Unit 6

Exemptions from the Brochure Rule

(applies to both state and federal law) 1. Contracts with an investment company registered under the Investment Company Act of 1940 (ex. mutual funds) are exempted because those contracts are covered by that act 2. Advisers entering into a contract providing solely for impersonal advisory services (that is, publishers of market letters)

Examples of conflicts of interest

- 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 broker-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; - A broker dealer publishing a favorable research report after underwriting the issuer's stock offering

Online Red Flags for Investors

-promises of high returns with no risk (many online scams promise unreasonably high short-term profits) -offshore operations (headquarters offshore, making it more difficult for scams to be shut down and funds to be recovered) -e-currency sites (If investors have to open e-currency accounts to transfer money, use caution. These sites may not be regulated, and con artists use them to cover up money trails) -recruit friends (many cons will offer bonuses if investors recruit their friends) -professional websites with little to no information -no written information (often fail to provide a prospectus or other form of written information detailing the risks of investment and procedures to get the investor's money out) -testimonials from other group members

Wrap Fee Program

A program under which a client is charged a specified fee, or fees, not based directly on transactions in a client's account, for investment advisory services (which may include portfolio management or advice concerning the selection of other investment advisers) and for execution of client transactions. Any registered IA compensated under this type of program for sponsoring, organizing, or administering the program, or for selecting, or providing advice to clients regarding the selection of, other investment advisers in the program, does not use the normal brochure or Part 2A of the ADV. Instead, that adviser furnishes clients and prospective clients Part 2A, Appendix 1.

Entangled

A social media term meaning that a securities firm has participated in the development of content on a third-party site to which it publishes links.

Conflict of Interest

A term used to describe the situation in which a person in a position of trust, contrary to the obligation and absolutely duty to act for the benefit of a designated individual, exploits the relationship for personal benefit, typically pecuniary. Best way to avoid these are to disclose them so that the customer can decide what to do

Disciplinary information (Brochure Supplement Disclosing Individual Advisory Personnel)

About material events within the past 10 years, although the SEC says that even if more than 10 years have passed since the date of the event, you must disclose the event if it is so serious that it remains currently material to a client's or prospective client's evaluation.

Prohibitions on Investment Adviser Advertising

An IA should not publish, circulate, or distribute any advertisement that is inconsistent with federal rules governing the use of advertisements. This includes: - Containing untrue statements of material fact; - that refer directly or indirectly to any testimonial of any kind; - 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; - that contain a statement that any analysis, report, or service will be furnished for free when that is not the case; - that refer to past specific recommendations of an adviser, which were or would have been profitable to any person. (However, the Rule does not prohibit an advertisement which sets out or offers to furnish a list of all recommendations made by such IA during the preceding year, provided that the advertisement or the list contains certain specific disclosures about the recommendations); - that advertise gross performance data (ex. the performance data that does not reflect the deduction of various fees, commissions, and expenses that a client would pay) unless the adviser also includes net performance information in an equally prominent manner; and - that represent or imply that the adviser has been sponsored, recommended, or approved, or that its abilities or qualifications have in any respect been passed upon by the SEC or the Administrator)

Brochure Delivery Requirements

Both federal and state-registered advisers must prepare and deliver a brochure to their clients. If the question does not specify federal or state-registered (or refer to the Investment Advisers Act of 1940 or the USA), you should assume they are asking about a state-registered adviser.

Additional Compensation (Brochure Supplement Disclosing Individual Advisory Personnel)

Compensation beyond that paid by the client (such as a sales award or other prize)

Static Content

Content that remains posted until changed by the person who established the account on the site. Other users/viewers cannot edit this information. This content is accessible to all visitors on the site. Examples include company websites, profiles, backgrounds, or walls.

Supervision (Brochure Supplement Disclosing Individual Advisory Personnel)

Includes providing the name, title, and telephone number of the individual responsible for supervising the supervised person's advisory activities on behalf of the firm. The IA must prepare a brochure supplement covering the following supervised persons: - Any supervised person who formulates investment advice for a client and has direct client contact - Any supervised person who has discretionary authority over a client's assets, even if the supervised person has no direct client contact

Typical Broker-Dealer Fees

Issuance of a stock certificate, transferring an account, wiring funds, margin account interest, account maintenance fees, safekeeping of funds/securities, late settlement fee, postage and handling

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. Administrators make sure that requirements/supporting documentations are met for registration, however they do not "approve or disapprove" of any securities.

Updating the Brochure

Must be updated: 1. Each year at the time of filing the annual updating amendment; and 2. promptly, whenever any information in the brochure becomes materially inaccurate

Brochure Supplement Disclosing Individual Advisory Personnel

Part 2B is a brochure supplement that must contain certain information about advisory personnel on whom clients rely for investment advice. Is also a narrative format in plain English and includes six required disclosure categories: - Cover page - Educational background and business experience - Disciplinary information - Other business activities - Additional compensation - Supervision

Delivery Requirements for State-registered advisers

Same as federally covered advisors with one exception. -Advisers are required to deliver the brochure to the client at least 48 hours before entering into an advisory contract or at the time of entering into an advisory contract, if the advisory client has the right to terminate the contract without penalty within 5 business days after entering into the client. (If they were charged a set up fee, it must be refunded)

Account maintenance fees (Typical Broker-Dealer Fees)

Similar to the monthly charge on your bank statement, many firms charge an annual account fee, particularly if a small amount

Disclosure Obligations as a Fiduciary in regards to Part 2 of Form ADV

Under federal and state law, IAs act in a fiduciary capacity and must make full disclosure to their clients of all material facts relation to the advisory relationship. As a fiduciary, they also must seek to avoid conflicts of interest with their clients, and, at a minimum, make full disclosure of all material conflicts of interest between them and their clients that could affect the advisory relationship.

Correspondence & Social Media SEC rules

Use of social media websites for business purposes should be treated no differently than any other business-related electronic communication. Firms must ensure that they have sufficient systems, policies, and procedures to supervise, review, and retain business communications made using social media sites.

Margin account interest (Typical Broker-Dealer Fees)

When purchasing on margin, money is borrowed, and the rate of interest charged on the borrowed funds must be disclosed

Affinity Fraud

fraud aimed at groups of people who share similar interests

Social Media Issues Related to Agents

- Personal devices & office devices 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 - Look out for the red flags - It is not the device or technology that determines if a piece delivered by a BD 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

Form ADV Part 2

A disclosure document that, under state and federal securities laws, is required to be given to clients. Sets out the minimum required disclosure that the brochure and brochure supplements (which IAs must deliver to clients/prospective clients) must contain. Consists of: - Part 2A of Form ADV: Firm Brochure - Part 2A Appendix 1 of Form ADV: Wrap Fee Program Brochure - Part 2B of Form ADV: Brochure Supplement (describes certain supervised persons)

Full and Truthful Disclosure in Part 2 of Form ADV

All information in the brochure and brochure supplements must be true and may not omit any material facts

Wiring funds (Typical Broker-Dealer Fees)

Although frequency 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.

Postage and handling (Typical Broker-Dealer Fees)

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

Issuance of a stock certificate (Typical Broker-Dealer Fees)

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.

Interactive Content

Social media content that the participants can engage with. Has input from both the creator and the viewer. Common examples include Facebook, Twitter, Instagram, and LinkedIn

Broker-Dealer Advertising (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 from this tool may rank securities using any criteria selected by the customer, and 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 or an externally recognized group of securities and to request lists of securities that meet broad, objective criteria. The BD does not impose limits on the manner in which the research tool searches through a wide universe of securities, nor does it control the generation of the list to favor certain securities. Similarly, the algorithms for these tools are not programmed to produce lists of securities based on subjective factors that the BD has created or developed, nor do the algorithms produce lists that favor those securities in which the BD makes a market or for which the BD has made a buy recommendation. - A broker-dealer allows customers to subscribe to emails or other electronic communications that alert customers to news affecting the securities in the customer's portfolio or on the customer's watch list. Such news might include price changes, notice of pre-scheduled events, or generalized information. The customer selects the scope of the information that the firm will send to him.

Broker-Dealer Advertising (considered a recommendation)

- A broker-dealer sends a customer-specific electronic communication 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 using 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

Required Disclosures under Appendix 1

- A statement on the cover page must clearly state and identify the document as a wrap fee program - The amount of the wrap fee charged for the program - Whether the fees are negotiable - The services provided under the program, including the types of portfolio management services - A statement that the program may cost the client more or less than purchasing these services separately - A description of the nature of any fees that the client may pay in addition to the wrap fee - If the person recommending the wrap fee program to the client receives compensation as a result of the client's participation in the program (must also explain, if applicable, that the amount of this compensation may be more than what the person would receive if the client participated in the firm's other programs or paid separately for investment advice, brokerage, and other services) - Describe how portfolio managers are selected and reviewed, the basis for recommending or selecting portfolio managers for particular clients, and the criteria for replacing or recommending the replacement of portfolio managers for the program and for particular clients; and - Disclose whether any of the firm's related persons act as a portfolio manager for a wrap fee program described in the wrap fee program brochure

Examples of failures to disclose material information to clients

- An adviser fails to disclose all fees that a client would pay in connection with the advisory contract, including how fees are charged and whether fees are negotiable - An adviser fails to disclose its affiliation with a broker-dealer or other securities professionals or issuers - If a state-registered adviser has discretionary authority or custody over a client's funds or securities, or requires prepayment of advisory fees of more than $500 from a client, six or more months in advance, the adviser fails to disclose a financial condition that is reasonably likely to impair the ability of the adviser to meet contractual commitments to those clients. In the case of a federal covered adviser, the dollar limit is more than $1,200. - An adviser may defraud its clients when it fails to use the average price paid when allocating securities to accounts to participating in bunched trades and fails to adequately disclose its allocation policy. This practice violates the act if securities that were purchased at the lowest price or sold at the highest price are allocated to favored clients with adequate disclosure - Any material legal action against the adviser must be disclosed to existing clients promptly. If the action occurred within the past 10 years, it must be disclosed by a state-registered adviser to prospective clients not less than 48 hours before entering into the contract, or no later than the time of entering into such contract if the client has the right to terminate the contract without penalty within five business days. In the case of a federal covered adviser, the 48-hour rule does no apply; disclosure is part of the brochure delivered no later than commencing the advisory agreement.

Firm social media 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 to minimize confusion and maximize expectations; and - Clearly describe the monitoring tools to be used by the firm

How can broker-dealers make 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 notification 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 to help clients compare fees between firms

Summary of Notice and Consent

- Investment advisers organized as a partnership must notify clients when there is a change involving a minority of the partners (ex. five equal partners, one dies, one retires - notification within a reasonable period) - Investment Advisers organized as corporations do not have to notify clients of changes to shareholders - Investment advisers may only assign client contracts with client permission. Assignment occurs when there is a change to a majority of the partners. In the case of a corporation, if a majority of the stock is pledged as collateral for a loan, then that is considered an assignment.

General Disclosure Requirements

- Recommended that advisory clients be given a written statement prepared by the adviser that makes all appropriate disclosures - Duty on behalf of the broker dealer & soliciting advisers to inform advisory clients of their ability to seek execution of transactions with broker dealers other than those who have employed the advisers - Must be made to all current clients and to prospective clients regarding material disciplinary action - 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 felony - SRO proceedings in which the adviser or management person caused the business to lose its registration or 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

Disclosure and client consent requirements to address conflicts of interest

- The client receives full written disclosure as to the capacity in which the adviser proposes to act - Client consent is obtained (may be obtained before or after the execution of the trade, but must be done prior to completion of the transaction)

Investor Concerns Regarding Social Media

- The role of the securities professional is to help protect clients from falling prey to the many phony schemes found on social networks. - Con artists take advantage of social media because it is much easier for them to establish trust and credibility quickly online

The investment advisory contract must disclose (according to federal and state laws)

- The services to be provided, including custody if appropriate; - The term of the contract (contracts can be of any length, not necessarily annual, but all renewals under state law, just as with initial contracts, must be in writing); - The amount of the advisory fee or the formula for computing the fee; - The amount or manner of calculation of the amount of any prepaid fee to be returned in the event of contract termination; - Whether the contract grants discretionary power to the adviser or its representatives; - That no assignment of the contract may be made by the adviser without the consent of the other party to the contract (the client); and - That, if the adviser is organized as a partnership, any change to a minority interest in the firm will be communicated to advisory clients within a reasonable period of time. A change to a majority of the partnership interests would be considered an assignment; - In regards to performance based compensation, all is prohibited, including provisions where the adviser's fee is increased for good performance and decreased for poor performance

Delivery Requirements for SEC-Registered Advisers

-Must be delivered to each client (even if the advisory agreement with the client is oral). -Must be given to client before or at the time an advisory agreement is entered into with that client - Every year, within 120 days of the end of the fiscal year, a free & updated brochure must be delivered to each client (should include either a summary of material changes or is accompanied by a summary of material changes, or alternatively, it would be permitted to deliver a summary of material changes that includes an offer to provide a copy of the updated brochure and information on how a client may obtain the brochure). - If there are no material changes, nothing needs to be sent

3 major differences between federal and state law regarding an investment advisory contract

1. The USA prohibits entering into, extending, or renewing any advisory services, unless the contract is in writing, while federal law permits the contract to be written or oral 2. The USA requires that fees be competitive, while federal law only requires that they be reasonable in view of the services rendered 3. NASAA Model Rule on performance-based compensation is a bit more stringent than that of the SEC as we will cover in the next unit

SEC definition of advertisement

Any notice, circular, website, letter, or other written communication addressed to more than one person, or any notice or other announcement in any publication or by radio or television, that offers: - Any analysis, report, or publication concerning securities; - Any graph, chart, formula, or other device to be used in making any determination concerning securities; or - Any other investment advisory service with regard to securities

Supervisory Actions to Be Taken by the Broker-Dealer or Investment Adviser

Before allowing associated persons to use social media for business purposes, a firm's policies and procedures must provide for personnel training and education relating to the parameters of permitted use. Both supervisory personnel and agents need to understand the difference between interactive and static content, between business and non-business communications, and whether the communication is a retail communication requiring pre-approval. At a minimum, firms that permit social media use must hold an annual training which will reinforce personnel understanding of the firm's policies and procedures as applied to this continuously evolving technology and limit the firm's compliance risk. Social media policies must include relevant privacy issues.

Narrative Format of Part 2 of Form ADV

Consists of a series of items that contain disclosure requirements for the firm's brochure and any required supplements. The items require narrative responses. If an item does not apply to their business, they must indicate that item is not applicable. There are 18 items on the ADV Pt 2 (19 for state-registered advisers only). Some of the items include: - A description of the types of advisory services provided - Fees and compensation - Methods of analysis, investment strategies, and risk of loss - Disciplinary information - How you select or recommend broker-dealers for client transactions - Custody Practices - Investment discretion

Solicitor's Brochure

Disclosure document must include: 1. The name of the solicitor 2. The name of the investment adviser 3. The nature of the relationship between the solicitor and the investment adviser The document must also disclose the fact that the solicitor will receive compensation, the terms of the compensation arrangement, and indicate whether the client will pay a specific charge or higher advisory fee because a solicitor recommended the IA to the client

Regulatory Concerns about Social Media

FINRA has offered guidance to broker-dealers and registered personnel in their notices to members regarding the use of different technologies and devices for the delivery of business communications. - The content delivered ultimately determines its supervisory and filing requirements (not the technology, platform, or device used to file it) - Compliance responsibilities when communicating via the internet or other electronic media are the same as in face-to-face or written communications. Therefore, all existing FINRA rules and regulations applicable to communications with the public would also be applicable to communications delivered electronically by any technology or device if the content is business related. Registered representatives must also be aware of the internal firm policies.

Guarantee Against Loss

Guaranteeing a client that a specific result will be achieved (gain or loss) with advice which will be rendered is a prohibition. This includes saying "If your investment doesn't make X, I'll pay the difference"

Cover page (Brochure Supplement Disclosing Individual Advisory Personnel)

Identifying the supervised person (or persons) covered by the supplement as well as the advisory firm

Educational background and business experience (Brochure Supplement Disclosing Individual Advisory Personnel)

Includes disclosing if the supervised person has no high school education, no formal education after high school, or no business background

Other business activities (Brochure Supplement Disclosing Individual Advisory Personnel)

Includes disclosing if the supervised person receives commissions, bonuses, or other compensation based on the sale of securities or other investment products, including as a broker-dealer or registered representative (agent), and including distribution or service (trail) fees from the sale of mutual funds

Investment Adviser Advertising

NASAA Model Rule states that publishing, circulating, or distributing any advertisement that does not comply with the Investment Advisers Act of 1940 would be prohibited.

Advertising

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. Examples include: - 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; - anything otherwise designed to supplement, detract from, supersede, or defeat the purpose or effect of any prospectus or disclosure

Adoption

Social media term meaning that a securities firm links to a third-party site and indicates that it endorses the content on that site

Broker-Dealers acting in Principal Capacity

The BD is the contra party to the trade when executing transactions for their clients. That is, they are on the other side of the trade. When the client is buying, the BD is selling it out of inventory and the firm's profit comes from a markup. If the client is selling a security and the BD purchases it for its inventory, the firm is acting as a principal and the profit comes from a markdown. Must disclose if they acted as a principal (and possibly must indicate the markup/markdown) by the completion of the trade (settlement date)

Filing the Part 2 of Form ADV

The IA must file the brochure(s) (and amendments) through the IARD system. If the IA is federal covered or in the process of registering with the SEC, it is not required to file the brochure supplements through the IARD or otherwise. However, a couple of the supplements must be preserved and made available to SEC staff upon request. If the IA is registered with or is in the process of registering with one or more state securities authorities, a copy of the brochure supplement (part 2B) must be filed for each supervised person doing business in that state.

Agency Cross Transaction

The adviser (or IAR acting on behalf of the firm) acts as an agent for both its advisory client and the party on the other side of the trade. Both state and federal law will permit an adviser to engage in these transactions provided the advisory client executes a written consent prospectively (in advance) authorizing the investment adviser to effect agency cross transactions as well as a number of disclosures. Client also must be sent a written trade confirmation that includes: - A statement of the nature of the transaction - The date and, if requested, the time of the transaction - The source and amount of any remuneration to be received by the IA or IAR in connection with the transaction

Broker-Dealers acting in Agency Capacity

The firm is acting like any other broker or agent (real estate broker, insurance agent, or employment agent) in that they are simply putting the buyer and seller together. Earn a commission. Must indicate if they acted as a broker and disclose the commission amount by the completion of the trade (settlement date)

Plain English supplement of Part 2 of Form ADV

The items in this part of Form ADV are designed to promote effective communication between the firm and their clients. The brochure and supplements must be written in plain English, taking into consideration the clients' level of financial sophistication. Specifically, the SEC states that the brochure should be concise and direct. The brochure should discuss any conflicts the adviser has or is reasonably likely to have and practices in which it engages or is reasonably likely to engage.

Essential disclosures advisers must make when participating in agency cross transactions

These requirements do not relieve advisers of their duties to obtain best execution and best price for any transaction. - The adviser will be receiving commissions from both sides of the trade - There is a potential conflict of interest because of the division of loyalties to both sides - On at least an annual basis, the adviser will furnish a statement or summary of the account identifying the total number of such transactions and the total amount of all remuneration from these transactions - In a conspicuous manner, indicates that this arrangement may be terminated at a time - No transaction is effected in which the same investment adviser or an investment adviser and any person controlling, controlled by, or under common control with that investment adviser recommended the transaction to both any seller and any purchaser

Late settlement fee (Typical Broker-Dealer Fees)

This is similar to the late fee on a credit card. When a client's payment arrives after settlement date (or is removed due to insufficient funds), the broker-dealer may assess a fee

Safekeeping of funds/securities (Typical Broker-Dealer Fees)

This is the charge made for maintaining custody of client assets, which is usually waived for larger accounts

Transferring an account (Typical Broker-Dealer Fees)

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

Guaranteed Security

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 these is that there is no guarantee on the performance of the investments. For example, gains cannot be part of the guarantee.