Unit 4 - Communications With Customers and Prospects

Prior to venturing into any form of social media, firm policies should

(1) be firmly established, (2) be precise, (3) clearly define the employees' responsibilities, (4) and explain how they are to be moni- tored on each electronic platform utilized by the firm

In simple terms, there are two loans taking place:

- the loan from the BD to the client with the client's securities used as collateral—that is covered in the credit agreement; and - the loan from a bank to the BD with the client's securities used as collateral for the BD's loan—the authorization for the BD to use those securities is found in the hypothecation agreement.

Not included in the fee disclosure documents are:

-commissions -markups and markdowns -advisory fees

Delivery of the investment adviser's brochure to the customer is due within

120 days of the end of the adviser's fiscal year.

Filing of the annual updating amendment to Form ADV with the appropriate regulatory body is within

90 days of the end of the adviser's fiscal year.

Discretionary Accounts

A discretionary account is one where the customer grants the power to a broker-dealer or investment adviser to make buy and sell decisions in the account without the need to have prior contact with the customer. Before a broker-dealer or agent can exercise discretion, a written discretionary authorization permitting such discretion must be received by the firm, and the account must be approved by a designated supervisor.

Investment Advisory Contracts

Another prohibition found in that Model Rule is "Indicating, in an advisory contract, any condition, stipulation, or provisions binding any person to waive compliance with any provision of the Uniform Securities Act or of the Investment Advisers Act of 1940." waivers are not permitted.

Exceptions to the Brochure Delivery Requirements

Delivery of the brochure and related brochure supplements need not be made to: ■ clients who receive only impersonal advice and who pay less than $500 in fees per year; or ■ an investment company registered under the Investment Company Act of 1940.

the three most important factors involved in avoiding disciplinary actions

Disclosure, Disclosure, Disclosure

GUARANTEE AGAINST LOSS

Guaranteeing a client that a specific result will be achieved (gain or no loss) with advice which will be rendered" as one of the prohibitions.

MISREPRESENTING A SECURITY'S REGISTRATION

It is prohibited to imply that registration of a security means that the Administrator (or any regulatory body) has approved of the issue. In fact, on the front page (or inside cover) of every prospectus is a statement called the disclaimer, which states that the security has not been approved or disapproved, and any representation to the contrary is a criminal offense.

MISREPRESENTING A SECURITIES PROFESSIONAL'S REGISTRATION

Representing that your registration implies any kind of approval of you or your qualifications is a prohibited practice. What you can state is that you are a registered agent of ABC Broker-Dealer, or you are a registered investment adviser representative of the XYZ Investment Adviser.

Fiduciary Responsibility of Investment Advisers

That is the primary reason why advisers need their clients' consent when acting as agents or principals in trades with them (as covered above). As fiduciaries, investment advisers must identify and address all material conflicts of interest by eliminating or disclosing such conflicts. If the adviser also engages in non-securities related activities, such as selling auto insurance or real estate, these represent potential conflicts of interest (time taken away from "watching the market") and must be disclosed.

NEW ACCOUNT AGREEMENT

This is basically a contract between the broker-dealer and the customer explaining the rights and obligations of both and the charges for the services that will be rendered.

Supervisory Actions to Be Taken by the Broker-Dealer

To mitigate these, it is suggested that firm policies should: ■ be committed to writing and communicated firmwide; ■ be written in a clear and concise manner so as to eliminate confusion; ■ define the responsibilities of all concerned parties, from registered representatives (agents) to principals, to minimize confusion and maximize expectations; and ■ clearly describe the monitoring tools to be used by the firm.

Receipt of the Options Account Agreement

Within 15 days after a customer's account has been approved for options trading, the broker-dealer must obtain from the customer a written agreement that the customer is aware of and agrees to be bound by FINRA rules applicable to the trading of option contracts and that the customer has received a copy of the current ODD.

Because trading options (puts and calls) generally involves a higher degree of risk than stocks, bonds, or mutual funds,

a designated supervisory person with knowledge about options must approve the account opening.

GUARANTEED SECURITY

a guaranteed security is where a party other than the issuer guarantees the payment of principal and interest (on a debt security) or dividend (on an equity security). The important thing about that guarantee is that there is no guarantee on the performance of the investment. That is, gains cannot be part of the guarantee.

The broadest definition of material would include

any actions taken against the firm or management persons by a court or regulatory authority within the past 10 years.

credit agreement

discloses the terms of the credit extended by the broker- dealer, including the method of interest computation and situations under which interest rates may change as well as the stipulation that the broker-dealer may use the client's margin securities as collateral for the loan that it makes to the client;

Because the brochure is really the only way the potential or existing client can learn about the investment adviser,

disclosure must be made to all current clients and to prospective clients regarding material disciplinary action

To provide some assurance that the act will not be violated, the regulators have recommended that

each of the adviser's advisory clients be given a written statement (brochure) prepared by the adviser that makes all appropriate disclosures.

testimonials for IAs are

forbidden

hypothecation agreement

gives permission to the broker-dealer to pledge cus- tomer margin securities as collateral. The firm hypothecates customer securities to the bank, and the bank loans money to the broker-dealer on the basis of the loan value of these securities

optional loan consent form

gives permission to the firm to loan customer margin securities to other customers or broker-dealers, usually for short sales.

Interactive content

has input from both the creator and the viewer. Common examples include Facebook, Twitter, Instagram, and LinkedIn.

Annual delivery Investment advisers do not have to deliver a summary of material changes or a brochure to clients if

if no material changes have taken place since the last summary and brochure delivery

One question asked on a new options account form that is not required on a normal brokerage account opening is

investment experience and knowledge (e.g., number of years, size, frequency, and type of transactions) for options, stocks and bonds, commodities, and other financial instruments.

Options Disclosure Document (ODD)

must be provided to any prospective options customer. customer receives ODD before first order

The disclosure statement should include the

nature and extent of any adverse interest of the adviser, including the amount of compensation he would receive in connection with the account

In the case of an advisory client for discretionary account

oral authorization may be relied upon for the first 10 business days after the initial discretionary trade in the account. After that time, however, without a written authorization, no further discretion may be exercised.

BD that purchase securities for or sells securities from its inventory is acting in the capacity of a

principal principal charge markups on sales from inventory

highlighting or making any other marks on a prospectus to draw attention to key points =

prohibited

Model Rule states that

publishing, circulating, or distributing any advertisement which does not comply with the Investment Advisers Act of 1940 would be prohibited.

Static content

remains posted until changed by the person who established the account on the site. Generally, static content is accessible to all visitors to the site. Examples of static content typically available through social networking sites include company websites, profiles, backgrounds, or walls.

the designated supervisory person shall

specifically approve or disapprove in writing the customer's account for options trading.

When acting in the capacity of agent (facilitating a transaction between buyers & sellers)

the BD receives a commission

Margin Account Risk Disclosure Document

the broker-dealer must pro- vide customers with a risk disclosure document. This information must also be provided to margin customers on an annual basis. The document discusses the risks associated with margin trading, some of which are listed below. ■ You can lose more funds than you deposit in the margin account. ■ The firm can force the sale of securities or other assets in your account(s) and do so with- out contacting you. ■ You are not entitled to choose which securities can be sold if a call for additional funds is not met. ■ You are not entitled to an extension of time to meet a margin call. ■ The firm can increase its house maintenance margin requirements at any time and is not required to provide you advance written notice.

the Administrator may by rule or order require the filing advertisement and sales literature unless

the security or trans- action is exempted or is a federal covered security.

it is important to know that broker-dealers must always indicate their capacity on

the trade confirmation, sent no later than completion of the trade (settlement date) They will indicate if they acted as a broker (and always disclose the amount of commission) or if they acted as a principal

NASAA's Statement of Policy on Dishonest or Unethical Business Practices of Broker-Dealers and Agents states that it is prohibited to execute any transaction in a margin account

without securing from the customer a properly executed, written margin agreement promptly after the initial transaction in the account.

Information that must be obtained from the client includes items such as:

■ does the client have the legal capacity to enter into agreements? That is, is the client of full legal age in the state of jurisdiction, and does she have the capacity to enter into the agreement? ■ employment information ■ the Customer Identification Program (CIP) notice. In order to help the government fight the funding of terrorism and money laundering activities, broker-dealers are required by federal law to obtain, verify, and record information that identifies each person who opens an account. That information includes the following four items: — name, — date of birth —note that the new account form only requires the account holder be of legal age while the CIP requires the actual date of birth, — a residential or business street address (no mail receiving or P.O. boxes), and — tax identification number (if a U.S. citizen, this is typically the Social Security number); ■ citizenship or visa details; and ■ financial information about the client.

Margin Accounts

allow investors to leverage their investment dollars. Through margin accounts, investors can borrow money from brokerage firms by pledging the purchased stock as collateral.

the following activities and communications as falling outside the definition of recommendation. (not a recommendation)

■ A broker-dealer creates a website that is available to customers or groups of customers. The website has research pages or electronic libraries that contain research reports (which may include buy-sell recommendations from the author of the report), news, quotes, and charts that customers can obtain or request. ■ A broker-dealer has a search engine on its website that enables customers to sort through the data available about the performance of a broad range of stocks and mutual funds, company fundamentals, and industry sectors. The data is not limited to, and does not favor, securities in which the BD makes a market or has made a buy recommendation. Customers use and direct this tool on their own. Search results may display current news, quotes, and links to related sites. ■ A broker-dealer provides research tools on its website that allow customers to screen through a wide universe of securities (e.g., all exchange-listed and Nasdaq securities) or an externally recognized group of securities (e.g., certain indexes) and to request lists of securities that meet broad, objective criteria (e.g., all companies in a certain sector with 25% annual earnings growth). The BD does not control the generation of the list in order to favor certain securities. For instance, the BD does not limit the universe of securities to those in which it makes a market or for which it has made a buy recommendation. ■ A broker-dealer allows customers to subscribe to emails or other electronic communica- tions that alert customers to news affecting the securities in the customer's portfolio or on the customer's watch list. The customer selects the scope of the information that the firm will send to him.

following communications as falling within the definition of recommendation: (recommendation)

■ A broker-dealer sends a customer-specific electronic communication (e.g., an email or pop-up screen) to a targeted customer or targeted group of customers, encouraging the particular customer(s) to purchase a security. ■ A broker-dealer sends its customers an email stating that customers should be invested in stocks from a particular sector (such as technology) and urges customers to purchase one or more stocks from a list with buy recommendations. ■ A broker-dealer provides a portfolio analysis tool that allows a customer to indicate an investment goal and input personalized information such as age, financial condition, and risk tolerance. The BD, in this instance, then sends the customer a list of specific securities the customer could buy or sell to meet the investment goal the customer has indicated. ■ A broker-dealer uses data-mining technology (the electronic collection of information on website users) to analyze a customer's financial or online activity—whether or not it is known by the customer—and then, based on those observations, sends (or "pushes") specific investment suggestions that the customer purchase or sell a security.

NASAA published an investor advisory regarding fees charged by broker-dealer firms for services and maintenance of investment accounts some ways that broker-dealers can make the disclosures easier for customers to follow:

■ Fees are typically disclosed when a customer account is opened. If the firm changes the fee schedule, be clear about it, and be sure to use appropriate methods to give advance notifi- cation of the changes to the customer. ■ Minimize the fine print, or at least make the fees and charges clear. Whether using a table, a chart, or a list, make sure it is easy for customers to determine what the fees and charges are and how they are computed. ■ Use standardized and uncomplicated terms to describe service and maintenance fees in order to help clients compare fees between different firms.

ISSUES RELATED TO AGENTS

■ In addition to computers in the office, personal devices (Blackberry, iPhone, Android, etc.) used to communicate with clients in a social media setting are covered by the rules. ■ Depending on the nature of the media, prior approval by a supervisory person may or may not be required. For example, an "unscripted" participation in an interactive electronic forum (such as Twitter) comes within the definition of retail communication, which does not require prior supervisory approval. On the other hand, a LinkedIn page would prob- ably require pre-approval. ■ Look out for the red flags. Certain activities, such as linking to third-party sites or receiv- ing data feeds from outside sources could contain information that NASAA considers objectionable. ■ It is not the device or technology that determines if a piece delivered by a broker-dealer or any agent is subject to approval and recordkeeping. Rather, it should always be the content that determines if a piece delivered by an agent is subject to approval and recordkeeping. ■ It is suggested that Twitter posts are easy to monitor, but sites such as Facebook are not, given what they've termed entanglement issues (i.e., the firm or its personnel is involved with the preparation of a third-party post) and the challenges they pose. Essentially, who is responsible for links to a third-party site, and who is responsible for third-party postings to an agent's Facebook page? ■ Specifically regarding Twitter, posts do not need supervisory pre-approval except for an agent's initial tweet. ■ LinkedIn is considered different from Facebook, as it is more of a business networking site than a social site. With that, it is believed that information limited to your current position, past positions, and job responsibilities allow the site to be left unmonitored as the firm would have no responsibility regarding that content for any individual. However, if testimonials are used on the site ("Joe is the best stockbroker in the world," or "I've made a ton of money because of Joe's recommendations"), or if recommendations are posted on the site, then that would make it a business site that the firm is now responsible for.

Examples of the more common fees that might be charged by a broker-dealer include the following:

■ Issuance of a stock certificate. Although most securities are kept in street name, there could be instances where the customer wants delivery of the physical certificate. There is usually a charge for this service. ■ Transferring an account. When a client decides to move the account from one broker- dealer to another, there is usually a charge to cover the administrative expenses of the transfer. ■ Wiring funds. Although frequently waived for those with large account balances, if the client needs money wired out of the account, a charge, similar to that made by most banks, is levied against the account. ■ Margin account interest. When purchasing on margin, money is borrowed and the rate of interest charged on the borrowed funds must be disclosed. ■ Account maintenance fees. Similar to the monthly charge on your bank statement, many firms charge an annual account fee, particularly if a small account. ■ Safekeeping of funds/securities. This is the charge made for maintaining custody of client assets, which is usually waived for larger accounts. ■ Late settlement fee. This is similar to the late fee on a credit card. When a client's pay- ment arrives after settlement date (or is returned due to insufficient funds), the broker- dealer may assess a fee. ■ Postage and handling. Although many firms absorb the cost of normal mailings, express or overnight delivery at the request of the client is usually subject to a charge

Online red flags for investors

■ Promises of high returns with no risk. Many online scams promise unreasonably high short-term profits. Guarantees of returns around 2% a day, 14% a week, or 40% a month are too good to be true. Remember that risk and reward go hand in hand. ■ Offshore operations. Many scams are headquartered offshore, making it more difficult for regulators to shut down the scam and recover investors' funds. ■ E-currency sites. If investors have to open an e-currency account to transfer money, use caution. These sites may not be regulated, and con artists use them to cover up money trails. ■ Recruit friends. Most cons will offer bonuses if investors recruit their friends into the scheme. ■ Professional websites with little to no information. These days anyone can put up a website. Scam sites may look professional, but they offer little to no information about the company's management, location, or details about the investment. ■ No written information. Online scam promoters often fail to provide a prospectus or other form of written information detailing the risks of the investment and procedures to get the investor's money out. ■ Testimonials from other group members. Scam artists frequently pay out high returns to early investors using money from later arrivals. This type of scam is a Ponzi scheme. Fraud aimed at groups of people who share similar interests is called affinity fraud.

Brochure Rule Required disclosure would include the following:

■ State or regulatory proceedings in which the adviser or a management person was found to have violated rules or statutes that led to the denial, suspension, or revocation of the firm's or the individual management person's registration ■ Court proceedings, such as a permanent or temporary injunction, against the firm or management person pertaining to an investment-related activity or any felony ■ Self-regulatory organization proceedings in which the adviser or management person caused the business to lose its registration; the firm or individual was barred, suspended, or expelled; or a fine in excess of $2,500 or a limitation was placed on the adviser or management person's activities

on rare occasions, an investment adviser might buy from or sell to an advisory client in the capacity of a principal. Or, the adviser might put together a buyer and seller act- ing in the capacity of an agent. This would be permitted with the following two requirements.

■ The client receives full written disclosure as to the capacity in which the adviser proposes to act. ■ Client consent is obtained. Both of these must be done prior to completion of the transaction

Unless otherwise provided in this rule, an investment adviser, registered or required to be registered under the Uniform Securities Act, must furnish each advisory client and prospective advisory client with:

■ a brochure, which may be a copy of Part 2A of its Form ADV or written documents containing the information required by Part 2A of Form ADV; ■ a copy of its Part 2B brochure supplement for each individual who — provides investment advice and has direct contact with clients in this state, or — exercises discretion over assets of clients in this state, even if no direct contact is involved; ■ a copy of its Part 2A Appendix 1 wrap fee brochure if the investment adviser sponsors or participates in a wrap fee account; ■ a summary of material changes, which may be included in Form ADV Part 2 or given as a separate document; and ■ such other information as the Administrator may require.

NASAA considers it to be an unethical business practice to use any advertising or sales presentation in such a fashion as to be deceptive or misleading. An example of such practice would be:

■ a distribution of any nonfactual data; ■ any material or presentation based on conjecture; ■ unfounded or unrealistic claims in any brochure, flyer, or display by words, pictures, or graphs; or ■ anything otherwise designed to supplement, detract from, supersede, or defeat the purpose or effect of any prospectus or disclosure.

The Uniform Securities Act also prohibits certain performance fee arrangements con- tingent on capital gains or appreciation being part of the advisory contract. There is an excep- tion, however, from the performance fee provisions for contracts with a qualified client defined as:

■ a natural person or company that immediately after entering into the contract has at least $1 million under the management of the investment adviser; or ■ a natural person or company that the IA has reason to believe that immediately before entering into the contract has a net worth exclusive of the primary residence (in the case of individuals, assets held jointly with a spouse, but no one else, can be used) in excess of $2.1 million. When computing the fee, both gains and losses must be considered (the fee cannot be based solely on gains).

For the purpose of the brochure rule, contract for impersonal advisory services means any contract relating solely to the provision of investment advisory services:

■ by means of written material or oral statements that do not purport to meet the objectives or needs of specific individuals or accounts; ■ through the issuance of statistical information containing no expression of opinion as to the investment merits of a particular security; or ■ any combination of the above services.

An investment adviser should not publish, circulate, or distribute any advertisement that is inconsistent with federal rules governing the use of advertisements. Included in the prohibi- tion are advertisements:

■ containing untrue statements of material fact; ■ that refer directly or indirectly to any testimonial of any kind; ■ that refer to past specific recommendations of the investment adviser, unless certain con- ditions are met (such as including all recommendations, both winners and losers, for a period of at least the previous 12 months); ■ that represent that a chart, formula, or other device being offered can, by itself, be used to determine which securities are to be bought or sold; or ■ that contain a statement that any analysis, report, or service will be furnished for free when that is not the case.

The account approval will indicate the:

■ date the options disclosure document (ODD) is furnished to the customer; ■ nature and types of transactions for which the account is approved (e.g., buying, covered writing, uncovered writing, spreading, discretionary transactions); ■ name of the agent assigned to the account; ■ name of the supervisor approving the account; ■ date of approval; and ■ dates of verification of currency of account information.

Annual Delivery An investment adviser, except discussed in the following, must:

■ deliver within 120 days of the end of its fiscal year a free, updated brochure and related bro- chure supplements, which include or are accompanied by a summary of material changes; or ■ deliver a summary of material changes that includes an offer to provide a copy of the updated brochure and supplements and information on how the client may obtain a copy of the brochures and supplements.

Delivery of the brochure and related supplements may be made electronically if the investment adviser:

■ in the case of an initial delivery to a potential client obtains verification that a readable copy of the brochure and supplements were received by the client; ■ in cases other than initial deliveries obtains each client's prior consent to provide the brochure and supplements electronically; ■ prepares the electronically delivered brochure and supplements in the format prescribed in the instructions to Form ADV Part 2; ■ delivers the brochure and supplements in a format that can be retained by the client in either electronic or paper form; and ■ establishes procedures to supervise personnel transmitting the brochure and supplements and prevent violations of this rule.

Initial Delivery An investment adviser, except as discussed in the following, must deliver the Part 2A brochure and any Part 2B brochure supplements required by the rule to a prospective advisory client:

■ not less than 48 hours prior to entering into any 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 five business days after entering into the contract.

The best way to avoid these conflicts of interest is to disclose them so that the customer can decide what to do. Some examples of potential conflicts of interest are:

■ offering a proprietary product, such as a house fund (a mutual fund where the underwriter or adviser is affiliated with the broker-dealer); ■ offering a limited partnership offering (DPP) where the sponsor is an affiliate of the bro- ker-dealer; ■ program sponsors, such as investment companies or insurance companies, providing incentives or rewards to agents for selling the sponsors' products; ■ a securities professional having a financial interest in any security being recommended; ■ a broker-dealer going public and placing shares of its own stock into discretionary accounts; and ■ a broker-dealer publishing a favorable research report after underwriting the issuer's stock offering.

Opening a margin account involves signing two agreements, with an optional third. Those are:

■ the credit agreement ■ the hypothecation agreement ■ the optional loan consent form