Closed-End Investment Companies .................................................7-15
Conclusion........................................................................................7-16

CHAPTER 8 VARIABLE CONTRACTS AND MUNICIPAL FUND SECURITIES

Annuities ................................................................................................8-1
Fixed versus Variable Annuities .............................................................8-1
Variable Annuities.............................................................................8-1
The Life of a Variable Annuity ................................................................8-3
Accumulation Period.........................................................................8-3
Annuity Period ..................................................................................8-4
Annuity Charges and Expenses .......................................................8-5
Qualified Annuities .................................................................................8-6
Equity-Indexed Contracts (EICs) ............................................................8-7
Variable Annuities–Suitability and Compliance Issues ...........................8-7
Municipal Fund Securities ......................................................................8-9
Local Government Investment Pools ................................................8-9
Section 529 College Savings Plans ..................................................8-9
Section 529A Plans ..........................................................................8-11
Conclusion........................................................................................8-12

CHAPTER 9 ALTERNATIVE INVESTMENTS

Other Types of Investment Companies ..................................................9-1
Exchange-Traded Funds (ETFs) ......................................................9-1
Exchange-Traded Notes (ETNs) ......................................................9-2
Other Types of Packaged Products .......................................................9-3
Hedge Funds ....................................................................................9-3
Private Equity Funds ........................................................................9-3

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Real Estate Investment Trusts (REITs) ..................................................9-4

Regulation ........................................................................................9-4
Investment Attributes ........................................................................9-4
Direct Participation Programs (DPPs) ....................................................9-5
Advantages of Limited Partnerships .................................................9-5
Disadvantages of Limited Partnerships ............................................9-6
General Partners ..............................................................................9-6
Limited Partners ...............................................................................9-6
DPP Offering Practices.....................................................................9-7
Tax Treatment of Individual Partners ................................................9-7
Types of Limited Partnerships ..........................................................9-8
Risk Summary ..................................................................................9-9
Conclusion........................................................................................9-10

CHAPTER 10 OPTION FUNDAMENTALS

Options ..................................................................................................10-1
Equity Options –Terminology .................................................................10-1
Buyers and Sellers ...........................................................................10-1
Types of Options ..............................................................................10-2
Components of an Option .................................................................10-2
Intrinsic Value and Time Value .........................................................10-3
Breakeven ........................................................................................10-5
Speculation versus Hedging .............................................................10-6
Option Events ........................................................................................10-6
Options Clearing Corporation (OCC)......................................................10-8
Options Disclosure Document ..........................................................10-9
Index Options ...................................................................................10-9
Hedging with Options .......................................................................10-9
Covered and Uncovered Option Positions ........................................10-9
Conclusion........................................................................................10-10

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CHAPTER 11 OFFERINGS
Capital Formation ...................................................................................11-1
Offering Securities to Investors.........................................................11-1
The Role of an Underwriter/Investment Banker......................................11-2
Underwriting Commitments ..............................................................11-2
Market-Out Clause ...........................................................................11-4
Shelf Registration .............................................................................11-4
Distribution of Securities ........................................................................11-4
Syndicate..........................................................................................11-4
Selling Group....................................................................................11-4
Determining the Public Offering Price (POP) ....................................11-4
Underwriting Spread .........................................................................11-5
Securities Act of 1933 – Registration .....................................................11-6
The Registration Process .................................................................11-6
The Pre-Registration (Pre-Filling) Period ..........................................11-7
The Cooling-Off Period .....................................................................11-8
The Post-Effective Period .................................................................11-9
Disclosure Requirements .......................................................................11-9
Aftermarket Prospectus Delivery Requirement .................................11-9
Types of Prospectuses .....................................................................11-10
Exempt Securities ..................................................................................11-11
Exempt Offerings ...................................................................................11-12
Regulation D.....................................................................................11-12
Rule 144 ...........................................................................................11-13
Rule 144A.........................................................................................11-14
Rule 145 ...........................................................................................11-14
Rule 147 and 147A ...........................................................................11-15
The Primary Market for Municipal Bonds ...............................................11-15
Issuing General Obligation (GO) Bonds ...........................................11-16

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Issuing Revenue Bonds ....................................................................11-16

New Issue Underwritings ..................................................................11-16
Forming a Syndicate ..............................................................................11-17
Underwriting Documentation ..................................................................11-17
Notice of Sale ...................................................................................11-17
Legal Opinion ...................................................................................11-17
Official Statement .............................................................................11-17
Official Statement Summary .............................................................11-18
New Issue Confirmations ..................................................................11-19
Conclusion........................................................................................11-19

CHAPTER 12 ORDERS AND TRADING STRATEGIES

Trade Capacity – How Broker-Dealers Act.............................................12-1
Fair Prices and Commissions – The 5% Markup Policy....................12-2
Discretionary Order/Discretion Not Exercised...................................12-4
Types of Transactions ............................................................................12-4
Types of Orders .....................................................................................12-5
Market Orders ..................................................................................12-5
Limit Orders ......................................................................................12-5
Stop (Loss) Orders ...........................................................................12-6
Stop-Limit Order ...............................................................................12-7
Order Qualifiers ................................................................................12-8
Conclusion........................................................................................12-9

CHAPTER 13 SETTLEMENT AND CORPORATE ACTIONS

Trading, Clearing, and Settlement..........................................................13-1
Settlement Dates ..............................................................................13-1
Customer Payment Versus Settlement .............................................13-2
Settlement Methods..........................................................................13-3
Delivery of Physical Securities ...............................................................13-4

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Paper Settlement ..............................................................................13-4

Corporate Actions ..................................................................................13-5
Corporate Actions in Equities ...........................................................13-5
Other Corporate Actions ...................................................................13-7
Forwarding Official Communications ......................................................13-8
Conclusion........................................................................................13-10

CHAPTER 14 CUSTOMER ACCOUNTS

Account Types and Characteristics ........................................................14-1
Margin Accounts ...............................................................................14-1
Options Accounts .............................................................................14-2
Discretionary Accounts .....................................................................14-2
Fee-Based versus Commission Based Accounts .............................14-4
Educational Accounts .......................................................................14-4
Coverdell Education Savings Account (ESA)....................................14-4
Section 529 College Savings Plans ..................................................14-5
Customer Account Registrations ............................................................14-5
Individual Account ............................................................................14-5
Joint Account ....................................................................................14-5
Corporate/Institutional Accounts .......................................................14-6
Partnership Accounts .......................................................................14-6
Trust Accounts .................................................................................14-6
Custodial Accounts ...........................................................................14-7
Retirement Accounts ..............................................................................14-8
Traditional Individual Retirement Accounts (IRAs) ............................14-8
Roth IRAs .........................................................................................14-10
Qualified Retirement Plans ....................................................................14-11
Employee Retirement Income Security Act (ERISA).........................14-11
Taxation of Retirement Plans ...........................................................14-12
Types of Plans..................................................................................14-12

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Conclusion........................................................................................14-13

CHAPTER 15 COMPLIANCE CONSIDERATIONS

New Account Documentation .................................................................15-1
Required Information ........................................................................15-1
SEC Recordkeeping Requirements ..................................................15-2
Know Your Customer Suitability .............................................................15-3
Suitability ..........................................................................................15-3
Anti-Money Laundering and the USA PATRIOT Act ..............................15-5
FinCEN’s Required Reports .............................................................15-5
Mandatory AML Compliance Programs ............................................15-6
SEC Regulation SP ................................................................................15-8
Identity Theft Prevention – FTC Red Flags .......................................15-9
Client Notifications ............................................................................15-9
Regulation of Communications ..............................................................15-11
Correspondence ...............................................................................15-11
Institutional Communications ............................................................15-11
Retail Communications .....................................................................15-12
Telemarketing – An Alternative Communication Method ........................15-12
National Do Not Call List ..................................................................15-13
Safekeeping of Customer Funds and Securities ....................................15-14
The Customer Protection Rule .........................................................15-14
Customer Free Credit Balances .......................................................15-14
FINRA Rules ....................................................................................15-15
Fidelity Bonds ...................................................................................15-15
Business Continuity Plan (BCP) .............................................................15-15
Books and Records ................................................................................15-16
Conclusion........................................................................................15-16

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CHAPTER 16 PROHIBITED ACTIVITIES

Manipulation...........................................................................................16-1
Misrepresentations ...........................................................................16-1
Regulation M ....................................................................................16-1
Market Rumors .................................................................................16-2
Front-Running ..................................................................................16-2
Trading Ahead of a Research Report ...............................................16-3
Excessive Trading Activity (Churning) ..............................................16-3
Marking-the-Close/Marking-the-Opening ..........................................16-4
Backing Away ...................................................................................16-4
Free Riding .......................................................................................16-4
Prohibited Trading Practices and Other Trading Rules ..........................16-5
Anti-Intimidation/Coordination Interpretation .....................................16-5
Payments to Influence the Market Price ...........................................16-5
Best Execution .................................................................................16-5
Time of Trade Disclosure (MSRB Rule G-47) ...................................16-6
Interpositioning .................................................................................16-6
Trading Ahead of Customer Orders
(Limit Order Protection Rule) ..........................................................16-7
Quoting a Security in Multiple Mediums............................................16-7
Mutual Fund Trading Rules ..............................................................16-7
Insider Trading .................................................................................16-8
Other Prohibited Activities ......................................................................16-10
The New Issue Rule .........................................................................16-10
Sharing in Accounts and Guarantees ...............................................16-12
Borrowing and Lending Practices with Customers............................16-13
Financial Exploitation of Specified Adults – FINRA Rule 2165..........16-13
Accounts at Other Broker-Dealers and Financial Institutions ............16-15
Payments to Unregistered Person ....................................................16-16

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Forgery .............................................................................................16-16
Books and Records ................................................................................16-17
Recordkeeping Formats ...................................................................16-17
Conclusion........................................................................................16-17

CHAPTER 17 SRO REQUIREMENTS FOR ASSOCIATED PERSONS

SIE Exam –The First Step to Registration ..............................................17-1
Associated Persons ..........................................................................17-1
Activities of Non-Registered Persons ...............................................17-2
Registered Representative Designations ..........................................17-3
Principal Designations ......................................................................17-4
Supervision of Registered Representatives ...........................................17-5
Registration of Representatives of Principals .........................................17-6
Form U4 and the Central Registration Depository ............................17-6
Statutory Disqualification ..................................................................17-7
Background Check .................................................................................17-8
Fingerprinting Requirement ....................................................................17-8
State Registration (Blue-Sky Rules) .......................................................17-9
Continuing Education .......................................................................17-9
Regulatory Element ..........................................................................17-9
Firm Element ....................................................................................17-10
Conclusion........................................................................................17-10

CHAPTER 18 EMPLOYEE CONDUCT AND REPORTABLE EVENTS

Employee Conduct .................................................................................18-1
Registration of Representatives and Form U4 ..................................18-1
The Central Registration Depository .................................................18-3
Updating Form U4 ..................................................................................18-3
Form U5 ...........................................................................................18-3
Complaints .......................................................................................18-5

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Red Flags .........................................................................................18-6

Personal Activities of Employees ...........................................................18-7
Outside Business Activities...............................................................18-7
Private Securities Transactions ........................................................18-7
Influencing or Rewarding Employees of Others
(The Gift Limit)................................................................................18-8
MSRB Political Contribution Rule (G-37)................................................18-9
Conclusion........................................................................................18-11

CHAPTER 19 ECONOMIC FACTORS

Economics .............................................................................................19-1
Measuring National Output ...............................................................19-1
Inflation .............................................................................................19-1
Deflation ...........................................................................................19-2
Measurements of Economic Activity ......................................................19-3
The Business Cycle ..........................................................................19-3
Business Cycle Indicators ................................................................19-4
The Effect of the Business Cycle on Securities Markets ...................19-5
Classifications of Common Stocks ...................................................19-6
Influencing the Economy – Monetary and Fiscal Policy..........................19-8
Keynesian Theory.............................................................................19-8
Monetary Theory ..............................................................................19-8
Tools of the Federal Reserve Board ......................................................19-10
Reserve Requirements .....................................................................19-10
Discount Window ..............................................................................19-10
Federal Funds ..................................................................................19-11
Open Market Operations ..................................................................19-11
Margin Requirements .......................................................................19-13
Moral Suasion ..................................................................................19-13
Effects of the FRB’s Activities ...........................................................19-13

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International Economic Factors ..............................................................19-14

Exchange Rates ...............................................................................19-14
Balance of Payments........................................................................19-15
Financial Statements..............................................................................19-15
The Balance Sheet ...........................................................................19-15
Components of the Balance Sheet – Assets.....................................19-17
The Liabilities Section.......................................................................19-17
The Stockholders’ Equity Section .....................................................19-17
The Income Statement .....................................................................19-18
Components of the Income Statement .............................................19-18
Conclusion........................................................................................19-19

CHAPTER 20 INVESTMENT RISKS

Investment Risks....................................................................................20-1
Systematic (Non-Diversifiable) Risk..................................................20-1
Attempting to Control Risk Through Diversification ................................20-5
Buy-and-Hold ...................................................................................20-5
Portfolio Rebalancing .......................................................................20-5
Indexing ............................................................................................20-6
Active Strategies ....................................................................................20-6
Sector Rotation.................................................................................20-6
Dollar Cost Averaging ............................................................................20-7
Hedging .................................................................................................20-7
Equity Options ..................................................................................20-7
Index Options ...................................................................................20-7
Index Options ...................................................................................20-7
Currency Options..............................................................................20-7
Conclusion........................................................................................20-8

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 INTRODUCTION

Introduction
About the Securities Industry Essentials (SIE) Examination
The SIE Exam is an introductory-level exam that assesses a candidate’s knowledge of basic
securities industry information including concepts fundamental to working in the industry, such as
types of products and their risks; the structure of the securities industry markets, regulatory
agencies and their functions; and prohibited practices.

The SIE Exam is a 75 multiple-choice question exam with an additional 10 experimental questions
included. These experimental questions don’t count for or against a person’s score. Candidates are
given 1.75 hours to complete the exam and the minimum required passing score is 70%. The
questions are divided into the following four sections:

Corresponding STC
Sections Number of Questions
Study Manual Chapter
1 Knowledge of Capital Markets 12 1, 2, 11, 19
2 Understanding Products and Their Risks 33 3, 4, 5, 7, 8, 9, 10, 20
Understanding Trading, Customer Accounts,
3 23 6, 12, 13, 14, 15, 16
and Prohibited Activities
4 Overview of Regulatory Framework 7 17, 18
Total: 75

 The SIE Exam is open to any person who is age 18 or older, including students and prospective
candidates who are interested in demonstrating basic industry knowledge to potential
employers.
 Association with a firm is not required, and individuals are permitted to take the exam before or
after associating with a firm.
 Essentials exam results are valid for four years.

Before candidates test, we recommend that they visit our website at www.stcusa.com to see if there
have been any changes or supplemental materials created for this exam.

Course Materials
STC’s Securities Industry Essentials (SIE) Examination Training Program consists of the following
materials:
1. 20-chapter study manual
2. Final examinations with explanations

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INTRODUCTION

Study Manual and Exam Breakdown

The study manual, which represents the first phase of your exam preparation, consists of 20
chapters that cover the topics tested on the SIE Examination. After reading each chapter, STC
strongly suggests that students go to their my.stcusa.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.

Final Examinations
The final examinations and corresponding explanations represent the most important part of your test
preparation. These examinations will assist you in applying the information that you learned in the
study manual to questions that are posed in the multiple-choice format and used in the SIE Exam.

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 SIE Examination. By concentrating only on
the correct response and disregarding the explanation, you run 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.

Registering for the Examination

In order to take an examination, a candidate will need to make a test appointment. Please use the
following information to schedule an appointment and/or to learn more about examination centers:
Prometric Exam Centers
www.prometric.com/finra
(800)578-6273 (toll free)

Prometric’s website will provide the most up-to-date information regarding “Test Center Security”
and “Test Break Policies.” The exam center will provide candidates with:
 A four-function calculator
 Two dry erase boards
 A dry-erase pen

SIE 2 Copyright © Securities Training Corporation. All Rights Reserved.

 INTRODUCTION

For more information related to scheduling an exam, as well as what to expect on both the day of
your exam and after, please use the following link that is provided by FINRA:
www.finra.org/industy/qualification-exams
(800)999.6647 (toll free)

The following link provides a tutorial on the exam format:

www.finra.org/sites/default/files/external_apps/proctor_tutorial.swf.html

Standardized Test-taking Tips

As with any standardized test, you may be able to increase your score by employing good test-taking
techniques. An efficient technique will ensure an overall understanding of the question while
helping to avoid careless errors. It will also help you to stay alert throughout the entire exam. Here is
a step-by-step approach that may work well for you.
Step 1: Read the question the first time through without trying to answer it. Merely form an
understanding of what the question is about.
Step 2: Carefully read the four choices. Remember that a multiple-choice examination actually
gives you the answer. Your job is to recognize the correct choice from among the other distractions.
By keeping these choices in mind when you reread the question, you will be able to efficiently
pinpoint the important information and filter out extraneous material.
Step 3: Reread the question slowly. Stop at the end of each sentence and absorb the information.
You may have to exaggerate this in the beginning as you get used to applying the deep concentration you
need to assure that you recognize all important facts and catch misleading words or phrases (e.g.,
not, except).
Step 4: Make sure that you fully understand what the question is asking. You cannot possibly
answer a question correctly before you know what it is looking for. You may have to look back to the
question for additional facts before you are ready to actually choose your answer.
Step 5: Read each choice a second time. As you read a choice, decide whether it is a possible
answer or not. Eliminate the incorrect choices. If you can eliminate three of the four choices, you
have your answer. If you only eliminate one or two, this will help you narrow it down to your best
choices. Reconsider the remaining choices by comparing their differences and decide which answer
is more correct. Once you have made your decision, DO NOT LOOK BACK!

NOTE: For Roman numeral questions, do any elimination before trying to answer the question. The
answer will usually include only two or four choices.

It is very important that you practice your technique so that you become proficient by the time you
sit for the examination. The best place to do this is on the final examinations. Not only will this
practice build your technique but it will also help you to identify any problem areas you may have. A
list of common test-taking problems follows.

Copyright © Securities Training Corporation. All Rights Reserved. SIE 3

INTRODUCTION

Test-taking Pitfalls
Reading the Question Too Fast Half the battle of passing a standardized examination is determining
what the question is asking. Regardless of how many times you read a question, you cannot absorb
the information if you read the question too quickly. One technique that will help to slow you down
while you are studying is to use your answer sheet to expose only one line of the question at a time.
This way you will not be tempted to read on to the end of the question and will concentrate on what
you are presently reading. While this technique cannot be used on the computerized exam, the
practice should be helpful.

Changing Answers Going back and changing an answer means that you are second-guessing
yourself. If you employ a good test-taking strategy, there is nothing you will gain from going back to
a question a second time. If you think you may obtain the information you need from another
question, please remember that this exam is written by expert test writers and they are not going to
give anything away.

Formulating an Answer Too Quickly When you are ready to answer a question, make sure to
consider all four choices given. Do not formulate an answer on your own and merely look for that
choice while disregarding the others. Remember that there will often be more than one correct
choice and while your choice may be right, it may not be the best response.

Making Careless Errors You must not have any preconceived notions when reading a test question.
Always read what is written, not what you expect to see. By keeping an open mind, reading the
questions slowly and at least two times through, you should be able to avoid these types of errors.

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.

SIE 4 Copyright © Securities Training Corporation. All Rights Reserved.

 Securities Training Corporation

SIE Two Week Training

An examination should first be taken with the SHOW EXPLANATIONS turned on. After completing all of the examinations with SHOW EXPLANATIONS
switched on, begin the process over again by retaking each examination without the explanations shown

MONDAY TUESDAY WEDNESDAY THURSDAY FRIDAY

To complete each chapter: Take Progress Exams

Complete Chapters 4-5 Complete Chapters 7-10 Complete Chapters 14-15
2 A and B
1. Watch the On Demand
Lecture for the chapter
Take Progress Exams (Approx. 10 hours) Take Progress Exams
2. Read the chapter in the Complete Chapters 11-13
1 A and B 3 A and B
study manual
3. Build a 10-question (Approx. 8.5 hours)
custom exam for the
Complete Chapter 6 Complete Chapter 16
chapter *
(Approx. 8.5 hours)
4. Create a custom

WEEK 1
(Approx. 8.5 hours)
flashcard deck for the
chapter

Complete Chapters 1- 3
(Approx. 7.5 hours)

Take Final Exam 2 Take Final Exam 5 Take Greenlight 2

Complete Chapters 17-19 Complete Chapter 20
Take Final Exam 8
Take Progress Exams Take Final Exam 3 Take Final Exam 6
(Approx. 7.5 hours)
4 A and B (Approx. 3.0 hours)
Take Greenlight Exam 1 Take Final Exam 4 Take Final Exam 7

WEEK 2
Take Final Exam 1 (Approx. 4.5 hours) (Approx. 4.5 hours)
(Approx. 6.5 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 selects Build Exam. You can choose whether or not to have the explanation appear
after each question is answered.

Copyright © Securities Training Corporation. All Rights Reserved. Customer Service 800 STC – 1223 Press 1 │Instructor Hotline 800 782 – 3926
Securities Training Corporation

SIE Three Week Training

An examination should first be taken with the SHOW EXPLANATIONS turned on. After completing all of the examinations with SHOW EXPLANATIONS
switched on, begin the process over again by retaking each examination without the explanations shown

MONDAY TUESDAY WEDNESDAY THURSDAY FRIDAY

To complete each chapter: Take Progress Exams
Complete Chapters 3 - 5 Complete Chapters 8 - 9 Complete Chapter 10
1 A and B
1. Watch the On Demand
Lecture for the chapter
(Approx. 7.5 hours) (Approx. 5 hours) Take Progress Exams
2. Read the chapter in the Complete Chapters 6 - 7 2 A and B
study manual
3. Build a 10-question
(Approx. 6 hours) (Approx. 3.5 hours)
custom exam for the
chapter *

WEEK 1
4. Create a custom
flashcard deck for the
chapter
Complete Chapters 1- 2
(Approx. 5 hours)

Complete Chapters 11 - 12 Complete Chapters 13 - 14 Complete Chapter 15 Complete Chapters 17 - 19 Complete Chapter 20
Take Progress Exams
(Approx. 5 hours) (Approx. 5 hours) (Approx. 7.5 hours) Take Progress Exams
3 A and B
4 A and B

WEEK 2
Complete Chapter 16 (Approx. 3.5 hours)
(Approx. 6 hours)

Take Greenlight 1 Take Final Exam 2 Take Final Exam 4 Take Final Exam 6 Take Greenlight 2

Take Final Exam 1 Take Final Exam 3 Take Final Exam 5 Take Final Exam 7 Take Final Exam 8

WEEK 3
(Approx. 3 hours) (Approx. 3 hours) (Approx. 3 hours) (Approx. 3 hours) (Approx. 3 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 selects Build Exam.
You can choose whether or not to have the explanation appear after each question is answered.
Copyright © Securities Training Corporation. All Rights Reserved. Customer Service 800 STC – 1223 Press 1 │Instructor Hotline 800 782 – 3926
 Securities Training Corporation

SIE Four Week Training

An examination should first be taken with the SHOW EXPLANATIONS turned on. After completing all of the examinations with SHOW EXPLANATIONS
switched on, begin the process over again by retaking each examination without the explanations shown

MONDAY TUESDAY WEDNESDAY THURSDAY FRIDAY

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

WEEK 1
deck for the chapter

Complete Chapter 1

(Approx. 2.5 hours)

Take Progress Exams Complete Chapters 14 - 15

Complete Chapters 7 - 8 Complete Chapters 9 - 10 Complete Chapters 12 - 13
2 A and B
(Approx. 5 hours)
(Approx. 5 hours) (Approx. 5 hours) Complete Chapter 11 (Approx. 5 hours)

(Approx. 3.5 hours)

WEEK 2
* 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 selects Build Exam. You
can choose whether or not to have the explanation appear after each question is answered.

Copyright © Securities Training Corporation. All Rights Reserved. Customer Service 800 STC – 1223 Press 1 │Instructor Hotline 800 782 – 3926
 Securities Training Corporation

SIE Four Week Training

Take Progress Exams Complete Chapters 17 - 18 Complete Chapter 19 Complete Chapter 20 Take Greenlight Exam 1
3 A and B
Take Progress Exams
(Approx. 5 hours) (Approx. 2.5 hours) 4 A and B Take Final Exam 1
Complete Chapter 16
(Approx. 3.5 hours)

WEEK 3
(Approx. 3 hours)
(Approx. 3.5 hours)

Take Final Exam 2 Take Final Exam 4 Take Final Exam 6 Take Final Exam 8 Take Greenlight 2

Take Final Exam 3 Take Final Exam 5 Take Final Exam 7 (Approx. 1.5 hours) (Approx. 1.5 hours)

WEEK 4
(Approx. 3 hours) (Approx. 3 hours) (Approx. 3 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 selects Build Exam. You
can choose whether or not to have the explanation appear after each question is answered.

Copyright © Securities Training Corporation. All Rights Reserved. Customer Service 800 STC – 1223 Press 1 │Instructor Hotline 800 782 – 3926
 CHAPTER 1

Overview of Market
Participation and
Market Structure
Key Topics:

 Types of Issuers

 How Firms Function

 Types of Investors

 Primary vs. Secondary Markets

 Clearing and Settlement

 CHAPTER 1 – OVERVIEW OF MARKET PARTICIPANTS AND MARKET STRUCTURE

This chapter begins with an examination of the different market participants and the roles they play.
The chapter then reviews the market structure of the securities industry, including the process by
which securities are created and subsequently traded. Finally, the chapter will focus on ensuring that
SIE Examination candidates become comfortable with some of the terminology that will be
encountered throughout this study manual. As will become evident, finance has a language of its
own. Please keep in mind that a glossary is located at the end of this study manual and can be useful
in reviewing the language of the industry. Good luck in your studies!

Market Participants
The process of matching investors who have money with issuers that need money is one of the primary
purposes of the securities industry. Ultimately, the securities marketplaces and its participants provide
the bridge between those with capital (money) to invest and those that need the capital for financing
purposes.

What’s an Issuer?
An issuer is defined as a legal entity that sells securities in order to finance its operations. Issuers
include businesses that need capital to grow and prosper, as well governments that typically borrow
funds as a means of paying their bills or building infrastructure. Issuers include, but are not limited to:
 The U.S. Treasury and various U.S. government agencies
 Foreign governments
 State and local governments
 Corporations
 Banks

There are two primary methods that issuers use to raise capital—issuing debt securities (bonds) and
issuing equity securities (stocks). Let’s briefly define each security type.

Debt Securities Both corporations and various government borrowers raise funds through the
issuance of publicly traded loans, which are referred to as bonds, notes, or debt instruments. A bond
is a security that represents the amount of indebtedness (principal) that the issuer owes to the
investor. Investors who purchase bonds are considered creditors of the issuer and essentially lend
their funds to the issuer for a specified period (until maturity).

The issuer is required to repay the principal balance of the bond at a future date and will typically
make interest payments over the life of the loan. If the issuer misses an interest or principal payment,
it’s considered to be in default.

Equity Securities Traditionally, corporations raise capital through the issuance of stock (equity). If
an investor purchases the stock, she has an ownership interest in the underlying business and, if the
company is profitable, may be entitled to a portion of the profits (through a dividend distribution).

Copyright © Securities Training Corporation. All Rights Reserved. SIE 1-1

CHAPTER 1 – OVERVIEW OF MARKET PARTICIPANTS AND MARKET STRUCTURE

The ownership interest typically does not have a maturity date and the payment of any dividends is
voluntary for the issuer. Both stocks and bonds will be covered in greater detail later in this manual.

Financial firms are the bridges that connect issuers and investors. These firms generally fall into
one of two broad categories—broker-dealers or investment advisers. Let’s examine the distinction
between these two types of financial firms.

What’s a Broker-Dealer?
The term broker-dealer refers to the two capacities in which a firm may operate. A broker is defined
as any person that engages in the business of effecting agency transactions in securities for the
account of others. Essentially, brokers match up buyers and sellers and earn a commission for their
efforts. As a comparison, think of how a real estate agent is employed by a real estate broker and
acts on behalf of customers to earn commissions.

A dealer is defined as any person that engages in the business of buying and selling securities for its
own account. Firms acting as dealers engage in principal transactions in which they buy securities
directly from their clients and hold them in inventory, or they sell securities to clients from their
inventory. For executing these trades, dealers are entitled to either a markup or markdown. Now,
consider the similarity to a car dealer that buys for or sells from its inventory and will either
markdown the car cost when buying or markup the car cost when selling.

Since firms are continuously executing trades as either a broker or a dealer, it’s convenient to
simply refer to them as broker-dealers. Additional details of the capacities in which broker-dealers
operate will be provided in Chapter 12.

Broker-Dealer Departments Many brokerage firms (broker-dealers) are divided into several
distinct departments. SIE Examination candidates are expected to have a general idea of the
responsibilities of the employees who work in each of these areas.

Investment Banking (IB) Investment banking is the area that works directly with the issuers to
arrange and structure their securities offerings. For example, this department may advise an issuer
that intends to raise funds through an issuance of stocks, bonds, or a combination of both.
Remember, investment bankers are often referred to as the underwriters of securities. IB may also
assist companies that seek to merge with or acquire other companies (M&A) or those that need to
restructure due to a bankruptcy.

Research The analysts in a firm’s research department study both the markets and individual
issuers in order to issue recommendations. The typical recommendations are to buy, sell, or hold.

Sales Financial professionals who work in the sales area typically market individual stocks or
bonds, but also packaged products (e.g., mutual funds) to both retail investors and institutions.
Historically, sales personnel have been referred to as stock or bond brokers. However, for the SIE
Examination, these salespersons will likely be referred to as registered representatives (RRs) or
investment adviser representatives (IARs).

SIE 1-2 Copyright © Securities Training Corporation. All Rights Reserved.

 CHAPTER 1 – OVERVIEW OF MARKET PARTICIPANTS AND MARKET STRUCTURE

Trading Trading professionals handle the execution of trades for both the firm’s clients and the
firm’s own (proprietary) account. These trades may occur either in electronic marketplaces, such as
Nasdaq, or hybrid marketplaces, such as the New York Stock Exchange (NYSE).

Operations The operations area ensures that all of the paperwork, funds, and securities transfers
that are associated with a trade (or processing) are handled efficiently and according to specific
industry standards. Operations personnel perform functions such as generating customer
statements, confirmations, and tax records, as well as assisting in the transfer of securities and/or
funds. These personnel are also responsible for ensuring that all firm and client assets are organized
properly and safeguarded.

What’s a Market Maker?

When a broker-dealer chooses to display quotes into a trading system to indicate its readiness to
buy and/or sell securities at specific prices, the firm is referred to as a market maker. In most cases,
a market maker is required to make regular bids and offers and meet specific capital requirements.

A market maker’s quote is two-sided since it indicates the price at which it’s willing to buy a security
from (bid), or sell a security to (ask/offer), other market participants. For example:

Bid Ask
17.05 17.08
Price at which Price at which
the firm will buy the firm will sell

Generally, a market maker must be prepared to buy or sell a minimum unit of trading (100 shares) at
the quoted prices.

What’s a Trader?
Other firms and individuals that simply choose to trade securities for the firm’s benefit (proprietary
trading) or for the benefit of the firm’s clients (without the interest in making markets) are referred
to as traders. These traders are under no obligation to enter quotes into a marketplace; instead, they
execute trades against the quotes of market making firms.

What’s an Investment Adviser?

Many financial firms act as investment advisers, rather than functioning as broker-dealers. So,
what’s the difference between a broker-dealer and an investment adviser? Essentially, it comes
down to how each is compensated for the services it provides. Broker-dealers earn compensation
(e.g., commissions) for executing transactions, while investment advisers charge fees for providing
advice to their clients. These fees are often based on a percentage of assets under management
(AUM) and are charged regardless of whether any trades occurred in their clients’ accounts.

Copyright © Securities Training Corporation. All Rights Reserved. SIE 1-3

CHAPTER 1 – OVERVIEW OF MARKET PARTICIPANTS AND MARKET STRUCTURE

Investment advisers come in all shapes and sizes. Some manage hundreds of millions of dollars for
mutual funds, while others have small practices and work exclusively with individual investors.

Municipal Advisors A municipal advisor is a specialized type of advisor that provides advice
either to or on behalf of a municipal entity, such as a state, county or city. An advisor’s client is
typically the issuer, not the investor. These financial professionals provide advice related to the
structure, timing, and terms of a municipal finance offering. The municipal advisor definition is
broad and includes financial advisors, third-party marketers, placement agents, solicitors, finders,
and swap advisors that engage in municipal advisory activities. For example, let’s assume that a
town intends to issue bonds to raise funds for the construction of a new gymnasium. If the mayor
and members of the town council lack the necessary financial or securities knowledge, they may
hire a municipal advisor to act as an intermediary between the town and the underwriter.

Types of Investors
As mentioned earlier, broker dealers connect issuers and investors in primary offerings, but are also
involved in the trading of the issued securities. Investment advisers also often assist investors in
building a balanced portfolio through a process that’s referred to as asset allocation. Now let’s
examine some of the different types of investors.

Retail Investors
Many investors who directly buy stocks or bonds from broker dealers are retail investors.
Essentially, this term means “regular individuals” who have limited assets and income. These
investors may hold assets in one person’s name (a single account) or perhaps together with their
spouse or a friend (a joint account). Other forms of retail ownership include various retirement
accounts, such as IRAs, or custodial accounts that are established for children.

The primary focus of securities regulation (to be described in Chapter 2) is on protecting these retail
investors. Many professionals define a retail investor as a person who does not meet the definition
of an institutional investor (described below).

Accredited Investors
The Securities and Exchange Commission (the primary regulator for the securities industry)
categorizes certain investors who, by the nature of their income or assets, are viewed as more
sophisticated and/or able to assume greater risk.

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 CHAPTER 1 – OVERVIEW OF MARKET PARTICIPANTS AND MARKET STRUCTURE

These investors are referred to as accredited investors and include the following:
 Financial institutions (e.g., banks), large tax-exempt pension plans, and private business
development companies
 Directors, executive officers, or general partners of the issuer
 Individuals who meet either one of the following two criteria:
‒ Have a net worth of at least $1,000,000 (excluding their primary residence) or
‒ Have gross annual 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

Institutional Investors
Institutional investors are typically large entities that pool their money to purchase securities.
Institutional investors include banks, insurance companies, pension plans, endowments, and
hedge funds. The SEC refers to certain institutions as qualified institutional buyers (QIBS); however,
to be considered QIBs, the buyers must satisfy the following three-part test:

1. First, only certain types of investors are eligible, including:

 Insurance companies
 Registered investment companies
 Registered investment advisers
 Small business development companies
 Private and public pension plans
 Certain bank trust funds
 Corporations, partnerships, business trusts, and certain non-profit organizations
2. The buyer must be purchasing for its own account or for the account of another QIB.
3. The buyer must own and invest at least $100 million of securities of issuers that are not
affiliated with the buyer.

Under no circumstances is an individual (even one who meets the standard of being an
accredited individual investor) considered to be a QIB. Remember, QIBS are not humans, they’re
entities (e.g., firms).

By specifically defining both institutional and non-institutional (retail) investors, securities

regulators are able to create rules which are applicable to only one type of investor.

Market Structure
The way that the securities market is structured involves the issuance of the securities in one
market (the primary market) and the trading of the securities in another market (the secondary
market). This next section will examine these two markets.

Primary Market
Let’s start with the premise that a new start-up company needs money for its expansion goals and
will be issuing shares of its stock.

Copyright © Securities Training Corporation. All Rights Reserved. SIE 1-5

CHAPTER 1 – OVERVIEW OF MARKET PARTICIPANTS AND MARKET STRUCTURE

Since the company is unaware of the nuances of raising capital, it works with the investment
banking department of a brokerage firm. The investment banker will assume the role of the
underwriter by agreeing (for a fee) to market the shares to the ultimate investors. These investors
could include insurance companies, investment companies, pension funds, as well as individuals
throughout the country. As the securities are sold to investors, most or all of the proceeds received
will go to the issuer. Since this issuance marks the beginning of the shares’ existence, this is referred
to as the primary market.

The primary market is regulated by the SEC under the Securities Act of 1933. The process by which
issuers offer their securities will be covered in detail in Chapter 11.

Secondary Market
After the primary distribution of the issuer’s shares, the investors that purchased the shares from
the issuer will inevitably want to sell them. The market that brings together these buyers and sellers
is referred to as the secondary market. In the secondary market, the funds are no longer directed to
the issuer; instead, the securities and the funds pass between investors. Let’s examine some of the
markets in which these securities trade.

Exchange Market Traditionally, stock markets were broken down into two categories—physical
trading venues, such as the NYSE, and over-the-counter (OTC) marketplaces. Exchanges offer a
centralized trading venue that functions as an open outcry auction market. The auctioneer who
controls trading in a given stock is referred to as a designated market maker (DMM). Over time,
many modern exchanges began to shift to hybrid trading methodologies in which trading would
occur on a face-to-face basis on a physical floor as well as through electronic linkages.

Today, the distinction between physical and electronic markets is less important since many stock
exchanges have eliminated their physical trading floors. Nasdaq, which is one of the world’s largest
stock markets, has always been an electronic trading venue, but is still classified by the regulators as
an exchange. Any equity securities that meet the standards for trading on a national exchange (e.g.,
NYSE and Nasdaq) are referred to as listed securities.

Nasdaq The National Association of Securities Dealers Automated Quotation System (Nasdaq) is
perhaps the most recognized equity dealer-to-dealer network (described below). Although it wasn’t
always the case, the SEC classifies Nasdaq as a securities exchange. The Nasdaq system provides
quotes on select securities that have been properly registered and meet specific listing criteria, such
as aggregate issuer assets, the number of shareholders, and the number of outstanding shares.

Dealer-to-Dealer Market When stocks don’t qualify for listing on either a physical or electronic
exchange, they’re considered to be trading over-the-counter (OTC) and the stocks are referred to as
OTC equities or unlisted securities. In OTC markets, trades occur in non-physical dealer-to-dealer
networks that connect participants through phones or, more likely, computers. Two networks
which provide dealers with quotes on these securities are the OTC Bulletin Board (OTCBB) or the
Pink Marketplace (a platform that was created by the OTC Markets Group). Neither the OTCBB nor
the Pink Marketplace are registered as exchanges with the SEC and typically don’t have the same
level of trading activity as the NYSE and Nasdaq.

SIE 1-6 Copyright © Securities Training Corporation. All Rights Reserved.

 CHAPTER 1 – OVERVIEW OF MARKET PARTICIPANTS AND MARKET STRUCTURE

Non-Equities Unlike equity securities, corporate, municipal, and U.S. government bonds don’t
have organized exchanges. Although some corporate bonds (e.g., convertible bonds) can be bought
and sold on certain stock exchanges, most bonds are traded in the OTC market through various
dealer-to-dealer networks.

Other Execution Methods and Venues

In recent years, market participants have created alternatives to the NYSE and Nasdaq for trading
listed securities. Many broker-dealers have abandoned their market making operations on the
traditional exchanges and directed orders to high frequency trading firms. Other broker-dealers have
found alternative trading venues which compete with the NYSE and Nasdaq for trading volume.

The Third Market Electronic, internet-based trading doesn’t require that orders be sent to the
physical trading floor because alternative markets have emerged. The third market refers to
exchange-listed securities being traded over-the-counter or away from traditional exchanges. While
some of the trading in listed stocks still occurs on their primary exchanges, third-market volume
has grown in the last several years. In a manner that’s similar to traditional exchanges, the third
market brings together investors and also accommodates after-hours trading.

The Fourth Market The fourth market refers to direct institution-to-institution trading and does
not involve the public markets or exchanges. While some of this trading involves different portfolio
managers contacting one another by phone, most true fourth-market trades are internal crosses set
up by broker-dealers that execute trades for institutional accounts. These proprietary trading
systems (PTSs) are established to facilitate the institution-to-institution trading are often
considered a part of the fourth market.

Essentially, the third market involves transactions between dealer-brokers and large institutions,
while the fourth market only involves transactions between large institutions. The activities of these
markets have little or no influence on the workings of the typical stock trading by an average investor.

Electronic Communication Networks (ECNs) ECNs are market centers (i.e., exchanges) that
allow for both the quoting and trading of exchange-listed securities. The objective of an ECN is to
provide an electronic system for bringing buyers and sellers together (matching). These systems allow
subscribers to disseminate information about orders, execute transactions both during the trading
day and after-hours, and buy and sell anonymously. ECNs charge subscribers a fee for using their
systems and act in only an agency (broker) capacity.

Dark Pools A dark pool is a system that provides liquidity for large institutional investors and
high-frequency traders, but it does not disseminate quotes. The name is derived from the fact that
the details of the quotes are concealed from the public. The system may be operated by broker-
dealers or exchanges, and it allows these specific investors to buy and sell large blocks of stock
anonymously. The objective is to allow these investors to trade with the least amount of market
impact and with low transaction costs. Some dark pools provide order matching systems and may
also allow participants to negotiate prices.

Copyright © Securities Training Corporation. All Rights Reserved. SIE 1-7

CHAPTER 1 – OVERVIEW OF MARKET PARTICIPANTS AND MARKET STRUCTURE

Clearing and Settlement – An Overview

What happens after a trade occurs? At this point, the buyer and seller must agree on the terms of the
transaction (clear the trade). Ultimately, the buyer is expected to pay for the security, and the seller
is expected to deliver the security. This simultaneous payment and delivery process between the
two parties is referred to as settlement.

The modern securities clearing process is a complicated one that involves many parties that are tied
together by various computer and communications systems. In a well-developed capital market,
such as the one here in the U.S., the majority of trades are processed electronically with very few
paper securities transactions occurring.

The Depository Trust & Clearing Corporation (DTCC)

The Depository Trust & Clearing Corporation is a securities depository and a national
clearinghouse for the settlement of transactions in equities, corporate, municipal, and U.S.
government bonds, mortgage-backed securities, money-market instruments, and over-the-counter
derivatives. The DTCC also has significantly expanded its ability to process transactions in mutual
funds and insurance products. The DTCC’s function is to automate and centralize the clearing and
settlement of trades among its (owners) members. Most major financial institutions in the U.S. are
members of the DTCC system. The primary goal of the system is to eliminate physical securities in
order to increase the speed and reduce the cost of clearing and settling trades.

The National Securities Clearing Corporation (NSCC) and the Fixed Income Clearing Corporation
(FICC) are both subsidiaries of the DTCC. The NSCC clears equity trades for both U.S. and foreign
issuers, while the FICC clears bond trades.

Ownership The DTCC is a non-profit, industry-owned corporation. Its owners include broker-
dealers, investment banks, commercial banks, and mutual fund companies. The DTCC and its
subsidiaries are regulated by the SEC and the depository is also a member of the U.S. Federal
Reserve System.

Processing the Trade – Clearing and Introducing Firms

The clearing process will often involve two different types of firms—clearing firms and introducing
firms. Due to the cost and complexity of creating and maintaining a fully functional trade
processing area, many smaller broker-dealers (introducing firms) choose to hand off all or part of
their trade processing and clearing functions to larger broker-dealers (clearing or carrying firms).
The costs of clearing include a significant investment in hardware, software, and personnel.

Let’s take a look at the difference between the responsibilities of these two firms.

Clearing Firms One step below the DTCC on the trade processing hierarchy are the clearing firms
(also referred to as full-service firms). These substantial broker-dealers perform order execution,
clearing, and settlement functions. Clearing firms interface with the DTCC directly for both their
own transactions as well as those of any other broker-dealers that choose to clear through them.

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Introducing Firms Introducing firms neither process customer transactions nor do they operate
their own clearing operations. Instead, they contract with clearing firms to perform these services.
While customers of an introducing firm consider that firm to be their broker-dealer, customer funds
and securities are actually physically held at the clearing firm, from which they generally also
receive statements and confirmations.

The following diagram is an overview of the clearing process which involves both introducing and
clearing firms:

Introducing Firms – Fully Disclosed Versus Omnibus Accounts

A clearing broker may provide introducing firms with back office and related recordkeeping
functions on either a fully disclosed or omnibus basis. The differences between these two
arrangements involve the level of detail the clearing firm will have regarding the customer as well as
which entity will be responsible for providing trade details to the customer.

Introducing Firms – Fully Disclosed Accounts Many introducing firms operate through a
clearing firm on a fully disclosed basis. This means that information about each of the individual
customers of the introducing firm will be transmitted to the clearing firm and the clients’ assets are
held at the clearing firm. The clearing firm establishes separate accounts for each client and is
responsible for all of the paperwork associated with the accounts, such as the delivery of
confirmations and statements.

The paperwork will be identified as coming from the clearing firm, but it will contain additional
identifying information so that the client can determine to which introducing firm the paperwork is
related. For example, a client’s statement may list ABC Clearing at the top of the document, but will
also contain the name and contact information for XYZ Brokers, the introducing firm.

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Introducing Firms – Omnibus Accounts Not all of the relationships between introducing and
clearing firms are fully disclosed. For example, ABC Bond Brokers, Inc. is a fixed-income broker-dealer
that has a complete back-office operation for clearing its bond trades and holding customer
positions. However, the firm will occasionally accept an order from a customer for common stock.
Since the firm does not want to set up clearing operations to handle these infrequent accommodation
transactions, it has arranged for DEF Clearing to execute and clear its customers’ stock trades. ABC
does not provide DEF Clearing with details regarding the individual clients. Instead, ABC uses a
single omnibus account that’s specifically designated by the clearing firm for customers of ABC Bond
Brokers. In this type of arrangement, since the clearing firm does not have information on each
individual customer, the recordkeeping responsibilities belong primarily to the ABC Bond Brokers,
the introducing firm.

Other Customers of Clearing Firms

Although clearing firms have traditionally serviced smaller broker-dealers, these firms are not their
only customers. Clearing firms also do extensive business with investment companies (mutual
funds), investment advisers, and hedge funds. Investment companies will be described in Chapter 7.

Hedge Funds A hedge fund is a private, actively managed investment fund that uses sophisticated
strategies in an attempt to generate returns that are higher than traditional stock or bond
investments. These strategies could include:
 Concentrated speculative investments on a given company or industry
 Arbitrage (a relational trade between two investments)
 Short selling (speculating on the downward movement of a company’s stock)
 Currency or commodities trades
 Margin (the use of leverage)

Prime Brokerage Accounts One service that clearing firms typically offer is prime brokerage. The
prime brokerage relationship consist of a bundled package of services that’s offered to hedge funds,
institutions, and high net worth individual clients. The clearing firm acts as a centralized location
for holding all of the positions that were created by the various executing firms through which the
client trades.

Prior to prime brokerage, clients were required to open a separate account at each executing
broker-dealer. After trades were executed, each broker-dealer would then provide confirmations
and statements to the client. The challenge for the client was the combining all of the information
that it received from its various accounts to understand its overall position. In a prime-brokerage
arrangement, the client chooses one firm as its prime broker to consolidate the bookkeeping
process. Although the client may still use several broker-dealers for execution purposes (and as a
source of research, allocations on IPOs, etc.), all of the trades are ultimately handled through its
account at its prime broker. Therefore, the client receives one set of reports, rather than several.

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 CHAPTER 1 – OVERVIEW OF MARKET PARTICIPANTS AND MARKET STRUCTURE

A simplified picture of this relationship follows:

Clearing Options Contracts

Options are derivative trading products that track the value of an individual stock, an index, or foreign
currency. Options contracts can be purchased either on one of the options exchanges or in the over-the-
counter market. Options contracts that are purchased on an exchange are referred to as listed
options. Options contracts will be examined in Chapter 10.

Currently, listed options trade on the following exchanges:

 The Chicago Board Options Exchange (CBOE)
 The Boston Options Exchange (BOX)
 The NYSE Acra
 The Nasdaq PHLX (formerly the Philadelphia Stock Exchange)
 The International Securities Exchange (ISE)

A key feature of exchange-traded options is standardization, which means that the terms of the
contracts are set and uniform. The DTCC does not clear options trades; instead, this is the job of the
Options Clearing Corporation (OCC).

The Options Clearing Corporation (OCC) Listed options are issued and guaranteed by the
Options Clearing Corporation much in the same way that the DTCC guarantees locked-in trades for
its members. The OCC is regulated by the Securities and Exchange Commission and is owned
proportionately by the exchanges where listed options trade.

The OCC acts as the third party in all option transactions. Broker-dealers deal directly with the OCC
rather than with each other when settling trades. When customers buy or sell option contracts, their
broker-dealers must settle the transactions with the OCC within one business day.

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CHAPTER 1 – OVERVIEW OF MARKET PARTICIPANTS AND MARKET STRUCTURE

Other Entities That Keep Markets Running Smoothly

In addition to DTCC, there are other types of financial institutions that help keep the equity, bond,
and options markets operating smoothly. These intermediaries include custodians, transfer agents,
registrars, and trustees. Each of these institutions are described in this final section.

Custodians Issuers typically use banks or other financial institutions to holds customers' securities
for safekeeping. Although a custodian may hold assets in physical form, it’s much more common for
securities to be held in book entry (electronic) form.

Registrars and Transfer Agents Issuers that have publicly traded securities outstanding typically
use banks or trust companies to keep track of the owners of their stocks and bonds. Typically the firms
that provide recordkeeping services act as both registrar and transfer agent.

A registrar's function is to maintain the ownership register of the issuer for each issue of its securities.
The registrar records the name, address, and tax identification or Social Security number of each
individual owner. These securities may be held in certificate form or by the investor’s brokerage firm in
street name (i.e., in the name of the broker-dealer).

The transfer agent is responsible for:

 The issuance and cancelation of certificates to reflect changes in ownership
 Acting as the company’s paying agent for interest payments on bonds and for cash or stock
dividends on equities
 Acting as proxy agent (sending voting materials) and mailing agent (mailing the company’s financial
reports to shareholders)
 Handling lost, destroyed, or stolen certificates

Securities Trustees For some types of investments, such as select bonds, loans, or trusts, a
trustee is assigned to hold security interests that are created on trust for the benefit of various
creditors (e.g., banks or bondholders). Some bond trustees also ensure that issuers abide by
promises (covenants) that are found in a formalized agreement which is referred to as a trust
indenture. Additionally, these trustees may represent investors in the event of default and/or
bankruptcy.

Conclusion
This concludes the overview of the various market participants and their roles in the financial
services industry as well as the structure of the securities markets. The next chapter will examine
the regulatory framework in which issuers, financial firms, and investors transact business.
Remember, this chapter was simply an overview. Later chapters will provide greater insight into the
concepts that have been introduced in this first chapter.

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 CHAPTER 1 – OVERVIEW OF MARKET PARTICIPANTS AND MARKET STRUCTURE

Create a Chapter 1 Custom Exam

Now that you’ve completed Chapter 1, 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 Chapter
1 and, at the bottom of the screen, enter 10 questions in the Number of Questions box, and then
select Build Exam.

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 CHAPTER 2

Overview of Regulation

Key Topics:

 How Firms are Regulated

 The Federal Reserve Board

 Fundamental Federal Acts

 The Securities Investors Protection Corporation

 Self-Regulatory Organizations
 CHAPTER 2 – OVERVIEW OF REGULATION

Passing the Securities Industry Essentials (SIE) Examination will be the first step to achieving a career
in the financial services industry. As this chapter will describe, financial services firms and their
employees are subject to a significant number of federal, state, and industry regulations. This chapter
will provide a broad overview of the securities industry’s multi-layered regulatory structure.

Regulation
There are four tiers to regulation—federal laws, state laws, self-regulatory organization (SRO) rules
and regulations, and firm-specific (in-house) policies and procedures. All of these different levels of
regulation influence the activities of all persons who operate in the securities industry.

Federal Regulation
For broker-dealers, all of their capital raising, sales, trading, and operations activities are heavily
regulated. The primary regulation comes from laws (also referred to as Acts) that have been passed by
Congress. These Acts are enforced by the U.S. Securities and Exchange Commission (SEC), which is a
part of the U.S. federal government.

The SEC The Securities and Exchange Commission is an independent, federal government
agency that’s responsible for protecting investors, maintaining fair and orderly securities trading
markets, and facilitating capital formation in the primary market. The SEC is also charged with
ensuring that Congress’ demands are implemented.

Authority of the SEC The SEC has jurisdiction over securities transactions that are executed on an
interstate basis (i.e., across state borders). The SEC may investigate potential securities law
violations through its Division of Enforcement which prosecutes cases on behalf of the
Commission. The SEC may also bring civil actions. If criminal activity is discovered by the
Commission, the case falls under the jurisdiction of the Department of Justice (DOJ).

Other Federal Regulators

In addition to the SEC, other divisions of the federal government are involved in the securities
markets. These include the Department of Treasury and the IRS, both of which are responsible for
identifying and investigating illegal activities that have occurred (or may occur) within the financial
markets (e.g., money laundering). In fact, the IRS is also provides guidance to investors concerning
the tax implications of holding, buying, and selling various types of securities.

The Federal Reserve Board (FRB) The Federal Reserve (the Fed) is an independent agency of the
federal government that functions as the U.S. central bank. The Fed’s Board of Governors, also
referred to as the Federal Reserve Board (FRB), is responsible for controlling the nation’s monetary
policy (money supply and interest rates). The FRB’s mandate is to create conditions which will
result in maximum employment and stable prices.

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CHAPTER 2 – OVERVIEW OF REGULATION

To do this, the FRB controls or sets the discount rate, reserve requirements, and margin
requirements on securities purchases. In order to influence the rate that member banks charge
each other on overnight loans (which is referred to as the fed funds rate), the Fed will buy and sell
securities. These FRB tools will be examined in greater detail in Chapter 19.

Federal Deposit Insurance Corporation (FDIC) The Federal Deposit Insurance Corporation is an
independent agency that was created by the Congress. The FDIC’s role is to maintain stability and
public confidence in the nation's financial system. The FDIC insures banking deposits and
examines financial institutions for both safety and soundness in an effort to protect the nation’s
financial system. The current FDIC insurance coverage limit is $250,000 per depositor, per FDIC-
insured bank.

SRO Regulation
Although the SEC is in charge of overall regulation, the creation and enforcement of day-to-day
rules that brokerage firms must follow are often handled by self-regulatory organizations (SROs),
including the Financial Industry Regulatory Authority (FINRA), the Municipal Securities
Rulemaking Board (MSRB), and Chicago Board Options Exchange (CBOE), etc. The primary
purpose of these different self-policing organizations is to promote fair and equitable trading
practices. SRO rules require firms to use reasonable due diligence when dealing with customers.
However, since SROs are not a part of the U.S. government, they lack the power to arrest or
imprison any person who violates their rules.

Financial service firms (e.g., broker-dealers) are required to join an SRO and are referred to as
member firms. The employees of these member firms are referred to as associated persons.

State (Blue-Sky) Regulation

Each state has the authority to impose additional requirements for issuers, broker-dealers and their
agents (registered representatives), and investment advisers and their representatives. Typically, a
state requires both broker-dealers and their agents to be registered in the state in order to transact
business there. Additionally, issuers are generally required to register their securities prior to selling
them in a given state. These rules, which are established under the Uniform Securities Act (USA), are
referred to as the blue-sky laws due to the use of the term in a state court decision in the early 1900s.

North American Securities Administrators Association (NASAA) The provisions of the Uniform
Securities Act (USA) are established by the North American Securities Administrators Association
and enforced by the individual states. States typically enhance their securities regulations by
imposing more stringent regulations than those that are written in the USA. Each state has its own
securities regulations departments and the person is charge of is referred to as the Administrator or
Commissioner. NASAA is the oldest international investor protection organization and its focus is
protecting investors from fraud. NASAA’s membership includes Administrators of the 50 states, the
District of Columbia, the U.S. Virgin Islands, Puerto Rico, Canada, and Mexico.

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 CHAPTER 2 – OVERVIEW OF REGULATION

Firm (In-House) Rules

Member firms are required to establish and maintain a system to supervise the activities of their
personnel. Firms must clearly outline their policies and procedures by creating internal Written
Supervisory Procedures (WSP). A firm’s WSP is essentially a manual that details the rules and identifies
the person(s) responsible for their enforcement. Within a firm, there are three different categories of
personnel—registered principals, registered representatives (RRs), and unregistered employees. The
registered persons who manage and supervise RRs are referred to as principals. The unregistered
employees are often administrative personnel, technology personnel, or other support staff.

Why Take the SIE Exam?

A person who is interested in the possibility of beginning a career in the securities industry will first need
to pass the Securities Industry Essentials (SIE) Examination. However, many of these successful
candidates will subsequently take jobs with broker-dealers or investment advisers which will require that
they become registered as representatives of the firms (i.e., as registered representatives of broker-dealers
or as investment adviser representatives of advisers.)

Once the SIE is completed, the candidate must take an additional exam, such as the Series 6, Series 7, or
Series 65. Each representative will be assigned to a supervising principal who is responsible (and liable)
for the representative’s actions. As evidenced by the diagram below, an RR sits on the bottom of the
regulatory pyramid.

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CHAPTER 2 – OVERVIEW OF REGULATION

Federal Regulation – The Acts

Passing the SIE Exam requires an understanding of the regulatory environment in which securities are
issued and traded. The following section is a brief description of some of the major federal legislations
with which candidates will need to be familiar. Since the Securities Act of 1933, the Securities
Exchange Act of 1934, the Investment Company Act of 1940, and the Investment Advisers Act of 1940
are the most heavily tested regulations, they will be covered in greater detail in subsequent chapters.

The Securities Act of 1933

The Securities Act of 1933 was the first federal legislation to cover the securities industry and its main
focus is the primary market. As mentioned in Chapter 1, the primary market refers to the market in
which corporations and other issuers attempt to sell their securities (e.g., stocks and/or bonds) to the
investing public. The Securities Act of 1933 demands that investors be provided with full and fair
disclosure so that they’re able to make informed investment decisions. The Act also provides specific
rules for the conduct of both issuers and the investment bankers (underwriting firms).

The Securities Exchange Act of 1934

The Securities Exchange Act of 1934 establishes the rules for activities which are conducted in the
secondary market. The two most recognized secondary markets are the New York Stock Exchange
(NYSE) and Nasdaq. The Act of 1934 created the Securities and Exchange Commission (SEC) and gave it
preeminent regulatory authority over domestic securities dealings in both the primary and secondary
markets. Additionally, the Act of 1934 gave the Federal Reserve Board (FRB) regulatory oversight
regarding the extension of credit (i.e., use of margin) in the securities industry. The margin
requirements are established under the provisions of Regulation T. A margin account is created for
investors who borrow money to purchase securities or to engage in the short selling of securities. Briefly,
short selling is a trading strategy in which an investor borrows the shares that are sold. A short seller’s
belief is that the stock will decline in value (i.e., he’s bearish) which will allow him to purchase the
borrowed stock and deliver it back at a lower price. This type of trading will be covered in Chapter 12.

The Maloney Act of 1938

The Maloney Act allowed for the creation of non-exchange SROs. Most securities transactions are
not executed on a physical exchange; instead, they’re conducted in other venues that were referred
to as over-the-counter (OTC) markets. The National Association of Securities Dealers (NASD) was
created in 1939 to act as the self-regulatory organization for the OTC market. In addition, in 1975,
the scope of the Maloney Act enabled the creation of the Municipal Securities Rulemaking Board
(MSRB). However, in 2007, the NYSE and NASD merged their member regulation and enforcement
functions and created the Financial Industry Regulatory Authority (FINRA).

As SROs, FINRA and the MSRB are responsible for maintaining fair and orderly securities markets,
promoting best execution and fair treatment of clients, and establishing rules and regulations that
protect investors.

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 CHAPTER 2 – OVERVIEW OF REGULATION

The Investment Company Act of 1940

The Investment Company Act regulates companies that are formed to pool together money from
investors and invest the funds in securities. The most popular of these companies are the open-end
investment companies, which are more commonly referred to as mutual funds. Investment
companies will be covered in detail in Chapter 7.

The Investment Advisers Act of 1940

The Investment Advisers Act regulates firms that are established as investment advisers (IAs). The
Act both defines the term investment adviser and provides a number of exclusions from the IA
definition. To meet the investment adviser definition, a firm must satisfy all three parts of an ABC
Test which includes:
 Providing Advice,
 Operating as a Business, and
 Receiving Compensation for the advice

Examples of investment advisers include firms that manage mutual fund portfolios as well as firms
that manage wrap accounts and collect a single fee to cover the costs related to investment advice
along with the costs of transactions.

Exclusions from the IA definition are available to broker-dealers, specific types of professionals
(lawyers, accountants, teachers, engineers), and publishers. For the professionals to be excluded,
the investment advice being provided must be incidental to their actual profession. For example, if
an accountant decides to hold himself out to the public as an investment adviser and charge a
separate fee for that service, the exclusion will not apply.

The result of the Investment Company Act and the Investment Advisers Act is that a mutual fund
must register with the SEC as an investment company and the firm that manages the assets of the
mutual fund must register as an investment adviser.

The Securities Investor Protection Act of 1970 (SIPA)

The SIPA enabled the creation of the Securities Investor Protection Corporation (SIPC); an industry-
funded, non-profit insurance entity. SIPC provides insurance coverage for the customers of brokerage
firms in the event that the firms become insolvent (bankrupt); however, it does not protect the
customers against market losses or employee misconduct.

SIPC covers securities that are registered in street name (i.e., customer securities being held in the name
of the broker-dealer). Any broker-dealers that use the mails or other instruments of interstate commerce
are required to be members of SIPC.

SIPC Coverage SIPC provides coverage for each separate customer (retail and institutional) to a
maximum of $500,000, of which no more than $250,000 may be for cash holdings. If a customer
maintains both a cash and a margin account with the same brokerage firm, the accounts are combined
when determining SIPC coverage.

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CHAPTER 2 – OVERVIEW OF REGULATION

A cash account is established if a customer does not borrow funds from a brokerage firm, while a margin
account involves a customer borrowing funds to purchase securities. However, a customer who
maintains a joint account with a spouse or a customer who has an IRA each have separate coverage for
these accounts.

The following examples will clarify the rule:

Customer 1 has a cash account and a margin account with a broker-dealer. She has $300,000 of stock
and $50,000 of cash in her cash account and her margin account has equity of $40,000. In this case, the
cash account and the margin account will be combined for determining SIPC coverage. The customer
will be protected for a total of $390,000. In a margin account, it’s the equity balance, not the market
value, that’s subject to SIPC coverage.

Customer 2 has a cash account with $50,000 of securities and $320,000 of cash. He is protected for a total
of $300,000 ($50,000 securities and $250,000 cash), since the maximum protection for cash is $250,000.

Customer 3 has a cash account with $180,000 of securities and $10,000 of cash and a joint account with
her husband that contains $400,000 of securities. Her cash account is protected for a total of $190,000.
Her securities are covered in full and, since her cash position is less than $250,000, it too is covered in
full. The joint account is considered as a separate customer and receives full coverage.

Not Covered SIPC coverage does not apply to:

 Securities that are specifically identifiable as belonging to a customer (not in street name) since
these types of securities are distributed to the customer without regard to the dollar limits
 Commodities accounts
 Other broker-dealers that have securities in the possession of a failed broker-dealer
 Personal accounts of senior officers of the firm

SIPC Procedures If a broker-dealer declares bankruptcy, a trustee is appointed by a federal court. The
trustee is required to notify the broker-dealer’s customers of the firm’s insolvency and handle the
orderly liquidation of the funds and securities that are in the broker-dealer’s possession.

If a customer has a claim for securities that cannot be specifically identified as being in the possession of
the broker-dealer, the dollar amount of the customer’s claim will be based on the market value of the
securities on the day that the court appoints a trustee. Securities that are in the possession of the failed
broker-dealer will be distributed to customers. If there are insufficient securities in the possession of the
failed broker-dealer, the securities on hand will be distributed to the claimants on a proportionate basis.

Customers who have claims that exceed the maximum dollar limits of SIPC coverage will rank with
other general creditors for the balance of their claims. For example, a customer who has stock in the
possession of a failed broker-dealer with a value of $525,000 will receive SIPC coverage of $500,000, but
will be treated as a general creditor for the remaining $25,000.

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SIPC Disclosure When an account is opened, SIPC member firms must provide all new customers
with written notification that they may obtain information about SIPC by contacting the insurer. The
firm must provide customers with both SIPC’s website address and a telephone number that may be
used to obtain the referenced information. This information includes the SIPC brochure—a detailed
document that explains coverage under the insurance program.

In addition, member firms must provide existing customers with this information in writing at least
once per year. In situations in which both an introducing firm and a clearing firm service an account,
either one of these firms may fulfill these requirements.

The Employee Retirement Income Security Act of 1974 (ERISA)

ERISA covers the administration of private, qualified retirement accounts, such as the popular
401(k) plans. ERISA provides standards for the funding, vesting, and eligibility of these plans, as well
as the fiduciary responsibilities of pension fund trustees.

The Securities Acts Amendments of 1975

These Amendments created the Municipal Securities Rulemaking Board (MSRB) to act as the SRO for
firms that transact business in municipal securities. Although the MSRB has no enforcement
authority, it’s responsible for formulating and interpreting the rules and regulations that are then
enforced by other regulatory entities, such as FINRA or the SEC.

The Insider Trading and Securities Fraud Enforcement Act of 1988

The Insider Trading Act was created as a response to the scandals of the 1980s. Insider trading
involves the illegal trading on the material, non-public information (i.e., information that’s not
available to the public that could affect the value of publicly traded securities). Both tippers
(information givers) and tippees (information receivers) may be held liable for violations.

Although insider trading was prohibited by the Acts of 1933 and 1934, there were no specific penalties
prescribed. For any individuals convicted of insider trading, the Act of 1988 established criminal
penalties to include a fine as high as $5 million and/or up to 20 years imprisonment. At the civil level,
the SEC may sue for up to three times the profit made or loss avoided (referred to as treble damages).

The Penny Stock Reform Act of 1990

The Penny Stock Reform Act regulates the solicited sales of certain low-priced securities to potential
new customers. Penny stocks are defined as non-exchange-traded securities (i.e., OTC equities)
that trade for less than $5 per share. Since penny stocks are often risky and highly volatile, the rules
require a firm to obtain a signed disclosure document from potential buyers which states that they
understand the risks involved.

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The Federal Telephone Consumer Protection Act of 1991

The Telephone Consumer Protection Act was passed to address consumer complaints that related
to the practice of cold calling. Due to the Act, any person with a profit motive who calls prospects
must maintain a Do Not Call List and refrain from continuing to solicit business from any persons
who request that their name be placed on that list. Solicitation calls may only be made from 8:00
a.m. to 9:00 p.m. local time of the called party.

The USA PATRIOT Act of 2001

The purpose of this Act is to deter and punish any terrorist acts that occur both in the U.S. and
around the world, to enhance law enforcement investigatory tools, to establish a process for
verifying the identity of potential customers, and to strengthen measures to prevent, detect and
prosecute international money laundering and financing of terrorism. Additionally, the Act requires
all appropriate elements of the financial services industry to report potential money laundering.

SIE candidates must be able to quickly pick out the relevant rules and regulations that apply to a
situation. Since the information above is simply a quick snapshot of each law, more detailed
information about them will be provided in later chapters.

The following page will provide a summary of all of the important Acts that may appear in exam
questions.

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 CHAPTER 2 – OVERVIEW OF REGULATION

Federal Law Summary

The Name of the Law Key Words or Relevant Points to Look for on the SIE Examination

 IPO and new issue regulation  Full disclosure through a prospectus

Securities Act of 1933  Primary markets  Red Herring
 Issuer sales  No SEC approval

 Secondary market (trading markets) regulation

Securities Exchange Act
 Established antifraud rules and margin requirements (Reg. T)
of 1934
 Created the SEC

Maloney Act of 1938  Created the former SRO for Over-the-Counter (OTC) Markets (the NASD)

 More than 100 shareholders

Investment Company Act
 Minimum $100,000 in assets
of 1940
 Annual reports to SEC; semiannual reports to shareholders
 ABC Test (Advice, Business, Compensation)
Investment Advisers Act
of 1940
 Incidental advisers (lawyers, accountants, teachers, engineers) are excluded from the
adviser definition

 Protection against broker-dealer bankruptcy

Securities Investor Protection  $500,000 coverage per separate customer
Act of 1970 (SIPA)  $250,000 limitation on cash coverage
 Industry-funded; not part of U.S. Government

 Misuse of material, non-public information by any person

Insider Trading and Securities  SEC may sue for treble damages (three-times)
Fraud Enforcement Act of 1988  $5,000,000 maximum fine and/or 20 years imprisonment
 Tippers and tippees may both be liable

Telephone Consumer  Do Not Call Lists

Protection Act of 1991 (TCPA)  Call time limited to 8:00 a.m. to 9:00 p.m. (customer’s time zone)
 Anti-Money Laundering
 Currency Transaction Reports (CTRs) for transactions exceeding $10,000
The USA PATRIOT Act of 2001
 Suspicious Activity Report (SAR) for transactions equal to or exceeding $5,000
 Customer Identification Program (CIP)
 Regulates solicited sales of penny stocks
Penny Stock Reform Act
 Stock priced below $5.00 per share
of 1990
 Establishes significant disclosure rules

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CHAPTER 2 – OVERVIEW OF REGULATION

Self-Regulatory Organizations
FINRA
As previously described, the Financial Industry Regulatory Authority (FINRA) is the primary SRO for
the securities industry and is responsible for the content of the SIE Exam. Many of the rules on which
candidates will be tested are FINRA rules and may be broken down into the following categories:
1. Conduct Rules These rules govern the interactions between customers and firms and cover
areas such as compensation, communications, and sales practice violations. Many of these
rules will be covered in Chapters 17 and 18.
2. Uniform Practice Code (UPC) UPC rules govern trading and the proper settlement of
transactions. The goal of the Uniform Practice Code is to standardize the procedures for doing
business in financial markets. Examples of UPC issues likely to be encountered on the
examination include settlement and corporate actions which will be covered in Chapter 13.
3. Code of Procedure (COP) The COP covers the process used to discipline any person that violates
FINRA rules. Remember, FINRA acts like a COP for the securities industry (using the COP).
4. Code of Arbitration The Code of Arbitration provides a process for resolving disputes
between members, as well as those that involve public customers. Generally, arbitration is used
to settle monetary disputes.

The table below summarizes the use of the Code of Procedure versus the Code of Arbitration:

Code of Procedure Code of Arbitration

Determine disciplinary actions for
Purpose rule violations
Provide for settlement of disputes

FINRA versus broker-dealers

Parties and/or registered representatives
Broker-dealers, RRs, customers

 Fine
 Censure
Possible Negative Monetary or other compensation
 Suspension
Outcomes settlements
 Expulsion
 Other appropriate sanctions

Appeal Process Yes No

The Municipal Securities Rulemaking Board (MSRB)

The Securities Acts Amendments of 1975 required dealers that participate in municipal securities
transactions to be registered with the SEC and also created the Municipal Securities Rulemaking
Board. The MSRB was established to function as an independent, self-regulatory organization and
charged with primary rulemaking authority for the municipal securities industry.

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 CHAPTER 2 – OVERVIEW OF REGULATION

The MSRB requires every broker or dealer that engages in municipal securities business to comply
with its rules. The MSRB is mainly concerned with the standards of professional practice, including
qualifications of broker-dealers, rules of fair practice, and recordkeeping. Interestingly, MSRB rules
don’t apply to the issuers of municipal securities.

Enforcement of MSRB Rules Although the MSRB formulates and interprets its rules, it has no
enforcement power. Instead, the MSRB is controlled by the SEC and MSRB rules are enforced by
either the SEC or another regulatory agency.

Type of Firm: MSRB rules are enforced by:

Broker-dealers  SEC or FINRA
 Comptroller of the Currency for national banks
 Federal Reserve Board for non-national banks that are members of the FRB system
Bank dealers
 Federal Deposit Insurance Corporation (FDIC) for non-national banks that are not
members of the FRB system

The Chicago Board Options Exchange (CBOE)

The CBOE functions as a trading venue for options contracts in individual stocks, stock indexes,
interest rates, as well as exchange-traded funds (ETF) and is also the SRO for the options market.
The CBOE is the largest options market in the U.S. and is regulated by the Securities and Exchange
Commission and owned by CBOE Global Markets. The specifics of option contracts will be covered
in Chapter 10 and ETFs will be covered in Chapter 9.

Firm Specific Rules

Internal Compliance
Not all oversight is handled by the SEC or FINRA. Internal compliance professionals (many of
whom are principals) oversee all employee and customer activities to ensure that both federal
securities laws and industry rules are being followed. For example, a member firm’s supervising
principals routinely monitor both employee and client trading activity to uncover evidence of
wrongdoing, such as insider trading.

Essentially, compliance works with sales professionals to develop policies and procedures which
allow them to sell securities and to grow the firm’s business in an ethical and compliant manner.
Compliance professionals are responsible for creating their firms’ house rules that form the basis of
the previously described Written Supervisory Procedures (WSPs). These “in-house” rules are not
tested on the SIE Exam since they vary from firm-to-firm. When preparing for the SIE Exam, an
important distinction to remember is that a firm’s internal rules may be more stringent and
materially different from the minimum standards that are set by the SEC and SROs.

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CHAPTER 2 – OVERVIEW OF REGULATION

The Importance of Understanding Regulation

There are two reasons for devoting such a significant amount of time to covering the different
regulations. The first is to reinforce the importance of these regulations by providing a framework
that will be helpful once a person begins her career in the financial services industry. The second is
that the test itself is prepared by the major SROs—namely FINRA and the MSRB. In large part,
passing the SIE Examination is a function of knowing the general and specific rules and regulations
that govern the securities industry from the perspective of the SEC and the SROs that enforce these
same rules and regulations.

Conclusion
This concludes the two overview chapters. Chapter 1 detailed the various market participants, while
this chapter examined the regulatory framework in which these market participants operate. Now
let’s begin to examine the various securities products, with special emphasis placed on reviewing
their risks and rewards.

Create a Chapter 2 Custom Exam

Now that you’ve completed Chapter 2, log in to my.stcusa.com and create a 10-question custom
exam.

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 CHAPTER 3

Equity Securities

Key Topics:

 Corporate Structure

 Characteristics of Common Stock

 Classifications of Common Stock

 Types of Preferred Stock

 Rights vs. Warrants

 CHAPTER 3 – EQUITY SECURITIES

The goal of this chapter is to increase a person’s knowledge of the following equity-related
concepts: · features of ownership (e.g., order of liquidation and limited liability), voting
rights, convertibility, as well as control and restrictions (e.g., SEC Rule 144). The process of
issuing and trading these securities will be covered in Chapter 11 of the study manual.

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 may 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 generally is 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. As briefly mentioned in Chapter 1, 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 do
not 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 3 – EQUITY SECURITIES

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 Stock
Common stock is (1) the basic unit of corporate ownership, (2) the most widely issued type of stock,
and (3) the first type of stock that a corporation issues. For bookkeeping purposes, common stock is
usually issued with a par (face) value that’s an arbitrary amount and is used for the company’s financial
statement. There’s no relationship between the par value of an equity security and its market value.

Let’s analyze the progression of a company’s shares from the time of incorporation to the point at
which the corporation may choose to purchase its shares in the open market.

Authorized Shares At the time of incorporation, a company is authorized to issue a certain

number of shares. Once the original number of shares is set, it can be changed only by a majority
vote of the stockholders and by revising the corporate charter (the documents that establishes the
corporation). Most corporations issue fewer shares than what’s authorized in order to keep a certain
amount of stock available for future use.

Issued Shares Issued shares represent the number of shares that have been sold by the
corporation. Any shares that haven’t been sold or distributed are referred to as unissued shares.

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 CHAPTER 3 – EQUITY SECURITIES

Treasury Stock For various reasons, a corporation may ultimately repurchase some of its issued
shares. When stock is issued and subsequently repurchased by the company, it’s referred to as
treasury stock. As long as the stock remains in the treasury, it has no voting rights and does not receive
dividends. Treasury stock appears as an informational item on the corporation’s balance sheet.

Outstanding Stock The term outstanding stock refers to the number of shares that have been
issued to the public, minus any stock that has been repurchased by the company (treasury stock).
Outstanding stock receives dividends and has voting rights. Many market professionals refer to a
company’s market capitalization to indicate its size, which is found by multiplying the current
market price of the stock by the number of outstanding shares.

Issued Stock – Treasury Stock = Outstanding Stock

Example: Although ABC Corporation is authorized to issue 10,000,000 shares, it has only
issued 4,500,000 million shares. Later, due to ABC having repurchased 500,000 shares of
the stock for its treasury, ABC has 4,000,000 shares outstanding.

Rights of Common Shareholders

As specified in a corporation’s charter and bylaws, all shareholders are provided with certain rights,
which may include the following:
 Right of inspection
 Right to vote
 Right to receive dividends
 Right to evidence of ownership
 Right of transfer

Right of Inspection Stockholders have the right to inspect certain books and records of the
company, including the stockholders’ list and the minutes of stockholders’ meetings. This right is
usually exercised through the receipt of an audited annual report.

Right to Vote The ability to vote is typically associated with common stockholders. They may
attend annual shareholder meetings and vote on important issues, including the election of
members to the board of directors, whether the stock may be split, and whether the company is
able to merge with or acquire another company. It’s important to remember that shareholders vote
on whether the corporation may execute a stock split, but NOT on whether the corporation should
pay cash and/or stock dividends. Rather than allowing common stockholders to decide whether
they deserve any form of distribution, all dividend decisions are made by the board of directors. The
number of votes that are available to each shareholder is determined by the number of shares the
person owns. For instance, if a person owns 100 shares, she is provided with 100 votes.

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CHAPTER 3 – EQUITY SECURITIES

Voting Methods The two different voting methods that may be used by a company are statutory
and cumulative. With statutory voting, a shareholder is given one vote, per share owned, per voting
issue. Therefore, the more shares a person owns, the greater her voting power. For that reason,
statutory voting is considered to be beneficial for the larger, more substantial (majority)
shareholders.

With cumulative voting, shareholders are able to multiply the number of shares that they own by
the number of voting issues. The result of that calculation is the total number of votes that
shareholders may cast in any manner that they choose. Cumulative voting tends to favor the
smaller, less substantial (minority) shareholders.
Example: XYZ Corporation is holding an election for it board of directors. There are three
seats available, but five potential candidates. With three seats available, this represents
three voting issues. If shareholders are required to use statutory voting, an investor who
owns 1,000 shares is able to cast a maximum of 1,000 votes to three of the five candidates.
On the other hand, if cumulative voting is required, an investor who owns 1,000 shares is
able to cast 3,000 votes in any manner that she chooses (1,000 shares x 3 voting issues),
which is a significant benefit if she really favors one of the five candidates.

The following diagram shows the difference between statutory and cumulative voting:

Candidates
1 2 3 4 5
Statutory: 1,000 votes 1,000 votes 1,000 votes
Cumulative: 3,000 votes
Please note, the statutory voter could have chosen to cast votes for only two of the
directors, but would still be limited to a maximum of 1,000 votes for each. The
cumulative voter’s 3,000 votes could have been cast in multiple ways (e.g., 1,500 votes
for 2 candidates or 1,000 votes for 3 directors).

Right to Receive Dividends Although not guaranteed, companies will often pay out a portion of
its profits to shareholders. The portion of a company’s profit that’s paid to common and preferred
shareholders is referred to as a dividend. Dividend payouts and stock splits will be covered in detail
in Chapter 13.

Right to Evidence of Ownership Shareholders have the right to receive one or more stock
certificates as proof of ownership. The certificate states the name of the corporation, the name of
the owner, and the number of shares that are owned by the stockholder. The certificate must also
show the names of both the transfer agent and registrar and include the signature of an authorized
corporate officer. As with a check, a stock certificate must be endorsed by the owner when it’s sold
to be considered in good deliverable form.

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 CHAPTER 3 – EQUITY SECURITIES

Right of Transfer Stockholders have the right to freely transfer their shares by selling them, giving
them away, or bequeathing them to heirs. There are some cases in which shares are not freely
transferable, such as when a person buys shares before the company’s initial public offering (IPO)
or acquires shares as part of their work compensation. These restricted shares often include a
legend (warning) to indicate that the shares are ineligible for transfer.

Restricted Securities – Lock-Up Agreements and Legends For certain investors who own
restricted securities, a lock-up agreement dictates the amount of time that pre-IPO investors (e.g.,
private placement buyers, management, venture capitalists, and other early investors) must wait
before selling their shares after the company has gone public. Although these lock-up agreements 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 for a profit once the issue goes public.

The lock-up period also restricts or limits the supply of shares being sold in the market. Shares that are
subject to a lock-up agreement will have the restrictive legend printed across the face of the certificate
to indicate that the securities haven’t 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.

Rule 144
Rule 144 regulates the sale of restricted securities and control (affiliated) securities. Restricted
securities are the unregistered securities that are typically acquired by investors through private
placements. Control securities are registered securities that are acquired by control (affiliated)
persons in the secondary market. Control persons may include officers, directors, or other insiders
(those with more than 10% ownership) and their respective family members. Both restricted
securities and control securities must be sold according to the provisions of Rule 144.

Holding Period For the restricted securities of a reporting company (one that’s subject the
reporting requirements of the Securities Exchange Act of 1934), the purchaser must generally hold
the securities for six months before he can dispose of them. The six-month holding period starts
from the time the securities were fully paid for (no margin) by the original purchaser. However,
there is no holding period requirement that applies to control securities. In other words, securities
that are acquired in the public market are not restricted and there’s no mandatory holding period
for an affiliate that purchases the securities. Despite the lack of a required holding period, the resale
of an affiliate’s control securities is subject to other conditions of the rule.

Notice of Sale Under Rule 144, a person that intends to sell either restricted or control securities
must notify the SEC by filing Form 144 at the time the sell order is placed with the broker-dealer.
Once notification is made, the SEC provides a 90-day period during which the securities may be
sold. If the securities are not sold during this period, an amended notice must be filed. An
exemption from the notice of sale requirement is available if the amount of the sale does not exceed
5,000 shares or securities with a value that does not exceed $50,000. In other words, if a person is
not selling an excessive number of shares or the aggregate dollar value of the sale is insignificant, no
filing with the SEC is required.

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CHAPTER 3 – EQUITY SECURITIES

Volume Limitation Under Rule 144, the maximum amount of securities that a control person of
an exchange-listed company may sell over any 90-day period is the greater of 1% of the total shares
outstanding or the average weekly trading volume during the four weeks preceding the filing.
For example, an issuer has 7,000,000 shares outstanding and the average weekly
trading volume for the past four weeks was 60,000 shares. Since 1% of the total shares
outstanding is 70,000 shares and the four-week average is 60,000 shares, the holder can
sell the greater of these two amounts, which is 70,000 shares.

Classification of Stocks
Specific stocks are often categorized based on the size (e.g., large-, mid-, or small-cap) or type of
issuing company, assumed risk, expected return, or correlation to the business cycle. The following
section lists some of the more common classifications.

Blue-Chip Stocks
Blue-chip stocks are high-grade issues of major companies that have long and unbroken records of
earnings and dividend payments. The term is used to describe the common stock of large, well-
established, stable, and mature companies that have great financial strength.

Growth Stocks
A growth stock is an issue of a company whose sales, earnings, and share of the market are
expanding faster than the general economy and the industry average. Typically, this type of
company is aggressive, research minded, and retains most of its earnings to finance expansion and,
therefore, pays little or no cash dividends.

Defensive Stocks
Defensive stocks are associated with companies that are resistant to a recession, including sectors
of necessary services (utilities), production of consumer staples (tobacco, pharmaceuticals, soft
drinks, and candy), and essentials (food). Essentially, defensive stocks are related to companies that
perform well regardless of the current economic environment. It’s important to distinguish
between a defensive stock and a defense stock. A defense stock is issued by a company that’s
involved in the manufacture of materials that are used by the armed services to defend the country.

Income Stocks
Income stocks are issued by companies that pay higher-than-average dividends in relation to their
market price. This type of stock is generally attractive to investors, particularly the elderly and
retired, who are interested in current income as opposed to capital appreciation. Utility stocks are
often placed in the income stock category

Cyclical Stocks
Cyclical stocks are associated with companies whose earnings fluctuate with the business cycle.
When business conditions improve, the company’s profitability is restored and the price of its
common stock rises.

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 CHAPTER 3 – EQUITY SECURITIES

However, when conditions deteriorate, business for the company falls off sharply and its profits are
diminished. This ultimately causes the stock’s price to decline. Examples of companies whose stock
is considered cyclical include household appliance, steel, construction, and automobile companies.

American Depositary Receipts (ADRs)

ADRs facilitate the trading of foreign stocks in the United States. An ADR represents a claim to foreign
securities while the actual underlying shares are held by U.S. banks located overseas. ADRs trade in
U.S. markets, either on an exchange or over-the-counter, and are priced and pay dividends in U.S.
dollars, rather than in a foreign currency. ADR shareholders have dividend rights, but don’t directly
receive preemptive rights (to be covered shortly).

An ADR may be sponsored or unsponsored. For a sponsored ADR, the company whose stock
underlies the ADR pays a depositary bank to issue ADR shares in the U.S. This sponsorship permits
the company to raise capital in the U.S. and list the ADR on either the NYSE or Nasdaq. Many of the
largest ADRs are sponsored. For an unsponsored ADR, the company does not pay for the cost
associated with trading in the U.S.; instead, a depositary bank issues the ADR. Unsponsored ADRs
trade in the OTC market and are usually quoted on the OTC Link—an electronic exchange that
executes trades in securities that are not eligible for NYSE or Nasdaq listing.

Preferred Stock
Preferred stock is often issued by established companies that already have common stock
outstanding. These shares are suitable for investors who are more interested in income than capital
appreciation (i.e., the same type of investors who might otherwise purchase bonds). Unlike common
shares, preferred shares generally lack voting rights.

Preferred stock is normally issued with a par (face) value of $100, which corresponds to its initial
market price, and carries a specified dividend. For example, a 5% preferred stock is expected to pay
an annual dividend of $5 (5% of the par value of $100). However, the dividend rate for preferred
stock may also be stated as a dollar amount (e.g., $3 preferred stock is expected to pay a 3% annual
dividend). A preferred stock’s dividend rate generally represents the maximum amount that the
preferred stockholders may receive. If a company is not doing well, its board of directors may
choose to pay less than the full amount or may choose to pay nothing at all.

Corporations attempt to make their preferred stock marketable to specific investors by adding
features to their shares. Let’s examine the different types of preferred stock.

Cumulative Preferred Stock

What happens if a corporation fails to pay the full dividend on its preferred stock? If the preferred
stock is cumulative, then all of the preferred dividends that are in arrears (owed) must be paid
before the common stockholders receive dividends. Most preferred stock is cumulative.

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CHAPTER 3 – EQUITY SECURITIES

Assume that Widget, Inc. has issued 5% preferred cumulative stock. Over the last three years, the
widget market has been in turmoil due to the introduction of the gidget—a cheaper foreign-made
substitute. As a result, Widget, Inc. has paid only the following dividends to its preferred stockholders:

Dividends Paid Dividends in Arrears

Year 1 $2 $3
Year 2 $2 $3
Year 3 $3 $2

In Year 4, the widget market rebounds after several gidgets spontaneously combust. Now Widget,
Inc. has sufficient earnings to pay dividends to both its preferred and common stockholders. Before
the common stockholders receive any dividend payments, the company must pay $13 to the
preferred shareholders (the missing amounts of $3 for Year 1, $3 for Year 2, $2 for Year 3, and the
full stated $5 for Year 4).

Non-Cumulative Preferred Stock

If preferred stock is non-cumulative, any missed dividend payments don’t accumulate. Instead,
only the current year’s dividend must be paid before common stock dividends are paid.

Now, assume that Widget, Inc. has issued 5% non-cumulative stock. Again, the widget market has been
in turmoil for the last three years and, as a result, the company has paid only the following dividends:

Dividends Paid
Year 1 $2
Year 2 $2
Year 3 $3

In Year 4, if the widget market rebounds, how much must Widget, Inc. pay to its non-cumulative
preferred shareholders if it also wants to pay a common dividend? Only $5 since the preference is
limited to the current year’s dividend for non-cumulative preferred stock. Remember, non-
cumulative preferred stock is not entitled to any missing or unpaid dividends.

Participating Preferred Stock

For preferred stock, the stated return is generally the maximum annual income that an investor can
expect to receive. However, an investor who purchases participating preferred stock may receive a
greater dividend if the company is doing well and its common dividends exceed a specified
amount. For example, an investor owns a 5% preferred stock, with a potential 3% additional payout.
This investor is entitled to the 5% dividend, but could receive up to 8% if the common stock
dividends reach a specified level.

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 CHAPTER 3 – EQUITY SECURITIES

Callable Preferred Stock

A company that issues callable preferred stock has the right to repurchase the stock (i.e., to call it
back) at a specified price at some time in the future. In order to induce investors to buy the stock,
the call price is typically higher than the stock’s par value.

Convertible Preferred Stock

For investors who want greater potential for capital appreciation than preferred stocks typically
provide, convertible preferred stock may be a suitable choice. The trade-off is a lower dividend rate
than what’s offered by other types of preferred stock. Investors who purchase convertible preferred
stock are able to, at their discretion, convert the par value of the preferred stock into a predetermined
number of common shares at a specified price—which is the stated conversion price.

To determine the conversion ratio (i.e., the number of shares to which an investor is entitled), the par
value of the preferred stock ($100) is divided by its conversion price. For example, if the conversion
price is $25, then the conversion ratio is 4-for-1 ($100 par value ÷ $25). In this case, the preferred
stockholder will receive four shares of common stock for every one share of preferred stock.

A feature that an issuer may add to convertible preferred stock is to make the stock callable. The
choice of whether to convert the stock or allow it to be called will generally depend on the relative
value of the common stock received through conversion as compared to the call price. The
preferred stock will typically trade at a value which reflects the best choice for the customer.
For example, a notice is published stating that RMO 5% convertible preferred stock will be
called at $102 per share. The preferred is convertible into 2 shares of common stock and
RMO’s common stock is selling in the market at $55 per share. After the notice appears, the
price of the preferred stock will most likely trade in the market at a price near $110.

Why is this the case? Since the convertible preferred stock has a conversion value of $110 ($55 per
common share x 2 share conversion ratio), the market price of the preferred stock will reflect the
increased value of the common stock. The call price of $102 doesn’t reflect the common stock’
increased value.

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 3 – EQUITY SECURITIES

Rights and Warrants – Derivative Securities

Derivative securities are special types of investments that track the value of common stock or
another underlying asset. For example, imagine a security which provides the owner with the
opportunity to buy 100 shares of ABC stock at $75 per share regardless of how high the stock may
rise. This is precisely the position in which the buyer of a warrant will find herself. If ABC rises
above $75, the warrant has value since the investor is entitled to buy the shares at a price that’s
below the current market price. On the other hand, if ABC declines in value to below $75, the
warrant will have little value since ABC stock is able to be purchased in the market at a better price
than what’s available through the warrant.

The following section will examine two types of derivatives that are issued by a corporation—rights
and warrants. Chapter 10 will examine options contracts—a different type of derivative that’s often
issued by a third party, such as the Options Clearing Corporation (OCC).

Preemptive Rights
An exclusive privilege for common stockholders is that they may be entitled to preemptive rights. If
a corporation is seeking to raise more capital and intends to issue additional shares of stock, a rights
offering may be conducted to provide current shareholders with the opportunity to buy the shares
before they’re offered to the public. By participating in the offering, the current shareholders are
able to maintain their percentage of ownership in the company. If shareholders choose not to
subscribe to the offering, their percentage of ownership and ability to control the company’s future
will be diluted by the new stock offering.

Rights Offering and Subscription Price In a rights offering, all existing common stockholders
automatically receive one right for every one share they own. However, the number of rights
required to buy one new share of stock, the price at which the shares may be acquired, and the
available period for exercising the rights will vary. Typically, the offer is good for only a limited
number of days and the preset purchase price is below the current market value of the stock. This
preset exercise price is referred to as the subscription price.
For example, Widget Inc. has 1,000,000 shares of outstanding stock and plans to issue an
additional 1,000,000 shares to the public. An investor who currently owns 100,000 shares
(10% of the outstanding stock) will receive 100,000 rights. These rights will allow her to
purchase 100,000 shares at a favorable price and maintain her 10% ownership in the
company. If she does not exercise her rights within a certain period, the rights will expire.

Investors who acquire rights have two viable options. First, the holder may choose to exercise the
rights by tendering them to the issuer’s transfer agent. Second, the rights may be freely transferred
(traded) since they usually trade in the same market as the underlying stock.

Warrants
A warrant is another type of derivative on an equity security that may be issued by corporations.
Like rights, warrants give the holders the ability to buy the issuer’s common stock at a specified price
(the subscription price) in the future.

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 CHAPTER 3 – EQUITY SECURITIES

However, unlike stock rights that have a relatively short life, warrants have a maturity that’s often
set years in the future. In fact, some warrants have a perpetual (endless) life.

Another way that warrants differ from stock rights is that a warrant’s subscription price is usually
set at a price that’s higher than the current market price of the stock. Therefore, if a stock later
increases in value (above the subscription price), the holder of the warrant will be in a position to
realize a profit. Companies typically issue warrants in connection with an offering of stock or
bonds. By including the warrants, investors are given an added incentive (i.e., as a sweetener) to
purchase these issues. Warrants are usually able to be detached from the securities with which they
were originally issued and may be sold separately.

Intrinsic Value If the stock’s market price rises above the warrant’s subscription price, then the
warrant has intrinsic value. For example, if the warrant’s subscription price is $30 and the stock’s
market price is $33, then the warrant has intrinsic value of $3 (i.e., the investor could acquire the
stock for $30 and sell the shares at $33, for a 3-point gain). However, to reflect the possibility that
the stock’s price may increase further before the warrant expires, the actual value of the warrant
may be even higher than the intrinsic value.

Rights Warrants
Purchasers of the issuer’s
Issued to: Existing common stockholders
stocks or bonds
Subscription Price: Below current market value Above current market value

Maturity: Short-term (30-45 days) Long-term (Years, not days)

Miscellaneous Equity Rules

FINRA Rule 2261 – Disclosure of Financial Condition
If requested, a member firm is required to make available for inspection by a regular customer the
information related to the firm's financial condition as disclosed in its most recent balance sheet.
The balance sheet may be delivered to a customer in either physical or electronic form.

FINRA Rule 2262 – Disclosure of Control Relationship with Issuer

A brokerage firm that has a control relationship with the issuer of any security is required to
disclose this fact to its customers. The disclosure must be provided either before or at the time of
executing a transaction in the security. Two situations in which a control relationship exists are if
the member firm is a publicly traded company or if it’s a subsidiary of a publicly traded company.
For example, a customer has an account at LRR Investments and is purchasing 1,000 shares of LRR
Incorporated, which is listed on the NYSE. In this case, LRR Investments is required to disclose the
existing control relationship between the two firms.

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CHAPTER 3 – EQUITY SECURITIES

SEC Rule 10b-18 – Purchases of Certain Equity Securities by the Issuer

For a variety of reasons, an issuer of securities may be tempted to purchase its stock in an effort to
increase the price. To minimize the possibility of manipulation, the SEC has created Rule 10b-18
which controls how an issuer or any affiliates may purchase its own stock in the secondary market.
Some of the legitimate reasons for issuers to purchase their own stock in the open market include
for stock buyback plans or for funding employee stock purchase plans.

Safe Harbors Under 10b-18 The SEC will not assume that an issuer is attempting to manipulate
its stock price if the issuer adheres to the following conditions:
 Only one broker-dealer is used to place bids and make purchases during any trading session.
 Purchases are not made during certain times of the day. Issuers are prohibited from making a
purchase that is the first reported transaction for that day and from making a purchase during the
last 30 minutes of the normal trading day. If the issuer’s stock is actively traded, the purchase
prohibition changes to within the last 10 minutes of the trading day.
 The bid or purchase price of securities is limited to certain prices. The price may not be higher than
the highest independent bid or the last independent transaction price, whichever is higher. For
example, if the last independent transaction was $23.53 and the current bid/ask spread is $23.50 -
$23.60, the highest price at which the issuer may buy its stock is $23.53.
 The amount of stock purchased on any single day is limited. The total volume on any single day may
not exceed 25% of the average daily trading volume (ADTV) for that security.

Conclusion
This concludes the introductory chapter on equity securities. Chapter 11 will examine the process
of issuing these securities in the primary market which is regulated by the provisions of the
Securities Act of 1933. Chapter 12 will cover the process by which securities are purchased and sold
in the secondary market. The next chapter will provide an introduction to bonds.

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 CHAPTER 4

An Introduction to
Debt Instruments

Key Topics:

 Characteristics of Bonds

 Bond Pricing

 Price vs. Yields

 Retirement of Debt

 Convertible Bonds
 CHAPTER 4 – INTRODUCTION TO DEBT INSTRUMENTS

Chapter 3 described equity issuance—a method that corporations use to raise capital by selling an
ownership interest to investors. Corporations can also raise capital by issuing bonds. Unlike
shareholders, investors who buy bonds don’t become part owners of the company; instead, these
investors become creditors. Essentially, think of purchasers of bonds as taking on the role of a bank by
lending money to the issuer for a certain period. In return, the corporation agrees to pay these
investors interest, as well as to repay the original amount of the loan when the bond matures.

Although bonds are categorized based on the entity that issues them, all of these debt instruments have
certain fundamental traits in common. This chapter will examine these common characteristics, while
the next chapter will cover specific details related to bonds that are issued by corporations, the U.S.
Government, municipalities, and other borrowers.

Introduction to Debt Instruments

Basic Bond Characteristics
A bond is a contract between an issuer and an investor. As stated previously, the investor lends money to
the issuer and the issuer (debtor) promises to repay debt service. Debt service represents the total of all
interest payments over the bond’s life and the final repayment of the loan value (principal) at maturity.
The issuer must stand ready to make these payments since it will be in default if any are missed.

For an issuer, raising capital through debt is referred to as leverage financing since the issuer is
borrowing against its net worth. When a corporation has more debt than equity outstanding, it’s
considered a leveraged issuer.

Let’s examine some key terms that are used when describing bonds.

Par Value The par value of a bond (also referred to as the principal or face value) is the amount that
the issuer agrees to pay the investor when the bond matures. An investor who buys a bond with a par
value of $1,000 expects to receive $1,000 when the bond reaches maturity. Regardless of the amount
an investor pays for a bond, if it’s held to maturity, the issuer is obligated to pay the par value. Most
bonds are issued in multiples of $1,000, but some (e.g., U.S. Treasury securities) may be issued in
denominations as small as $100.

Coupon Rate Obviously, investors don’t buy bonds just to receive their principal back at some
future date. The issuer must also agree to pay investors interest on the loan until the bond matures.
The rate of interest is generally fixed at the time the bond is issued and, with some exceptions,
remains the same for the life of the bond. This fixed rate of interest is also referred to as the bond’s
coupon rate. The interest paid is calculated based on the bond’s $1,000 par value, not the price paid
for the bond. Ultimately, the primary reason that investors purchase bonds is to generate income
represented by their bond’s coupon rate.

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CHAPTER 4 – INTRODUCTION TO DEBT INSTRUMENTS

Generally, bonds with longer maturities offer higher coupons. Since the investor’s money is at risk for a
long period, the investor expects a higher rate of return than those offered by shorter-term investments.
Short-term bonds are usually safer investments since buyers know that their money will be returned
relatively quickly. For this safety, investors are willing to accept lower rates of interest. Of course, there
are other factors that may affect the yield of bonds. If an issuer is considered a high credit risk, it must
offer higher yields to attract investors than an issuer with a higher credit rating. The term yield is used in
different ways. In some situations, yield may refer to the return on an investment; however, in the case
of a debt instrument that’s purchased at par value, it refers to the interest payments.

In order to determine the amount of interest that the investor will receive annually, the bond’s par value
($1,000) is multiplied by its stated interest rate. For example, if a client purchases a 6% corporate bond,
she will receive $60 per year ($1,000 x 6% = $60). Since bonds usually pay interest twice per year
(semiannually), the investor will receive two $30 payments every year ($60 ÷ 2 = $30).

The bond’s maturity date is important in determining when an investor will receive her interest
payments. One of the payment dates will always be the month and day of maturity, while the other is
six months from that date. Therefore, if the investor’s 6% corporate bond matures on June 1, 2030,
she will receive two payments per year—one every June 1 and the other every December 1.

Fixed or Variable Rates As previously mentioned, a bond’s interest rate is set at the time of
issuance and generally remains fixed for the life of the bond. However, in some cases, as interest rates
move up or down, the coupon rate will be adjusted to reflect market conditions. These adjustable rate
bonds are sometimes referred to as variable or floating rate securities.

Initial Interest Payment Traditionally, bonds pay interest on the 1st or 15th of the month to ease
paperwork issues. However, newly issued bonds pay interest from the dated date (the date from
which interest begins to accrue), which may not fall on the 1st or 15th. For this reason, the very first
coupon on a newly issued bond may be for more or less than the traditional six-month period as
the issuer tries to get synchronized with the 1st or 15th payment date. If the first coupon is for more
than six months, it’s referred to as a long coupon; if the first coupon is for less than six months, it’s
referred to as a short coupon.

Accrued Interest Since bond interest is paid semiannually, a bondholder who sells a bond
between interest payments is usually entitled to the interest earned during the period when he still
owned the bond. This accrued interest is the amount of interest that the seller is entitled to receive
(from the buyer) and the amount that the buyer is required to pay (to the seller) for a bond being
sold in the secondary market. For calculation purposes, corporate and municipal bonds use 30 days
in every month and 360 days in the year, while U.S. government T-notes and T-bonds use actual
days in every month and 365 days in the year.

Zero-Coupon Bonds Zero-coupon bonds don’t pay periodic interest. Instead, an investor
purchases a zero-coupon at a deep discount from its par value, but redeems the bond for its full
face value at maturity. The difference between the purchase price and the amount that the investor
receives at maturity is considered the bond’s interest. Usually, the longer the zero-coupon bond’s
maturity, the deeper its discount will be from par value.

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 CHAPTER 4 – INTRODUCTION TO DEBT INSTRUMENTS

Interest Bearing Bonds Zero Coupon Bonds

Pay interest at regular intervals Interest paid as a lump sum when bond matures
For investors who desire current income For investors who desire a lump sum at some future date

Maturity Date This is the date on which the bondholder will receive the $1,000 return of principal
from the issuer. The maturity or due date is identified on the face of the bond.

Serial versus Term Issues Corporations and other entities routinely issue millions of dollars worth
of bonds at the same time. There are several ways that the issuer may structure its loan repayment.
Two of the common forms are term and serial.

If all of the bonds in an offering are due to mature on the same date, it’s referred to as a term bond
issue. On the other hand, if parts of an offering will mature sequentially over several years, it’s
referred to as a serial bond issue. For example, an issuing corporation may sell $50 million par value
of bonds with $10 million coming due each year over a five-year period. With serial issues, an
investor could purchase a quantity of bonds that mature at the same time or, if she wants, she could
purchase bonds with different maturities. A serial bond may be structured so that principal and
interest payments represent approximately equal annual payments over the life of the offering,
which is referred to as level debt service.

Why Bond Prices Fluctuate from Par

The par value of a bond can differ greatly from the price that investors pays to purchase the bond
(i.e., the market price). Although most bonds are initially sold at par value, as time goes by, these
bonds may trade in the market at prices that are less than or more than par. A bond that’s sold for
less than its par value is selling at a discount, while a bond that’s sold for more than its par value is
selling at a premium.

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CHAPTER 4 – INTRODUCTION TO DEBT INSTRUMENTS

Discounts and Premiums

The reasons for these discounts or premiums typically relate to the changes in prevailing market
interest rates (i.e., interest-rate risk) or concerns about the creditworthiness of the issuer (i.e., credit
risk). Let’s carefully analyze these two risk factors.

Interest-Rate Risk Investors who purchase bonds assume the risk that the bond’s market value
may decline if market interest rates rise. Interest-rate risk implies that as market rates increase,
investors will not be interested in purchasing existing bonds at par since they’re able to obtain
higher yields by purchasing new bonds. Therefore, existing bonds will need to be offered at a
discount (put on sale) in order to attract purchasers. Conversely, if interest rates fall after a bond
has been issued, the bond will likely trade at a premium to par. A more detailed description of
interest-rate risk will be provided Chapter 20.

Credit Risk Credit risk is a recognition that an issuer may default and may not be able to meet its
obligations to pay interest and principal to the bondholders. Not surprisingly, issuers that are
considered high credit risks must pay a higher rate of interest in order to induce investors to
purchase their bonds. Generally, if a company is perceived as becoming more risky, the prices of its
bonds will fall; however, if a company is viewed as improving, its bond prices tend to rise.

Measuring Credit Risk Securities that are issued by the U.S. government have the lowest possible
credit risk since the government’s risk of defaulting is virtually zero. This is due to the fact they’re
backed by the full faith and credit and taxing authority of the U.S. government.

Credit risk is more difficult to evaluate when the bonds are issued by a corporation or a municipality.
Most investors rely on an organization that specializes in analyzing the credit of bond issues. Some
of the credit rating companies that provide bond ratings are Moody’s, Standard and Poor’s (S&P),
and Fitch Investors Service. Each company evaluates the possibility that an issuer may default and
assigns the issue a credit rating. Later, this rating may be raised or lowered depending on
subsequent events. A lowered credit rating may cause a bond’s market price to drop significantly.

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 CHAPTER 4 – INTRODUCTION TO DEBT INSTRUMENTS

Below are the ratings of Moody’s, Standard and Poor’s, and Fitch from the highest to the lowest:

Moody’s S&P Fitch

Best Quality Aaa AAA AAA
Investment High Quality Aa AA AA
Grade Upper Medium A A A
Medium Baa BBB BBB
Ba BB BB
B B B
Speculative
Caa CCC CCC
Grade
Ca CC CC
C C C
D DDD
DD
D

For bonds issued by corporations, Moody’s further subdivides each major rating category by using
a 1, 2, or 3, with 1 being the highest. For example, Aa1 is higher than Aa2, however, Aaa3 is higher
than Aa1.
Standard & Poor’s uses a plus (+) and minus (-) to further distinguish between ratings. For example,
A+ is better than A; however, A- is better than BBB+.

It’s important to note that only relatively large issues are rated. This does not necessarily mean that
an unrated issue is of poor quality; instead, it may suggest that an issue may be too small to apply
for and be given a rating.

Bond Pricing
A bond’s price is usually stated as a percentage of its par value. For example, a bond with a price of
100 is selling at 100% of its par value, or $1,000 (100% of $1,000). A bond with a price of 90 is selling
at a discount equal to 90% of its par value, or $900. A bond with a price of 110 is selling at a
premium which is equivalent to 110% of its par value, or $1,100.

A bond’s price may also be expressed in terms of points. Each point is equal to 1% of the bond’s par
value, or $10. Therefore, a quote of 99 points is equal to $990 (99 points x $10 per point = $990). A
bond selling at 100 is selling for 100 points or $1,000. If the bond’s price increases to 101, it’s selling
for $1,010 (101% of the par value).

Bond Price Percentage of Par Value Price in Dollars

99 99% $990 Discount
100 100% $1,000 Par
101 101% $1,010 Premium

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CHAPTER 4 – INTRODUCTION TO DEBT INSTRUMENTS

Smaller Pricing Increments Of course bonds don’t always trade in even point values; their prices will
1
often include a fraction. Traditionally, corporate and municipal bonds trade in increments of /8 of a
1
point, while Treasury notes and bonds trade in increments of /32 of a point. For pricing purposes,
rather than working with a fraction, let’s convert the fraction to a decimal by dividing the numerator
1 5 15
by the denominator. For example, /8 becomes .125, /8 becomes .625, and /32 becomes .46875.
5
Therefore, a bond quoted at 93 /8 would be converted to 93.625% of par, or $936.25.

Following are some additional pricing examples:

Corporate and Municipal Bonds: Treasury Notes and Bonds:

1 8
87 /8 = 87.125 = $871.25 99.08 = 99 /32 = 99.250 = $992.50
7 16
100 /8 = 100.875 = $1,008.75 100.16 = 100 /32 = 100.50 = $1,005.00
3 24
103 /8 = 103.375 = $1,033.75 103.24 = 103 /32 = 103.75 = $1,037.50

Note: Treasury bills trade on a yield basis.

Prices and Yields: An Inverse Relationship

A bond’s coupon (interest rate) is generally fixed for its life. As market interest rates change, new
bonds will be issued with either higher or lower coupon rates than what existing bonds pay. In
order to be able to keep pace with current interest rates, the values (market prices) of existing bonds
will adjust based on the relative coupon rates of existing and new issues.

As stated earlier, if interest rates rise, the value (price) of existing bonds will fall since the demand
for existing bonds that offer lower interest rates will decline. If interest rates fall, the value (price) of
existing bonds will rise since they’re worth more than a new bond issued with a lower coupon. So
essentially, there is an inverse relationship that exists between market interest rates and existing
bond prices.

PRICE

MARKET
RATES

To summarize, as interest rates increase, the prices of existing bonds decrease and, as
interest rates decrease, the prices of existing bonds increase.

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 CHAPTER 4 – INTRODUCTION TO DEBT INSTRUMENTS

Calculating Bond Yields

As with any other investor, a bondholder is interested in determining her investment’s return or
yield. There are three different measures for determining a bond’s yield—nominal yield (or
coupon), the current yield (annual interest ÷ current market price), and yield-to-maturity (effective
return). These three measurements of return will be covered in detail in Chapter 6.

Redeeming Bonds Prior to Maturity

When a bond reaches its maturity date, the bondholder will redeem it to the issuer and receive the
bond’s par value plus her last interest payment. At this point, the issuer’s obligation to the
bondholder has ended and the debt is considered retired. However, some bonds are redeemed
before they mature.

Call Provisions
A bond offering may include a call provision which allows the issuer to redeem its outstanding
bonds before they reach maturity. If called, the investor receives the full return of principal plus any
accrued interest. From the issuer’s perspective, the benefit is that it’s no longer required to make
periodic interest payments once the bond issue has been called. One of the main reasons that
issuers make bonds callable is to have the ability to take advantage of declining interest rates. In an
effort to entice investors to buy callable bonds, their yields (coupons) are typically higher than
those of non-callable bonds.

Call Protection and Call Premium Most callable bonds contain a restriction on how soon the
bonds may be called—typically 5 to 10 years after the date of issuance. This is referred to as call
protection. If the call protection period runs out and the bonds are subsequently called, the issuer is
often required to pay the bondholders more than the par value in order to compensate them for the
early redemption of the bonds. This additional amount is referred to as a call premium.

For example, in January 20XX, an issuer sold bonds that mature in 20 years. Beginning
10 years after issuance, the bonds are callable at 102. If a bondholder buys one of these
bonds and the issuer calls back after 10 years, she will receive $1,020 ($20 more than the
bond’s par value). The call protection gives the investor the assurance of knowing that her
bond cannot be called for 10 years.

Issue Date First Call Date Maturity Date

Jan 20XX 10 years later 10 years later

Bond has call Bond may

protection be called

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CHAPTER 4 – INTRODUCTION TO DEBT INSTRUMENTS

Call Types Some calls are in-whole, which means that the entire issue is being called at one time.
Other calls are partial (lottery calls), which means that some of the bonds will be retired early, but
others will remain outstanding. Finally, some bonds may have catastrophe call provisions which are
enacted only if a bond’s underlying collateral is destroyed. For example, a bond is issued to
generate funds which will be used to construct a bridge. If later, due to severe flooding, the bridge
washes into the water, the issue may be called with the bondholders being paid back with insurance
proceeds. Both partial and in-whole calls must be disclosed to a client prior to a bond’s purchase
and noted on the confirmation. However, due to the unlikelihood of occurrence, catastrophe calls
are exempt from this rule.

Put Provisions Bonds may also be issued with a put provision, which is the opposite of a call
provision. This feature gives the bondholder the right to redeem the bond on a specified date (or
dates) prior to maturity. For bonds which offer the put feature, their yields are generally lower since
the bondholders are given the ability to redeem their bonds in the event that interest rates rise.

Convertible Bonds
In order to offer investors more of an incentive to buy its bonds, a corporation with a weak credit
rating may issue convertible bonds. A convertible bond gives an investor the ability to convert the par
value of his bond into predetermined number of shares of the company’s common stock. For the
purchaser, the tradeoff for this opportunity is that convertible issues traditionally offer lower
coupons than similar non-convertible issues. If the bonds are converted, the debt becomes equity
and the issuers’ capital structure will be significantly altered.

Converting Bonds to Stock The price at which the bond can be converted is referred to as the
conversion price and is set at the time that the bond is issued. To determine the conversion ratio
(i.e., the number of shares the investor will receive at conversion), the par value of the bond ($1,000)
is divided by the conversion price.

Par Value of Bond

Conversion Ratio =
Conversion Price

For example, if Widget Inc. issues 10% convertible bonds with a conversion price of $40,
the conversion ratio is 25 shares for each bond. Put another way, the bondholder is able to
exchange the bond and, in return, receive 25 shares of stock.

$1,000 Par Value

Conversion Ratio = = 25 shares per bond
$40 Conversion Price

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 CHAPTER 4 – INTRODUCTION TO DEBT INSTRUMENTS

The conversion ratio is the number of shares that an investor receives when surrendering a $1,000
face amount of bonds. When the conversion ratio is multiplied by the conversion price, the result
will always equal $1,000. Therefore, a conversion is immediately profitable if the underlying stock is
trading at a premium to the conversion price. Consider the examples below:

Conversion Price Conversion Ratio Price x Ratio

$10 100 $1,000

$20 50 $1,000

$40 25 $1,000

$50 20 $1,000

$100 10 $1,000

Whether it’s worthwhile for investors to convert their bonds into stock depends largely on the price
of the underlying stock compared to the market value of the bond.
For example, let’s assume that Widget’s bond is convertible at $40 and is trading in the
market at 85. Also, Widget’s common stock is currently trading at $35 per share. What’s the
best choice for the investor, selling the bond or converting the bond to stock and selling the
stock?

If the bond is sold in the market, the investor will receive $850 (85% of par). On the other hand,
if the bond is converted into 25 shares ($1,000 ÷ $40 = 25). The 25 shares could then be sold for
$35 per share, which results in sales proceeds of $875 (25 shares x $35). Therefore, the best
choice for the investor is to convert the bond into stock and sell the stock.

Advantages and Disadvantages of Convertible Bonds Convertible bonds allow corporations to

borrow money at a lower rate (lower coupon) since the convertible feature is attractive to investors.
Investors are willing to accept the lower interest rate in exchange for the opportunity to convert the
bonds into common stock. In addition, the investor has some downside protection because, even if
the price of the stock falls, the convertible bond still has inherent value as a bond.

A disadvantage to convertible bonds is that if all of the bonds are converted into stock, then the number
of outstanding shares may increase dramatically. From the issuer’s point of view, conversion adjusts the
mandatory debt obligation into equity and deleverages the corporation’s balance sheet. This
deleveraging is useful because it removes both the near-term and long-term debt service obligations.
Remember, dividend payments to common shareholders are voluntary, while interest payments to
bondholders are mandatory. Therefore, after conversion, the former bondholders are no longer owed
money at maturity. The bonds are eliminated and will be replaced with an ownership interest.

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CHAPTER 4 – INTRODUCTION TO DEBT INSTRUMENTS

Forced Conversion Most convertible issues are callable which provides the issuer with the ability
to (at its option) redeem the bonds prior to maturity. However, if the call (redemption) price of the
bond is less than the conversion value, the bondholder could be forced to either convert the bond
immediately or accept less than its conversion value. This possibility, referred to as forced
conversion, may be a disadvantage for investors.
For example, Rob owns a corporate bond that’s convertible at $40. With the underlying
stock currently selling at $45 per share, the corporation indicates that the bond will be
called at 105 ($1,050) on the next call date. If Rob asks his RR what action to take, what
should she tell him?

Step 1: Determine the conversion ratio:

Par Value of Bond $1,000

Conversion Ratio = = = 25 shares
Conversion Price $40

Step 2: Figure out what Rob will receive after the bond is converted and the stock is sold:

Conversion Value = Number of shares x Price Per Share

Conversion Value = 25 shares x $45 = $1,125

Rob’s RR should recommend that he convert the bond to stock since the shares are worth
$1,125, while he would receive only $1,050 if he allowed the bond to be called.

Conversion is NOT Taxable If the owners of convertible bonds or convertible preferred stock
convert those securities into the common stock of the corporation, the conversion is NOT a taxable
event. When these securities are converted, the cost basis for the common stock received will be
based on the cost basis of the original security. A taxable event arises only when the investor
subsequently sells the acquired shares.
For example, an investor purchased a convertible RFQ corporate bond for $1,200 and
converted the bond into 40 shares of common stock. The investor’s overall cost basis is
$1,200, while her cost basis per share is $30 ($1,200 ÷ 40 shares). If the stock was later
sold for $32 per share, she would report a capital gain of $2 per share, or $80.

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 CHAPTER 4 – INTRODUCTION TO DEBT INSTRUMENTS

Conclusion
The next chapter will examine the characteristics of specific types of bonds, including corporate
issues, U.S. Treasury and agency securities, and municipal issues. Additionally, the various methods
of underwriting these securities will be described.

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 CHAPTER 5

Types of Debt
Instruments

Key Topics:

 U.S. Treasury and Government Agency Securities

 Municipal GO and Revenue Bonds

 The Underwriting Process

 Types of Corporate Bonds

 Money Markets
 CHAPTER 5 – TYPES OF DEBT INSTRUMENTS

The previous chapter examined some basic characteristics that are shared by debt securities. This
chapter will cover the specific features of debt instruments that are issued by the U.S. Treasury and
agencies, municipal governments, and corporate issuers. The securities differ in their relative safety
profile and the tax status of their interest payments.

Types of Debt Instruments

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.

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 SIE Examination. Marketable instruments 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 bonds and Treasury notes are interest-bearing securities that have all 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. However,
please note that most examples in this study manual will use a par value of $1,000.

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The interest received on T-notes and T-bonds is taxed at the federal level, but exempt from state
and local taxation. The main reason for purchasing Treasury securities is the safety that comes
with a government-backed investment.

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. 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. The interest received on
TIPS is taxed at the federal level, but exempt from state and local taxation.
An investor purchased a 4% TIPS with an original principal value of $1,000. Due to
inflation, if the principal is adjusted to $1,030, how much interest will she receive for her
next semiannual payment?
TIPS pay a fixed rate of interest, but it is based on an inflation-adjusted principal. In
this example, the 4% coupon rate is multiplied by the adjusted principal of $1,030,
for an annual interest amount of $41.20. However, the investor’s next semiannual
payment is $20.60 ($41.20 ÷ 2).

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.

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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
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.

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.

Cash Management Bills (CMBs)

CMBs are unscheduled, short-term debt offerings that are used to smooth out Treasury cash flows.
CMBs are issued at a discount, but will mature at their face amount. The duration of CMBs may be
as short as one day.

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U.S. Treasury Securities Auctions – The Primary Market

The government sells Treasuries through auctions that are conducted by the U.S. Treasury. These
auctions vary in frequency depending on the securities being sold. This schedule is detailed in the
chart below:

Summary of Treasury Auctions

Treasury Type Frequency Auction Date Issue Date
4-week bill Weekly Tuesday Thursday
13- and 26-week Weekly Monday Thursday
52-week bill Every four weeks Tuesday Thursday
2-, 3-, and 5-year note Monthly Varies End of month
10-year note Quarterly Feb., May, Aug., & Nov. 15th of the month
30-year bond Quarterly Feb., May, Aug., & Nov. 15th of the month

Competitive versus Non-Competitive Tenders When Treasury auctions are held, securities firms
compete by submitting bids to buy Treasuries through an automated system. These bids are referred
to as competitive tenders since they specify the price and/or yield at which the firm is willing to buy
the Treasuries. (Competitive bids are similar to limit orders to buy stock at a specific price, but may
not be filled). However, if an individual wants to purchase Treasuries, she usually submits a non-
competitive tender. (Non-competitive bids are similar to market orders placed to buy stock since they
don’t specify a price and are guaranteed to be filled.) Non-competitive bids are filled first; however, the
bidders must agree to accept the yield and price as determined by the auction. All winners of the
auction will ultimately pay the lowest price of the accepted competitive tenders. This single price
auction process is referred to as a Dutch auction.

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.

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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).

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., homeowners or farmers).

Although GSE securities are not backed by the U.S. government, they are considered to have minimal
default risk. Examples of GSEs include:
 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 the Government National
Mortgage Association (GNMA or Ginnie Mae), the Federal National Mortgage Association (FNMA or
Fannie Mae), and the Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac).

Pass-Through Certificates
The most common security 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.

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

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 (FHLMC)

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 (FNMA)

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 (GNMA)

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.

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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. The estimated
yield on a mortgage-backed security reflects its estimated average life based on the assumed prepayment
rates for the underlying mortgage loans.

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 20.

Municipal Bonds
Municipal bonds are issued by states, territories and possessions of the United States, as well as
other political subdivisions (e.g., counties, cities, or school districts). Public agencies (e.g.,
authorities and commissions) also have the authority to issue municipal bonds. Unlike U.S.
Treasury securities, these debt instruments carry some level of default risk since municipal bonds
are not backed by the federal government.

For most investors, the primary advantage of municipal bonds is that the interest received is typically
exempt from federal tax. Another advantage is that most states don’t tax the interest from bonds that
are issued within their state borders if they’re purchased by their state residents. For this reason,
investors tend to buy in-state bonds to avoid potential federal, state, and (in some cases) local taxes.

Types of Municipal Bonds

There are primarily two types of municipal bonds—general obligation bonds (GOs) and revenue
bonds. GO bonds may be issued to meet any and all needs of the issuer. In a sense, GO bonds are
issued for general purposes. On the other hand, revenue bonds are typically issued to fund a specific
project or facility, such as a bridge or toll road. For revenue bonds, the cash flows that are generated
by the specific project (e.g., tolls, usage fees) are used to repay bondholders.

General Obligation (GO) Bonds

A general obligation bond is secured by the full faith, credit, and taxing power of the issuer. Therefore,
only issuers that have the ability to levy and collect taxes may issue GO bonds. State or local governments
are able to issue general obligation bonds based on their statutory or constitutional powers. However,
prior to issuing general obligation bonds, issuers must obtain voter approval. Essentially, this voting
requirement is due to the fact that taxpayer money is being used to pay debt service.

Authority to Issue A statutory power is a law that’s passed by a state or local government which allows
for the issuance of securities. The constitutional powers to issue general obligation bonds are derived
from the state constitution. These statutory and constitutional powers may also limit the amount of debt
that an issuer is able to incur. In other words, a GO bond issuer may be subject to a debt ceiling.

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Backing State general obligation bonds are usually secured by income tax, sales tax, gasoline tax,
excise tax, and other taxes that are collected at the state level. For local jurisdictions, such as
counties and cities, the most common source of tax revenue is from levies on real property. School
taxes are also assessed at the local level and are normally a significant portion of a person’s real
estate tax assessment. In addition, other non-tax revenue (e.g., parking fees, park and recreational
expenses, and licensing fees) may be used to pay the debt service on GO bonds.

Revenue Bonds
Revenue bonds are issued for either projects or enterprise financings in which the issuer pledges to
repay the bondholders using the revenues that are generated by the project or facility. Issuers of
revenue bonds may be authorized political entities (e.g., state or local governments), an authority
(e.g., the Port Authority of New York and New Jersey), or a commission that’s created to issue bonds
for purposes of building and operating a project.

Revenue bonds can be used to finance airports, water and sewer systems, bridges, turnpikes,
hospitals, and many other facilities. Concessions, tolls, and user fees that are associated with the use
of these facilities are used to make interest and principal payments on the bonds. Revenue bonds
are generally considered riskier than GO bonds since the generated revenues may prove to be
unreliable or insufficient to fund debt service.

Another source of revenue originates from rental or lease payments. For example, a state may create
a non-profit authority to issue revenue bonds in order to build a school. The local government that
uses the school will lease the facility from the authority and the lease payments will be used by the
issuer to pay interest and principal.

Revenue bonds may be issued when voter approval for general obligation bonds cannot be
obtained. Also, revenue bonds may be issued to finance capital projects when statutory or
constitutional debt limitations prevent a municipality from issuing general obligation bonds.

Types of Revenue Bonds

Revenue bonds are generally characterized by the project that the bond is financing or by the source(s)
backing the bond. The following list represents some of the more common types of revenue issues.

Housing Revenue Bonds Housing bonds are issued by state or local housing finance agencies in
an effort to help fund single family or multi-family housing and are normally for low or moderate
income families. In some cases, the proceeds of the bond offering are lent to the real estate
developers that are constructing the property.

Dormitory Bonds Dormitory bonds are issued to build housing for students at public universities
and are repaid from a portion of students’ tuition payments.

Health Care Revenue Bonds Health care bonds are used for the construction of non-profit
hospitals and health care facilities.

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Utility Revenue Bonds Utility bonds are issued to finance gas, water and sewer, and electric
power systems that are owned by a governmental unit. The bonds are normally backed by the user
fees that are charged to customers.

Transportation Bonds Transportation bonds are used to finance projects such as bridges,
tunnels, toll roads, airports, and transit systems. User fees (e.g., tolls) are used to pay the debt
service on these bonds.

Special Tax Bonds Special tax bonds are backed by special taxes (e.g., taxes on tobacco, gasoline,
hotel/motel stay) for a specific project or purpose, but not by ad valorem (property) taxes. For example,
highway bonds that are payable from an excise tax on gasoline are considered special tax bonds.

Special Assessment Bonds Special assessment bonds are payable only from a specific charge on
those who directly benefit from the facilities. Examples include bonds that are issued to develop or
improve water and sewer systems, sidewalks, and streets.

Moral Obligation Bonds Moral obligation bonds are first secured by the revenues of a project;
however, if revenues are insufficient to pay debt service requirements, the state (or a state agency) is
morally obligated (but not legally required) to provide the needed funds. Prior to issuing the bonds as
moral obligation bonds, the legislative approval of the state government must be obtained.

Lease Rental Bonds Lease rental offerings involve one municipal entity leasing a facility from
another. For example, a state building authority may issue bonds to build a college dormitory and
then the authority will lease the dorm to the college. The bonds issued by the building authority will
be paid from the revenues that are generated through lease payments received from the college.

Private Activity Bonds If more than 10% of the bond’s proceeds will be used to finance a project
for use by a private entity (e.g., a corporation or professional sports team) and if more than 10% of
the bond’s proceeds will be secured by property used in the private entity’s business, the bonds are
referred to as private activity bonds.

Industrial Development Revenue (IDR) Bonds IDR bonds are a type of private activity bond that are
issued by a municipality and secured by a lease agreement with a corporation. The purpose for the
offering is to build a facility for a private company. The security’s credit rating is based on the
corporation’s ability to make lease payments since the municipality does not back the bonds.

Taxable Municipal Bonds In certain cases, a municipality may not be able to issue bonds that are
exempt from federal income tax. This may occur when the bonds are issued to finance projects that
don’t provide a significant benefit to the general public.

Some examples of situations in which a bond may lose its tax exemption include 1) an offering in
which the proceeds are being used to build a sports facility or certain types of housing, or 2) an offering
designed to allow an issuer to borrow funds in order to replenish its unfunded pension liabilities.

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Double-Barreled Bonds Double-barreled bonds are backed by a specific revenue source (other
than property taxes) as well as the full faith and credit of an issuer with taxing authority (a GO
issuer). Essentially, debt service on the bonds will be paid by a combination of tax dollars and
revenue dollars from the project being constructed.

The following chart summarizes the differences between GO and revenue bonds:

General Obligation Bonds (GOs) Revenue Bonds

States or local governments, an authority,
Issuer: States and local municipalities
or agency
Required for issuance: Voter approval Feasibility study (described later)
Taxes Collected revenues generated by a
 State GOs: Secured by income, sales, financed project
Source of the funds and other state-collected taxes  Concessions
backing the bonds:  Local GOs: Secured by property tax  Tolls
(ad valorem tax on assessed property  User fees
value)  Rental or lease payments
Paying the general operating expenses of Construction of airports, water and sewer
a municipality and for capital systems, bridges, toll roads/turnpikes,
Use of the funds:
improvement projects (e.g., roads, parks, hospitals, etc.
schools, and government buildings)

Now that both GO and revenue bond issues have been examined, let’s consider shorter term
municipal instruments.

Municipal Notes
Municipal notes are short-term issues that are normally issued to assist in financing a project or to
assist a municipality in managing its cash flow. Municipal notes are interest-bearing securities that
ultimately pay interest at maturity.

Tax Anticipation Notes (TANs) TANs are issued to finance current municipal operations in
anticipation of future tax receipts from property taxes. Also, TANs are typically classified as general
obligation securities.

Revenue Anticipation Notes (RANs) RANs are issued for the same purpose as TANs except that
the anticipated revenues are typically from federal or state subsidies. RANs are also typically
classified as general obligation securities.

Tax and Revenue Anticipation Notes (TRANs) TRANs are created when TANs and RANs are
issued together.

Bond Anticipation Notes (BANs) BANs are issued to obtain financing for projects that will
eventually be financed through the sale of long-term bonds.

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Grant Anticipation Notes (GANs) GANs are issued in expectation of receiving funds (grants) from
the federal government.

Construction Loan Notes (CLNs) CLNs are issued by municipalities to provide funds for the
construction of a project that will eventually be funded by a bond issue.

Ratings for Municipal Notes

As described in Chapter 4, Moody’s and Standard and Poor’s issue ratings for fixed-income
securities. Both organizations also have a rating system that’s specific to municipal notes.

Moody’s has four rating categories for municipal notes and variable rate demand obligations
(VRDOs) – which are described below. The first three ratings are considered Moody’s Investment
Grade (MIG) ratings, with the fourth considered a speculative grade. VRDOs receive ratings based
on a variation of the MIG scale—the Variable Municipal Investment Grade (VMIG) system.
MIG 1 (VMIG 1): Superior credit quality
MIG 2 (VMIG 2): Strong credit quality
MIG 3 (VMIG 3): Acceptable credit quality
SG: Speculative grade credit quality

Standard and Poor’s has the following four rating categories for municipal notes:
SP-1+: Very strong capacity to pay principal and interest
SP-1: Strong capacity to pay principal and interest
SP-2: Satisfactory capacity to pay principal and interest
SP-3: Speculative capacity to pay principal and interest

Other Municipal Securities

Auction Rate Securities
Auction rate securities (ARSs) are long-term investments that have a short-term twist—the interest rates
or dividends that they pay are reset at frequent intervals through auctions. Investors who purchase ARSs
are typically seeking a cash-like investment that pays a higher yield than what is available from money-
market mutual funds or certificates of deposit. Generally, there are two types of ARSs, bonds with long-
term maturities (20 to 30 years) and preferred shares with a cash dividend. Both the interest rate on the
bonds and the dividend on the preferred shares will vary based on rates that are set through Dutch
auctions for a specified short period that’s usually measured in days—7, 14, 28, or 35. Auction rate bonds
are issued by entities such as corporations, municipalities, student loan authorities, and museums, while
auction rate preferred shares are issued by closed-end funds (which are described in Chapter 7).

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Variable Rate Demand Obligations (VRDOs)

Another long-term security that’s marketed as a short-term investment is a variable rate demand
obligation (VRDO). A VRDO’s interest rate is adjusted at specified intervals (daily, weekly, monthly)
and, in many cases, this adjustment allows the owner to sell or put the security back to the issuer or
a third party on the date that a new rate is established. If this is done, the investor will receive the
par value plus accrued interest.

Investors who are interested in short-term investments may also purchase other tax free money-
market instruments such as tax-exempt commercial paper and tax-free money-market funds. Tax-
exempt commercial paper has a maximum maturity of 270 days and is normally backed by a bank
line of credit.

The Primary Market for Municipal Bonds

Like U.S. government and government agency securities, 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 Municipal Securities Rulemaking Board (MSRB)—the SRO for firms that
deal in municipal securities—formulates the rules and regulations that relate to municipal underwritings.

Issuing GO Bonds
Since GO bond issues are backed by taxes, the following two requirements must be satisfied:
1. Voter Approval The issuance of general obligation bonds usually requires voter approval
since it’s the funds that are generated by taxing citizens that are used to pay the debt service.
For a general obligation bond, the indenture (written contract) will typically include the
statutes which permit the issuer to levy taxes.
2. Debt Ceiling Limitations A GO issue is generally subject to debt limitations that are placed on
the municipality by a voter referendum or by statutes. A municipality is not permitted to issue
bonds in excess of its debt limitation since doing so would exceed its debt ceiling.

Issuing Revenue Bonds

Since revenue bonds are backed by the user fees that are generated by a project or facility (and not
by taxes), voter approval is not required. However, there are special procedures to be followed and
requirements to be met prior to issuing revenue bonds. One of these procedures is conducting a
feasibility study.

Feasibility Study A municipality must hire a consulting engineer to study the project and present
a report to identify whether the project will be able to bring in the necessary revenues. This report
examines the need for the proposed project and whether the project is a sound economic
investment. An accounting firm is usually retained to help determine whether the revenues will be
sufficient to cover expenses and debt service.

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New Issue Underwritings

Once a municipal issuer has determined that there is a need for a bond issue and has followed the
preliminary steps required to offer a bond (e.g., obtaining voter approval for a GO issue or
completing a feasibility study for a revenue issue), it may continue the process of issuance. At this
point, the municipality will typically seek the assistance of an underwriter (investment banker).

Role of the Underwriter A municipal underwriter plays an important role in the process of
offering securities. The underwriter acts as a vital link between the issuer and the investing public by
assisting the issuer in pricing the securities, structuring the financing, and preparing a disclosure
document (referred to as the official statement).

Selecting an Underwriter In some cases, the issuer will simply appoint its underwriter by using a
process that’s referred to as a negotiated sale. Another method involves requesting that interested
underwriters submit proposals through a bidding process that’s referred to as a competitive sale.

Negotiated Sale With a negotiated sale, an issuer brings its issue to market by selecting the lead
underwriter or senior manager that will sell the issue to the public. Essentially, the issuer requests
the assistance of the firm with which it wants to work. The size of the issue, the coupon rate,
possible call provisions, and other details are generally decided during the issuer’s negotiation with
the underwriter.

Competitive Sale Rather than selecting its underwriter, an issuer may invite interested underwriters
to compete against one another by submitting bids for the issue. The syndicate that submits the
best bid is awarded the bonds. Normally, the best bid is the one that presents the issuer with the
lowest interest cost over the life of the issue.

The following summarizes the primary method that different issuers use for underwriting purposes:
 U.S. government securities – Auction process
 Municipal general obligation bonds – Competitive sale
 Municipal revenue bonds – Negotiated sale
 Corporate bonds – Negotiated sale

Forming a Municipal Syndicate

Traditionally, several broker-dealers will combine to form an underwriting syndicate and one firm
will act as the syndicate manager (lead underwriter). The syndicate is essentially a group of
underwriters that share the liability and risk for selling the issue. Although the syndicate’s
composition may change, it’s usually comprised of firms that have worked together in the past.
Municipal issues are typically sold on a firm-commitment basis, which means that the selected/
winning syndicate is fully responsible for selling the entire offering. The underwriting process will
be described in more detail in Chapter 11.

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CHAPTER 5 – TYPES OF DEBT INSTRUMENTS

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 Type of Secured Bond Collateral
are secured by third-party securities that are
owned by the issuer. The securities (stocks Mortgage Real Estate
and/or bonds of other issuers) are placed in Equipment Trust Equipment
escrow as collateral for the bonds.
Collateral Trust Stocks or Bonds

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 CHAPTER 5 – TYPES OF DEBT INSTRUMENTS

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.

Asset-backed securities are generally sold and traded according to their “average life” rather than
their stated maturity dates.

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

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CHAPTER 5 – TYPES OF DEBT INSTRUMENTS

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.

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.

Other Types of Corporate Bonds

Income Bonds
Income bonds are normally issued by companies in reorganization (bankruptcy). The issuer promises
to repay the principal amount at maturity, but does NOT promise to pay interest unless it has sufficient
earnings. Since interest payments are not promised, income bonds trade flat (without accrued
interest), sell at a deep discount (well below par), and are considered speculative investments.

Eurodollar Bonds, Yankee Bonds, and Eurobonds

A Eurodollar is a dollar-denominated deposit that’s made outside of the United States. Eurodollar
bonds pay their principal and interest in U.S. dollars, but are issued outside of the U.S. (primarily in
Europe). The issuers of Eurodollar bonds include foreign corporations, foreign governments, and
international agencies, such as the World Bank.

Another common type of bond that’s denominated in U.S. dollars is a Yankee bond. Yankee bonds
allow foreign entities to borrow money in the U.S. marketplace. These bonds are registered with the
SEC and sold primarily in the U.S.

A Eurobond is sold in one country, but denominated in the currency of another. The issuer,
currency, and primary market may all be different. For example, a Russian manufacturer could sell
bonds that are denominated in Swiss francs in London. This type of bond, which is referred to as a
foreign pay bond, can be greatly affected by interest-rate movements in the country in which it’s
denominated.

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 is also a
diverse group of participants that utilize the money market, including the Federal Reserve Board,
banks, securities dealers, and corporations.

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 CHAPTER 5 – TYPES OF DEBT INSTRUMENTS

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. Short-term needs
are met by the issuance of 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).

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 wish 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 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 (a
higher 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.

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CHAPTER 5 – TYPES OF DEBT INSTRUMENTS

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 is 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

Federal Funds (Fed Funds) The monies borrowed overnight on a bank-to-bank basis are referred
to as fed funds. This interbank borrowing is usually done to allow a bank to meet the reserve
requirement which is set by the Federal Reserve. One bank with excess reserves may lend them to
another bank that’s in need of reserves. This allows the bank with excess reserves to earn interest on
funds that would otherwise remain idle.

The rate charged on these overnight loans is referred to as the fed funds rate. The rate fluctuates on a daily
basis and is a leading indicator of interest-rate trends since it reflects the availability of funds in the
system. Although the Federal Reserve does not set the fed funds rate, it will attempt to influence the
rate through its purchases and sales of government securities in the secondary market.

Other short-term interest rates tend to follow changes in the fed funds rate. A bank charges the
prime rate when providing loans to corporations that are among the bank’s best credit-rated
customers. Other corporations may be charged a higher rate, but the rate will be based on the prime
rate. The London Interbank Offered Rate (LIBOR) is the average rate that banks charge each other on
loans for London deposits of Eurodollars.

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 CHAPTER 5 – TYPES OF DEBT INSTRUMENTS

Bond Taxation Summary

As this chapter comes to a conclusion, the following chart should be useful in identifying the tax
implications of the interest for each type of bond.

Security Federally Taxable State/Local Taxable

T-Bill Yes No

T-Note/T-Bond Yes No

TIPS Yes No

STRIPS Yes No

Government National Mortgage Association (GNMA) Yes Yes

Federal National Mortgage Association (FNMA) Yes Yes

Federal Home Loan Mortgage Corporation (FHLMC) Yes Yes

Federal Farm Credit Banks (FFCBs) Yes No

Federal Home Loan Banks (FHLBs) Yes No

Student Loan Marketing Association (SLMA) Yes Varies

Municipal Bonds No Varies*

Territory/Possession Bonds No No

Corporate Bonds Yes Yes

*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.

Conclusion
This concludes the discussion on the types of debt instruments. The next chapter will examine the
various measurements of return for both equity and debt investors.

Create a Chapter 5 Custom Exam

Now that you’ve completed Chapter 5, log in to my.stcusa.com and create a 10-question custom
exam.

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 CHAPTER 6

Investment Returns

Key Topics:

 Return on Investments

 Price versus Yield

 Cost Basis and Capital Events

 Measuring Return

 Averages and Indexes

 CHAPTER 6 – INVESTMENT RETURNS

Most individuals who invest their money expect a profit or a positive return. This chapter will cover
the various methods that investors use to measure the performance of their stock and/or bond
investments. These returns may come in the form of periodic dividends that are paid on equities or
interest that’s paid on bonds. Another form of return is any change in value (either appreciation or
depreciation) that may occur between the purchase and sale of a given investment. The end of the
chapter will examine the use of benchmarks, which many investors use to gauge the relative
performance of their investments.

Return on Equity Investments

Chapter 3 described that buying a corporation’s equity securities makes the investor a part owner of
the corporation. In some cases, corporations may choose to allow its shareholders to participate in
its earning by paying out dividends. Dividend payments are voluntary, unlike bond interest
payments which are mandatory.

Dividends
Common stock does not receive a specific annual dividend; instead, the board of directors decides
what dividends (if any) the company is able to pay to its common shareholders. Dividends are paid
on a per-share basis. As it relates to dividends, there are three important dates that are set by the
paying corporation:
 Declaration date: The declaration date is the date on which the dividend is authorized. If a
company’s board declares a $.10 dividend, its stockholders as of a specific date will receive $.10
for each share that they own.
 Payment date: The payment date is the date on which the declared dividend will be paid.
Dividends are usually paid quarterly and are taxable in the year in which they’re paid/received.
 Record date: The record date is the date on which an investor must officially own the stock to
be entitled to receive the dividend.

For example, on December 1, the board of Widgets, Inc. declares a dividend of $1 per share that’s
payable on January 3 to shareholders of record on December 15. Any person who is on Widget
Corporation’s records as a shareholder as of December 15 will receive the $1-per-share dividend on
January 3.

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CHAPTER 6 – INVESTMENT RETURNS

Ex-Dividend Rule Although a corporation’s board of directors sets the declaration, payment, and
record date, the ex-dividend date is set by the SRO for the market on which the stock trades (e.g.,
FINRA). The ex-dividend date represents the date on which a stock begins to trade without its
dividend. A stock will typically trade ex-dividend one business day prior to the record date (i.e., record
date minus one business day). So ultimately, an individual who purchases a stock for regular-way
settlement (trade date + 2 business days, or T + 2) either on or after the ex-dividend date will not be
entitled to the quarterly cash dividend since he will not own the stock by the record date.

The following example is used to explain the concept:

MAY 20XX
S M T W Th F S
1 2 3 4 5 6 7
8 9 10 11 12 13 14
Ex-Dividend Record
Date Date

For example, on Monday, April 25, the board of directors of XYZ Corporation declares a
$.60 dividend which will be paid on Friday, May 27, to all stockholders of record on May
12. The stock will trade ex-dividend on Wednesday, May 11 (one business day prior to the
record date). Assuming a two business day settlement, any trade that’s executed on May
11 will not settle until May 13 (the day after the record date). Therefore, investors who
purchase XYZ stock on or after May 11 will not be entitled to the dividend.

The ex-dividend date represents the first day that a stock begins to trade without its dividend.
Therefore, on the ex-dividend date, the stock’s price will be reduced by an amount equal to the
dividend to be paid. For example, if a stock paying a $.50 dividend closes at $20 per share on the day
before the ex-date, it will open at a price of $19.50 on the ex-dividend date. For any dividend that’s
1
in a fractional amount, the reduction must cover the full dividend (i.e., a dividend of $0.12 /2 results
in a reduction of $0.13).

Due Bills If a trade is executed prior to the ex-dividend date, the buyer is entitled to the dividend.
However, if the seller fails to deliver the securities by the record date, the seller will remain as the
shareholder of record for the dividend payment. The seller will receive the dividend, but not be
entitled to it. Therefore, good delivery rules require a due bill to accompany the stock which creates
a liability for the seller and a receivable for the buyer.

Using the calendar from the previous example with a record date of Thursday, May 12, if an investor
purchases stock on Tuesday, May 10, the transaction will settle in two business days—Thursday, May
12. The buyer will receive the dividend because the transfer agent will be made aware of the name of
the new owner in time to change the shareholder’s record for the upcoming dividend. Because the
stock trades ex-dividend on Wednesday, May 11, from that date forward, the buyer will be able to
purchase the stock at a price that does not include the dividend. A due bill will be required only if the
buyer purchases the stock before the ex-date, but the seller delivers the security after the record date.

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 CHAPTER 6 – INVESTMENT RETURNS

Using Cash Settlement A buyer may still obtain the dividend after the normal ex-date by purchasing
the security and using a cash (same day) settlement on a date up to, and including, the record date. In
the preceding example, if the investor buys for cash as late as Thursday, May 12, she is entitled to the
dividend. In this case, the price of the stock is adjusted to reflect buyer’s receipt of the dividend. For a
cash settlement trade, the ex-dividend date is the business day following the record date.

Stock Dividends Rather than making a cash distribution, a company may elect to pay a dividend
to its shareholders in the form of additional shares of stock.
For example, an investor bought 100 shares of Widget, Inc. for $80 per share; therefore,
his cost basis is $8,000. If Widget, Inc. declares a 10% stock dividend the investor will be
entitled to an additional 10 shares (100 x 10%). Unlike ordinary cash dividends, stock
dividends are not taxable until the shares are subsequently sold. Ultimately, the investor
will be holding an increased number of shares, but at a reduced price per share. Although
this form of distribution is not taxable, the IRS requires the investor to adjust her cost
basis on the stock as follows:
 Original cost basis = $80.00 per share ($8,000 ÷ 100 original shares)
 Adjusted Cost basis = $72.72 per share ($8,000 ÷ 110 current shares)

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 by its current market price.
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

Return on Bond Investments

As described in Chapter 4, when an issuer sells bonds, it’s obligated to make consistent interest
payments to the bondholders that are allowing it to borrow their money. This fixed rate of interest is
also referred to as the bond’s coupon rate. Remember, regardless of whether a bond is purchased at
a premium, par, of discount price, its interest rate is always based on its par value of $1,000. The
basic formula for determining the dollar amount of interest paid each year is the bond’s coupon
rate multiplied by its par value.
Example 1: If a client purchases a 6% corporate bond and pays $875, she will receive
$60 per year ($1,000 x 6% = $60).
Example 2: If a client purchases an 8% corporate bond and pays $1,000, she will receive
$80 per year ($1,000 x 8% = $80).
Example 3: If a client purchases a 9% corporate bond and pays $1,100, she will receive
$90 per year ($1,000 x 9% = $90).

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CHAPTER 6 – INVESTMENT RETURNS

Prices and Yields – An Inverse Relationship

As previously mentioned, a bond’s coupon (interest rate) is generally fixed for its life. Therefore, as
market interest rates change, new bonds will be issued with either higher or lower coupon rates
than what existing bonds pay. To keep pace with current interest rates, the value of existing bonds
will need to change. As interest rates rise, the value (price) of existing bonds will fall since the
demand for existing bonds that offer lower interest rates will decline. On the other hand, if interest
rates fall, the value (price) of existing bonds will rise since they’re worth more than new bonds
being issued with lower coupons.

PRICE

MARKET
RATES

To summarize, as interest rates increase, the prices of existing bonds decrease and, as
interest rates decrease, the prices of existing bonds increase.

Understanding this fundamental inverse relationship between market interest rates and existing
bond prices is the first step in determining what an investor actually earns. The simple discussion
regarding the amount of interest a bondholder receives by multiplying the par value by the coupon
rate may be insufficient. Since investors will likely purchase bonds in the secondary market at a
price other than par value, when they’re considering their actual return on investment, they will
need to account for the price difference and subsequent return of par at maturity.

Calculating Bond Yields

As with any other investors, bondholders are interested in determining their investment’s return or
yield. There are three different measures for determining a bond’s yield—nominal yield, current
yield, and yield-to-maturity.

Nominal Yield A bond’s nominal yield is the same as its 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, it’s simply a place to begin the yield discussion.

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.

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 CHAPTER 6 – INVESTMENT RETURNS

Current yield is calculated by dividing the bond’s annual interest payment by the bond’s current
market price.

Annual Interest
Current Yield =
Current Market Price

Since a bond’s nominal yield is fixed, if an investor purchases a 10% bond, she will receive $100 per
year ($1,000 x 10%). However, the determination of her current yield will be very different
depending on the price she pays.

Price Paid Annual Interest Current Yield Calculation Current Yield

$900 (discount) $100 $100 ÷ $900 11.11%
$1,000 (par) $100 $100 ÷ $1,000 10%
$1,100 (premium) $100 $100 ÷ $1,100 9.09%

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 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).

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 to be calculated for exam
purposes. Instead, the goal should be to gain an understanding of the concept.

Basis A bond’s yield-to-maturity is also referred to simply as its yield or its basis. Therefore, a
7.44% yield-to-maturity, a 7.44% yield, and a 7.44 basis are synonymous.

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CHAPTER 6 – INVESTMENT RETURNS

The term basis is derived from one method of expressing yield. One basis point is equal to 1/100 of
1% and, for that reason, a 1% difference in yield equals 100 basis points. The term basis points may
be used to compare the yields of two different bonds. For example, if Bond A is trading at a 4.55
basis and Bond B is trading at a 4.95 basis, then Bond B is trading 40 basis points higher than Bond
A. If an investor purchased Bond B with a 4.95 basis, it would provide a pick-up yield of 40 basis
points over Bond A.

YTM Example 1 An investor purchases a 10% bond for $900 (at a discount). If the bond matures in
10 years, the bond’s yield-to-maturity will include:
1. The bond’s semiannual interest payments for the next 10 years, plus
2. The $100 gain that she will receive when the bond matures ($1,000 par value – $900 market
price), plus
3. The interest earned from reinvesting the semiannual coupon payments

Since the investor purchased this bond at a discount, the bond’s yield-to-maturity will be greater
than both its nominal yield and current yield.

YTM Example 2 Now let’s assume that the investor purchases the same 10-year, 10% bond for
$1,100 (at a premium). In this case, the yield-to-maturity will include:
1. The bond’s semiannual interest payments for the next 10 years, minus
2. The $100 loss that she will incur when the bond matures ($1,100 market value – $1,000 par
value), plus
3. Interest earned from reinvesting the semiannual coupon payments

Since the investor purchased the bond at a premium, the yield-to-maturity will be less than both its
nominal yield and current yield. If she had purchased the bond at par, then its yield-to-maturity
would be the same as its nominal yield and current yield.

Dollar Price Nominal Yield Current Yield Yield-to-Maturity

$900 (discount) 10% 11.11% Greater than 11.11%
$1,000 (par) 10% 10% 10%
$1,100 (premium) 10% 9.09% Less than 9.09%

Using a see-saw or teeter-totter diagram is probably the easiest way to visualize the relationship
between bond yields. The bond’s price will be placed on the left, with the yields placed to the right.

In the diagram below, since the nominal yield is fixed, it’s always placed at the top of the triangle.
The yield-to-maturity is always placed at the far end, while the current yield will always be placed in
between the nominal yield and the yield-to-maturity.

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 CHAPTER 6 – INVESTMENT RETURNS

PRICE NY CY YTM

To determine the relationship of yields on a discount or premium bond, just imagine the slope of
the line and remember the order in which yields are plotted.

For illustration purposes, the following diagrams will use the yields shown on the previous page:

$1,000 10% 10% 10%

>11.11% $1,100
11.11%
10% 10%
9.09%
$900 <9.09%

To summarize:
 If an investor purchases a bond at par, the nominal yield, current yield, and yield-to-maturity
will all be equal.
 If an investor purchases a bond at a discount, the highest yield will be the yield-to-maturity,
followed by the current yield, with the nominal yield as the lowest.
 If an investor purchases a bond at a premium, the highest yield will be the nominal yield,
followed by the current yield, with the yield-to-maturity as the lowest.

Call Provisions
Some bonds may include a call provision which allows the issuer to redeem (call) the outstanding
bonds before they reach their final maturity. If called, the issuer is often required to pay the
bondholders more than the par value to compensate them for the early redemption of the bonds.

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CHAPTER 6 – INVESTMENT RETURNS

This additional amount is referred to as a call premium. This event obviously impacts the bondholder’s
return since he’s receiving more than par and receiving it prior to the bond’s expected maturity.

Yield-to-Call The yield-to-call represents a bond’s yield if it’s called prior to maturity. For callable
bonds, there is uncertainty as to whether the bond will be called. For that reason, when the bond’s
yield is quoted to an investor, both the yield-to-call and yield-to-maturity must be calculated.
Regulations stipulate that the yield being disclosed to investors must be the lower of the two yields.
This conservative return estimate is referred to as providing the bond’s yield-to-worst.

Cost Basis, Capital Events, and Return of Capital

So far, the primary focus has been on the effect of interest and dividend payments for investors.
But, what happens if the value of investors’ underlying investment rises or falls? If the investor has
not yet sold, there’s no taxable event. In other words, these unrealized capital gains or losses (paper
profits or losses) have no impact on the investor’s tax situation. On the other hand, if the gains or
losses are realized, they must be reported on the investor’s tax filing.

Cost Basis The term cost basis refers to the total amount that an investor has paid to purchase a
security. The calculation typically includes the commissions or other fees which are paid to the
brokerage firm when the securities are purchased. Some securities make distributions that can be
reinvested to purchase additional securities. The investor’s total cost basis will increase since he is
required to pay tax on the distribution.

Investors often need assistance in determining their basis in a security. For example, if a person
inherits securities, the beneficiary’s basis is the value of the securities on the date of the original
owner’s death. Brokerage firms assist investors with calculating cost basis by sending an IRS Form
1099 which provides useful tax related information.

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 prior to its sale, the gain is
considered short-term and is taxed at the same rate as the investor’s ordinary income rate
(marginal tax rate). However, if the investment had been held for more than one year prior to its
sale, the gain is considered long-term and is taxed at a lower rate. Currently, the maximum rate at
which long-term gains are taxed is 20%.

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

Return of Capital A return of capital occurs when an investor receives a portion of her original
investment back. Since this payment is not considered either income or 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.

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 CHAPTER 6 – INVESTMENT RETURNS

Measuring Return
Many investors will measure their investment return in relation to the amount of risk they assume,
while others measure return against a predetermined benchmark. This section will examine some
of the more popular measurements of return.

Total Return
The total return calculation takes into account all of the cash flow received from dividends and/or
interest, plus any appreciation or depreciation in the value of the investment. This return is
expressed as a percentage and is usually calculated over a period of one year. The total return on an
investment is calculated as follows:

(Ending Value – Beginning Value) + Investment Income

Total Return =
Beginning Value

Example: An investor purchases 1,000 shares of VPN at $25 per share. VPN pays an $0.80
annual dividend. After one year, the stock’s market value has declined to $23 per share.
What is the investor’s total return?
In this example, the investor’s total purchase was $25,000; however, after one year, the
value of the stock had declined to $23,000. During the year, the company paid a dividend
of $0.80 per share; therefore, the investor received $800 (1,000 x $0.80). The investor’s
total return calculation is shown below:

[($23,000 – $25,000) + $800] ($1,200)

= = – 4.8%
$25,000 $25,000

The investor has a loss of 4.8%.

Inflation-Adjusted Rate of Return Inflation-adjusted rate of return, also referred to as the real
interest rate, measures the true yield of a fixed-income payment after removing the effects of inflation.

Inflation-Adjusted Return = Actual Return – Rate of Inflation

ABC Corporation’s bond has a nominal yield of 8%. If the rate of inflation is 3%, what is
the bond’s inflation-adjusted rate of return? Based on the formula shown above, the
inflation-adjusted rate of return is 5% (8% – 3%).

Risk-Free Return Risk-free return is the return on an investment that has no risk. The rate of
return on a U.S. Treasury bill (T-bill) is most often used to represent the risk-free return rate.

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CHAPTER 6 – INVESTMENT RETURNS

Risk-Adjusted Return Risk-adjusted return measures how much an investment returns in

relation to the risk that was assumed to attain it. For exam purposes, calculating the risk-adjusted
return is unnecessary, but having a basic understanding of the concept and its components is
important.

Averages and Indexes

Investors often compare their performance to a given benchmark. The benchmark could be an
average or index that monitors the performance of a group of securities. Some indexes are intended
to reflect the entire market and are referred to as broad-based, while others measure only a
segment of the market (or particular industry) and are referred to as narrow-based.

The Dow Jones Averages The Dow Jones Composite Average consists of 65 stocks and is broken
down into the following three subaverages:
 Dow Jones Industrial Average, which consists of 30 stocks
 Dow Jones Transportation Average, which consists of 20 stocks
 Dow Jones Utility Average, which consists of 15 stocks

Of the three subaverages, the Dow Jones Industrial Average (DJIA) is the most commonly quoted
measure of the stock market. The DJIA contains 30 of the leading blue-chip companies that
represent the backbone of industry in the United States. Included in this average are companies
such as Apple, General Electric, IBM, and Microsoft.

The Standard & Poor’s 500 Index The S&P 500 Index contains stocks that are listed on the NYSE
and Nasdaq. Compared to the Dow Jones Averages, the S&P 500 provides a broader measure of the
market and 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. The index is further divided into
four sub-indexes for industrial, transportation, financial, and utility issues.

The Wilshire Associates Equity Index The Wilshire Associates Equity Index consists of stocks
that trade on the New York Stock Exchange and Nasdaq. The Wilshire Index represents the dollar
value of all the stocks and is considered the broadest of all indexes and averages.

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Other Equity Indices The Major Market Index consists of 20 well-known, highly capitalized stocks.
The Nasdaq Composite Index consists of all Nasdaq listed securities, and the Nasdaq 100 consists of
100 of the largest companies that are listed on Nasdaq. The Russel Index follows 2,000 small-cap
company stocks and is considered the benchmark for the small-cap component of the market.

Debt or Bond Indices In addition to equity indices, there are also benchmarks for debt securities.
For example, Barclays Capital and other brokerage firms have created a number of indices that are
based on various types of debt securities in the market. There are also municipal bonds indices that
are created by The Bond Buyer—a financial publication that specializes in the municipal market.

Tracking Performance One of the most important things for an investor to track is how his
investments are performing relative to a benchmark or index. For instance, what if his equity
portfolio had increased 5% over the last 12 months, but the S&P 500 Index was up 10% over that
same period. In this case, the investor should likely examine the individual stocks in his portfolio to
determine the appropriate alteration(s).

Conclusion
This concludes the examination of investment returns. The next few chapters will cover several
popular packaged products, such as mutual funds, exchange-traded funds, and annuities.

Create a Chapter 6 Custom Exam

Now that you’ve completed Chapter 6, log in to my.stcusa.com and create a 10-question custom
exam.

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 CHAPTER 7

Packaged Products

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 7 – PACKAGED PRODUCTS

This chapter will examine different packaged products such as mutual funds, closed-end funds, and
unit investment trusts (UITs). Although each of these investments has different characteristics, they
have one element in common—each provide investors with an efficient way to quickly buy or sell a
group of underlying stocks and/or bonds. SIE candidates should place special emphasis on the
mechanics of buying and selling these products as well as the appropriate client disclosures.

Types of 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 (UITs), and management companies. The Act further divides management
companies into open-end and closed-end companies. Open-end management companies are more
commonly referred to as mutual funds.

Types of Investment Companies

Face Amount Unit Investment Trusts

Management Companies
Certificate Companies (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). A mutual fund’s BOD will hire
an expert (i.e., an investment adviser) to perform the security selection and trading functions.

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.

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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:
 At least 75% of the assets must be invested in a diversified manner with:
a. No more than 5% of the invested assets may be invested in any one company.
b. No more than 10% of the voting stock of any one company may be owned.

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

A non-diversified investment company usually invests in one specific asset category or industry, and in
a few securities within each category/industry. The risk with non-diversification is that bad news from
just one or two companies in a particular industry can hurt the prices of all stocks in that industry.

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. Note, an investment adviser (IA) is the management
company, while investment adviser representatives (IARs) are the individuals who work for the IA.

Liquidity Liquidity is defined as the ability to sell an asset at a reasonable price within a short
period. Mutual funds are extremely liquid investments; however, unlike standard stocks, mutual
fund shares are not traded throughout the day. Instead, mutual fund shares are issued by, and
subsequently redeemed back to, the fund itself.

Exchanges at Net Asset Value Another benefit of investing in mutual funds is that shareholders
may exchange the shares they own in one fund for shares of another fund at the net asset value (the
fundamental value of the shares) as long as both funds are in the same family (brand name). If the
exchange is made within the same fund family, an additional sales charge will not be assessed.

Convenience A person who wants to invest monthly may arrange to have the funds automatically
deducted from their checking accounts. Investors are also able to have 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 recordkeeping and ensures that shareholders receive regular reports that show
their purchases, redemptions, and 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.

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 CHAPTER 7 – PACKAGED PRODUCTS

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). Also, a
fund must have a minimum net worth of $100,000 in order to offer its shares to the public.

The Prospectus A fund’s prospectus is the primary disclosure document for potential investors
and includes the following information:
 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 a salesperson when buying shares)
 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 since mutual fund purchases are primary issuances. 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, registered
representatives are not permitted to alter, mark, or highlight a prospectus in any way.

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.
 The net asset value (NAV) is also referred to as the bid or redemption price.
 The public offering price (POP) is also referred to as 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 any person who requests it.

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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. A fund has a board of directors
that’s responsible for administering the fund for the benefit of the shareholders. The fund’s
shareholders are the persons who invest their money in the 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
 Appointing the fund’s principal officers that 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. IAs research
and analyze financial and economic trends and decide which securities the fund should buy or sell
in order to maximize performance. For these services, the investment adviser is paid a management
fee which is based on the assets under management (AUM), but not based on performance.

Custodian Bank In order to prevent the theft or loss of a fund’s assets, the Investment Company
Act requires the fund to appoint a qualified bank as its custodian that will maintain its assets. The
custodian is responsible for safeguarding the fund’s cash and securities and collecting dividend and
interest payments from these securities. However, the custodian neither guarantees 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, such as
issuing new shares and canceling the shares that investors redeem. Today, most of these securities
functions are done electronically without physical certificates changing hands.

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The transfer agent also distributes capital gains and dividends to the fund’s shareholders and
forwards the required documents to shareholders, including statements and annual reports.

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 the fund’s shares to investors. All FINRA member firms must use the same pricing and
may not sell fund shares at a discount to a non-member firms.

Three Distribution Methods

Dealers
1) Fund Principal Underwriter Dealers Investors
Dealers

2) Fund Principal Underwriter Investors

3) Fund Investors

Categories of Mutual Funds

Aggressive Growth Funds These 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.

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.

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. Although
specialized funds are riskier than more diversified funds, they allow fund managers the opportunity
to take advantage of unusual situations.

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.

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CHAPTER 7 – PACKAGED PRODUCTS

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 interest-rate risk.

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. The fund attempts to produce the same return as the index; therefore,
investors cannot expect the fund’s returns to outperform the relevant benchmark. These funds
typically have low expenses.

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.

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.

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.

Buying and Selling Mutual Fund Shares

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

Net Asset Value + Sales Charge = Public Offering Price

The equation above represents the process that’s 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.

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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) 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 fund must be computed at least once per day. A fund’s prospectus discloses
the cutoff time that’s used for share purchases and redemptions and explains how its NAV is
calculated. The NAV is normally computed daily as of the close of trading on the New York Stock
Exchange (4:00 p.m. Eastern Time).

End of Day Pricing Orders to buy and sell fund shares are based on the next computed price. 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); it will not be executed until
the close of business on Thursday. This is an important distinction between mutual funds and other
types of funds, such as closed-end funds or ETFs. (ETFs will be discussed in the next chapter.)
Shares of closed-end funds and ETFs trade throughout the day like individual stocks and bonds.

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 actually determined
by the fund or its principal underwriter. Typically, a mutual fund’s ex-dividend date is the business
day following the record date.

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

POP – NAV
Sales Charge % =
POP

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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(CDSC) Rather than assessing a sales
charge at the time of purchase, some funds allow investors to buy shares at the NAV and will then
assess a sales charge when the investors redeem their shares. Usually, the longer the investor owns
the shares, the greater the decrease will be in the back-end load. Due to the decreasing charge, this
form of load is referred to as a contingent deferred sales charge (CDSC). In fact, if the investor holds
the shares long enough, there may 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 If customers purchase investment company shares that assess a deferred
sales charge at redemption, FINRA rules require that they be provided with 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 no sales charge is assessed at the
time that Class B shares are purchased, RRs may not attempt to sell them as the equivalent of a no-
load.

No-Load Funds Not all mutual funds assess sales charges. When a mutual fund sells its shares to
the public at their net asset value (i.e., with no sales charge), it’s referred to as a no-load fund. In
other words, this fund’s 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 the
salespersons.

To be marketed as a no load fund, this type of 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, funds assess annual fees that are based on the NAV of their
holdings including 12b-1 fees, service fees, and administrative fees.

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12b-1 Charges (Distribution Fees) In a 12b-1 arrangement, mutual funds may pay for
distribution expenses through deductions from the portfolio’s assets. These 12b-1 charges are used
to pay the costs of distributing the fund’s shares to the public and will cover expenses such as sales
concessions and the costs associated with advertising and the printing of the prospectus.

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 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. These ongoing trailer fees are paid to RRs as compensation for
continuing to service their clients’ accounts.

Administrative Charges Administrative charges are deducted from the net assets of an
investment company and used to pay various costs including the payments that are made to
custodian banks and/or transfer agents.

Fee Disclosure 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 that are used to
pay operating costs and is calculated by dividing the fund’s total expenses by the average net assets
in the portfolio. The expense ratio includes the management fee, administrative fees, and 12b-1
fees, but does not include sales charges.

Total Expenses
Expense Ratio =
Average Net Assets

Expense ratios typically range between .20% and 2% of a fund’s average net assets and must be
disclosed in the fund’s prospectus. The expense ratio varies based on the type of fund and the share
class that’s 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:

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Class A Shares 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 (both of which are described below). 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 invested in the
fund. The $50 is deducted as a sales charge and benefits the selling brokers.

Class B Shares 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. Once the specified number of years has passed and the back-end
charge is reduced to zero, most Class B shares will convert to Class A shares. Unlike Class A shares,
Class B shares don’t qualify for breakpoint (sales charge) discounts.

Class C Shares Class C shares assess an up-front sales charge, which is usually 1%, plus many
assess an annual 12b-1 fee or level load that’s usually 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 Share Classes Many fund families 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 provider must fully disclose each of the share classes that it offers as well as
the different sales charges and applicable 12b-1 fees.

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

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.

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Fund Families The term fund families or fund complexes is used when defining a single
investment company or mutual fund company that has many different types of mutual funds from
which a customer may choose to purchase. A fund family is essentially a brand name that applies to
several related individual mutual funds. 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 switch 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). A fund’s breakpoints must be clearly stated in its prospectus.

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 example, a person who invests between $100,000 and $250,000 will pay a reduced
percentage sales charge or load of 3.25%.

Determining the Offering Price for a Reduced Load Since breakpoints affect the purchase price of
mutual fund shares, SIE candidates should be able to determine a fund’s offering price based on the
reduced sales charge percentage. This adjusted POP is calculated by using the following formula:

NAV
POP =
(100% – Sales Charge %)

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CHAPTER 7 – PACKAGED PRODUCTS

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 is the adjusted offering price for the
investor?

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

At this price, the investor is able to purchase 9,671.18 shares ($100,000 ÷ $10.34).

Letter of Intent (LOI) A letter of intent qualifies an investor for a discount made available through
breakpoints without initially depositing the entire amount required. The letter indicates the
investor’s intention to deposit the required funds over the next 13 months. The LOI may be
backdated for 90 days to include prior purchases.

Since letters of intent are non-binding, an investor will not be penalized for failing to make the
additional purchases. However, this failure will result in a price adjustment that equals the higher
sales charge that would have 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 (fund complex) 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

Letters of Intent Rights of Accumulation

The investor is able to add up all of the purchases

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

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 CHAPTER 7 – PACKAGED PRODUCTS

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 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
receive the money or reinvest it. However, mutual funds make the choice easy by allowing investors to
reinvest their dividends and other distributions, usually at the NAV, without paying a sales charge.

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

Redeeming Shares
An investor may redeem (sell) 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 that’s 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 funds systematically. If investors
elect to begin a systematic withdrawal plan, they will receive regular payments, typically on a
monthly or quarterly basis. Payments are first made from dividends and then capital gains;
however, if these amounts are insufficient, 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.

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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’re 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.

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.

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.

No Discounts on Class B Shares RRs should not recommend buying Class B shares to a client
who intends to place a large order. The client should be directed toward Class A shares since only
this share class qualifies for breakpoints.

Switching Shares When an RR recommends that a client sell the existing mutual fund shares that
she owns of one fund family and invest the proceeds into another fund family, the RR’s
recommendation is referred to as switching. The concern is that the movement between different
fund families will result in a new sales charge being assessed.

Exchanging Shares Most mutual funds offer investors the ability to sell shares of one fund and buy
shares of another fund within the same fund family without sales charge implications. Unlike
switching shares, exchanging shares doesn’t create a sales practice issue.

However, regardless of whether the investor is involved in switching or exchanging shares, the IRS
considers them both the sale of one fund’s shares and the purchase of another fund’s shares. Any
resulting gain or loss will represent a taxable event for the investor.

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 CHAPTER 7 – PACKAGED PRODUCTS

Other Types of Investment Companies

Although mutual funds are by far the most common type of investment company, let’s examine
some of the other varieties.

Face-Amount Certificate Companies

These types of investment companies are 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 Trusts

Unit investment trusts (UITs) are formed under a legal document that’s referred to as 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. Investors are able to buy or sell
SBIs in the secondary market. Each unit entitles the holder to an undivided interest in the UIT’s
portfolio that’s proportionate to the amount of money invested.

UITs are supervised, but not managed, investment companies. In other words, UITs don’t utilize
the services of investment advisers to determine what securities to buy and sell. Since these trusts
are not managed, they don’t have associated management fees.

Closed-End Investment Companies

Closed-end investment companies are the other type of management company. Unlike open-end
management companies (mutual funds), closed-end funds typically conduct a one-time issuance of
common shares to the public. Although they may issue additional shares later, they don’t
continuously issue new shares or stand ready to redeem their shares for cash. Beyond issuing
common shares, closed-end funds may also issue senior securities (i.e., preferred stock or bonds).

After a closed-end investment company issues its shares, these shares trade in the secondary
market. Therefore, an investor who wants to purchase shares in a closed-end investment company
will buy them on a traditional exchange (e.g., the NYSE or Nasdaq). As these securities trade in the
secondary market, there is no prospectus delivery requirement. Additionally, the shares are able to
be purchased on credit (i.e., they’re marginable).

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

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CHAPTER 7 – PACKAGED PRODUCTS

Below are two summary tables which summarize investment 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
May issue only common shares
as 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
Fund sponsor does not stand ready to redeem shares
next 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

Comparison of Investment Companies

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

Conclusion
This concludes the examination of mutual funds and related packaged products that are subject to
the Investment Company Act of 1940. The next chapter will describe some additional forms of
bundled investments.

Create a Chapter 7 Custom Exam

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exam.

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 CHAPTER 8

Variable Contracts and

Municipal Fund
Securities
Key Topics:

 Types of Annuities

 Annuity Phases

 Qualified Annuities and Equity Indexed Annuities (EIAs)

 Municipal Fund Securities

 CHAPTER 8 – VARIABLE CONTRACTS AND MUNICIPAL FUND SECURITIES

This chapter will examine the details regarding variable annuities, including the different types, their
unique tax implications, as well as suitability considerations. Additionally, the last section of this
chapter will describe municipal fund securities, such as local government investment pools (LGIPs),
Section 529 educational plans, and 529 ABLE plans.

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 (either all at once or over time) 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 quickly. From an investor’s perspective, it’s
important to understand the different features of the contracts.

The majority of annuities are non-qualified, which means that the contract owner invests money on
an after-tax basis with the interest credited to the account accumulating on a tax-deferred basis. In
other words, an annuitant is not required to pay taxes on the income or growth until she begins
taking distributions or withdraws funds from the account. 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 the same rate as the owner’s ordinary income. Non-qualified annuities will form the
basis of this examination of annuities.

Fixed versus Variable Annuities

There are two types of annuity contracts—fixed and variable. With a fixed contract, the investor
receives a fixed rate of interest and the investment risk is assumed by the insurance company. For this
reason, fixed contracts are not considered securities and are governed under state insurance law only.
On the other hand, variable contracts offer returns that fluctuate and the investor assumes all of the
investment risk. 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.

Variable Annuities
Variable annuities were created to provide investors with greater protection against inflation than
what traditional, fixed annuities can offer. The contract owner is also given a level of control over
how her contributions are invested—at least during the annuity’s accumulation phase (the period
during which she is depositing funds into the annuity).

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CHAPTER 8 – VARIABLE CONTRACTS AND MUNICIPAL FUND SECURITIES

Although it’s only insurance companies that issue variable annuities, these contracts are not
considered forms of life insurance. A firm that offers variable annuities must be a broker-dealer
that’s registered with the SEC. Also, the registered representatives who sell variable annuities must
obtain a state insurance license as well as either a Series 6 or Series 7 FINRA registration.

In a variable annuity, when a person decides to annuitize, she will begin to receive payouts from the
annuity and, in turn, relinquish control of the principal value of the contract to the insurance
company. Once the benefit payments start, the amount will vary from month-to-month depending
on the performance of the investments in the separate account (described below). If these
investments perform well, the payments to the annuitant may increase. Conversely, if they perform
poorly, then the payments may decrease. For variable annuities, the insurance company does not
guarantee a minimum rate of return. Variable annuities are not suitable for all investors. Before
considering variable annuities, investors should exhaust all of their options in saving for retirement
on a pre-tax basis—such as through IRAs or 401(k) plans.

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 (which is used for fixed annuities). All of the income and capital gains
that are generated by the investments in the separate account are credited to the account. Also, any
capital losses that are incurred by the separate account are then charged to the account; however, it’s
not affected by any other gains or losses that the insurance company incurs. If the insurance
company becomes insolvent, its creditors may not make claims against the assets in the separate
account, but they may make claims against the assets in the general account. The separate accounts
of variable products are generally required to be registered as investment companies under the
Investment Company Act of 1940.

Subaccounts For variable annuities, the separate accounts typically contain a variety of different
underlying portfolios or subaccounts (which are similar to the fund choices that investment companies
offer to their investors). The contract owners are able to allocate their payments among these different
subaccounts based on their investment objectives. Additionally, contract owners are generally allowed
to transfer their money from one subaccount to another as their investment goals change.

Separate Account

Subaccount A Subaccount B Subaccount C Subaccount D

Growth Income Long-Term Bonds Aggressive Growth

Each of the subaccounts typically corresponds to a different underlying mutual fund (or unit
investment trust), such as a large-cap stock fund, a long-term bond fund, or a money-market fund.
Another subaccount may have a fixed rate of return which is guaranteed by the insurance company.
The value of the other underlying subaccounts will fluctuate based on changing market conditions.

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 CHAPTER 8 – VARIABLE CONTRACTS AND MUNICIPAL FUND SECURITIES

In a variable annuity, a contract owner who invests in any subaccount (other than the fixed-rate
subaccount), assumes all of the investment risk. An insurance company does not guarantee a
minimum rate of return for most of its variable annuity subaccounts. Variable annuities are classified
as securities; therefore, they must be registered with the SEC and sold by prospectus. The separate
accounts and underlying subaccounts must also be registered with the SEC as investment companies.

The Life of a Variable Annuity

Most variable annuities involve two periods—the accumulation and the annuity period. In other words,
there is a pay-in period as well as a pay-out period. The details of these two are summarized below.

Accumulation Period
The accumulation (pay-in) period of a variable annuity begins when a person first directs her
contributions to the insurance company. During the accumulation period, the value of the
annuitant’s investment in the separate account is calculated by using an accounting measurement
that’s referred to as an accumulation unit. Essentially, the accumulation units are purchased at net
asset value (NAV). The NAV of the subaccount units is calculated using the same method that’s
employed by mutual funds.

Total Net Assets

NAV Per Unit =
Total Units Issued

The calculation is done at the end of every business day (usually at the close of trading on the
exchanges). The actual price that annuitant’s will pay for their units is the next calculated NAV. This
approach is referred to as forward pricing. However, the value of the units will fluctuate along with the
changing value of the underlying portfolios of the separate account. If the investments in the separate
account perform well, then the units will increase in value; however, if the investments in the
separate account perform poorly, then the units will decrease in value.

With each investment, the insurance company first deducts the applicable commissions or other
charges and then uses the remainder of the annuitant’s investment (the net payment) to buy the
accumulation units in the subaccounts that are selected.

Cash Surrender Annuitants may cancel (surrender) their variable annuities at any time during
the accumulation period and receive the annuity’s current value. Also, annuitants may instead
choose to withdraw a part of their annuity’s value at any time (a partial surrender). However, as
described earlier, an annuitant may be required to pay surrender charges that are determined by
how long she has held the annuity. The surrender will also result in the requirement to pay taxes on
any increase in the value of her annuity.

For variable annuities, insurance companies don’t guarantee a minimum cash surrender value. Therefore,
if a person surrenders her annuity, she may receive less than the total amount that she has invested.

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CHAPTER 8 – VARIABLE CONTRACTS AND MUNICIPAL FUND SECURITIES

Loans Some insurance companies allow their contract owners to borrow against the value of
their annuity contracts during the accumulation period. A loan that’s taken against an annuity is
not tax-free. Instead, the IRS considers the loan to be a taxable distribution. An insurance company
will usually charge interest on the loan and will therefore reduce the number of accumulation units
that the client owns in relation to the amount of the loan. If the contract owner repays the loan, then the
insurance company will again increase the number of accumulation units that she owns.

Death Benefits Although variable annuities are not life insurance policies, these contracts often
have an associated death benefit. Therefore, at the time of purchase, the contract owner designates
a person as her beneficiary to receive this benefit in the event of her death.

If the annuitant dies during the accumulation period, the beneficiary receives the greater of:
1. The sum of all of the contract owner’s payments into the annuity, or
2. The value of the annuity on the day of the annuitant’s death

For example, a person has paid a total of $50,000 into a variable annuity and designated
his son as his beneficiary. If the annuitant dies one year later when the value of his
annuity is $45,000, then the beneficiary receives $50,000.

Because mutual funds lack the death benefit feature, this is one reason that clients may prefer to
purchase annuity contracts despite the fact that they’re relatively more expensive.

Annuity Period
The annuity (pay-out) period begins when an annuitant decides to receive income payments from
the annuity. Prior to this point (during the accumulation period), the contract holder is permitted to
surrender the annuity in exchange for its current value. However, once a person decides to
annuitize, she may no longer surrender the annuity or freely withdraw money from it. Instead, she
is receiving payments based on the performance of the assets in the separate account.

Annuity Units At annuitization, the insurance company converts all of the accumulation units
into annuity units. Annuity units represent the accounting measurement that’s used to determine
the dollar amount of each payment that will be made to the annuitant.

The number of annuity units represented in each payment is fixed at this time. The value of each
payment that’s made to the annuitant is based on a fixed number of annuity units multiplied by a
fluctuating value.

To calculate the annuitant’s payment, the insurance company takes the following into
consideration the:
 Annuitant’s age and gender
 Settlement (payout) option selected
 Annuitant’s life expectancy
 Assumed interest rate

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 CHAPTER 8 – VARIABLE CONTRACTS AND MUNICIPAL FUND SECURITIES

Settlement Payout Options There are several methods for receiving payments from an annuity.
An annuitant may choose from the options described below in order 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.

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.

Annuity Charges and Expenses

In an annuity, the entire contribution is not invested in the separate account since purchases are
subject to various sales charges and fees. Registered representatives must explain each of these
costs to their clients prior to effecting 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 is assessed on Class B mutual fund shares.

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CHAPTER 8 – VARIABLE CONTRACTS AND MUNICIPAL FUND SECURITIES

Although FINRA rules specify a maximum sales charge of 8.5% for mutual fund sales, there is 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 Charges An insurance company may not refuse to meet the obligation of providing
its annuitants with a lifetime income even if they live longer than expected. The pledge that the
company makes is referred to as the mortality guarantee. There are two types of mortality risks that
are associated with annuities.

First, the insurance company may guarantee its annuitants that it will make payments to them for
the rest of their lives. When calculating these payments, the company takes into account the
annuitant’s expected life span.

Second, most variable annuities also guarantee that if the contract owner dies during the annuity’s
accumulation phase, the company will return a certain amount of money (i.e., a death benefit) to
the person who is designated as the beneficiary by the contract owner.

Qualified Annuities
Although any person may invest in a non-qualified annuity, a tax-deferred, qualified annuity is a
special type that may only be established by non-profit organizations or public school systems for their
employees. The employees may set aside a portion of their income on a pre-tax basis in order to
fund the annuity. The employers may also contribute to the annuity on their employees’ behalf.
The amount contributed by the employees is excluded from their taxable income.
For example, a public school teacher who earns $35,000 per year has $2,000 withheld
from his paycheck annually to purchase units in a tax-deferred annuity. This will result
in his taxable income being only $33,000 per year.

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 CHAPTER 8 – VARIABLE CONTRACTS AND MUNICIPAL FUND SECURITIES

The money that the employees contribute into qualified annuities accumulates on a tax-deferred
basis until the employees ultimately withdraw the funds. Since the contributions are made with
pre-tax dollars, all of the payouts from the annuity are taxed as ordinary income.

Let’s assume that during a person’s working life he had contributed $100,000 into a tax-deferred annuity
and the value of his investment has grown to $250,000. At retirement, if he withdraws the entire value of
his annuity, he is required to pay ordinary income taxes on the entire amount. The entire amount is
taxable because the annuitant has a zero cost basis (i.e., none of the invested funds have been taxed).

Equity-Indexed Contracts (EICs)

EICs are contracts that combine the features of both fixed and variable annuities; however, they’re not
required to be registered with the SEC as securities. An equity indexed contract offers clients a
minimum guaranteed rate of return or floor (similar to a fixed contract), but also offers upside
potential (similar to a variable contract).

The insurance company links the return of these types of contracts to an equity index, such as the
S&P 500 Index. If the index performs poorly, the client will still earn the minimum guaranteed rate.
On the other hand, if the index appreciates above a preset level, the investor will earn a return that
exceeds the minimum guaranteed rate. Some contracts are issued with a participation rate which
may limit the amount of the index’s appreciation that the client will earn.
For example, an EIC has a participation rate of 80% and the associated index’s return is
10%. In this case, the investor will not share in the entire return of the index. Instead, the
investor’s return is capped at 8% (10 x 80%).

Although these contracts offer the benefit of tax-deferred growth, clients may lose money when
surrendering the contract in the early years since expenses, CDSCs, and premature distribution
penalties often apply. The market does not cause the value of these investments to decline; instead,
it’s the impact of fees being deducted.

Suitability As with variable annuities, equity-indexed annuities are not suitable for all investors,
particularly older investors, who may need access to their money for medical or living expenses.
EIAs should never be sold to short-term investors since the surrender period for an equity-indexed
annuity may be as long as 15 years.

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 can understand
the risks inherent with equity investments. An investor’s hope is that the contract will continually grow
at a rate that will provide a hedge against inflation risk.

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Generally, variable annuities are not suitable for senior investors; instead, they’re more appropriate
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, many
annuities impose significant charges on investors who surrender their contracts early. If an
1
annuitant withdraws funds prior to reaching the age of 59 /2, he is required to pay taxes on any
increases in the value of his annuity plus he is subject to a 10% tax penalty.

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 (since most contracts have CDSCs), the intended use of the deferred variable annuity, existing
assets (including outside investment and life insurance holdings), liquidity needs, liquid net worth,
risk tolerance, and tax status.

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 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.

Review of 1035 Exchanges Although 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 exchange 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 or investment advisory fees).

FINRA Concerns Historically, some salespersons have sold annuities to the wrong investors and/or
recommended inappropriate exchanges within contracts. Additionally, annuities often have higher
expenses than similar mutual funds that could instead be placed within a retirement account. Any
persons 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 to employer-sponsored plans is that they’re 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.

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 CHAPTER 8 – VARIABLE CONTRACTS AND MUNICIPAL FUND SECURITIES

Municipal Fund Securities

Although municipal fund securities constitute municipal securities, they may not have many of the
features that are typically associated with traditional municipal securities. Instead, municipal fund
securities appear to have features more similar to investment company securities or variable
contract products. For instance, municipal fund securities provide investment returns and are
valued based on the investment performance of an underlying pool of assets with an aggregate
value that may increase or decrease from day-to-day, rather than providing interest payments
(either paid currently or at maturity) at a stated rate or discount, as is the case with traditional
municipal securities. In addition, unlike traditional municipal securities, municipal fund securities
don’t have stated par values or maturity dates and cannot be priced based on yield or dollar price.

Let’s examine three different forms of municipal fund securities—local government investment
pools (LGIPs), 529 college savings plans, and 529A plans.

Local Government Investment Pools

LGIPs are trusts that are established by state and local governments and offer municipalities a place
to invest their money. Government entities use their surplus cash to purchase interests in a trust,
which invests the assets in a large portfolio of securities, according to the trust’s investment
objectives and state laws. Since only municipal governments and their instrumentalities may invest
in LGIPs, they’re not open to investment by the public.

The purpose of LGIPs is to encourage the efficient management of the cash reserves of government
entities, who otherwise have limited investment options. LGIPs offer an investment alternative that
minimizes the risk of principal loss while offering daily liquidity and a competitive rate of return. By
pooling their funds, government participants benefit from economies of scale, diversification,
professional portfolio management, and liquidity.

Section 529 College Savings Plans

Section 529 of the IRS Code, which was amended by Congress in 1996, enabled the establishment of
state-sponsored, tax-deferred, college savings vehicles. The two types of 529 plans that can be used
to meet the expenses of higher education are prepaid college tuition plans and college savings plans.

Prepaid Tuition Plans (PTP) Prepaid tuition plans are designed to cover tuition costs at public in-
state colleges and universities. The donor may pay for amounts of tuition in one lump-sum or
through installment payments. Some prepaid tuition plans offer contracts for a two-year or four-
year undergraduate program and can cover one to five years of tuition. Other plans may even allow
for the contract to be applied to graduate school.

Residency Requirements and Other Limitations Many PTP plans require that the donor or the
beneficiary be a resident of the state that offers the plan. Some plans also limit enrollment to a certain
period each year and they may limit the expenses that are covered. For example, some plans may
cover the costs of tuition, books and laboratory fees, but may not cover the costs of room and board.

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Prepaid tuition plans don’t provide the donor any investment options. The price of the contract is
determined prior to purchase and usually depends on the type of contract, the current grade of the
beneficiary, and the current and projected cost of tuition.

Transferability If the beneficiary of a prepaid tuition plan chooses not to attend a college covered
by the plan, most plans provide for a transfer to another sibling of the original beneficiary. In some
cases, age restrictions may apply. Additionally, if the sibling decides not to attend college or if the
donor cancels the plan, only the original contribution will be returned and any interest earned on
the plan will be lost. In fact, some plans may charge a cancellation fee.

Prepaid tuition plans are not considered to be municipal fund securities. In effect, these plans lock
in tuition costs at today’s levels and protect the saver against future cost increases. Unlike college
savings plans, tuition plans are not self-directed and typically offer guaranteed returns.

College Savings Plans College savings plans, which most simply recognize as 529 plans, are
more similar to a 401(k) plan in that they offer mutual fund type investments that grow on a tax-
deferred basis. Some plans offer rather limited investment choices, including aged-based portfolios
that automatically adjust the asset allocation based on the beneficiary’s age. These plans typically
move money from stock funds to bond funds as the child grows closer to college age.

Under federal law, contributions are made with after-tax dollars, but any earnings grow on a tax-
deferred basis. Earnings in a 529 plan account are not subject to federal income tax, and in many
cases are not subject to state income tax when used for the qualified higher education expenses.
Qualified education expenses include those incurred for tuition and fees, room and board, as well
as books, supplies, and equipment. 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.

Expanded Use of 529 Plans Beginning in 2018, the government 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.

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.

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 CHAPTER 8 – VARIABLE CONTRACTS AND MUNICIPAL FUND SECURITIES

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 who are funding multiple 529 plans. The total amount able to be contributed to a 529 plan is
determined by the state. Most states use a total that’s sufficient to pay for an undergraduate degree.

529 Plan Advantages These plans allow the owner to change beneficiary once per year; however,
the new beneficiary must be a family member of the previous beneficiary in order to retain federal
tax benefits. The ability to change beneficiaries means that funds which were contributed to a 529
plan may leave donors’ estates, but not their control. Many plans have no time limit as to when the
funds must be withdrawn and the donor will authorize the payment of any future educational
expenses. Additionally, twice every 12 months, account owners can adjust their holdings in a 529
plan (this was previously only allowed once every 12 months).

Direct or Adviser Sold There are two method by which 529 plans may be sold to customers. One is
referred to as direct-sold, in which there’s no salesperson and the plan is sold directly through the
529 savings plan’s website or through the mail. The other method is adviser-sold, in which the plan
is sold by through a broker-dealer that has entered into a signed selling agreement with the primary
distributor of the 529 plan. Some states may only offer plans directly (typically to their residents),
while others have selling agreements with broker-dealers and offer the plans directly. The fees that
are paid may be lower in direct-sold plans, but the customer will not receive the advice of an
investment professional. Obviously, adviser-sold plans offer the advice of an adviser.

Section 529A Plans

Similar to 529 college savings plans, 529 ABLE (or simply referred to as 529A) accounts are savings
accounts that are administered by the states. The 529A plan was authorized under the Achieving a
Better Life Experience (ABLE) Act to supplement the support of persons who are disabled or who
meet the government’s definition of disabled and are receiving Social Security disability, Medicaid,
or private insurance payments. In the past, if a disabled person earned more than $700 per month
or had assets in excess of $2,000, he risked having to forfeit eligibility for government programs.
Today, a 529A account will not impact Medicare or Social Security payments unless the current
account value exceeds $100,000. Once the account value is again below the $100,000 level, federal
and state aid resumes. The maximum contribution limit is $500,000.

A 529A account may be opened in any state that has a nationwide ABLE program. The maximum
contribution into the account is $15,000 per year and it’s made on an after-tax basis at the federal
level (may be pre-tax at the state level). Unlike a 529 plan, there is no five-year front loading of
contributions and there may only be one 529A account per beneficiary. The earnings are tax-free if
they’re used for qualified expenses, including basic living expenses, education, employment
support, housing, financial management, legal fees, transportation, and wellness. If the funds are
used for non-qualified expenses, the earnings are subject to taxes at ordinary tax rates and a 10%
tax penalty.

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Upon the termination of disability status or death of the beneficiary, the assets in the 529A plan are
used to pay off the state Medicaid agency for any expenses that were paid out after the ABLE plan
was established. The assets of the plan may also be rolled over to an eligible sibling without a
taxable event. Offering documents associated with 529A plans, as well as continuing disclosure
documents, are available on the MSRB’s Electronic Municipal Market Access (EMMA) system.
EMMA is an online repository that is maintained by the MSRB.

Conclusion
This ends the chapter on variable contracts/annuities and municipal fund securities. These products
have unique features and can be very attractive to a wide variety of investors. The next chapter will
continue to examine securities products, including direct participation programs (DPPs), real estate
investment trusts (REITs), hedge funds, and exchange-traded products (ETPs).

Create a Chapter 8 Custom Exam

Now that you’ve completed Chapter 8, log in to my.stcusa.com and create a 10-question custom
exam.

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 CHAPTER 9

Alternative Investments

Key Topics:

 Exchange-Traded Funds and Exchange Traded Notes

 Hedge Funds and REITS

 Limited Partnership
 CHAPTER 9 – ALTERNATIVE INVESTMENTS

This chapter will examine some additional types of packaged products, such as exchange-traded
funds (ETFs), hedge funds, and real estate investment trusts (REITs). The final section of this chapter
will describe direct participation programs (DPPs), which are fairly complicated products that offer
several unique tax benefits.

Other Types of Investment Companies

Mutual funds are by far the most common type of investment company; however, their shares may
only be purchased or sold (issued or redeemed) at the end of the trading day. For investors who
want the ability to trade packaged products (especially index fund-like products) throughout the
day, exchange-traded funds (ETFs) are available.

Exchange-Traded Funds (ETFs)

ETFs issue shares that represent an interest in an underlying basket of securities which typically
mirrors a specific index. Some of the indexes to which ETFs are linked represent the securities of a
particular country or industry.

Some ETF examples 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

Passive Versus Active Active management refers to the selection of securities in a portfolio by a
professional manager. The ultimate goal of the manager is to outperform the market. On the other
hand, passive management involves simply attempting to match the market by tracking an index.

Fee Considerations The fees associated with passive management are lower than the costs that
are added for the selection of securities for a portfolio that’s actively managed. Unlike purchasers of
mutual fund shares who may be assessed sales charges, purchasers of ETF shares pay commissions
on their transactions.

How ETF Differ from Mutual Funds Unlike mutual funds, ETFs trade on an exchange and have
prices that are determined continuously by the forces of supply and demand. Additionally, ETFs
often have lower expenses than mutual funds and their shares may both be sold short and
purchased on margin.

Lately, specific types of ETFs—inverse and leveraged ETFs—have become popular among
sophisticated investors. The value of inverse ETFs should increase when the market drops or
decrease when the market rises. Leveraged ETFs seek to provide investors with a multiple of the
return of a benchmark index.

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CHAPTER 9 – ALTERNATIVE INVESTMENTS

Inverse ETFs An inverse ETF is designed to perform in a manner that’s the inverse of the index
being tracked. This reverse tracking is accomplished by short selling the underlying investments in
the index (i.e., borrowing securities and selling them with the belief that they will fall in value) or
through other advanced strategies using futures and derivatives. The goal of an inverse ETF is to
provide a return that’s equivalent to short selling the stocks in the index. For example, if the S&P
500 Index falls by 1.5% on a given day, the inverse ETF should rise by approximately 1.5%. These
products are often used by investors with long positions as a hedge against a bear market.

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). On the other hand, 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 to meet their objectives. In other words, all price movements are
calculated on a percentage basis for that day only. On the next day, the process will restart. 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, both leveraged
ETFs and inverse ETFs are generally only appropriate for short-term trading purposes.

Exchange-Traded Notes (ETNs)

ETNs are a type of unsecured debt security that pays a return which is linked to an underlying
market index or other benchmark. Like ETFs, ETNs trade on exchanges and are available in both
inverse and leveraged varieties. These hybrid versions are designed as short-term trading vehicles.

Return ETNs are different than traditional bonds since they don’t typically make interest
payments. Instead, ETNs pay the holder an amount which is based on the performance of an
underlying index or benchmark. The maturities of ETNs can range from 10 to 30 years.

Issuer Credit Risk ETNs are created by a bank or other financial intermediary and are unsecured
debt obligations of the issuer. Since an ETN is a debt obligation of the issuer and backed by only the
issuer’s full faith and credit, the issuer’s credit quality is a risk factor to consider when determining
whether to invest in an ETN.

Fee Considerations There are two types of costs that are associated with ETNs. First there are
reoccurring costs, such as fees included in the reference index or benchmark as well as the daily
investor fees that will lower the indicative closing value of the ETN. The term indicative value is the
reference value of the benchmark minus the daily investor fee. The other cost is the amount of
brokerage commissions that investor’s may pay when buying and/or selling ETNs.

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 CHAPTER 9 – ALTERNATIVE INVESTMENTS

Other Types of Packaged Products

Hedge Funds
Hedge funds are private investment pools that are not required to register with the SEC under the
Investment Company Act of 1940. These investments are often sold under a Regulation D (private
placement) exemption and their purchasers are typically institutional and high net worth investors
that can understand the unique risks associated with these products, such as their lack of liquidity
and their potential use of leverage by the fund managers. These funds typically have high minimum
initial investment requirements (often $1 million or greater).

Unregulated Since hedge fund offerings are generally limited to accredited investors, these products
qualify for exemptions from the federal regulations that govern short selling, use of derivatives,
leverage, fee structures, and the liquidity of the investment. Due to these exemptions, hedge funds
may use strategies that are prohibited for more heavily regulated investment entities (e.g., mutual
funds). Ultimately, hedge funds are more complex and may expose investors to many different
types of investment risk.

Illiquid Unlike mutual funds, hedge funds are not required to publish their net asset value daily
and impose restrictions on withdrawals which make these assets less liquid. Since hedge funds don’t
offer investors the ability to redeem at the NAV on a daily basis, these products are unsuitable for
investors who are seeking liquidity. In addition, most hedge funds raise capital by offering investors
limited partnership units (described later in this chapter), which will also limits their liquidity.

Compensation Mutual funds cannot assess a sales charge that exceeds 8.5% of the fund’s public
offering price; however, hedge funds often impose higher and more complex fees. One typical
arrangement is a two-and-twenty fee which involves a hedge fund manager charging a 2%
management fee and then taking 20% of any of the profits.

Private Equity Funds

Hedge funds often attempt to amplify investment results while engaging in the trading of existing
securities. Traditionally, the role of raising capital for start-up businesses was filled by private
equity (PE) and venture capital (VC) funds. In many ways, these types of funds are similar to hedge
funds, especially due to their lack of regulation and liquidity.

Unregulated and Illiquid Similar to hedge funds, PE and VC funds raise capital by offering investors
limited partnership units that are sold as private placements (under the Reg. D exemption). For that
reason, hedge funds are normally available to accredited investors only. These funds are not regulated
under the Investment Company Act of 1940 and have no active trading venues.

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CHAPTER 9 – ALTERNATIVE INVESTMENTS

Real Estate Investment Trusts (REITs)

Regulation
Although real estate investment trusts have some features that are similar to investment
companies, these products are not categorized under the Investment Company Act of 1940.
However, the Securities Act of 1933 regulates REITs as securities and requires that prospectuses are
sent to any investors who purchase shares that are offered to the public in the primary market.

Investment Attributes
REITs create a portfolio of real estate investments from which investors may earn profits. REITs
invest in many different types of residential and commercial income-producing real estate, such as
apartment buildings, shopping centers, office complexes, storage facilities, hospitals, and nursing
homes. Income is received from the rental income being paid by the tenant that leases the real
estate which is owned by the REIT. These investments are actually suitable for both retail and
institutional investors.

The three types of REITs are listed below:

1. Mortgage REITs Mortgage REITs provide funding to real estate purchasers by acting in the
same capacity as a bank. Mortgage REITs borrow funds from investors and then invest the funds
in mortgages and typically earn income based on the difference between these two rates of
interest (which is referred to as the spread).
2. Equity REITs Equity REITs own and operate income-producing real estate, such as apartment
buildings, commercial property, shopping malls, vacation resorts, and other retail properties.
3. Hybrid REITs These business structures are a combination of mortgage REITs and equity
REITs. By purchasing a hybrid REIT, the investor can take advantage of buying a security that
invests in the actual equity ownership of real estate as well as investing in an interest-rate
sensitive security (i.e., the mortgage REIT).

Liquidity There are three varieties of REITs. The first are those that are sold under Regulation D as
private placements and not registered with the SEC. The other two are registered and are either
listed or non-traded (unlisted). Most REITs are exchange-listed, traded each business day, and are
reported on customer account statements at their current market value per share. On the other
hand, private REITs and non-traded REITs are illiquid and are as difficult to price as hedge fund or
limited partnership investments. These non-traded REITs are reported on customer account
statements at their estimated market value per share.

Tax Treatment of REITs The benefit of qualifying as a real estate investment trust is the favorable tax
treatment that’s provided under the Internal Revenue Code. Unlike other corporations, there’s no
double taxation on the dividends that a REIT pays to its shareholders. If 90% of the ordinary income
generated from the portfolio is distributed to investors, the income will only be taxed once (at the
investors’ levels). The REIT avoids paying taxes on distributed income in substantially the same manner
as a regulated investment company. However, unlike DPPs, REITs don’t pass-through operating losses.

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To qualify for the special tax treatment, a REIT must satisfy the following three income tests:
1. At least 95% of its gross income must be derived from dividends, interest, and rents from real
property.
2. At least 75% of its gross income must be derived from real property income (e.g., rents or interest).
3. No more than 30% of its gross income may be derived from the sale or disposition of stock or
securities that have been held for less than 12 months.

Tax Treatment for the Investor Real estate investment trusts offer investors a stable dividend based
on the income they receive and most investors purchase these securities for this reason. The
dividends that REITs pay to their shareholders don’t qualify for the reduced 20% tax rate that’s
given to the dividend distributions paid on common and preferred stock. Instead, the dividends
received by REIT investors are taxed as ordinary income. However, based on the 2018 tax reforms,
the following additional benefits are provided:
 20% of the income that’s distributed by REITs is deductible (excluded from tax).
 The maximum tax rate on ordinary income has been lowered to 37% (from 39.6%).

Direct Participation Programs (DPPs)

A direct participation program is a type of investment in which the results of the business venture
(cash flow, profits, and losses) directly flow through to the investors. Although DPPs come in
different forms, such as general partnerships, joint ventures, and Subchapter S Corporations, this
program will focus on limited partnerships.

To establish a limited partnership, the partnership files a Certificate of Limited Partnership with the
state. A limited partnership requires a minimum of two partners—one general partner and at least
one limited partner. The general partner (GP) is responsible for managing the program and must
contribute at least 1% of the program’s capital. The limited partner (LP) is a passive investor who
has no control over managerial decisions. Instead, limited partners are typically the investors who
contribute a large amount of the program’s capital.

Advantages of Limited Partnerships

Some of the benefits of this ownership structure include the following.

Favorable Tax Treatment Unlike corporations, partnerships are not taxable entities. Instead, the
partnership’s income (or loss) is allocated directly to the partners for tax treatment on their personal
income tax returns (i.e., it has pass-through treatment and is reported as passive). Any passive income
that’s distributed is taxed as ordinary income. Since the business doesn’t pay tax, limited partners may
receive more income from a profitable DPP than from a profitable corporation since a corporation’s
dividends are paid as after-tax distributions.

As is the case with REITs, beginning in 2018, DPP investors receive the following tax benefits:
 20% of the income that’s passed through by partnerships is deductible (excluded from tax).
 The maximum tax rate on ordinary income has been lowered to 37% (from 39.6%).

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Limited Liability In return for a share in a project’s income and deductions, limited partners
assume financial risk only to the extent of their investment. In other words, limited partners cannot
lose more than the amount that they have at risk.

Diversification Many limited partnerships invest in assets that have little or no correlation to the stock
and bond markets. These programs may provide an investor with a level of diversification that may not
be available from traditional mutual fund offerings.

Disadvantages of Limited Partnerships

Some of the drawbacks to this form of investment include the following.

Lack of Control Limited partners may have no managerial authority regarding the daily business
of the partnership. Unlike a traditional corporation, there may be very little (if any) oversight of the
management by an independent board of directors.

Illiquidity Since a limited partner’s investment is normally unable to be sold quickly, it’s an
illiquid investment. In most cases, there’s no actively traded public market for these investments
and limited partners are often required to obtain the permission of the general partner to sell their
interest in the partnership.

Tax Issues Owning a limited partnership will likely complicate a client’s year-end tax filing. Since
many partnerships are constructed in such a way to take advantage of certain benefits that exist in
the U.S. tax code, any change in tax laws or adverse IRS rulings could negatively impact a limited
partner’s future returns.

Possible Capital Call Unlike the previously described investments, investors in limited
partnerships may be asked to contribute additional funds after their initial investment. Failure to
make the additional contribution could result in the investors forfeiting their interest in a project.

General Partners
General partners have unlimited liability and are responsible for all management affairs of the
partnership. GPs also assemble investors’ capital, collect fees for overseeing the partnership’s
operations, keep the partnership books, and direct the investment of the partnership’s funds.
General partners have a fiduciary relationship to the limited partners in these programs.

Limited Partners
In the simplest terms, limited partners are passive investors that make no day-to-day management
decisions. In fact, if limited partners take on an active role in the management of the programs, they
may be considered general partners and will have unlimited liability.

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 CHAPTER 9 – ALTERNATIVE INVESTMENTS

The following table provides a summary of each partner’s rights and obligations:

Limited Partnership Summary

General Partner Limited Partner
Day-to-day manager with unlimited personal liability Passive investor with limited liability
Must have at least a 1% interest Contributor of capital
Fiduciary toward limited partner Has the right to:
 Lend to the partnership
 Inspect books
 Compete
Last in priority at liquidation: Ways to endanger “limited” status:
 Secured Creditor  Negotiate contracts
 General Creditor  Hire/fire employees
 Limited Partner  Lend her name
 General Partner

DPP Offering Practices

To raise money, the general partner (also referred to as the program’s sponsor) may conduct either
a public or private securities offering. In a public offering, the general partner will hire an underwriter
(also referred to as a syndicator) to market the program to the public and will register the DPP’s interests
with the SEC. Disclosure is made to investors through an offering prospectus. Although these
securities may be registered with the SEC, DPP interests are generally illiquid since they’re not
traded on an exchange (i.e., they’re unlisted).

If sales are executed by an underwriter (syndicator), the purchasers must be accepted by the general
partner to be valid. At times, GPs may themselves act as syndicators or they may hire an independent
investment banker to assist in the distribution. In either case, the maximum underwriting
compensation for a public offering is 10% of the gross dollar amount of the securities being sold.

In a private placement, the sponsor will attempt to locate investors without the assistance of an
underwriter. These types of offerings are conducted under Regulation D of the Securities Act of 1933
and are exempt from registration. In a Reg. D offering, disclosure is provided to investors through
an offering memorandum.

Tax Treatment of Individual Partners

Passive Activities Passive activities are investments in which an owner of a business does not
materially participate in its operations throughout the year. Investments in direct participation
programs and rental activities are considered passive activities.

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CHAPTER 9 – ALTERNATIVE INVESTMENTS

Losses that are generated by passive activities may only be deducted against income from passive
activities. If passive losses exceed passive income, the excess passive losses may be carried forward
indefinitely to offset passive income in future years.

As an added benefit, when the ownership interest in a passive activity is sold, the investor can deduct
all passive losses that are carried forward against any form of income—passive or non-passive.

Types of Limited Partnerships

Historically, limited partnerships have been established to allow for investment in a wide variety of
assets, including timber, minerals, farming, ranching, real estate, and energy. The SIE Examination
will primarily focus on two types of programs—real estate as well as oil and gas. Let’s examine the
details of each type.

Types of Real Estate Limited Partnerships The primary advantage for investing in real estate is
the fact that land is a commodity for which supply is fixed, but demand is constantly increasing.
Real estate programs focus on raw land, new construction, existing properties, and government-
assisted housing.

Raw Land For the purpose of land speculation, limited partnerships may purchase large tracts of
raw (undeveloped) land. Investments in raw land offer no depreciation deductions and little or no
periodic income. The motivation behind speculation in raw land is the potential capital
appreciation to be achieved after selling property that has significantly increased in value.

New Construction Generally, the objective of investments in new construction is capital

appreciation; however, there may be some cash flow if the properties are leased to tenants after
construction. A real estate construction program involves a large financial commitment which is
usually accomplished through leverage (borrowing).

Existing Properties Certain programs are formed primarily to purchase existing commercial
properties and apartments. Returns in these programs are predictable and offer a high degree of
certainty. For investors in existing property partnerships, two benefits are the immediate cash flow
from rentals and the availability of depreciation allowances.

Government-Assisted Housing Government-assisted housing projects are created to provide low-

cost housing for low-income families. Most federally subsidized housing programs are part of the
Section 8 Program which is administered by the Department of Housing and Urban Development
(HUD)—a government agency. The costs associated with construction, rehabilitation, or acquisition
of low-income housing qualify for tax credits, which is the major benefit of these programs.

Types of Oil and Gas Limited Partnerships Oil and gas programs are formed for the exploration,
drilling, or development of oil and natural gas. Management typically provides the technology and
organization; however, it may not specifically identify the areas to be drilled until after the program
is created.

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 CHAPTER 9 – ALTERNATIVE INVESTMENTS

Exploratory Program Exploratory drilling, also referred to as wildcatting, involves searching for oil
and gas in unproven areas. Due to the uncertainty of success, these programs are considered high-
risk ventures.

Developmental Program In a developmental program, leases are acquired for the right to drill in
proven areas. Although this type of program has high deductibility, its lower risk equates to a lower
potential return than what’s offered by a wildcatting program. The lower risk is based on the belief
that a productive exploratory well could be surrounded by equally productive drilling locations.

Balanced Program A balanced drilling program involves a combination of both exploratory and
developmental drilling. The exploratory drilling provides the potential for high yields, while the
development drilling offsets the high risks associated with the exploratory drilling.

Income Program An income program acquires interests in already producing wells. These well
sites are acquired from oil and gas operators that have completed the drilling and have chosen to
sell the reserves, rather than holding and operating the sites. Since income programs are the most
conservative oil and gas offerings, they may be suitable for clients who are somewhat risk-averse
and are seeking to diversify a stock or bond portfolio with an income objective.

Risk Summary
Before investing in a limited partnership, investors should be aware of the various risk components that
are inherent in the program and should evaluate the relative degree of risk that each component
contributes to the overall risk of the investment. Some of the risk considerations include:
 Management ability of the general partners
 Illiquid nature of limited partnership units
 Possible loss of capital and unpredictability of income
 Ability of the investor to pay any potential future assessments
 Rising operating costs
 Availability of good properties or leases
 Changes in the tax laws and government regulations
 Economic and environmental occurrences (e.g., an energy crisis)

Investor Certification Prior to executing sales, registered representatives are required to certify
that they have informed their customers of all relevant facts relating to both the lack of
marketability and liquidity of limited partnerships. In addition, RRs must have reasonable grounds
to believe that their customers have sufficient net worth and income to withstand the potential loss
of their entire investment.

Discretionary Accounts Due to the complexity of these products and the requirement to certify
the eligibility of investors prior to purchase, RRs are not permitted to exercise discretion when
recommending a DPP. In other words, a customer’s written approval is required to be obtained
prior to purchase.

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CHAPTER 9 – ALTERNATIVE INVESTMENTS

Comparison of Alternative Investments

Secondary Market Subject to
Product Marginable
Trading Act of 1940
ETFs Yes Yes Yes
ETNs Yes No Yes
Hedge Funds No No No
PE Funds No No No
REITs Generally No Generally
DPPs Limited No No

Conclusion
This concludes the chapter on alternative investments. The next chapter will examine options
contracts, which are a form of derivative investment that can be used to speculate on the direction
in which an underlying instrument will move, as a hedge against adverse movement in an
underlying instrument, or to generate income in a portfolio.

Create a Chapter 9 Custom Exam

Now that you’ve completed Chapter 9, log in to my.stcusa.com and create a 10-question custom
exam.

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 CHAPTER 10

Options

Key Topics:

 Buyers versus Sellers

 Calls and Puts

 Options Terminology

 The OCC

 Speculation and Hedging

 CHAPTER 10 – OPTIONS

The goal of this chapter is to increase a person’s knowledge of the following option-related concepts
—hedging or speculation, expiration date, strike price, premium, underlying security or cash settlement,
in-the-money versus out-of-the money, covered versus uncovered positions, American versus European
exercise, exercise and assignment procedures, varying strategies (e.g., long, short), special disclosures (e.g.,
Options Disclosure Document (ODD), and the Options Clearing Corporation (OCC) for listed options.

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 writer or seller 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

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CHAPTER 10 – OPTIONS

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)

 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 )

Components of an Option
An equity option is a contract to buy or sell a specific number of shares of a particular stock at a
fixed price over a certain period. An option contract is described by the name of the underlying
security, the expiration month of the contract, the exercise (strike) price, and the type of option. For
example, let’s assume that an investor purchased one call option on XYZ stock, with a May
expiration, an exercise price of $30, and a premium of 3. The contract will appear as follows:

Number of Underlying Expiration Exercise Option

Investor is: Premium
Contracts Security Month Price Type
Long 1 XYZ May 30 Call 3

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 CHAPTER 10 – OPTIONS

The individual components of the option contract shown above represent the following:

Underlying Security — XYZ Each equity option typically represents the right to buy or sell 100
shares (one round lot) of the underlying stock.

Expiration Month — May All listed options (those that trade on an exchange) have fixed
expiration dates. If an option has not been exercised or liquidated prior to its expiration, it expires
(ceases to exist). In this example, the buyer of the call has the right to purchase 100 shares of XYZ
stock from the writer until the option expires in May.

Exercise (Strike) Price — 30 The exercise price, also referred to as the strike price, is the price at
which the call owner may buy stock from the writer. For put options, it’s the price at which the put
owner may sell stock to the writer.

Type of Option — Call Remember, a call option gives the owner of the contract the right to buy the
stock, while the seller accepts the obligation to sell the stock if exercised against. In our example, the
call buyer has the guaranteed ability to purchase 100 shares of XYZ at a price of $30, regardless of how
high the price of XYZ increases between the time the option is purchased and its expiration in May.

Premium — 3 The current market price of this option contract is 3 points, or $3 per share. Since
the contract is for 100 shares, the purchase price is $300 ($3 x 100 shares). This is the amount that a
buyer pays to the seller for the rights conveyed by the contract.

The market price (premium) is not a fixed component of an option contract. Instead, it’s constantly
changing and is determined in the secondary market between buyers and sellers. The premiums of
call and put options are determined by changes in the prices of the underlying securities. In other
words, as the market values of the underlying assets rise and fall, so too do the option premiums.

The premium is influenced by a number of factors including the:

 Relationship between the current market price of the underlying stock and the strike price of the
option contract
 Time remaining until the expiration of the option
 Volatility of the underlying stock

Intrinsic Value and Time Value

The premium of an option is potentially made up of two components—intrinsic value and time
value. Intrinsic value is the amount by which an option is in-the-money, while time value is the
portion of an option’s premium that exceeds its intrinsic value.

For calculation purposes, remember than an option will only have INtrinsic value if it’s IN-the-
money.

Option Premium = Intrinsic Value + Time Value

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CHAPTER 10 – OPTIONS

In-, At-, and Out-of-the-Money The relationship between the strike price of an option and the
current market price of the underlying security determines whether an option is in-, at-, or out-of-
the-money.

For call options, the relationships may be summarized as follows:

 Calls are IN-THE-MONEY if the stock’s market price is
above the strike price of the option.
 Calls are AT-THE-MONEY if the stock’s market price is
the same as the strike price of the option.
 Calls are OUT-OF-THE-MONEY if the stock’s market price is
below the strike price of the option.

For put options, the relationships are the opposite:

 Puts are IN-THE-MONEY if the stock’s market price is
below the strike price of the option.
 Puts are AT-THE-MONEY if the stock’s market price is
the same as the strike price of the option.
 Puts are OUT-OF-THE-MONEY if the stock’s market price is
above the strike price of the option.

The following illustrations summarize when options are in-, at-, and out-of-the-money:

32 2 pts. in-the-money

31 1 pt. in-the-money

For an XYZ May 30 call If XYZ = 30 At-the-money

29 1 pt. out-of-the-money

28 2 pts. out-of-the-money

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 CHAPTER 10 – OPTIONS

32 2 pts. out-of-the-money

31 1 pt. out-of-the-money

For an XYZ May 30 put If XYZ = 30 At-the-money

29 1 pt. in-the-money

28 2 pts. in-the-money

Keep in mind, the intrinsic value of an option will either be a positive amount or zero; there will be
no negative intrinsic value. If an option is in-the-money, it has positive intrinsic value; however, if
an option is at-the-money or out-of-the-money, it has zero intrinsic value.

An important note is that intrinsic value is a concept that applies to an option contract; it’s NOT
based on whether the investor is a buyer or seller of the contract. Option buyers prefer that their
options gain intrinsic value since they own the assets and want them to increase in value. On the
other hand, writers dislike intrinsic value since this in-the-money amount represents a potential
obligation if the contract is exercised (assigned to the writer).

Determining Time Value Since only in-the-money options have intrinsic value, any premium
associated with at- or out-of-the-money options will consist only of time value. However, for in-the-
money options, the time value may be determined by simply subtracting the intrinsic value from
the premium. Using the earlier example, let’s assume the XYZ May 30 call has a premium of 3 at a
time when XYZ stock is trading at $32 per share. The premium of 3 consists of the 2 points of
intrinsic value (from 30 to 32), with the remainder being 1 point of time value.

If the XYZ May 30 call has a premium of 3, but the stock is trading at $30 per share, how is the
premium determined? With the stock at $30, a 30 call option is at-the-money. This would mean that
the option has zero intrinsic value, and therefore, the entire 3-point premium is time value.

Generally, the longer the time until an option expires, the greater its time value. If it’s currently
January, an XYZ August 30 call will trade at a higher premium than an XYZ May 30 call since the
August option has more life remaining than the May option. However, an option’s time value will
diminish with the passage of time and, at expiration, it will have no remaining time value.

Breakeven
The premium of an option is a vital component in calculating an investor’s breakeven point. The
breakeven point represents the price at which a stock must be trading so that an investor will
neither make nor lose money.

To find the breakeven point, remember the phrase “Call UP and Put DOWN.” For calls, it’s the strike
price plus (or UP) by the premium, but for puts, it’s the strike price minus (or down) by the premium.

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CHAPTER 10 – OPTIONS

 For buyers of options, breakeven represents the amount they need the underlying stock to move
in their favor to recapture the premium paid.
– Breakeven for the buyer of a call: Strike price + premium
– Investor buys an XYZ May 50 call at 5. The breakeven point is if the stock rises to $55.
– Breakeven for the buyer of a put: Strike price – premium
– Investor buys an XYZ May 45 put at 4. The breakeven point is if the stock falls to $41.
 For sellers of options, breakeven represents the amount they can afford the underlying stock to
move against them because they received the premium.
– Breakeven for the seller of a call: Strike price + premium
– Investor sells an XYZ May 50 call at 5. The breakeven point is if the stock rises to $55.
– Breakeven for the seller of a put: Strike price – premium
– Investor sells an XYZ May 45 put at 4. The breakeven point is if the stock falls to $41.

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 sales price (the strike price) if the
underlying stock falls in value. Hedging will be covered in greater detail later in this chapter.

Option Events
Since an option is a security with a fixed life, the contract will eventually be subject to one of three
possibilities. The contract may be liquidated, it may be exercised, or it may expire.

Liquidate, Trade, or Close-out Liquidating (trading) an option position is essentially an

alternative to exercising the option. To liquidate an option, an investor (either the buyer or seller)
executes an opposite transaction on the same option contract. Since there is an active and liquid
secondary market for listed option contracts, an investor who is long an XYZ May 30 call may close
out the position by selling it. On the other hand, an investor who is short an XYZ May 30 call may
close out that position by buying it.
 The buyer of an option creates the position with an opening purchase and could subsequently
liquidate the position through a closing sale.
 The seller of an option creates the position with an opening sale and could subsequently
liquidate the position through a closing purchase.

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 CHAPTER 10 – OPTIONS

The difference between what an investor pays and what he receives is the profit or loss.
For example, an investor bought (made an opening purchase) an XYZ May 30 call at 3.
Later, XYZ stock has increased to $40 and the investor liquidates the position (makes a
closing sale) for its adjusted premium of 11 (10 points of intrinsic value and 1 point of
remaining time value). Since the investor originally paid $300, but later sold the call for
$1,100, his resulting gain is $800.

Exercise The second event that would close an option position is an exercise. The investor who is
long an option has the exclusive right to exercise that option. The two styles of exercise are:
 American Style Exercise: Options using American style may be exercised at any time up to the
day on which they expire. All listed equity options use American style exercise.
 European Style Exercise: Options using European style may only be exercised at a specified
point in time, usually on the day of expiration. European style exercise is prevalent with index and
currency options.

If an investor is long an XYZ May 30 call and the underlying stock is trading at $38 per share, the call
holder could exercise the option and buy the stock at the strike price of $30 per share. Thereafter,
the investor could sell the stock in the market for $38 per share, which results in a gain of $8 per
share (actual gain is less the premium paid).

Similarly, an investor who is long an XYZ May 30 put may choose to exercise that contract if the
stock is trading at $22. Assuming the investor did not currently own the stock, he could buy it in the
secondary market for $22 per share, and then immediately sell the stock at the strike price of 30. The
purchase at $22 and subsequent sale at $30 would result in a gain of $8 per share (actual gain is less
the premium paid).

If a buyer exercises an option, the seller is required to fulfill his obligation. For this reason, the seller is
considered to have been assigned an exercise notice. If the seller of a May 30 call is exercised against, he
must deliver 100 shares of XYZ at a price of $30 per share, regardless of the market value of the stock at
that time. The seller of a put has an opposite obligation. If the seller of an XYZ May 30 put is exercised
against, he must buy 100 shares of XYZ stock for $30 per share, even if the stock is worth much less.

Buyer’s Exercise / Writer’s Assignment Step 1 - The process begins when an investor decides to
exercise her contract and notifies her broker-dealer. Step 2 - The broker-dealer will then notify the
Options Clearing Corporation (OCC). Step 3 - Once the OCC (discussed later) receives exercise
instructions from the purchaser’s broker-dealer, it will randomly issue the exercise notice to a
broker-dealer whose account shows a short option position that’s identical to the long option
position being exercised. Step 4 - The broker-dealer that receives the exercise notice, must select a
client to whom the notice will be assigned. There are three methods by which this assignment may
be accomplished — (1) using random selection, (2) using first-in, first-out (FIFO), or (3) using any
other method that’s deemed to be fair and equitable. Every member firm must notify its clients as to
which method is used and how it will be implemented.

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CHAPTER 10 – OPTIONS

For equity options, since exercise involves the purchase and sale of the underlying stock, settlement
of an exercised option occurs in two business days (T + 2).

A picture of the steps involved in the exercise of an option is shown below:

Options Clearing
Corporation (OCC)  Broker-Dealer A
Issues the exercise notice to a broker-
dealer using Random Selection Broker-Dealer B

  Broker-Dealer C
Customer’s
Broker-Dealer 
Assigns the notice to a customer using:
1. Random Selection,
 2. FIFO, or
3. Another fair and equitable method

Long 1 ABC Feb 60 Call Short 1 ABC Feb 60 Call

Expiration The last event that could close an option position is the expiration of the contract. If an
option is at- or out-of-the-money on the expiration date, the holder of the contract has no incentive
to exercise the contract. Also, since there would be no time remaining on the contract, the contract
expires worthless. This expiration triggers the maximum profit for the seller of a call or put (i.e., the
premium initially received). Conversely, the expiration of an option triggers the maximum loss that
the buyer of the call or put could experience (i.e., the premium paid).

Deadlines for Expiration In the life of an option, the third Friday of the expiration month is an
important day. Although most options expire at 11:59 p.m. ET on the third Friday of the expiration
month, a buyer must notify her brokerage firm of her intent to exercise the option by 5:30 p.m. ET
on that Friday. Additionally, at 4:00 p.m. ET on that third Friday, options stop trading.

Options Clearing Corporation (OCC)

In an effort to eliminate the possibility of option sellers being unable to fulfill their obligation and to
protect options investors from counterparty risk, the OCC guarantees all listed options. Essentially,
the OCC acts as a seller for every buyer and a buyer for every seller.

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 CHAPTER 10 – OPTIONS

Options Disclosure Document

Either at or before the time that an option account is opened for a customer, a member firm is
required to provide the customer with the options disclosure document (ODD)—also referred to as the
Characteristics and Risks of Standardized Options. This brochure offers investors with a description of
the options market and discusses the relevant terminology, tax implications, transaction costs, margin
requirements, and trading risks. The disclosure document is created by the OCC.

Index Options
As mentioned in the introduction of this chapter, options are also available on indexes (e.g., the S&P
500). Although there are many similarities in the analysis of equity options and index options, one
significant difference involves exercise settlement.

Cash Settlement With equity options, the exercise settlement involves the receipt or delivery of
the underlying stock; however, with index options, the exercise settlement involves the receipt or
delivery of cash. The seller of an index option must deliver to the buyer cash which represents the
amount by which the option is in-the-money (i.e., the difference between the contract’s strike price
and the index value).

Hedging with Options

Many people view options as risky, speculative investments; however, options can actually provide
a significant hedge (protection) for an investor with an existing stock position. For example, when a
person wants to insure or protect his life, home, or car, he purchases an insurance policy. Similarly,
if a person has either a long or short stock position and wants to hedge or protect against potential
risk, he may purchase an option.

The following chart summarizes the two basic hedging strategies:

Hedging Strategy Reasons

 Provides the right to sell
If Long Stock Buy a Put
 Protects downside risk
 Provides the right to buy
If Short Stock Buy a Call
 Protects upside risk

Long and Short Hedge If an investor is long stock and fears that the stock will decline, buying a
put on the stock creates a long hedge. This is an effective protection strategy since the put will gain
value as the stock declines; therefore, any loss on the stock is offset by the gain on the put. To
breakeven on the position, the stock must rise by an amount equal to the stock’s purchase price
plus the premium paid.

If an investor is short stock and fears that the stock will rise, buying a call on the stock creates a short
hedge. This is an effective protection strategy since the call will gain value as the stock rises;
therefore, any loss on the stock is offset by the gain on the call. To breakeven on the position, the
stock must decline by an amount equal to the short sale proceeds minus the premium paid.
Remember, to hedge or protect a position, an investor must buy the option.

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CHAPTER 10 – OPTIONS

Covered and Uncovered Option Positions

The concept of covered or uncovered relates to the seller of an option position. It’s the
responsibility of a firm’s margin department to verify that a client who writes an option is in a
position to deliver securities (if short a call) or cash (if short a put) if exercised against.

Covered Call The seller of a call is obligated to sell (deliver) the underlying stock if the buyer of the
call exercises the contract. Therefore, for the call to be covered, the seller must own the underlying
stock. If an investor is long XYZ stock and has written (is short) an XYZ call option, he has created a
covered call and is interested in generating income on his portfolio. A covered call writer anticipates
that the market price of the underlying security will not rise above the strike price prior to expiration
and hopes that the option will expire worthless. If the contract expires, the investor will generate
income from the premium received plus any potential cash dividend that’s paid on the stock. To
breakeven on the position, the investor can afford the stock declining by an amount equal to the
premium received (stock purchase price minus premium received).

Uncovered Call If an investor sells an XYZ call and does not own XYZ stock, it’s an uncovered call. An
uncovered call writer has an unlimited maximum potential loss since there is no limit as to how high
the price of the security may rise. The investor is effectively short the stock since she does not own the
deliverable if the contract is assigned. This risky position may only be created in a margin account.

Covered Put The seller of a put is obligated to buy the underlying stock if the buyer of the put
exercised the contract. Therefore, for the put to be covered, the seller must either be short the
underlying stock or deposit cash equal to the strike price. If an investor sells an XYZ put and does not
deposit sufficient cash, the position is considered an uncovered put.

Summary of Profit and Loss Potential for Various Positions

Long Call Unlimited profit; limited loss
Long Put Limited profit; limited loss
Short Call (Uncovered) Limited profit; unlimited loss
Short Put (Uncovered) Limited profit; limited loss
Covered Call Limited profit; limited loss

Conclusion
This concludes the chapter on options. Remember, the four basic option strategies are directional
bets in which an investor is either bullish or bearish on an underlying stock. The buyers risk their
money (premium) in return for significant potential profits. On the other hand, the writers receive
their money (premium) up front and will retain these funds if the option expires worthless. Lastly,
remember that hedgers buy options as insurance for their core stock position.

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 CHAPTER 11

Offerings

Key Topics:

 Primary Market and Underwriting Commitments

 The Securities Act of 1933

 Exempt Securities and Transactions

 Municipal Offering
 CHAPTER 11 – OFFERINGS

As described earlier, one of Wall Street’s functions is to assist issuers in raising capital. For most firms,
the investment banking (underwriting) division handles these money raising efforts. Let’s first examine
some of the language that’s associated with these financing transactions and then move onto the
federal regulations and SRO rules the relate to new issues.

Capital Formation
When a corporation or other type of issuer intends to raise capital, it usually does so by selling
stocks and/or bonds through a formal offering. The nature of these offerings will differ depending
on the type of issuer and investors involved in the transactions. Certain issuers (e.g., corporations)
are often subject to various federal regulations when they issue securities, while others (e.g., the
U.S. Treasury) are exempt from this level of SEC oversight.

Offering Securities to Investors

Public Offerings Securities may be offered or issued in two ways—public offerings and private
placements. The primary advantage of a public offering is that an unlimited number of investors
(both retail and institutional) are permitted to participate. However, the disadvantages of a public
offering include the regulatory costs (legal and accounting) and time required to fulfill the
disclosure requirements of the Securities Act of 1933.

Private Placements In some cases, institutional investors (e.g., pension funds, insurance
companies, venture capitalists, and 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 advantages of a private placement is that it’s faster and less costly
than a public offering. However, there may be limits as to the type and number of investors that
may participate in these types of transactions.

Initial Public Offering (IPO) Versus 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. Keep in mind; these additional (post-IPO) offerings are still
considered primary distributions. The best way to define a primary distribution is that it’s an
offering in which the proceeds of the deal are paid to the issuer.

Disclosure of Participation or Interest in Primary or Secondary Distribution (FINRA Rule 2269)

While involved in a follow-on offering, a FINRA member firm may be recommending or trading the
existing shares of a company in the secondary market, while also soliciting potential investors for
the additional shares being offered. FINRA rules generally require written disclosure to customers
for trades in any security in which a firm is participating in the distribution or is otherwise
financially interested.

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CHAPTER 11 – OFFERINGS

Combined (Split) Offerings In a combined offering, some of the shares are offered by the issuer, while
the remainder are offered by selling shareholders. The shares being sold by the company are newly
created, constitute a primary offering, and increase the company’s number of outstanding shares. The
company issuing the securities receives the proceeds on this portion of the sale. When the company’s
existing shares are sold by some of its current (selling) shareholders, it’s considered a secondary
offering. The selling shareholders receive the proceeds on this portion of the offering, not the issuer.

If the offering is split, it’s imperative for the underwriters to disclose to any purchaser that a portion of
the offering’s proceeds will be paid to the selling shareholders. Selling shareholders may include
officers of the company or early-entrance investors (e.g., the institutional investors that were
mentioned previously) that are seeking to either cash out or reduce their holdings in the company.

The Role of an Underwriter/Investment Banker

An underwriter is a broker-dealer that helps corporations or municipalities that are interested in
raising capital. 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 brings together the issuer and potential buyers. The proceeds of these offerings may
represent new funds to the issuer or they may be used to refinance its capital structure.

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 agreement.

Firm-Commitment (Acting as Principal) If a syndicate agrees to purchase the entire offering from
the issuer and absorb any securities that remain unsold, it’s engaging in a firm-commitment
underwriting. In this case, the syndicate is firmly committing itself to the issuing corporation for the
entire amount of the offering. Regardless of whether it can sell all of the securities, the syndicate
acts in a principal (at risk) capacity.
For example, a corporation wants to sell $10,000,000 of stock, but the syndicate is only
able to sell $8,000,000. In a firm commitment, the syndicate members will absorb the
$2,000,000 of unsold stock for their own accounts.

Best-Efforts (Acting as Agent) In a best-efforts underwriting, the syndicate agrees to sell as much
of the new offering as they’re able. Best-efforts underwriters are acting in the capacity of an agent by
finding purchasers for the issuer, rather than as a principal for their own accounts.
For example, a corporation wants to sell $10,000,000 of stock, but the underwriters are
only able to sell $8,000,000. In a best-efforts underwriting, only the $8,000,000 of stock
will be issued. The unsold portion is returned to the issuer.

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 CHAPTER 11 – OFFERINGS

Under certain circumstances, a corporation may require a specific minimum amount of capital to
be raised. The reason for this is that the issuer may determine that raising a lesser amount will be
insufficient to accomplish its objectives. Ultimately, if the minimum contingency is not met, the
offering will be cancelled.

All-or-None One of these contingencies is the best-efforts-all-or-none. As in a simple best-efforts

arrangement, the underwriters act as agents for the issuer and attempt to sell as much of the offering as
possible. However, if the entire offering is not sold, all sales that were made must be cancelled and
the money must be returned to the subscribers.

Mini-Maxi Another variation of a best efforts underwriting is the mini-maxi underwriting. With this
form, there is a minimum threshold of sales that must be met for the offering to avoid being cancelled.
However, once that minimum is met, additional sales may be made up to a specified maximum amount.
For example, a corporation intends to sell $10,000,000 of stock. Based on the company’s
capital needs, it requires that at least 70% of the offering be sold. Therefore, a minimum of
$7,000,000 of the stock must be sold or the entire issue will be cancelled. Once the minimum
sales level has been satisfied, the underwriters will continue to sell the remaining securities
($3,000,000) without the risk that the offering will be cancelled.

Standby Agreements If a corporation intends to sell additional shares, it may conduct a

preemptive rights offering (as described in Chapter 3). In this offering, the current shareholders are
given rights which provide them with the opportunity to purchase additional shares at a small
discount before the offering is made public.

However, out of the fear that a significant number of existing shareholders will choose to leave the
rights unsubscribed, the issuer may arrange for a standby underwriting. In a standby underwriting
arrangement, the syndicate (in return for a fee) agrees to purchase any unsubscribed shares
remaining after the rights offering. Standby agreements are executed on a firm-commitment basis.

Type of Underwriting Comments Liability for Unsold Shares

Firm-Commitment Syndicate must absorb losses on unsold shares Syndicate

Best-Efforts Unsold shares are returned to issuer Issuer

Best-Efforts All-or-None Offering is cancelled if all shares are not sold Issuer

Best-Efforts Mini-Maxi Offering is cancelled if set minimum is not sold Issuer

Syndicate agrees to buy any shares not purchased
Standby Syndicate
by existing stockholders in a rights offering

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CHAPTER 11 – OFFERINGS

Market-Out Clause
If the written agreement that’s entered into by the underwriting syndicate and the issuer contains a
market-out clause, the syndicate may be permitted to cancel the agreement. The justification for
cancelling the commitment is based on certain events occurring that make marketing the issue difficult
or impossible. Examples include a material adverse event that affects the (proposed) issuer or a general
disruption in financial markets.

Shelf Registration
Certain issuers of existing publicly traded securities can utilize a form of registration that allows them
to sell additional securities on either a delayed or continuous basis. This process is referred to as shelf
registration and is allowed only for an amount that may reasonably be sold within three years after the
initial date of registration. The advantage of the shelf registration method is that the issuer can
complete all the necessary paperwork in advance and be prepared to market the shares to the public
when conditions are the most favorable.

Distribution of Securities
A broker-dealer that’s contemplating the possibility of becoming the syndicate manager in a distribution
of securities must perform due diligence on both the issuer and the issue. 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 offer the securities.

Syndicate
If the syndicate manager is interested in working with an issuer, it will then form a syndicate by
inviting other firms 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 each firm’s rights and obligations.

Selling Group
In some cases, the syndicate will recruit other broker-dealers to assist in the distribution. These
firms are selling group members that do not assume financial liability for the offering; instead, they
act as sales agents. Any shares that are not sold by the selling group are retained by the syndicate
since the syndicate members remain financially liable for any unsold shares. To join a selling group,
a broker-dealer must sign a selling group agreement which provides details regarding the relationship
and responsibilities between the selling group and the syndicate manager. The underwriters and
selling group members are collectively referred to as distribution participants.

Determining the Public Offering Price (POP)

For a primary offering, the price is fixed and will apply to all sales that are made to the public. To
price an IPO, the underwriters will take various factors into account including corporate earnings,
dividend payouts, the prices of similar companies currently trading in the secondary markets,
indications of interest, and current market conditions. To price a subsequent offering, the
underwriters normally price it at a small discount to the current market price of the existing shares.

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 CHAPTER 11 – OFFERINGS

Underwriting Spread
The term underwriting spread refers to the difference between the amount paid by the investing
public and the amount received by the issuing corporation. In fact, the spread represents the
syndicate’s gross profit. Depending on how the shares are sold, the spread may be shared by the
manager, syndicate members, and selling group members.

The spread consists of the following components:

 Manager’s Fee—the portion that’s paid to the managing underwriter for each share of the
offering
 Member’s/Underwriter’s Fee—the portion that’s paid to the syndicate member that assumes
the risk or liability for the shares
 Concession—the portion that’s paid to the firm that sells the shares

Example: The Distribution of an Underwriting Spread

Member’s/Underwriter’s
Public Offering Price:
Fee: $.20
$10.00

Manager’s Fee: $.10 Concession: $.50

Proceeds to Issuer: $9.20

Syndicate Compensation In the example above, the corporation is issuing stock to the public at
$10 per share, with a total spread of $.80 per share. Of the $.80 spread per share, $.10 is allocated to
the manager, $.20 is allocated to the firm that assumes liability for the shares, and $.50 is allocated
to the firm that sells the shares.

Selling Group Compensation Remember, the selling group is comprised of broker-dealers that
don’t assume financial liability. Therefore, if a selling group member sells the shares, it’s only
entitled to the $.50 selling concession per share.

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CHAPTER 11 – OFFERINGS

The table below provides details regarding the potential compensation of each entity:

If the Manager If a Syndicate If a Selling Group

Sells Shares Member Sells Shares Firm Sells Shares

Manager’s Compensation $.80 $.10 $.10

Syndicate Member’s
.00 $.70 $.20
Compensation
Selling Group Member’s
.00 $.00 $.50
Compensation

Payments for Market Making Broker-dealers that act as underwriters may also choose to act as a
market maker for an issuer’s securities in the secondary market. In this scenario, FINRA is
concerned that issuers may compensate these firms to agree to act as market makers. Since issuers
are not regulated by FINRA, the rule prohibits a FINRA member firm or any person who is
employed by the member from accepting any payment or other compensation (either directly or
indirectly) from an issuer of a security or any affiliate or promoter for:
 Publishing a quote (including indications of interest)
 Acting as a market maker in a security
 Submitting an application in connection with market-making activity

The rule does not prohibit a member firm from accepting (1) payment for bona fide services, such as
investment banking (which includes underwriting fees), and (2) reimbursement for registration fees
that are paid to the SEC or a state regulator, or for listing fees that are imposed by an SRO.

Securities Act of 1933 – Registration

Many corporate offerings are subject to SEC registration requirements. The Securities Act of 1933
attempts to prevent fraud in the sale of new issues by requiring registration and ensuring that
investors are provided with adequate 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 Process

Let’s take a look at the process by which securities are registered. The process includes the
following three phases:
1. The preregistration period
2. The cooling-off (waiting) period
3. The post-effective period

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 CHAPTER 11 – OFFERINGS

Pre-Registration Period Cooling-Off Period Post-Registration Period

- Prepare registration statement - Extends for 20 days from - Final prospectus issued
- No discussions with customers amendment, unless accelerated - Sales confirmed
- Preliminary prospectus delivered - 25/40/90-day aftermarket
- Blue-Sky the issue prospectus requirement for dealers
- Hold due diligence meeting
- Accept indications of interest

The Pre-Registration (Pre-Filing) Period

During the pre-registration phase, an issuer prepares its registration statement. 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. When the registration statement is completed, the issuer files it with the
SEC. The date on which it’s filed marks the end of the pre-registration period.

Registration Statement According to 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
 Funds paid to affiliated persons or businesses of the issuer
 Shareholdings of senior officers, directors, and underwriters, and identification of individuals
who hold at least 10% of the company’s securities

Issuers are also required to prepare a prospectus for distribution to potential purchasers. The
prospectus is essentially an abbreviated version of the registration statement.

No Guarantees (Section 23 of the Securities Act of 1933) The SEC does not guarantee the
truthfulness of the information that’s contained within a registration statement. Additionally, the
SEC does not guarantee the accuracy or completeness of the filing. What this basically means is that
underwriters are prohibited from suggesting that an offering has been “approved of” or
“guaranteed by” the SEC. The cover page of a prospectus will include the following disclaimer:
Neither the Securities and Exchange Commission nor any other regulatory body has
approved or disapproved of these securities or passed upon the accuracy or adequacy of
this prospectus. Any representation to the contrary is a criminal offense.

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CHAPTER 11 – OFFERINGS

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 does not judge the investment merits of the
issue or the appropriateness of the pricing of the issue. If the SEC believes the registration
statement to be incomplete or misleading, it sends a deficiency letter to the issuer. If this happens,
the issuer is required to refile an amended registration statement for SEC review.

Preliminary Prospectus (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 been
declared 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 that provide an indication of interest (the indications are non-
binding for either party)

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)

No Prospectus Alterations For a new issue, the prospectus is the primary source of information for
most retail investors. This document may not be amended or altered in any way, including
highlighting, summarizing, or underlining relevant portions of the document.

State or Blue-Sky Laws As mentioned in an earlier chapter, in addition to satisfying SEC registration
requirements, issuers are required to comply with applicable state registration laws for the securities
that they issue. 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 three methods of state securities registration are:

1. Notification (also referred to as Filing) – This method is not allowed in all states. Notification is
used by larger issuers that are simply required to submit 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 that’s filed
under the Securities Act of 1933 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.

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 CHAPTER 11 – OFFERINGS

Due Diligence Just prior to the SEC’s anticipated determination of the effective date, a due
diligence meeting is held. The participants at this meeting include the lead underwriter(s), 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.

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 after 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.

The Post-Effective Period

Once the offering’s registration is declared effective, the public offering price (POP) is set by the
underwriters. Only at this point can sales of the offering begin. Purchasers must be provided with a
copy of the final prospectus (which includes the offering price) by no later than the time a sale is
confirmed. Under SEC rules, providing clients with electronic access to a prospectus equates to the
delivery of the relevant documentation.

Actions by Salespersons After the effective date, the deal will be priced and syndicate members
will be notified of their allocation of shares. The firm’s registered representatives should then
contact all 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.

Disclosure Requirements
Aftermarket Prospectus Delivery Requirement
Although the delivery of a prospectus is typically a primary market requirement, depending on the
type of company that’s issuing the security, a dealer may be required to satisfy an aftermarket
prospectus delivery requirement. The requirement differs based on:
1. Whether the offering is an IPO or a follow-on, and
2. Whether the company is/will be listed on an exchange (e.g., NYSE or Nasdaq) or is an unlisted
over-the-counter security that is/will be trading on the OTC Bulletin Board or Pink Marketplace

Essentially, if more information is known about the offering or if the company is satisfying an
exchange’s listing standards, it will be required to provide a prospectus for a shorter period.

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CHAPTER 11 – OFFERINGS

The following table summarizes a dealer’s prospectus delivery requirement in the after-market:

After-Market Prospectus Delivery Requirements

Security Time Frame
For an unlisted IPO 90 days
For an unlisted follow-on offering 40 days
For an IPO of a security to be listed on the NYSE or Nasdaq 25 days
For an NYSE or Nasdaq-listed follow-on offering No requirement

Types of Prospectuses
Definition According to the Securities Act of 1933, a prospectus is defined as any notice, circular,
advertisement, letter, or communication (whether written or broadcast on television or radio) that
offers a security for sale. Although this is a very broad definition, it includes an exemption if the
information only identifies the security, the price, the name of the underwriters, and from whom a
prospectus may be obtained. This type of advertisement is referred to as a tombstone and is used to
provide information to potential investors and to suggest that they request a prospectus.

Statutory Prospectus The statutory prospectus is a condensed form of the registration statement that
includes:
 Risk factors and use of proceeds
 Dividend policy
 Industry and other data
 Capitalization
 Selected consolidated financial data
 Management’s discussion and analysis of financial condition and results of operations
 Business and management
 Executive and director compensation
 Principal and selling stockholders
 Description of capital stock
 Shares eligible for future sale
 Underwriting conflicts of interest and legal matters

Preliminary Prospectus In a preliminary prospectus (red herring), the following information can be
omitted:
 The offering price of the issue
 The underwriting discounts (or commissions) and discounts to dealers
 The amount of proceeds to be received by the issuer
 Conversion rates or call prices
 Other matters that are dependent on the offering price

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 CHAPTER 11 – OFFERINGS

Once the offering is declared effective, the final version of the statutory prospects will include the
final offering price, size of the offering, discounts to dealers, etc.

Mutual Fund Summary Prospectus While a statutory prospectus is based on the information
that’s contained within the registration statement, a summary prospectus further summarizes the
information. The summary prospectus is often used as a stand-alone sales tool for mutual fund
offerings provided the investor is informed of the availability of a longer form (statutory)
prospectus. Both of these documents may usually be found on the fund sponsor’s website. This
summary is often only three to four pages long and must include:
 Investment objective
 Costs
 Principle investment strategies, risks, and performance
 Name of investment adviser, as well as the name, title, and length of service of up to five
portfolio managers
 Purchase (including minimum purchase amounts), redemption, and tax information
 Financial intermediary compensation information

Free Writing Prospectus A free writing prospectus (FWP) is any communication that does not
meet the standards of a statutory prospectus. Examples of free writing prospectuses include:
 Press releases
 E-mails or web pages
 Preliminary or final term sheets
 Video recordings (electronic road shows)
 Various marketing materials

These communications constitute an offer to sell or a solicitation to buy the securities that are
related to a registered offering. FWPs are generally filed with the SEC and used after the formal
registration statement has been filed.

Offering Memorandum For private placements, no registration or prospectus is required to be

filed with the SEC. However, the issuer will provide a specific detailed written disclosure document
to its purchasers. This document is referred to as an offering memorandum or private placement
memorandum (PPM).

Exempt Securities
Certain issuers are not required to register their securities with the SEC. For issuers that qualify for
an exemption from registration, there is significant time and cost savings.

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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 maximum maturity of 270 days
(e.g., commercial paper)
 Securities issued by domestic banks and trust companies
 Securities issued by small business investment companies

Although these securities are exempt from the registration and prospectus requirements of the
Securities Act of 1933, they remain subject to the Act’s anti-fraud provisions.

Exempt Offerings
In some cases, rather than being based on the issuer or type of security, the exemption from
registration is based on the manner in which the securities are being offered.

Regulation D
Under Regulation D, an issuer’s private placement of securities qualifies for an exemption provided
the following conditions are met:
 The issuer has 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 the private placement memorandum.
 The issuer must be assured that the buyer does not intend to make a quick sale of the securities.
This is usually accomplished by means of an investment letter (also referred to as a lock-up
agreement).
 The securities are sold to no more than 35 non-accredited investors.

Accredited Investor For private placements, there is no restriction on the number of accredited
investors. An accredited investor includes any of the following:
 Financial institutions (e.g., banks), 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 (not including primary residence) 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

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Restrictive Legend Shares that are acquired through a private placement carry a restrictive legend
that’s printed across the face of the certificate. The legend indicates 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.

Rule 144
Rule 144 regulates the sale of restricted stock and control (affiliated) stock. Restricted stock is
unregistered stock and is typically acquired by an investor through a private placement. Control
stock is registered stock and is acquired by a control (affiliated) person in the secondary market.
Control persons may include officers, directors, or other insiders (those with more than 10%
ownership) and their respective family members. Any stock that’s acquired by control persons, even
if purchased in the open market, must be sold according to Rule 144. Insiders may also have other
regulatory requirements which restrict their ability to sell stock.

Holding Period Rule 144 imposes certain holding periods on investors. For restricted stock, the
purchaser must hold the stock for a specific period before he may dispose of it. If the issuer is a
reporting company, the holding period is six months; however, if the issuer is a non-reporting
company, the holding period is one year. For control stock, there is no mandatory holding period.

Filing Requirement Under Rule 144, an investor who intends to sell either restricted or control
stock must file Form 144 to notify the SEC at the time he places the sell order with the broker-
dealer. If the securities are not sold within 90 days of the date that the notice was filed with the SEC,
an amended notice must be filed. However, SEC notification is not required if the amount of the
sale does not exceed 5,000 shares and the dollar amount does not exceed $50,000.

Volume Limitation Rule 144 sets a limitation on the amount of stock that an affiliate may sell over
any 90-day filing period. For NYSE- and Nasdaq-listed stock, the maximum that may be sold is the
greater of 1% of the total shares outstanding or the stock’s average weekly trading volume of the past
four weeks.

For restricted (private placement) stock, there is no volume restriction for non-affiliates of the issuer.
Non-affiliates are persons who are not associated with the issuer. However, volume restrictions
continue to apply to insiders and affiliates.
For example, an issuer has 7,000,000 shares outstanding and the average weekly trading
volume for the past four weeks was 60,000 shares. Since 1% of the total shares
outstanding is 70,000 shares and the four-week average is 60,000 shares, an affiliated
holder is able to sell the greater of these two amounts, which is 70,000 shares.

Restricted Stock
Issuer Holding Period Affiliated Seller Non-Affiliated Seller
Reporting Company Six Months Volume Restrictions Apply No Volume Restrictions
Non-Reporting Company One Year Volume Restrictions Apply No Volume Restrictions

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CHAPTER 11 – OFFERINGS

Private Investment in Public Equity (PIPE) Although most private placements occur prior to the
issuer’s IPO, a PIPE offering is a private placement that occurs afterward. A broker-dealer assists an
issuer by distributing restricted (i.e., unregistered) securities to a small group of accredited investors,
such as hedge funds. These restricted securities are typically purchased at a discount to the issuer’s
publically traded stock. Often PIPE investors hold the restricted securities for a short period and,
upon registration, will then quickly resell them in the public marketplace.

Rule 144A
Rule 144A is designed to permit sales of restricted securities to sophisticated investors without
being subject to the conditions that are imposed by Rule 144. Ultimately, Rule 144A creates a more
liquid private placement market. The securities being offered under Rule 144A may be equity or
debt securities and they may be offered by either a domestic or foreign issuer. After the issuance,
the securities may be immediately resold to qualified institutional buyers.

Qualified Institutional Buyers (QIBs) To be considered a qualified institutional buyer, the entity
must satisfy the following three-part test:
1. First, only certain types of investors are eligible, including:
 Insurance companies
 Registered investment companies and registered investment advisers
 Small business development companies
 Private and public pension plans
 Certain bank trust funds
 Corporations, partnerships, business trusts, and certain non-profit organizations
2. The buyer must be purchasing for its own account or for the account of another QIB.
3. The buyer must own and invest at least $100 million of securities of issuers that are not
affiliated with the buyer.

Note: Under no circumstances is an individual considered to be a QIB.

Rule 145
Under Rule 145 of the Securities Act of 1933, certain types of securities reclassifications are
considered to be sales and are subject to the registration and prospectus requirements of the Act.
The reclassifications include:
 An issuer that substitutes one security for another
 A merger or consolidation in which the securities of one corporation are exchanged for the
securities of another corporation
 A transfer of assets from one corporation to another

However, stock splits, reverse stock splits, or changes in par value are not considered
reclassifications and are therefore not subject to the rule.

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 CHAPTER 11 – OFFERINGS

Subject to Rule 145 Not Subject to Rule 145

 Substitutions  Stock splits
 Mergers/Consolidations  Reverse stock splits
 Transfers of assets  Changes in par value

Rule 147 and 147A

A federal registration exemption is available for securities that are sold within the borders of one
state, provided the instruments of interstate commerce are not used to sell the securities. If a
company is conducting an offering and only selling its securities to its state residents, the offering is
exempt from SEC or federal registration. However, the issuer is required to register the securities in
the state in which it’s being sold.

Under Rule 147, an issuer is required to meet one of the following four 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

Provisions include:
 The issuer must utilize a reasonable belief standard when determining the residency of the
purchaser at the time the securities are sold. 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.

The Primary Market for Municipal Bonds

Although municipal securities are exempt from the registration and prospectus requirements of the
Securities Act of 1933, their underwriting process follows many of the same guidelines that are used
for corporate underwritings.

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CHAPTER 11 – OFFERINGS

The Municipal Securities Rulemaking Board (MSRB), which is the self-regulatory organization
(SRO) for firms that deal in municipal securities, formulates the rules and regulations that relate to
municipal underwritings. Remember, even if a specific security is exempt from registration, the
antifraud provisions of the Securities Act of 1933 apply to all securities.

Issuing General Obligation (GO) Bonds

Since GO bond issues are backed by taxes, the following two requirements must be satisfied:

Voter Approval The issuance of general obligation bonds usually requires voter approval since its funds
that are generated by taxing citizens which are used to repay the debt. The indenture (bond resolution)
for a general obligation bond will usually include the statutes which permit the issuer to levy taxes.

Debt Ceiling Limitations A GO issue is generally subject to debt limitations that are placed on the
municipality by a voter referendum or by statutes. Prior to the issuance of the bonds, these legal
obligations must be upheld. A municipality is not permitted to issue bonds in excess of its debt
limitation since doing so will exceed its debt ceiling.

Issuing Revenue Bonds

Since revenue bonds are backed by the user fees that are generated by a project or facility and not
by taxes, they don’t require voter approval. However, there are special procedures to be followed
and requirements to be met prior to issuing revenue bonds. One of these procedures is conducting
a feasibility study.

Feasibility Study To identify whether a revenue project will be able to bring in the necessary
revenues the municipality must hire a consulting engineer to study the project and present a report.
This report examines the general need for the proposed project and whether the project is a sound
economic investment. An accounting firm is usually retained to help determine if the revenues will
be sufficient to cover expenses and debt service.

New Issue Underwritings

Once a municipal issuer has determined that there is a need for a bond issue and has followed the
preliminary steps required to offer a bond (e.g., obtaining voter approval for a GO issue or
completing a feasibility study for a revenue issue), it may continue the process of issuance. To do
so, a municipality will normally seek the assistance of an underwriter (investment banker).

Selecting an Underwriter In some cases, the issuer will simply appoint its underwriter using a
process that’s referred to as a negotiated sale. Another method involves requesting that interested
underwriters submit proposals through a bidding process and is referred to as a competitive sale.

Municipal Advisors The issuer may also employ the services of a municipal advisor to assist with
the offering. Municipal advisors are persons who advise municipal issuers on the structure, timing,
and/or terms of their municipal offerings in return for a fee. The firms that employee these
individuals are required to be registered with the MSRB.

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Forming a Syndicate
As is often the case for corporate offerings, broker-dealers will combine to form a syndicate with
one firm acting as the syndicate manager (lead underwriter). Since municipal issues are typically
sold on a firm-commitment basis, firms that are asked to join the syndicate must be financially
strong enough to absorb unsold bonds if there are problems distributing the issue.

Responsibilities of Syndicate Manager (Rule G-11) The manager generally makes the largest
underwriting commitment. Some of the responsibilities of the manager include keeping track of all
sales and the number of bonds that remain unsold, presiding over the preliminary pricing meeting
in which the members are asked to submit their pricing scale, and maintaining/preserving books
and records related to syndicate operations. These records include:
 Settlement date with issuer
 Allotment of securities and sale prices
 Names of syndicate members and their percentage of liability

Syndicate Letter For a competitive sale, as the manager forms the syndicate, it will invite other
firms to participate by sending a syndicate letter which binds all of the members together. For a
negotiated sale, the document is referred to as the agreement among underwriters.

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 through a competitive sale, it will advertise through a Notice of
Sale. The Notice of Sale typically contains essential information that an underwriter needs in order
to submit a bid, including the size of the offering, its maturity date, the coupon rate, and the details
related to the bidding process.

Legal Opinion
Every municipal issue must be issued with a legal opinion. The legal opinion is written by a
recognized bond counsel that’s hired by the issuer to attest to the validity and tax-exempt status of
the bond issue. Essentially, the legal opinion assures investors that the issuer has the legal right to
issue the bonds.

Official Statement
The primary client disclosure document that’s used in municipal offerings (both negotiated and
competitive) 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 Securities Act of 1933.

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CHAPTER 11 – OFFERINGS

The official statement contains detailed information about both the issuer and the offering and, if
produced, it must be distributed to investors. As is the case with a prospectus, there is both a
preliminary and final version of the official statement. Final official statements must be provided to
customers at the time that the trade is confirmed.

Contents of a Typical Official Statement

1. Offering terms
2. Summary statement
3. Purpose of the issue
4. Authorization of the bonds
5. Security of the bonds
6. Description of the bonds
7. Description of the issuer
8. Construction program
9. Project feasibility
10. Regulatory matters
11. Specific provisions of the Indenture and/or the Resolution
12. Legal proceedings
13. Tax status
14. Continuing disclosure certification
15. Appendix
a. Various consultant reports
b. Legal opinion
c. Financial statements and audit

Official Statement Summary

Preliminary and final official statements are not considered advertising since they’re either prepared
by or for the issuer. However, if an official statement is altered by a municipal securities firm to create
a summary or abstract of the official statement, it’s considered advertising. Due to the alteration, the
summary of an official statement must be approved by a Municipal Securities Principal.

Electronic Municipal Market Access (EMMA) – Rule G-32 This rule requires that disclosure
documents be filed with the MSRB and provided to customers. EMMA is the MSRB’s data port
through which municipal bond underwriters and issuers submit specific documents (e.g., official
statements).

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 CHAPTER 11 – OFFERINGS

EMMA provides free public access to official statements, trade data, credit ratings, educational
materials, and other information about the municipal securities market. EMMA presents the
information in a manner that’s specifically tailored for retail, non-professional investors who may
not be experts in financial or investing matters.

If an official statement has been submitted to EMMA, a broker-dealer may send a notice to any
customers who purchase a new issue of municipal securities which advises them as to how an official
statement may be obtained from EMMA. This process may be used instead of sending a physical copy
of the official statement to a customer. However, the notice must include a statement that a copy of
the official statement will be provided by the broker-dealer upon request. Therefore, if a customer
contacts the broker-dealer and requests a printed copy of an official statement, it must be sent.

Assignment of Underwriter and Obtaining CUSIP Numbers In addition to their EMMA

submission requirements, underwriters are also expected to apply for a CUSIP number. CUSIP is an
acronym for the Committee on Uniform Security Identification Procedures. This nine-digit, alpha-
numeric number is used to identify securities and is assigned to each maturity of a municipal
security offering. The application window for a CUSIP is as follows:
1. For a negotiated sale, the underwriter must apply by no later than the time that pricing
information for the issue is finalized.
2. For a competitive sale, the underwriter must apply immediately after receiving notification of
the award from the issuer.
3. A financial advisor must apply by no later than one business day after dissemination of a
notice of sale.

New Issue Confirmations

Each customer who purchases a new issuance of municipal bonds must be provided with a final
confirmation and a copy of the official statement by no later than the settlement date. For a negotiated
sale, the following information must be disclosed to the customer either separately or included in
the official statement:
 The amount of the underwriting spread
 The amount of any fee received by the broker-dealer for acting as agent for the issuer
 The initial reoffering price for each maturity in the offering

Conclusion
This ends the discussion of offerings. Once issued, most securities may be freely resold to other
investors at the prevailing market price. The following chapters will examine the secondary market
in which these securities trade between retail and institutional investors. Trading markets are
governed by the Securities Exchange Act of 1934(‘34 Act.) and various SRO rules.

Create a Chapter 11 Custom Exam

Now that you’ve completed Chapter 11, log in to my.stcusa.com and create a 10-question custom
exam.

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 CHAPTER 12

Orders and
Trading Strategies

Key Topics:

 Trade Capacity

 5% Policy

 Types of Transactions

 Types of Orders
 CHAPTER 12 – ORDERS AND TRADING STRATEGIES

The goal of this chapter is to increase a person’s knowledge of different types of orders, including market
orders, limit orders, and stop orders. The chapter will also address how broker-dealers can execute
securities trades; specifically, as either an agent or a principal. Trading strategies, such as going long or
going short will be covered, as well as details regarding whether those positions are bullish or bearish.
Finally, the chapter will examine the process of selling options on both a covered and uncovered basis.

Trade Capacity – How Broker-Dealers Act

When executing trades, broker-dealers can act in two capacities—as a broker and as a dealer.
However, to execute a customer transaction, a firm may act in only one of the two capacities.

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 buying or selling shares for its own account; instead, the
broker tries to find a buyer or seller for its customer. This activity is also referred to as brokering a trade.

Commissions When a firm acts in a broker (agent) capacity, it earns a commission for its efforts.
The commission is a separate dollar amount that must be noted on the client’s trade confirmation.
However, if a trade is not executed, no commission is earned.

Dealers (Principals) When a firm buys securities for, or sells securities from, its own account
(inventory), it’s acting as a dealer (principal). A dealer that always stands ready to buy or sell a
specific stock is also referred to as a market maker in that stock. 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 $19.90 – $20.25, it’s willing buy stock at $19.90 per share and sell it for $20.25
per share to other dealers. The $.35 difference between the bid of $19.90 and the ask of $20.25 is the
spread—a source of profit for the market maker.

Bids and offers are typically posted in round lots (i.e., 100-share multiples). Investors who want to
trade less than 100 shares are trading in odd lots. For example, if an investor buys 567 shares of XYZ
stock, she is purchasing five round lots of 100 shares plus an odd lot of 67 shares. This order may be
placed on one ticket.

Markups/Markdowns When acting in a dealer capacity, a firm will adjust its prices for retail
customers, in other words, the dealer will include either a markup or markdown. All markups and
markdowns are calculated from a security’s inside market. The inside market represents the highest
bid and the lowest ask (offer) of any market maker in a given security.

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CHAPTER 12 – ORDERS AND TRADING STRATEGIES

Let’s assume that a security’s inside market is of $20.00 – $20.20. In this case, if a client wants to sell
stock to a dealer, the firm 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, a dealer may offer to sell her the shares
at $20.26—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. These price adjustments are built into the
net price of the trade, but are generally required to be noted on the client’s trade confirmation.

To summarize:  When acting as a broker:  When acting as a dealer:

– The firm is an agent. – The firm is a principal.
– It does not assume risk. – It does assume risk.
– It earns a commission. – It earns a markup or markdown.

Fair Prices and Commissions – The 5% Markup Policy

FINRA members are prohibited from charging prices or commissions that are unfair or excessive. To
assist members in determining the appropriate level of charges, FINRA has developed the 5%
Markup Policy. Although stated in terms of a markup, the policy applies to markups, markdowns,
and commissions. The guideline applies when a broker-dealer is acting in an agency or principal
capacity for transactions involving both exchange-listed and non-exchange-listed securities.

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In some ways, the 5% Policy seems like a fairly simple principle. For example, at a time when a
stock’s market price is $20, a broker-dealer sells stock to a customer at $21 per share. The firm
charged a $1 per share markup which is exactly 5%. The percentage is calculated by dividing the
markup of $1 by the prevailing market price of $20.

However, part of the determination regarding an acceptable markup involves the consideration of all
relevant factors. Over the years, FINRA has taken many enforcement actions against firms that it
believes have charged excessive markups. By reviewing those decisions, it has developed some
guidelines for determining the fairness of transaction compensation.

Factors That Influence the Level of Markups Since FINRA emphasizes that 5% is merely a
guideline, it’s possible that certain circumstances will justify higher markups; while conversely,
there are other times when even 5% is too much.

The following factors are considered when determining whether a markup is excessive:
 The type of security involved – Some securities carry higher markups than others as a matter of
industry practice. For example, the markups on common stocks or limited partnership units
typically are higher than the markups on bonds.
 The availability of the security in the market – If more effort is required to locate a particular
security and execute a transaction, then a higher markup is justified.
 The price of the security – The percentage of markup generally increases as the price of the
security decreases. This is due to the fact that lower-priced securities may require more
handling and expense.
 The amount of money involved in a transaction – A transaction for a small total dollar amount
may require greater handling expenses on a proportionate basis than a larger transaction.
 Disclosure – Disclosing to the customer that the circumstances may warrant a higher-than-normal
markup helps to make the dealer’s case. However, the circumstances also must justify the charges.
 The pattern of markups – FINRA’s punishment tends to be most severe on firms that show a
persistent pattern of excessive markups. However, the markup in each transaction must be justified
on its own merits.
 The nature of the broker-dealer’s business – Firms that offer certain additional services to
customers (e.g., research) may justify charging higher markups than firms that don’t offer these
services. However, if a firm has high expenses for services that provide no benefit to customers,
then these expenses don’t justify higher charges.

Proceeds Transactions A proceeds transaction occurs when a customer directs a member firm to
sell a security and use the proceeds of the sale to buy another security. For these types of transactions,
the member firm must follow the 5% policy and compute the markup as if the customer had
purchased the securities for cash. Therefore, the compensation received on the customer’s sale is
added to the compensation that the firm received on the customer’s purchase. In other words, the
charge assessed on the liquidation is added to the charge for the subsequent purchase. For example, a
customer instructs her brokerage firm to sell $5,000 of ABC stock and use the proceeds to purchase
$5,000 of XYZ stock. When computing the markup percentage, the member firm must use its total
compensation (from both the customer’s sale and purchase) as a percentage of $5,000.

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CHAPTER 12 – ORDERS AND TRADING STRATEGIES

Exemptions Securities that require the delivery of a prospectus or offering circular are exempt from
the provisions of the 5% policy because these primary issuances are sold at a specific public offering
price. Examples of the securities that are exempt include initial public offerings, municipal bonds, and
mutual fund shares.

Discretionary Order/Discretion Not Exercised

If a client has granted discretionary authority to his registered representative, this should be indicated
for each discretionary order. When completing an order ticket, if a client consents to a specific trade
recommendation before execution, it’s important for the RR to check off discretion not exercised.

The importance lies in the fact that discretionary trades have more heightened supervisory
requirements. Keep in mind, indicating discretion not exercised is not the same as indicating that the
trade was unsolicited. If placing a trade was the client’s idea, the order ticket is marked unsolicited.
On the other hand, if the trade was recommended by the registered representative, the ticket should
be marked solicited.

Types of Transactions
When an order is placed, the first determination to verify for the order ticket is the client’s desired action or
intent. These may include:
 A purchase
 A long sale
 A short sale

When purchasing securities, the client must designate whether the trade is to be paid in full or being
paid for with borrowed funds (on margin). When selling securities, the process can be a bit more
complicated. With sales, the issue becomes whether the customer is selling securities that she owns
or selling securities that she does not currently own (i.e., securities that have been borrowed). If the
customer sells stock that she currently owns, it’s referred to as a long sale and she must either have
the securities in her account with the broker-dealer or be able to deliver them promptly. Conversely,
what if the customer does not currently own the stock being sold?

Short Positions A short sale is one in which the investor sells shares that she does not own;
therefore, the shares must be borrowed. As long as the shares are able to be borrowed, the short
seller’s broker-dealer will execute the short sale. Since the borrowed shares will ultimately need to
be returned to the lender, the short seller will need to buy back the stock at some point in the future.
A profit for the short seller is realized if she is able to buy the shares back at a price that’s less than
the price at which they were originally sold. The strategy for a short seller is bearish (i.e., she will
profit if the price of the stock falls). On the other hand, if the price rises, the investor’s loss could be
significant since the stock would need to be purchased at a price that’s higher than the price at
which the shares were originally sold.

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 CHAPTER 12 – ORDERS AND TRADING STRATEGIES

For example, an investor sells shares short 100 shares at $50. The investor receives proceeds of
$5,000 into her account, but will need to spend money to buy the shares back at some point in the
future. Later, if the stock is trading for $40, the investor can buy the stock back to cover the short
position and realize a profit of $1,000 ($5,000 sales proceeds – $4,000 total purchase). However, if
the share price had risen to $60 and the investor bought the shares back, she would realize a loss of
$1,000 ($5,000 sales proceeds – $6,000 total purchase).

Margin Requirement Short sales must be executed in a margin account. Brokerage firms provide short
sellers with stock that has been borrowed from other margin customers. However, the other margin
customers must provide permission for the firm to lend their securities to short sellers. The permission is
obtained through the signing of a loan consent agreement at the time that the account is opened.

As long as the short seller’s margin account maintains the minimum required equity, there is no set
time by which the short seller must repurchase the borrowed shares. While maintaining a short
position, if a cash dividend is paid on the borrowed stock, the short seller is responsible for paying
the dividend to the lender.

Covered and Uncovered Options Writers As described in Chapter10, if the seller of a call option
owns the underlying stock, she is considered to be the seller of a covered call. The position is covered
because the client is able to deliver the shares if the contract is exercised and she is assigned. On the
other hand, if the seller of a call does not own the shares, she is considered to be uncovered or naked.
These terms indicate that, if assigned, the writer is at risk of being required to buy shares at an
unknown market price in order to complete the delivery of the shares to the call buyer. Uncovered call
writing is riskier than covered writing and may only be executed in a margin account.

Types of Orders
Market Orders
The most basic type of order is a market order. When placing this order, the client does not specify a
price. Instead, the order will be executed at the best available price when the order is entered (i.e., the
highest bid for market orders to sell and the lowest offer for market orders to buy). Although market
orders will be immediately executed, the client is not assured of a specific execution price. Market
orders are often used for stocks that have active (liquid) markets in which the spread (difference
between the bid and ask price) is narrow.

Limit Orders
When customers want to buy or sell securities at a specific price, they enter limit orders. A limit order may
be executed only at the specified price or better. A buy limit order may only be executed at the limit
price or lower, while a sell limit order may only be executed at the limit price or higher.

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CHAPTER 12 – ORDERS AND TRADING STRATEGIES

For example, let’s assume XYZ stock is currently BUY LIMIT ORDER
trading at $31. A customer wants to buy the 40
stock if it drops slightly and, therefore, enters a
limit order to buy 100 shares of XYZ at $30. The 35
order may not be executed unless the stock is
Price 30
able to be purchased at $30 or below.
25
A buy limit order is placed below the current EXECUTION AT OR BELOW $30
20
market price of a security.

Time

Now, let’s assume a client originally bought SELL LIMIT ORDER

stock at $22 and it’s now trading at $29. If the 40
client wants to sell the stock, but only if it rises EXECUTION AT OR ABOVE $30
slightly, he may place a sell limit order at $30. 35
The order will not be filled unless the stock is Price 30
able to be sold at $30 or above.
25
A sell limit order is placed above the current 20
market price of a security.

Time

Since limit orders are entered away from the market price, a person who places a limit order must be
patient. Depending on which way the market moves, he may not receive an execution. If the market
price does not trade at or better than the customer’s limit price, the client will not receive a trade
execution. If the customer’s order was entered as a day order (only good for one day) and it didn’t
receive execution, it would need to be reentered on the following day.

Limit orders are often used for large orders in thinly or infrequently traded securities in which the
spread is wide (i.e., a larger distance between the bid and ask prices). Although an investor is able to
specify the price of a limit order, the risk is that the order may never be executed.

Stop (Loss) Orders

Again, investors who enter either market or limit orders want to receive execution. However, stop orders
are often entered by customers who are trying to prevent a large loss or protect a profit on an existing
stock position. In most cases, these investors would rather not receive execution on their stop orders.

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A stop order is a contingent order, which means that it won’t receive execution unless the market
rises or falls to a certain price. This certain price that’s specified by the investor is referred to as the
stop price. If the market reaches the stop price, the stop order is activated (triggered) and becomes a
market order to buy or sell. Since an activated stop order becomes a market order, the investor is
guaranteed that the order will be executed; however, there’s no guarantee as to the price of execution.

Sell Stop Order A sell stop order is placed below the current market price of the security and is
used to limit a loss or protect a profit on a long stock position.
For example, a customer purchases 100 shares of XYZ stock at $25 and determines that
she would like to limit any losses to approximately 5 points; therefore, she enters a sell
stop order at $20. If the stock falls to $20 (the stop price) or below, the sell stop order is
triggered and becomes a market order to sell 100 shares of XYZ. With this order, the
customer is attempting to limit the loss on her position immediately.

Rather than XYZ stock declining in price, let’s assume that it appreciates to $35. The customer may
decide that she wants to protect this profit by entering a sell stop order at $33. If the stock
subsequently falls and trades at or below $33, the order will be activated and when the customer
sells the stock, she will have protected a portion of her profits.

Buy Stop Order A buy stop order is placed above the current market price of the security and is
used to limit a loss or protect a profit on a short sale. Remember, short sellers anticipate that the
security will fall in value (i.e. bearish), but they will lose money if the position rises.
For example, a customer sells short 100 shares of ABC at $40 and is bearish. However, he
would like to protect his position against a rise in the price of ABC and places a buy stop
order at $45. If ABC stock rises to the stop price of $45 or above, the customer’s order will
be activated and he will buy 100 shares at the market to close out (buy back) the short
position. Once the order is activated, he is not guaranteed an execution price of $45, but is
guaranteed that the position will be closed out (covered) immediately.

Stop-Limit Order
A stop-limit order is similar to a stop order in that if the market trades at or through the preset stop
price, the order will be activated. However, once activated, a stop-limit order becomes a limit order
and may be executed only at a specified price or better. These orders are a combination of both stop
orders and limit orders, which means the customer may not receive execution on the order.
Essentially, a stop-limit order presents a risk/reward trade-off. The risk is that since a specific limit
price is set, the order may never receive execution. The reward is that, if the order receives
execution, the customer will receive the preset limit price or better.

Sell Stop-Limit Order As with a sell stop order, a sell stop-limit order is placed below the current
market price of the security and is used to limit the loss (or protect a profit) on a long position.
However, once activated, the sell stop-limit order becomes a sell limit order and, therefore,
execution will only occur if the stock can be sold at the limit price or higher.

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CHAPTER 12 – ORDERS AND TRADING STRATEGIES

For example, an investor purchases 1,000 shares of DEF at $15 and, fearing a decline in
its price, places a sell stop-limit order at $10. After the order is entered, market
transactions occur as follows:
Trigger Execution

$10.70…$10.45…$10.05…$10.00…$9.97…$9.97…$10.00

The order is activated by the first trade at $10.00 and becomes a limit order to sell 1,000
shares at $10.00 or higher. After being triggered, notice that the stock subsequently fell
below the stop price. The order was only able to be executed because the stock increased
back to $10.00. Remember, once activated, the risk is that, unless the order can be filled at
the limit price or higher, the order will not be filled.

Buy Stop-Limit Order As with a buy stop order, a buy stop-limit order is placed above the current
market price of the security and is used to limit the loss (or protect a profit) on a short position.
However, once activated, the buy stop-limit order becomes a buy limit order and, therefore,
execution will only occur if the stock can be purchased at the limit price or lower.
For example, an investor sells short 1,000 shares of GHI at $20 and, fearing a rise in its
price, places a buy stop-limit order at $24. After the order is entered, market transactions
occur as follows:
Trigger Execution

$23.55…$23.80…$23.95…$24.02…$24.03…$24.02…$24.00

The order is activated by the trade at $24.02 (notice that the market traded through the
stop price of $24.00) and becomes a limit order to buy 1,000 shares at $24.00 or lower.
After being triggered, notice that the stock subsequently rose above the stop price. The
order was only able to be executed because the stock decreased back to $24.00.
Remember, once activated, the risk is that, unless the order can be filled at the limit price or
lower, the order will not receive execution.

Order Qualifiers
When orders are being placed, there are several different qualifiers that may be used. However, let’s
consider two of the more important order qualifiers.

Day Order Unless otherwise specified, every order is considered a day order and will be available
for execution from 9:30 a.m. to 4:00 p.m. Eastern Time (ET). If the order is not executed during the
normal trading day, it’s cancelled at the end of the day.

Good-‘Til-Cancelled (GTC) or Open Order A GTC order is one that remains in effect on a broker-
dealer’s order book until it’s either executed or cancelled. Any firm that accepts GTC orders should
periodically update them with the exchange(s). GTC orders must also be updated due to any partial fills.
A customer may enter an order that’s good for a week, a month, or another specified time. If the order is
not executed by the end of the specified time, the customer’s brokerage firm will simply cancel it.

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 CHAPTER 12 – ORDERS AND TRADING STRATEGIES

Conclusion
This concludes the examination of the capacities in which a broker-dealer operates, the various trading
strategies, and the different types of orders. The next chapter will focus on settlement of transactions
and corporate actions, such as dividend payments and stock splits.

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 CHAPTER 13

Settlement and
Corporate Actions

Key Topics:

 Transaction Settlement

 Securities Delivery

 Corporate Actions

 Forwarding Official Communications

 CHAPTER 13 – SETTLEMENT AND CORPORATE ACTIONS

The previous chapter examined the mechanics of order entry and various trading strategies. This
chapter will describe the actions that occur after a trade is executed. These actions include the process
by which transactions are cleared and settled. Lastly, details regarding the various adjustments that
may be made to a client’s position after settlement will be reviewed.

Trading, Clearing, and Settlement

The trading process begins with an order being entered through the submission of either a paper or
electronic order ticket. If the order is executed, the two firms involved must agree on the details of
the trade. This agreement is referred to as clearing or affirming the trade. Finally, the buyer and
seller must swap securities for funds in a process that’s referred to as settlement. The settlement
process is typically facilitated through a third party, such as Depository Trust and Clearing
Corporation (DTCC) (which was described in Chapter 1).

Let’s examine some of the different terms that are vital to this process:

 Order Entry – The placing of a trade into the system either using either a print or electronic ticket
 Execution – The occurrence of a trade or fill in the secondary market (i.e., on the NYSE or Nasdaq)
 Clearing – Agreement by executing firms as to the details of a trade
 Settlement – The swapping of securities for funds that completes the transaction between firms
 Custody and Safekeeping – The safeguarding of client and firm assets after settlement

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. 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).

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CHAPTER 13 – SETTLEMENT AND CORPORATE ACTIONS

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 offer a slightly lower price for the shares.

Cash Settlement The 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 On certain occasions securities are authorized, but not yet issued (e.g., new issues,
spin-offs, etc.) These transactions will settle when the security becomes available for delivery.

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 obligation with those of the firms involved in a given trade. Regulation T
requires that customer payment for purchases in cash and margin accounts 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.

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 CHAPTER 13 – SETTLEMENT AND CORPORATE ACTIONS

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 settlement)
U.S. Government Next Business Day Exempt from Reg. T
Securities (T + 1) (generally settlement)
Next Business Day Four business days
Option Trades
(T + 1) (T + 4)
Cash transactions for any security settle on the same day.

Settlement Methods
Today, for most securities, the settlement process is handled electronically by the Depository Trust
Clearing Corporation (DTCC); however, some security positions are not DTCC-eligible. Essentially,
the DTCC simply adjusts the security positions and cash balances of the contra-parties on its
internal books. Since the settlement is guaranteed by the DTCC, there’s no contra-party risk.

The client-to-broker-dealer payment and delivery (this is not settlement) is also often handled
electronically since clients typically hold positions in street name. Because of this, there are very
few paper securities deliveries between customers and their broker-dealers.

DTCC Settlement Rules for settlement of contracts between member firms are established under
FINRA’s Uniform Practice Code. Again, settlement represents the day on which the buying firm
must pay for the securities and the selling firm must deliver them and receive the proceeds from the
sale. For example, stock trades done regular-way will settle on the second business day after the
trade (T + 2). As noted earlier, the DTCC simply journals the movement of security positions and
monies between each clearing firm’s account. This process is referred to as book-entry settlement.

Book-Entry Settlement Rather than making physical delivery of securities or cash when settling
securities trades, many firms use book-entry settlement. If a firm intends to use book-entry settlement,
all transactions in depository-eligible securities must be settled through a registered securities
depository, such as the DTCC or the National Securities Clearing Corporation (NSCC). For locked in
(affirmed) stock trades, each firm is actually settling the position with the NSCC—the DTCC subsidiary.

Depository-eligible securities are those that may be deposited at the clearing agency for which
ownership can be transferred through book-keeping entries rather than through physical delivery of
certificates. Cash transfers are also processed through book entries by the clearing agency rather than
through a bank routing process.

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CHAPTER 13 – SETTLEMENT AND CORPORATE ACTIONS

Delivery of Physical Securities

Paper Settlement
In some cases, physical securities may be delivered for settlement. Reasons for this include that the
client 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
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.

Restricted Securities As mentioned in Chapter 11, securities that carry a restrictive legend are not
considered to be in good delivery 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.

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 CHAPTER 13 – SETTLEMENT AND CORPORATE ACTIONS

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.

Corporate Actions
As illustrated by the table below, the corporate actions area of a broker-dealer handles a variety of
post-settlement issues. These issues range from stock splits and stock buybacks (described in
Chapter 3), to major events such as mergers and tender offers.

Corporate Actions
 Stock Splits  Proxy Notices
 Exchange Offers  Tender Offers
 Stock Buybacks  Spinoffs
 Rights Offerings  Mergers and Acquisitions

Corporate Actions in Equities

Stock Splits (Forward Splits) If a company chooses to split its stock, it’s usually done to decrease
the price of its stock in order to make it more marketable. The company issues more shares at a
certain ratio to its existing stock (e.g., 2-for-1, 3-for-2). The stock’s par value and market price are
adjusted accordingly. Although the markets tend to react favorably to a stock split, there is really no
immediate change in the absolute value of an investor’s holdings.

To determine the number of shares that an investor will own after a split, the number of shares owned
is multiplied by the split ratio. For example, let’s assume that Widget Inc. has 100,000 shares of stock
outstanding and the shares have significantly increased in price to $100 per share. If Widget splits its
stock 2-for-1, an investor who owned 1,000 shares before the split will own 2,000 after the split.
2
1,000 x /1 = 2,000

To find the price of the stock after the split, the current price is multiplied by the inverse of the split
ratio. If the stock was worth $100 per share before the split, it will be worth $50 per share after the split.
1
$100 x /2 = $50

Remember, the investor’s total share value remains the same. The value was $100,000 before the
split (1,000 x $100) and is still $100,000 after the split (2,000 x $50).

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CHAPTER 13 – SETTLEMENT AND CORPORATE ACTIONS

The Value of the Investor’s Holdings Doesn’t Change.

For stock splits, the ex-dividend date is the business day following the payable date. To ensure that
the proper shareholder receives the additional shares, the stock will trade with a due bill attached
beginning on the record date and continuing through the payable date.

Reverse Stock Split There are times in which a company’s shares may be trading at a very low price.
Since many investors shy away from low-priced stocks (those that sell for $5.00 per share or less), a
company may want to raise the price of its stock. Executing a reverse stock split can help the
company accomplish this objective.

In a forward stock split, the number of outstanding shares are increased and the price is decreased.
However, in a reverse stock split, the company decreases its number of outstanding shares and
increases the stock’s price proportionally. For example, let’s assume that Microcap Holdings has
10,000 shares outstanding and the shares are trading at $1.00 per share. If Microcap executes a 1-for-5
split, each stockholder will receive one share for each five shares currently owns. The result is that
5
Microcap will now have 2,000 shares outstanding with a market value of $5 per share ($1/share x /1).

Tax Impact of Stock Splits and Stock Dividends Stock splits and stock dividends are not taxable to
the investor. The only action that must be a taken is for the investor to adjust his per share cost
basis in the security.
Example 1: Jon Smith bought 100 shares of XYZ Corp for $4000. His cost basis is computed
as $4000/100 shares or $40 per share. If the stock had a 2-for-1 split, Mr. Smith would end
up with 200 shares (2/1 x 100). His new cost basis would be $20 per share ($4,000/200).
Example 2: Mike Jones bought 100 shares of XYZ Corp for $5,000. His cost basis is computed as
$5,000/100 shares or $50 per share. If the company paid a 10% stock dividend, Mr. Jones
would end up with 110 shares. His new cost basis would be $45.45 per share ($5,000/110).

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 CHAPTER 13 – SETTLEMENT AND CORPORATE ACTIONS

Tender Offers A tender offer is a public offer which indicates a person’s or company’s (including
the issuer’s) intent to buy a specific stock at a fixed price (normally above the current market price)
in order to take control of the company or to gain representation on its board of directors. Tender
offers may be placed to purchase all of the outstanding shares or for only a limited number of
shares. In a partial tender offer, the exact number of shares that will be accepted from any person
who tenders her stock is unknown until all of the tenders are collected and counted. For example, if
a buyer is attempting to acquire 10 million shares, but 20 million shares are tendered, each person
who tenders the shares may potentially have only 50% of her shares accepted for tender.

What May be Tendered? An investor may participate in a tender offer if she:

 Has title to the stock (or her agent has title to the stock). This includes owning the stock or an
equivalent security, such as a convertible security, warrant, or right.
 Has entered into an unconditional contract to buy the stock, but has not yet received delivery
 Owns a call option and has exercised the option

If convertible securities, rights or warrants are tendered and accepted, only then will the investors
be obligated to convert/tender the securities into the underlying stock and make delivery. However,
an important note is that an investor must exercise her call options to participate in a tender offer.
Since call options are not issued by the company, these securities must first be exercised.

Exercising Rights and Warrants A broker-dealer’s corporate actions area handles all client
instructions regarding the disposition of rights and warrants. These instructions could include
purchasing the underlying shares or selling the derivatives in the open market. Rights may be freely
transferred and usually trade in the same market as the underlying stock. For example, if Widget
stock trades on the NYSE, then so too will the Widget rights. If an investor chooses not to exercise
her rights, she can sell them in the open market. However, if the investor wants to exercise her
rights, she will typically tender them to the issuer’s transfer agent.

Other Corporate Actions

Mergers and Acquisitions The difference between these two terms is somewhat difficult to
define. Generally if two companies combine, it’s referred to as a merger. Merger examples include
the creation of The Bank of New York Mellon or TimeWarner. An acquisition implies that one
company is purchasing the other. An acquisition example is Amazon’s purchase of Whole Foods.

Spinoffs In some situations, a company may want to spin off a business unit to existing
shareholders. Examples include Metlife’s spin off of Brighthouse Financial and Ebay’s spin off of
PayPal.

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CHAPTER 13 – SETTLEMENT AND CORPORATE ACTIONS

Forwarding Official Communications

Official Communications One of the many services that a broker-dealer may provide to its customers
is safekeeping. The securities may be held in bearer form, book-entry form, or registered in the name
of the customer with the firm holding them to provide protection against loss or theft. In many
cases, customer securities are held in street-name (in the name of the broker-dealer) to facilitate
transfers. When securities are held in street-name, the customer is considered the beneficial owner
of the securities. Many times the issuer knows the identity of the beneficial owners of its securities;
however, in other cases, the owners may prefer that the issuer not know their identity.

If the broker-dealer receives official communications that are directed to the beneficial owners, it must make
a reasonable effort to retransmit the information to the owners. Official communication is considered any
relevant information that’s distributed by the issuer, a trustee, or a state or federal taxing authority.

Beneficial Owners As just described, beneficial owners are persons who have security positions
that are being held by a financial intermediary (e.g., a broker-dealer or trustee) with which they do
business. These positions are typically registered in street name and each individual customer’s
ownership is internally recorded on the firm’s stock record.

For example, if ABC Brokerage holds 15,000,000 shares of Big-Time Industries, the issuer (Big-Time
Industries) may not have access to the individual client names which make up the broker-dealer’s
street name position—it depends on the client’s status.

Non-Objecting Beneficial Owner (NOBO) If a beneficial owner gives permission to her broker-dealer
to release her name and address to the issuer, she is considered a non-objecting beneficial owner. With
this information, the issuer is directly able to provide NOBOs with shareholder communications,
including proxies and financial filings (e.g., Forms 10-K and 10-Q).

Objecting Beneficial Owner (OBO) If a client instructs her broker-dealer to keep her personal
information confidential, it may not be provided to issuers. In this case, the issuer will distribute the
communications in bulk to the broker-dealer. In turn, the broker-dealer will redistribute the
material to the objecting beneficial owners.

Proxies As described in Chapter 3, a corporation’s common stockholders have the right to vote
on issues that impact the corporation. Although these stockholders may choose to vote in person,
most vote by proxy (voting power of attorney). By signing a proxy, shareholders give another person
the authority to vote on their behalf. Broker-dealers that hold customer securities in street-name
are responsible for promptly forwarding these proxies to the beneficial owners.

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 CHAPTER 13 – SETTLEMENT AND CORPORATE ACTIONS

An example of a proxy is shown below:

Management Proxy
MaxCo Corporation
Proxy for Annual Shareholders Meeting
To Be Held July 1, 20XX

The Undersigned hereby constitutes and appoints HAROLD THOMAS and JOHN PUBLIC and each of
them, with power of substitution, as attorneys and proxies to appear and vote all of the shares of stock
standing in the name of the undersigned, at the Annual Meeting of the Stockholders of MaxCo Corporation,
to be held at 5691 Oak Street, Chip City, California, on July 1, 20XX at 2pm and any adjournments thereof:

1. Authority to vote for the election of directors

 WITH  WITHOUT

2. The appointment of Beans & Franks LLP as auditors for the Corporation
 FOR  AGAINST

3. Upon such other business as may properly come before the meeting or any adjournment thereof.

The share represented by this proxy will be voted as specified.

The undersigned hereby acknowledge the receipt of the Notice of Meeting and Proxy Statement.

Dated_________________ 20_______

____________________________________________________
(Please sign name exactly as registered on stock certificate)

Forms 10-K and 10-Q A broker-dealer is required to promptly forward all issuer-related financial
information to its customers who own the stock. The information includes 10-K filings (annual
reports) and 10-Q filings (quarterly reports).

Charging Issuers for Services A member firm may charge issuers for forwarding materials to the
beneficial owners. The reimbursement rates are standardized under FINRA rules.

Charging Customers for Services A member firm may also charge its customers for services, including
safekeeping of securities, collection of dividends and interest, and exchange or transfer of securities.
However, the charges must be reasonable and cannot unfairly discriminate between customers.

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CHAPTER 13 – SETTLEMENT AND CORPORATE ACTIONS

A member firm is not permitted to charge a customer for forwarding proxies or other financial
reports from a corporation since reimbursement is typically collected from the issuer directly. The
member firm is required to forward these materials to its customers if the corporation reimburses
the member firm for the expenses involved.

Conclusion
That concludes the chapter on Settlement and Corporate Actions. The next chapter will examine
the paperwork requirements and associated regulations regarding customer accounts.

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 CHAPTER 14

Customer Accounts

Key Topics:

 Account Types and Characteristics

 Customer Account Registrations

 Retirement Accounts
 CHAPTER 14 – CUSTOMER ACCOUNTS

This chapter will focus on the different types of customer accounts and their characteristics. Some of
the accounts to be examined are defined by whether credit has been extended by the broker-dealer,
while others are recognized by the purpose of the account. Additionally, this chapter will cover the
different account registrations, including individual, joint, corporate, custodial, as well as retirement.

Account Types and Characteristics

Cash Accounts
A cash account is a type of brokerage account in which the investor is required to pay the full
amount for the securities being purchased. In a cash account, an investor is not allowed to borrow
funds from his broker-dealer in order to pay for transactions in the account. Most firms require that
customers pay for their trades by the settlement date or risk incurring potential interest charges.
However, Regulation T requires customers to pay for their purchases within two business days of
regular-way settlement (i.e., S + 2).

Margin Accounts
A margin account is a type of brokerage account in which a broker-dealer lends money to the
customer so that he is able to purchases securities. The broker-dealer will hold the purchased
securities as collateral for the loan. Margin increases the customer’s purchasing power, but also
exposes investors to the potential for large losses if the securities decline in value. Transactions that
are executed in a margin account are also subject to Regulation T requirements. Reg. T impacts
margin accounts in the following two ways: 1) customers are typically required to deposit 50% of the
trade amount and the firm will lend the other 50%, and 2) customers may pay their portion within
two business days of regular-way settlement. There are two types of positions that may be
established in a margin account:
 Long—the client borrows funds from the broker-dealer to purchase shares and
 Short—the client borrows shares from the broker-dealer in order to execute a short sale
− For both long and short positions, no loan (money or stock) is provided unless the customer
deposits at least $2,000.

Margin Agreements To open a margin account, a margin agreement must be signed by the client
which contains the following key provisions:
 The credit agreement discloses the terms under which the broker-dealer will finance the
customer’s purchase, including both how interest is calculated and how it’s charged to the
account.
 The hypothecation (pledge) agreement indicates that the securities purchased by the customer
will collateralize the debt to the broker-dealer. In addition, the broker-dealer may
rehypothecate the securities (i.e., use the customer’s securities to obtain a loan from a bank).
 The loan consent agreement gives the broker-dealer the right to lend the customer’s securities to
other clients or broker-dealers (for short-sale purposes). Since a customer loses the right to vote
the loaned stock, the signing of this part of the margin agreement is optional.

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CHAPTER 14 – CUSTOMER ACCOUNTS

Although selling stock short in a margin account does not involve the same type of financing arrangement
as a long purchase, a margin agreement is still required. This is required since the broker-dealer will
be selling borrowed stock on behalf of the customer.

Margin Disclosure Statement For any customer who opens a margin account with a member
firm, a Margin Disclosure Statement must be provided to indicate that:
 The customer can lose more money than the amount deposited in the margin account.
 The firm can force the sale of securities or other assets in the account.
 The firm can sell the customer’s securities or other assets without contacting him.
 The customer is not entitled to choose which securities or other assets in his account are
liquidated or sold to meet a margin call.
 The firm can increase its in-house maintenance margin requirements at any time and is not
required to provide the customer with prior written notice.
 The customer is not entitled to an extension of time for a margin call.

Options Accounts
Options trading involves the high degree of risk that purchasers may lose their entire investment if the
option expires. Therefore, options trading may not be suitable for all customers. Firms must have a
procedure in place that requires a customer’s account to be approved for options trading before the firm
may accept an order from a customer to buy or write (sell) options.

Options Agreement To open an options account, a registered representative must gather a customer’s
financial and background information to determine both his ability to understand the nature of the
investment and willingness to assume risk. This information is obtained through an Options
Account Agreement which is completed by an RR on behalf of the customer. The broker-dealer
attempts to verify this information by sending the agreement to the customer. This verification is
done by having the customer complete the form or correct any of the entered information. If there
is no response from the customer concerning his personal data, the information may be considered
verified. However, if the customer refuses to provide certain requested information, a note to this effect
must be made on the agreement.

Discretionary Accounts
A non-discretionary brokerage account is one in which the customer decides which securities to buy
and sell. If an RR makes a transaction recommendation to the customer who has this type of
account, it requires the customer’s specific approval before execution.

On the other hand, if a customer has given trading authorization (written power of attorney) to a
registered representative, the account is generally referred to as a discretionary account. If a member
firm permits discretionary accounts, a principal must accept the discretionary authorization in writing
before it becomes effective. Thereafter, each discretionary order must be approved by the principal
promptly (i.e., on the day of the trade, but not in advance) and the account’s activity must be reviewed
frequently. The customer may decide to offer this person either full or limited authorization.

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Limited versus Full POA A limited trading authorization permits the authorized person 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 can 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.

One area of concern in discretionary accounts is excessive trading—also referred to as churning. When
investigating allegations of excessive trading, the most important elements are the number and size of
the transactions in relation to the investment objectives of the customer.

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.

Disclosing Conflicts 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 wants to place some of the issue in a customer’s
discretionary account, the firm must obtain the customer’s written consent prior to executing 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.

The orders that provide time and/or price discretion are referred to as not-held orders and are
limited to the trading day on which the order was placed. 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

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Fee-Based versus Commission Based Accounts

Customers who purchase and sell securities are either charged a percentage-based fee that’s based
on assets under management (AUM) or they incur a charge for each transaction.

In a fee-based account, a customer is charged an annual fee for investment advice, regardless of
whether any transactions occur. On the other hand, in a commission-based account, a customer
pays a commission or other type of payment on each investment transaction.

Although being charged a single fee for all account services may seem like an attractive feature, it may not
be the best approach for all customers. For customers who favor a low turnover strategy, being
charged commissions for each executed transaction may be less expensive than a fee-based
account. On the other hand, for customers who favor strategies that involve higher turnover, the
fee-based account may be more economical than a commission-based account.

Another type of payment option is referred to as a wrap fee account. In this type of investment
account, customers are charged a single, bundled, or “wrap” fee that covers investment advice,
brokerage services, administrative expenses, and other fees and expenses. The fee is generally based
on a percentage of the assets under management.

Educational Accounts
In addition to saving for their own retirement, many parents and grandparents attempt to partially
or fully fund education savings plans for members of their families. Contributions to these plans are
made on an after-tax basis. The U.S. government’s tax code offers incentives to funding these plans
by allowing the generated earnings to be distributed on a tax-free basis if they’re used for qualifying
educational expenses.

Coverdell Education Savings Account (ESA)

A Coverdell ESA is not a retirement account; instead, it’s a tax-advantaged method of saving money for
a designated beneficiary’s elementary or higher education. A parent, grandparent, or even a non-
relative who has adjusted gross income within certain limits may make a maximum after-tax
contribution of $2,000 per year to an account established for a beneficiary who is under the age of 18.

Although the contribution is non-deductible, the money accumulates on a tax-deferred basis and
withdrawals are tax-free if they’re used to pay for the beneficiary’s expenses at an eligible educational
institution. However, if the withdrawals are not used to pay for the beneficiary’s educational expenses,
then the earnings portion of the withdrawal is subject to ordinary income taxes plus a 10% tax
penalty. If the money is not used by the beneficiary’s 30th birthday and is withdrawn, it is subject to
ordinary income taxes as well as a 10% penalty. To avoid the penalty, the money may also be transferred
to a family member who is under the age of 30.

Unlike state sponsored 529 plans, investment options in Coverdell accounts are self-directed.
Investors may buy and sell virtually any type of securities. Coverdell ESAs may be set up at
brokerage firms, mutual fund companies, and other financial institutions.

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Section 529 College Savings Plans

As covered in detail in Chapter 8, 529 plans are not retirement accounts; instead, they’re versatile
savings vehicles that offer federal, and possibly state, tax benefits. The plans are generally operated
by a state and are designed to help families set aside funds for future college and K-12 education
costs. Funds in these programs are not taxed at the federal level if they’re used for qualified
education expenses, the definition of which has been expanded to include computers and up to
$10,000 per year in K-12 tuition.

Section 529 plans can be used to meet costs of qualified colleges nationwide. With most plans, a
person’s choice of school is not impacted by the state in which a 529 plan is formed. For example, a
person can be a resident of State A, invest in a plan that’s offered by State B, and ultimately attend a
college in State C.

Customer Account Registrations

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 Account
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.

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, under Customer
Identification Program (CIP) rules, firms are still required to maintain records regarding the
beneficial owners of all such accounts.

Joint Account
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)
 Joint Tenancy in Common (JTIC or TenCom)

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Joint Tenancy with Right of Survivorship and Joint Tenancy in Common are the most common forms
of joint ownership. JTWROS accounts are often created by spouses and each person fully owns the
account. 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.

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 one of the account owners.

Corporate/Institutional 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 or responsible for 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. The following table identifies when the corporate resolution and/or charter are required:

Activity Corporate Resolution Corporate Charter

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

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 recordkeeping purposes,
member firms are required to maintain a copy of the partnership agreement in the account file.

Trust Accounts
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

Revocable and Irrevocable Trusts When it comes to understanding trusts, knowing the
difference between revocable and irrevocable trusts is crucial. The importance lies in the significant
differences in the legal and tax consequences.

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Revocable Trusts Revocable trusts, also referred to as living trusts or inter vivos trusts, can be
changed at any time. In other words, if a person has second thoughts about a provision in the trust
or changes her mind about who should be a beneficiary or trustee of the trust, then she can modify
(amend) the terms of the trust agreement. Additionally, if a person decides that she does not like
any of the features of the trust, then she can either revoke the entire agreement or change/amend its
contents. The downside of a revocable trust is that assets funded into the trust are considered the
person’s personal assets for creditor and estate tax purposes.

Irrevocable Trusts An irrevocable trust is simply a trust that cannot be changed after the
agreement has been signed. The typical revocable trust will become irrevocable when the person
who created the trust dies. At this point, the trust can be designed to break into a separate
irrevocable trusts for the benefit of a surviving spouse or into multiple irrevocable lifetime trusts for
the benefit of children or other beneficiaries. Irrevocable trusts are commonly used to remove the
value of property from a person’s estate so that the property cannot be taxed when the person dies.
In other words, the person who transfers assets into an irrevocable trust is giving over those assets
to the trustee and beneficiaries of the trust so that the person no longer owns the assets.

Custodial Accounts
Since minors are not permitted to open accounts in their own names, any accounts opened for their
benefit must be established as custodial accounts. Although most states use age 18 as the age of
majority, each state sets its own standard. There are two approaches to opening accounts for minors—
UGMA and UTMA accounts.

Uniform Gifts to Minors Act (UGMA) and Uniform Transfers to Minors Act (UTMA)
Accounts for minors are generally opened under either the Uniform Gifts to Minors Act (UGMA) or the
more updated Uniform Transfers to Minors Act [UTMA]. The provisions of both Acts are very similar.

Under the UGMA/UTMA, an irrevocable gift of cash or securities is given to a minor by an adult donor.
An adult custodian is appointed to act as a fiduciary for the minor. There may be only one custodian
and only one minor per account and the custodian may also be a donor. Although there is no
limitation on the amount of gifts that may be given, taxes may be due from the donor if certain
dollar thresholds are exceeded (currently $15,000 per year).

Most custodial accounts are registered in the name of the custodian for the benefit of the minor. For
ease of trading, an account opened under UTMA may allow for street name holding. The account is
opened under the minor’s Social Security number and the minor is responsible for paying taxes on
any income generated in the account. Provided the custodian is not the donor of the assets in the
account, a custodian may receive a fee for managing the account.

Due to an amendment to the Uniform Prudent Investor Act (UPIA), a custodian is permitted to
authorize investment discretion to a competent third party (e.g., an RR or investment adviser
representative). This is especially important for situations in which the custodian lacks investment
experience and wants to take advantage of another person’s expertise.

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There are certain restrictions that apply to custodial accounts. As with most fiduciary accounts,
UGMA accounts may not be margin accounts. This prohibition limits some of the
investments/activities that can be executed in the accounts. For example, since commodity futures
may only be purchased on margin and engaging in short sales may only be done in a margin
account, neither of these activities is allowed in a custodial account.

Retirement Accounts
Traditional Individual Retirement Accounts (IRAs)
One of the more popular retirement accounts are IRAs which are funded directly by the individual
owners. Prior to recommending investments to be made in these individual plans, RRs should be
assured that their customers are making full use of any work-sponsored plans since most employer
plans allow for pre-tax contributions and may have lower overall expenses than self-directed accounts.

1
Any person who is under the age of 70 /2 and has earned income from employment during the year
may establish an IRA. Earned income may be derived from wages, salaries, commissions,
professional fees, and taxable alimony. However, earned income does not include interest,
dividends, capital gains from investments, income from annuities, or rental income from real estate.

Under certain circumstances, IRA contributions are tax-deductible; however, in all cases, the
income earned by the money invested in an IRA accumulates on a tax-deferred basis until it’s
withdrawn. An IRA account may not trade on margin and must specify a beneficiary who will
receive the account’s assets in the event of the account owner’s death.

A person may maintain an IRA at either a bank or brokerage firm. Although the institution acts as a
custodian for the account, the account owner is responsible for deciding how the funds are to be
invested. They may be placed in a wide variety of investment vehicles including stocks, bonds,
mutual funds, annuities, or U.S. gold coins. However, money contributed to an IRA may not be used
to purchase life insurance or collectibles such as art, antiques, stamps, etc. The income earned from
investments in IRAs accumulates tax-deferred until it’s withdrawn.

Contribution Limits The maximum amount that an individual may contribute to an IRA on an
annual basis is $6,000 or 100% of earned income—whichever is less. Contributions in excess of this
amount are subject to a 6% tax penalty for over-funding. Individuals who are age 50 and older are
allowed to make an additional $1,000 catch-up contribution, which increases their annual
contribution to $7,000. Please note, contributions must be made in cash; a person may not
contribute property.

Spousal Accounts If both spouses of a married couple are employed, each may separately open an
IRA and contribute a maximum of $6,000 annually. Married couples with only one employed spouse may
also contribute a maximum of $12,000 per year into two separate IRAs, assuming the working spouse has
earned income of at least $12,000 per year. However, no more than $6,000 may be contributed to either
account. The account for the non-working spouse is referred to as a spousal account.

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Deductibility of IRA Contributions A single person who is not covered by an employer-sponsored

retirement plan may always deduct an IRA contribution of up to $6,000 annually from his taxable
income. The same is true of a married person and his spouse provided neither person participates in
such a plan. However, if a person or his spouse is covered by an employer-sponsored plan, the person’s
taxable income determines the level of deductibility of the contribution (full, reduced, or zero).

Transfers and Rollovers An investor may transfer funds from one IRA to another without incurring
taxes. A transfer is a situation in which plan assets move directly from one trustee to another. There
is no limit to the number of these transactions that may be executed annually.

An investor may also roll over distributions from qualified retirement plans, such as 401(k)s, into IRAs
without incurring taxes. In a rollover, the investor takes receipt of the money. To avoid a tax penalty,
the rollover must be completed within 60 days and may only be done once every rolling 12 months.

Early Withdrawals from IRAs An investor who withdraws money from an IRA before reaching the
1
age of 59 /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 investor who earns $45,000 per year takes a $5,000 withdrawal
from her IRA in order to move overseas. 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.

1
Investors who are under the age of 59 /2 will not be subject to a tax penalty for early withdrawals
from an IRA 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 money is used to pay certain medical expenses that are not covered by insurance or medical
insurance premiums when the owner is unemployed
 The money is used for expenses related to being a qualified first-time home buyer ($10,000 limit)
 The money is used to pay qualified higher education expenses (including tuition, fees, books,
and room and board) for the account holder or a member of her immediate family
 The withdrawals are set up as a series of substantially equal periodic payments that are taken
over the owner’s life expectancy

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

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Required Minimum Distributions (RMDs) Investors who have not yet begun to take withdrawals from
1
their traditional IRAs by the age of 70 /2 may also incur a 50%tax penalty (the penalty is based on the
amount that should have been taken). The IRS will levy this penalty if the investor does not start taking
1
withdrawals by April 1 following the year in which the person reaches the age of 70 /2. Please note that
this RMD provision applies to traditional IRAs, not Roth IRAs.

Roth IRAs
The Taxpayer Relief Act of 1997 introduced another type of IRA, commonly referred to as the Roth
IRA. Unlike a traditional IRA, contributions to a Roth IRA are not tax-deductible. Since investors
contribute to Roth IRAs with after-tax dollars, they may withdraw contributions at any time without
being required to pay taxes.

The accumulated earnings in a Roth IRA may also be withdrawn tax-free, provided the account has
been in existence for at least five years and one of the following conditions is satisfied:
1
 The account owner is age 59 /2 or older
 The account owner has died or become disabled
 The money is used for qualified first-time home buyer expenses ($10,000 lifetime limit)
 The money is used to cover certain medical expenses or medical insurance premiums
 The money is used to pay for qualified higher education expenses

If these conditions are not met, then the account owner will be subject to ordinary income taxes
plus a 10% tax penalty on the earnings generated by the contributions made to the account.
Investors are not subject to required minimum distributions in a Roth IRA.

Contribution Limits The contribution limits for Roth IRAs are the same as those set for traditional
IRAs—the lesser of $6,000 or 100% of earned income. A married person may also contribute $6,000
per year to a spouse’s Roth IRA even if the spouse is not employed outside the home or earns very
little. However, the total contributions to any one person’s IRA (traditional and Roth) cannot exceed
$6,000 per year.

Eligibility Any person, regardless of age, is eligible to open a Roth IRA provided her income does
not exceed certain levels. Participation in an employer-sponsored retirement plan is not relevant for
determining the eligibility for contributing to a Roth IRA.

Ultimately, a person may lose the ability to contribute to a Roth IRA if his adjusted gross income
exceeds a specific amount which is determined by the IRS. However, there is no income limit that
precludes a person from converting her traditional IRA into a Roth IRA.

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Traditional IRA Roth IRA

100% of earned income, up to a maximum of $6,000 100% of earned income, up to a maximum of $6,000
Similarities

Spousal option: An extra $6,000 Spousal option: An extra $6,000

Age 50 or older: An extra $1,000 Age 50 or older: An extra $1,000

May be a deductible contribution Contribution is NEVER deductible

Contribution is always allowed Higher-income individuals may not contribute
Differences

Required minimum distribution (RMD) by April 1

following year the owner reaches 70 1/2 No withdrawal requirement
(50% penalty for failing to begin distributions)
Withdrawals are subject to tax Withdrawals are tax-free

Qualified Retirement Plans

Employee Retirement Income Security Act (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. Qualified retirement plans meet both ERISA and IRS
requirements and receive favorable tax treatment. To be qualified, a plan must be established in
writing and must adhere to the following guidelines:
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.

If established correctly, a qualified plan will have the following characteristics:

 Pre-tax contributions: Employer and employee 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
 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.
 Non-discrimination: Qualified plans may not discriminate in favor of only highly compensated
employees.

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These plans provide employers a tax break for the contributions that they make on behalf of their
employees. Additionally, qualified plans allow employees to defer a portion of their salaries into the
plan which reduces their immediate income-tax liability by reducing the employee’s reportable
taxable income. Ultimately, qualified retirement plans help employers attract and retain good
employees.

There are two types of qualified plans—defined benefit and defined contribution. A defined benefit
plan gives employees a guaranteed payout and puts the risk on the employer to save and invest
properly to meet the plan’s liabilities. However, with a defined contribution plan, the contribution is
fixed, but there is no guaranteed benefit at retirement. The amount employees receive in retirement
is dependent on how well they save and invest on their own behalf during their working years.

Taxation of Retirement Plans

For tax purposes, there are three distinct phases in these plans—contributions, growth of investment, and
distribution. Retirement and education savings 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 ordinary income.

Since a person’s contribution is made pre-tax, 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. If
a plan is funded solely with pre-tax contributions, it’s said to have a zero cost basis (i.e., the funds
have not yet been subject to tax).

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, securities may be bought and sold 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.
* Note: The government may even allow the owners of certain plans, such as Roth IRAs
and 529 college savings plans, to avoid taxation on the plan growth if the assets are used
for the purpose for which they were intended and held within the plan for a minimum
prescribed period.

Types of Plans
Profit-Sharing Plans Profit-sharing plans are funded by employers and allow for discretionary annual
contributions from company profits. If the company is not doing well, the employer may skip that
year’s contribution entirely. The decision as to whether contributions will be directed to the plan is
made by the board of directors of the employer. Ultimately, providing this employee benefit may
have a positive impact on an employer’s ability to recruit and retain quality employees.

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If a company decides to contribute funds to the plan, it must allocate these funds to the employees in
accordance with a predetermined formula. Generally, each participant receives a certain percentage of
his salary. For example, if a company decides to contribute 10% of each employee’s salary for one year,
then an employee earning $30,000 would receive a $3,000 contribution. Companies with
unpredictable cash flows may find profit-sharing plans work well with their business.

Limitations on Contributions The employer contributions are tax-deductible and the earnings grow
on a tax-deferred basis; however, the maximum annual contribution amount is determined by the
IRS (inflation adjusted).

401(k) Plans 401(k) plans provide employees with retirement plan benefits that are based on the value
in the employee’s account at retirement. Both employers and employees can contribute to the plan.
These plans are suitable for any small to large employers (including both for-profit and non-profit
businesses) that want to offer a salary reduction plan with design options to their employees.

In most plans, the employees decide how to allocate their contributions from a list of investment
options that are selected by their employer. This list typically includes stock funds, bond funds, a
money-market fund, a guaranteed investment contract and, occasionally, employer stock. Registered
representatives should caution clients, particularly if they’re older, about investing too much of their
401(k) contributions in their employer’s stock. The fear is the potential devastating impact on a client’s
retirement portfolio if the stock declines in value shortly before the client is planning to retire.

Contribution Limits The contributions are made pre-tax (deductible) and the earnings grow on a
tax-deferred basis; 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.

Conclusion
This concludes the review of both the different types of customer accounts and the different forms
of account registration. The next chapter will focus on a broker-dealer’s compliance considerations.
Attention will be paid to anti-money laundering (AML) provisions, recordkeeping requirements,
and communication with the public.

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 CHAPTER 15

Compliance
Considerations

Key Topics:

 Opening and Updating Client Accounts

 USA Patriot Act and Anti-Money Laundering Rules

 Regulation SP and Customer Statements

 Communication Rules and Protecting the Customer

 CHAPTER 15 – COMPLIANCE CONSIDERATIONS

The goal of this chapter is to increase a person’s knowledge of the rules and regulations regarding anti-
money laundering (AML), AML compliance programs, monetary reports, the U.S. Treasury’s Office of
Foreign Asset Control (OFAC), recordkeeping requirements, customer mail, business continuity plans,
privacy requirements, Regulation S-P, communications with the public, telemarketing, suitability
requirements, and know-your-customer (KYC) rules.

New Account Documentation

This chapter will address the process of opening customer accounts. For broker-dealers and their RRs,
proper compliance with many securities industry requirements begins with how they collect and document
customer information for opening and maintaining accounts. Effective recordkeeping protects the interests
of the customers, the firms, and the registered representatives. When opening a new account, certain
information regarding the customer must be obtained to comply with industry rules.

FINRA’s Know Your Customer (KYC) Rule requires firms to use reasonable diligence to know the essential
facts regarding every customer as well as any person who has been given the authority to act on the
customer’s behalf. The USA PATRIOT Act (described later in the chapter) imposes additional requirements
on firms regarding both the verification of potential clients’ identities and subsequent monitoring to
ensure that they’re in compliance with anti-money laundering regulations.

Customer information is collected on a new account form not only to satisfy regulatory requirements,
but also to help the registered representative and the firm understand the customer’s investment
objectives and ensure that her suitability concerns are addressed. Of course, every firm’s new account
form is slightly different, but all firms must collect certain minimum information in order to meet
industry standards.

Required Information
A registered representative who intends to open an account for a customer must obtain all required
information prior to entering the initial order in the account. According to FINRA, the following
customer information is required to be obtained:
 The customer’s name and residence (although a P.O. box may not be used to open an account,
correspondence may be sent to a P.O. box)
 Whether the customer is of legal age
 The name of the registered representative (RR) who is responsible for the account. If there is more than
one RR responsible for the account, a record of the scope of responsibility for each representative is
required. This provision does not apply to an institutional account *.
 The signature of the partner, officer, or manager (principal) who approves the account

* An institutional account is one that’s established for a bank, savings and loan association, insurance
company, registered investment company, registered investment adviser, or any person with total
assets of at least $50 million.

If the customer is a business or organization rather than a person, an RR is required to obtain the
names of the individuals who are authorized to transact business for the account.

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Prior to the settlement date of the initial transaction, a registered representative must also make a
reasonable effort to obtain the following customer information:
 Taxpayer ID number (TIN), such as a Social Security number
 Occupation and name and address of the customer’s employer
 Whether the customer is associated with another member firm

This requirement does not apply to either institutional accounts or accounts in which transactions are
only effected in non-recommended investment company shares (mutual funds).

Required Signatures Once the customer’s information is obtained, a principal of the firm must sign
the new account form to indicate his approval. Although many broker-dealers have in-house rules
requiring customers to sign the new account form, industry rules don’t require their signatures when
opening a cash account. However, for customers who are seeking to open margin and/or option
accounts, their signatures are required.

SEC Recordkeeping Requirements

In addition to FINRA’s recordkeeping requirements for customer accounts, SEC Rule 17a-3 requires
broker-dealers to maintain the following records for each customer or owner of an account:
 Name
 Tax ID number
 Address
 Telephone number
 Date of birth
 Employment status, occupation, and whether the customer is associated with a broker-dealer
 Annual income and net worth (excluding principal residence)
 Investment objectives

Any information that provides insight into a client’s investment experience is critical when determining
suitability; however, information regarding a client’s educational background is not required to be
collected.

There may be circumstances in which customers are unwilling to provide their broker-dealers with certain
personal information (e.g., their financial background). If an effort is made to collect the information, but
the prospective customer refuses, an RR should (as a matter of good practice) document the fact that the
effort was made to obtain the data. The documentation could be as simple as writing refused in the
appropriate space on an account form, with no explanation required. Principals may refuse to approve an
account if they feel that the prospective customer has provided the firm with insufficient information to
appropriately assess investment objectives and/or suitability issues.

Trusted Contact Person When a customer account is opened, a firm must make a reasonable effort to
obtain the name of, and contact information for, a trust contact person of the customer’s choosing. If
obtained, the firm is required to disclose to the customer in writing, which may be electronic, that an
associated person of the firm is authorized to contact the trusted contact person and disclose
information about the customer’s account.

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The purpose of any disclosure is to address possible financial exploitation or to confirm the specifics of
the customer’s current contact information, health status, or the identity of any legal guardian, executor,
trustee, or holder of a power of attorney.

Verification and Ongoing Updating of Client Information To ensure that an RR has properly
characterized a client’s profile and investment objective, copies of the account record or the
documentation of the information collected must be sent to the customer either within 30 days of
opening the account or with the client’s next statement. Periodic updates and verification of account
information must be sent to the customer at least every 36 months.

Change of Information If a customer provides a broker-dealer with updated account record

information, the broker-dealer must send a copy of the revised account record to the customer.
Member firms are required to send the updated documentation within 30 days after it received
notification of the change or at the time the next statement is mailed to the customer.

Examples of the changes that may be made to an account record include a name, address, and/or
investment objective change. If a request is made to change a client’s address, notification must be
sent to both the previous address on file and to the registered personnel who are responsible for the
account within 30 days of the change.

Know Your Customer and Suitability

A broker-dealer must use reasonable diligence to learn the important facts regarding every customer.
In other words, according to the regulators, it’s vital to know your customer to provide them with
appropriate services. This obligation extends to any person who is authorized to act on behalf of a
customer, including an investment adviser that 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 are the proper investment recommendations able to 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 specific transaction or investment strategy (e.g., day trading or margin trading). These
recommendations must be based on information that’s obtained from the customers and then used to
identify their investment profile. 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

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Although customers are not obligated to provide all of the information listed above, an RR should make
an effort to obtain as much information as possible to provide the most suitable recommendations.

An investment recommendation should be in the customer’s (not RR’s) best interest. The simple fact
that a customer may agree to a recommendation does not relieve a firm of its suitability obligation.
Some examples of potential violations of the suitability rule include:
 RRs making recommendations of one product over another in an effort to generate large commissions
 RRs making mutual fund recommendations that are designed to maximize their commissions rather
than to establish a portfolio for their customers
 RRs attempting to increase their commissions by recommending the use of margin
 RRs recommending a new issue that’s heavily promoted by their firm in an effort to keep their jobs

FINRA has established the following three main suitability obligations:

1. The reasonable basis obligation – 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 should not be recommended to customers.
2. The customer-specific obligation – Requires a member firm and its RRs to have a reasonable basis
to believe that a recommendation is suitable for a particular individual based on the customer’s
investment profile
3. The quantitative obligation – Requires a member firm and its RRs to have a reasonable basis to
believe that a series of recommended transactions, even if they’re suitable for a customer, are
not excessive when considering the customer’s investment profile

Age-Based Suitability Concerns A customer’s age is typically one of the factors used to determine if a
specific transaction is suitable. For clients who are younger and willing to assume greater risks, listing
their investment objective as growth and/or speculation may be suitable. However, age-based suitability
determinations are more difficult for income producing investments since they range from high risk
(non-investment grade securities) to very safe instruments (U.S. Treasury securities).

In fact, there are certain situations in which a firm may determine that age is irrelevant in determining
suitability. For example, if a customer is seeking liquidity to meet a short term obligation, age is not a factor
when making the investment decision since liquidity is the overriding concern. If a client is seeking capital
preservation, age is again not a factor since safety of principal is the overriding concern.

Institutional Suitability Institutional 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 relatively new to the investment process. For a broker-dealer to determine the extent of its
suitability obligations regarding an institutional customer, there are two important guidelines:
1. The firm and the RRs servicing the account must have a reasonable basis to believe that the
institutional customer can evaluate 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.

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When dealing with institutional customers, firms are exempt from the customer-specific obligation that
was listed previously. However, the reasonable basis and quantitative obligations standards still apply.

Anti-Money Laundering and the USA PATRIOT Act

The Bank Secrecy Act (BSA) is the primary U.S. anti-money laundering (AML) law. However, the BSA
has been amended to include certain provisions of the USA PATRIOT Act to detect, deter, and disrupt
terrorist financing networks that use laundered money to fund their operations. In response to the
September 11, 2001 attack, President Bush signed the USA PATRIOT Act into law. The Act imposed a
number of new regulatory obligations on broker-dealers and focused renewed attention on previously
established AML laws.

Money laundering generally takes place in the following three stages:

1. Placement—The money launderers place illegal cash into the flow of a broker-dealer’s business,
most often through the purchase of securities.
2. Layering—The launderers execute transactions in several layers to avoid detection or the
triggering of a reporting requirement. One form of layering (also referred to as structuring)
involves the purchase of several blocks of securities each with cashier’s checks that are drawn on
different institutions and in amounts of less than $10,000. Taking opposite positions on the same
security (e.g., both long and short positions) or using different customer accounts for each
purchase are other sophisticated forms of layering.
3. Integration—The launderers put the proceeds from the transactions back into the stream of
commerce, making them appear to be from a legitimate source. For example, securities are purchased
with illegally obtained cash, then after their sale, the proceeds are deposited in a bank account. Once
the funds are used to purchase goods and services, the money has now been successfully integrated
into the legitimate economy.

FinCEN’s Required Reports

The Financial Crimes Enforcement Network (FINCEN) is a part of the U.S. Department of the
Treasury whose main purpose is to create and implement policies and procedures that are designed
to detect and prevent money laundering.

The two primary means by which FinCEN accomplishes its objectives are:
1. Requiring financial institutions (e.g., broker-dealers) to file certain transactions reports under the
provisions of the Bank Secrecy Act (BSA), and
2. Providing law enforcement agencies with the information from the reports to assist in combating
money laundering

Broker-dealers are required to file Bank Secrecy Act Currency Transaction Reports (BCTRs). The BCTR
is filed for all cash transactions that exceed $10,000 and are executed by a single customer during one
business day. The definition of currency includes both cash and coins. The reporting requirement is
also triggered if a customer places multiple, smaller transactions in a single day that, in the aggregate,
exceed $10,000.

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For example, one morning, a customer deposits $6,000 of cash at one of her brokerage firm’s
branch offices. Later, on the same day, she deposits an additional $7,000 in traveler’s checks at
one of the firm’s other branch offices. The broker-dealer must file a BCTR to report these
transactions since they total more than $10,000 when combined and they occurred on the
same day.

The customer’s actions are an example of structuring. Structuring occurs when a customer executes
several small transactions in dollar amounts that are below the reporting thresholds to evade the
reporting requirements. Registered representatives should be on the alert for clients who execute
several transactions in amounts that are just below the $10,000 reporting level or clients who deposit
instruments that are sequentially numbered.

Broker-dealers may also be required to file Suspicious Activity Reports (SARs). Until the USA PATRIOT
Act was passed, only broker-dealers that were subsidiaries of bank holding companies were required
to file SARs.

Today, a firm must file an SAR whenever a transaction (or group of transactions) equals or exceeds
$5,000 and the firm suspects one of the following activities:
 The client is violating federal criminal laws.
 The transaction involves funds related to illegal activity.
 The transaction is designed to evade the reporting requirements (structured transactions).
 The transaction has no apparent business or other legitimate purpose and the broker-dealer
cannot determine a reasonable explanation after examining all the available facts and
circumstances surrounding the transaction (i.e., something just does not seem right).

The filing of an SAR is confidential, as is the information contained in the report. Under no
circumstances may a registered representative inform the subject of an SAR that the report has been
filed. Instead, disclosure may only be made to federal law enforcement or securities regulators.

Mandatory AML Compliance Programs

All broker-dealers are now required to establish AML Compliance Programs which, at a minimum,
must include:
 Policies and procedures that are reasonably expected to detect and report suspicious transactions
and deter money laundering
 The designation of a compliance officer who is responsible for the firm’s AML program (There is
no requirement for this person to be FINRA-registered.)
 An ongoing employee training program
 An independent audit function to test the effectiveness of the firm’s AML program

Industry rules also require AML programs to be in written form and approved by a member of senior
management. The independent audit function, sometimes referred to as a stress test, must be
conducted annually unless the member firm does not execute transactions for customers or otherwise
hold customer accounts (i.e., it’s a proprietary trading firm). In these cases, the stress test is only
required to be conducted every two years (on a calendar-year basis).

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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 are also required to maintain records of the information used to verify a
person’s identity and determine whether the person is listed as a known or suspected terrorist or an
affiliated organization.

Office of Foreign Assets Control (OFAC) List Firms and their representatives must make certain
that they’re not doing business with any person whose name is on a list that’s maintained by the
Treasury Department’s Office of Foreign Assets Control (OFAC).

The OFAC List identifies known and suspected terrorists, other criminals, as well as pariah nations
(e.g., Syria and Iran). 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’re 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:
 Name
 Date of birth (for an individual, not a business)
 Address (For an individual this must be a residential or street address. For 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 (e.g., driver’s license or passport) or non-documentary (e.g.,
references from other financial institutions or consumer reporting agencies) 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 if 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 Under the CIP rules, 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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Penalties In an effort to discourage money laundering activities, the penalties for violating existing
AML laws are severe and include both potential incarceration and fines. Under criminal law, a
registered representative who is found guilty of facilitating money laundering may be sentenced to 20
years in prison and may receive a fine of up to $500,000 per transaction or twice the amount of the
funds involved—whichever is greater.

Registered representatives don’t need to have knowledge of a money laundering scheme or even
participate in it to be prosecuted. Instead, RRs and their firms may be held liable for being willfully
blind to the activity.

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 from and about their 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.

Confidentiality Requirements and Safeguard Requirements In order to safeguard customer records

and information, every broker-dealer is required to adopt policies and procedures to physically safeguard
customer records and information. These polices must ensure the security and confidentiality of customer
records and information, protect against anticipated threats or hazards to the security or integrity of
customer account records, and protect against unauthorized access to or use of customer records or
information that could result in substantial harm or inconvenience to any customer.

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) at the time of the account opening and annually thereafter.

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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.

The timing of the notice depends on the client’s relationship with the firm. Regulation SP divides
clients into two categories—consumers and customers. A consumer is a person who is in the process
of providing information to the firm in connection with a potential transaction. A customer is a person
who has an ongoing relationship with the firm.
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.

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. For
customers, a firm must initially provide a privacy notice at the time the relationship is first
established. Thereafter, it must follow up with an updated version of this notice annually.

The notice must disclose to consumers/customers 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. 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. 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. This requirement raises
an important question—can 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.

Client Notifications
Once an account is opened, broker-dealers are required to provide the client with information, including
trade confirmations, statements, and other miscellaneous mailings. The SEC mandates the frequency
and timing of the delivery of this information.

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Account Statements and Other Notifications At least quarterly, broker-dealers are required to
provide customers with account statements. Most firms 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.

Confirmations Statements The SEC requires broker-dealers to provide customers with a detailed
confirmation of each purchase or sale. The confirmation must be given or sent at or before the
completion of any transaction—which is generally the settlement date. The 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 a cross)
− Principal for its own account
 The commission, mark-up, or mark-down for the transaction, calculated in compliance with
applicable rules and expressed as a total dollar amount and as a percentage of the prevailing
market price.
 The dollar price and yield information on debt securities
 Whether a security is callable and a statement that further information will be provided on request
 The settlement date

Even if an RR has discretion over a customer’s account, confirmations for all transactions must be
sent to the customer. Statements and trade confirms may also be sent to an investment adviser or
other third party, but only if the written consent of the customer is obtained.

Holding of Client Mail A firm may hold mail for a customer who will not be receiving it at his usual
address provided the firm:
 Receives written instructions from the customer which include the time period during which the
mail will be held. If the period requested exceeds three consecutive months, the customer’s
instructions must include the valid reason for this request. However, convenience is not
considered a valid reason for this type of request.

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 Gives written disclosure to the customer regarding alternative methods through which he may
monitor the account (e.g., through e-mail or the firm’s website).
 At reasonable intervals, verifies that the customer’s instructions still apply.

During the time that the customer’s mail is being held, the firm is also required to ensure that the mail
is not being tampered with, held without the customer’s consent, or used by any of the firm’s
associated persons in a manner that violate securities laws.

Electronic Delivery of Client Records All account records, such as confirmations, statements, and
tax reporting information may be delivered to the client electronically. Under SEC rules, providing client
access to the records equates to delivery. Essentially, if a client chooses to receive electronic documents,
there is no need to follow up with paper copies. Some firms may charge customers a nominal processing
fee if they choose to have confirmations processed in a paper format.

Regulation of Communications
FINRA divides communications with the public into three categories—correspondence, institutional
communications, and retail communications. 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 that’s sent to one person.
However, FINRA’s current definition is more precise. Correspondence is defined as written or electronic
messages that a member firm sends 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 and/or prospective). The typical
delivery methods include physical (paper) written letters, text messages, and e-mail.

Institutional Communications
Institutional communication 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
 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.”

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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
Retail communication 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, static 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.

Approvals Correspondence and institutional communication must be supervised and reviewed by

the brokerage firm; however, they don’t require approval. Unless an exception applies, retail
communication must be approved by a qualified principal (supervisor) of the firm. In addition,
certain types of retail communication (e.g., those related to options and mutual funds) must also be
filed with FINRA.

Telemarketing — An Alternative Communication Method

The process of attracting new customers is often accomplished through telephone solicitations or
cold calling. In an effort to combat abuses, Congress passed the federal Telephone Consumer
Protection Act of 1991 which applies to both wired and wireless telephone numbers.

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The industry has incorporated the main provisions of this law into their SRO rules, including the
following:
 Telephone solicitations may be placed only between 8:00 a.m. and 9:00 p.m. local time of the
party being called, unless that person has given prior consent or the person being called is another
broker-dealer.
 When calling prospective customers, callers must provide their name, the entity or person on
whose behalf the call is made (e.g., the name of the member firm), a telephone number or address
where that entity or person may be reached, and that the purpose of the call is to solicit the
purchase of securities or other related services. This information must be provided promptly and
in a clear and conspicuous manner.
 Each broker-dealer is responsible for creating a Do Not Call List. If an individual is solicited by
telephone and asks not to be called again, the broker-dealer must place that number on the list.
Under FINRA rules, broker-dealers are required to honor a person’s do not call request within a
reasonable period, which may not exceed 30 days from the date the request was made. In
addition, the firm must train its registered personnel to use the list properly and must create a
written policy to describe how the list will be maintained.
 Registered representatives may not make calls that harass or abuse the person called. Examples of
prohibited behavior include using language that may be interpreted as threatening or
intimidating, using profane or obscene language, or causing a phone to ring repeatedly or
continuously with the intent to annoy, abuse, or harass.
 When a broker-dealer engages in telemarketing, it’s required to ensure that its outbound
telephone number is not being blocked by the recipient’s caller identification service.
 The rule prohibits the use of pre-recorded messages unless the broker-dealer has received the
caller’s prior written permission.

FINRA recognizes that when a representative has an existing relationship with a customer, it may be
important to contact the client outside the 8:00 a.m. to 9:00 p.m. window. Therefore, the time-of-day
and disclosure requirements don’t apply to calls made to clients with whom the firm has an
established business relationship. However, the purpose of these calls must be to maintain or service
the existing accounts of the firm.

An established business relationship between a broker-dealer and a person exists when one of the
following conditions is met:
 Within 18 months prior to the telemarketing call, the person has made a securities transaction, or
has a security position, a money balance, or account activity with the broker-dealer or its clearing
firm.
 Within 18 months prior to the telemarketing call, the firm making the call is considered the
broker-dealer of record for the account.
 Within three months prior to the telemarketing call, the person has contacted the broker-dealer to
inquire about a product or service that’s offered by the firm.

National Do Not Call List

When a person registers her telephone number on the Federal Trade Commission’s (FTC) National Do
Not Call registry, an RR is prohibited from contacting her. Firms are required to update their Do Not Call
list by contacting the FTC and adding any telephone number that appears on the national list.

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However, one exception to the prohibition is when the person to be called has given prior written
consent to being contacted by the member firm. Another exception is based on a personal relationship
that exists between the RR and the person to be called, such as a family member, friend, or an
acquaintance.

Safekeeping of Customer Funds and Securities

Several SEC rules are designed to protect customer funds and securities that are in the possession of
broker-dealers.

The Customer Protection Rule

SEC Rule 15c3-3 (the Customer Protection Rule) contains provisions to ensure the safekeeping of both
customer securities and customer funds. The rule defines a customer as any person for whom the
broker-dealer holds funds or securities, but does not include another broker-dealer, a partner, officer,
or director of the broker-dealer, or a subordinated lender.

Customer Securities A broker-dealer is required to promptly obtain and thereafter maintain

physical possession or control of all fully paid and excess margin securities that belong to its
customers. The term control of securities means that the securities are under the direct control of the
broker-dealer. The rule defines several sites as good control locations, including the office of the
broker-dealer, in transit between its offices, or in an SEC-approved depository (e.g., the DTC).

Excess margin securities are defined as those securities whose value exceeds 140% of the debit (loan)
balance of a customer. For example, a customer who owns stock worth $10,000 and has a debit balance
of $5,000 would have excess margin securities worth $3,000 ($10,000 – [140% x $5,000]).

On a daily basis as of the close of the preceding business day, a broker-dealer is required to compute the
quantity of fully paid and excess margin securities that are in its possession or control and those that
are not in its possession or control. The broker-dealer is required to take affirmative action to
promptly obtain possession and control of the required amount of securities. If a customer sells
securities and fails to deliver the securities within 10 business days of the settlement date, the broker-
dealer must buy in the customer. Under exceptional circumstances, the broker-dealer may apply to
FINRA for an extension.

Customer Free Credit Balances

SEC rules require broker-dealers to advise their customers regarding their free credit balances on at
least a quarterly basis. Free credit balances represent the funds that are available to customers, but
that are currently on deposit in their accounts (e.g., sales proceeds that haven’t been reinvested or
withdrawn). Customers must receive written notice of the amount that’s due to them along with a
statement that the funds are payable on demand. The notice is also required to state that the funds
are not segregated and may be used in the conduct of the broker-dealer’s business. If the broker-
dealer sends statements to its customers more frequently than quarterly, notification of the free credit
balances must be sent with each statement.

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A broker-dealer is not required to comply with these provisions if it segregates customer free credit
balances in such a way that prohibits their use by the broker-dealer.

FINRA Rules
While most financial responsibility rules have been created by the SEC, FINRA has additional rules
that are designed to enhance the fiscal security of members and their customers.

Disclosure of Financial Condition Member firms are required to send balance sheets to customers
every six months and (upon request) make available to customers a copy of the firm’s most recent
balance sheet. A customer is defined as any person having funds or securities in the possession of the
member firm.

Fidelity Bonds
FINRA members that are required to join the Securities Investors Protection Corporation (SIPC) must
maintain a blanket fidelity bond (essentially an insurance policy) which covers officers and employees
and provides protection against loss for fidelity (on premises or in transit), forgery and alteration
(including check forgery), securities loss (including securities forgery), and counterfeit currency. The
bond must include a provision that the carrier will promptly notify FINRA if the bond is canceled,
terminated, or substantially modified.

Business Continuity Plan (BCP)

What steps must a member firm make if it’s faced with a catastrophe, such as flooding or a terrorist
attack? Although a member firm’s WSP manual is designed to establish its day-to-day policies and
procedures, FINRA also requires that its members have plans in place to address the unexpected.
Broker-dealers must establish a written business continuity plan that will identify the procedures to be
followed in the event of an emergency or significant business disruption.

These procedures must provide for all customer obligations being met and must address the firm’s
existing relationship with other broker-dealers and counterparties. The plan is required to be
reviewed annually in light of any changes to the firm’s business structure, general operations, or
location. The BCP is not required to be filed with FINRA, but it must be made available to an SRO
upon request.

Although there are many elements that make up a business continuity plan, at a minimum, the plan must
address the following concepts:
 Data backup and recovery
 Financial and operational assessments
 Alternative communications between the firm and customers and between the firm and employees
 Alternative physical location for employees
 Regulatory reporting and communications with regulators

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Each member firm must provide its SRO with emergency contact information, including the designation of
two emergency contact persons. At least one of these individuals must be a member of senior management
and a registered principal of the member firm. If the second contact person is not a registered principal, she
must be a member of senior management who has knowledge of the firm’s business operations.

FINRA Rule 4370 also specifies that both emergency contact persons must be associated persons of the
member firm. In the case of a small firm with only one associated person (e.g., a sole proprietorship
without any other associated persons), the second emergency contact person may be either a registered or
non-registered person with another firm who has knowledge of the member firm’s business operations.
Possible candidates for this role include the firm’s attorney, accountant, or a clearing firm contact.

Client Disclosure Each member firm must disclose to its customers how its business continuity
plan addresses the possibility of a future significant business disruption and how the member plans to
respond to these events. This disclosure must be provided in written format at the time an account is
opened and must be posted on the member’s website.

Books and Records

The SEC and SROs rely on broker-dealer records and reports to monitor compliance with industry rules.
Therefore, it’s critical for a broker-dealer to maintain accurate records and file timely reports. SEC Rule
17a-3 requires broker-dealers to create specific records, while Rule 17a-4 requires those records to be kept
for a number of years after their creation. Records may be divided into those that must be retained for the
life of the firm, those that must be retained for six years, and those that must be retained for three years.
Note that all records must be kept in an easily accessible place for the first two years of their existence.

Lifetime Records Six-Year Records Three-Year Records

Blotters (records of original entry), Trade tickets, confirms, statements,
Corporate or partnership
municipal complaints*, new account Forms U4/U5 and employee records, all
documents
forms, PoAs communications, trial balances, etc.
* FINRA requires that complaint records be maintained for four years at the OSJ.

Conclusion
The goal of this significant chapter was to provide details regarding many of the requirements that apply
to the smooth operation of a brokerage firm. Firms are required to adhere to KYC rules, AML rules,
privacy and recordkeeping requirements, as well as the process for handling the different forms of
communication. The next chapter will examine activities which are prohibited for member firms.

Create a Chapter 15 Custom Exam

Now that you’ve completed Chapter 15, log in to my.stcusa.com and create a 10-question custom
exam.

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 CHAPTER 16

Prohibited Activities

Key Topics:

 Manipulative and Deceptive Practices

 Regulation M

 Insider Trading

 New Issue Rule

 Books and Records

 CHAPTER 16 – PROHIBITED ACTIVITIES

The goal of this chapter is to increase a person’s knowledge of securities-related prohibited and illegal
activities. The chapter will cover market manipulation, insider trading rules, FINRA’s IPO regulations,
sharing in customer accounts, borrowing or lending to clients, exploitation of seniors, activities of
unregistered people, and prohibited activities related to recordkeeping.

Manipulation
The Securities Exchange Act of 1934 prohibits manipulative and deceptive practices in the sale of securities.
The section of the Act that contains specific anti-manipulation provisions is Rule 10b-5, which states:

It shall be unlawful for any person, directly or indirectly, by the use of any means or
instrumentality of interstate commerce, or of the mails or of any facility of any national
securities exchange,
(a) To employ any device, scheme, or artifice to defraud,
(b) To make any untrue statement of a material fact or to omit to state a material fact
necessary in order to make the statements made, in the light of the circumstances under which
they were made, not misleading, or
(c) To engage in any act, practice, or course of business which operates or would operate as a
fraud or deceit upon any person,
In connection with the purchase or sale of any security.

Although the law is somewhat open-ended, over the years the SEC has identified some specific trading
activities which are illegal. In addition, two additional rules support the prohibition listed above:
 SEC Rule 10b-1 states that the prohibition also applies to securities that are exempt from SEC
registration.
 SEC Rule 10b-3 states that the prohibition also applies to broker-dealers.

In summary, these three provisions prohibit manipulation of any security, whether registered or not, by
persons and broker-dealers. This section will focus on some specific types of market manipulation.

Misrepresentations
Under SEC Rule 15c1-3, it’s a manipulative act for any brokerage firm to represent that a firm’s
registration with the SEC implies that the SEC has approved the firm. Instead, the SEC only requires
registration; it does not approve the firm or its activities.

Regulation M
Most aspects of new securities offerings are governed by the Securities Act of 1933, which was
described in Chapter 11. However, the Securities Exchange Act of 1934 also contains some
provisions that affect the sale of new issues, particularly the activities of the underwriters that
participate in follow-on offerings.

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Before major federal securities laws were passed in the 1930s, syndicate members often conditioned
the market for the new issues that they were about to distribute. After these underwriters sold their
allotments and stopped their behind-the-scenes activities, the stocks involved would experience a
significant decline and cause unassuming investors to suffer large losses.

In order to regulate trading practices involving new issues and the firms that initially profit from the
sale of new issues, the SEC enacted Regulation M. The rule covers issuers distributing IPOs as well
as those distributing additional securities to the public. Under Regulation M, the SEC restricts
distribution participants (such as underwriters and issuers) from aggressively bidding for or making
purchases in the secondary market of a stock that’s currently being offered in a distribution.
However, many of these participants are allowed to make passive markets (i.e., not driving up the
price). This restriction is in effect for a limited period that revolves around the effective date.

Regulation M attempts to prevent upward price manipulation before the pricing of the offering since
this practice generally results in the issuer receiving greater proceeds for the offering and the
underwriters receiving more in fees. However, certain exceptions are permitted when the SEC believes
the chances of manipulation are low. Under certain conditions, the SEC also makes exceptions for
market makers and syndicate members that are seeking to support (stabilize) the price of the new
issue. Stabilization is permitted at or below the public offering price (POP) since this activity is
designed to protect the new issue’s price from dropping substantially.

Market Rumors
Some investors have spread false or misleading information about companies to influence the price of
stocks and bonds. The development of the internet and the overwhelming popularity of social media
have increased the ability to fraudulently impact the price of securities using unsubstantiated rumors.
The spreading of rumors can impact the price of a security in either a positive or negative manner. For
example, in an effort to drive down the price of a company’s stock, a person may use social media to
falsely state that the company is being investigated by the government.

When the purpose of the rumor is to drive the price of a stock up, the SEC refers to this practice as pump-
and-dump. This type of manipulation occurs when a larger investor, or group of investors, owns stock
and spreads false positive news about the company to create a buying frenzy (pump). Before the news
can be confirmed, the investor(s) sells the shares at a profit (dump).

Front-Running
If a broker-dealer or any persons are aware of a large impending order (block trade) that has not yet
been executed, it’s prohibited for them to execute an order for a proprietary account or an account
in which they have discretion. Since block trades have the potential to move the market price of a
security, the broker-dealer and/or associated persons have an opportunity to profit before other
market participants can act. This prohibited activity is referred to as front-running.

Similarly, if a broker-dealer or any of its associated persons have material, non-public information
regarding block trades on a company’s stock, they’re prohibited from placing orders for any related
security of the company (e.g., convertible preferred stock or bonds, or options) in the previously
mentioned accounts.

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This prohibition applies until the information about the block trades has been made publicly
available, through reporting on the tape or through a third-party news wire service. When a partial
execution of a block occurs, the trading prohibition remains in effect until information about
execution of the entire block has been made public.

For purposes of this rule, a block trade is generally defined as a transaction that involves 10,000
shares or more, or options representing that number of shares. However, in certain circumstances,
FINRA may consider a smaller number of shares as a block.

Trading Ahead of a Research Report

Due to the potential for abuses, industry regulators have long been concerned about the interaction
between research departments and trading desks. Of specific concern is a firm’s trading department
buying or selling a company’s securities just before the release of a research report by the firm’s
research department. This practice is often referred to as trading ahead of research.

For favorable reports, firms have argued that their purchases were based on their desire to meet
anticipated customer demand for that security. Without the accumulation, customers who are
interested in buying the security based on the contents of the report would be required to pay higher
prices due to the increase in demand. However, the regulators have not accepted this argument. In
fact, FINRA created a rule that prohibits a member from establishing, increasing, decreasing, or
liquidating an inventory position in a security or derivative of that security based on material, non-
public, advanced knowledge of the content and timing of a research report in that security.

FINRA’s rule covers all securities of the issuer, including debt and derivatives. In addition, the rule
covers both exchange and non-exchange-listed securities. The member firm is required to establish,
maintain, and enforce policies and procedures that are designed to restrict or limit the flow of
information between the research and trading departments of the member firm. Therefore, the rule
requires the creation of information barriers to isolate the research department from the trading
department. These information barriers prevent a trading department from learning of a pending
research report regarding a security in which it has a position. Information barriers will also be
required for broker-dealers to prevent insider trading violations.

Excessive Trading Activity (Churning)

Churning is defined as excessive trading in customer accounts and is generally done to generate
additional fees and commissions. But, how much trading is too much? Although there is no number
of trades or percentage of portfolio turnover that constitutes a violation, the trading activity is viewed
in light of the customer’s objective. There is no need for a client to lose money for a churning
violation to occur. If an RR has been granted discretionary authority over a client’s account, it
doesn’t mean that he’s permitted to trade excessively. Instead, all trading must be suitable as to type,
size, and frequency.

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CHAPTER 16 – PROHIBITED ACTIVITIES

Marking-the-Close/Marking-the-Opening
In an SEC administrative proceeding against a broker-dealer, the marking-the-close practice was
described as:
…a series of transactions, at or near the close of trading, at or within minutes of 4:00
p.m., which either uptick or downtick a security. . . Marking-the-close represents a
possible departure from the normal forces of supply and demand that result in the fair
auction price for a security, and is of concern to those who regulate the markets.

Similar activity at the start of the day is referred to as marking-the-opening.

There are two primary motivations for marking-the-close. First, brokerage firms use a security’s
closing price in determining the margin requirements for their customers. Some firms use $5.00 per
share as a level at which they raise margin requirements, while other firms use a lower price.

When the stock drops to the predetermined price level, firms raise their requirements to 100% equity,
which means that they require full cash payment for the security. Second, a security’s closing price is
the price that’s shown in the newspapers as the final price for that security for that trading session.

In addition to affecting the value of the manipulator’s position, marking-the-close can have a wider
impact on the market. For instance, if the stock being manipulated is part of an index, the value of the
index can be affected by marking-the-close activity. Indexes are used for a wide variety of purposes
in the industry and are closely watched by investors making purchase or sale decisions.

In fact, simply changing a quote can be an example of marking-the-close. In one case, a trader
engaged in a pattern of upticking his firm’s quote on a regular basis within five minutes of the close.
This would often cause the firm’s bid to be the highest in the market at the end of the day. When the
market opened the next day, the trader would then downtick the bid.

Backing Away
Broker-dealers that trade on exchanges or OTC markets for their proprietary accounts are referred
to as market makers. When acting as market makers, broker-dealers have an obligation to stand
behind their quotes for the size and price being displayed (i.e., quotes are firm). If a market maker is
contacted by another dealer or customer and fails to honor its quote, it’s considered a backing away
violation. In doing so, the market maker violates FINRA and SEC rules and is subject to disciplinary
action. Failing to honor a quote can result in a monetary fine and/or suspension of the firm’s ability
to engage in market-making activities.

Free Riding
When a customer purchases securities in either a cash or margin account, Regulation T requires that
he promptly make payment. In this case, prompt typically means by no later than four business days
after the trade date (i.e., T + 4), which is the same as by no later than two business after regular-way
settlement (i.e., S + 2). In a cash account, the full purchase price must be paid; however, in a margin
account, a specified percentage of the purchase price is due (typically 50%).

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If the required amount is not paid by the Regulation T payment date (T + 4 or S + 2), the broker-dealer is
required to close out the transaction by selling out the securities and will then freeze the account for 90
days. During the period in which the account is frozen, the customer must pay for all purchases in
advance. If payment is made in advance for the 90-day period, the customer is considered to have
reestablished credit and may once again be extended normal credit terms (i.e., pay for trades in four days).

A potential violation involving purchased securities is referred to as freeriding. This prohibited practice
can be explained in the following steps:
1. A customer purchases securities in hopes of the value rising.
2. Before making payment, the securities rise in value.
3. The customer directs his firm to liquidate a portion of the securities and to use the sales proceeds
to cover the payment requirement.
4. Since the customer’s payment requirement is satisfied without having deposited funds, it’s
considered freeriding.

Prohibited Trading Practices and Other Trading Rules

The SIE exam may contain questions that relate to various types of violations which may occur
when broker-dealers trade securities. The following section will summarize some of FINRA’s rules
and interpretations.

Anti-Intimidation/Coordination Interpretation
Under this interpretation, the following actions are considered inconsistent with the just and
equitable principles of trade for any member or person associated with a member:
 To coordinate prices (including quotes), trades, or trade reports with any other member or
person associated with a member
 To direct or request another member to alter a price (including a quote)
 To engage, directly or indirectly, in any conduct that threatens, harasses, coerces, intimidates, or
otherwise attempts to improperly influence another member or person associated with a member
– This includes, but is not limited to, any attempt to influence another member or person
associated with a member to adjust or maintain a price or quote, regardless of whether it’s
displayed on an automated system that’s operated by Nasdaq.
 To engage in conduct that retaliates against or discourages the competitive activities of another
market maker or market participant

Payments to Influence the Market Price

Broker-dealers are prohibited from paying any party to influence the market price of a security.
Although firms are allowed to advertise and issue research report, they cannot pay any electronic or
public media outlet that has the ability to influence the price of a security.

Best Execution
If a broker-dealer fails to use reasonable diligence to assist customers in obtaining the best price on
purchases and sales, it’s a violation of FINRA and MSRB (for municipal securities) rules.

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To determine whether a member firm has used reasonable diligence, the following factors are
considered:
 The general character of the market for the security (e.g., the price, volatility, relative liquidity,
and available communications)
 The size and type of transaction
 The number of markets checked
 Accessibility of the quotation
 The terms and conditions of the order which resulted in the transaction (as communicated to
the member firm)

The market for municipal securities is not as centralized as corporate equity securities. For that
reason, the standards for best execution should be considered broadly, with the realization that
municipal securities currently trade over-the-counter without a central exchange or platform.

Time of Trade Disclosures (MSRB Rule G-47)

In addition to the best execution rule for municipal securities, a municipal securities dealer is
required to disclose to a client all material information that’s either known or reasonably accessible
to the market. These time of trade disclosures are required to be made at or prior to the time of the
trade and can be made either verbally or in writing. The main purpose of this rule is to require
dealers to disclose to clients all of the relevant information concerning the securities that they’re
considering purchasing or selling. Many municipal securities have unique features and
characteristics that should be disclosed to a client.

Additionally, the disclosure rules apply regardless of whether the transaction is recommended or
unsolicited, occurs in the primary market or secondary market, or is a principal or agency
transaction. The rule states that information is considered material if there is a substantial
likelihood that a reasonable investor would consider the information to be important or significant
when making an investment decision. A municipal securities dealer may NOT satisfy its disclosure
obligation by simply directing a customer to an established industry source or through a disclosure
that’s made in general advertising materials.

Interpositioning
Interpositioning is defined as the insertion of a third party between a customer and the best market
and is generally prohibited. In fact, 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. The best offer of any market maker is $40. Rather than buying directly from
the market maker, the broker-dealer interposes another firm that buys the stock at $40,
and then sells it to the member firm at $41. The member firm ultimately sells the stock to
the customer at $42 and the two firms share the one-point extra markup that was
charged to the customer.

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Please note, interpositioning isn’t prohibited if a member firm can demonstrate that an execution was
advantageous to its customer as a result of the intervention of a third party (e.g., the use of a broker’s
broker). This may occur when an order is crossed with a retail order from another firm or when the
member firm determines that the market may be adversely affected (to the detriment of the customer)
due to the disclosure of the member firm’s identity. An order may also be routed through a third party
if (1) that party is an established correspondent, (2) the name of the customer’s member firm is
provided, and (3) the customer is not charged for the correspondent’s services. However, the lack of
sufficient personnel to effectively execute an order is NOT a suitable reason for failing to obtain the
best price for a customer.

Trading Ahead of Customer Orders (Limit Order Protection Rule)

A broker-dealer is in violation of FINRA rules if the firm accepts and holds a customer order (either
market or limit) for an equity security and executes a trade involving that security for its own
account at the same price and on the same side of the market (buy or sell). For example, if a
customer places an order with her broker to buy 1,000 shares of XAM at $35 per share and, while
holding this order, the firm buys 1,000 shares of XAM at $35 for its own account, it has an obligation
(within 60 seconds) to fill the customer’s buy order at $35 or better.

An exception is granted if the firm had different departments that traded the same security under
certain conditions. In the previous example, if the department that purchased the shares of XAM at
$35 is different than the department that’s holding the customer’s order, the customer’s order is not
required to be executed. However, the two departments must have proper information barriers in
place for this exception to apply.

Quoting a Security in Multiple Mediums

In some circumstances, a broker-dealer may want to display a quote for the same security in more than
one market. FINRA permits a firm to engage in this practice, but requires the same price to be displayed.
For example, if a firm has placed an offer to sell stock at $20 per share in one market, and wants to enter
another offer for that same stock in another market, the offer to sell must also be $20 per share.

Mutual Fund Trading Rules

Under certain conditions, a mutual fund is permitted to buy securities from and/or sell securities to
another mutual fund without being subject to trading restrictions. Rules 17a-6 and 17a-7 of the
Investment Company Act of 1940 provide an exemption if the transactions are considered minor
and are strictly between portfolio affiliates or between an investment company and certain affiliate
persons. For example, a mutual fund can purchase securities from another mutual fund if both
funds are controlled by the same investment company.

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Insider Trading
Sections 10b5-1 and 10b5-2 of the Securities Exchange Act of 1934 are the most important rules that
relate to insider trading. Insider trading involves the purchase or sale of securities using material, non-
public information about those securities in a fraudulent manner. Material, non-public information is
considered information that, if released publicly, would most likely affect stock or bond prices.

The fraud usually involves either the misuse of confidential information by a person who has a
fiduciary duty to shareholders (e.g., an officer or director), or the misappropriation of confidential
information obtained from an employer (e.g., a broker-dealer employee who misappropriates and
uses sensitive information). Keep in mind, trading by a firm or individual that’s based on
information regarding a large client’s potential buying or selling does not constitute insider trading.
Instead, this prohibited practice is referred to as front-running.

If a corporation has material information, it must release it to the public before any person may use
the information to complete a transaction. Releasing the information only to broker-dealers,
financial analysts, shareholders, or any other limited group is prohibited. One way by which
information is considered to have been released publicly if it’s provided to the financial news
media. Once provide, the media will have the opportunity to disseminate it.

Tippers and Tippees In some situations, material, non-public information is passed from one
person (the tipper) to another person (the tippee). The tippee then trades on the information. If the
tippee knew, or should have known, that the information was confidential, both the tippee and the
tipper may have violated insider trading rules. For instance, assume a member of a corporation’s
board of directors tips a relative about a pending takeover involving the corporation. If the relative
trades on the information, this is likely a violation of the Exchange Act. Another example is when an
investment banker is working on a deal with a company and then tips off a trader. Ultimately, a
broker-dealer is responsible for the actions of its representatives even if the broker-dealer does not use
the information to trade for its own account.

Insider Trading Legislation Over the years, several high-profile cases brought significant congressional
interest in insider trading. Since some of these cases involved broker-dealer employees, the Insider
Trading Sanctions Act of 1984 (ITSA) and the Insider Trading and Securities Fraud Enforcement Act
of 1988 (ITSFEA) were the response.

Establishment of Procedures The ITSFEA required broker-dealers to establish, maintain, and

enforce written policies and procedures that are reasonably designed to prevent the misuse of
material, non-public information by both the firms and their associated persons. The ITSFEA
stipulates that any individual who purchases or sells a security while in possession of material, non-
public information, or has communicated such information to another party in connection with a
transaction, may be liable for trading violations under the Act.

Broker-dealers must not only create such written policies, they must also ensure that they’re
implemented. A broker-dealer with a written, well-thought-out system of procedures to prevent
insider trading may still be subject to SEC penalties if it fails to follow through on the procedures.

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These procedures should contain several key elements, including:

 A system for monitoring employees’ personal trading and trading in firm proprietary accounts
 Restricting or monitoring the trading of securities in which the firm has access to insider information
(watch lists and restricted lists)
 Procedures to restrict access to files containing confidential information, including the establishment
of information barriers (discussed next)
 Education of employees regarding insider trading issues

Information Barrier Procedures An information barrier consists of a set of procedures for preventing
the transmission of confidential information from one department to another within a broker-dealer.
(Information barriers were formerly referred to as Chinese Walls.) These barriers may be physical, but
also procedural. For firms that have access to confidential information, the importance of
implementing adequate information barrier procedures cannot be overstated. The SEC has not
mandated any particular system in order to account for the differences in the way various broker-
dealers operate. However, this also means there is no safe harbor for a firm’s information barrier
procedures. The burden is on the firm to be able to show that its procedures are adequate.

Restricted and Watch Lists Only firms that engage in investment banking, research, or arbitrage
activities are required to maintain restricted and watch lists. However, these firms must have written
procedures to address the use of material, non-public information by their employees. The restricted
and watch lists include securities that employees are either restricted or prohibited from trading, or
issues that are subject to closer scrutiny by the member firm. The restrictions or limitations associated
with the lists apply to employee transactions and to solicited transactions with customers.

The restricted list must be distributed to employees; however, the content of the watch list is
generally known only to selected members of the legal and compliance departments. The firm’s written
supervisory procedures should include a description regarding when and why securities have been added
to, or removed from, the lists. The restricted and watch lists should include the name of the contact
person who added the security to, or deleted it from, the list; however, the rationale for the decision
is not required.

Notifying Compliance If a securities professional comes into possession of material, non-public

information about a company, the best course of action is for her to immediately notify her Compliance
Department. At that point, the Compliance Department can put the issue on the firm’s watch list.

Consequences of Insider Trading Violations Violations of insider trading rules by broker-dealer

employees can have serious consequences for both the individual and the firm.

Civil Penalties Insider trading violations may result in civil penalties of up to three times the
amount gained, or loss avoided, in the transactions (i.e., the SEC can sue for treble damages). The
SEC may also demand disgorgement of profits. In other words, the inside trader could be required
to return any profits earned.

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Criminal Penalties The ITSFEA substantially increased the criminal penalties for violations of the
Exchange Act, including insider trading. An individual may be subject to fines of up to $5 million
and/or imprisonment for up to 20 years per violation. Corporations and other non-natural persons
may be fined up to $25 million per violation. The Department of Justice (DOJ) is responsible for
criminal actions.

Bounties The Act also allows the granting of bounties for information that leads to the payment of
penalties in connection with insider trading violations. The SEC has the power to determine the
amount of the bounty; however, it will not exceed 10% of the penalty.

Other Prohibited Activities

The New Issue Rule
New issues (e.g. IPOs) may dramatically increase in price immediately in the aftermarket (after the
shares are sold to initial investors). Under the FINRA rule titled Restrictions Preventing Associated
Persons from Buying IPOs (the New Issue Rule), a brokerage firm is required to make a bona fide
offering of new issues to the public and not withhold any shares for its own account, or employee
accounts, or accounts of other industry insiders. The rule also prohibits a FINRA member broker-
dealer from selling a new issue to an account in which a restricted person has a beneficial interest.

However, an exemption exists that allows personnel of a limited broker-dealer to purchase shares of a
new issue. A limited broker-dealer is one that restricts its business to investment company/variable
contract securities or direct participation programs. For example, a registered representative who is
employed by a firm that sells only mutual fund shares is exempt from this rule.

The rule contains definitions of key terms, a number of exemptions, and an obligation that the
broker-dealer should obtain a representation from the account holder stating that he is eligible to
purchase new issues. The following text details specifics of the rule.

New Issues New issues include all initial public offerings of equity securities that are sold under a
registration statement or offering circular. However, the following securities are NOT considered
new issues and may be sold to restricted persons:
 Secondary offerings
 Private offerings, including securities sold pursuant to Regulations D and 144A
 All debt offerings, including convertible and non-investment-grade debt
 Preferred stock and rights offerings
 Investment company offerings
 Exempt securities as defined under the Securities Act of 1933
 Direct participation programs and REITs
 Rights offerings, exchange offers, and offerings made pursuant to an M&A transaction
 ADR offerings that have a pre-existing market outside of the U.S.

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Preconditions for Sale Prior to selling a new issue to any account, a firm must meet certain
preconditions for sale. Before distributing shares of a new issue to an account, a firm must obtain
representation from the account holder, or any authorized party of the account, stating that the
account is eligible to purchase new issues. The representation from the account holder may be in the
form of an affirmative statement that positively declares that the account is eligible. This
information must be verified every 12 months.

Prohibited Sales A firm or any person associated with a member firm is prohibited from offering
or selling a new issue to any account in which a restricted person has a beneficial interest.
Additionally, a member firm or any person associated with a member firm may not purchase a new
issue unless an exemption applies.

Restricted Persons The following are considered restricted persons:

 FINRA member firms and any associated person (i.e., employee) of the member firm
 An immediate family member of an employee of a member firm. Immediate family members include
a spouse, children, parents, siblings, in-laws, and any other person who is materially supported by an
employee of a member firm. (Under the rule, aunts, uncles, and cousins are not defined as
immediate family members and are therefore not considered restricted persons.)
 The previously listed immediate family members are only considered restricted persons if any one of
the following three conditions apply:
1. The employee gives/receives material support to/from the immediate family member. Material
support is defined as providing more than 25% of the person’s income or living in the same
household as the person associated with the member firm.
2. The employee is employed by the member firm that’s selling the new issue.
3. The employee has the ability to control the allocation of the new issue.
For example, John is employed by ARW Investment Bank and he supports his
brother. His brother is considered a restricted person.
Another example: Keith is employed by NJF Investment Bank and his firm is the
managing underwriter of Mattco IPO. Keith’s immediate family members are
restricted from purchasing any of the shares in the Mattco IPO from NJF.

Other restricted persons include the following:

 Finders and fiduciaries, such as attorneys and accountants involved in the offering of the new issue
and any person to whom they provide material support
 Portfolio managers purchasing for their own account, which include persons who can buy or sell
securities on behalf of institutional investors (e.g., banks, investment companies, investment
advisers, insurance companies, savings and loan institutions) as well as any person to whom they
provide material support. These are people who are in a position to direct future business to the firm,
which is the reason for their restricted status. (It’s important to remember that a portfolio manager is
only a restricted person if she is purchasing an equity IPO for her personal account. There is no
restriction if she is purchasing shares for the fund that she manages.)
 Persons who own a broker-dealer (including any person who owns 10% or more of the firm).

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General Exemptions The New Issue rule also provides a number of general exemptions. The
exemptions allow a new issue (as defined under the rule) to be sold to the following accounts:
 Investment companies that are registered under the Investment Company Act of 1940
 The general or separate account of an insurance company
 A common trust fund
 An account in which the beneficial interest of all restricted persons does not exceed 10% of the
account. (This is a de minimis exemption that allows an account owned in part by restricted persons
to purchase a new issue if all restricted persons combined own 10% or less of the account.)
 Publicly traded entities, other than a broker-dealer or its affiliates, that engage in the public offering of
new issues
 Foreign investment companies
 ERISA accounts, state and local benefit plans, and other tax-exempt plans under IRS Code 501(c)(3)

Another exemption under the rule allows a broker-dealer to purchase shares of a new issue if the
offering is undersubscribed. This exception means that an underwriter can place shares in its own
investment account as long as all public demand for the shares has been met. However, an
underwriter cannot sell shares of an undersubscribed issue to other restricted persons.

Issuer-Directed Securities SRO rules permit certain persons that are related to the issuer to
purchase shares of a new issue as long as the issuer specifically directs securities to them. The
purchasers that fall under this exemption include the following:
 The parent company of an issuer
 The subsidiary of an issuer
 Employees and directors of an issuer

This exemption allows a registered representative to purchase her employing broker-dealer’s equity IPO
shares or the shares of the parent or subsidiary of the broker-dealer. In addition to a registered
representative, other restricted persons (e.g., immediate family members of employees of a broker-
dealer and finders and fiduciaries that are involved with the offering) may purchase shares of a new
issue, provided they’re employees or directors of the issuer.

Sharing in Accounts and Guarantees

Employees of FINRA and MSRB member firms are generally prohibited from sharing in profits or losses
in their customers’ accounts. However, an exception is made if the following conditions are met:
 The employee has made a financial contribution to her customer’s account and shares in the
profits or losses in direct proportion to her financial contribution
– This condition does not apply to situations in which the employee has an account with an
immediate family member (e.g., a joint account with a spouse or a parent)
 The customer’s prior consent is given
 The employing broker-dealer’s prior written consent is given

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Investment Advisory Accounts An exception to the prohibition on sharing in customer profits

and losses is made for investment advisory accounts in which a fee is charged. To qualify for the
exception, the employing firm’s and the customer’s prior written consent are required and the firm
must be in compliance with SEC regulations that relate to investment advisory services.

Guarantees Employees of member firms may neither guarantee against losses in customer
accounts or transactions within customer accounts, nor may they reimburse a customer for any
losses that at are incurred.

Borrowing and Lending Practices with Customers

Registered representatives are generally prohibited from borrowing money from, or lending money
to, a customer. However, the practices are permitted if a member firm implements written
procedures and satisfies any one of the following five provisions:
1. The customer and the registered person are immediate family members.
2. The customer is a financial institution that’s regularly involved in the business of extending credit
or providing loans.
3. Both persons are registered with the same firm.
4. The loan is based on a personal relationship between the customer and registered person.
5. The loan is based on a business relationship that’s independent of the customer-broker
relationship.

If any one of the conditions indicated in provisions 3, 4, or 5 is satisfied, the registered person is
required to notify the firm prior to the entering of these arrangements. The firm is also required to
provide written preapproval of these arrangements and maintain the approvals for a period of at least
three years after the arrangements are terminated. If the registered person involved in these practices
is terminated, the approvals must be maintained for at least three years after termination.

Financial Exploitation of Specified Adults – FINRA Rule 2165

FINRA created a hotline for seniors who had 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.

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.

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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 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 must be age 18 or older and would be essential in
assisting the firm in protecting the customer’s account and its assets and also responding to
possible financial exploitation.

The trusted contact person’s name and contact information (mailing address, phone number and
email address) would be 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 to open 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 is 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 (ACATS
transfer). However, if the firm places a hold on an account, it must allow disbursements if there is
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.

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.

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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.

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’re employed. For example, if a registered person of ABC Brokerage approaches another
financial institution 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.

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CHAPTER 16 – PROHIBITED ACTIVITIES

Related and Other Persons This rule also applies to accounts in which securities transactions can
be executed and in which the employee has beneficial interest, including any account that’s 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 to maintain the account. Also, the
employee is required to provide written notification to the executing firm of his employment with
another broker-dealer.

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.

Payments to Unregistered Person

A broker-dealer is not permitted to pay any form of compensation to either another broker-dealer
or a person associated with another broker-dealer unless they’re properly registered. The term
compensation is broad and includes commissions, discounts, concessions on new issues, and fees.

Retiring Representatives If a bona fide contract is created, a member firm is permitted to

continue to pay commissions to retiring representatives after they leave the firm, but only based on
their existing accounts. The language of the contract between the retiring RR and the firm must
stipulate that the RR is prohibited from soliciting new business or opening new accounts.

Forgery
The act of forgery involves one person signing another person’s name to a document without
authorization, or causing another person to do so. Obviously, forgery is a serious offense that may result
in criminal prosecution as well as regulatory sanctions. RRs must also be careful not to inadvertently
commit a technical forgery. This occurs when a well-meaning representative signs a client’s name to a
document because she believes that she has the client’s authorization.

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Books and Records

Recordkeeping Formats
As described in Chapter 15, 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 (the records that must be kept) and
Rule G-9 (how long the records must be kept).

Conclusion
This concludes the chapter devoted to providing information regarding the securities-related activities
that are considered prohibited and illegal. Much of the attention is focused on market manipulation,
insider trading rules, FINRA’s IPO regulations, sharing in customer accounts, borrowing or lending to
clients, exploitation of seniors, and recordkeeping. The next chapter will examine the regulations that
apply to the associated persons of member firms.

Create a Chapter 16 Custom Exam

Now that you’ve completed Chapter 16, log in to my.stcusa.com and create a 10-question custom
exam.

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 CHAPTER 17

SRO Requirements for

Associated Persons

Key Topics:

 SIE and Employees of Member Firms

 Registered Representatives and Principals

 Registration and Continuing Education

 CHAPTER 17 – SRO REQUIREMENTS FOR ASSOCIATED PERSONS

This chapter will focus on the registration requirements that apply to associated persons. The focus
will be on details regarding the SIE Examination, the different SRO registration categories,
fingerprinting, statutory disqualification, and the activities of non-registered persons. Additionally,
the industry-mandated continuing education program will be examined, including both the firm
element and regulatory elements. This chapter and the next chapter will include information
regarding registration documentation (both Forms U4 and U5).

SIE Exam – The First Step to Registration

Beginning on October 1, 2018, FINRA has restructured its qualification program by implementing the
Securities Industry Essentials (SIE) Exam to ensure that potential industry professionals have a broad
knowledge of the fundamental concepts and rules of the securities industry. The SIE Exam brings
together much of the information that’s static and unlikely to be impacted by regulatory changes,
such as basic product knowledge, the structure and function of securities industry markets, regulatory
agencies and their functions, and regulated and prohibited practices. The goal of the SIE Exam is to
reduce the redundancy of subject matter content that’s addressed on multiple exams.

Some of the key features of the SIE Exam include the following:
 The exam is open to any person who is age 18 or older, including students and prospective
candidates who are interested in demonstrating their basic industry knowledge to potential
employers.
 Current association with a member firm is not required; instead, individuals are permitted to
take the exam either before or after associating with a firm.
 Exam results are valid for four years.

However, passing the SIE exam alone will not qualify a person for FINRA registration. To become an
associated person of a member firm, an individual will also be required to pass an appropriate
representative-level qualification exam which relates to the registration category pertaining to his
intended job function. For example, on October 10, 2018, if a person is applying for registration as a
General Securities Representative, he is required to pass both the SIE Exam and the new, revised
General Securities Representative (Series 7) examination. These requirements also apply to applicants
who are seeking a representative-level registration as a prerequisite to a principal-level registration.
Additionally, current registered representatives will be considered to have passed the SIE Exam.

Associated Persons
According to FINRA, associated persons are defined as any:
 Officers, directors, partners, or branch managers of a member firm
 Employees of the member firm, unless the employee’s function solely and exclusively clerical or
ministerial
 Persons engaged in investment banking or securities business that’s controlled by the member firm

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Activities of Non-Registered Persons

Although some broker-dealer employees are not required to obtain securities registrations, their
ability to have direct contact with customers is somewhat limited. These non-registered persons may:
 Extend invitations to firm-sponsored events
 Inquire as to whether a prospective customer wishes to discuss investments with a registered
representative
 Inquire as to whether a prospective customer wishes to receive investment literature from the
firm

Non-registered persons who engage in the activities listed above need to be supervised closely by
their employing firms. These employees may not discuss either general or specific investment
products that are offered by their firms, prequalify prospective customers regarding their financial
status, investment history, and objectives, or solicit new accounts or orders.

A registered person may not offer to pay commissions or finder’s fees to a non-registered person
who generates referrals for the RR’s firm, such as an attorney or accountant. However, the RR may
recommend the services of the accountant or attorney to his clients.

Accepting Customer Orders The function of accepting customer orders is not considered a
clerical or ministerial function. In all circumstances, any person who is associated with a member
firm and accepts customer orders must be registered in an appropriate registration category. When
an appropriately registered person is unavailable, an unregistered associated person is not
considered to be accepting a customer order by occasionally transcribing order details that are
submitted by a customer as long as the registered person contacts the customer to confirm the
order details before the order is entered.

Most associated persons of a registered broker-dealer must register with FINRA based on the type
of business in which the firm is engaged, the securities products handled by the person, and the
capacity in which the person functions.

FINRA identifies two levels of qualification and registration:

 Registered representatives—generally sales personnel engaged in securities business activities.
 Principals—generally officers and other management or supervisory personnel who are
involved in day-to-day management or operations of the member firm’s securities business.

Of course, registered representatives and principals must pass qualifying examinations. For
example, the Series 7 – General Securities Registered Representative Exam for registered
representatives and the Series 24 – General Securities Principal for principals.

Let’s review the different types of registered representatives and supervising principals.

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 CHAPTER 17 – SRO REQUIREMENTS FOR ASSOCIATED PERSONS

Registered Representative Designations

For any new registrants to become registered representatives, they must pass the SIE Exam as well
as one of the following qualification exams:

FINRA Representative Designations

This limited representative exam qualifies a person to solicit,
purchase and/or sell the following securities products:
Investment Companies and
Series 6 Variable Contracts Products  Mutual funds, closed-end funds on the initial offering only, and
Representative unit investment trusts (UITs); variable annuities and variable life
insurance; and municipal fund securities (e.g., 529 savings
plans, local government investment pools)
This comprehensive exam qualifies a person to solicit, purchase
and/or sell all securities products in both the primary and secondary
General Securities market, including:
Series 7
Representative  Corporate securities, municipal fund securities, options, direct
participation programs, and investment company products and
variable contracts
This limited representative exam qualifies a person to be involved in
offerings of
Direct Participation Programs
Series 22  Direct participation programs (real estate, oil and gas, and
Representative
equipment leasing), limited partnerships, limited liability
companies, and S corporations
This representative exam allows a person to be involved in:
Series 57 Securities Trader  NASDAQ equity trading, OTC equity trading, and proprietary
trading
This representative exam allows a person to advise on and/or
facilitate the following:
Investment Banking  Debt and equity offerings (private or public offerings); mergers
Series 79
Representative and acquisitions; tender offers; financial restructurings and
asset sales; divestitures or other corporate reorganizations; and
business combination transactions
Private Securities Offerings This representative exam allows a person to solicit and sell private
Series 82
Representative placement securities products as part of a primary offering.
This representative exam is for any person responsible for:
 Client on-boarding, including account and document
maintenance; receipt and delivery of securities and funds;
Series 99 Operations Professional depository and firm account management and reconciliation;
settlement, contributing to the process of preparing and filing
financial regulatory reports; and defining and approving
business security requirements and policies for information
technology.

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CHAPTER 17 – SRO REQUIREMENTS FOR ASSOCIATED PERSONS

MSRB Representative Designations

This representative exam allows a person who is associated with a
Series 50 Municipal Advisor Representative municipal advisor to engage in municipal advisory activities on
behalf of the municipal advisor.
This representative exam allows a person to be involved in:
 Underwriting, trading or sales of municipal securities – including
municipal fund securities; financial advisory or consultant
Municipal Securities services for issuers in connection with the issuance of municipal
Series 52
Representative securities; research or investment advice with respect to
municipal securities; or any other activities which involve
communication, directly or indirectly, with public investors in
municipal securities.

Principal Designations
Any person seeking to become a principal of a member firm will need to take one of the following
exams; however, the specific exam taken will be determined by that person’s responsibilities.

FINRA Principal Designations

This limited principal exam allows a person to supervise sales of:
 Corporate securities (equity and debt); investment company
General Securities Sales products and variable contracts; municipal securities; options;
Series 9/10
Supervisor government securities; and direct participation programs.
 However, this person does not supervise underwriting, trading,
or overall firm compliance with financial responsibilities.
This principal exam allows a person to supervise:
 All areas of the member firm's investment banking and
securities business, such as underwriting, trading and market
Series 24 General Securities Principal making, advertising, and/or overall compliance with financial
responsibilities.
 However, this person does not supervise activities related to
municipal securities or options.

This principal exam allows a person to have regulatory compliance

Investment Companies and over sales of the following:
Series 26 Variable Contracts Products
Principal  Mutual funds; closed-end funds (initial offering only); variable
annuities; and variable life insurance

This principal exam allows a person to supervise:

Financial and Operations  Back office operations; preparation and maintenance of a
Series 27 member firm’s books and records; compliance with financial
Principal
responsibility rules that apply to self-clearing broker-dealers and
market makers

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 CHAPTER 17 – SRO REQUIREMENTS FOR ASSOCIATED PERSONS

MSRB Principal Designations

This limited principal exam allows a person to manage, direct, or
supervise one or more of the following activities:
 Underwriting of municipal fund securities; trading of municipal
Municipal Fund Securities Limited fund securities; selling municipal fund securities to customers;
Series 51
Principal communicating with customers or maintaining records relating to
any of the above activities; processing, clearing, and (in the
case of securities firms) safekeeping of municipal fund
securities; and training of principals or representatives.
This principal exam allows a person to manage, direct, or supervise
one or more of the following activities:
 Underwriting of municipal securities; trading of municipal
securities; buying or selling municipal securities from or to
Series 53 Municipal Securities Principal customers; rendering of financial advisory or consultant services
to issuers of municipal securities; communicating with
customers or maintaining records relating to any of the above
activities; processing, clearing, and (in the case of securities
firms) safekeeping of municipal securities; and training of
principals or representatives.

Failing an Exam If a person fails a qualification examination, a 30-day waiting period applies
between the first and second attempt, and again between the second and third attempt. However, if
a person fails the qualifying examination on his third attempt, he must wait 180 days between all
subsequent attempts.

Exam Confidentiality FINRA considers the content of its qualification exams confidential and
prohibits a person from sharing details with another person. According to FINRA, it’s a violation to:
 Remove all or part of a regulatory exam from an examination center
 Reproduce parts of an exam
 Disclose parts of an exam to another person
 Receive parts of an exam from another person
 Compromise the contents of a past or present exam in any way

Any person who violates the confidentiality rules of a regulatory examination may be subject to
sanctions as determined by FINRA’s Code of Procedure. Possible sanctions include the suspension
or revocation of the person’s registration.

Supervision of Registered Representatives

Each member firm must establish, maintain, and enforce written procedures for the supervision of
registered representatives and associated persons in order to ensure compliance with securities
laws, rules, and regulations.

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To adequately supervise their personnel and activities, member firms must comply with the
following requirements:
 Keep and preserve records for carrying out supervisory procedures
 Review and endorse, in writing, all transactions that are executed by registered representatives
and all correspondence that’s created in connection with those transactions
 Approve customer accounts and review them periodically in an effort to detect and prevent
abuses
 Inspect certain locations at least annually (e.g., an office of supervisory jurisdiction or OSJ)
 Ascertain the good character, business repute, qualifications, and experience of all persons
being certified for registration and monitor their good standing on a continuing basis

Each registered representative must be assigned to a specific supervisor or principal who has
passed the appropriate regulatory examination. A supervisor is required to review the activities of
the firm’s registered representatives and reasonably determine that the applicable rules and
regulations are being followed.

If the regulators find that a representative has violated an industry rule, one of their first questions
is likely to be, “Who was assigned to supervise that person?” The requirement that a representative
be assigned to a particular supervisor exists to ensure that a specific individual is responsible for the
activities of that person. On the actual examination, if a scenario-based question is asked regarding
the potential clarification of a rule, the correct answer may be to contact the designated supervisor.

Registration of Representatives and Principals

The registration process typically begins with the filing of an application with the regulators. The
application for registration is Form U4—the Uniform Application for Securities Industry
Registration or Transfer (which will be described in detail in Chapter 18).

Form U4 and the Central Registration Depository

Each individual who is to be registered under SRO rules must complete Form U4. This form, along
with a fingerprint card that’s used for identification purposes, is filed with and reviewed by FINRA’s
Central Registration Depository (CRD). Essentially, the CRD is an automated, computerized
database containing information regarding a registered person’s permanent record within the
securities business, including both employment and disciplinary history. The CRD provides
registration information regarding broker-dealers and registered representatives to state regulators,
other SROs, and the SEC.

On Form U4, an applicant must answer questions about his personal background, including both
residential and business history. The form also contains a series of questions about the applicant’s
history with respect to any violations of laws or SRO rules. For example, applicants are asked whether
the SEC has ever entered an order against them in connection with an investment-related activity.

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Statutory Disqualification
A broker-dealer may be prohibited from employing an individual who is subject to statutory
disqualification (often referred to as an SD person) in any capacity unless FINRA provides specific
permission. The denial of registration may be based on a person’s past transgressions, including:
 Being expelled or suspended from a self-regulatory organization
 Having a registration denied, suspended, or revoked by the SEC or another regulatory agency
(including the Commodity Futures Trading Commission [CFTC] or other foreign regulators)
 Violating or assisting in the violation of any securities law, commodities law, or rule of the
Municipal Securities Rulemaking Board (MSRB)
 When acting as a principal or supervisor, failing to reasonably supervise a subordinate who
violates rules. Disqualification does not apply if (1) there’s a supervisory system in place that’s
reasonably expected to detect the violation, and (2) the supervisor reasonably discharged
supervisory duties under the system.
 Being convicted within the last 10 years of any felony or a misdemeanor involving investments
and related to fraud, extortion, bribery, or other unethical activities

It’s also important to understand that the intentional submission of false information or the omission
of pertinent facts will result in the immediate statutory disqualification of an applicant. If a person is
convicted of a felony and is later pardoned, he must still report the conviction on Form U4. The pardon
releases an individual from the punishment for the felony, but does not remove the conviction.

To hire or continue to employ an SD person, a firm must file an application with FINRA requesting
special permission through a process referred to as an Eligibility Proceeding. FINRA’s Department
of Member Regulation evaluates the application and makes a recommendation to the National
Adjudicatory Council (NAC) to either approve or deny the request.

When analyzing a firm’s application, FINRA takes into consideration:

 The nature and gravity of the disqualifying event
 The length of time that has elapsed since the disqualifying event
 Whether any intervening misconduct has occurred
 Any other mitigating or aggravating circumstances
 The nature of the securities-related activity in which the applicant wishes to participate
 The disciplinary history and industry experience of both the member firm and the person being
appointed by the firm to serve as the responsible supervisor of the disqualified person

When considering whether a firm may employ a statutorily disqualified person, FINRA requires the
firm to engage in heightened supervision of the person and to include its supervisory plan for the
person in its application.

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The supervisory plan must be tailored to the specific SD person being supervised and often
includes the following cautionary measures:
 For suitability purposes, reviewing and approving all of the SD person’s order tickets, incoming
and outgoing correspondence, and new account forms
 Keeping written records of all supervisory reviews and approvals
 Meeting periodically with the SD person to review his transactions with clients
 Immediately reviewing customer complaints—whether written or oral—and forwarding the
complaints to the firm’s Director of Compliance

Background Check
Under FINRA’s background check rule, firms are responsible for investigating the good character,
business reputation, qualifications, and experience of any applicants applying for registration.
Additionally, it’s necessary for firm’s to perform a search of “reasonably available public records” to
verify the completeness and accuracy of the details that are included on a person’s Form U4. For a
person who switches firms, the new firm is also required to make a reasonable effort to review the
person’s most recent Form U5. Form U5 provides information regarding the reason for the
termination of a registration with a member firm, as well as any potential claims regarding
investment misconduct or other derogatory activities.

To maintain compliance, member firms are responsible for adopting written procedures for
verifying the information on Form U4. These procedures should specify the process for completing
the necessary public record research and stipulate the review will include, at minimum, a national
search of available filings.

Fingerprinting Requirement
Under federal securities laws, every partner, officer, director, and most employees of a broker-dealer
must be fingerprinted for purposes of completing a criminal background check. The associated person
must thereafter submit her fingerprints to the U.S. Attorney General.

However, this requirement does not apply to:

 Broker-dealers that sell only certain securities that are not ordinarily evidenced by certificates (e.g.,
mutual funds and variable annuities) and
 Associated persons who don’t:
– Sell securities
– Have access to securities, money, or original books and records
– Supervise persons who sell securities or have access to the above

Essentially, if a person comes into contact with funds, securities, or the firm’s books and records,
the fingerprinting requirement applies.

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 CHAPTER 17 – SRO REQUIREMENTS FOR ASSOCIATED PERSONS

State Registration (Blue-Sky Rules)

In addition to ensuring that RRs are properly registered under FINRA rules, RRs will need to be
properly registered as agents in each state in which they conduct business. Most states require that
representatives pass the Series 63, Series 65, or Series 66 Examination, each of which cover the state
securities regulations found in the Uniform Securities Act (USA). Firms must also submit an
application and pay fees to the appropriate state Administrator(s).

Similar issues arise regarding the registration of securities. Each security that’s sold to a customer
must either be registered (blue-skyed) under state law or be exempt from registration. If more than one
state is involved, such as when the representative is in one state and the client is in another, the
security must generally be registered or exempt in each jurisdiction.

Continuing Education
A member firm’s registered and associated persons are also required to participate in an industry-
mandated Continuing Education (CE) program. The program is divided into two parts:
1. The Regulatory Element—which is created and administered by regulators
2. The Firm Element—which is the responsibility of each broker-dealer

Regulatory Element
RRs are required to participate in Regulatory Element training at the two-year anniversary of their
initial securities registration and every three years thereafter. This requirement continues for as
long as a person is associated with a member firm in a registered capacity. The content of the
Regulatory Element CE requirement is written by the Securities Industry/Regulatory Council on
Continuing Education. In the computer-based training session, RRs are provided with information
about compliance, regulatory, ethical, and sales-practice standards. As they progress through the
program, RRs must answer questions based on the scenarios presented using the information they
have just seen.

FINRA will notify a broker-dealer at least 30 days in advance of an RR’s appropriate anniversary
date. This is the anniversary of a registered representative’s initial registration or any significant
disciplinary action (disciplinary action restarts the clock). The RR will then have 120 days from that
anniversary date to complete the Regulatory Element training. If the person does not complete the
training within the prescribed time frame, that person’s registration will become inactive. An RR
with an inactive registration is prohibited from performing any activity or receiving any
compensation that requires securities registration.

Rather than requiring a person to make a reservation at a testing center, FINRA has transitioned the
delivery of the Regulatory Element to an online format which is referred to as the CE Online
Program. This program provides participants with the flexibility to satisfy their CE Regulatory
Element requirement from either a home or office computer.

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CHAPTER 17 – SRO REQUIREMENTS FOR ASSOCIATED PERSONS

Firm Element
With regard to the Firm Element of Continuing Education, any registered person (and her
immediate supervisor) who has direct contact with customers in the conduct of a member firm’s
securities sales, trading, or investment banking activities is considered a covered person. At least
once per year, firms must demonstrate to the regulators that they have analyzed and prioritized the
training needs of their covered personnel and have developed a written training plan based on that
needs analysis.

A broker-dealer is required to maintain records documenting the content of its program and the
completion of the program by its covered registered persons. Unless a specific request is made, a
broker-dealer’s Firm Element plan is not required to be submitted for regulatory review. Minimum
standards for Firm Element plans require that they enhance the securities knowledge, skill sets, and
professionalism of registered representatives.

Such training must cover the securities products, services, and strategies offered by the firm, with
particular emphasis on:
 General investment features and associated risks
 Suitability and sales practice considerations
 Applicable regulatory requirements

Inactive Status—Military Duty After proper notification to FINRA, a registered person of a

member firm who volunteers for or is called into active duty in the Armed Forces of the United
States shall be placed on special inactive status. During the period of active service, individuals are
not permitted to function as RRs or contact customers; however, they may continue to receive
compensation based on securities transactions that are executed by existing clients.

While performing military service, these registered representatives are not subject to the two-year
inactive status limitation and are also exempt from continuing education requirements. At the time
of military discharge, the regulators provide registration relief regardless of whether these RRs
return to their previous employer or seek registration with another firm.

Conclusion
This closes the chapter on the regulation and registration requirements that apply to broker-dealer
employees. The next chapter will examine employee conduct and reportable events.

Create a Chapter 17 Custom Exam

Now that you’ve completed Chapter 17, log in to my.stcusa.com and create a 10-question custom
exam.

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 CHAPTER 18

Employee Conduct
and Reportable Events

Key Topics:

 Forms U4, U5, and U6

 FINRA and MSRB Investor Education

 Customer Complaints and Reporting Requirements

 Required Disclosures
 CHAPTER 18 – EMPLOYEE CONDUCT AND REPORTABLE EVENTS

This chapter will examine the process by which individuals register with FINRA as associated persons, as
well as the requirements for updating FINRA for any relevant changes in an individual’s application.
Parts of this chapter will expand on the registration documentation that was introduced in the previous
chapter. Additionally, an analysis is included of how member firms are required to handle customer
complaints and the various issues which result in reporting requirements for individuals and firms.

Employee Conduct
Registration of Representatives and Form U4
Any person who engages in the securities business of a member firm must be registered, except for
employees whose activities are solely clerical or ministerial. Member firms must investigate the
good character, business repute, qualifications, and experience of personnel whom they intend to
register with FINRA. To initiate registration, a person must complete Form U4—the Uniform
Application for Securities Industry Registration or Transfer.

Form U4 On Form U4, an applicant must answer questions about personal data, including residential
and business history. In addition, the form contains a series of questions about the applicant’s history
with respect to violations of laws or SRO rules. For example, applicants are asked whether the SEC has
ever entered an order against them in connection with an investment-related activity.

Disclosures by Applicant Page three of Form U4 contains a series of questions about the
applicant’s involvement in the following:
 Criminal legal proceedings (felonies and securities related misdemeanors)
 Regulatory disciplinary actions
 Civil judicial actions
 Customer complaints
 Terminations
 Financial events (bankruptcies, liens, bonding denials)

Applicants who file false, incomplete, or misleading information will have their registration suspended
or revoked. By signing the U4, registered representatives agree to file timely amendments (within 30
days) if any information on the form changes. The failure to provide complete disclosure of facts and
circumstances could potentially result in a person being barred from the securities industry.

A Yes answer to any of the questions related to violations of laws or SRO rules generally requires an
explanation on the appropriate disclosure reporting page (DRP) of the U4 and could lead to a statutory
disqualification.

Arbitration Disclosures Form U4 contains a predispute arbitration clause. By signing this form a
person agrees to use arbitration as the process for resolving disputes that involve his employer,
other member firms and associated persons, and customers.

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The member firm is required to make the following disclosures regarding arbitration:
1. You are agreeing to arbitrate any dispute, claim, or controversy that may arise between you and your
firm, or a customer, or any other person that is required to be arbitrated. This means you are giving
up the right to sue a member, customer, or another associated person in court, including the right to
a trial by jury, except as provided by the rules of the arbitration forum in which a claim is filed.
2. A claim alleging employment discrimination, including a sexual harassment claim, in violation of
a statute is not required to be arbitrated under FINRA rules. Such a claim may be arbitrated at
FINRA only if the parties have agreed to arbitrate it, either before or after the dispute arose. The
rules of other arbitration forums may be different.
3. A dispute arising under a whistleblower statute that prohibits the use of predispute arbitration
agreements is not required to be arbitrated under FINRA rules. Such a dispute may be arbitrated
only if the parties have agreed to arbitrate it after the dispute arose.
4. Arbitration awards are generally final and binding; a party’s ability to have a court reverse or
modify an arbitration award is very limited.
5. The ability of the parties to obtain documents, witness statements, and other discovery is
generally more limited in arbitration than in court proceedings.
6. The arbitrators are not required to explain the reason(s) for their award unless, in an eligible case,
a joint request for an explained decision has been submitted by all parties to the panel at least 20
days prior to the first scheduled hearing date.
7. The panel of arbitrators may include arbitrators who were or are affiliated with the securities industry
or public arbitrators, as provided by the rules of the arbitration forum in which a claim is filed.
8. The rules of some arbitration forums may impose time limits for bringing a claim in arbitration.
In some cases, a claim that is ineligible for arbitration may be brought in court.

Waivers A disqualified person may apply for a waiver from an SRO to enter or reenter the
securities industry; however, the waiver can only be granted following an Eligibility Proceeding. If
the SRO grants the waiver, it must notify the SEC. Ultimately, the SEC has the authority to overturn
the waiver. If the SEC has no objections, the person is often placed under heightened supervision
procedures at the employing broker-dealer and these procedures are detailed in the firm’s Written
Supervisory Procedures (WSP).

Generally, a prospective employee who is subject to disqualification may not associate with a FINRA
member in any capacity unless/until the waiver is granted. If a person is currently employed by the
member when the disqualifying event occurs, she may be permitted to continue to work in a limited
capacity pending the outcome of the Eligibility Proceeding.

Review of New Hires Each member needs to establish and implement written procedures that
are reasonably designed to verify the accuracy and completeness of the information contained in an
applicant’s initial or transfer Form U4. This review must take place no later than 30 calendar days
after the form is filed with FINRA.

If a person was previously registered with FINRA, a broker-dealer must obtain and review the latest
Form U5—the Uniform Termination Notice for Securities Industry Registration, which will be examined
in greater detail shortly. Review of Form U5 must be completed within 60 days of the date that the
person files an application for registration. If an applicant seeking registration receives a request for a
copy of their Form U5, he must provide the form within two business days of the request.

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 CHAPTER 18 – EMPLOYEE CONDUCT AND REPORTABLE EVENTS

The Central Registration Depository

The Central Registration Depository (CRD) is an automated database that contains information
concerning the employment and disciplinary histories of registered persons. The CRD system is
used to process applications for agent registrations for the states, as well as for processing
applications for withdrawal, for agents and broker-dealers. If any information on an individual’s
Form U4 changes, an amendment to the CRD must be filed promptly.

Updating Form U4
Providing 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. 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 have an in-house rule that requires notification if a
registered person is 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, with the applicable details. The firm must also provide the
former employee with a copy of the form. Form U5 includes the reason for the RR’s departure
(voluntary or involuntary) and must be updated (within 30 days) if answers to certain questions
change following termination. If a broker-dealer receives a written customer complaint after the RR
has left the firm, it’s still required to notify FINRA regardless of how long ago the RR had left the
firm. There is no requirement to send a copy of the complaint to the RR.

Even after termination, FINRA maintains jurisdiction over any associated persons previously
employed by the broker-dealer for two years. For this reason, a person who terminates her
registration, but wants to return to a brokerage firm as a registered representative without having to
requalify by examination, must do so within a two-year period.

Form U6 Regulators, states, and/or jurisdictions use Form U6 to report disciplinary actions
against registered representatives and/or firms. 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 Form U6 is fed into the CRD system and some of the content may be available to the public
through FINRA’s BrokerCheck website.

Release of Disciplinary Information BrokerCheck is FINRA’s public disclosure program and

provides information about the disciplinary history of member firms or registered representatives.

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The BrokerCheck system provides information on individuals who are currently registered or have been
registered within the last 10 years. This information is on file with CRD and can be obtained by the public
through a toll-free telephone number or the website of FINRA Regulation. The information provided
about individuals includes the following:
 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

If a currently registered person disagrees with the information found on BrokerCheck, he is required to
file an amended Form U4 with FINRA. However, if a person is not currently registered with FINRA (but
was registered within the last 10 years), he must 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, in writing (which may be electronic),
the following:
 FINRA’s BrokerCheck hotline number
 FINRA website address
 A statement regarding the availability of an investor brochure that includes information describing
FINRA’s BrokerCheck

However, any member that does not carry customer accounts and does not hold customer funds or
securities is exempt from these provisions.

MSRB rules also contain an Investor Education Rule, which requires that the following disclosures
are made at least once every calendar year:
 That the regulated entity is registered with the MSRB and the SEC
 The MSRB’s website address
 That there is a brochure (Investor Brochure) available on the MSRB’s website which describes
the protections available under MSRB rules as well as the process by which a complaint may be
filed with the appropriate regulatory authority

A previous MSRB rule stated that investors would only receive information about filing a complaint
with the appropriate regulatory authority when they made a complaint to or about a firm. Firms are
now required to annually notify a customer about the availability of educational material.

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Expungement If information in the CRD system is incorrect, FINRA has established procedures
for the removal (expungement) of disputed information that relates to arbitration cases from an
RR’s CRD record. This removal of information from the CRD 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.

Complaints
FINRA defines a complaint as any written statement of a customer, or any person acting on behalf of a
customer, which alleges a grievance involving the activities of any persons 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. If received, the original customer complaint must be forwarded to
a supervising principal. The principal’s responsibility is to review and initial the complaint.

Member firms are required to maintain a separate file of all written complaints, including e-mail
and text messages, in each office of supervisory jurisdiction for four years. The file must also contain
a description of actions taken by the member, if any, regarding the complaint and must contain, or refer
to another file containing, any correspondence related to the complaint. Response to a customer’s
written complaint may be in written or oral form. Note that even if a member has not received any
complaints, a complaint file (even if empty) must be maintained.

CRD Updates Member firms may be required to file a report with FINRA regarding certain
customer complaints and other incidents that may arise. If the reporting requirement is triggered, a
member firm must report these events promptly, but by no later than 30 calendar days after learning
of them. Events that may require reporting include the discovery by the firm that it or one of its
associated persons:
 Is the subject of any written customer complaint involving allegations of theft, misappropriation of
funds or securities, or forgery
 Has been found to have violated any securities law or regulation or any standards of conduct of any
government agency, self-regulatory organization, financial business, or professional organization
 Has been denied registration or has been expelled, enjoined, directed to cease and desist,
suspended, or otherwise disciplined by any securities, insurance, or commodities regulator, foreign
regulatory body, or self-regulatory organization
 Has been named as a defendant in any proceeding brought by a domestic or foreign regulatory
body or self-regulatory organization alleging the violation of any securities, insurance, or
commodities regulation
 Has been indicted or convicted of, or pleaded guilty to or no contest to, any felony or misdemeanor
involving securities, bribery, burglary, larceny, theft, robbery, extortion, forgery, counterfeiting,
fraudulent concealment, embezzlement, fraudulent conversion, or misappropriation of funds

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 Is a director, controlling stockholder, partner, officer, or sole proprietor of, or an associated person
with, a broker-dealer, investment company, investment advisor, underwriter, or insurance company
that was suspended, expelled, or had its registration denied or revoked by any domestic or foreign
regulatory body, or pleaded no contest to any felony or misdemeanor in a domestic or foreign court
 Is a defendant or respondent in any securities or commodities-related civil litigation or arbitration-
that resulted in an award or a settlement of more than $15,000 (for any associated persons) or more
than $25,000 (for member firms)
 Is the subject of any action taken by the member firm against an associated person of that firm that
results in a suspension, termination, withholding of commissions, or the imposition of fines in excess
of $2,500

Quarterly Reports FINRA members are required to provide FINRA with statistical and summary
information about customer complaints on a quarterly basis, even if the complaint does not trigger
the preceding reporting requirement. The report is due on the 15th of the month following the end
of the calendar quarter in which the complaints were received. However, if no complaints were
received during the quarter, no report is required to be filed.

Confidential Settlement of Complaints The terms of a customer’s settlement against a broker-

dealer may be confidential. Although this means that the customer may not disclose the terms, the
registered person is still required to report the terms to CRD.

Red Flags
SEC has emphasized that “reasonable supervision” requires strict adherence to internal company
procedure (i.e., WSP), but principals are also expected to identify problematic situations despite having
limited information. Supervising principals are required to look for any indication of real or potential
violations of securities regulations. These indications of potential wrongdoing are often referred to as red
flags. Since the shortest path to failure is to ignore potential problems, principals must respond to red flags.

When a red flag is discovered, a supervisor must do the following:

1. Investigate the situation This means that the supervisor must make a reasonable effort to
ascertain all of the relevant facts and circumstances that led to the red flag. This investigation
should include an evaluation of all documentation that’s available, and often involves direct
contact with the client. Regulators often want to see that supervisors have ongoing
communication with the clients of the RRs who are under their supervision.
2. Document the investigation This means that all of the records reviewed, interviews conducted,
and clients contacted need to be documented in writing. It’s important to show the steps that
were taken and the specific nature of conversations and interviews conducted. In a formal action
by the regulators, the notes and records of the supervisor are often key elements of the
investigation. From a regulator’s viewpoint, if documentation is not in writing, it didn’t happen.
3. Pursue the investigation to a conclusion Often an investigation will involve more than one
supervisor or department. It’s important that the supervisor who initiates the investigation take
responsibility to ensure that the matter is brought to some resolution. In fact, the resolution may be
that no violation occurred. Customer complaints and other allegations often arise from poor
communication between RRs and clients and/or between RRs and firms.

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A red flag does not necessarily mean that a violation has occurred. Regardless of the findings, the
supervisor must bring the investigation to a conclusion and must document this conclusion and
how it was determined.

Any investigation should be as objective as possible, and should always include evidence other than
an employee’s word. This could include consulting other supervisors or members from other
departments, such as compliance or legal. The employee’s prior conduct should always be taken into
account. Violations are often not isolated incidents, but rather part of a pattern of ongoing
misconduct. An RR who has a history of previous misconduct may be a red flag for a supervisor to
investigate. Also, hiring an RR who has demonstrated a pattern of unauthorized transactions
without being monitored has been viewed as a failure to supervise by some regulatory authorities.

Personal Activities of Employees

Outside Business Activities
Registered representatives who are employed by FINRA member firms must provide written notice
to their employers before participating in any business activities outside of the scope of their
normal relationship with their firms (e.g., a second job on weekends). The purpose of notification is
to guard against potential conflicts of interest. For example, if a registered representative is a member
of a publicly traded company’s board of directors and the RR’s firm recommends that company’s
securities, a conflict of interest exists. Even part-time employment by a registered representative
must be reported to the broker-dealer. However, charitable activities or volunteer work conducted
by registered employees are not required to be documented.

Private Securities Transactions

Private securities transactions are those that are executed outside of the regular scope of an associated
person’s employment with a member firm. An associated person who engages in these types of
transactions must provide written notice to his employing member. If a registered person executes
securities transactions without providing notice to his employer, it’s a prohibited practice which is referred
to as selling away. Selling away may include participating in private placements, traditional public offerings,
and arranging loans. FINRA has established the following rules regarding private securities transactions:
 If the associated person will receive compensation for the transaction, the member must specifically
approve the transaction in writing for the person to be permitted to participate. In this case, the
transaction must be recorded on the member firm’s books.
‒ Compensation for this activity can come in many forms, including commissions, finders’ fees,
securities (or the right to receive securities), and tax benefits.
 If the associated person will not receive compensation for the transaction, the employee is still
required to provide written notification to her employer.

Personal transactions involving investment company and variable annuity securities are not
covered by this rule.

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Influencing or Rewarding Employees of Others (The Gift Limit)

Under the gift limit rule, FINRA member firms and their associated persons may not provide gifts
that exceed $100 per year to any person, principal, proprietor, employee, agent, or representative of
another firm if the payment or gratuity is in relation to the business of the employer of the recipient
of the payment or gratuity. The underlying concern is that the gifts could cause the recipient to act
in a manner that’s contrary to the interests of the employer and/or its clients because of the gift.
However, the rule does not apply to gifts that a firm makes to its own employees or gifts that are
made by an employee to a coworker.

Valuing a Gift Generally, a gift should be valued at the greater of its cost or its market value at the
time it was given. If a gift is given to a group, a pro rata amount is deemed to have been given to
each of the individuals. For example, if a $200 gift basket is sent to a branch office of four
individuals, each individual is considered to have received a gift valued at $50 ($200 ÷ 4 = $50).

Personal, De Minimis, Promotional, or Commemorative Gifts Some gifts, because of their nature and
the circumstances surrounding them, are more clearly personal gifts rather than gifts connected to the
firm’s business. For example, wedding gifts and congratulatory gifts on the birth of a child are personal
gifts that are excluded from the $100 aggregate limit. De minimis gifts are those that have a trivial or
minimal value. Typically, these gifts include pens, notepads, or modest desk ornaments. Promotional
gifts are those that display a firm’s logo and have nominal value, including umbrellas, tote bags, and
shirts. For de minimis and promotional gifts to be excluded, their value must be well below the $100
limit. Commemorative items are generally decorative (e.g., Lucite plaques) and serve to recognize a
business transaction or relationship. These commemorative gifts are also excluded from the limit.

Business Entertainment Ordinary and usual business entertainment is excluded from the limit if
two conditions are met:
 The business entertainment is not so frequent as to raise a question of impropriety.
 The member or its associated persons host the clients and guests.

Business entertainment may include a social, hospitality, charitable, or sporting event, a meal, or other
leisure activity. In addition to the event itself, the term business entertainment includes transportation and
lodging expenses that are incidental to the event. Generally, although no business is being conducted, a
person associated with the member firm must accompany and participate with the employee. Providing
tickets, but not accompanying the employee, is considered a gift rather than business entertainment.

Member Compensation Related to the Sale of Securities Products Broker-dealers that create
investment companies (e.g., mutual funds) may not pay other broker-dealers a commission in the
form of securities (e.g., stocks and/or options). With certain exceptions, registered representatives
are prohibited from receiving compensation for the sales of direct participation programs (DPPs), real
estate investment trusts (REITs), investment company securities, or variable contracts products (e.g.,
variable annuity or variable life insurance), either in cash or otherwise from any person other than
the member firm with whom they are associated. For example, an RR cannot accept compensation
directly from a mutual fund distributor for selling its funds. Instead, the distributor should make
payments to the RR’s broker-dealer, which then determines the RR’s compensation.

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Cash compensation includes any discount, concession, commission, service or other fee, asset-based sales
charge, loan, override, or cash employee benefit received in connection with the sale and distribution of
DPPs, REITs, investment company or variable contract securities. Non-cash compensation is any
compensation in the form of merchandise, gifts and prizes, travel expenses, meals, and lodging.

De Minimis Exceptions There are several exceptions that permit RRs to receive cash or non-cash
items from outside parties. For example, representatives may accept gifts of up to $100 per person,
per year from a person who is affiliated with an investment company or variable contract issuer or
distributor.

Gifts of occasional meals, as well as tickets to sporting events, the theater, or comparable
entertainment, are also acceptable as long as they are not excessive. Although the exceptions are
based on the assumption that the gift is not preconditioned on the achievement of a sales target, the
gifts may be used to recognize past performance or to encourage future sales.

The Training and Education Exception FINRA recognizes that investment company and variable
contract issuers and distributors (which are referred to as offerors) perform a valuable service when
they provide training to member firms and their RRs regarding the products and services they offer.
For that reason, industry rules permit offerors to pay or reimburse for meetings that serve an
educational function. However, the following conditions apply:
 RRs must have their broker-dealer’s permission to attend the meeting.
 Attendance may not be tied to the achievement of a sales target.
 The location of the meeting must be appropriate.
 Payments or reimbursements for guests of RRs, such as spouses, are not permitted.

In-House Incentive Programs A broker-dealer is free to create its own internal sales programs with
non-cash incentives, such as merchandise and vacation trips. A firm may even accept contributions
by offerors to its non-cash programs. However, FINRA has placed some conditions on these
arrangements. One of the restrictions requires that a non-cash incentive program for investment
company securities or variable contracts be based on the RR’s total production for all of the
investment company securities or variable contract products that are distributed by the broker-
dealer. In addition, the credit earned by an RR toward the incentives being offered must be equally
weighted among the products in the program.

MSRB Political Contribution Rule (G-37)

If no regulations existed, municipal securities dealers could make extensive political contributions
in order to gain favor with politicians who might, in return, direct municipal securities underwriting
business their way. To limit this pay-to-play practice, the MSRB has created specific rules against it. For
purposes of Rule G-37, a political contribution includes any item of value such as a gift, subscription,
loan, advance, or deposit of money. Also included is any reimbursement of debt that’s incurred in a
political campaign or payment for transition or inaugural expenses of a successful candidate. The
MSRB believes that the potential of making excessive contributions undermines not just the
integrity of the municipal securities market, but also investor confidence in the market.

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Rule G-37 applies to contributions that are made by municipal finance professionals (MFPs). MFPs
are considered associated persons of a broker-dealer who primarily engage in underwriting,
trading, sales, financial advisory or consulting services, and research or investment advice related to
municipal securities. However, registered representatives who simply recommend municipal securities
to retail investors are generally excluded from the definition. On the other hand, any representative
who solicits municipal securities business from issuers is considered an MFP.

If a municipal securities broker-dealer makes certain political contributions to officials of issuers, it’s
prohibited from engaging in negotiated municipal securities business with that issuer for two years.
However, MFPs of the broker-dealer may make certain contributions without triggering the two-year
ban. No violation is considered to have occurred if:
1. The MFP is entitled to vote for the official, and
2. The contribution does not exceed $250 per election

Interpretations Since there have been many questions raised by municipal securities dealers
concerning the application of this rule, the MSRB has provided firms with guidance by issuing an
interpretative notice, which includes the following examples:

Example 1 An MFP contributes more than $250 and the ban is triggered. If the MFP
leaves the firm, the ban is still in place. If that MFP is hired at a new firm
and is still defined as an MFP, the new firm will also be prohibited from
engaging in negotiated municipal securities business based on the date of
the contribution. However, if the MFP is hired at a new firm and is not
defined as an MFP, the two-year ban does not apply to the new firm.
Example 2 While employed at Dealer A, an MFP contributes $200 to a candidate.
Three months later, while now employed as an MFP with Dealer B, the
same MFP contributes another $200 to the same candidate. The two-year
ban will only apply to Dealer B.
Example 3 A two-year look-back period applies to MFP contributions. If an individual is
not an MFP, but she made contributions to a political candidate that
would have resulted in a violation, the firm that employs the individual
would be subject to the underwriting ban if she is employed in the role of
an MFP within two years of the contribution.
Example 4 If a contribution to a political candidate is made from a joint checking account, the
contribution will be split evenly by the contributors and the contribution limit
applies. Therefore, if the check from the joint account exceeds $500, a violation
occurs. On the other hand, if the check is signed only by the MFP, the entire amount
is attributable to the MFP. If the spouse of an MFP made a contribution by writing
a check from a personal (rather than joint) account, the contribution is NOT
considered to have originated from the MFP. In which case, there is no limit on the
amount that the spouse may contribute under Rule G-37.

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Conclusion
This concludes the chapter on the FINRA registration process for associated persons and the requirements for
informing FINRA for any relevant changes in an individual’s application. The next chapter will examine
economic factors and how they influence the decisions made by issuers and investors.

Create a Chapter 18 Custom Exam

Now that you’ve completed Chapter 18, log in to my.stcusa.com and create a 10-question custom
exam.

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 CHAPTER 19

Economic Factors

Key Topics:

 Measuring the Economic Climate

 Key Interest Rates and Stock Classification

 Monetary and Fiscal Policy

 International Activities and Fundamental Tools

 CHAPTER 19 – ECONOMIC FACTORS

This chapter will examine several widely accepted measurements of economic conditions and how the
economy impacts the decision making process of both issuers and investors. Consideration will be given to
how economic factors influence market participants, including the level of interest rates, the outlook for
inflation, relative currency valuations, and the perceived direction of the economy. The chapter will also
briefly examine some basic financial statements that are used by investors to judge the underlying health of a
corporate issuer. The format and contents of these statement s are established by the provisions of the
Securities Act of 1934.

Economics
The performance of an investment is influenced by the performance of the economy. An impending
recession may reduce demand for equity securities, while the effects of inflation or deflation may
interfere with anticipated returns across many asset classes. The fear of rising interest rates (and
falling bond prices) may cause fixed-income investors to shorten their maturities. Currency instability
may cause investors to rebalance the global exposure of their portfolios. Essentially, when formulating
an overall investment strategy, numerous economic factors must be considered.

Measuring National Output

Economists typically attempt to measure the relative economic health of a given country. Two of
the most significant measures of U.S. economic activity are the Gross National Product and Gross
Domestic Product.

Gross National Product (GNP) GNP measures the total value of all of the goods and services that
are produced by a national economy. For the U.S., GNP includes the goods and services being
produced overseas by a U.S. company.

Gross Domestic Product (GDP) GDP has replaced GNP as the most important measure of output
and spending within the U.S. The reason for its importance is that GDP includes the output of all of
the goods and services that are produced by labor and property located in the U.S., without regard
to the origin of the producer. For example, in the U.S., GDP includes a Toyota plant in Columbus,
Ohio. Components of GDP include consumer spending, investments, government spending, and
net exports. The most useful variation of GDP is real GDP. Real GDP is adjusted for inflation using
constant dollars and is considered the key measure of aggregate economic activity. Rising GDP
signifies economic growth and potential inflation.

Inflation
Inflation is defined by a persistent and appreciable rise in the general level of prices. Inflation occurs
when the demand for goods and services in the market increases at a faster rate than the supply of
these items. In other words, inflation is when there is too much money chasing too few goods.

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Consumer Price Index (CPI) The Consumer Price Index is widely considered to be the most
important measure of inflation. CPI measures the prices of a fixed basket of goods that are bought by
typical consumers. If the prices of these goods are rising, then the economy is experiencing inflation.

Inflationary periods are typically characterized by rising interest rates. Along with bonds, interest-
rate-sensitive stocks, such as those issued by utilities and financial service companies, also have
significant reactions to changes in interest rates. Since utility companies are highly leveraged, it
becomes more expensive for these companies to raise money when interest rates increase.
Increasing interest charges cause a drain on earnings, which results in a decline in the prices of
these securities.

Equities as an Inflation Hedge historically, equity securities or other related products, such as
equity mutual funds, equity ETFs, and variable annuities, have provided the best protection against
inflation. Securities which provide payments that are set at the time of issuance and remain
unchanged regardless of the inflation rate are most susceptible to inflation risk (also referred to as
purchasing-power risk).

Commodities as an Inflation Hedge Commodities, such as gold and silver, tend to perform well
during inflationary periods. Customers are able to gain exposure to these asset classes through
direct investments in the commodities or through futures or derivative products, such as mutual
funds and ETFs.

Fixed-Income Investors Fear Inflation In comparison to equities, fixed-income securities are

more vulnerable to inflation. Inflation actually represents a dual risk for bondholders—(1) rising
interest rates will cause the market prices of their holdings to fall, and (2) the purchasing power of their
interest payments will decrease. If higher rates are anticipated, bond investors will make
adjustments to shorten their maturities (i.e., decrease portfolio duration) in order to minimize the
effect of downward pricing pressure. Some bondholders may also attempt to protect their portfolios
by purchasing inflation-indexed bonds, such as Treasury Inflation Protected Securities (TIPS).

Real Interest Rate The real interest rate is the rate of interest that a bond investor expects to
receive after allowing for the decline in his purchasing power due to inflation. The formula for
computing the real rate is the bond’s yield minus the inflation rate. For example, if an investor buys
a 5% bond while the rate of inflation is 2%, he expects to earn a real interest rate of 3%. This is one
of the reasons why bond investors demand higher returns during an inflationary period. Essentially,
they are factoring in the decline of the purchasing power of their future payments.

Yield – Inflation Rate = Real Interest Rate

Deflation
Deflation is characterized by a persistent and appreciable decline in the general level of prices.
Deflation may be caused by the supply of goods and services exceeding the demand for those items,
resulting in producers lowering their prices to compete for the limited demand.

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Deflation should not be confused with disinflation. Again, deflation is a drop in prices, while
disinflation is a reduction in the rate of inflation.

Measurements of Economic Activity

The following table summarizes some of the more common measurements of economic activity
that students may encounter on the SIE Exam:

Economic Terms
Measurement of the output of goods and services that are produced
Gross Domestic within the U.S. (disregards the origin of the producer)
Product (GDP)  A key measure of aggregate economic activity

Consumer Price Measures the change in the prices of goods purchased by typical consumers
Index (CPI)  A key measure of inflation

Too much money chasing too few goods

Inflation  Leads to a rise in the prices of goods and services
 High inflation usually accompanies high interest rates
A general decline in prices, often caused by a reduction in the supply of
Deflation money or credit
 Interest rates trend downward

Note: In many cases throughout the regulatory examination, an acronym (e.g., GDP, CPI) may be
used in place of the full name.

The Business Cycle

Over time, a pattern has emerged of the economic ebb and flow and it’s the business cycle that
represents this repetitive succession of changes in economic activity. The business cycle has four
phases—expansion (recovery), peak, contraction (recession), and trough.

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Expansion In the expansion phase, business activity is growing, production and demand are
increasing, and employment is expanding. At this point, businesses and consumers normally
borrow money to expand, which causes interest rates to rise.

Peak As the cycle moves into the peak, demand for goods begins to overtake supply. Since
consumers have a large amount of available funds to use for pursuing a limited amount of goods,
prices begin to rise, thereby creating inflation. With the increasing cost of products, the consumer’s
purchasing power is reduced.

Contraction As prices rise, demand diminishes and economic activity begins to decrease. At this
point, the cycle then enters the contraction (recession) phase. As business activity contracts,
employers lay off workers and unemployment increases. This usually causes the rate at which
prices are rising (inflation) to decline (disinflation). In real terms, the situation in which prices are
falling is referred to as deflation.

Trough The cycle finally enters the trough at the bottom of the economy’s decline. Lower prices will
eventually stimulate demand and cause the economy to move into a renewed period of expansion that
is referred to as a recovery.

At times, the economic decline may be pronounced. By definition, a recession occurs when Real GDP
declines for two successive quarters (six months). On the other hand, a depression occurs when
Real GDP declines for a more prolonged period.

Business Cycle Indicators

Although the economy tends to follow a general pattern, it is often difficult to determine the actual
direction at any given time. Economists use three types of indicators that provide monthly data on
the movement of the economy as the business cycle enters its different phases. The three economic
indicators are leading, coincident, and lagging. Although there are different definitions of these
terms, this manual uses the most well-recognized version from The Conference Board—a global,
independent research association.

Leading Economic Indicators Leading economic indicators precede the upward and downward
movements of the business cycle and may also be used to predict the near-term activity of the
economy. The government index of 10 leading economic indicators is released monthly. The
components of the index include:
 Average weekly hours, manufacturing
 Average weekly initial claims for unemployment insurance
 Manufacturing new orders, consumer goods and materials
 ISM Index of New Orders (this reflects the level of new orders from customers)
 Manufacturers’ new orders, non-defense capital goods excluding aircraft orders
 Building permits, private housing units

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 The prices for the S&P 500 Index common stocks

 Leading Credit Index (This index consist of six financial indicators based on various yields)
 Interest-rate spreads, 10-year Treasury bonds less federal funds
 Average consumer expectations for business conditions

Coincident Economic Indicators Coincident indicators usually mirror the movements of the business
cycle. The composition of the coincident economic indicators includes the following four components:
 Employees on non-agricultural payrolls
 Personal income less transfer payments (Transfer payments represent aid for individuals in the
form of Medicare, Social Security, and veterans’ benefits, etc.)
 The Index of Industrial Production
 Manufacturing and trade sales

Lagging Economic Indicators The index of lagging indicators represents items that change after
the economy has moved through a given stage of the business cycle. The index of lagging indicators
should confirm the economic condition portrayed by previous leading and coincident indexes.
Lagging indicators include the following components:
 Average duration of unemployment
 Ratio of manufacturing and trade inventories to sales
 Change in labor cost per unit of output for manufactured goods
 The average prime rate charged by banks
 Commercial and industrial loans outstanding
 Ratio of consumer installment credit to personal income
 Change in the Consumer Price Index for services

The Effect of the Business Cycle on Securities Markets

As the economy moves through the different phases of the business cycle, the bond and equity markets
react to these changes. Naturally, investors view these changes and take corresponding actions in
an attempt to take advantage of changes in the economy.

Interest-Rate Changes The level and direction of interest rates will influence numerous
investments and may indicate inflationary trends. Therefore, interest rates and the effects of
inflation will be important factors for investors to consider when choosing their investments.

Since bond investors are concerned with the possibility of inflation eroding the purchasing
power of their interest and principal payments, it’s important that they earn a rate of return
that out-performs the rate of inflation. For this reason, an investor may choose to calculate
the real interest rate on his investment.

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Numerous interest rates are published each day in The Wall Street Journal. Some of the most
important rates include:
 Prime Rate The prime rate is what commercial banks charge their best corporate clients.
 Discount Rate The discount rate is what the depository institutions are charged when they
borrows from the Federal Reserve.
 Federal Funds Rate The fed funds rate is what is charged on an overnight loan of reserves
between member banks.
 Call Rate The call rate is what commercial banks charge on collateralized loans to broker-
dealers (for margin purposes).

From lowest to highest, the usual order of these rates is—the fed funds rate, the discount rate, the
call rate, and the prime rate.

Classifications of Common Stocks

Market professionals classify common stocks into various categories that are based on how they
perform during various economic conditions, their market capitalization, as well as their potential for
short-term or long-term capital gains. Although basic descriptions for many of these classifications
were given in Chapter 3, this section will provide more detailed information on them.

Cyclical Stocks The performance of cyclical stocks is often parallel to the changes in the economy.
If the economy is in a period of prosperity, these companies prosper; however, as the economy
falters, cyclical stocks decline. The common stock of a machine tool company is an example of a
cyclical stock. As the economy expands, new orders for machinery increase and the stocks of
machine tool companies perform well. Other examples of cyclical stocks include basic industries
(e.g., rubber, steel, and cement), construction firms, transportation, automotive, and energy
companies, as well as homebuilders and manufacturers of durable goods.

Defensive Stocks The stocks of defensive companies have a smaller reaction to changes in the
business cycle than cyclical stocks. Examples of defensive companies include utility, tobacco,
alcohol, cosmetic, pharmaceutical, and food companies. Since people need basic services to exist,
these companies are the last to be negatively affected as the economy moves through difficult
periods. Generally, the demand for the products/services that are provided by defensive companies
is not diminished by a downturn in the economy.

Growth Stocks Growth stocks are related to companies whose sales and earnings are growing
at a faster rate than the overall economy. These companies often reinvest most of their earnings
in order to keep expanding and therefore pay little or no dividends to their shareholders. On
average, these stocks are riskier than other stocks, but also offer greater potential for capital
appreciation. For investors with an objective of capital appreciation, rather than current
income, these stocks are an appropriate long-term investment.

From an analytical point of view, growth stocks have high price-to-earnings (P/E) ratios and low
dividend payout ratios. To calculate the P/E ratio, the stock’s current market price is divided by
its earnings per share.

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For example, if ABC is trading at $180 per share and its earnings are $10 per share, then its P/E
ratio is 18. To calculate the dividend payout ratio, the dividends per share being paid to
shareholders is divided by the earnings per share. Therefore, if ABC paid a $2.00 dividend, its
dividend payout ratio is 20% ($2/$10).

Value Stocks A value stock is one that tends to trade at a lower price relative to the issuing
company’s fundamentals (i.e., dividend yield, earnings per share, sales, price-to-earnings ratio, market
price-to-book value) and is therefore considered undervalued by a value investor. These companies
tend to have high dividend yields, low price-to-book ratios, and/or low price-to-earnings ratios.

The risk of purchasing a value stock is that there may be a valid reason as to why it’s undervalued
and why investors keep ignoring this security, which results in a price that does not rise. A term
used to describe value investors is contrarian, since they purchase stocks which are not popular
with other investors.

Market Capitalization Another method of categorizing a stock is according to the total value of the
issuing company’s outstanding common shares, which is also referred to as its market capitalization.
To calculate a company’s market capitalization, its total number of outstanding common shares is
multiplied by its current price. For example, if XYZ Co. has 10,000,000 shares of outstanding common
stock and the shares are selling for $25 per share, XYZ’s market capitalization is $250,000,000
(10,000,000 x $25).

A company’s outstanding shares include shares that are held by institutions, retail investors, as well
as the restricted shares held by insiders, but does not include treasury shares (i.e., shares that have been
repurchased by the company). Remember, a company’s outstanding shares are found by subtracting
the number of treasury shares from the number of shares that the company has issued.

The following table lists the main categories and their commonly applied capitalization values:

Category Market Capitalization

Large-capitalization (large-cap) stocks More than $10 billion
Middle-capitalization (mid-cap) stocks Between $2 billion and $10 billion
Small-capitalization (small-cap) stocks Between $300 million and $2 billion
Micro-capitalization (micro-cap) stocks Between $50 million and $300 million
Nano-capitalization (nano-cap) Below $50 million

The boundaries between the categories are neither officially defined, nor clear-cut. Over time, a
stock’s category can change as its market value rises and falls.

Small-cap stocks are generally the equities of newer, less-established companies, while more well-
established issuers typically have mid-cap or large-cap valuations. Small-caps tend to be more
volatile than large- or mid-cap stocks, but also often include companies that are growing faster and
have more potential for capital appreciation.

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The micro-cap category includes companies with very small capitalization ($50 million to $300
million). These companies typically have a low price-per-share and are extremely volatile and risky.
Lastly, the newest unofficial category is nano-cap. These stocks are of companies with capitalizations
of less than $50 million. Nano-caps have a low price-per-share and are extremely volatile and risky.

Influencing the Economy – Monetary and Fiscal Policy

There are many theories as to why the economy moves in a cyclical fashion and what may be done to
control that cycle. Let’s review two of the more popular economic theories—Keynesian and Monetary.

Keynesian Theory
Keynesian economic theory states that government intervention in the economy is necessary for
sustained economic growth and stability. As introduced by British economist John Maynard
Keynes, this theory further states that the government should use fiscal policies (i.e., tax and spend
programs) to combat the effects of inflation and deflation, as well as to influence economic activity.

Fiscal Policy Fiscal policy involves the government’s use of taxation and expenditure programs to
maintain a stable, growing economy. For example, if the economy is in a recession or trough, the
government may increase its spending to stimulate demand. Alternatively, it may cut taxes to
increase the disposable income of consumers. These actions would (indirectly) stimulate demand. On
the other hand, if the economy is overheated (i.e., exhibiting too much demand), the government
may cut its spending or increase taxes.

Fiscal policy is set by the President and Congress; therefore, some decisions may be based on
political motives, rather than those that are purely economic. However, the primary focus of fiscal
policy is on economic growth and high employment. Conversely, monetary policy is controlled by
the Federal Reserve, a body that is theoretically independent of the political process.

Monetary Theory
Monetary policy attempts to control the supply of money and credit in the economy. The adjustments
will affect interest rates and cause an increase or decrease in economic activity. The Federal Reserve
System implements monetary policy in the U.S. and primarily focuses on controlling inflation.

Easing or Tightening of Money The method that the FRB uses to accomplish its goals is to ease
or tighten money supply. When implemented by the FRB, an easy money policy involves increasing
the money supply and lowering of rates, both of which should eventually stimulate the economy.
On the other hand, when adopting a tight money policy, the FRB reduces the money supply and
raises rates, both of which should diminish economic activity and control inflation.

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Yield Curves During periods of easy money when interest rates are declining, yields on short-term
debt securities will be lower than those on long-term debt securities. Yield curves will tend to slope
upward from the shorter to the longer maturities, as illustrated by the normal yield curve diagram
shown below. On the other hand, during periods of tight money, the yield curve may invert. This
means that short-term interest rates will be higher than long-term rates. As illustrated by the
inverted yield curve diagram shown below.

Normal, Upward Sloping Inverted, Downward Sloping

Money Supply Money is the unit of value by which goods and services are measured and is the
medium of exchange through which business is transacted. The Federal Reserve Board attempts to
control the money supply and credit to maintain a stable, growing economy with the aim of
combating inflation.

However, before getting into specifics, let’s define several measures of money supply:

Definitions of the Money Supply

Currency in circulation
M1 + demand deposits
+ other checkable deposits
M1
+ money market deposit accounts (MMDAs)
M2 + savings and relatively small time deposits
+ balances at money funds
+ overnight repurchase agreements at banks

Shifts in economic conditions will influence the FRB’s focus on the money supply figures. Each
week the FRB compiles and publishes figures on the size of the money supply according to the M1
measure. On a monthly basis, the FRB publishes figures on M2.

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Tools of the Federal Reserve Board

In an effort to implement its monetary policy, the FRB has the following tools at its disposal:
 Setting reserve requirements
 Setting the discount rate
 Implementing open market operations
 Setting margin requirements
 Using moral suasion

Reserve Requirements
Member banks are required to keep a portion of their deposits on reserve with the FRB. By adjusting
the amount that banks must keep on reserve, the FRB is able to either tighten or ease the money
supply. If reserve requirements are lowered, the banks are able to extend more credit, which causes the
money supply to increase and interest rates to fall. The opposite effect occurs if there is an increase in
reserve requirements.

After meeting its reserve requirement, a bank will seek to lend the remaining funds to borrowers.
The amount of funds that a bank has above the reserve requirement is referred to as its excess
reserves. The money spent by borrowers may eventually be deposited in another bank. This process
continues as money is deposited from one bank to another, thereby creating a multiplier effect on
deposits. In other words, the multiplier effect is the rate at which banks can create new money by
re-lending deposits and, in turn, creating new deposits.

Discount Window
The FRB was originally established to aid the banking system by acting as a banker’s banker in
emergency situations. The FRB always stands ready to lend money to its members and fulfills that
function through its discount window. As described earlier, the rate charged by the FRB for the
loans that are made to its members is referred to as the discount rate.

When members of the FRB borrow funds through the use of the discount window, new money is
injected into the system (which then is expanded by the multiplier effect). The FRB can encourage
or discourage borrowing from the FRB’s discount window by changing the rate of interest it charges
for those loans.

By decreasing the discount rate, the FRB encourages borrowing, which leads to the expansion of
money supply. Conversely, the money supply will contract with an increase in the discount rate. Any
change in the discount rate is usually seen as a very strong sign that monetary policy has shifted.

The discount rate is the only rate that is directly set by the FRB. Although it is largely symbolic, it
acts as a benchmark off of which other key interest rates are set, such as the fed funds rate.

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Federal Funds
Based on deposits, withdrawals, and loan demands, a bank may find itself with either an excess
reserve position or a deficit reserve position. If a bank has excess reserves, it may lend additional
funds to borrowers (e.g., commercial banks) that are in a deficit reserve position.

These short-term loans of excess reserves that banks lend to one another are referred to as federal
funds and the rate of interest charged on these loans is the federal funds rate.

The federal funds rate is determined by supply and demand. Since federal funds are used for short-
term (overnight) purposes, they are considered money-market instruments. Due to the short
duration of the loan, the fed funds rate is normally considered to be the most volatile interest rate.
The effective fed funds rate is published daily and shows the average rate that was charged the
previous night for federal funds.

Although the FRB does not directly set the fed funds rate, it does set a target or range. The FRB’s
open market operations are designed to maintain the fed funds rate within this prescribed target.

Open Market Operations

While the reserve requirements and the discount window involve very public moves on the part of
the FRB, open market operations may be implemented very quietly and without significant
disruption to the financial markets.

The Federal Open Market Committee (FOMC) oversees the FRB’s buying and selling of U.S. government
securities in the secondary markets. FOMC operations are the FRB’s most effective and frequently used
tool of monetary control. For the FRB, it is also the most flexible tool and the easiest to reverse.

Open market operations typically involve the purchase and sale of U.S. government securities—
primarily Treasury bills. However, the FRB also trades government notes and bonds. These trades
are executed through primary government dealers, which are the nation’s largest banks and
brokerage firms that have been appointed by the FRB.

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Buying Securities By purchasing securities through its open market operations, the FRB is
injecting money into the banking system in order to stimulate investment and business activity.
When the FRB buys securities, it pays for these securities with funds that are subsequently deposited
in commercial banks. This action causes deposits at banks to increase, reserves to increase, and adds
to the funds that are available for loans. At this point, money becomes more available and interest
rates tend to move downward. This is referred to as an easing of the money supply. Since buying
securities increases the money supply, this action may lead to inflation.

Selling Securities If the FRB wishes to tighten (reduce) the money supply, it will sell securities to
banks and securities dealers. The banks and dealers will pay for these securities by withdrawing the
money from their demand (checking) accounts. The withdrawal of money from the banks will decrease
the amount of money available for loans and will have a tightening effect on the money supply, causing
interest rates to rise. Since selling securities reduces the money supply, this action may curb inflation.

Repurchase Agreements A repurchase agreement (also referred to as a repo) is a contract that is

entered into by the Federal Reserve to purchase U.S. government securities at a fixed price from
dealers with provisions for their resale back to the dealer at the same price plus a negotiated rate of
interest. When the FRB executes a repo, it is lending money and, therefore, increasing bank reserves
(an easing of the money supply).

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A reverse repo (also referred to as a matched sale) occurs when the FRB sells securities to dealers
with the intention of buying the securities back at a future date. This has the short-term effect of
absorbing funds from the money supply (a tightening of the money supply).

Margin Requirements
The Securities Exchange Act of 1934 provided the Federal Reserve Board with the power to
determine the amount of credit that may be extended to purchase securities. The provisions are
established under Regulation T and apply to brokerage firms, while the provisions of Regulation U
apply to banks and all other lenders.

By increasing margin requirements, the FRB reduces the amount of money that brokers and banks
may lend, causing the money supply to tighten. Changing the margin requirement is the least
effective method the FRB has to control credit since it affects only securities market transactions.

Moral Suasion
There are times when the FRB attempts to influence bank lending policies through moral suasion
(i.e., jawboning). The FRB exerts its influence through the public media or through the examiners
who are sent to member banks. Its efforts to control the money supply by these means are limited by
the extent to which they are able to elicit cooperation from these institutions.

Effects of the FRB’s Activities

As with any product, when the supply increases, the price of that product will decrease. Conversely,
if the supply contracts, the price will increase. The price of money is the interest rate that lenders
charge borrowers; therefore, as the FRB changes the supply of money, the price of money (interest
rates) must also change. As interest rates change, the FRB will adjust its monetary policy in order to
influence the various sectors of the economy.

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To summarize, the Federal Reserve Board’s activities tend to cause the following adjustments to the
money supply and interest-rate levels:

Effect on Money Supply and Impact on General

Activity
Credit (Loan) Availability Interest Rate Levels

Increase bank reserve requirements Decrease (Tightening) Increase

Increase the discount rate Decrease (Tightening) Increase

Increase margin requirements Decrease (Tightening) Increase

Sell government securities in the

Decrease (Tightening) Increase
open market

Decrease bank reserve requirements Increase (Easing) Decrease

Decrease the discount rate Increase (Easing) Decrease

Decrease margin requirements Increase (Easing) Decrease

Buy government securities in the

Increase (Easing) Decrease
open market

Any method or tool that creates additional money for the banking system is potentially inflationary.
On the other hand, any tool or method that shrinks the amount of money available to the banking
system is potentially deflationary. The FRB will use each of its tools to influence inflation and
deflation.

Comparison of Keynesian and Monetary Policy

Keynesian Monetarist

Principally Attempts to Influence Taxes and Expenditures Money Supply

Responsible for Implementation Congress Federal Reserve Board

International Economic Factors

Exchange Rates
Changes in interest rates affect not only the domestic economy, but also international economic
activity. If interest rates in the U.S. are higher than interest rates overseas, foreign investors who
want to earn the higher rate may need to invest in the U.S. However, in order to invest in the U.S.,
foreign investors must first convert their funds into dollars.

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If an investor intends to immediately exchange currencies (e.g., British Pounds for U.S. dollars), the
conversion is based on the spot rate. The spot rate is the current value of a currency (or other asset).
The name spot rate is derived from the fact that it’s the price a person can get “on the spot.”

As demand for dollars increases, the price of dollars (the exchange rate) will increase. Therefore,
when U.S. interest rates are higher than foreign rates, it may lead to a stronger dollar. Conversely, a
decline in U.S. interest rates will likely cause a weakening of the dollar.

Balance of Payments
Foreign exchange rates also have an impact on foreign trade. If a county’s exports (the goods sent
overseas) exceed its imports (the goods received from overseas), the country is considered to have a
trade surplus. Conversely, if imports exceed exports, a country is operating under a trade deficit. To
correct a trade deficit, the dollar should weaken, which will cause U.S. goods to become cheaper
(more competitive) abroad and foreign goods to become more expensive in the United States. This
leads to more U.S. exports and fewer U.S. imports, which should help to alleviate the trade
imbalance. Essentially, U.S. importers (and consumers) prefer a strong dollar, while U.S. exporters
(producers) prefer a weak dollar.

Financial Statements
While there is no doubt that the level of overall economic activity is an important factor to consider
when making investment decisions, fundamental analysis is much more specific. This discipline
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 affect the prospects for a given company.

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 term balance sheet is used since the total assets must
always equal the total liabilities plus the stockholders’ equity. Therefore, the basic formula is:

Assets = Liabilities + Stockholders’ Equity (Net Worth)

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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

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).

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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 can 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.

Fixed Assets Fixed assets are items that are used by the company in its day-to-day operations to
create its products. This section includes the company’s physical property, such as land, buildings,
equipment, and furniture.

Intangible Assets Although intangible assets do not 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 and represents the amount that was paid above the fair market value to
acquire an asset (or 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.

Long-term Liabilities Long-term liabilities are debts that are incurred by a corporation which
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. Capital surplus, or paid-in capital, is the amount of
premium above the par value that is paid by investors who purchase the shares from the issuing
corporation.

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The Income Statement

The other significant financial document used in fundamental analysis is the income statement—also
referred to as the profit and loss statement. The income statement shows a company’s financial
performance during a specified period and provides detailed information about the company’s
revenues and expenses. If revenues exceed expenses, the difference represents the company’s net
income. However, if expenses exceed revenues, the result for the company is a net loss.

National Corporation Income Statement

For period ending December 31, 20XX
Sales $660,000
Less:
Operating Expenses:
Cost of Goods Sold 240,000
Selling and Administrative Expenses 120,000
300,000
Less:
Depreciation Expense 80,000
Operating Income 220,000
Plus:
Other Income 30,000
Earnings Before Interest and Taxes 250,000
Less:
Bond Interest Expense 27,000
Earnings Before Tax 223,000
Less:
Taxes (21% Rate) 46,830

Net Income or (Loss) $176,170

Components of the Income Statement

Sales (revenues) represent the total money received and the amounts billed (although not yet
collected) from the company’s primary source of business. Sales are reduced by day-to-day
operating expenses to arrive at operating income. Operating expenses reflect the daily costs of
doing business and include the amount claimed for the depreciation of fixed assets.

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Operating income is adjusted for other forms of income (or expenses) that are not generated by
normal operations, leaving earnings before interest expense and taxes (EBIT). Other income usually
represents income generated by investments (dividends and interest). However, other income may
also reflect non-recurring or extraordinary items, such as earnings from the sale of assets or losses
incurred by discontinuing a part of the business.

To determine a company’s net income (or net loss), EBIT is first reduced by bond interest and then
by taxes. Many financial professionals use earnings before interest expense, taxes, depreciation,
and amortization (EBITDA) as a measure of a company’s cash flow. Although depreciation is
subtracted from income, it’s actually a non-cash expense because it’s based on the theoretical wear
and tear of assets (there’s no cash outlay).

Measuring Profitability The operating profit margin is used as a measurement of a corporation’s

profitability. The calculation for operating profit margin is net operating income divided by sales.
Another formula that requires the income statement is the bond coverage ratio, which is calculated
by dividing EBIT (or EBITDA) by the interest expense.

Conclusion
This concludes the chapter on economics. The final chapter of the study manual will examine
investment risks. As described in this chapter, some of these risks are due to broad economic
conditions, while others are specific to a given product.

Create a Chapter 19 Custom Exam

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exam.

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 CHAPTER 20

Investment Risks

Key Topics:

 Systematic Risks

 Unsystematic Risks

 Portfolio Strategies

 Hedging
 CHAPTER 20 – INVESTMENT RISKS

Investment risk can broadly be defined as the likelihood that an investor loses money. Some risks are
specific to a particular company, while others affect an entire asset class of securities. This chapter will
examine several different types of risk and explore ways that investors attempt to mitigate potential
investment losses.

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 first 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—diversifiable and non-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.

Beta – Measuring Non-Diversifiable Risk Avoiding diversifiable risk is as simple as constructing a

portfolio of relatively uncorrelated assets (those with movements that are unrelated); 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.

The amount of non-diversifiable risk associated with a particular portfolio or asset is measured as beta.
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 (typically considered the S&P 500 Index) is assigned a beta
value of 1.0. Stocks or portfolios with betas above 1.0 will have greater volatility than the market and
those with betas below 1.0 will have lower volatility than the market. Most market professionals use the
term beta when referring to the volatility of equity securities.

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Interest-Rate Risk As mentioned in Chapter 4, 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 at par ($1,000) due
to the fact 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.

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.

As stated previously, 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 or return is
an investment’s return minus the rate of inflation (as measured by the Consumer Price Index, or
CPI). For example, if an investment has an 8% return and CPI is 3%, the real rate of return is 5%.

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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.

Alpha As referenced earlier, beta measures how volatile an investment is relative to the market as
a whole. However, alpha measures the risk that is 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%).

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.

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.

Copyright © Securities Training Corporation. All Rights Reserved. SIE 20-3

CHAPTER 20 – INVESTMENT RISKS

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.

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 is 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
purchased 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. The ratings
companies that were described in Chapter 4 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.

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 CHAPTER 20 – INVESTMENT RISKS

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.

Attempting to Control Risk Through Diversification

Allocating assets into an optimal portfolio based on a client’s risk tolerance and investment objectives is
also referred to as strategic asset allocation. In theory, an optimal portfolio is the best mix of assets
based on the client’s goals and level of risk aversion. However, since various asset classes provide
differing rates of return over time, the original asset allocation will eventually drift from the initial
mix. For purposes of determining what’s best for a client, there are numerous thoughts regarding
any shift in asset allocation. This next section will examine different approaches for clients who
either do or don’t chose to make a portfolio correction.

Buy-and-Hold
Any investor who follows the buy-and-hold approach will not change her asset allocation. By not
restoring the original strategic asset allocation, transaction costs and tax consequences are
minimized since there is no selling or purchasing of assets. In addition, the portfolio retains any
assets that may be steadily appreciating.

However, one of the problems with the buy-and-hold approach is that, as the asset mix of the
portfolio drifts, its risk/reward characteristics are altered. In particular, its volatility—as measured
by the portfolio’s standard deviation—may become quite different from the original allocation. In
fact, the difference may be so significant that it’s no longer compatible with the client’s risk
tolerance.

Portfolio Rebalancing
Portfolio rebalancing involves a process of buying and selling assets on a periodic basis. Through
rebalancing, the original strategic asset allocation—and its risk/reward characteristics—may be
restored. With this approach, adjustments may be based on either time or value. If time is used as
the focus, portfolio rebalancing may be done based on a prearranged schedule (e.g., monthly,
quarterly, or annually). On the other hand, if adjustments are triggered by value change, the need to
rebalance is based on an asset class growing or shrinking beyond a set tolerance level from the
original allocation (e.g., ±10%).

More frequent rebalancing will keep a client’s portfolio closer to its strategic allocation. However,
more frequent rebalancing will result in higher transaction costs as some assets are sold and others
are purchased.

Both the buy-and-hold and systematic rebalancing approaches assume that markets are efficient.
Or, put another way, it’s impossible to time changes in asset balances to take advantage of market
movements. These passive approaches to asset allocation are in agreement with the market theory
which is referred to as the Efficient (Capital) Market Hypothesis.

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CHAPTER 20 – INVESTMENT RISKS

Indexing
Investors who subscribe to the efficient market hypothesis and believe that market timing is ineffective
usually favor buy-and-hold strategies and engage in market indexing. Indexing involves either
maintaining investments in companies that are part of major stock (or bond) indexes or investing in
index funds directly. Some of the indexes on which funds may be based include the DJIA, the S&P
500, the S&P 400, or the Russell 2000. An actively managed fund attempts to outperform a relevant
index through superior stock-picking techniques; however, the composition of an index changes
infrequently. On average, an index fund manager makes fewer trades than an active fund manager.
The result of indexing is that there are lower trading expenses than actively managed investments
and fewer tax liabilities to be passed on to shareholders.

Active Strategies
Investors who believe securities markets are not perfectly efficient may utilize an active strategy
(e.g., market timing) to alter their portfolio’s asset mix in order to take advantage of anticipated
economic events. This market timing approach is often referred to as tactical asset allocation.
An investor’s portfolio currently has an asset mix of 35% large-cap, 15% mid-cap and 10%
small-cap equity index funds, 30% bonds, and 10% money-markets. If the investor is
employing an active asset allocation approach and believes that small-cap stocks will
outperform the market as a whole, what action could he take?
The investor could increase the small-cap stock allocation from 10% to 15% and reduce the
mid-cap stock allocation. If the small-cap sector appreciates as predicted, the investor could
then sell out of the small-cap asset class and reallocate into a different asset class. Essentially,
the investor is trying to identify and buy into sectors that will outperform the market.

Sector Rotation
Sector rotation is an investment strategy that involves moving money from one industry or sector to
another in an attempt to beat the market. Since not all sectors of the economy perform well at the
same time, this method of asset allocation may allow investors to profit as the economy moves from
one cycle to another.

The business (economic) cycle follows a certain pattern—early recession, full recession, early recovery,
and full recovery. Although the length and severity of any of these stages may vary, this is the general
pattern. Certain sectors of the economy tend to do better than others during different stages in the
business cycle. For example, during the early part of a recession, utilities tend to perform well, while
airlines tend to do badly since people have less discretionary income to spend on travel.

A portfolio manager who employs a sector rotation strategy will try to anticipate the next turn in the
business cycle and shift assets to the sectors that will derive the most benefit. Therefore, if the manager
believes that a recession is near its end and the economy is entering the recovery period, she would
begin shifting funds to the sectors that would profit the most from the change, such as companies
that make durable consumer goods (e.g., automobiles, appliances, etc.).

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 CHAPTER 20 – INVESTMENT RISKS

Dollar Cost Averaging

Once the selection has been made regarding the best assets to purchase, investors may choose to
use a systematic approach to investing. With dollar cost averaging, a person invests a fixed-dollar
amount at regular intervals, regardless of the market price of the security. This fixed-dollar approach
may be used rather than trying to predict the best time to invest. An investor using dollar cost
averaging will be able to buy more shares when the price is low, but fewer shares when the price is
high. As a result, the investor’s average cost per share is lower than the average of the prices at
which the investor purchased the shares. This method of investing makes no attempt to time the
market; instead, investors buy regardless of whether the market is high, low, or somewhere in the
middle. This technique is designed to take the emotion out of the investment process and accepts
that markets are subject to erratic swings.

Hedging
Once assets are allocated into a client’s optimal portfolio, the client may ask, “Are there ways for me to
reduce risk?” For many, the answer is yes and it’s referred to as hedging. Hedging (protection) essentially
involves the client buying insurance to guard against the market moving against her.

Equity Options
If an investor has an existing stock position, an equity option can be purchased as an effective hedge. If
an investor has a long position in a stock, she could purchase a put option which provides protection
against a possible decline in the value of the stock. The reason that a put purchase is a hedge is that it
gives the investor the right to sell the stock at the option’s strike price if the stock declines in value.

On the other hand, if an investor has an existing short stock position, he may choose to purchase a call
option to protect against a potential increase in the value of the stock that was sold short. The reason that
a call purchase is a hedge is that it gives the investor the right to buy the stock at the option’s strike price
and to use the acquired stock to cover the short position.

Index Options
Equity options are effective tools for protecting single stock positions; however, there’s an easier
way to hedge a portfolio against risk? Let’s assume that an investor is worried about a market crash.
She could buy put options on a broad-based index, such as the S&P 500. If the value of the
underlying index decreases below the strike price, the intrinsic value of the options increases. In this
case, the investor has essentially purchased a blanket policy that covers her entire stock portfolio.
What if the investor has a more concentrated position? In this case, she could buy put options on a
narrow-based (specialized) index to adequately protect her position.

Currency Options
Currency options allow investors to take a position based on the value of a foreign currency as it
compares to the U.S. dollar. These contracts are U.S. dollar-settled, which means that there is no delivery
or receipt of a foreign currency if the option is exercised.

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CHAPTER 20 – INVESTMENT RISKS

In the U.S., there are no calls or puts available on the U.S. dollar; instead, investors take option positions
on a foreign currency with the U.S. dollar on the other side of the contract. An investor’s gain or loss is
based on the inverse relationship between value of the foreign currency and the value of the U.S. dollar.

Let’s consider how a U.S. importer may use currency options for hedging purposes. For example,
ABC Importers is based in the U.S. and is buying goods from a company in France. ABC enters into a
contract in which it will acquire goods from the French company and must pay for the goods in
euros. ABC’s costs will rise if the value of the euros rise and the value of the U.S. dollar falls. As a
hedge, ABC Importers may buy euro calls since the options will become more valuable if the euro
does rise in value, which will offset the higher costs for the French goods.

Conclusion
This concludes the reading portion of the SIE Exam preparation. Students are encouraged to review
their notes and contact Securities Training Corporation with any conceptual questions prior to
moving on to the final examinations.

Best of luck in the next phase of your studies!

Create a Chapter 20 Custom Exam

Now that you’ve completed Chapter 20, log in to my.stcusa.com and create a 10-question custom
exam.

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Index
A Arbitration disclosures, 18-1
ARSs (auction rate securities), 5-11
ABS (asset-backed securities), 5-15 Asset allocation, 1-4, 8-10, 20-5–20-6
ACATS transfer, 16-14 original, 20-5
Active management, 9-1 original strategic, 20-5
Active strategies, 20-6 strategic, 20-5
Activities of non-registered persons, 17-1–17-2 tactical, 20-6
Anti-fraud provisions, 11-12 Asset allocation funds, 7-6
Actual return, 6-9 Asset-backed securities (ABS), 5-15
Additional disclosure, 7-3 Assets under management. See AUM
Adjusted cost basis, 6-3 Assignment of CUSIP numbers, 11-19
Administrators, 2-2 Associated persons, 2-2, 15-2, 15-11, 15-16, 16-
ADRs (American depositary receipts), 3-7, 20-4 2, 16-8, 16-11, 16-17–18-3, 18-5, 18-7, 18-
ADTV (average daily trading volume), 3-12 9–18-10
After-market prospectus delivery requirements, unregistered, 17-2
11-10 At-the-money, 10-4–10-5
Age-based suitability, 15-4 Attorney general, 17-8
Aggressive growth, 8-2 Auction process, 5-13
Aggressive growth funds, 7-5 single price, 5-4
Agreement by executing firms, 13-1 Auction rate bonds, 5-11
All-or-none, 11-3 Auction rate securities (ARSs), 5-11
Alpha, 20-3 AUM (assets under management), 1-3, 7-4, 14-4
Alternative investments, 9-1–9-10 Authorized shares, 3-2
American depositary receipts. See ADRs Availability of breakpoints and rights of
American style exercise, 10-7 accumulation, 7-12
AML (anti-money laundering), 2-9, 14-13–15-1, Average consumer expectations, 19-5
15-5 Average daily trading volume (ADTV), 3-12
AML compliance programs, 15-1, 15-6–15-7
Amortization, 19-19 B
principal, 5-15
Annual shareholders meeting, 13-9 Back-end loads and contingent deferred sales
Annuitant, 8-1–8-8 charges, 7-8
Annuities, 6-11, 8-1–8-8, 14-8 Background check, 17-8
equity-indexed, 8-7 Balanced program, 9-9
fixed, 8-1–8-2, 20-2 Balance of payments, 19-15
non-qualified, 8-6 Balance sheet, 3-11, 11-7, 15-15, 19-15, 19-17
qualified, 8-6–8-7 corporation’s, 3-3, 4-9
sold, 8-8 sample, 19-16
straight-life, 8-5 Bank dealers, 2-11
tax-deferred, 8-6–8-7 Bankers’ acceptances, 5-17
Annuitization, 8-4 Bankruptcy, 1-2, 1-12, 2-6, 3-1–3-2, 3-9, 5-14, 5-
Annuitize, 8-2, 8-4–8-5 16, 18-1
Annuity units, 8-4–8-5 Bank Secrecy Act (BSA), 15-5
Anti-Intimidation/Coordination Interpretation, BANs (Bond Anticipation Notes), 5-10, 18-10
16-5 Basic bond characteristics, 4-1
Anti-money laundering Basis, 2-11, 6-5–6-6, 7-4, 8-1, 9-2, 15-6, 17-6
. See AML after-tax, 8-1, 8-11, 14-4
regarding, 15-1 annual, 7-13, 14-8
Appeal process, 2-10 bank-to-bank, 5-18
Arbitrage, 1-10 continuous, 11-4
Arbitration, 2-10, 18-2, 18-4–18-5 daily, 5-18, 9-3, 15-14
customer-initiated, 18-4 disclosed, 1-9
regarding, 18-2 face-to-face, 1-6
Arbitration awards, 18-2 firm-commitment, 5-13, 11-3, 11-17
final, 18-3 for-cash, 13-2

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 interstate, 2-1 Books and records, 3-3, 15-16, 16-17
monthly, 5-6, 19-9 Bounties, 16-10
omnibus, 1-9 Branch offices, 15-6, 18-7
ongoing, 7-3 brokerage firm’s, 15-6
periodic, 20-5 Breakpoint sales, 7-14
per-share, 6-1 BrokerCheck, 18-3–18-4
pre-tax, 8-2, 8-6, 14-11 BSA (Bank Secrecy Act), 15-5
proportionate, 2-6, 12-3 Business Continuity Plan (BCP), 15-1, 15-15–15-
quarterly, 7-9, 7-13, 15-14, 18-6 16
reasonable, 15-3–15-5, 16-14 Business development companies, 1-5, 11-14
regular, 16-4 private, 1-5, 11-12
regular-way, 13-1 Buy-and-hold approach, 20-5
tax-deferred, 8-1, 8-7–8-8, 8-10, 14-4, 14-8,
14-13 C
tax-free, 14-4
uncovered, 12-1 Calendar days, 7-13, 18-2, 18-5
Basis points, 6-6 Call options, 10-2–10-5, 12-5, 13-7, 20-7
BCP. See Business Continuity Plan Call protection, 4-7
Bearer form, 13-8 Call provisions, 4-7–4-8, 5-13, 6-7
Bearish, 2-4, 10-2, 10-10, 12-1, 12-4, 12-7 catastrophe, 4-8
Beneficiary, 8-4–8-6, 8-9–8-12, 14-4, 14-6–14-9 Call rate, 19-6
designated, 8-5, 14-4 Calls
new, 8-11 catastrophe, 4-8
original, 8-10 covered, 10-10, 12-5
Best-efforts all-or-none, 11-3 euro, 20-8
Best-efforts mini-maxi, 11-3 lottery, 4-8
Best execution rule, 16-6 telemarketing, 15-13
Beta, 20-1, 20-3 uncovered, 10-10, 12-5
Bid, 1-3, 3-12, 5-3–5-4, 7-3, 11-17, 12-1, 12-5– Call UP and Put DOWN, 10-5
12-6, 16-4 Capital, 1-1, 3-2, 3-6–3-7, 3-9–3-10, 4-1, 5-14, 7-
best, 5-13 5–7-6, 9-3, 9-6–9-8, 11-1, 11-3, 19-6–19-7,
firm’s, 16-4 20-4–20-5
highest, 12-1, 12-5 additional, 3-1, 11-1
highest independent, 3-12 company’s, 11-3
regular, 1-3 investor’s, 5-14
submitting, 5-4, 5-13 loss of, 9-9, 20-4
Blotters, 15-16 paid-in, 19-17
Blue-chip stocks, 3-6 potential, 3-2, 9-8
Blue-Sky Rules, 17-9 program’s, 9-5
Board, 3-1, 6-1, 7-4, 7-15, 8-9–8-10, 14-9 raising, 1-6, 2-1, 3-1, 4-1, 9-3, 11-1–11-2
corporation’s, 6-2, 16-8 return of, 6-8
independent, 9-6 venture, 9-3
BOD, 3-1, 7-1 Capital events, 6-8, 8-1
mutual fund’s, 7-1 Capital gains, 4-10, 6-8, 7-2, 7-13, 8-2, 14-8
Bond Anticipation Notes (BANs), 5-10, 18-10 distributes, 7-5
Bond Buyer, 6-11 long-term, 19-6
Bond counsel, recognized, 11-17 unrealized, 6-8
Bondholders, 1-12, 3-1–3-2, 4-2–4-4, 4-7–4-10, Capitalization, 11-7, 11-10, 19-8
5-8, 5-14–5-15, 6-3–6-4, 6-7, 19-2, 20-4 Capital losses, 6-8, 8-2
corporation’s, 3-2 Capital preservation, 7-6, 15-4
existing, 20-2 Capital requirements, 1-3
inflation hurts, 20-2 Capital risk, 20-4
repay, 5-7 Capital structure, 3-2, 4-8, 11-2
secured, 5-14–5-15 Capital surplus, 19-16–19-17
Bonds, 1-1–1-2, 1-12, 3-1, 3-11–4-11, 5-3, 5-7–5- Cash account, 2-6, 14-1, 15-2, 16-4
16, 5-19–6-1, 6-3–6-9, 7-6–7-7, 7-15–7-16, Cash balances, 13-3
11-16–11-18, 15-15, 16-2, 20-2–20-4, 20-6 Cash dividends, 3-6, 5-11, 12-5
Book-entry form, 5-2, 5-4, 13-8 ordinary, 6-3

© Securities Training Corporation. All rights reserved. 2

 potential, 10-10 Confirmations, 1-3, 1-9–1-10, 4-8, 15-10–15-11,
quarterly, 6-2 16-16
Cash management bills. See CMBs client’s trade, 12-1–12-2
Cash settlement, 6-3, 10-1, 10-9, 13-2 final, 11-19
Cash transactions, 13-3, 15-5 Consumer Price Index. See CPI
Catastrophe, 15-15 direct, 17-2, 17-10, 18-6
CBOE (Chicago Board Options Exchange), 1-11, Contingent Deferred Sales Charges. See CDSCs
2-2, 2-11 Continuing education, 17-9–17-10
CDs (Certificates of Deposit), 5-11, 5-17–5-18 industry-mandated, 17-9
CDs Convertible bonds, 1-7, 4-8–4-10
brokered, 5-18 COP (Code of Procedure), 2-10
jumbo, 5-18 Corporate/Institutional accounts, 14-6
long-term, 5-18 Correspondence, 15-1, 15-11–15-12, 17-6, 18-5
traditional bank-issued, 5-18 Cost basis, 4-10, 6-3, 6-8, 13-6
CDSCs (Contingent Deferred Sales Charges), 7- investor’s, 6-8
8, 7-10, 8-7–8-8 new, 13-6
Censure, 2-10 total, 6-8
Central Registration Depository. See CRD zero, 8-7, 14-12
Certificates of Deposit. See CDs Coupon rate, 4-1–4-2, 5-2, 5-13, 6-4, 11-17, 20-2
CFTC, 17-7 bond’s, 4-1, 6-3
Chicago Board Options Exchange. See CBOE higher, 20-2
Chinese walls, 16-9 lower, 4-6, 6-4
Churning, 14-3, 16-3 relative, 4-6
CIP (Customer Identification Program), 2-9, 14- Coverdell Education Savings Account, 14-4
5, 15-7 CPI (Consumer Price Index), 5-2, 19-2–19-3, 20-
Clearing, 1-8, 1-10, 13-1, 17-5 2
Clearing and introducing firms, 1-8 CRD (Central Registration Depository), 17-6,
Clearing broker, 1-9 18-3–18-4, 18-6
CLNs (Construction Loan Notes), 5-11 Creditors, 1-1, 1-12, 3-1, 4-1, 5-14, 8-2, 14-7
Closed-end funds, 5-11, 7-1, 7-7, 7-15–7-16, 17- general, 2-6, 5-15, 9-7
3–17-4 unsecured, 3-2
Closed-end investment companies, 7-15 Credit ratings, 5-1, 11-19
CMBs (Cash Management Bills), 5-1, 5-3 Credit risk, 4-4, 5-1, 5-4, 5-15, 7-6, 20-4
Code of Arbitration, 2-10 higher-than-normal, 5-16
Code of Procedure. See COP CTRs (Currency Transaction Reports), 2-9
Coincident economic indicators, 19-5 Cumulative preferred stock, 3-7
Collateral trust, 5-15 Cumulative voting, 3-4
College savings plans, 8-9–8-11, 14-5, 14-12 Currency, 1-10, 2-11, 5-16, 10-1, 15-5, 19-9, 20-4
Commissions, 1-2–1-3, 2-1, 5-7–5-8, 7-15–7-16, counterfeit, 15-15
11-10, 12-1–12-2, 14-4, 14-8, 15-4, 15-10, foreign, 1-11, 3-7, 20-7–20-8
16-3, 16-16, 17-2, 18-5, 18-7–18-8 Currency options, 10-7, 20-7
applicable, 8-3 Currency risk, 20-4
charged, 14-4 Currency Transaction Reports (CTRs), 2-9
large, 15-4 Currency Transaction Reports, 15-5
Commodity Futures Trading Commission, 17-7 Current yield, 4-7, 6-3–6-7
Common shareholders, 3-3, 4-9, 6-1 CUSIP Numbers, 11-19, 13-4
Common stock, 1-10, 3-2, 3-6–3-7, 3-9–3-10, 4- Custodial accounts, 1-4, 14-7–14-8
8–4-10, 5-14, 6-1, 6-10, 11-1, 12-3, 19-5–19- Custodian, 1-12, 7-4, 14-7–14-8
6, 19-16 adult, 14-7
shares of, 3-9, 4-10 fund’s, 7-4
Competitive bids, 5-4 Custodian Bank, 7-4, 7-9
Complaints, 17-8, 18-3–18-6 Custody, 13-1
address consumer, 2-8 Customer Free Credit Balances, 15-14
municipal, 15-16 Customer Identification Program. See CIP
original customer, 18-5
written, 18-5 D
Confidentiality requirements, 15-8
Dated date, 4-2

© Securities Training Corporation. All rights reserved. 3

Day order, 12-6, 12-8 common, 3-8
DCA. See Dollar cost averaging corporation’s, 9-5
Death Benefits, 8-4, 8-6 high, 7-6, 19-7
associated, 8-4 higher, 7-6
contract’s, 8-5 lower, 7-6
Debentures, 5-15, 19-16 periodic, 6-1
subordinated, 5-15 preferred, 3-7
Debt service, 4-1, 5-7–5-10, 5-12, 11-16 quarterly, 6-3, 20-4
Default risk, 5-7, 20-4 stable, 9-5
Defined benefit plan, 14-12 unpaid, 3-8
Defined contribution plan, 14-12 DJIA (Dow Jones Industrial Average), 6-10, 9-1,
Deflation, 5-2, 19-1–19-3, 19-8, 19-14 20-6
Delivery, 1-9, 5-17, 7-3, 10-9, 11-9, 12-4–12-5, DMM (designated market maker), 1-6
13-2–13-4, 13-7, 15-9–15-11, 17-3, 17-9, 20- Dollar cost averaging (DCA), 7-13, 20-7
7 Double-barreled bonds, 5-10
broker-to-broker, 13-4 Dow Jones Industrial Average. See DJIA
good, 13-2, 13-4 DPPs (direct participation programs), 8-12–9-1,
paper securities, 13-3 9-4–9-5, 9-7, 9-9–9-10, 11-11, 16-10, 17-3–
received, 13-7 17-4, 18-8, 20-3
Department of Justice (DOJ), 2-1, 16-10 DRP (disclosure reporting page), 18-1
Department of Treasury, 2-1 DTC, 15-14
Depository Trust and Clearing Corporation. See DTCC (Depository Trust and Clearing
DTCC Corporation), 1-8, 1-11–1-12, 13-1, 13-3
Derivatives, 3-10, 9-2–9-3, 13-7, 16-3 Duration, 5-3, 20-2
financial, 9-2 bond’s, 20-2
Designated market maker (DMM), 1-6 decrease portfolio, 19-2
Directed orders, 1-7 short, 19-11
Direct participation programs. See DPPs
Direct Participation Programs Representative, E
17-3
Disciplinary actions, 2-10, 16-4 EBIT, 19-19
significant, 17-9 EBITDA, 19-19
Disciplinary information, 18-3 Education Savings Account (ESA), 14-4
Disclosure, 2-9, 3-11, 9-7, 12-3, 15-3, 15-6, 15-8, EIAs, 8-7
15-12, 15-16, 16-6–16-7, 18-1, 18-3 EICs (Equity-Indexed Contracts), 8-7
fair, 2-4 Electronic communication networks (ECNs), 1-
special, 10-1 7
written, 7-8, 11-1, 15-11 Electronic delivery of client records, 15-11
Disclosure documents, 5-13, 8-12, 10-9, 11-11, Electronic Municipal Market Access. See EMMA
11-18 EMMA (Electronic Municipal Market Access),
primary, 7-3 8-12, 11-18–11-19
signed, 2-7 Employee Retirement Income Security Act. See
written, 11-11 ERISA
Disclosure of control relationship, 3-11 Equipment trust certificates, 5-14
Disclosure of financial condition, 3-11, 15-15 Equity securities, 1-1, 1-6–1-7, 3-1–3-12, 16-7,
Disclosure of participation, 11-1 16-10, 19-1–19-2, 20-1–20-2
Discount rate, 2-2, 19-6, 19-10, 19-14 ERISA (Employee Retirement Income Security
Discount window, 19-10–19-11 Act), 2-7, 14-11
Discount yield, 5-3 ERISA accounts, 16-12
Discretionary accounts, 9-9, 14-2–14-3 ESA (Education Savings Account), 14-4
Discretionary order, 12-4, 14-2–14-3 ETFs (exchange-traded funds), 2-11, 6-11, 7-7,
Disqualification, 17-7, 18-2 9-1–9-2, 9-10, 19-2
Diversification, 7-1, 8-9, 9-6, 20-1–20-2, 20-5 ETFs
Dividends, 3-1–3-4, 3-7–3-8, 5-11, 5-14, 6-1–6-3, inverse and leveraged, 9-1–9-2
6-9, 7-4–7-5, 7-13, 9-4–9-5, 14-8, 14-11–14- leveraged long, 9-2
12, 19-6–19-7, 19-17, 19-19, 20-4 triple-long, 9-2
annual, 3-7, 6-1, 6-3, 6-9 triple-short, 9-2
annualized, 6-3 ETNs (Exchange-Traded Notes), 9-2, 9-10

© Securities Training Corporation. All rights reserved. 4

Eurobonds, 5-16 16-5, 16-12–16-14, 16-17–17-2, 17-5, 17-7,
Eurodollar bonds, 5-16 17-9–18-7, 18-9
Eurodollars, 5-16, 5-18 Firm element, 17-1, 17-9–17-10
European style exercise, 10-7 First-in, first-out (FIFO), 10-7–10-8
Exchange-traded funds. See ETFs FNMA (Federal National Mortgage
Exchange-traded notes. See ETNs Association), 5-5–5-6, 5-19
Ex-dividend date, 6-2–6-3, 7-7, 13-6 FOMC (Federal Open Market Committee), 19-
Exempt, 4-8, 5-1–5-2, 5-5, 5-7, 5-9, 5-12, 5-17, 11
11-12, 11-15–11-17, 12-4, 13-3, 16-1, 16-10, Form 1099-DIV, 7-2
17-9–17-10, 18-4 Form U4, 17-1, 17-6–17-8, 18-1, 18-3
Exercise, 3-10, 10-1–10-3, 10-7–10-8, 13-7, 15-7 amended, 18-4
Exploratory program, 9-9 complete, 17-6, 18-1
Expulsion, 2-10 person’s, 17-8
Form U5, 17-8, 18-2–18-3
F Form U6, 18-3
jurisdictions use, 18-3
Face-amount certificate company issues debt Forward splits, 13-5
certificates, 7-15 Fourth market, 1-7
FDIC (Federal Deposit Insurance Corporation), FRB (Federal Reserve Board), 2-1–2-2, 2-4, 2-11,
2-2, 2-11, 5-18 5-16, 13-2, 19-8–19-14
FDIC insurance, 5-18 Free writing prospectus (FWPs), 11-11
Federal Deposit Insurance Corporation. See FTC (Federal Trade Commission’s), 15-9, 15-13
FDIC Full POA, 14-3
Federal Farm Credit Banks. See FFCBs Fully disclosed accounts, 1-9
Federal Home Loan Banks. See FHLBs
Federal Home Loan Mortgage Corporation. See G
FHLMC
Federal Housing Administration (FHA), 5-6 G-37, 18-9
Federal Housing Administration, insured, 5-6 GANs (Grant Anticipation Notes), 5-11
Federal Land Banks, 5-5 GDP (Gross Domestic Product), 19-1, 19-3
Federal National Mortgage Association. See General obligation bonds, 5-7–5-8, 5-10, 5-12,
FNMA 11-16
Federal Open Market Committee (FOMC), 19- issuance of, 5-12, 11-16
11 General Securities Principal, 17-2, 17-4
Federal Reserve, 2-1, 5-18, 19-6, 19-8, 19-12 General Securities Registered Representative
Federal Reserve Board. See FRB Exam, 17-2
Federal Telephone Consumer Protection Act, 2- General Securities Representative, 17-1, 17-3
8, 15-12 revised, 17-1
Federal Trade Commission (FTC), 15-9, 15-13 General Securities Sales Supervisor, 17-4
Fee-based account, 14-4 Gift limit, 18-7
FFCBs (Federal Farm Credit Banks), 5-5, 5-19 Gifts, 14-7, 18-7–18-9
FHA (Federal Housing Administration), 5-6 commemorative, 18-8
FHLBs (Federal Home Loan Banks), 5-5, 5-19 congratulatory, 18-8
FHLMC (Federal Home Loan Mortgage initial, 8-10
Corporation), 5-5–5-6, 5-19 irrevocable, 14-7
Fidelity bonds, 15-15 personal, 18-8
Fiduciaries, 7-12, 9-7, 14-7, 16-11–16-12 promotional, 18-8
FIFO (first-in, first-out), 10-7–10-8 tax-free, 8-10
Financial Crimes Enforcement Network Ginnie Mae, 5-5–5-6
(FinCEN), 15-5 GNMA (Government National Mortgage
Financial exploitation of specified adults, 16-13 Association), 5-5–5-6, 5-19
Financial Industry Regulatory Authority. See GNP (Gross National Product), 19-1
FINRA Good delivery form, 13-4
FinCEN (Financial Crimes Enforcement Good delivery rules, 6-2
Network), 15-5 Government agencies, 1-1, 5-1, 5-5–5-6, 5-16, 9-
FINRA (Financial Industry Regulatory 8, 18-5
Authority), 2-2, 2-4, 2-10–2-12, 7-14, 11-6, federal, 2-1
12-2–12-3, 15-1–15-2, 15-11–15-16, 16-3– Government agency securities, 5-12, 11-12

© Securities Training Corporation. All rights reserved. 5

Government National Mortgage Association. Inflation, 5-2, 8-1, 14-13, 19-1–19-4, 19-8–19-9,
See GNMA 19-12, 20-2
Gramm-Leach-Bliley Act, 15-8 effects of, 6-9, 19-1, 19-5, 19-8
Grant Anticipation Notes (GANs), 5-11 potential, 19-1
Gross Domestic Product. See GDP purchasing, 19-2
Gross National Product (GNP), 19-1 rate of, 6-9, 19-2–19-3, 19-5, 20-2
Growth and income funds, 7-6 Inflation-Adjusted Return, 6-9
Growth funds, 7-5–7-6 Inflation risk, 8-7, 19-2
Growth stocks, 3-6, 7-6, 19-6 Information barriers, 16-3, 16-7, 16-9
GSEs (government-sponsored enterprises), 5- Initial public offering. See IPO
4–5-5 Initial public offering, 7-5, 11-1, 12-4, 16-10
GTC orders, 12-8 Insiders, 3-5, 11-13, 19-7
Guaranteed bonds, 5-16 Insider trading, 2-7, 2-11, 16-8, 16-10
Guardianship, 16-14 Insider Trading and Securities Fraud
Enforcement Act, 2-7, 2-9, 16-8
H Insider Trading Sanctions Act, 16-8
Institutional communications, 15-11–15-12
Health Care Revenue Bonds, 5-8 Institutional investors, 1-4–1-5, 7-10, 9-4, 11-1–
Hedge, 8-7, 9-2, 9-10, 10-6, 10-9, 20-7–20-8 11-2, 11-19, 15-11–15-12, 16-11
Hedge funds, 1-5, 1-10, 8-12–9-1, 9-3–9-4, 9-10, large, 1-7
11-14, 20-3 Institutional suitability obligations, 15-4
Holding of client mail, 15-10 Insurance, 4-8, 10-10, 14-9, 18-5, 20-7
Holding period, 3-5, 11-13 Insurance companies, 1-5–1-6, 8-1–8-4, 8-6, 11-
long, 8-1 1, 11-14, 15-1, 15-11, 16-11–16-12, 16-15,
mandatory, 3-5, 11-13 18-5
required, 3-5 issuing, 8-8
Housing Revenue Bonds, 5-8 Interactive electronic forums, 15-12
HUD (Housing and Urban Development), 5-6, Interest, 3-1–3-2, 4-1–4-4, 5-1–5-3, 5-5–5-8, 5-
9-8 10–5-11, 5-14–6-1, 6-3–6-4, 6-6, 6-8–6-9, 9-
4–9-6, 11-6–11-10, 16-10–16-13, 18-7, 19-
I 10–19-12, 19-17–19-19
accrued, 4-2, 4-7, 5-12, 5-16
IARs (investment adviser representatives), 1-2, annual, 4-7, 6-5
2-3, 7-2 bond’s, 4-2
IAs See investment advisers periodic, 4-2
Identity theft prevention, 15-9 undivided, 5-5, 7-15
IDR (Industrial Development Revenue), 5-9 Interest bearing bonds, 4-3
Inactive status, special, 17-10 Interest payments, 1-1, 1-12, 3-1, 4-1–4-3, 4-9,
Income bonds, 5-16 5-1, 5-3, 5-16, 7-4, 8-9, 9-2, 19-2, 20-2
Income funds, 7-6 bond’s, 6-5, 20-4
Income tax, 5-8, 14-11 bond’s semiannual, 6-6
federal, 5-9, 8-10 consistent, 6-3
personal, 9-5 guaranteed, 3-1
Index, 1-11, 6-10–6-11, 7-6, 8-7, 9-1–9-2, 10-1, periodic, 4-7
10-7, 10-9, 16-4, 16-17, 19-3–19-5, 20-1, 20- semiannual, 5-2
6–20-7 Interest-rate risk, 4-4, 5-15, 7-6, 20-2
broad-based, 20-7 Interest rates, 2-1, 2-11, 4-1–4-2, 4-4, 4-6, 4-8, 5-
coincident, 19-5 2, 5-5, 5-7, 5-11, 6-3–6-4, 19-1–19-2, 19-4–
reference, 9-2 19-6, 19-8–19-15, 20-1–20-5
specified, 9-2 bond’s, 4-2
underlying, 9-2, 20-7 changes in, 19-2, 19-14, 20-2
Index funds, 7-6, 20-6 current, 4-6, 6-4
small-cap equity, 20-6 declining, 4-7, 5-7
Indexing, 20-6 high, 19-3
Index options, 10-9, 20-7 key, 19-10
Individual Retirement Accounts. See IRAs lower, 4-6, 4-9, 6-4, 20-2
Industrial Development Revenue (IDR), 5-9 real, 6-9, 19-2, 19-5
rising, 19-1–19-2, 20-2

© Securities Training Corporation. All rights reserved. 6

 short-term, 5-18, 19-9
volatile, 19-11 Keynesian and Monetary policy, 19-14
International Securities Exchange (ISE), 1-11 Keynesian Theory, 19-8
Interpositioning, 16-6–16-7 Know-your-customer (KYC), 15-1
Inter vivos trusts, 14-7 KYC rules, 15-16
In-the-money, 10-1, 10-3–10-5, 10-9
Intrinsic value, 3-11, 10-3, 10-5, 20-7 L
negative, 10-5
points of, 10-5, 10-7 Large-capitalization, 19-7
positive, 10-5 Layering, 15-5
zero, 10-5 Legal opinion, 11-17–11-18
Introducing firms, 1-8–1-10 Legend, 3-5, 11-13, 13-2, 13-4–13-5, 15-11
Inverse ETFs, 9-1–9-2 restrictive, 3-5, 11-13, 13-4
Investment adviser representatives (IARs), 1-2, Legislative risk, 20-3
2-3, 7-2 Letter of Intent. See LOI
Investment advisers (IAs), 1-2–1-4, 1-10, 2-2–2- Level debt service, 4-3
3, 2-5, 7-1–7-2, 7-4, 7-15, 11-11, 14-7, 15-3, Level load, 7-10
15-10, 16-11 Leverage, 1-10, 9-3, 9-8
Investment Advisers Act, 2-4–2-5, 2-9, 7-2 Leveraged ETFs, 9-1–9-2
Investment bankers, 1-2, 1-6, 2-4, 5-13, 11-2, LGIPs (local government investment pools), 8-
11-16, 16-8 1, 8-9, 17-3
Investment companies, 1-10, 2-5, 7-1, 7-3, 7-7, Liabilities, 19-15–19-16
7-9, 7-15–7-16, 8-2–8-3, 9-1, 9-4, 16-7, 16- LIBOR (London Interbank Offered Rate), 5-18
11–16-12, 16-15, 18-5, 18-8–18-9 Liens, 5-14, 18-1
closed-end, 7-15 Life annuity, 8-5
common type of, 7-15, 9-1 last survivor, 8-5
involving, 18-7 unit refund, 8-5
non-diversified, 7-2 Life insurance, 8-2
open-end, 2-5 Lifetime records, 15-16
registered, 1-5, 11-14, 15-1, 15-11 Limited partner (LP), 9-3–9-9, 12-3, 17-3, 20-3
regulated, 9-4 Limited partnerships, 9-5–9-6, 9-8–9-9, 17-3,
single, 7-11 20-3
Investment Companies and Variable Contracts Limited POA, 14-3
Products Principal, 17-4 Limit Order Protection Rule, 16-7
Investment Companies and Variable Contracts Limit orders, 5-4, 12-1, 12-5–12-8
Products Representative, 17-3 Liquidity, 1-7, 5-5, 5-18, 7-2, 7-6, 8-8–8-9, 9-3–9-
Investment Company Act, 2-4–2-5, 2-9, 7-1, 7- 4, 9-9, 15-3–15-4, 20-3
3–7-4, 7-13, 7-16, 8-2, 9-3–9-4, 16-7, 16-12 Liquidity risk, 5-7, 20-3–20-4
Investment risks, 8-1, 8-3, 9-3, 15-4, 19-19–20-8 Local government investment pools. See LGIPs
IPO (initial public offering), 1-10, 3-5, 7-5, 11-1, Lock-up agreements, 3-5, 11-12
11-4, 11-9–11-10, 12-4, 16-10 LOI (Letter of Intent), 7-12, 7-14
IRAs (Individual Retirement Accounts), 1-4, 2-6, London Interbank Offered Rate (LIBOR), 5-18
8-1–8-2, 8-8, 14-8–14-10 Long-term gains, 6-8
IRS, 2-1, 6-3, 7-14, 8-4, 14-10, 14-12–14-13 Long-term liabilities, 19-16–19-17
IRS Code, 8-9, 16-12 LP. See limited partner
ISE (International Securities Exchange), 1-11
Issuer-Directed Securities, 16-12 M
ITSA, 16-8
ITSFEA, 16-8, 16-10 M&A, 1-2
Mail, 2-5, 8-11, 13-4, 15-10–15-11, 16-1
J customer’s, 15-11
registered, 13-4
Joint Tenancy, 14-5–14-6 Major Market Index, 6-11
Joint Tenancy with Right of Survivorship Maloney Act, 2-4, 2-9
(JTWROS), 14-5–14-6 Management companies, 7-1–7-2, 7-15
Joint Tenancy in Common (JTIC), 14-5 open-end, 7-1, 7-15
Management fee, 7-4, 7-9, 8-6, 9-3
K

© Securities Training Corporation. All rights reserved. 7

Margin, 1-10, 2-4, 3-5, 9-1, 12-4, 14-1, 14-6, 14- Municipal Fund Securities Limited Principal,
8, 15-4 17-5
open, 15-2 Municipality, 4-1, 4-4, 5-8–5-13, 8-9, 11-2, 11-16
operating profit, 19-19 Municipal notes, 5-10–5-11
Margin account, 2-4–2-6, 10-10, 12-5, 13-2–13- Municipal offerings, 11-16–11-17
3, 14-1–14-2, 14-8, 16-4 Municipal revenue bonds, 5-13
short seller’s, 12-5 Municipal securities, 2-7, 5-11–5-12, 8-9, 11-12,
Markdowns, 1-2, 12-1–12-2 11-15–11-16, 11-18–11-19, 13-1, 13-3, 16-
Market capitalization, 19-6–19-7 5–16-6, 17-4–17-5, 18-9
Market Making, 11-6 issuers of, 2-11, 17-5
Market manipulation, 16-1, 16-17 traditional, 8-9
Market orders, 5-4, 12-1, 12-5, 12-7 Municipal securities broker-dealer, 18-9
Market theory, 20-5 Municipal Securities Principal, 11-18, 17-5
Market timing, 20-6 Municipal Securities Representative, 17-4
Marking-the-close, 16-4 Municipal Securities Rulemaking Board. See
Marking-the-opening, 16-4 MSRB
Markups, 1-2, 12-1–12-3 Mutual funds, 1-2, 1-4, 1-8, 1-10, 2-5, 6-11–7-2,
extra, 16-6 7-4–7-5, 7-7–7-9, 7-11, 7-13–7-16, 8-8, 9-1,
higher-than-normal, 12-3 9-3, 16-7, 17-3–17-4
Maturity date, 1-2, 3-1, 4-3, 4-7, 8-9, 11-17, 20-2
bond’s, 4-2 N
Member firms, 2-2–2-3, 2-7, 13-2–13-3, 14-6,
15-3, 15-15–15-16, 16-13, 16-15, 16-17, 17- NAC (National Adjudicatory Council), 17-7
6, 17-8, 18-1, 18-3–18-5, 18-9 Nano-cap, 19-7–19-8
MFP (municipal finance professionals), 18-9– Nano-capitalization, 19-7
18-10 NASAA (North American Securities
MFP contributions, 18-10 Administrators Association), 2-2
Microcap, 13-6 Nasdaq, 1-3, 1-6–1-7, 2-4, 3-7, 6-10–6-11, 7-15,
Micro-capitalization, 19-7 9-1, 11-9–11-10, 13-1, 16-5
Mid-cap, 19-7, 20-6 National Adjudicatory Council (NAC), 17-7
Middle-capitalization, 19-7 National Association of Securities Dealers
Mini-maxi, 11-3 (NASD), 1-6, 2-4, 2-9
Monetarist, 19-14 National Securities Clearing Corporation
Monetary policy, 19-8, 19-10, 19-13–19-14 (NSCC), 13-3
nation’s, 2-1 National Uniform Practice Committee, 13-2
Monetary Theory, 19-8 NAV (net asset value), 7-2–7-3, 7-6–7-8, 7-11–7-
Money laundering, 2-1, 15-5–15-6, 15-8 16, 8-3, 9-3
international, 2-8 Negotiable CDs, 5-18
potential, 2-8 New York Stock Exchange. See NYSE
Money-market, 5-11, 5-16–5-17, 7-6, 20-6 NOBOs (Non-Objecting Beneficial Owner), 13-8
Money market deposit accounts (MMDAs), 19- Nominal yield, 4-7, 6-4–6-7, 6-9
9 Non-agricultural payrolls, 19-5
Money-market funds, 7-6, 8-2, 14-13 Non-cash compensation, 18-8
tax-free, 5-12 Non-competitive bids, 5-4
Money-market instruments, 1-8, 5-17, 7-6 Non-competitive tenders, 5-4
Money supply, 2-1, 19-8–19-10, 19-12–19-14 Non-Objecting Beneficial Owner (NOBOs), 13-8
Moody’s Investment Grade, 5-11 Non-qualified annuities, 8-1
Mortgage bonds, 5-14 Non-registered persons, 15-16, 17-1–17-2
MSRB (Municipal Securities Rulemaking North American Securities Administrators
Board), 2-2, 2-4, 2-7, 2-10–2-12, 5-12, 8-12, Association (NASAA), 2-2
11-16, 11-18, 16-5, 16-17, 17-7, 18-9–18-10 Notice of sale, 3-5, 11-17, 11-19
Municipal Advisor Representative, 17-4 NSCC (National Securities Clearing
Municipal advisors, 1-4, 11-16, 17-4 Corporation), 13-3
Municipal bonds, 4-6, 5-7, 5-12, 5-19, 11-15, 11- NYSE (New York Stock Exchange), 1-3, 1-6–1-7,
17, 11-19, 12-4, 13-2 2-4, 3-7, 3-11, 6-10, 7-7, 7-15, 11-9–11-10,
Municipal bonds indices, 6-11 13-1, 13-7
Municipal finance professionals. See MFP
Municipal fund securities, 8-1–8-12, 17-3–17-5 O

© Securities Training Corporation. All rights reserved. 8

 P/E, 19-6
OBO (Objecting Beneficial Owner), 13-8 PE (private equity), 9-3, 11-1
OCC (Options Clearing Corporation), 1-11, 3- PE funds, 9-10
10, 10-1, 10-7–10-9 Penny Stock Reform Act, 2-7, 2-9
OFAC (Office of Foreign Asset Control), 15-1, Pension plans, 1-5, 14-11
15-7 large tax-exempt, 1-5
Offering memorandum, 9-7, 11-11 public, 1-5, 11-14
Official statement, 5-13, 11-17–11-19 P/E ratio, 19-6–19-7
final, 11-18 Pink Marketplace, 1-6, 11-9
Official Statement Summary, 11-18 PIPE (Private Investment in Public Equity), 11-
Omnibus Accounts, 1-9–1-10 14
Open-end funds, 7-16 PoAs, 14-3, 15-16
Open order, 12-8 Political risk, 20-3
Operations Professional, 17-3 POP (public offering price), 7-3, 7-6–7-8, 7-11–
Options, 1-11, 3-10, 4-10, 8-2, 8-4–8-5, 9-2, 10- 7-12, 9-3, 11-4–11-5, 11-9, 12-4, 16-2
1–10-10, 13-2, 13-7, 14-2, 15-12, 16-2–16-3, Preferred stock, 3-2, 3-7–3-9, 5-14, 7-15–7-16, 9-
17-3–17-4, 20-4, 20-7–20-8 5, 19-16, 20-2
equity, 10-1–10-3, 10-8–10-9, 20-7 callable, 3-9
exchange-traded, 1-11 convertible, 3-9, 4-10, 16-2
exercised, 10-8 non-cumulative, 3-8
in-the-money, 10-5 participating, 3-8
listed, 1-11, 10-1, 10-3, 10-8 Pre-Filing, 11-7
out-of-the-money, 10-5 Prepaid Tuition Plans (PTP), 8-9–8-10
purchasing, 10-6 Prepayments, 5-7, 20-5
seller’s, 13-2 Pre-registration, 11-7
Options Account Agreement, 14-2 Pre-tax, 8-8, 8-11, 14-12–14-13
Options accounts, 10-9, 14-2, 14-6, 15-2 Primary market, 1-5–1-6, 2-1, 2-4, 2-9, 3-12, 5-4,
Options Clearing Corporation. See OCC 5-16, 9-4, 11-9, 16-6
Opt-out, 15-8–15-9 Primary market for municipal bonds, 5-12, 11-
Order, 1-7, 1-10, 3-1, 3-5, 7-7, 11-9, 12-1, 12-4– 15
13-1, 13-4, 14-2–14-3, 16-2, 16-6–16-7, 16- Prime brokerage accounts, 1-10
14, 16-16, 17-2 Principal designations, 17-4
Order qualifiers, 12-8 Principals, 2-3, 2-11, 3-2, 7-4, 11-2, 12-1, 15-2,
Order ticket, 12-4 15-10, 17-2, 17-6, 18-6
electronic, 13-1 registered, 2-3
Ordinary income taxes, 8-7, 14-4, 14-9–14-10 training of, 17-5
OSJ, 8-8, 15-16, 17-6 Privacy of consumer financial information, 15-8
OTC. See Over-the-Counter Private equity (PE), 9-3, 11-1
OTCBB (OTC Bulletin Board), 1-6, 11-9 Private equity funds, 9-3
OTC markets, 1-6–1-7, 2-4, 3-7, 16-4 Private Investment in Public Equity (PIPE), 11-
OTC Markets Group, 1-6 14
Out-of-the-money, 10-4–10-5, 10-8 Private offerings, 16-10
Outstanding shares, 19-7 Private placement memorandum, 11-11–11-12
Over-the-Counter (OTC), 1-6–1-8, 1-11, 2-4, 2- Private placements, 3-5, 9-3–9-4, 9-7, 11-1, 11-
9, 3-7, 11-9, 16-6 11–11-14, 18-7, 20-3
Private Securities Offerings Representative, 17-
P 3
Profit-sharing plans, 7-12, 14-12
Packaged products, 1-2, 7-1–7-16, 9-1, 9-3 Proprietary accounts, 16-2, 16-4
Partners, 9-5, 14-6, 15-1, 15-14, 17-1, 17-8, 18-5 firm, 16-9
general, 1-5, 9-5–9-7, 9-9, 11-12 Prospectus, 2-9, 7-3, 7-8–7-11, 8-1, 8-3, 8-5, 11-
Partnership accounts, 14-6 7–11-12, 11-17–11-18, 12-4
Partnership agreement, 14-6 final, 11-7, 11-9
Partnerships, 1-5, 9-5–9-7, 11-14–11-15, 14-6 preliminary, 11-7–11-10
existing property, 9-8 statutory, 11-10–11-11
general, 9-5 Proxy notices, 13-5
Passive approaches, 20-5 Proxy statement, 13-9
PATRIOT Act, 2-8–2-9, 15-1, 15-5–15-6 PTP. See Prepaid Tuition Plans

© Securities Training Corporation. All rights reserved. 9

Public appearance, 15-12 Registrars and transfer agents, 1-12
Public offering price. See POP Registration statement, 11-6–11-11, 16-10
Pump-and-dump, 16-2 amended, 11-8
formal, 11-11
Q issuer’s, 11-8
Regular-way settlement, 6-2, 14-1, 16-4
QIBs (qualified institutional buyers), 1-5, 11-14 Regulation SP, 15-8–15-9
Qualification exams, 17-5 Regulatory element, 17-1, 17-9
Qualified institutional buyers. See QIBs Regulatory risk, 20-3
Quotes, 1-3, 1-6–1-7, 4-5, 11-6, 16-4–16-5, 16-7 Rehypothecate, 14-1
display, 1-3 REITs (real estate investment trusts), 8-12–9-1,
disseminate, 1-7 9-4–9-5, 9-10, 11-11, 16-10, 18-8
firm’s, 16-4 REITs
market maker’s, 1-3 non-traded, 9-4
two-sided, 12-1 private, 9-4
Repos, 5-17–5-18, 19-12
R reverse, 5-18, 19-13
Repurchase agreements, 5-17, 19-12
RANs (Revenue Anticipation Notes), 5-10 Required minimum distributions (RMDs), 14-
Ratings for municipal notes, 5-11 10–14-11
Ratio Restricted persons, 16-10–16-12
bond coverage, 19-19 Retail communications, 15-11–15-12
dividend payout, 19-7 Retirement plans, 7-10, 8-1, 14-12
expense, 7-9 employer-sponsored, 8-8, 14-9–14-10
low dividend payout, 19-6 qualified, 14-9, 14-11
low price-to-book, 19-7 work-sponsored, 8-1
low price-to-earnings, 19-7 Revenue Anticipation Notes. See RANs
price-to-earnings, 19-7 Revenue bonds, 5-7–5-8, 5-10, 5-12, 11-16
Real estate investment trusts. See REITs Rights of Accumulation (ROAs), 7-10, 7-12–7-13
Real GDP, 19-4 Rights offering, 3-10, 13-5, 16-10
Rebalance, 19-1, 20-5 Risk, 4-2, 4-4, 5-7, 5-13–5-14, 6-8–6-10, 7-1–7-3,
Record date, 6-1–6-3, 7-7, 13-6 9-9, 10-6, 11-2–11-3, 11-11–11-12, 12-2, 12-
Recordkeeping formats, 16-17 5–12-8, 14-1–14-2, 19-19–20-4, 20-7
Record retention, 15-7 additional, 5-18
Records, 6-1–6-2, 11-8, 11-17, 14-5, 15-1, 15-7, amount of, 6-9, 20-1
15-11, 15-13, 15-16, 16-17, 17-4, 17-6, 17-8, buyers, 10-10
17-10, 18-6 contra-party, 13-3
complaint, 15-16 counterparty, 10-8
following, 15-2 diversifiable, 20-1
maintaining, 16-17, 17-5 downside, 10-9
original, 16-17 event, 20-3
permanent, 17-6 exchange-rate, 20-4
shareholder’s, 6-2 financial, 9-6
unbroken, 3-6 high, 9-9, 15-4
written, 17-8 high credit, 4-2, 4-4
Redemption fees, 7-13 lower, 9-9
funds waive, 7-13 mortality, 8-6
Redemptions, 4-10, 7-2, 7-7–7-8, 7-13, 11-11 prepayment, 5-7, 5-15, 20-4
early, 4-7, 6-7 reinvestment, 5-18, 7-6, 20-4
Red Flags Rule, 15-9 systematic, 20-1, 20-3
Registered bonds, 13-4 unsystematic, 20-3
Registered persons, 2-3, 15-3, 16-13, 16-15, 17- upside, 10-9
2, 17-6, 17-10, 18-3–18-4, 18-6, 20-1 Risk-adjusted return measures, 6-10
covered, 17-10 Risk-free return, 6-9
Registered representatives RMD provision, 14-10
. See RRs RMDs (Required Minimum Distributions), 14-
current, 17-1 10–14-11
supervision of, 17-5 ROAs. See Rights of Accumulation

© Securities Training Corporation. All rights reserved. 10

Rollover, 14-9 Share classes, 7-7, 7-9–7-10, 7-14
Roth IRAs, 14-10–14-12 Shareholders, 1-6, 1-12, 2-9, 3-1, 3-3–3-4, 3-10,
RRs (registered representatives), 2-2–2-3, 2-10, 4-1, 6-1–6-3, 7-2–7-5, 7-13, 9-4–9-5, 13-6,
7-8–7-9, 7-13–7-14, 9-9, 14-2–14-3, 14-6– 13-8, 16-8, 19-6–19-7
14-8, 14-13–15-4, 15-8–15-14, 16-16, 17-2– current, 3-10, 11-3
17-3, 17-6, 17-9–18-1, 18-3–18-4, 18-6–18-9 existing, 11-3, 13-7
Rule G-8, 16-17 fund’s, 7-4–7-5
Rule G-9, 16-17 individual, 3-1
Rule G-11, 11-17 Shareholders of record, 6-1–6-2
Rule G-32, 11-18 SIPA, 2-5, 2-9
Rule G-37, 18-9–18-10 SIPC (Securities Investor Protection
S Corporation), 2-5, 2-7, 15-15
SLMA (Student Loan Marketing Association), 5-
Safe harbors, 3-12, 16-9 19
SAI (Statement of Additional Information), 7-3 Small-capitalization, 19-7
Sales charges, 7-3, 7-6–7-11, 7-13, 7-15–7-16, 8- Small-caps, 19-7
5–8-6, 9-3 Special Assessment Bonds, 5-9
additional, 7-2 Speculative grade, 5-11
asset-based, 18-8 Split, 3-3, 11-2, 13-5–13-6, 18-10
deferred, 7-8 Stabilization, 16-2
higher, 7-12 Standby agreements, 11-3
mutual fund’s, 7-7 State Administrator, 11-8
paying reduced, 7-12 Statement of Additional Information (SAI), 7-3
reduced, 7-7, 7-10–7-12 Statements, 1-9–1-10, 7-5, 11-8, 11-18–11-19,
statutory maximum, 8-6 15-9–15-11, 15-14, 15-16–16-1, 16-16, 18-4,
up-front, 7-6, 7-10 19-1, 19-15
Sales concessions, 7-9 client’s, 1-9
Sales literature, 15-12 false, 18-3
Sales loads, 7-3, 7-8 misleading, 11-8
deferred, 7-8 monthly, 15-10
SAR (Suspicious Activity Report), 2-9, 15-6 written, 18-5
SBIs, 7-15 Statutory disqualification, 17-1, 17-7, 18-1
Secondary distribution, 11-1 immediate, 17-7
Secondary market, 1-5–1-6, 2-4, 2-9, 3-12, 4-2, Statutory voting, 3-4
5-18, 7-15–7-16, 9-10, 10-3, 10-6–10-7, 11- Stock, 1-4–1-7, 3-2–3-3, 3-6–3-7, 3-9–3-12, 4-8–
1, 11-4, 11-6, 16-2, 16-6 4-10, 6-1–6-3, 6-9–6-10, 7-5–7-7, 10-5–10-
active, 5-18 7, 10-9–10-10, 12-1–12-8, 13-5–13-7, 19-6–
Secondary offerings, 16-10 19-8, 20-1–20-4, 20-6–20-7
Sector funds, 7-5 additional shares of, 3-10, 6-3
Sector rotation, 20-6 borrowed, 2-4, 12-5
Secured creditor, 3-2, 5-15, 9-7 capitalized, 6-11
Securities Exchange Act, 2-4, 2-9, 3-5, 11-19, 13- cyclical, 3-6, 19-6
2, 16-1, 16-8, 19-13 foreign, 3-7
Securities Fraud Enforcement Act, 2-7, 2-9, 16-8 high tech, 7-5
Securities Industry Essentials Exam, 2-1, 2-3, industrial, 6-10
17-1 interest-rate-sensitive, 19-2
Securities Investor Protection Act, 2-5, 2-9 issuance of, 1-1–1-2
Securities Investor Protection Corporation. See issuing, 5-14, 11-5
SIPC listed, 1-7
Securities Investors Protection Corporation, 2- loaned, 14-1
5, 15-15 long, 10-9
Self-directed accounts, 14-8 low-priced, 13-6
Self-regulatory organization. See SROs mid-cap, 19-7
Serial issues, 4-3 non-cumulative, 3-8
Settlement, 1-8, 2-10, 6-3, 7-7, 8-4, 10-8, 12-9– outstanding, 3-3, 3-10
13-10, 17-3, 18-4–18-5 penny, 2-7, 2-9
Settlement date, 11-17, 11-19, 13-1–13-2, 14-1, preferred cumulative, 3-8
15-2, 15-10, 15-14 registered, 11-13

© Securities Training Corporation. All rights reserved. 11

 restricted, 11-13 Tippees, 2-7, 2-9, 16-8
short, 10-9 Tippers, 2-7, 2-9, 16-8
small-cap, 19-7, 20-6 TIPS (Treasury Inflation-Protected Securities),
small-cap company, 6-11 5-1–5-2, 5-19, 16-8
traditional, 1-10 Title, 11-11, 13-7
transportation, 6-10 legal, 5-14
treasury, 3-3 T-notes, 5-1–5-2
unregistered, 11-13 Trade confirmations, 15-9
unsold, 11-2 Trade date, 6-2, 13-1, 16-4
utilities, 20-2 Trading ahead, 16-3, 16-7
utility, 3-6, 6-10 Trailing commissions, 7-9
voting, 7-2 TRANs (Tax and Revenue Anticipation Notes),
Stock dividends, 3-3, 6-3, 13-6 5-10
common, 3-8 Transfer, 3-3, 3-5, 7-4, 8-2, 8-8, 8-10, 13-8, 14-9,
Stockholders, 3-1–3-5, 5-14–5-15, 6-1–6-2, 13-6, 16-14, 17-6, 18-1
13-8, 18-5, 19-15–19-17 Transfer agent, 1-12, 3-4, 6-2, 7-4–7-5, 7-9, 13-
existing, 11-3 4–13-5
preferred, 3-2, 3-7–3-9, 5-15 fund’s, 7-4
Stockholders’ Equity, 19-15 issuer’s, 3-10, 13-7
Stop-limit order, 12-7–12-8 Treasuries, 1-1, 2-1, 5-1–5-4, 5-6, 11-1, 15-5, 20-
Stop order, 12-1, 12-6–12-8 4
activated, 12-7 Treasury bill, 5-1–5-2, 6-9, 19-11
Strategies, 1-10, 10-1–10-2, 12-4, 14-4, 17-10 Treasury bonds, 5-1
active, 20-6 Treasury Inflation Protected Securities, 19-2
advanced, 9-2 Treasury Inflation-Protected Securities. See
basic hedging, 10-9 TIPS
basic option, 10-10 Treasury notes, 5-1
buy-and-hold, 20-6 Treble damages, 2-7, 2-9, 16-9
low turnover, 14-4 Trough, 19-3–19-4, 19-8
sector rotation, 20-6 TRs (Treasury Receipts), 5-3
Strike price, 10-1, 10-3–10-7, 10-10, 20-7 Trust accounts, 14-6
contract’s, 10-9 single, 7-12
option’s, 20-7 Trusted contract person, 16-15
STRIPS (Separate Trading of Registered Interest Trustee, 1-12, 2-6, 5-14, 7-12, 7-15, 13-8, 14-6–
and Principal Securities), 5-1, 5-3, 5-19 14-7, 14-9, 15-3, 15-9
Student Loan Marketing Association (SLMA), 5- pension fund, 2-7
19 T-STRIPS, 5-1
Subordinated creditors, 5-15
Suitability, 8-7, 15-1, 15-3 U
determining, 15-2, 15-4
Suspicious Activity Report. See SAR UGMA (Uniform Gifts to Minors Act), 14-7
Syndicate, 5-13, 11-2–11-5, 11-17 UITs (unit investment trusts), 7-1, 7-15, 16-16,
winning, 5-13 17-3
Uncovered option positions, 10-9
T Underwriters, 1-2, 1-4, 1-6, 5-13, 7-4–7-5, 9-7,
11-2–11-4, 11-6–11-10, 11-16–11-17, 11-19,
TANs (Tax Anticipation Notes), 5-10 16-1–16-2, 16-12, 18-5
Taxable municipal bonds, 5-9 managing, 11-5, 11-7, 16-11
Tax and Revenue Anticipation Notes (TRANs), municipal, 5-13
5-10 municipal bond, 11-18
Tax Anticipation Notes. See TANs principal, 7-4–7-5, 7-7
Taxpayer ID number (TIN), 15-2, 15-7 Underwriting, 4-11, 11-1, 11-3, 11-19, 17-4, 18-9
T-bonds, 5-1–5-3 best-efforts, 11-2–11-3
Telemarketing, 15-1, 15-12–15-13 firm-commitment, 11-2
Telephone Consumer Protection Act (TCPA), 2- mini-maxi, 11-3
8–2-9 standby, 11-3
Term issues, 4-3 Underwriting spread, 11-5
Territory/possession bonds, 5-19 Underwriting syndicate, 5-13, 11-2, 11-4

© Securities Training Corporation. All rights reserved. 12

Uniform Gifts to Minors Act. See UGMA YTM. See Yield-to-Maturity
Uniform Practice Code (UPC), 2-10
Uniform Prudent Investor Act (UPIA), 14-7 Z
Uniform Securities Act, 2-2, 11-8, 17-9
Uniform Transfers to Minors Act (UTMA), 14-7 Zero coupon bonds, 4-3
Unit investment trusts. See UITs
Unregistered person, 16-16
UPC (Uniform Practice Code), 2-10
UPIA (Uniform Prudent Investor Act), 14-7
Utility Revenue Bonds, 5-9
UTMA (Uniform Transfers to Minors Act), 14-7

Variable annuities, 8-1–8-8, 17-3–17-4, 17-8, 18-

8, 19-2, 20-2
deferred, 8-8
non-qualified, 8-8
regarding, 8-1
Variable Contracts Products Principal, 17-4
Variable Contracts Products Representative, 17-
3
Variable Municipal Investment Grade (VMIG),
5-11
Variable rate demand obligations. See VRDOs
VMIG (Variable Municipal Investment Grade),
5-11
Volatility, 10-3, 16-6, 20-1, 20-5
lower, 20-1
Voter approval, 5-7–5-8, 5-10, 5-12, 11-16
obtaining, 5-13, 11-16
Voting methods, 3-4
VRDOs (variable rate demand obligations), 5-
11–5-12

Warrant, 3-10–3-11, 12-3, 13-7

Wildcatting, 9-9
Wilshire Associates Equity Index, 6-10
Written customer complaints, 18-3–18-5
WSP (Written Supervisory Procedures), 2-3, 2-
11, 15-9, 16-9, 18-2, 18-6

Yankee Bonds, 5-16

Yield, 4-2, 4-7, 5-3–5-4, 6-4–6-6, 6-8–6-9, 8-9,
19-2
bond’s, 4-7, 6-4, 6-8
higher, 5-3, 5-11, 5-15
highest, 6-7
pick-up, 6-6
Yield basis, 4-6, 5-3
discounted, 5-3
Yield curves, 19-9
Yield-to-call, 6-8
Yield-to-Maturity (YTM), 4-7, 6-4–6-8

© Securities Training Corporation. All rights reserved. 13