65- sec. 7: Ethical Practices and Fiduciary Obligations

Regulation S-P

-Enacted by SEC to protect the privacy of customer information -Requires privacy notice describing privacy policies -**Permits firms to disclose nonpublic personal info to unaffiliated third parties unless the customer OPTS OUT of the disclosure --**Requires that the customer be given 30 DAYS TO OPT OUT before disclosure of nonpublic personal info may be made

Form ADV-E

-ONLY applies to IA's who have custody of client accounts -requires an annual surprise examination by an independent public accountant -the form is used as a cover page and contains info about the adviser and about the exam conducted

General rule is that state-registered IAs who have custody must maintain a net worth of at least $35k. However, this is waived in two cases:

1. Advisers having custody solely due to direct fee deduction and who keep the required records and make notifications to clients 2. Advisers having custody solely due to advising pooled investment vehicles and who keep the required records and make notifications to clients

TWO major benefits to an IA using a qualified custodian

1. Because the custodian is sending the quarterly reports to the client, that administrative burden is lifted from the IA 2. No requirement for a surprise annual audit by an independent accountant

Q: Investment Adviser registered with the state wishes to take custody of a client's funds and securities. Which statement describes the NASAA rules regarding notification to the Administrator? A. Adviser must supply prompt notification to the Administrator by immediately updating form ADV B. Adviser must notify Admin within 90 days of the end of its fiscal year by updating its form ADV C. If the Adviser will be using a qualified custodian, no notification is necessary D. Prompt notification to the Admin is made by the independent accounting firm performing the adviser's annual surprise audit

A

If an unaffiliated person acts on behalf of an investment adviser in an attempt to solicit or refer new investment advisory clients, which of the following conditions is NOT required by the Investment Advisers Act of 1940 for the adviser to pay the solicitor a fee for this service? A) The solicitor must be registered as an investment adviser. B) The adviser must be registered as an investment adviser. C) There must be a written agreement between the solicitor and the investment adviser. D) There can be no outstanding SEC order barring the solicitor's activities.

A An unaffiliated (nonemployee, or third party) solicitor is usually not required to register as an investment adviser or investment adviser representative under the Investment Advisers Act of 1940 as long as certain stipulations are met. The solicitor is not under the control of the SEC. There must be a written agreement between the solicitor and the investment adviser for whom he solicits clients. The solicitor cannot have a disciplinary item in his background that would prohibit that solicitor from registering as an adviser or adviser representative.

Which of the following is NOT true regarding the Securities Exchange Act of 1934? A) The act bars the use of arbitrage by broker-dealers. B) The act prohibits the spread of false rumors to induce others to trade. C) The act proscribes the use of wash trades. D) The act prohibits the simultaneous purchase and sale of a security to create the appearance of trading.

A Arbitrage is a legal activity, usually performed by traders at broker-dealers, which takes advantage of momentary discrepancies in the price of a security in different markets. The act prohibits any form of manipulation of securities prices or any practices that would influence the market price of a security. This includes wash trades, which are simultaneous purchases and sales that create the appearance of trading activity, and the use of rumors to induce others to trade.

Under the USA, all of the following statements are true regarding investment advisory contracts EXCEPT A) they cannot allow for prepaid advisory fees B) they can only allow fees to be performance related under certain limited circumstances C) they must be in writing D) they cannot be assigned without customer approval

A Nothing in the USA prohibits prepaid advisory fees. The contract must describe the nature of these fees and the circumstances, if any, under which any or all of the prepaid fee may be returned in the event of early cancellation of the contract. The USA requires initial and renewal contracts to be in writing and state that assignment may take place only with the client's consent. There are certain circumstances, such as an investor with a net worth of at least $2 million, where performance-based fees are permitted.

One of your very best clients introduces you to his son and then, one week later, is injured in an accident and is totally paralyzed and unable to speak. The son calls you and enters an order for his father's account that is entirely consistent with your client's trading habits. As an agent, you would A) refuse the trade without a signed power of attorney B) act in accordance with the client's last will and testament C) follow the son's instructions D) visit your client in the hospital and ask him to squeeze your hand if he wishes to go ahead with the trade

A Nothing takes place in an account without instructions from the client or someone else with written trading authorization. Nothing in the question indicates that the son has trading authority. There is no will yet because the client is still alive.

The duties and responsibilities of a fiduciary are spelled out in A) the Uniform Prudent Investors Act of 1994 B) the Investment Advisers Act of 1940 C) the Uniform Gift to Minors Act D) the Summary Plan Document of the DOL

A The UPIA is the legal guide for fiduciaries, who must act with skill and caution in the best interest of their clients.

All of the following statements concerning an agency cross transaction for an advisory client are true EXCEPT A) an investment adviser may recommend the transaction to both parties to the transaction B) an investment adviser must make prior written disclosure to the advisory client that it will act as broker-dealer for, have a potential conflict of interest with, and may collect commissions from both parties C) an advisory client must provide prior written consent for the adviser to be able to engage in agency cross transactions D) it is a transaction in which a person acts as an investment adviser in relation to a transaction in which the adviser or related person acts as a broker-dealer for both the advisory client and another person on the other side of the transaction

A The investment adviser handling an agency cross transaction may not recommend the transaction to both parties. An agency cross transaction is a transaction in which a person acts as an investment adviser in relation to a transaction in which the adviser or related person acts as a broker-dealer for both the advisory client and another person on the other side of the transaction. An advisory client must provide prior written consent for an adviser to be able to do agency cross transactions as part of his operating plan. An investment adviser must make written disclosure to the advisory client that it will act as broker-dealer for, have a potential conflict of interest with, and may collect commissions from both parties.

Discretionary Account

Account set up with preapproved authority for a securities professional to make transactions without having to ask for specific approval. Discretion is defined as the authority to decide: -which security -number of shares or units -whether to buy or sell

An investment adviser prepares a slick advertising piece containing the relevant information from the firm's Form ADV - Part 2. One of the firm's IARs secures a contract with a new client and presents the brochure at that time. While explaining the terms of their agreement, the IAR mentions that the client may withdraw within the first 48 hours without any penalty. Upon returning to the office, the IAR realizes that he forgot to have the client sign a receipt for the disclosure document. Under the NASAA Model Rule on Unethical Business Practices of Investment Advisers, Investment Adviser Representatives, and Federal Covered Advisers, A) the IAR has acted in an unethical manner by giving incorrect information regarding the penalty-free withdrawal privilege B) there is a violation because the brochure must be delivered at least 48 hours prior to entering into the contract. C) there is no violation as long as the customer signs a waiver agreeing to these terms. D) there is a violation because the IAR failed to obtain the signed receipt.

A The problem here is that the client has 5 days to withdraw, not 48 hours. Under Rule 203(b)-1 of the Uniform Securities Act, an investment adviser, or investment adviser representative must deliver the brochure to an advisory client or prospective advisory client not less than 48 hours prior to entering into any investment advisory contract with such client or prospective client; or at the time of entering into any such contract, if the advisory client has a right to terminate the contract without penalty within 5 business days after entering into the contract. A signed receipt is not necessary and waivers are never allowed.

You are an IAR. One of your clients is a C level officer with a publicly traded corporation. When needing to relieve yourself, you are shown to the executive washroom. While cleaning up, you notice a report, stamped "Confidential" and a quick peek reveals that it is highly favorable to the company. Under the NASAA Model Rule on Unethical Business Practices of Investment Advisers, Investment Adviser Representatives, and Federal Covered Advisers, you A) cannot buy any of the stock for personal or client accounts B) should tell your client what you saw and ask permission to act on this information C) contact the Administrator immediately D) can accept unsolicited orders from clients and buy for your personal account only

A This is a case of "accidentally" acquiring material, inside, nonpublic information. Under no circumstance are you permitted to make any use of this until the report is made public. However, you may accept unsolicited customer orders (unless they were in the washroom with you), but you can't do anything for yourself.

Q: Which of the following would be deemed to have custody of customer funds or securities? A. Adviser receives the proceeds of sales in the customer's account B. Adviser receives a fee of $1500 as a prepayment for the next contract year C. Adviser has investment discretion over the account D. All of these

A Under the Investment Adviser Act of 1940, discretion and substantial prepayments are NOT considered custody. Access to funds in the client's account is considered custody.

A fiduciary, acting in accordance with the UPIA, would choose investments on the basis of all of the following EXCEPT A) transaction costs B) other resources of the beneficiaries C) general economic conditions D) needs for liquidity, regularity of income, and preservation or appreciation of capital

A Under the Uniform Prudent Investor Act, transaction costs are not a primary factor in a trustee's determination of which investments to choose for the trust. They may be a factor in determining where to execute the transactions. The key for the prudent investor is to use skill and caution examining all of the factors involved to meet the stated objectives.

Direct Fee Deduction

An adviser who has custody because the adviser's fees are directly deducted from the client's accounts must also provide the following A. Written authorization B. Notice of fee deduction: each time a fee is deducted from a client's account: -send the client a notice of the fee amount -send the client an invoice itemizing the fee HRA has custody (technically) since they can pull out an adviser fee

When it comes to safeguarding confidential information pertaining to the account(s) of an individual customer or family, the rules deal primarily with what is called a covered account. A key factor in determining if an account meets the definition is A) if the customer owns the underlying security on which the call option is sold B) the ability of the customer to move funds out of the account on multiple occasions C) that the account is in the name of an institutional customer D) the ability of the customer to make a one-time wire to a foreign bank account owned by a family member

B A covered account is an account, primarily for personal, family, or household purposes, that involves or is designed to permit multiple payments or transactions. Where the money goes is less of a factor than the frequency of transactions. The only time when a single transaction account might be covered is if there is reason to believe that the identity of the customer is at risk—not likely when wiring to a family member. Institutions are not included in the definition and owning the stock underlying the sale of a call option means the option is covered—totally different from the topic here.

According to the Investment Advisers Act of 1940, under which of the following circumstances is an exculpatory provision acceptable in a contract between an investment adviser and its clients? A) The client has received written disclosure of this provision and has signed a written acceptance prior to any transaction. B) This provision is prohibited under all circumstances. C) The client is purchasing government securities only. D) The client is a broker-dealer.

B An exculpatory (culpa meaning fault) provision is never acceptable in an investment advisory contract. Its purpose is to exclude officers and directors from liability for disregard of their duties. This might also be phrased as the client waiving his rights, and is also not permitted.

An agent is employed by a broker-dealer that sets a high minimum net worth requirement for clients to open margin accounts. In an effort to ensure that a client qualifies, the agent adds $100,000 to the value of the client's assets. Under the NASAA Statement of Policy on Dishonest or Unethical Business Practices of Broker-Dealers and Agents, this would be A) prohibited because margin trading is not suitable for this client B) prohibited because the agent is entering fictitious information on the client account form C) prohibited only if this is done without the client's written consent D) permitted because margin trading can lead to greater client profits

B Even though the agent thinks this action is beneficial for the client, the NASAA policy prohibits entering any fictitious information on a client's account records, even when suggested by the customer.

IA runs an ad in the newspaper. Ad describes describes the nature of the firm's model portfolio and indicates that it had outperformed the overall market by 800% over the last 10 years, and therefore they guarantee that their clients will more than keep pace w/ inflation. At the bottom of the ad in small print says "Results are not guaranteed. Past performance is not indicative of future results." This is an example of: A) properly worded disclaimer B) improper hedge clause C) violation of an investment adviser's fiduciary responsibility D) wrap fee account

B Hedge clauses may not be used to disclaim statements that are inherently misleading. No ad can guarantee a statement like that

Qualified custodian

Bank or savings association that has deposits insured by FDIC under Federal Deposit Insurance Act, a registered broker-dealer, and a foreign financial institution that customarily holds financial assets for customers.

Which of the following phrases best describes a prudent investor? A) The custodian for a minor under the Uniform Transfers to Minors Act B) A person in a fiduciary capacity who invests in a prudent manner C) A trustee who invests with reasonable care, skill, and caution D) An investment adviser representative (IAR) handling a discretionary account

C Although all of these may have a fiduciary responsibility, the definition, as expressed in the Uniform Prudent Investor Act of 1994, requires reasonable care, skill, and caution.

Q: Alberto is an IAR with an investment adviser registered in 3 states. Although he relies heavily on the recommendations furnished by the IA's research department, he occasionally does his own research for his personal account. As an ACCESS PERSON, Alberto: A. would be prohibited from trading in his personal account B. would be prohibited from trading these securities in his personal account until his research was publicly available C. Must report any personal transactions on a quarterly basis

C Because he is an access person, any personal securities transactions must be reported on a quarterly basis. He CANNOT use research reports developed by the firm until they were made publicly available, but his own personal research doesn't come under that requirement

ABC Advisers, Inc., a federal covered investment adviser is a wholly owned subsidiary of ABC Corporation, a holding company that also owns ABC Securities, a full-service broker-dealer that is a member of the New York Stock Exchange and FINRA. One of the clients of ABC Advisers calls his IAR to explain that he has just received a margin call in his ABC Securities account. Under these circumstances, it would NOT be prohibited for the IAR to use securities owned in the advisory account to obtain a loan for this client A) if the client agreed to repay the loan within 30 days B) because ABC Advisers, Inc. is in the money lending business C) because the 2 firms are affiliated D) when the client has furnished ABC Advisers, Inc., with a proper discretionary trading authorization

C In most cases, the only money lenders on the exam will be banks and broker-dealers. If an advisory client receives a margin call from activity in his brokerage account, securities owned in the advisory account may be used by the affiliated broker-dealer to meet the margin deficiency.

According to NASAA's Model Rule on Unethical Business Practices of Investment Advisers, Investment Adviser Representatives, and Federal Covered Advisers, which of the following is unethical? A) Omitting nonmaterial facts in a presentation to an advisory client about a recommended investment B) Borrowing funds for personal use from a client that is a bank C) Recommending a certain limited partnership investment to all clients D) Exercising discretion with regard to the time or price of an order without written authorization from the client

C Recommending an investment without determining its suitability to each client is considered unethical. When the same investment is recommended to all clients, it is called a blanket recommendation and almost always raises the suitability question.

Under the NASAA Model Custody Rules, and IA is deemed to have custody of customer funds and securities when A. securities inadvertently received are returned to the customer within 3 business days of receipt B. checks made payable to the investment adviser are returned to the customer within 3 business days of receipt C. checks made payable to an unrelated third party are returned to the customer within 3 days of receipt D. checks made payable to an unrelated third party are forwarded to that third party within 3 business days of receipt

C Whenever an IA receives customer checks made payable to an unrelated third party, FAILURE to forward, or not return, that check to that third party within 3 business days of receipt is considered to be maintaining custody.

When an investment adviser prepares a BCP, it should be based on I. the size of the firm II. the firm's annual net income III. the number of locations of the firm IV. the types of services provided

I III and IV The amount of an investment adviser's net income is not relevant to a BCP

Sharing in Accounts

Cannot share directly or indirectly in profits or losses in the account of a customer without prior written consent

Definition of Custody

CUSTODY: -holding, directly or indirectly, client funds or securities, OR having authority to obtain possession of them -includes: 1. possession of client funds, unless you receive them inadvertently and return them to the sender within 3 business days 2. any arrangement where you are authorized to withdraw client funds or securities maintained with a custodian upon your instruction to the custodian 3. any capacity that gives legal ownership to client funds DIRECT FEE DEDUCTION: -considered having custody because fees are directly deducted from client accounts -must provide: 1. written authorization from each client 2. notice of fee deduction -send custodian notice of amount -send client an invoice itemizing the fee 3. notice of safeguards -notifies Administrator on Form ADV QUALIFIED CUSTODIAN: -bank or savings associations -registered broker-dealer -foreign financial institution

Written policies and procedures reasonably designed to safeguard customer information from cyber security threats would include all of the following EXCEPT A) encrypting personally identifiable information. B) conducting periodic risk assessments. C) implementing a firewall. D) maintaining the minimum required cybersecurity insurance coverage.

D

A broker-dealer holds fully paid-for customer securities for safekeeping. Under the NASAA Statement of Policy on Unethical and Dishonest Business Practices of Broker-Dealers and Agents, the broker-dealer A) may lend them to make delivery on short sales B) would be in violation unless a properly executed margin agreement was in effect C) must pay interest to the clients D) must segregate them

D Any securities held in custody by a broker-dealer (or, for that matter, an investment adviser) must be segregated from those belonging to the broker-dealer (or investment adviser). To do otherwise would be to commit the prohibited practice of commingling.

Time or Price Discretion

Exception to the requirement of having WRITTEN consent by a client to have discretionary authority -Discretion can be granted by the client to purchase or sell a specific amount of security -***oral grant of time or price discretion is limited to the END OF THE BUSINESS DAY on which the customer grants it

Section 28e (Safe Harbor) provisions of Sec Exchange Act 1934

Describes compensation to an IA from a BD that will generally not be considered unethical Soft dollar practices: arrangements under which products or services other than execution of securities transactions are obtained by an IA from or thru a BD -research reports

Business Continuity and Succession Plans

Designed to provide for the sudden and unexpected events that can disrupt day-to-day business operations -All IAs are required to have this

Selling Away

Effecting securities transactions NOT recorded on the books or records of the BD -Unless the transactions are authorized in writing by the BD before execution, this is prohibited

Compliance Programs

Investment Advisers Act of 1940 requires each IA registered with the SEC to review the policy and procedures ANNUALLY -No test

Wash Trade (Market Manipulation)

Is an order to buy or sell securities resulting in NO CHANGE OF BENEFICIAL OWNERSHIP for the purpose of: -Creating a false or misleading appearance of active trading in and publicly traded security -Creating false or misleading appearance with respect to the market for any such security **No real change in ownership has occurred, but to the marketplace, it appears that volume and/or price is increasing***

Matched Orders (Market Manipulation)

Occurs when an order to buy or sell securities is entered with knowledge that a MATCHING ORDER on the opposite side of the transaction has been or will be entered for the purpose of: -Creating a false or misleading appearance of active trading in and publicly traded security -Creating false or misleading appearance with respect to the market for any such security **Increased volume in a security can induce unsuspecting investors to purchase the security***

Hedge Clauses

Or an exculpatory clause -Basically a provision inserted by an IA to waive the implied fiduciary responsibilities of the relationship -*WAIVERS ARE NEVER PERMITTED* -Some hedge clauses are allowed such as ones that state that IAs are not liable for losses caused by events beyond their control (war, strikes, market fluctuations, etc.)

Discretion for IAs

Oral discretion is also permitted to be used for transactions in a customer's account during the FIRST 10 BUSINESS DAYS -After that, if written authorization has nit been received

Q: An investment adviser takes custody of a client's funds and securities. Client account statements must be sent no less frequently than

Quarterly

Section 13(f) filings

Requires any SEC registered IA that exercises investment discretion over an equity portfolio with a market value on the last day of trading in any preceding 12 months of $100 million or more in 13f securities must file a Form 13F with the SEC -File the form QUARTERLY with the SEC with 45 DAYS of the end of each quarter *Purpose of this is to require institutional investment managers who give investment discretion over accounts holding certain levels of securities to make periodic public disclosures of significant portfolio holdings

Political Contributions by IAs (Pay to Play Rule)

SEC rule that prohibits investment advisers from receiving compensation for advisory services to a government entity for 2 years after the advisory firm or any covered employee makes a political contribution to a public official -Advisory relationship can continue, just without compensation Many Exceptions -De minimis exception: allows covered employees to make contributions up to $350 per official per election in which they can vote

Rules on Custody of Funds and Securities

Safekeeping Required: -in order to have custody of client funds, MUST: A. have a qualified custodian (i.e. Fidelity, Schwab) B. notify clients of the custodians name, address, etc when accounts are opened C. account statements are delivered to clients, either -by the custodian, quarterly -by the adviser, quarterly (must be verified by independent public accountant at least once per year) (Notify Admin in writing on ADV that IA has/will have custody, if no rule prohibiting custody) EXCEPTIONS: 1. Shares of Mutual Funds -may use the funds transfer agent in lieu of a custodian 2. Privately Offered Securities -securities acquired from issuer non involving a public offering -securities uncertified -securities transferable only with prior consent of issuer or holders of outstanding securities of the issuer 3. Registered Investment Companies **most IA's do not take custody of and therefore are unable to accept direct delivery of customer securities except under limited conditions

Lending or Borrowing

Securities pros can't borrow money or securities from a client unless they are a financial institution engaged in the business of loaning money, or if they have some sort of affiliation with your firm

When an IA with discretion over a client's account directs trade executions to a specific BD and uses the commission dollars generated to acquire software that analyzes technical market trends, it is known as:

Soft dollar compensation

Splitting Commissions

Splitting the agent's commissions or profits from the purchase or sale of securities with any person not also registered as an agent for the same BD. They can do this WITHOUT disclosing the split to their clients UNLESS it increases the transaction cost to the client

Directed Brokerage

The practice of asking or permitting clients to send trades to a specific BD for execution -When an IA suggests the client to use a specific BD, disclosure of an possible conflicts of interest must be made

Trade Aggregation and Allocation

The practice of bundling trades to obtain volume discounts on execution costs.

Front Running

The unethical practice of a securities professional placing a personal order ahead of a previously received customer order. Occurs most frequently when the firm has received an institutional order of sufficient size to move the market

Improper Hypothecation

Unethical to hypothecate (pledge as collateral) a customer's securities unless the BD secures written consent promptly after the client's initial transaction

performance-based compensation exceptions

performance-based compensation is prohibited under all circumstances unless a client is (qualified): -natural person or company that immediately AFTER entering the contract has at least $1 million under the management of the IA -natural person or company that had $2.1 million, exclusive of their residency, immediately PRIOR to entering the contract -natural person who is an officer or director of the IA or an IAR who has been employed by in the industry for 12 or more months