Unit 13
Which of the following would be considered an unethical business practice? A) Agents correcting execution orders in their customer's accounts B) Agents exercising discretion in discretionary accounts C) Broker-dealers sending retail clients an email 30 days in advance of a change to fees D) Broker-dealers charging larger-than-ordinary commissions on certain transactions
A) Agents correcting execution orders in their customer's accounts When a good-faith error is made, only the firm can make the correction; the regulators are concerned that giving that power to an agent could lead to covering up unethical activity. When the security involved in the trade is thinly traded (inactive), it is customary to charge a higher commission to cover the added expense. Broker-dealers are required to deliver a copy of their fee schedule no later than account opening. When changes are made, notice must be given at least 30 days in advance and may be done electronically (by email or posting on the firm's website).
If John Good, a properly registered investment adviser, opens his own office and hires several representatives to work for him, his business card may not read A) Good Performance Advisers, Inc. B) Good and Associates Investment Advisers, Inc. C) Good's Investment Advisers, Inc. D) John Good Investment Advisers, Inc.
A) Good Performance Advisers, Inc. John Good, a registered investment adviser, cannot put on his business card "Good Performance Advisers." In this instance, the word Good can be interpreted as an adjective modifying the word performance, as opposed to John's given name, Good. An adviser cannot present himself to the public in terms that can be misleading or interpreted as exaggerating performance. The other three choices are appropriate because they do not use Good as an adjective touting the results of the adviser, but as the name of the adviser.
If an investment adviser wishes to engage in an agency cross transaction involving advisory clients, it would be prohibited from A) obtaining written consent from the parties prior to engaging in agency cross transactions. B) representing both the buyer and the seller. C) earning a commission on both the purchase and the sale. D) recommending the trade to both sides.
D) recommending the trade to both sides. In an agency cross transaction, the IA represents advisory clients on both sides of the trade and may earn a buying and selling commission. To engage in these types of transactions, written notice must be furnished to advisory clients before the trade. These transactions can never be recommended to both sides of the trade.
Which of the following are prohibited practices? 1. An investment advisory firm organized as a partnership fails to inform its clients of the departure of a partner with a very small interest in the partnership. 2. An investment advisory firm charges an annual fee equal to 2% of the first $250,000 in assets under management; 1% of the next $500,000; and 0.5% for everything in excess of $750,000. 3. The majority stockholder of a registered investment adviser pledges his stock as collateral for a loan taken out by the firm to expand its services without obtaining client consent for assignment of their contracts. 4. An investment advisory firm engages in agency cross transactions. A) I and III B) I and IV C) III and IV D) I, II, III, and IV
A) I and III Any change in the ownership of an investment advisory firm organized as a partnership, no matter how small, requires notification to all clients within a reasonable amount of time. If the firm is structured as a corporation, pledging a controlling interest in the company's stock is viewed as an assignment of the contracts. This requires the consent of the clients. Agency cross transactions—that is, where the adviser represents both sides of the trade—are permitted as long as the adviser makes the proper written disclosures and does not make the buy-sell recommendations to both parties. Choice II is an example of a graduated fee schedule where the management fee is reduced as the size of the account increases—there is nothing prohibited about this very common practice in the industry.
Performance guarantees are prohibited under state and federal regulations. Which of the following is an example of a performance guarantee offered by a broker-dealer? A) Our firm is so confident that this recommendation will perform as predicted that it has established an escrow account with the administrator to protect investors against loss. B) Our firm is so confident that this recommendation will perform as predicted that it has purchased 1,000 shares for the firm's investment account. C) Our firm's research department has set a 12-month price target on this recommendation of $50 per share. D) Our firm is so confident that this recommendation will perform as predicted that it will buy this security back from any customer at the prevailing market price.
A) Our firm is so confident that this recommendation will perform as predicted that it has established an escrow account with the administrator to protect investors against loss. The classic performance guarantee states that the customer cannot lose money. That is prohibited. Buying shares of a recommended security is simply a case of the firm putting its money where its mouth is. There is nothing wrong with setting a price target; nothing is guaranteed. Buying back a security at the prevailing market price (the price on the day the customer wishes to sell) does not guarantee against loss.
All of the following activities of an investment adviser are prohibited under the Uniform Securities Act except A) disclosing potential conflicts of interest. B) engaging in a practice not expressly forbidden by the act but defined as unethical by courts, self-regulatory organizations such as FINRA, or both. C) deliberately omitting a material fact when soliciting a client. D) selling recommended securities to a client from one's own account without disclosing this fact to the client.
A) disclosing potential conflicts of interest. Potential conflicts of interest must be disclosed to clients. The USA gives the Administrator, and self-regulatory organizations, the power to define certain practices as unethical with the same force as those spelled out in the act. Omitting a material fact is specifically prohibited under the act. Investment advisers must always disclose the capacity in which they acted in a transaction with advisory clients.
ABC Securities, a registered broker-dealer, has a wholly owned subsidiary, ABC Real Estate Ventures. ABC Real Estate Ventures is in the business of structuring limited partnership offerings designed to afford qualified investors an opportunity to earn income from commercial property. If an agent representing ABC Securities were to recommend one of these programs to a qualified client, A) disclosure of the potential conflict of interest must be made. B) the agent would be engaging in an unethical business practice. C) it would be necessary to obtain consent of the agent's supervisor. D) a sale could not take place without a review by the firm's compliance officer.
A) disclosure of the potential conflict of interest must be made. One of the more common cases of a conflict of interest is when a broker-dealer (or one of its agents) recommends a security issued by an entity affiliated with the firm. As long as disclosure of the relationship is made, there are no problems. Compliance officers do not review every transaction—they look for the red flags.
In addition to transaction costs (e.g., commissions or markups), most broker-dealers have a schedule of miscellaneous fees. The purpose of these fees is to A) help reimburse the broker-dealer for expenses incurred in performing the transaction or a service for the client. B) increase the broker-dealer's net income. C) keep commissions low while making up the difference with fees. D) build in a hidden markup.
A) help reimburse the broker-dealer for expenses incurred in performing the transaction or a service for the client. Executing a transaction for clients frequently incurs expenses that commissions don't cover, such as clearing fees and execution facility fees. There are services performed for clients, such as postage and handling, for which expenses are incurred. Although charging these fees does have a positive effect on the firm's bottom line, they are designed for reimbursement purposes, not as an additional source of income.
Broker-dealers are required to furnish clients with a fee disclosure document. All of the following are true statements about that document except A) it must be filed with the Administrator of the state in which the broker-dealer's principal office is located. B) changes to the fee schedule must be announced in advance. C) it must be up-to-date. D) changes to the fee schedule may be shown on the firm's website.
A) it must be filed with the Administrator of the state in which the broker-dealer's principal office is located. There is no requirement that the fee schedule be filed with the Administrator. It must be up-to-date, and any changes must be announced in advance (usually a minimum of 30 days). There are a number of ways to disclose the fees—the firm's website is one of them.
A state-registered investment adviser would like to employ the services of an individual as a solicitor to help bring in more business. The solicitor will be compensated by receiving a percentage on all assets placed under management. In order to do this, all of the following must be complied with except A) the client must sign the advisory contract at the same time that the investment adviser's brochure is delivered. B) the solicitor is considered a supervised person. C) the terms of the investment adviser's compensation must be spelled out. D) the solicitor must be registered as an investment adviser representative in order to receive compensation based upon advice.
A) the client must sign the advisory contract at the same time that the investment adviser's brochure is delivered. The investment advisor's (IA's) brochure must be delivered prior to or at the time of the initial sales presentation. As a practical matter, the signing of the contract generally won't take place until the prospective client decides to engage the services of the IA. Any individual employed by an investment adviser whose role is soliciting for advisory clients must be registered as an IAR. Do not confuse this with unaffiliated third parties who are endorsing the investment adviser for compensation.
Jake Aaron is registered as an agent with ABC Securities, a broker-dealer registered with the SEC doing business in 34 states. In addition, Aaron has his own investment advisory business, Jake's Money Advisers, and is registered with the SEC. To comply with all appropriate regulations, which of the following would have to be stated on the business card for Jake's Money Advisers? 1. Jake Aaron, RIA 2. Jake's Money Advisers, RIA 3. Jake's Money Advisers, registered investment adviser 4. Securities offered through ABC Securities A) I, III, and IV B) III and IV C) II and IV D) I and III
B) III and IV It is not permissible to use the initials RIA, but one would properly describe the fact that the firm is a registered investment adviser. If one is registered as an agent with a broker-dealer, that fact always must be stated on that person's business card.
According to the Investment Advisers Act of 1940, which of the following statements about agency cross transactions is not true? A) Advisers must send statements to clients no less frequently than annually that identify the total number of these transactions during the period and the total amount of commissions received. B) Investment advisers can recommend these transactions to both the buyer and the seller if both clients give written consent. C) Advisers must provide a written disclosure of potential conflict of interest before obtaining the client's written consent to execute such a transaction. D) These transactions are allowed if the adviser is acting in the best interest of the client with respect to obtaining the best possible price.
B) Investment advisers can recommend these transactions to both the buyer and the seller if both clients give written consent. An agency cross transaction occurs when an investment adviser acts as a broker for one or both sides of a transaction involving an advisory client. Investment advisers cannot recommend cross transactions to both buyer and seller, even if written consent is given. These transactions can be executed if the adviser is acting in the best interest of the client with respect to obtaining the best possible price. Disclosure is also required. The adviser must send a statement on at least an annual basis identifying the total number of these transactions during the period covered and the total amount of commissions received. Advisers must provide a written disclosure of potential conflict of interest before obtaining the client's written consent to execute such a transaction.
Individuals who operate an investment advisory firm as a sole proprietorship would not be able to include on their business cards or stationery the initials A) CPA. B) RIA. C) MBA. D) CFA®.
B) RIA. The initials RIA may not be used; only registered investment adviser may be used in communications with the public such as business cards, stationery, and websites. Obviously, the other designations can be used only if the person earned the credential.
Matt, a registered investment adviser, operates an office down the hall from Jane, a CPA. Because Jane has no interest in portfolio management, she frequently refers her clients to Matt for investment advice. When one of Jane's clients signs a letter of engagement with Matt, Matt sends Jane a $200 referral fee. This occurred five times in the previous year. This situation is A) prohibited. B) permitted if the referral fee is disclosed to the appropriate clients. C) permitted because there were fewer than six occurrences involving referral fees. D) permitted without restriction.
B) permitted if the referral fee is disclosed to the appropriate clients. The marketing rule for investment advisers permits investment advisers to pay third parties for their endorsements as long as the required disclosures are made. A written agreement between the parties is required when the compensation, cash or non-cash, exceeds the de minimis amounts (more than $1,000 during the preceding 12 months). If this had occurred a sixth time, then the total would have been $1,200 and would have required a written agreement between Matt and Jane. It isn't the number of endorsements but rather the dollar amount that triggers the need for the written agreement.
Federal covered investment advisers must comply with the SEC's Model Marketing Rule for Investment Advisers. That rule includes A) a prohibition against reduced-fee introductory offers. B) requiring a written agreement between an investment adviser and a promoter who receives more than $1,000 over a 12-month period for endorsing the services of the adviser. C) a requirement that a copy of all advertisements be sent to the SEC at the time they are disseminated to the public. D) a prohibition against showing the adviser's past performance.
B) requiring a written agreement between an investment adviser and a promoter who receives more than $1,000 over a 12-month period for endorsing the services of the adviser. SEC-registered investment advisers must comply with the SEC Model Marketing Rule for investment advisers. This SEC rule incorporated significant amendments to the Investment Advisers Act of 1940. Among the requirements of the rule is that an adviser who compensates a nonaffiliated third-party promoter for endorsing the services of the IA must have a written agreement with that promoter if the compensation will exceed $1,000 over a 12-month period. Advertisements may not contain false statements, refer selectively to past recommendations, refer to a chart or device for evaluating securities without explaining its limitations and difficulties, or offer anything free of charge if, in fact, there will be some requirement (however minor) for obtaining the free item. There is no federal filing requirement for advertisements of covered IAs. As long as the past performance is displayed in a manner consistent with the rules, there is no problem.
The SEC has determined that advertising regarding past recommendations made by investment advisers is misleading if which of these are true? 1. Results do not reflect the deduction of fees. 2. Actual market conditions during the referenced period are not disclosed. 3. The advertisement does not reflect performance for a minimum period of three years. 4. The advertisement does not disclose that it applies to only a specific group of clients. A) I and II B) I, II, III, and IV C) I, II, and IV D) II and IV
C) I, II, and IV Advertising that reflects past performance must show a minimum period of one year, not three. All investment advisers' advertising must reflect deduction of fees; disclose the specific group of clients to which it applies, if applicable; and state actual market conditions during the referenced period.
Which of the following statements is correct? A) A state-registered investment adviser collecting fees of $500 for six months or more in advance is considered to be receiving a substantial prepayment. B) Both state-registered and federal covered investment advisers who have custody of clients' securities are required to provide audited balance sheets to their clients. C) State-registered investment advisers who have custody of clients' securities are required to provide audited balance sheets to their clients. D) Federal covered investment advisers who have custody of clients' securities are required to provide audited balance sheets to their clients.
C) State-registered investment advisers who have custody of clients' securities are required to provide audited balance sheets to their clients. It is only state-registered investment advisers who must provide audited balance sheets to clients for whom they maintain custody. In order to be considered a substantial prepayment of fees, state laws require it they be more than $500 for six or more months in advance.
Consent of the client before completion of a trade made between the firm and a client must be made when A) a broker-dealer will be acting in the capacity of a principal. B) a broker-dealer will be acting as a contra party to the trade. C) an investment adviser will be acting in the capacity of a principal. D) a broker-dealer will be acting in the capacity of an agent.
C) an investment adviser will be acting in the capacity of a principal. In those uncommon cases where an investment adviser acts in the capacity of a principal (or agent) with an advisory client, consent of the client before completion of the transaction is required. In the case of broker-dealers, disclosure of capacity on the trade confirmation, but not consent, is needed.
Alexander is registered as an agent with WorthMore Securities, a broker-dealer registered with the SEC and 10 states. He is also an investment adviser representative (IAR) with their wholly owned subsidiary, WorthMore Investments, a federal covered investment adviser. Many of Alexander's advisory clients also maintain brokerage accounts at WorthMore Securities. If one of those clients were to call Alexander and enter an order to purchase shares of a stock the broker-dealer is selling out of inventory, A) consent of the client would be necessary anytime an advisory client is sold securities out of the broker-dealer's inventory. B) the commission charged on the trade would have to be fair and reasonable. C) consent of the client would not be necessary as long as the only capacity in which Alexander is acting is that of an agent. D) the order would have to be refused because of the potential conflict of interest.
C) consent of the client would not be necessary as long as the only capacity in which Alexander is acting is that of an agent. Only when acting in an advisory capacity is there a requirement to obtain client consent when selling out of inventory. In this case, unless there was a statement to the effect that the security had been recommended by Alexander, this is just a brokerage transaction and consent is not necessary (although the principal capacity would have to be stated on the trade confirmation). Because this is a principal transaction, there is no commission, only a markup.
In designing a client's portfolio, a registered investment adviser representative of Greater Wealth Advisory Services recommends the purchase of several stocks from the inventory of Greater Wealth's wholly owned broker-dealer. Under the Investment Advisers Act of 1940 this activity requires written: A) consent of and the disclosure to the client prior to execution of the transaction. B) disclosure to the client. C) disclosure to the client and consent prior to completion of the transaction. D) consent of the client.
C) disclosure to the client and consent prior to completion of the transaction. Unlike broker-dealers, investment advisers must obtain the consent of and make written disclosure to the client of the intent to act as agent or principal in any transaction with that advisory client. SEC Release IA-1732 requires that this be accomplished before the completion of the transaction, where completion is defined as settlement date.
In reviewing prospectuses and registration statements, the SEC A) guarantees the adequacy of the disclosures made in a prospectus. B) passes on the merits of a particular security covered by a registration statement. C) does not approve or disapprove of the issue. D) certifies the accuracy of the disclosures made in a prospectus.
C) does not approve or disapprove of the issue. The SEC requires full disclosure regarding a new issue so that investors can make informed decisions on the security. The SEC does not, however, guarantee the accuracy or adequacy of the information, nor does it approve or disapprove of the issue.
A broker-dealer publishes a list of securities it approves for inclusion in IRAs. This means A) the broker-dealer has committed an unethical business practice because use of the word approved is prohibited. B) an agent for the broker-dealer can place these in clients' IRAs knowing that the suitability requirements have been met. C) the broker-dealer has evaluated these securities and believes they would be suitable for inclusion for retirement planning. D) the broker-dealer has consulted with the regulatory bodies and has received approval from them to recommend these securities for IRAs.
C) the broker-dealer has evaluated these securities and believes they would be suitable for inclusion for retirement planning. Approved is an odd word in this industry. It can never be used with reference to any regulator commenting on the status of a security or an individual. However, a broker-dealer creating an approved list of securities is not unethical or prohibited as long as it is clear that it is the broker-dealer and not any regulator granting the approval. Even though the firm has listed these securities as suitable for IRAs, that does not relieve the individual agent of verifying the suitability for each client for whom they are recommended.
Under the USA, all of the following statements are true regarding investment advisory contracts except A) they cannot be assigned without customer approval. B) they can allow fees to be performance related only under certain limited circumstances. C) they cannot allow for prepaid advisory fees. D) they must be in writing.
C) they cannot allow for prepaid advisory fees. 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 to 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 $2.2 million, where performance-based fees are permitted.
A working group convened by NASAA has developed a model fee disclosure schedule to help investors better understand the costs involved in doing business with their broker-dealer. The template has broker-dealers disclosing which of the following fees? A) Advisory fees B) Commissions C) Markups and markdowns D) Account closing fees
D) Account closing fees It is very common for a broker-dealer to charge a fee for processing the closing of an account. There are three primary expenses involved with brokerage accounts that are not included in the fee disclosure template. Those are: 1. commissions; 2. markups and markdowns; and 3. advisory fees for those firms that are also registered as investment advisers.
Which of the following statements regarding the Investment Advisers Act of 1940 and the adviser's brochure is correct? A) Each client must receive the brochure no later than 48 hours after entering into the advisory contract. B) Annual delivery of a summary of material changes relieves the adviser of the obligation to deliver a brochure. C) Advisers must deliver the brochure to clients for whom they offer impersonal advisory services only when the annual charge does not reach $500. D) Each client must receive the brochure no later than their entrance into the advisory contract.
D) Each client must receive the brochure no later than their entrance into the advisory contract. The Advisers Act requires that the adviser's brochure be delivered at or prior to the entry of the initial contract. Thereafter, SEC rules require that a brochure—or summary of material changes, if any—be delivered to all clients within 120 days of the end of the adviser's fiscal year. If there are no material changes, a brochure does not have to be sent. The summary includes an offer to provide a copy of the updated brochure and information on how the client may obtain it. There is no 48-hour rule under federal law like there is for state law, and in any event, that law has a 48-hour-in-advance requirement. Only when the charge for the impersonal advice is $500 per annum or more is there a requirement to deliver the brochure.
An investment advisory contract is considered assigned if an adviser formed as A) a partnership with five partners and adds two partners. B) a corporation with five officers and adds two officers. C) a corporation with two officers and adds five officers. D) a partnership with two partners and adds five partners.
D) a partnership with two partners and adds five partners. If an advisory firm is formed as a partnership and there is a change in the majority of partners, this is considered to be an involuntary assignment to the new partnership. In this case, client approval of the contract assignment (not the addition of the partners) is required. This rule applies to partnerships. In the case of a corporation, a change in the ownership of a majority of the stock (or a pledge of a majority interest in the stock) would be considered an assignment.
A third-party post has been made on a broker-dealer's Facebook page. If the firm has involved itself in the preparation of the content, this would be known as A) disgorgement. B) replacement. C) misrepresentation. D) entanglement.
D) entanglement. The entanglement theory means the firm is or its personnel are entangled (take part in) the preparation of the third-party post. A similar concept is that of adoption. This is when the broker-dealer explicitly or implicitly endorsed or approved the content posted by the third party but had no role in its preparation.
One way to make money is to buy low and sell high. If an investment adviser has developed a proprietary charting system that has had a very high degree of success in picking stocks near their market bottoms, any advertisement about the system must A) provide customer testimonials evidencing their satisfaction with the system. B) indicate the length of time the system has been in play. C) show performance for at least the past 12 months, including both winners and losers. D) indicate that there are limitations and difficulties to using the system.
D) indicate that there are limitations and difficulties to using the system. Anytime you see a question dealing with advertising a charting system (or investment formula, etc.), always look for limitations and difficulties in the answer.
One way in which an investment adviser acting in the capacity of an agent in a transaction with a client differs from a broker-dealer performing the same task is that the investment adviser A) may not charge a commission on the transaction. B) shall notify the Administrator of its capacity in the proposed transaction. C) shall disclose the agency capacity before the transaction. D) shall obtain client consent before completion of the transaction.
D) shall obtain client consent before completion of the transaction. In order to act as an agent (or principal) in a trade with an advisory client, there are two requirements: 1. Client receives full written disclosure as to the capacity in which the adviser proposes to act 2. Consent of the client Both of these are required before the completion of the transaction.
An agent is discussing an equity index annuity purchase with a client. The agent explains that there are several that she feels are equally suitable for the client, but one of the companies is offering a trip for two to Las Vegas for reaching certain sales goals. She continues by stating that this sale will put her over the goal and win her the trip. If the client purchases that annuity, the agent A) will probably be disciplined for failure to disclose the potential conflict of interest. B) should pack her bags and leave the firm before the compliance department learns of her actions. C) should only sell what is suitable for the client based on all available information. D) should pack her bags for the trip; she earned it.
D) should pack her bags for the trip; she earned it. The annuity recommended by the agent is offering an incentive. The agent is clearly disclosing that fact to the client, and if the client goes ahead and makes the purchase, it is with full knowledge of the potential conflict of interest. The question states that the agent considers this annuity, along with others, to be suitable.
As long as properly disclosed, a broker-dealer would be permitted to charge a fee for all of these except A) issuing a stock certificate. B) annual maintenance fees. C) wiring funds to the client's bank. D) solicitation of proxies.
D) solicitation of proxies. Broker-dealers are not permitted to charge for soliciting proxies; the issuer is responsible for reimbursing the broker-dealer for any of its expenses. All of the other charges are permitted if fully disclosed to clients. This is a case where you answer the question correctly because you know the other choices are permitted charges. On the exam, the correct choice might be something that is not covered in the course. However, as is the case with this question, the three incorrect choices are well described in the LEM.
XYZ is an investment adviser registered in States B, C, and D. Part of its service is offering a comprehensive financial plan, for which there is an initial fee of $2,500. During a discussion with a prospect, one of its investment adviser representatives seeks to allay the individual's concerns by informing her that once the firm delivers its brochure and receives the client's payment, there is a three-day period during which the client may cancel the contract and receive a refund of that fee. In this case, A) the investment adviser representative is in violation because the brochure must be delivered at least 48 hours before signing the contract. B) there is no violation because the 5-day penalty-free withdrawal feature is only found in state law and does not apply to SEC-registered advisers. C) there is no violation because firms and their representatives can always make their rules more stringent than the regulators' rules. D) the investment adviser representative is in violation because the time period is 5 days.
D) the investment adviser representative is in violation because the time period is 5 days. The agent has committed an unethical business practice because the NASAA Model Rule dealing with advisers' brochures requires a five-day penalty-free period when the brochure is not delivered at least 48 hours prior to entering into the contract. The firm and its agents cannot impose house rules that take away the client's rights.
Under the NASAA brochure rule requirements for investment advisers, an investment adviser (unless qualifying for an exemption) must deliver, A) at least 48 hours in advance of entering into the advisory contract, a copy of the adviser's brochure. B) a free, updated brochure and related brochure supplements every year, even when there are no material changes. C) within 90 days of the end of its fiscal year, a free, updated brochure and related brochure supplements that include or are accompanied by a summary of material changes. D) within 120 days of the end of its fiscal year, a free, updated brochure and related brochure supplements that include or are accompanied by a summary of material changes.
D) within 120 days of the end of its fiscal year, a free, updated brochure and related brochure supplements that include or are accompanied by a summary of material changes. The rule calls for delivery within 120 days of the end of the fiscal year. The 48-hour rule is not mandatory; if the adviser waits until the signing of the advisory contract, there is a five-day penalty-free withdrawal privilege granted to the customer. If there are no material changes, delivery of an annual brochure is not required.
