Securities Industry

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

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Table of Contents

Introduction
About the Securities Industry Essentials (SIE) Examination ........................................................ 1
Course Materials .......................................................................................................................... 1
Study Manual and Exam Breakdown ..................................................................................................... 1
Chapter Quizzes .................................................................................................................................... 2
Final Examinations ................................................................................................................................. 2
Registering for the Examination ................................................................................................... 2
Standardized Test-Taking Tips .................................................................................................... 3
Test-Taking Pitfalls ....................................................................................................................... 3
Study Calendars........................................................................................................................... 4

Chapter 1 – Overview of Market Participants and Market Structure .................... 5

Market Participants ...................................................................................................................... 6
What’s an Issuer? .................................................................................................................................. 6
What’s a Broker-Dealer? ........................................................................................................................ 7
What’s a Market Maker? ........................................................................................................................ 8
What’s a Trader?.................................................................................................................................... 8
What’s an Investment Adviser (IA)? ....................................................................................................... 8
Types of Investors ........................................................................................................................ 9
Retail Investors ...................................................................................................................................... 9
Accredited Investors............................................................................................................................... 9
Institutional Investors ........................................................................................................................... 10
Market Structure......................................................................................................................... 10
Primary Market ..................................................................................................................................... 10
Secondary Market ................................................................................................................................ 11
Other Execution Methods and Venues................................................................................................. 11
Clearing and Settlement – An Overview..................................................................................... 12
The Depository Trust & Clearing Corporation (DTCC) ......................................................................... 13
Processing the Trade – Clearing and Introducing Firms ...................................................................... 13
Introducing Firms – Fully Disclosed Versus Omnibus Accounts .......................................................... 14
Other Customers of Clearing Firms...................................................................................................... 15
Clearing Options Contracts .................................................................................................................. 16
 Other Entities That Keep Markets Running Smoothly ................................................................ 16
Conclusion ........................................................................................................................................... 17
Chapter 1 Summary ............................................................................................................................. 18
Complete a Chapter 1 Quiz .................................................................................................................. 18

Chapter 2 – Overview of Regulation..................................................................... 19

Regulation .................................................................................................................................. 20
Federal Regulation ............................................................................................................................... 20
Other Federal Regulators ..................................................................................................................... 20
SRO Regulation ................................................................................................................................... 21
State (Blue-Sky) Regulation ................................................................................................................. 21
Firm (In-House) Rules .......................................................................................................................... 21
Why Take the SIE Exam? .................................................................................................................... 22
Federal Regulation – The Acts ................................................................................................... 22
The Securities Act of 1933 ................................................................................................................... 22
The Securities Exchange Act of 1934 .................................................................................................. 23
The Maloney Act of 1938 ..................................................................................................................... 23
The Investment Advisers Act of 1940................................................................................................... 23
The Securities Investor Protection Act of 1970 (SIPA) ......................................................................... 24
The Employee Retirement Income Security Act of 1974 (ERISA) ........................................................ 25
The Securities Acts Amendments of 1975 ........................................................................................... 25
The Insider Trading and Securities Fraud Enforcement Act of 1988.................................................... 25
The Penny Stock Reform Act of 1990 .................................................................................................. 26
The Federal Telephone Consumer Protection Act of 1991 .................................................................. 26
The USA PATRIOT Act of 2001 ........................................................................................................... 26
Self-Regulatory Organizations ................................................................................................... 28
FINRA .................................................................................................................................................. 28
The Municipal Securities Rulemaking Board (MSRB) .......................................................................... 28
The Chicago Board Options Exchange (CBOE) .................................................................................. 29
Internal Compliance ............................................................................................................................. 29
The Importance of Understanding Regulation...................................................................................... 29
Conclusion ........................................................................................................................................... 30
Chapter 2 Summary ............................................................................................................................. 30
Complete a Chapter 2 Quiz .................................................................................................................. 30

Chapter 3 – Equity Securities ............................................................................... 31

 The Corporation – Equity Securities ........................................................................................... 32
Corporate Organization ........................................................................................................................ 32
Raising Capital – Financing the Corporation ........................................................................................ 32
Different Types of Equity Securities ..................................................................................................... 33
Common Stock........................................................................................................................... 33
Rights of Common Shareholders ......................................................................................................... 34
Rule 144 ............................................................................................................................................... 36
Classification of Stocks .............................................................................................................. 37
Blue-Chip Stocks.................................................................................................................................. 37
Growth Stocks ...................................................................................................................................... 37
Defensive Stocks ................................................................................................................................. 37
Income Stocks...................................................................................................................................... 37
Cyclical Stocks ..................................................................................................................................... 37
American Depositary Receipts (ADRs) ................................................................................................ 37
Preferred Stock .......................................................................................................................... 38
Cumulative Preferred Stock ................................................................................................................. 38
Non-Cumulative Preferred Stock.......................................................................................................... 39
Participating Preferred Stock................................................................................................................ 39
Callable Preferred Stock ...................................................................................................................... 39
Convertible Preferred Stock ................................................................................................................. 39
Common versus Preferred Stock ......................................................................................................... 40
Rights and Warrants – Derivative Securities .............................................................................. 40
Preemptive Rights ................................................................................................................................ 41
Warrants............................................................................................................................................... 41
Miscellaneous Equity Rules ....................................................................................................... 42
FINRA Rule 2261 – Disclosure of Financial Condition ......................................................................... 42
FINRA Rule 2262 – Disclosure of Control Relationship with Issuer ..................................................... 42
SEC Rule 10b-18 – Purchases of Certain Equity Securities by the Issuer ............................................. 42
Conclusion ........................................................................................................................................... 43
Chapter 3 Summary ............................................................................................................................. 43
Complete a Chapter 3 Quiz .................................................................................................................. 43

Chapter 4 – An Introduction to Debt Instruments ............................................... 44

Introduction to Debt Instruments ................................................................................................ 45
Basic Bond Characteristics .................................................................................................................. 45
 Why Bond Prices Fluctuate from Par ......................................................................................... 47
Discounts and Premiums ..................................................................................................................... 48
Bond Pricing ............................................................................................................................... 49
Prices and Yields: An Inverse Relationship ................................................................................ 50
Calculating Bond Yields ....................................................................................................................... 51
Redeeming Bonds Prior to Maturity ........................................................................................... 51
Call Provisions ..................................................................................................................................... 51
Convertible Bonds ................................................................................................................................ 52
Conclusion ........................................................................................................................................... 55
Chapter 4 Summary ............................................................................................................................. 55
Complete a Chapter 4 Quiz .................................................................................................................. 55

Chapter 5 – Types of Debt Instruments ............................................................... 56

Types of Debt Instruments ......................................................................................................... 57
Treasury Securities .............................................................................................................................. 57
Treasury Notes (T-Notes) and Treasury Bonds (T-Bonds) .................................................................. 57
Treasury Inflation-Protected Securities (TIPS) ..................................................................................... 58
Non-Interest-Bearing Securities ................................................................................................. 58
Treasury Bills (T-Bills) .......................................................................................................................... 58
Stripped Securities ..................................................................................................................... 59
Treasury STRIPS ................................................................................................................................. 59
Cash Management Bills (CMBs) .......................................................................................................... 59
U.S. Treasury Securities Auctions – The Primary Market .......................................................... 60
Agency Securities ...................................................................................................................... 60
Federal Agencies ................................................................................................................................. 60
Government-Sponsored Enterprises .................................................................................................... 61
Mortgage-Backed Securities ...................................................................................................... 61
Pass-Through Certificates .................................................................................................................... 61
Federal Home Loan Mortgage Corporation (FHLMC) .......................................................................... 62
Federal National Mortgage Association (FNMA) .................................................................................. 62
Government National Mortgage Association (GNMA) .......................................................................... 62
Municipal Bonds ......................................................................................................................... 63
Types of Municipal Bonds .......................................................................................................... 63
General Obligation (GO) Bonds ........................................................................................................... 63
Revenue Bonds.................................................................................................................................... 63
Types of Revenue Bonds ..................................................................................................................... 64
 Municipal Notes.................................................................................................................................... 66
Ratings for Municipal Notes ................................................................................................................. 67
Other Municipal Securities ......................................................................................................... 67
Auction Rate Securities ........................................................................................................................ 67
Variable Rate Demand Obligations (VRDOs) ...................................................................................... 67
The Primary Market for Municipal Bonds ................................................................................... 68
Issuing GO Bonds ................................................................................................................................ 68
Issuing Revenue Bonds ....................................................................................................................... 68
New Issue Underwritings...................................................................................................................... 68
Forming a Municipal Syndicate ............................................................................................................ 69
Corporate Bonds ........................................................................................................................ 69
Types of Corporate Bonds ......................................................................................................... 69
Secured Bonds..................................................................................................................................... 70
Unsecured Bonds................................................................................................................................. 70
Other Types of Corporate Bonds ............................................................................................... 71
Income Bonds ...................................................................................................................................... 71
Eurodollar Bonds, Yankee Bonds, and Eurobonds .............................................................................. 71
The Money-Market ..................................................................................................................... 72
Types of Money-Market Securities ....................................................................................................... 72
Bond Taxation Summary ...................................................................................................................... 74
Conclusion ........................................................................................................................................... 74
Chapter 5 Summary ............................................................................................................................. 75
Complete a Chapter 5 Quiz .................................................................................................................. 75

Chapter 6 – Investment Returns ........................................................................... 76

Return on Equity Investments .................................................................................................... 77
Dividends ............................................................................................................................................. 77
Calculating Current Yield (Dividend Yield) ........................................................................................... 79
Return on Bond Investments ................................................................................................................ 79
Prices and Yields – An Inverse Relationship .............................................................................. 79
Calculating Bond Yields ....................................................................................................................... 80
Call Provisions ..................................................................................................................................... 83
Cost Basis, Capital Events, and Return of Capital ..................................................................... 83
Measuring Return....................................................................................................................... 84
Total Return ......................................................................................................................................... 84
 Averages and Indexes ......................................................................................................................... 85
Conclusion ........................................................................................................................................... 86
Chapter 6 Summary ............................................................................................................................. 87
Complete a Chapter 6 Quiz .................................................................................................................. 87

Chapter 7 – Packaged Products ........................................................................... 88

Types of Investment Companies ................................................................................................ 89
Open-End Management Companies (Mutual Funds) ........................................................................... 89
Additional Disclosure: The Statement of Additional Information (SAI) ................................................. 91
The Organization of a Mutual Fund ...................................................................................................... 92
Categories of Mutual Funds ................................................................................................................. 93
Buying and Selling Mutual Fund Shares .................................................................................... 94
Net Asset Value ................................................................................................................................... 94
Fees and Charges................................................................................................................................ 96
Classes of Shares ................................................................................................................................ 97
Methods of Reducing Sales Charges ................................................................................................... 98
Dollar Cost Averaging (DCA) ............................................................................................................. 100
Redeeming Shares ............................................................................................................................ 101
Systematic Withdrawal Plans ............................................................................................................. 101
Prohibited Sales Practices ................................................................................................................. 101
Other Types of Investment Companies .................................................................................... 102
Face-Amount Certificate Companies ................................................................................................. 102
Unit Investment Trusts ....................................................................................................................... 102
Closed-End Investment Companies ................................................................................................... 103
Conclusion ......................................................................................................................................... 103
Chapter 7 Summary ........................................................................................................................... 104
Complete a Chapter 7 Quiz ................................................................................................................ 104

Chapter 8 – Variable Contracts and Municipal Fund Securities....................... 105

Annuities .................................................................................................................................. 106
Fixed versus Variable Annuities ............................................................................................... 106
Variable Annuities .............................................................................................................................. 106
The Life of a Variable Annuity .................................................................................................. 108
Accumulation Period .......................................................................................................................... 108
Annuity Period .................................................................................................................................... 109
Annuity Charges and Expenses ......................................................................................................... 110
 Qualified Annuities ................................................................................................................... 111
Equity-Indexed Contracts (EICs) .............................................................................................. 112
Variable Annuities—Suitability and Compliance Issues ........................................................... 112
Municipal Fund Securities ........................................................................................................ 113
Local Government Investment Pools ................................................................................................. 114
Section 529 College Savings Plans ................................................................................................... 114
Section 529A Plans ............................................................................................................................ 116
Conclusion ......................................................................................................................................... 116
Chapter 8 Summary ........................................................................................................................... 117
Complete a Chapter 8 Quiz ................................................................................................................ 117

Chapter 9 – Alternative Investments .................................................................. 118

Other Types of Investment Companies .................................................................................... 119
Exchange-Traded Funds (ETFs) ........................................................................................................ 119
Exchange-Traded Notes (ETNs) ........................................................................................................ 120
Other Types of Packaged Products ......................................................................................... 120
Hedge Funds...................................................................................................................................... 120
Private Equity Funds .......................................................................................................................... 121
Real Estate Investment Trusts (REITs) .................................................................................... 121
Regulation .......................................................................................................................................... 121
Investment Attributes ......................................................................................................................... 121
Direct Participation Programs (DPPs) ...................................................................................... 123
Advantages of Limited Partnerships................................................................................................... 123
Disadvantages of Limited Partnerships .............................................................................................. 124
General Partners ................................................................................................................................ 124
Limited Partners ................................................................................................................................. 124
DPP Offering Practices ...................................................................................................................... 125
Tax Treatment of Individual Partners ................................................................................................. 125
Types of Limited Partnerships ............................................................................................................ 126
Risk Summary .................................................................................................................................... 127
Conclusion ......................................................................................................................................... 128
Chapter 9 Summary ........................................................................................................................... 128
Complete a Chapter 9 Quiz ................................................................................................................ 128

Chapter 10 – Options........................................................................................... 129

 Options ..................................................................................................................................... 130
Equity Options – Terminology .................................................................................................. 130
Buyers and Sellers ............................................................................................................................. 130
Types of Options ................................................................................................................................ 131
Components of an Option .................................................................................................................. 131
Intrinsic Value and Time Value........................................................................................................... 132
Breakeven .......................................................................................................................................... 135
Speculation versus Hedging............................................................................................................... 135
Option Events........................................................................................................................... 135
Options Clearing Corporation (OCC)........................................................................................ 138
Options Disclosure Document ............................................................................................................ 138
Index Options ..................................................................................................................................... 138
Hedging with Options ......................................................................................................................... 138
Covered and Uncovered Option Positions ......................................................................................... 139
Summary of Profit and Loss Potential for Various Positions .............................................................. 139
Conclusion ......................................................................................................................................... 140
Chapter 10 Summary ......................................................................................................................... 140
Complete a Chapter 10 Quiz .............................................................................................................. 140

Chapter 11 – Offerings ........................................................................................ 141

Capital Formation ..................................................................................................................... 142
Offering Securities to Investors .......................................................................................................... 142
The Role of an Underwriter/Investment Banker ....................................................................... 143
Underwriting Commitments ................................................................................................................ 143
Market-Out Clause ............................................................................................................................. 144
Shelf Registration ............................................................................................................................... 144
Distribution of Securities........................................................................................................... 145
Syndicate ........................................................................................................................................... 145
Selling Group ..................................................................................................................................... 145
Determining the Public Offering Price (POP) ..................................................................................... 145
Underwriting Spread .......................................................................................................................... 145
Securities Act of 1933 – Registration ....................................................................................... 147
The Registration Process ................................................................................................................... 147
The Pre-Registration (Pre-Filing) Period ............................................................................................ 147
The Cooling-Off Period ...................................................................................................................... 148
 The Post-Effective Period................................................................................................................... 149
Disclosure Requirements ......................................................................................................... 150
Aftermarket Prospectus Delivery Requirement .................................................................................. 150
Types of Prospectuses....................................................................................................................... 150
Exempt Securities .................................................................................................................... 152
Exempt Offerings ..................................................................................................................... 152
Regulation D ...................................................................................................................................... 152
Rule 144 ............................................................................................................................................. 153
Rule 144A .......................................................................................................................................... 154
Rule 145 ............................................................................................................................................. 154
Rule 147 and 147A ............................................................................................................................ 155
The Primary Market for Municipal Bonds ................................................................................. 155
Issuing General Obligation (GO) Bonds ............................................................................................. 156
Issuing Revenue Bonds ..................................................................................................................... 156
New Issue Underwritings.................................................................................................................... 156
Forming a Syndicate ................................................................................................................ 156
Underwriting Documentation .................................................................................................... 157
Notice of Sale ..................................................................................................................................... 157
Legal Opinion ..................................................................................................................................... 157
Official Statement ............................................................................................................................... 157
Official Statement Summary............................................................................................................... 158
New Issue Confirmations ................................................................................................................... 159
Conclusion ......................................................................................................................................... 159
Chapter 11 Summary ......................................................................................................................... 159
Complete a Chapter 11 Quiz .............................................................................................................. 159

Chapter 12 – Orders and Trading Strategies ..................................................... 160

Trade Capacity – How Broker-Dealers Act............................................................................... 161
Fair Prices and Commissions – The 5% Markup Policy ..................................................................... 162
Discretionary Order/Discretion Not Exercised .................................................................................... 164
Types of Transactions .............................................................................................................. 164
Types of Orders ....................................................................................................................... 165
Market Orders .................................................................................................................................... 165
Limit Orders........................................................................................................................................ 165
Stop (Loss) Orders ............................................................................................................................. 166
 Stop-Limit Order ................................................................................................................................. 167
Order Qualifiers .................................................................................................................................. 168
Conclusion ......................................................................................................................................... 168
Chapter 12 Summary ......................................................................................................................... 168
Complete a Chapter 12 Quiz .............................................................................................................. 168

Chapter 13 – Settlement and Corporate Actions ............................................... 169

Trading, Clearing, and Settlement ............................................................................................ 170
Settlement Dates................................................................................................................................ 170
Customer Payment Versus Settlement .............................................................................................. 171
Settlement Methods ........................................................................................................................... 172
Delivery of Physical Securities ................................................................................................. 173
Paper Settlement ............................................................................................................................... 173
Corporate Actions .................................................................................................................... 174
Corporate Actions in Equities ............................................................................................................. 174
Other Corporate Actions .................................................................................................................... 176
Forwarding Official Communications ........................................................................................ 177
Conclusion ......................................................................................................................................... 178
Chapter 13 Summary ......................................................................................................................... 179
Complete a Chapter 13 Quiz .............................................................................................................. 179

Chapter 14 – Customer Accounts ...................................................................... 180

Account Types and Characteristics .......................................................................................... 181
Cash Accounts ................................................................................................................................... 181
Margin Accounts ................................................................................................................................ 181
Options Accounts ............................................................................................................................... 182
Discretionary Accounts ...................................................................................................................... 183
Fee-Based versus Commission Based Accounts .............................................................................. 184
Educational Accounts......................................................................................................................... 184
Customer Account Registrations .............................................................................................. 185
Individual Account .............................................................................................................................. 185
Joint Account...................................................................................................................................... 186
Corporate/Institutional Accounts ........................................................................................................ 186
Partnership Accounts ......................................................................................................................... 186
Trust Accounts ................................................................................................................................... 187
Custodial Accounts ............................................................................................................................ 187
 Retirement Accounts ................................................................................................................ 188
Traditional Individual Retirement Accounts (IRAs) ............................................................................. 188
Roth IRAs ........................................................................................................................................... 190
Qualified Retirement Plans....................................................................................................... 191
Employee Retirement Income Security Act (ERISA) .......................................................................... 191
Taxation of Retirement Plans ............................................................................................................. 192
Types of Plans ................................................................................................................................... 192
Conclusion ......................................................................................................................................... 194
Chapter 14 Summary ......................................................................................................................... 194
Complete a Chapter 14 Quiz .............................................................................................................. 194

Chapter 15 – Compliance Considerations ......................................................... 195

New Account Documentation ................................................................................................... 196
Required Information.......................................................................................................................... 196
SEC Recordkeeping Requirements ................................................................................................... 197
Know Your Customer and Suitability ........................................................................................ 198
Suitability ............................................................................................................................................ 198
Regulation Best Interest (Reg BI)............................................................................................. 200
Anti-Money Laundering and the USA PATRIOT Act ................................................................ 200
FinCEN’s Required Reports ............................................................................................................... 201
Mandatory AML Compliance Programs ............................................................................................. 202
SEC Regulation S-P ................................................................................................................. 204
Privacy of Consumer Financial Information........................................................................................ 204
Identity Theft Prevention—FTC Red Flags Rule ................................................................................ 205
Client Notifications ............................................................................................................................. 205
Regulation of Communications ................................................................................................ 207
Correspondence................................................................................................................................. 207
Institutional Communications ............................................................................................................. 207
Retail Communications ...................................................................................................................... 207
Telemarketing — An Alternative Communication Method ........................................................ 208
National Do Not Call List .................................................................................................................... 209
Safekeeping of Customer Funds and Securities ...................................................................... 209
The Customer Protection Rule ........................................................................................................... 209
Customer Free Credit Balances ......................................................................................................... 210
FINRA Rules ...................................................................................................................................... 210
 Fidelity Bonds..................................................................................................................................... 210
Business Continuity Plan (BCP) ............................................................................................... 211
Books and Records .................................................................................................................. 211
Conclusion ......................................................................................................................................... 212
Chapter 15 Summary ......................................................................................................................... 212
Complete a Chapter 15 Quiz .............................................................................................................. 212

Chapter 16 – Prohibited Activities ...................................................................... 213

Manipulation ............................................................................................................................. 214
Misrepresentations ............................................................................................................................. 214
Regulation M ...................................................................................................................................... 214
Market Rumors................................................................................................................................... 215
Front-Running .................................................................................................................................... 215
Trading Ahead of a Research Report................................................................................................. 216
Excessive Trading Activity (Churning)................................................................................................ 216
Marking-the-Close/Marking-the-Opening ........................................................................................... 217
Backing Away..................................................................................................................................... 217
Free Riding......................................................................................................................................... 217
Prohibited Trading Practices and Other Trading Rules ............................................................ 218
Anti-Intimidation/Coordination Interpretation ...................................................................................... 218
Payments to Influence the Market Price............................................................................................. 218
Best Execution ................................................................................................................................... 218
Time of Trade Disclosures (MSRB Rule G-47) .................................................................................. 219
Interpositioning ................................................................................................................................... 219
Trading Ahead of Customer Orders (Limit Order Protection Rule)..................................................... 220
Quoting a Security in Multiple Mediums ............................................................................................. 220
Mutual Fund Trading Rules ................................................................................................................ 220
Insider Trading ................................................................................................................................... 220
Other Prohibited Activities ........................................................................................................ 222
The New Issue Rule ........................................................................................................................... 222
Sharing in Accounts and Guarantees .................................................................................................. 225
Borrowing and Lending Practices with Customers ............................................................................. 225
Financial Exploitation of Specified Adults – FINRA Rule 2165........................................................... 226
Accounts at Other Broker-Dealers and Financial Institutions ............................................................. 228
Payments to Unregistered Person ..................................................................................................... 228
 Forgery ............................................................................................................................................... 229
Books and Records .................................................................................................................. 229
Recordkeeping Formats ..................................................................................................................... 229
Conclusion ......................................................................................................................................... 230
Chapter 16 Summary ......................................................................................................................... 230
Complete a Chapter 16 Quiz .............................................................................................................. 230

Chapter 17 – SRO Requirements for Associated Persons ............................... 231

SIE Exam – The First Step to Registration ............................................................................... 232
Associated Persons ........................................................................................................................... 232
Activities of Non-Registered Persons ................................................................................................. 233
Registered Representative Designations ........................................................................................... 234
Principal Designations........................................................................................................................ 235
Supervision of Registered Representatives ............................................................................. 236
Registration of Representatives and Principals ........................................................................ 237
Form U4 and the Central Registration Depository ............................................................................. 237
Statutory Disqualification .................................................................................................................... 238
Background Check .................................................................................................................... 239
Fingerprinting Requirement ........................................................................................................ 239
State Registration (Blue-Sky Rules) ......................................................................................... 239
Continuing Education ......................................................................................................................... 240
Regulatory Element............................................................................................................................ 240
Firm Element ...................................................................................................................................... 240
Maintaining Qualifications Program (MQP) ........................................................................................ 241
Conclusion ......................................................................................................................................... 241
Chapter 17 Summary ......................................................................................................................... 242
Complete a Chapter 17 Quiz .............................................................................................................. 242

Chapter 18 – Employee Conduct and Reportable Events................................. 243

Employee Conduct ................................................................................................................... 244
Registration of Representatives and Form U4 ................................................................................... 244
The Central Registration Depository .................................................................................................. 246
Updating Form U4 .................................................................................................................... 246
Form U5 ............................................................................................................................................. 246
Complaints ......................................................................................................................................... 248
 Red Flags ........................................................................................................................................... 249
Personal Activities of Employees................................................................................................ 250
Outside Business Activities ................................................................................................................ 250
Private Securities Transactions .......................................................................................................... 250
Influencing or Rewarding Employees of Others (The Gift Limit) ........................................................ 250
MSRB Political Contribution Rule (G-37).................................................................................. 252
Conclusion ......................................................................................................................................... 254
Chapter 18 Summary ......................................................................................................................... 254
Complete a Chapter 18 Quiz .............................................................................................................. 254

Chapter 19 – Economic Factors ......................................................................... 255

Economics................................................................................................................................ 256
Measuring National Output................................................................................................................. 256
Inflation............................................................................................................................................... 257
Deflation ............................................................................................................................................. 257
Measurements of Economic Activity ........................................................................................ 258
The Business Cycle ........................................................................................................................... 258
Business Cycle Indicators .................................................................................................................. 259
The Effect of the Business Cycle on Securities Markets .................................................................... 260
Classifications of Common Stocks ..................................................................................................... 261
Influencing the Economy – Monetary and Fiscal Policy ........................................................... 263
Keynesian Theory .............................................................................................................................. 263
Monetary Theory ................................................................................................................................ 263
Tools of the Federal Reserve Board......................................................................................... 264
Reserve Requirements ...................................................................................................................... 265
Discount Window ............................................................................................................................... 265
Federal Funds .................................................................................................................................... 265
Open Market Operations .................................................................................................................... 266
Margin Requirements ......................................................................................................................... 267
Moral Suasion .................................................................................................................................... 267
Effects of the FRB’s Activities ............................................................................................................ 267
International Economic Factors ................................................................................................ 268
Exchange Rates ................................................................................................................................. 268
Balance of Payments ......................................................................................................................... 268
Financial Statements ................................................................................................................ 269
 The Balance Sheet............................................................................................................................. 269
Components of the Balance Sheet – Assets ...................................................................................... 271
The Liabilities Section ........................................................................................................................ 271
The Stockholders’ Equity Section....................................................................................................... 271
The Income Statement ....................................................................................................................... 272
Components of the Income Statement ............................................................................................... 272
Conclusion ......................................................................................................................................... 273
Chapter 19 Summary ......................................................................................................................... 273
Complete a Chapter 19 Quiz .............................................................................................................. 273

Chapter 20 – Investment Risks ........................................................................... 274

Investment Risks ...................................................................................................................... 275
Systematic (Non-Diversifiable) Risk ................................................................................................... 275
Unsystematic (Diversifiable) Risk ....................................................................................................... 277
Attempting to Control Risk Through Diversification .................................................................. 279
Buy-and-Hold ..................................................................................................................................... 279
Portfolio Rebalancing ......................................................................................................................... 279
Indexing.............................................................................................................................................. 279
Active Strategies ...................................................................................................................... 280
Sector Rotation .................................................................................................................................. 280
Dollar Cost Averaging .............................................................................................................. 280
Hedging .................................................................................................................................... 281
Equity Options .................................................................................................................................... 281
Index Options ..................................................................................................................................... 281
Currency Options ............................................................................................................................... 281
Conclusion ......................................................................................................................................... 282
Chapter 20 Summary ......................................................................................................................... 282
Complete a Chapter 20 Quiz .............................................................................................................. 282
SIE 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 Chapters
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. Chapter quizzes to test comprehension after completing each chapter
3. Final examinations with explanations

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.

Copyright © Securities Training Corporation. All Rights Reserved. 1

INTRODUCTION SIE

Chapter Quizzes
The chapter quizzes are an invaluable part of your preparation for the SIE Exam. A quiz should be taken after
completing each chapter to determine whether the fundamental concepts being addressed are understood. To
enhance your understanding, an explanation is provided after each question is answered, regardless of whether
the correct choice was selected.

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. Note: In the Final Exam product, Custom Exams may be created to focus
on questions from one chapter or from multiple chapters.

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

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)

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SIE INTRODUCTION

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’s 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’s 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’s 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.

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.

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INTRODUCTION SIE

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’s 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’re 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. Don’t 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’s 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
STC provides sample study calendars which are designed to help students in organizing their time and
allowing for a manageable amount of daily study. Remember, these calendars are simply suggestions for how
you may plan your studies. Feel free to make any modifications that you deem appropriate.

The calendars are available for download on your student dashboard on www.my.stcusa.com.
 Click on the link to “Calendars and Crunch Time Facts” that appears below the Securities Industry
Essentials (SIE) Exam course title
 Choose the calendar that best fits your needs

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 Chapter 1

Overview of Market
Participants and Market
Structure

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CHAPTER 1 – OVERVIEW OF MARKET PARTICIPANTS AND MARKET STRUCTURE SIE

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. 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 as 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). The ownership interest
typically doesn’t 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.

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 SIE CHAPTER 1 – OVERVIEW OF MARKET PARTICIPANTS AND MARKET STRUCTURE

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).

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.

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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 Size

17.05 17.08 10 x 20
Price at which Price at which
the firm will buy the firm will sell

In the example above, the firm is willing to buy 1,000 shares (10 round lots of 100 shares) at 17.05 and/or sell
2,000 shares (20 round lots of 100 shares) at 17.08. Generally, if no size is indicated, 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 (IA)?

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.

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. The regulator with
whom the IA must register is often determined by its assets under management (AUM):
 If the IA has AUM of less than $100 million, it must register with the state(s) in which it conducts business.
 If the IA has AUM between $100 and $110 million, it may register with either the SEC or the state(s).
 If the IA has AUM in excess of $110 million, it must register with the SEC.

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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 doesn’t 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. 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 have attained a certain professional certification (e.g., certified financial planner, or CFP)
or designation such as a current Series 7, Series 65, or Series 82 registration that’s in good standing
 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

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CHAPTER 1 – OVERVIEW OF MARKET PARTICIPANTS AND MARKET STRUCTURE SIE

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. FINRA’s
“institutional account” definition also includes an account of an individual or other entity with total assets of at
least $50 million.

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  Small business development companies
 Registered investment companies  Private and public pension plans
 Registered investment advisers  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. 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.

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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. The OTC Pink Market (a platform that was created by
the OTC Markets Group) is a network that provides dealers with quotes on these securities. The OTC Pink
Market is not registered as an exchange with the SEC and typically doesn’t have the same level of trading
activity as the NYSE and Nasdaq.

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.

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CHAPTER 1 – OVERVIEW OF MARKET PARTICIPANTS AND MARKET STRUCTURE SIE

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 doesn’t 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 doesn’t 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.

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.

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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.

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.

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CHAPTER 1 – OVERVIEW OF MARKET PARTICIPANTS AND MARKET STRUCTURE SIE

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.

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 doesn’t 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 doesn’t 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 doesn’t have information
on each individual customer, the recordkeeping responsibilities belong primarily to the ABC Bond Brokers, the
introducing firm.

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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 consists 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.

Here’s a simplified picture

of this relationship:

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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. Currently, listed options
trade on the following exchanges:
 The Chicago Board Options Exchange (CBOE)
 The Boston Options Exchange (BOX)
 The NYSE Arca
 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 doesn’t clear options trades; instead, this is the job of the Options Clearing
Corporation (OCC). (Details on options contracts will be examined in Chapter 10.)

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.

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 hold 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. The registrar
also ensures the corporation doesn’t issue more shares than the number of authorized shares. Issued 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).

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The transfer agent is responsible for:

 The issuance and cancelation of certificates to reflect changes in ownership
 Maintaining a list of current shareholders who are eligible to receive additional shares after a stock split
 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

Although both the transfer agent and registrar keep a list of shareholders, only the registrar ensures that the number
of issued shares don’t exceed the number of authorized shares.

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 Summary
Now that you’ve completed this chapter, for the following commonly tested concepts, you should be able to:
 Understand the functions of a broker-dealer depending on the sector in which it operates:
‒ Investment bankers in the primary market
‒ Market makers in the secondary market
• Distinguish between a firm acting as broker versus a dealer
 Compare and contrast the characteristics of different types of investors
‒ Institutional, accredited, QIB, individual
 Understand the difference between the primary and secondary markets
 Identify the characteristics of:
‒ Physical versus electronic market platforms
‒ Regulated versus unregulated sectors of the market (NMS securities compared to OTC equities)
‒ Third Market and Fourth Market
 Recognize the step-by-step transaction process from initiation to completion (and the unique terminology
associated with each step)
 Understand the role of the DTCC in electronically handling the clearing, settlement, and custody of
securities transactions
 Describe the distinction of roles between clearing and introducing firms
 Describe the roles of other participants in meeting the industry’s recordkeeping and custody requirements

Complete a Chapter 1 Quiz

Log in to my.stcusa.com. From your Dashboard, select Chapter Quizzes, then scroll down and select Chapter 1.

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 Chapter 2

Overview of Regulation

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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 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. 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.

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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
department and the person in charge of this department 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.

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.

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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
79. 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.

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.

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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.

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.

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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 doesn’t 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.

A cash account is established if a customer doesn’t 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’s 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 doesn’t 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

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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.

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.

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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 investments, the rules require firms to obtain a signed
disclosure document from potential buyers which states that they understand the risks involved. Two of the
primary risks of penny stock investments are their high volatility and low liquidity.

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.

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

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
 Established antifraud rules and margin requirements (Reg. T)
Act 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
 Minimum $100,000 in assets
Act of 1940
 Annual reports to SEC; semiannual reports to shareholders

 ABC Test (Advice, Business, Compensation)

Investment Advisers
 Incidental advisers (lawyers, accountants, teachers, engineers) are excluded from the
Act of 1940
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
 SEC may sue for treble damages (three-times)
Securities Fraud Enforcement
 $5,000,000 maximum fine and/or 20 years imprisonment
Act of 1988
 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
The USA PATRIOT  Currency Transaction Reports (CTRs) for transactions exceeding $10,000
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
 Stock priced below $5.00 per share
Act of 1990
 Establishes significant disclosure rules

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CHAPTER 2 – OVERVIEW OF REGULATION SIE

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. FINRA members generally include broker-
dealers that are members of a national securities exchange (e.g., Nasdaq). 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.
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 (covered in a later chapter).
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 rule
Purpose violations
Provide for settlement of disputes

FINRA versus broker-dealers and/or

Parties registered representatives
Broker-dealers, RRs, customers

 Fine
 Censure
Possible Negative Monetary or other compensation
 Suspension
Outcomes  Expulsion
settlements
 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. 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.

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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.

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.

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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.

Chapter 2 Summary
Now that you’ve completed this chapter, for the following commonly tested concepts, you should be able to:
 Describe the roles of U.S. government agencies that influence the securities markets:
‒ The SEC
‒ The FRB (“the Fed”)
‒ The FDIC
 Compare and contrast the roles of the SEC and NASAA
 Describe the purpose for the SIE Exam, what passing the exam means, and potential next steps
 Compare and contrast the characteristics of:
‒ The Securities Act of 1933 and the Securities Exchange Act of 1934
 Compare and contrast the characteristics of:
‒ The Investment Company Act of 1940 and the Investment Advisers Act of 1940
 Understand the purpose of the Securities Investor Protection Act of 1970
‒ Recognize and apply SIPC protection coverage provisions
 Compare and contrast the characteristics of:
‒ The Code of Conduct and the Code of Arbitration
 Understand the Federal Law Summary Table
 Understand the unique characteristics of the MSRB as an SRO
 Recognize the responsibility firms have to establish a written supervisory procedures (WSP) manual

Complete a Chapter 2 Quiz

Log in to my.stcusa.com. From your Dashboard, select Chapter Quizzes, then scroll down and select Chapter 2.

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 Chapter 3

Equity Securities

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CHAPTER 3 – EQUITY SECURITIES SIE

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 his 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 don’t receive guaranteed interest payments
and there’s no maturity date on their investments.

So, what’s the upside for equity investors? If a company prospers, the shareholders can expect to share in its
profits in the form of cash or stock distributions (dividends) and experience an increase in the value of their
shares. However, if a company fails, the shareholders are more likely than other investors to lose their entire
investment. This is due to the fact that, if the corporation is forced to liquidate its assets under Chapter 7
bankruptcy, bondholders and other creditors have a higher claim to the company’s assets and will be paid first.

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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.
Investors provide capital Investors provide capital
The name preferred is derived from the fact that these and, in turn, may receive: and, in turn, receive:
owners have preference over common stockholders  Dividends  Interest
regarding payment of dividends. This preference also  Potential capital  Principal at maturity
extends to a bankruptcy proceeding conducted under appreciation  Liquidation preference
over stockholders
Chapter 7 or Chapter 11 of U.S. law. In both Chapter 7  Creditor status
and Chapter 11 bankruptcy proceedings, the corporation’s
secured creditors have the highest claim. Administrative claim holders are paid next, followed by unsecured
creditors, then are preferred stockholders, and the 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 establish 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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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 doesn’t 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 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 evidence of ownership
 Right to vote  Right of transfer
 Right to receive dividends

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’s provided with 100
votes. If any shareholders are unable to vote in person, they can vote by proxy which involves allowing
another person to cast their votes.

Corporations may issue different classes of common stock. Class A common shares allow the holders the
ability to vote. However, Class B stock may be issued with no voting rights, limited voting rights, or super
voting rights. Class A stock generally carries a higher value than any Class B stock that offers either no voting
rights or limited voting rights.

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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.

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.

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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 doesn’t exceed 5,000 shares and the aggregate dollar value of the sale
doesn’t exceed $50,000. In other words, if a person is not selling an excessive number of shares and the
aggregate dollar value of the sale is insignificant, no filing with the SEC is required.

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.

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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. 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).

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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 doesn’t 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.

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).

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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.

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.

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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’s 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 

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).

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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 him to
purchase 100,000 shares at a favorable price and maintain his 10% ownership in the
company. If he doesn’t exercise his 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. 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.

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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.

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’s 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.

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 SIE CHAPTER 3 – EQUITY SECURITIES

 The amount of stock purchased on any single day is limited. The total volume on any single day cannot
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.

Chapter 3 Summary
Now that you’ve completed this chapter, for the following commonly tested concepts, you should be able to:
 Understand that common stock:
‒ Is suitable for investors seeking growth
‒ Has the most risk if a corporation declares bankruptcy
 Understand that common shareholders have the right to vote in corporate elections (e.g., board of
directors, mergers), but not for cash or stock dividends
‒ Review the statutory versus cumulative voting example
 Understand that treasury shares have been repurchased by the corporation and have no voting or dividend
rights
 Define the terms restricted stock and control stock and understand their differences
 Understand that preferred stock:
‒ Is suitable for investors seeking income
‒ Has interest rate risk
‒ Doesn’t offer voting rights
‒ Receives dividends before the common shares
 Calculate the required dividend to be paid on any cumulative preferred stock that’s in arrears
 Understand the stability of convertible preferred stock prices during periods of fluctuating interest rates
 Recognize the differences between the pricing and maturities of rights and warrants
 Understand that American Depositary Receipt (ADRs):
‒ Provide U.S. investors with the ability to buy stock in a foreign company
‒ Trade in U.S. markets, are valued in U.S. dollars, and pay dividends in U.S. dollars
‒ May be sponsored (the ADRs trade on exchanges) or unsponsored (the ADRs trade in over-the-
counter markets)
‒ Have market risk and currency risk

Complete a Chapter 3 Quiz

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 Chapter 4

An Introduction to Debt
Instruments

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 SIE CHAPTER 4 – AN 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 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.

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.

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CHAPTER 4 – AN INTRODUCTION TO DEBT INSTRUMENTS SIE

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.

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

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 SIE CHAPTER 4 – AN INTRODUCTION TO DEBT INSTRUMENTS

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.

In some cases, an issuer may structure an offering so that some of it matures serially, with a large portion of the
offering being paid off at the final maturity. This form is referred to as a balloon maturity.

Why Bond Prices Fluctuate from Par

The par value of a bond can differ greatly from the price that investors pay 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 – AN INTRODUCTION TO DEBT INSTRUMENTS SIE

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.

In general, when interest rates change, the prices of long-term bonds will fluctuate more than the prices of short-
term bonds. In other words, bonds with longer maturities have more interest-rate risk than short-term bonds.
However, please be careful not to confuse this with which rates are more volatile. Short-term interest rates
change more often and more sharply (they’re more volatile) than long-term rates. 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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 SIE CHAPTER 4 – AN 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 doesn’t 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).

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CHAPTER 4 – AN INTRODUCTION TO DEBT INSTRUMENTS SIE

Bond Price Percentage of Par Value Price in Dollars

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

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

87 1/8 = 87.125 = $871.25 99.08 = 99 8/32 = 99.250 = $992.50
100 7/8 = 100.875 = $1,008.75 100.16 = 100 16/32 = 100.50 = $1,005.00
103 3/8 = 103.375 = $1,033.75 103.24 = 103 24/32 = 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’s an inverse
relationship that exists between market interest rates and existing bond prices.

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 SIE CHAPTER 4 – AN INTRODUCTION TO DEBT INSTRUMENTS

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.

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.

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CHAPTER 4 – AN INTRODUCTION TO DEBT INSTRUMENTS SIE

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, he will receive $1,020 ($20 more than the
bond’s par value). The call protection gives the investor the assurance of knowing that his
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

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 (and prices higher) 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 issuer’s 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

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 SIE CHAPTER 4 – AN INTRODUCTION TO DEBT INSTRUMENTS

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

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.

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CHAPTER 4 – AN INTRODUCTION TO DEBT INSTRUMENTS SIE

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.

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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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.

Chapter 4 Summary
Now that you’ve completed this chapter, for the following commonly tested concepts, you should be able to:
 Understand and define the terms:
‒ Debt service, par value, coupon rate or nominal yield, current yield, yield-to-maturity (YTM), yield-
to-call (YTC), dated date (and when it’s used), and accrued interest
 Recognize and understand the process used for calculating accrued interest for the different types of bonds
(which use a 30-day month and a 360-day year versus actual days in a month and a 365-day year)
 Define and understand the difference between serial and term bonds
 Recognize and understand how interest rate risk and credit risk affect bond prices
 Recognize and understand the role of bond ratings companies and what their ratings signify
 Recognize and understand the term points and the trading units in which different bonds trade
(i.e., 1/8 or 1/32 of a point)
 Define and understand the terms call provision, call protection, call premium, and put provision
 Recognize and understand the formula for conversion ratio and when it’s used
 Recognize and understand the tax consequences of a conversion

Complete a Chapter 4 Quiz

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 Chapter 5

Types of Debt
Instruments

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 SIE 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 he receive for his
next semiannual payment?
TIPS pay a fixed rate of interest, but it’s 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.

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.

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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, most agency debt is highly rated and many agency
offerings have AAA ratings. Also, as with U.S. Treasury securities, agency debt is issued in book-entry form
and quoted in fractions of 1/32nds of a point.

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

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

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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 a wholly owned
corporation that operates within the U.S. Department of Housing and Urban Development. Ginnie Mae’s purpose
is to provide financing for residential housing. Although Ginnie Mae securities are explicitly backed by the full
faith and credit of the U.S. government, any interest earned on them is subject to federal, state, and local taxes.

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

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

Prepayment Risk In addition to the risks that are inherent in many fixed-income investments (e.g.,
interest-rate, credit, and liquidity risk), mortgage-backed securities are subject to a special type of risk which is
referred to as prepayment risk. This is the risk that’s tied to homeowners paying off their mortgages early.
When interest rates fall, homeowners have an incentive to refinance and pay off their existing mortgages. This
risk, and others, will be described in more detail in Chapter 20.

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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.

Backing State general obligation bonds are usually secured by income tax, sales 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 (ad valorem tax). 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 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 created to issue bonds for purposes of building and operating a project.

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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.

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.

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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 Bonds (IDB) IDBs 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 doesn’t 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.

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.

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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, financed project
Source of the funds sales, 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
Use of the funds: improvement projects (e.g., roads, parks,
systems, bridges, toll roads/turnpikes,
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 they’re
issued in anticipation of receiving revenues at a future date. Depending on the facility that’s generating the
revenue, it could be in the form of federal or state subsidies.

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.

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.

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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’s 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).

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.

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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.

New Issue Underwritings

Once a municipal issuer has determined that there’s 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.

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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.

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.

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Secured Bonds
With secured bonds, if the issuer falls into bankruptcy, the trustee will take possession of the assets, liquidate
them, and then distribute the proceeds to the bondholders. Therefore, if the company defaults, secured
bondholders have a higher degree of protection.

The following are the different types of secured bonds that companies issue:

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

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

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

Type of Secured Bond Collateral

Mortgage Real Estate

Equipment Trust Equipment

Collateral Trust Stocks or Bonds

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

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

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

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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. Secured creditors, including secured bonds
Administrative expense claims (taxes, current wages, as well
2. as lawyer and accountant fees)
3. General creditors, including debentures
4. Subordinated creditors, including subordinated debentures
5. Preferred stockholders
6. Common stockholders

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

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 United States (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 United States.

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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 (e.g., T-bills),
government agencies, banks, and corporations. There’s also a diverse group of participants that utilize the money
market, including the Federal Reserve Board, banks, securities dealers, and corporations. Money-market
transactions provide an avenue for both acquiring money (borrowing) and investing (lending) excess funds for short
periods. Typically, the investment period ranges from overnight to a few months, but may be as long as one year.

Types of Money-Market Securities

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

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

Commercial Paper When corporations need long-term financing, they issue bonds. 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.

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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.

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 million or
more (also referred to as jumbo CDs). There’s an active secondary market in these securities. CDs of up to
$250,000 are currently insured by the Federal Deposit Insurance Corporation (FDIC).

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

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 doesn’t set the fed funds rate, it will attempt to influence the rate through its
purchases and sales of government securities in the secondary market.

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CHAPTER 5 – TYPES OF DEBT INSTRUMENTS SIE

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.

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.

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Chapter 5 Summary
Now that you’ve completed this chapter, for the following commonly tested concepts, you should be able to:
 Recognize and understand the types of U.S. government direct obligations
 Recognize and understand non-interest-bearing securities
 Recognize the characteristics of the U.S. Treasury security auction market
 Recognize and understand government/sponsored agency securities
‒ Government National Mortgage Association (GNMA), Federal National Mortgage Association
(FNMA), Federal Home Loan Mortgage Corporation (FHLMC), Federal Farm Credit Bank (FFCB),
and Federal Home Loan Bank (FHLB)
 Understand the characteristics of mortgage-backed securities (MBS)
‒ Understand the impact of prepayment risk on MBS
 Identify and understand the two types of municipal bonds
‒ General obligation (GO) bonds
‒ Revenue bonds (including the different forms)
 Understand the characteristics and ratings for municipal notes
 Understand the characteristics of municipal auction rate securities (ARS)
 Understand the characteristics of variable rate demand obligations (VRDO)
 Understand the primary market for municipal bonds
‒ The issuance of GO bonds
‒ The issuance of revenue bonds
 Understand the new issue underwritings process and components of the underwriting spread
 Understand the process of forming an underwriting syndicate
 Recognize and understand the types of corporate bonds
‒ Secured bonds, unsecured bonds (debentures), income bonds
‒ Eurodollar bonds (and Eurodollars), Yankee bonds, Eurobonds
‒ Money market securities
 Understand the tax implications for bond interest

Complete a Chapter 5 Quiz

Log in to my.stcusa.com. From your Dashboard, select Chapter Quizzes, then scroll down and select Chapter 5.

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 Chapter 6

Investment Returns

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 SIE 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 doesn’t 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.

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).

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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 in a fractional amount, the reduction must cover the full
dividend (i.e., a dividend of $0.12 ½ 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 doesn’t
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.

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’s 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.

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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
divided 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, or 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).

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.

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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 he 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.

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, he will receive $100 per year
($1,000 x 10%). However, the determination of her current yield will be very different depending on the price
he pays.

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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 he 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 he receives at maturity
(par). An investor who purchases a bond at par will get his money back at maturity. An investor who
purchases a bond at a discount will have a profit since he paid less for the bond than its par value. An investor
who purchases a bond at a premium will have a loss since he 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.

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 he 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 he will incur when the bond matures ($1,100 market value – $1,000 par value), plus
3. Interest earned from reinvesting the semiannual coupon payments

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CHAPTER 6 – INVESTMENT RETURNS SIE

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 he 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.

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%

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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. 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 (YTC) The yield-to-call represents a bond’s yield if it’s called prior to maturity. For callable
bonds, there’s 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. If a bond is trading at a discount, the yield-to-
call is higher than the yield-to-maturity; however, if a bond is trading at a premium (and callable at par), the
yield-to-maturity is higher than the yield-to-call.

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’s 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 market value of the securities on the date of the original owner’s death
(or the net asset value on the date of death if it’s mutual fund shares being received). By receiving the market
value at the time of death, the beneficiary has a higher (i.e., stepped up) cost basis, which reduces his potential
capital gain. Brokerage firms assist investors with calculating cost basis by sending an IRS Form 1099 which
provides useful tax related information.

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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.

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’s 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%.

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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’s 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. However, in some cases,
the rate of return on a 10-year U.S. Treasury note is used as an alternative.

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

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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 5000 Index The Wilshire 5000 Index tracks the performance of virtually all publicly traded
companies in the United States (i.e., those that trade on the New York Stock Exchange and Nasdaq). The
Wilshire 5000 Index represents the dollar value of all the stocks and is considered the broadest of all indexes
and averages.

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.

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Chapter 6 Summary
Now that you’ve completed this chapter, for the following commonly tested concepts, you should be able to:
 Recognize and understand the difference between the ex-dividend date and the record date
 Explain what happens to a stock’s price on the ex-dividend date
 Understand the impact and tax treatment of stock dividends
 Recognize and understand what a bond’s coupon rate represents for its semi-annual interest payments
 Recognize and understand the relationship between bond prices and bond yields
‒ Understand what happens to bond prices if interest rates rise
‒ Understand what happens to bond prices if interest rates fall
 Recognize and understand the difference between a bond’s nominal yield, current yield, and yield-to-
maturity
 Identify the relationship of the three yields if a bond is trading at a discount
 Identify the relationship of the three yields if a bond is trading at a premium
 Define and understand the term basis points
 Define cost basis
 Understand the relationship between cost basis, sales proceeds, and capital gains or losses
 Understand the process for determining an investment’s total return
 Understand the process for calculating an investment’s current yield
 Recognize and understand the difference between narrow-based and broad-based indexes
 Compare and contrast the characteristics of the S&P 500 Index and the Dow Jones Industrial Average

Complete a Chapter 6 Quiz

Log in to my.stcusa.com. From your Dashboard, select Chapter Quizzes, then scroll down and select Chapter 6.

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 Chapter 7

Packaged Products

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This chapter will examine different packaged products such as mutual funds, closed-end funds, and unit
investment trusts (UITs). Although each of these investments have 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
Management Unit Investment
Certificate
Companies Trusts (UITs)
Companies

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. On the other hand, a non-
diversified management 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.

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.

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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. Rules require the prospectus to be delivered by no later than the time
the customer receives a confirmation. 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.

Structure of a Mutual Fund

Shareholders The Fund Board of Directors

Investment Custodian Transfer Principal Service

Adviser Bank Agent Underwriter Providers

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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.

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 non-member firms.

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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.

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.

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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. Since index mutual funds are passively, rather than
actively managed, they typically have lower management fees.

Value Funds These funds invest in “out-of-favor” companies that are considered undervalued and are
often in the process of restructuring. Due to the nature of their investments, value funds are most suitable
for investors with long time horizons.

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. 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
total net assets (securities valued at their current Net Asset Value =
Number of Outstanding Shares
market price, plus cash, minus total liabilities)
by the total number of shares outstanding.

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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

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.

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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% (or 25 basis points) 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.

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.

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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 doesn’t
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. No-load funds typically have lower expense ratios, since their 12b-1 fees are limited to 25 basis
points per year.

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 classes with the following characteristics.

Class A Shares Class A shares usually have front-end loads, but have small or non-existent 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. This class of shares is most suitable for long-term investors. Although the front-end load may
seem high, the continuous internal expenses of Class A shares tend to be lower than those for Class B or C shares.

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. These shares are most suitable for investors who intend to redeem their shares within five to
seven years, especially if the back-end load decreases every year.

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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 what’s referred to as a level load, which means there’s an ongoing fee
(typically 1.0%) for as long as the investor holds the shares. As a result, this increases the expenses of the fund
and diminishes returns. These shares are most suitable for investors who will hold their shares for a short period
(more than one year, but less than three years). Although there’s no front-end load, a back-end load may be
assessed if shares are redeemed within one year. Class C shares typically have 12b-1 fees that are higher than
those of Class A shares.

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 Have a level load, which is
Sales Charges: Front-end load charge assessed if held less an ongoing fee
than 6 to 8 years (typically 1.0%)

Higher than for Class A Higher than for Class A

12b-1 Fees: Low or none
shares shares

Often convert to Class A Most suitable for short-term

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

Methods of Reducing Sales Charges

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

Fund Families The term fund 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.

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The following is an example of a breakpoint table:

Sales Charge As a Percentage

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

For 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 %)

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

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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 made in

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

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.

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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.

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.

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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.

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.

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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’s 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.

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 doesn’t 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

Product Secondary Market Trading Portfolio Marginable
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.

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Chapter 7 Summary
Now that you’ve completed this chapter, for the following commonly tested concepts, you should be able to:
 Recognize the three different types of investment companies
‒ Management companies (open- and closed-end), UITs, face amount certificate companies
 Understand the characteristics of open-end investment companies (mutual funds)
 Understand the mutual fund registration and prospectus requirements
 Identify the functions of the various service providers within the mutual fund structure
‒ BOD, investment adviser, custodian bank, transfer agent, underwriter, and dealers
 Recognize the major fund categories
‒ Identify the types of securities held within each fund
‒ Understand each fund’s investment objective and risk level
 Understand mutual fund pricing and the associated terms
‒ NAV, POP, forward pricing, sales charge, 12b-1 fees
 Calculate both the POP and sales charge percentage
‒ Understand the concept of a no-load fund and recognize the differences between class A, B, C
shares
• Review share class chart
 Understand the different methods by which sales charge is reduced
 Define and understand mutual fund sales practices and violations
‒ Breakpoints, letters of intent, and rights of accumulation
 Recognize different sales practice violations
‒ Breakpoint sales, large purchases of Class B shares, switching
 Define and understand the characteristics of dollar cost averaging
 Understand how closed-end investment companies differ from open-end investment companies
‒ Review the comparison table

Complete a Chapter 7 Quiz

Log in to my.stcusa.com. From your Dashboard, select Chapter Quizzes, then scroll down and select Chapter 7.

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 Chapter 8

Variable Contracts and

Municipal Fund
Securities

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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’s
depositing funds into the annuity).

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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 doesn’t 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. However, to change from one subaccount to
another, the owner needs to contact the insurance company that sponsors the contract.

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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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 doesn’t guarantee a minimum rate of return for most
of its variable annuity subaccounts. As a result, market risk is the greatest risk that a variable annuity contract
holder faces. 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’s 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 annuitants 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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Loans Insurance companies generally allow their contract owners to borrow against the value of their
annuity contracts during the accumulation period. As opposed to a withdrawal, the advantages of taking a loan
include the fact that the borrower will avoid surrender charges, potential taxes, as well as potential early
distribution penalties. Loans taken from annuities are typically required to be repaid within a specific period.
However, if the loan is not repaid, it will be considered a distribution and potentially subject to taxation and
early distribution penalties.

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’s 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. Although the amount of each payment is not guaranteed, the continual
payments are guaranteed by the insurer that sold the annuity.

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

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.

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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’s assessed on
Class B mutual fund shares. Although FINRA rules specify a maximum sales charge of 8.5% for mutual fund
sales, there’s no statutory maximum sales charge on variable products. Instead, sales charges for variable
annuities must be reasonable.

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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.

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.

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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’s 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 doesn’t 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. 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 annuitant withdraws funds prior to
reaching the age of 59 1/2, he’s required to pay taxes on any increases in the value of his annuity plus he’s
subject to a 10% tax penalty.

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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 people 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 being subject to increased fees or charges (e.g., mortality and expense
fees or investment advisory fees). Additionally, a principal must document whether another exchange has
been executed for the client within the preceding 36 months since this may be evidence of churning.

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.

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.

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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. 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.

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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 Although originally intended to accumulate funds to only pay for college
educational expenses, the funds in 529 plans may also be used for expenses related to elementary and secondary
schools at public, private, or religious institutions. Today, individuals are allowed 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—
as well as using their account proceeds for college costs. Additionally, an individual is now permitted to
withdraw up to $10,000 on a tax-free basis (a qualified withdrawal) to repay a qualified student loan as well
as expenses for certain apprenticeship programs. This is a lifetime limit that applies to the beneficiary and
each of the beneficiary’s siblings.

Contribution Limits Although current tax law allows a tax-free gift of up to $18,000 to any one person in any
given tax year, a 529 plan may be front-loaded with an initial gift of $90,000 which is treated as if it’s being
made over a five-year period (five contributions of $18,000 each). Individuals may contribute these same
amounts to 529 plans that are maintained for more than one beneficiary. In other words, if an individual has five
grandchildren, she’s able to contribute $90,000 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. (In 2023, the maximum tax-free gift was $17,000 and the front-loading amount
was $85,000.)

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). Currently, 529 plan assets cannot be rolled into IRAs; however, beginning in 2024, this will be
permitted with strict limitations.

Direct or Adviser Sold There are two methods 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.

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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 $18,000 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’s no five-year front loading of contributions and there
may only be one 529A account per beneficiary. The earnings are generally tax-free from both federal and
state taxes 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.

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).

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Chapter 8 Summary
Now that you’ve completed this chapter, for the following commonly tested concepts, you should be able to:
 Distinguish between fixed and variable annuities
 Recognize the key differences between an insurance company’s general account and a separate account
 Understand that separate accounts (and related subaccounts) of variable products are generally required to
be registered with the SEC as investment companies under the Investment Company Act of 1940
 Recognize the characteristics of both the Accumulation Phase and Annuity Phase of annuities and the tax
ramifications of taking withdrawals, loans, and annuity payments
 Understand the annuity payout options that are available at annuitization and where beneficiaries can be
named
 Understand the difference between contract owners, annuitants, and beneficiaries
 Calculate the death benefit in the event the owner dies during the Accumulation Phase
 Understand the charges and expenses associated with annuities
 Distinguish between qualified and non-qualified annuities and the resulting tax consequences of taking
withdrawals from them
 Define and understand the term cost basis
 Understand the difference between tax-deferred and tax-free
 Understand the different methods of funding an annuity
 Understand the suitability issues that arise when an annuity purchase or 1035 Exchange recommendation is
made
 Understand how equity-indexed annuities are different from variable annuities
 Understand the requirements for contributing funds to a 529 plan and rules for using the funds
 Understand the eligibility requirements and use of a 529 ABLE plan
 Recognize recent changes made to 529 and 529 ABLE plans as a result of the SECURE Act

Complete a Chapter 8 Quiz

Log in to my.stcusa.com. From your Dashboard, select Chapter Quizzes, then scroll down and select Chapter 8.

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 Chapter 9

Alternative Investments

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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.

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.

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

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).

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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). Also, unlike mutual funds and ETFs, hedge funds
are not required to disclose specific information regarding their holdings. The reason that hedge fund managers
take on additional risks is to generate larger returns than the overall market. Although specific securities positions
may vary from fund to fund, many hedge funds borrow money (i.e., use leverage) to increase their returns.

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 limit 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.

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.

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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). Both
listed and non-traded REITs avoid paying taxes on distributed income in substantially the same manner as a
regulated investment company. However, unlike DPPs, neither listed nor non-traded REITs pass-through
operating losses.

To qualify for the special tax treatment, all types of REITs 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 both listed
and non-traded 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.

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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, limited liability companies (LLCs) 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 Subchapter C Corporations—often simply referred to as corporations—are

taxed twice. Corporations are required to pay taxes on their income and then their shareholders pay taxes on
any dividends that the corporations distribute. 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%).

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.

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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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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 doesn’t materially
participate in its operations throughout the year. Investments in direct participation programs and rental activities
are considered passive activities. 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.

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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.

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.

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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.

Comparison of Alternative Investments

Product Secondary Market Trading Subject to Act of 1940 Marginable
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

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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.

Chapter 9 Summary
Now that you’ve completed this chapter, for the following commonly tested concepts, you should be able to:
 Recognize that an exchange-traded fund (ETF) is a type of investment company, but is NOT a mutual
fund
 Understand why ETFs are considered passively managed
 Recognize that an ETF can be structured as an inverse ETF or a leveraged ETF
 Define and recognize the characteristics of a leveraged inverse ETF
 Understand the characteristics of exchange-traded notes (ETNs)
 Understand whose credit rating is critical when evaluating an ETN
 Recognize that an ETN can be structured as an inverse ETN or leveraged ETN
 Understand the characteristics of a hedge fund
 Understand the characteristics of a real estate investment trust (REIT) and recognize the three different
types (mortgage, equity, and hybrid)
 Understand the different tax implications for both the REIT and the REIT investors
 Recognize the different forms of direct participation programs (DPPs)
 Understand how DPPs act as a flow through investment vehicle for tax purposes
 Recognize the structure of a limited partnership (LP) and understand its characteristics
 Understand the obligations and rights of the general and limited partners
 Understand the priority of liquidation of a limited partnership

Complete a Chapter 9 Quiz

Log in to my.stcusa.com. From your Dashboard, select Chapter Quizzes, then scroll down and select Chapter 9.

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 Chapter 10

Options

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CHAPTER 10 – OPTIONS SIE

The goal of this chapter is to increase a person’s knowledge of the following option-related concepts—
hedging, 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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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

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.

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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 that an option will only have INtrinsic value if it’s IN-the-money.

Option Premium = Intrinsic Value + Time Value

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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.

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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

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.

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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.
 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.

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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’s 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.

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’s 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.

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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.

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).

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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.

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 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

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 SIE CHAPTER 10 – OPTIONS

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.

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 doesn’t own XYZ stock, it’s an uncovered call. An
uncovered call writer has an unlimited maximum potential loss since there’s no limit as to how high the price of
the security may rise. The investor is effectively short the stock since she doesn’t 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 doesn’t 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

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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.

Chapter 10 Summary
Now that you’ve completed this chapter, for the following commonly tested concepts, you should be able to:
 Understand the fundamental definition of an option and related options terminology
 Understand rights and responsibilities of the buyer and seller involved in an option transaction
 Describe the difference between a call option and a put option
 Recognize the components an option’s premium:
‒ Intrinsic Value
‒ Time Value
 Distinguish between an option that’s in-, at-, or out-of-the-money
 Identify and describe the components of an options contract
 Understand the strategy for each option position:
‒ Long Calls and Short Puts = Bullish
‒ Short Calls and Long Puts = Bearish
 Determine the breakeven, maximum gain, and maximum loss for both the buyer and the seller of a call or
put option
 Distinguish between speculation and hedging positions
 Distinguish between covered and uncovered options positions
 Determine the impact of option events on the participants:
‒ Liquidation
‒ Exercise
‒ Expiration
 Describe the procedure for the exercise of an equity option
 Describe the role of the OCC in options transactions
 Understand the process and procedures for opening an options account
 Compare and contrast the characteristics of equity and index options

Complete a Chapter 10 Quiz

Log in to my.stcusa.com. From your Dashboard, select Chapter Quizzes, then scroll down and select Chapter 10.

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 Chapter 11

Offerings

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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 that 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.

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.

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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.

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

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Mini-Maxi Another variation of a best-efforts underwriting is the mini-maxi underwriting. With this form,
there’s 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

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.

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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. The role of the syndicate is to guarantee
(underwrite) the offering. A broker-dealer’s syndicate desk assists in the pricing of the offering, helps to build
the book of orders, markets (distributes) the issue and, if necessary, places a stabilizing bid.

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.

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. This portion is also referred to as the additional takedown.

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 Concession—the portion that’s paid to the firm that sells the shares. The term total takedown represents
the combination of the underwriter’s fee plus the concession, which is the amount that’s paid to a
syndicate member when it sells shares of the offering.

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.

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
$.80 $.10 $.10
Compensation
Syndicate Member’s
.00 $.70 $.20
Compensation
Selling Group Member’s
.00 $.00 $.50
Compensation

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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’s 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 doesn’t 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:

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.

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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 doesn’t guarantee the truthfulness
of the information that’s contained within a registration statement. Additionally, the SEC doesn’t 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.

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)

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During this period, underwriters are not permitted to:

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

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.

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.

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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 Pink Market

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. 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 As a condensed registration statement, the statutory prospectus includes:

 Risk factors and use of proceeds
 Dividend policy
 Industry and other data
 Capitalization and 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
 Shares eligible for future sale
 Underwriting conflicts of interest and legal matters

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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

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 doesn’t 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).

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Exempt Securities
Certain issuers are not required to register their securities with the SEC. For issuers that qualify for an
exemption from registration, there’s significant time and cost savings. 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 doesn’t 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’s 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’s 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 doesn’t exceed 5,000 shares or the dollar
amount doesn’t 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’s 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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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 publicly 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 Subject to Rule 145 Not Subject to Rule 145
changes in par value are not considered
 Substitutions  Stock splits
reclassifications and are therefore not subject to
 Mergers/Consolidations  Reverse stock splits
the rule.  Transfers of assets  Changes in par value

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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. 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.

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Issuing General Obligation (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 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.
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. 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’s 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 employ these individuals are required to be
registered with the MSRB.

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.

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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.

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’s 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.

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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). 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.

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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.

Chapter 11 Summary
Now that you’ve completed this chapter, for the following commonly tested concepts, you should be able to:
 Define the terms public offering, private placement, IPO, and split (combined) offering
 Understand the role of the underwriter/investment banker, syndicate member, and selling group
 Define the terms firm commitment, best efforts, all-or-none, mini maxi, and stand-by
 Define the terms market out clause and shelf registration
 Understand the term public offering price (POP) and how it’s established
 Recognize the components of the underwriting spread
 Understand the steps involved in the registration process
 Define the terms preliminary prospectus (Red Herring), statutory prospectus, mutual fund summary
prospectus, free writing prospectus, and offering memorandum
 Identify the exempt securities and exempt offerings
 Define the term accredited investor and understand the specific qualifications
 Define and understand the application of Rules 144, 144A, 145, 147, and 147A
 Define the terms qualified institutional buyer (QIB) and private investment in public equity (PIPE)
 Define the terms official statement and legal opinion
 Understand the purpose of the MSRB’s Electronic Municipal Market Access (EMMA) system

Complete a Chapter 11 Quiz

Log in to my.stcusa.com. From your Dashboard, select Chapter Quizzes, then scroll down and select Chapter 11.

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 Chapter 12

Orders and Trading

Strategies

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 SIE 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’s
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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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 doesn’t 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.

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.

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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 he owns or selling securities that he
doesn’t currently own (i.e., securities that have been borrowed). If the customer sells stock that he currently
owns, it’s referred to as a long sale and he must either have the securities in his account with the broker-dealer or
be able to deliver them promptly. Conversely, what if the customer doesn’t currently own the stock being sold?

Short Positions A short sale is one in which the investor sells shares that he doesn’t 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’s 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., he 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.

For example, an investor sells shares short 100 shares at $50. The investor receives proceeds of $5,000 into his
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, he 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.

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As long as the short seller’s margin account maintains the minimum required equity, there’s 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 Chapter 10, if the seller of a call option owns
the underlying stock, he’s 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 he’s assigned. On the other hand, if the seller
of a call doesn’t own the shares, he’s 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 doesn’t 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. There are
different ways that a customer may be place a market order for execution. For example, a customer’s market
order may simply state, “lighten up my holdings in XYZ by 300 shares.”

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.

For example, let’s assume XYZ stock is BUY LIMIT ORDER

currently trading at $31. A customer wants to 40
buy the stock if it drops slightly and,
therefore, enters a limit order to buy 100 35
shares of XYZ at $30. The order may not be Price 30
executed unless the stock is able to be
25
purchased at $30 or below.
EXECUTION AT OR BELOW $30
20
A buy limit order is placed below the current
market price of a security.
Time

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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
EXECUTION AT OR ABOVE $30
rises slightly, he may place a sell limit order 35
at $30. The order will not be filled unless the
Price 30
stock is 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 doesn’t 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. A stop order is a
contingent order, which means that it will not 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.

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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’s 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.
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

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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.

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.

Chapter 12 Summary
Now that you’ve completed this chapter, for the following commonly tested concepts, you should be able to:
 Recognize and understand the function of brokers (agents) and dealers (principals) act and how they’re
compensated
 Understand the 5% policy and the factors that influence a firm’s commission or markup
 Define the term proceeds transaction
 Recognize and understand the different types of transactions (e.g., purchase, long sale, short sale)
 Understand the difference between a covered and uncovered option writer
 Recognize and understand the various types of orders, including market, limit, and stop orders
 Define the terms day order and good ‘til cancelled (GTC or open order)
 Identify the price and size of a market maker’s quote
 Understand the types of purchases and sales that can be executed in cash and/or margin accounts

Complete a Chapter 12 Quiz

Log in to my.stcusa.com. From your Dashboard, select Chapter Quizzes, then scroll down and select Chapter 12.

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 Chapter 13

Settlement and
Corporate Actions

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CHAPTER 13 – SETTLEMENT AND CORPORATE ACTIONS SIE

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).

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.

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 SIE CHAPTER 13 – SETTLEMENT AND CORPORATE ACTIONS

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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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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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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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’s 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.
1,000 x 2/1 = 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.
$100 x 1/2 = $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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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 is 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 Microcap will now have 2,000 shares outstanding with a market value of $5
per share ($1/share x 5/1).

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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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.

Odd Lot Tenders Since a round lot of stock is 100 shares, investors who own less than 100 shares are referred
to as odd lot shareholders. Corporations with a large number of odd lot shareholders are often faced with large
administrative costs when dealing with their odd lot shareholders. To reduce these expenses, some companies
will buy these investors’ shares through an odd lot tender or odd lot buyback. These transactions work in the
same way as a normal tender, except that shareholders are only able to sell an odd lot in the tender offer. Unlike
dividends and stock splits, investors must agree (opt in) before participating in these transactions.

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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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’s 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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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. 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 13 Summary
Now that you’ve completed this chapter, for the following commonly tested concepts, you should be able to:
 Recognize and understand the dealer-to-dealer regular-way settlement dates for the following securities:
‒ Corporate and municipal securities
‒ U.S. government securities and options
• Review the Settlement Date chart
 Recognize and understand the difference between settlement date and Reg T payment date for both a cash
account and margin account
‒ Review the Settlement versus Customer Payment Date chart
 Understand the impact if payment is not made by the Reg T payment date
 Define the term cash settlement and understand how it differs from regular-way settlement
 Define the term freeriding and identify its occurrence
 Define the term good delivery and understand why a stock power is relevant
 For tender offers:
‒ Understand the term and the reason the company or a third-party may use this process
‒ Identify the number of shares a customer will receive if a tender offer is either undersubscribed or
oversubscribed
 For both a forward and reverse stock split:
‒ Calculate both the number of shares and the price per share after the split
• Review the 2-for-1 Stock Split Adjustment to Shares Outstanding graphic
‒ Understand the tax treatment of a stock split and calculate the revised cost basis

Complete a Chapter 13 Quiz

Log in to my.stcusa.com. From your Dashboard, select Chapter Quizzes, then scroll down and select Chapter 13.

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 Chapter 14

Customer Accounts

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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’s 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.
For example, if a customer buys 100 shares of ABC common stock with a $5,000 total
purchase price, he needs to deposit $2,500 ($5,000 purchase price x 50%) within two
business days of the settlement date (i.e., T+4).

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

Since not all margin customers start with substantial purchases, industry rules establish minimum equity
requirements for initial transactions in their margin accounts. For a long position, the customer’s minimum
required deposit is the lesser of $2,000 or 100% of the purchase price; however, for a short position, the customer’s
minimum required deposit is $2,000. If a customer’s initial purchase or short sale exceeds $4,000, then a deposit of
50% of the security’s market value is required. Essentially, for both long and short positions, no loan (money or
stock) is provided unless the customer’s equity is at least $2,000.

Marginable Securities Under Regulation T, only certain securities may be purchased using margin. These
marginable securities are listed on either the NYSE or Nasdaq (e.g., ETFs). This includes equities and
corporate bonds.

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On the other hand, non-marginable securities cannot be purchased on margin and these include mutual fund
shares, initial public offerings (IPOs), and over-the-counter (OTC) stocks. The fact that these securities are not
marginable doesn’t mean that they cannot be purchased in a margin account; it simply means that any trades
involving these securities must be paid for in full at the time of purchase.

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.

Although selling stock short in a margin account doesn’t 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.

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This verification is done by having the customer complete the form or correct any of the entered information.
If there’s 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.

Within 15 calendar days after a customer's account has been approved for options trading, the firm must
obtain from the customer a written agreement that she’s aware of and agrees to be bound by the rules that are
applicable to the trading of option contracts.

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. This
authorization gives the RR the ability to make certain investment decisions without the customer’s approval.

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.

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’s
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.

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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 withdrawals of funds Full POA
Not-Held Orders (for one day) None

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. Although the owner typically establishes a plan for a
family member, the beneficiary is not required to be a relative. 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.

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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’s 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’s 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.

Section 529 College Savings Plans As covered in detail in Chapter 8, Section 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, up to
$10,000 per year in K-12 tuition, and a lifetime limit of $10,000 to repay a qualified student loan as well as
expenses for certain apprenticeship programs.

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.

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Joint Account
Joint accounts have more than one owner of record; however, the owners don’t need to have an equal share of the
assets in the account. 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
that’s 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)

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 who’s permitted to enter transactions in the account, including the partner’s name, address,
citizenship, and tax identification number. A partnership agreement must be created to 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.

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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

Upon the death of the beneficiary, the remaining assets go to the beneficiary’s estate.

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.

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 doesn’t 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’s 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 $18,000
per year; however, in 2023, the amount was $17,000).

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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.

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.

Any person, regardless of age, who has earned income from employment during the year may contribute to a
traditional IRA. Earned income may be derived from wages, salaries, commissions, professional fees, and
taxable alimony. However, earned income doesn’t 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.

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Contribution Limits The maximum amount that an individual may contribute to an IRA on an annual basis is
$7,000 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 $8,000. Please note, contributions must be made in
cash; a person may not contribute property. (In 2023, the maximum annual IRA contribution was $6,500.)

Spousal Accounts If both spouses of a married couple are employed, each may separately open an IRA and
contribute a maximum of $7,000 annually. Married couples with only one employed spouse may also contribute
a maximum of $14,000 per year into two separate IRAs, assuming the working spouse has earned income of at
least $14,000 per year. However, no more than $7,000 may be contributed to either account. The account for the
non-working spouse is referred to as a spousal account.

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 $7,000 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’s 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) plans, 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 age of
59 1/2 will be required to pay a 10% tax penalty on the amount withdrawn, in addition to being liable for
ordinary income taxes on the withdrawal. The amount of the early withdrawal will be added to the investor’s
taxable income for that year.
For example, a 40-year-old 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.

Investors who are under the age of 59 1/2 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 for expenses related to the birth or adoption of a child ($5,000 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

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

Required Minimum Distributions (RMDs) Investors who wait too long to begin taking withdrawals from
their traditional IRAs may also incur a 25% tax penalty (the penalty is based on the amount that should have been
taken). The IRS will levy this penalty if the investor doesn’t start taking withdrawals by April 1 following the
year in which the person reaches the age of 73. (The penalty was decreased from 50% to 25% and the age was
increased from 72 to 73 as a result of the passage of the SECURE Act 2.0.) The RMD provisions also apply to
SEP-IRAs and SIMPLE IRAs, but not to Roth IRAs (since Roth IRAs are funded after-tax).

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:
 The account owner is age 59 1/2 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 for expenses related to the birth or adoption of a child ($5,000 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. There are exemptions
available to avoid the penalty, including substantially equal periodic payments being made over the
individual’s life, the one-time withdrawal of $10,000 for a first-time homebuyer, and the IRS withdrawing the
money directly in order to pay an IRS tax levy. It’s important to note that 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 $7,000 or 100% of earned income. A married person may also contribute $7,000 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 $7,000 per
year. (In 2023, the maximum annual Roth IRA contribution was $6,500.)

Eligibility Any person, regardless of age, is eligible to open a Roth IRA provided her income doesn’t
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’s
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 $7,000 100% of earned income, up to a maximum of $7,000
Similarities

Spousal option: An extra $7,000 Spousal option: An extra $7,000

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 in which the owner reaches 73 No withdrawal requirement
(25% 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 cannot 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’s 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. 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.

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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.

Eligibility With the passage of the Setting Every Community Up for Retirement Enhancement (SECURE) Act,
access to retirement savings plans has been enhanced. One of the enhancements specifically impacts employers
that offer 401(k) plans. Employers that maintain 401(k) plans are required to implement a dual eligibility
requirement under which employees are eligible to participate if they complete either:
1. A one-year of service requirement (with the existing 1,000-hour requirement) or
2. Three consecutive years of service during which the employees complete at least
500 hours of service

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.

Roth 401(k) Plans In many ways, Roth 401(k) plans are similar to 401(k) plans, with the exception of how
employees are taxed. In 401(k) plans, employees are allowed to make contributions on a pre-tax basis. Roth 401(k)
plans, just like Roth IRAs, only permit non-deductible (after-tax) contributions. However, qualified withdrawals
from Roth 401(k) plans are excluded from federal tax. This means that employees are not required to pay taxes on
capital gains, bond interest, or dividends.

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

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While a 403(b) plan is technically not a qualified plan, it resembles a 401(k) plan by allowing the participants
to exclude the contributions that they make from their taxable incomes (i.e., contributions are made pre-tax)
and the earnings grow on a tax-deferred basis. As with a 401(k) plan, the maximum annual contribution
amount to a 403(b) plan is determined by the IRS (inflation adjusted). Employers may also make matching
contributions for their employees. Investments in a 403(b) plan are typically limited to mutual funds, fixed
annuities, and variable annuities. An important note is that investors are not permitted to buy limited
partnerships in a 403(b) plan.

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.

Chapter 14 Summary
Now that you’ve completed this chapter, for the following commonly tested concepts, you should be able to:
 Recognize the characteristics of cash accounts and margin accounts
 Understand and apply the minimum equity requirements for a new margin account
 Understand the procedures and required disclosures for opening margin accounts and options accounts
 Understand the requirements for opening and maintaining a discretionary account
‒ Recognize the difference between full and limited power of attorney
 Understand the characteristics of a not-held order (time and/or price discretion)
 Compare and contrast the characteristics of:
‒ Fee-based versus commission-based accounts
‒ Coverdell ESAs versus 529 plans
 Understand the general process for opening a standard brokerage account, including:
‒ Information required and any additional documentation
‒ Rights, privileges, responsibilities, and limitations of the parties involved in a joint and/or minor’s
account
 Compare and contrast the different types of retirement accounts and determine the suitability for each
type of account
‒ Annual contribution limits
‒ Whether RMD rules apply
‒ Tax treatment of both contributions and withdrawals
 Understand the characteristics of employer sponsored (ERISA) plans and individual retirement plans

Complete a Chapter 14 Quiz

Log in to my.stcusa.com. From your Dashboard, select Chapter Quizzes, then scroll down and select Chapter 14.

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 Chapter 15

Compliance
Considerations

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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’s more than one RR
responsible for the account, a record of the scope of responsibility for each representative is required. This
provision doesn’t 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 doesn’t 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. 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.

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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

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.

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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 doesn’t 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.

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.

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Regulation Best Interest (Reg BI)

In June of 2019, the SEC adopted a package of rulemakings and interpretations that are designed to enhance the
quality and transparency of retail customers’ relationships with broker-dealers and investment advisers. These
rules will bring the legal requirements and mandated disclosures in line with reasonable investor expectations,
while preserving access (in terms of choice and cost) to a variety of investment services and products.
Specifically, these actions include new Regulation Best Interest, the new Customer Relationship Summary
(Form CRS), and separate interpretations under the Investment Advisers Act of 1940.

Regardless of whether a retail customer chooses a broker-dealer or an investment adviser (or both), the retail
customer is entitled to a recommendation (from a broker-dealer) or advice (from an investment adviser) that’s in
the customer’s best interest and that doesn’t place the interests of the firm or the financial professional ahead of the
customer’s interests. In other words, any strategy or product that firms or individuals recommend to retail
customers must be in the customers’ best interest (not just suitable).

Who’s a Retail Customer? Currently, Reg BI only applies to retail customers. According to the
regulation, a retail customer is defined as a natural person, or this person’s non-professional legal
representative, who:
 Receives a recommendation of any securities transaction or investment strategy involving securities from
a broker-dealer; and
 Uses the recommendation primarily for personal, family, or household purposes

Professional legal representatives (e.g., financial industry professionals) and other fiduciaries are not
considered retail customers.

Client Relationship Summary (Form CRS) Along with the passage of Reg BI, the SEC adopted a new
relationship summary disclosure document that broker-dealers must provide for retail customer—the Client
Relationship Summary (Form CRS). Form CRS must be no longer than two pages. The purpose of Form CRS
is to provide retail investors with information about the nature of their relationship with their financial
professional in a simple, easy-to-understand format.
 New retail investors must receive a copy of Form CRS by no later than the time they open a brokerage
account, place an order, or receive a new recommendation for an account type, securities transaction, or
investment strategy.

Broker-dealers must file Form CRS with the Central Registration Depository (CRD), while registered
investment advisers must file Form CRS with the Investment Adviser Registration Depository (IARD) as Part
3 of Form ADV.

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.

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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. FinCEN requires most corporate entities to report information about their control persons.
A control person is an individual who has significant responsibility to control, manage, or direct a legal entity.
This includes the chief executive officer (CEO), president, chief operating officer (COO), chief financial
officer (CFO), managing partner, general partner, managing member, and managing director. A control
person may or may not be a beneficial owner. 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.
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.

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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 doesn’t 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’s 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 doesn’t 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).

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.

Specially Designated Nationals and Blocked Persons 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).

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U.S. broker-dealers that operate in the U.S. or abroad, as well as foreign broker-dealers that operate in the
U.S., are subject to screening by OFAC. The list is referred to as the Specially Designated Nationals and
Blocked Persons List, or simply the SDN List. The SDN 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 SDN 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. In addition, broker-dealers are
required to retain records related to transmittals or transfers of funds (e.g., wire transfers) that exceed $3,000.
This includes the order details, names of the transmitter and recipient, as well as the identity of the recipient’s
financial institution.

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.

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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 S-P

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 S-P 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 policies 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 S-P is protecting a customer’s non-
public, personal information which includes information that a financial institution obtains from the customer.
Non-public information can also be created from customer lists based on personally identifiable information
(e.g.., 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., information found on the internet), and
information that’s required to be disclosed to the general public by federal, state, or local law.

Privacy Notice Under Regulation S-P, 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. 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 S-P 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.

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For example, if John has a meeting with a financial adviser from ABC Securities
about establishing a financial plan, he’s a consumer (a potential customer).
However, if John opens an account with ABC Securities, he’s 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 doesn’t 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 S-P 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.

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.

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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.
 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’s 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.

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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 doesn’t 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.” 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 doesn’t 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

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 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.

The industry incorporates the following provisions of this law into its SRO rules:
 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.

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 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. 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 doesn’t include another broker-dealer, a partner, officer, or director of the
broker-dealer, or a subordinated lender.

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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. 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
Disclosure of Financial Condition 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.
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. Similarly, MSRB firms must either give their
financial statements to their customers or publish their financials on their website on an annual basis.

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.

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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

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.

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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, Forms U4/U5
Corporate or partnership
municipal complaints*, new account and employee records, all
documents
forms, account statements, 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.

Chapter 15 Summary
Now that you’ve completed this chapter, for the following commonly tested concepts, you should be able to:
 Recognize the customer information that’s required to be obtained to open a new account
 Recognize the customer information that should be requested (NOT required)
 Understand the purpose for requesting the name of a customer’s trusted contact person
 Understand FINRA’s three suitability obligations:
‒ 1) Reasonable Basis Obligation, 2) Customer-Specific Obligation, 3) Quantitative Obligation
 Recognize the Bank Secrecy Act and the USA PATRIOT Act and how they regulate money laundering
‒ Recognize the three stages of money laundering (placement, layering, and integration)
 Understand the role of the Financial Crimes Enforcement Network (FinCEN) and its required reports
‒ Bank Secrecy Act Currency Transaction Report (BCTR) and Suspicious Activity Report (SAR)
 Understand the importance of Regulation S-P in protecting customers’ private information
 Understand the delivery requirements of customer communications, including account statements and trade
confirmations
 Define the three categories of customer communications:
‒ 1) Correspondence, 2) Retail Communication, and 3) Institutional Communication
 Understand the purpose of the Telephone Consumer Protection Act of 1991
 Understand the importance and requirements of a firm creating a Business Continuity Plan (BCP)
 Recognize records that are kept for three years, six years, or for the life of the firm (review the chart)

Complete a Chapter 15 Quiz

Log in to my.stcusa.com. From your Dashboard, select Chapter Quizzes, then scroll down and select Chapter 15.

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 Chapter 16

Prohibited Activities

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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 doesn’t 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. 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.

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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.

The SEC specifies that broker-dealers and underwriters are prohibited from promising to repurchase shares of
an IPO at no less than the original sales price. This manipulative practice of allocating IPO shares based
securing prearranged purchase orders from customers in the aftermarket at a specified price is referred to as a
tie-in arrangement (or laddering). The intent of laddering is to inflate the aftermarket price of an IPO and
cause other market participants to buy or bid for the security at higher prices. This prohibition applies
regardless of whether the transactions are actually executed. In addition, it’s a violation to encourage clients,
prior to the trading of an IPO, to provide information on the price and number of shares they’re willing to
purchase in the aftermarket.

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.

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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. 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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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 reports, 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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The following factors are used to determine whether a member firm has used reasonable diligence:
 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

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.

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.

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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.

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 doesn’t 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 is if it’s provided to the financial news media. Once provided, the media will have the
opportunity to disseminate it.

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Tippers and Tippees In some situations, material, non-public information (MNPI) 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 doesn’t 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.

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.

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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. Any
person who controls the violator (e.g., manager or supervisor) is subject to civil penalties not exceeding the
greater of $1 million or three times the profit gained or loss avoided as a result of the violation.

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 may range between 10% and 30% of the money collected.

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.

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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’s 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.

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 a written representation from
the account holder, or any authorized party of the account, which states 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.

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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’s purchasing an equity IPO
for her personal account. There is no restriction if she’s 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).

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 doesn’t 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

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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. For example, if a registered representative has a joint
account with a customer and contributes 25% to the account, the representative’s portion of any growth in the
account is limited to 25%.
– This condition doesn’t 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

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.

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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.

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 e-mail 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, as well as on the execution of transactions in the account. A hold may be placed on
any request for the proceeds of a sale to be sent to another person if there’s a reasonable belief of the
existence of financial exploitation. 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’s no reasonable belief of financial exploitation (e.g., normal bill paying).

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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.

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 may 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. Lastly, to provide greater
protection, if the firm’s internal review still supports its reasonable belief of the potential for financial
exploitation, the temporary hold may be extended by the member firm for no longer than 30 business days
following the date above unless it was terminated or extended by another authorized regulatory entity.
 Essentially, member firms are able to maintain a temporary hold on disbursements or transactions for a
maximum of 55 business days.

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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.

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.

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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.

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).

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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.

Chapter 16 Summary
Now that you’ve completed this chapter, for the following commonly tested concepts, you should be able to:
 Recognize how the Securities Exchange Act of 1934 prohibits manipulative and deceptive practices in the
sale of securities
 Understand the basic purpose of Regulation M of the Securities Exchange Act of 1934
 Recognize various prohibited activities, including spreading market rumors, front-running, trading ahead of
a research report, churning and reverse churning, marking-the-close/marking-the-open, etc.
 Recognize various prohibited trading practices, including making payments to influence market price,
interpositioning, trading ahead of customer orders, quoting a security in multiple mediums at different
prices, insider trading, etc.
 Understand the purpose of FINRA’s New Issue (Equity IPO) Rule and identify the eligible purchasers
 Understand the regulations regarding sharing in accounts, guarantees, and borrowing from or lending
money to clients
 Understand the rule regarding the financial exploitation of specified adults, as well as the importance of a
trusted contract person, and the implementation of a temporary hold
 Understand the rules regarding a member firm employee opening an account with another firm
 Understand the rules regarding the role and limitations of unregistered persons

Complete a Chapter 16 Quiz

Log in to my.stcusa.com. From your Dashboard, select Chapter Quizzes, then scroll down and select Chapter 16.

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 Chapter 17

SRO Requirements for

Associated Persons

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CHAPTER 17 – SRO REQUIREMENTS FOR ASSOCIATED PERSONS SIE

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’s 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 SIE

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
Series 6 and Variable Contracts  Mutual funds, closed-end funds on the initial offering only,
Products Representative and 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
General Securities and secondary 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
Series 22  Direct participation programs (real estate, oil and gas, and
Programs 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);
Series 79 mergers and acquisitions; tender offers; financial
Representative
restructurings and asset sales; divestitures or other
corporate reorganizations; and business combination
transactions
This representative exam allows a person to solicit and sell
Private Securities
Series 82 private placement securities products as part of a primary
Offerings Representative
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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 SIE CHAPTER 17 – SRO REQUIREMENTS FOR ASSOCIATED PERSONS

MSRB Representative Designations

This representative exam allows a person who is associated
Municipal Advisor
Series 50 with a municipal advisor to engage in municipal advisory
Representative
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
Municipal Securities consultant services for issuers in connection with the
Series 52
Representative issuance of municipal 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
products and variable contracts; municipal securities;
General Securities Sales
Series 9/10 options; government securities; and direct participation
Supervisor
programs.
 However, this person doesn’t 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
General Securities securities business, such as underwriting, trading and
Series 24 market making, advertising, and/or overall compliance with
Principal
financial responsibilities.
 However, this person doesn’t supervise activities related to
municipal securities or options.
This principal exam allows a person to have regulatory
Investment Companies compliance over sales of the following:
Series 26 and 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 SIE

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 fund securities; selling municipal fund securities to
Municipal Fund Securities
Series 51 customers; communicating with customers or maintaining
Limited Principal
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
Municipal Securities customers; rendering of financial advisory or consultant
Series 53
Principal 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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 SIE CHAPTER 17 – SRO REQUIREMENTS FOR ASSOCIATED PERSONS

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 doesn’t 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 doesn’t 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. 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

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 SIE CHAPTER 17 – SRO REQUIREMENTS FOR ASSOCIATED PERSONS

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 firms 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 doesn’t 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.

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.

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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 on an annual basis for each registration that they
hold (i.e., there are two requirements for individuals who are registered in both a representative and principal
capacity). The content of the Regulatory Element will be appropriate to each representative or principal registration
category a person holds. All covered persons must complete their Regulatory Element by December 31 of the
calendar year following the year in which they became registered and by December 31 of every year 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 and, during 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.

If the person doesn’t 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.

Firm Element
Any registered persons and their immediate supervisors are subject to the Firm Element continuing education
requirements. 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, and
applicable regulatory requirements

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 SIE CHAPTER 17 – SRO REQUIREMENTS FOR ASSOCIATED PERSONS

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 inactive registration
status limitations 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.

Maintaining Qualifications Program (MQP)

Under FINRA’s Maintaining Qualifications Program (MQP), individuals who terminate any of their
representative or principal registrations are able to maintain their qualifications by completing their annual CE
requirement. Individuals who pay a $100 annual fee to utilize this program are given a maximum of five years
to reregister with a member firm without being required to requalify by exam. To be eligible for the MQP,
individuals must meet the following conditions:
1. They must have been registered in the terminated registration category for at least one year immediately
prior to the termination in that category.
2. They must elect to participate in the MQP within two years from the date of termination.
3. They must complete all of their CE requirements by their due dates.
4. They cannot have been CE Inactive for two consecutive years.
5. They cannot be subject to statutory disqualification.

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.

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CHAPTER 17 – SRO REQUIREMENTS FOR ASSOCIATED PERSONS SIE

Chapter 17 Summary
Now that you’ve completed this chapter, for the following commonly tested concepts, you should be able to:
 Understand the purpose and key features of the SIE Exam, including limitations and subsequent
qualification exam requirement
 Define the term associated person
 Describe the permitted activities of non-registered persons as they relate to interaction with the public
‒ Restrictions, compensation, supervision
 Understand the general role/responsibilities of the different registered representatives and supervising
principals (Review the summary tables)
 Recognize the exam confidentiality requirements
 Describe the characteristics of Form U4 and the purpose of the Central Registration Depository (CRD)
 Describe the terms and conditions under which a member is subject to statutory disqualification
 Understand a firm’s request to FINRA of an eligibility proceeding with a pledge to conduct heightened
supervision
 Recognized the personnel who are required to be fingerprinted
 Distinguish between FINRA and Blue-Sky (state) registration requirements
 Understand the two elements of FINRA’s Continuing Education requirements
‒ Regulatory Element and Firm Element
 Understand how Special Inactive Status classification is given to a registered person who actively serves
in the military

Complete a Chapter 17 Quiz

Log in to my.stcusa.com. From your Dashboard, select Chapter Quizzes, then scroll down and select Chapter 17.

242 Copyright © Securities Training Corporation. All Rights Reserved.

 Chapter 18

Employee Conduct and

Reportable Events

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CHAPTER 18 – EMPLOYEE CONDUCT AND REPORTABLE EVENTS SIE

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 (personal bankruptcies, operation of business that went bankrupt, 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’s 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’s 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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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. Disclosure and updating Form U4 is also required
if a person is/has been subject to a judge’s bench warrant for failing to appear for felony charges. However,
for most misdemeanor charges, the issuance of a bench warrant is not required to be reported. 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. Please note, 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’s 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. However, if any registered persons apply under the previously referenced Maintaining
Qualifications Program (MQP), they’re given five years before being required to requalify.

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. 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.

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 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’s 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 At least once every calendar year, FINRA’s Investor Education and Protection Rule
requires member firms to provide the following to each customer, in writing (which may be electronic):
 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 doesn’t carry customer accounts and doesn’t 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’s 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.

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.

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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
 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

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  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 doesn’t 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.

A red flag doesn’t 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 includes consulting other supervisors or members from other departments (e.g., compliance or legal.)

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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. Thereafter, the member must provide written acknowledgement
of its receipt and may require the associated person to adhere to specific conditions in order to participate in the
transaction.

Personal transactions involving investment company and variable annuity securities are not covered by this
rule.

Influencing or Rewarding Employees of Others (The Gift Limit)

Under the gift limit rule, FINRA as well as MSRB 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.

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 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 doesn’t apply to gifts that a
firm makes to its own employees or gifts that are made by an employee to a co-worker.

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). Gifts of tickets to sporting or entertainment
events are valued at the greater of cost or face value, not market value. For example, let’s assume that a ticket
to a concert with a face value of $50, was purchased for $90, but can now be sold for $200. In this case, the
gift will be valued at $90.

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 which they’re 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’re 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 doesn’t 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 doesn’t
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’s 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’s 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.

Chapter 18 Summary
Now that you’ve completed this chapter, for the following commonly tested concepts, you should be able to:
 Recognize the contents of Form U4
‒ Required personal information and disclosures
‒ Arbitration provisions and required disclosures
 Understand the uses of Forms U4, U5, and U6
 Understand the purpose of FINRA’s BrokerCheck
‒ The information it provides
‒ The length of time the information is available
 Understand the investor education requirements of both FINRA and the MSRB
 Understand the procedures for customer complaints
‒ Recordkeeping requirement and quarterly reports
 The events which require FINRA notification
 Recognize and understand the rules, permissions, and notification requirements for registered persons as
it pertains to:
‒ Outside business activities
‒ Private securities transactions (Selling Away)
‒ Gifts and entertainment expenses
‒ Training and education seminars
‒ Political contributions

Complete a Chapter 18 Quiz

Log in to my.stcusa.com. From your Dashboard, select Chapter Quizzes, then scroll down and select Chapter 18.

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 Chapter 19

Economic Factors

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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 statements 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 final value of all of the goods
and services that are produced within the U.S., without regard to the origin of the producer. For example, in
the U.S., GDP includes the net profits (i.e., sales price – production costs) made by 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.

Balance of Payments For multinational corporations to pay for imports and receive money for exports,
foreign currency transactions are required. The balance of payments is how economists measure the payments
coming into and going out of a country. There are two parts to the balance of payment:
1) the current account and 2) the capital account. Among other things, the current account measures the balance
of trade for the year. The capital account focuses on net changes in ownership of assets (e.g., selling land to a
foreign investor). A positive balance of payments occurs when cash inflows exceed cash outflows (e.g., a
country exports more than it imports). For example, foreign investors buying U.S. Treasuries has a positive
effect on the balance of payments for the United States.

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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’s too much money chasing too few goods.

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 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:

Bond Yield – 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‘re factoring in the decline of the purchasing power of their future payments.

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.

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.

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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.

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’s referred
to as a recovery.

Business Cycle Indicators

Although the economy tends to follow a general pattern, it’s 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
 The prices for the S&P 500 Index common stocks
 Leading Credit Index (This index consists of six financial indicators based on various yields)
 Interest-rate spreads, 10-year Treasury bonds less federal funds
 Average consumer expectations for business conditions

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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:
1. Employees on non-agricultural payrolls
2. Personal income less transfer payments (Transfer payments represent aid for individuals in the form of
Medicare, Social Security, and veterans’ benefits, etc.)
3. The Index of Industrial Production
4. 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.

The Wall Street Journal publishes important rates on a daily basis and some of the most important are:
 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 borrow from
the Federal Reserve.
 Federal Funds Rate The fed funds rate is what’s 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.

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Price Elasticity of Demand The price elasticity of demand represents the sensitivity of the demand for a
specific good after a change in its price. Goods with elastic demands are very sensitive to price changes. This
means that small changes in price will produce large changes in demand. Historically, soft drinks have been
elastic since consumers buy less when their price rises. Goods that have inelastic demand are relatively
insensitive to changes in price. Consumers will continue to buy goods with inelastic demand even as prices
rise. For example, medicine and other pharmaceuticals often have inelastic demands.

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.

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.

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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 doesn’t 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 don’t 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.

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.

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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. The U.S. Department of Treasury is a part of the executive branch and runs the federal
government’s budget. The Treasury’s responsibilities include the collection of taxes through the Internal
Revenue Service (IRS) and the spending of government money. While the Treasury implements fiscal policy, it
doesn’t have direct control over it. Conversely, monetary policy is controlled by the Federal Reserve—a body
that’s 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 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.

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 (i.e., a normal yield curve). 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. The normal and inverted yield curves are illustrated by the diagrams shown below.

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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.

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

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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’s an increase in reserve requirements. Changing the
reserve requirement will have the greatest impact on the money supply.

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’s directly set by the FRB. Although it’s largely symbolic, it acts as a
benchmark from which other key interest rates are set, such as the fed funds rate.

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’re 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 doesn’t 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.

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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’s 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.

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.

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Repurchase Agreements A repurchase agreement (also referred to as a repo) is a contract that’s 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’s lending money and, therefore, increasing bank reserves (an easing of the money supply).
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’re
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.

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

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Effect on Money Supply and Impact on General

Activity
Credit (Loan) Availability Interest Rate Levels

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. 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 base currency compared to a counter 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.

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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’s 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.

On the other hand, technical analysts base their investment decisions on market data and attempt to identify
trading opportunities in price trends and patterns seen on charts.

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 don’t have physical value, they add substantial value to a
company. Some intangible assets differentiate the company from its competitors and are proprietary, such as
patents, intellectual property, trademarks, franchises, and copyrights. Goodwill is another intangible asset 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’s 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.

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.

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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.

Chapter 19 Summary
Now that you’ve completed this chapter, for the following commonly tested concepts, you should be able to:
 Define and understand the following common measurements of economic output:
‒ Gross National Product (GNP) and Gross Domestic Product (GDP)
 Define the terms inflation and deflation and understand how they’re measured
 Understand the importance of the Consumer Price Index (CPI)
 Calculate the Real Interest Rate for a fixed income security
 Recognize the four phases of the Business Cycle and the types of companies that benefit in each phase
 Recognize the different types of economic indicators
 Identify and understand key interest rates in the economy
‒ Prime Rate, Discount Rate, Fed Funds Rate, Broker Call Rate
 Understand the characteristics of Keynesian and Monetary economic policies
 Understand the characteristics of the different yield curves (e.g., normal and inverted)
 Understand the definition of money supply
 Recognize the various tools used by the FRB and how they impact the economy
‒ Review the chart on how FRB activity impacts interest rates and credit
 Define the term balance of payments
 Understand the various financial statements that are used by fundamental analysts
‒ Balance sheets and income statements

Complete a Chapter 19 Quiz

Log in to my.stcusa.com. From your Dashboard, select Chapter Quizzes, then scroll down and select Chapter 19.

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 Chapter 20

Investment Risks

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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 (which may
be referred to as the beta coefficient). 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.

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.

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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%.

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).

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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’s specific to a particular company. Using beta, investors can
predict a stock’s rate of return. Thereafter, alpha can be calculated by taking what the stock actually earned
and subtracting its expected return. For example, based on its beta, a stock is expected to earn 5%. If the
stock actually earned 8%, then alpha was 3% (8% – 5%). On the other hand, if the stock only earned 4%,
the alpha is -1% (4% – 5%).

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 an investment may lose value due to changes in a
country’s government or regulations. Although this risk may apply to both domestic and foreign investments, it’s
typically associated with emerging markets countries and may include acts of war, terrorism, and military coups.

Liquidity Risk Liquidity risk is the risk that investors may be unable to dispose of a securities position
quickly and at a price that’s reasonably related to recent transactions. This type of risk tends to increase as the
amount of trading in a particular security decreases. For instance, the shares of large blue-chip companies are
highly liquid, while the stocks of small companies are typically less liquid. Investments which are not traded in
the market, such as hedge funds, private placements, direct participation programs (limited partnerships), and
real estate have a significant lack of liquidity.

Opportunity (Cost) Risk Opportunity cost or opportunity risk represents the possibility that the return of
a selected investment is lower than another investment that was not chosen. For example, an investor may be
planning to hold a bond until maturity and is therefore unconcerned with the potential decline in its price if
interest rates rise. After all, as long as there’s no issuer default, he will receive the bond’s par value at
maturity. Of course, the problem with this approach is that it fails to take into account the higher return that
the investor could have possibly earned from an alternative investment.

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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’s based in the U.S. if it earns revenue in a foreign
country. For example, a U.S. company sells its products and services in Europe and earns revenue in euros.
If the U.S. dollar increases or strengthens in value, the euro will decline and cause the dollar value of this
revenue to fall. In addition, if the dollar strengthens, this company’s products will be less competitive in
Europe and result in the company exporting less.

Capital Risk Capital risk is the risk that an investor could lose all or a portion of her investment. Purchasers of
options are significantly impacted by capital risk because, if the options purchased expire worthless, the investor
will lose 100% of his capital. On the other hand, if an investor 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.

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.

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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’s 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.

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.

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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.).

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.

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 SIE CHAPTER 20 – INVESTMENT RISKS

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’s no delivery or receipt of a
foreign currency if the option is exercised. 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.

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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!

Chapter 20 Summary
Now that you’ve completed this chapter, for the following commonly tested concepts, you should be able to:
 Define and provide examples of systematic (non-diversifiable) risk
‒ Identify which securities have market risk
‒ Identify which securities have interest rate risk and Inflation risk
‒ Identify which securities have event Risk
 Define and provide examples of non-systematic (diversifiable) risk
‒ Identify which securities have business risk, regulatory risk, and legislative risk
‒ Identify which securities have capital risk
‒ Identify which securities have liquidity risk
‒ Identify which securities have currency risk and political risk
‒ Identify which securities have credit risk and prepayment risk
 Define the terms alpha and beta and understand the type of risk(s) they measure
 Understand that duration is a measure of interest rate risk
 Define an efficient market and understand the type of investors who subscribe to the Efficient Markets
Hypothesis
 Understand the differences between strategic and tactical asset allocation
‒ Recognize that sector rotation is an active investment strategy
‒ Recognize that buy-and-hold, portfolio rebalancing, and indexing are all passive investment
strategies
 Identify the types of risks that options can minimize through hedging

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