Unit 6

Under both Federal and State acts, the investment advisory contract prohibits....

- Prohibits waiving fees in the event of losses in the client's account (The Model Rule) - On the exam, unless the question refers to one of the exceptions we're going to learn about in the next unit, you should always take the attitude that performance-based compensation is prohibited

Broker-Dealer Advertising

- Can't be deceptive or misleading - highlighting or excerpting of a prospectus is prohibited. - Advertisements are never filed with the SEC. - a broker-dealer's website is advertising 1. Distinguish what is and is not a recommendation. a. Libraries of research reports, news and quotes, screening tools, etc. are not recommendations. b. Targeted email or pop-up, list of specific securities to reach a client's goals, buy recommendations from a specific sector, etc. are recommendations.

Typical Broker-Dealer Fees

- Issuance of a stock certificate - Account transfer - wiring funds - margin account interest - postage and handling - annual account fee - safekeeping of certificates - late settlement fee

Unethical Advertising

- 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. - Somewhat related, and also prohibited, is highlighting or making any other marks on a prospectus to draw attention to key points.

Investment Advisers do not have to deliver brochures if the advisory clients are limited to the following:

- investment companies or insurance companies - An adviser who only provides impersonal advisory services (subscriptions) at an annual charge of less than $500

Online Red Flags for Investors

- promises of high returns with no risk - offshore operations - E-currency sites - recruit friends - professional websites with little to no information - no written information - testimonials from other group members

Under both Federal and State acts, the investment advisory contract must contain....

- services to be provided - duration of contract (renewals under state law must be in writing but can be verbal under federal law.) - advisory fee - formula for computing advisory fee - amount of prepaid fee returned if the contract is terminated - whether the contract grants discretionary power to the adviser or its representatives - no waiver of fees for underperformance - that no assignment of the contract may be made by the adviser without the consent of the other party to the contract (the client) - 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 and consent is needed

Advertising that reflects past performance must show a minimum period of how long?

1 year

Assignment of the Advisory Contracts

1. A change of management control is deemed to be considered an assignment of the advisory contracts 2. In a partnership, a change to a majority of the partnership interests would be considered an assignment and consent is needed 3. Investment advisers may only assign client contracts with client permission. An assignment occurs when there is a change to a majority of the partners (in our previous example, if one more of the partners left, that would be 3 out of 5—a majority). 4. 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 5. No assignment of the contract may be made by the adviser without the consent of the other party to the contract (the client)

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

1. 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. 2. Applies to supervisory personnel, agents, and IARs 3. Initial and annual training recommended 4. Monitoring

Social Media Communications: Regulatory Concerns

1. Content, not delivery method 2. Compliance same as in written communications 3. Agent's or IAR's use of personal tools for business use 4. Supervision for recordkeeping and training

Term - Adoption

Adoption is a social media term meaning that a securities firm links to a third-party site and indicates that it endorses the content on that site. A firm may be deemed to "adopt" a third-party post or content on a third-party site if the firm or its personnel explicitly or implicitly endorses or approves the post or the content.

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). - e.g., the parent company for a subsidiary's debt 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.

Contents of the solicitor's brochure

A solicitor is someone being paid to go out and solicit business Contents of the brochure contains: - The name of the solicitor - the name of the investment adviser - the nature of the relationship between the solicitor and the IA - the that the solicitor with receive compensation, the terms of the compensation arrangement, and indicate whether the client will pay a specific charge or a higher advisory fee because the solicitor recommended the IA to the client

Affinity Fraud

A type of fraud using social media where the fraudsters pretend to be members of a group, sometimes using respected leaders of the group to spread the word about the scheme. Frequently aimed at ethnic and religious groups.

Testimonials

Although the rules do not prohibit testimonials for broker-dealers, they are strictly forbidden for use by IAs. In March 2014, the SEC published an interpretive release dealing with testimonials for investment advisers using social media. Included in that release is the statement that third-party use of the "like" feature on an investment adviser's social media site could be deemed to be a testimonial if it is an explicit or implicit statement of a client's experience with the adviser.

When must material information be disclosed?

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 not apply; disclosure is part of the brochure delivered no later than commencing the advisory agreement.

Brochure Rules

Brochure is Form ADV Part 2A (describes the firm) and Supplement, Form ADV 2B (describes the personnel who make the advisory decisions) - Part 2A Appendix 1 of Form ADV: Wrap Fee Program Brochure Most Investment Advisers have to have to prepare brochures for their clients Updated annually at time of updating amendment Only in the case of state-registered investment advisers is it required to file the brochure supplements

Term - Entangled

Entangled is 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. If a firm permits a third-party post on its website or it provides links to a third-party site, it will be considered that the firm is entangled with that post or link if the firm participates in the development or preparation of the content.

If a broker-dealer forms a subsidiary to start an investment adviser, existing clients of the BD wishing to become clients of the IA must...

Enter into a new contract for advisory services.

Unlawful Representations

Securities Professionals - cannot infer or imply approval of qualifications by any regulatory body Securities Registrations - cannot infer or imply approval of issue by any regulatory body - disclaimer on prospectus states that the security has not been approved or disapproved, and any representation to the contrary is a criminal offense.

Wrap Fee Brochure

Charge a fixed fee for portfolio management, advice, and execution Wrap fee brochure based on Appendix 1 of Form ADV Part 2A Must be provided in lieu of a standard brochure and must disclose the wrap fee may cost more than purchasing services separately Must identify whether any of its related persons is a portfolio manager in the wrap fee program and, if so, describe the associated conflicts

Not included in the fee disclosure documents are:

Commissions, markups and markdowns, and advisory fees. Those disclosures are made in other documents, not the fee disclosure schedule.

Form ADV Part 2 contains

Form ADV Part 2 is a disclosure document that, under state and federal securities laws, is required to be given to clients. The Part 2 consists of the following three parts: - 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)

Summary of Brochures

Form ADV facts: - Part 1B is only filed by state-registered advisers; only state-registered advisers file Part 2 with their regulator a. federal covered advisers must keep theirs on hand for inspection; - Part 2A is the brochure which must be delivered to clients of all IAs within 120 days of the end of the fiscal year. A brochure supplement may be delivered instead showing the material changes. If there are no material changes, there is no need to send a brochure. The Part 1A annual amendment must be sent to the SEC or Administrator within 90 days after the end of the fiscal year.

Performance Guarantees

Guaranteeing results is unethical (minimize losses or assuring profits) - Agent agreeing to buy back at original price or with a bonus is unethical Although performance guarantees are prohibited, under certain circumstances, investment advisers can receive performance-based compensation - Of course, it must go both ways; if the performance of the account is below that of the index, the fee is reduced.

Delivery Requirements of Brochures

Must deliver the current brochure and supplement to a client or prospective client before or at the time of entry into an investment advisory contract with that client. - the very latest you can give a client a brochure is at the time of entry into the investment contract. Special Rule under state registered investment advisors (USA) - 48 hour in advance rule - If the brochure is not delivered 48 hours in advance, the client has five business days' right to rescind without penalty - applies to firms that charge an upfront fee - the only thing the advisor is permitted to keep is the daily fee

Regulation Best Interest

If enacted, this rule will require a broker-dealer to act in the best interest of a retail customer when making a recommendation of any securities transaction or investment strategy involving securities to a retail customer. Regulation Best Interest is designed to make it clear that a broker-dealer may not put its financial interests ahead of the interests of a retail customer in making recommendations and is more stringent than the current suitability requirements.

Correcting bona fide errors

If justified, a broker-dealer, but not an associated person of the firm, may correct a bona fide error. An associated person of a broker-dealer cannot do this because of the concern that any such payment may conceal individual misconduct.

If their are material changes in the brochure since last annual updated amendment.

If there are material changes in the brochure since the last annual updating amendment, deliver the following to each client annually within 120 days after the end of the fiscal year: - a free current brochure - a summary of material changes to the brochure including an offer to provide a copy of the updated brochure and information on how a client may obtain a brochure - It may be delivered electronically - if no material changes, no brochure or summary is required to be sent out - must include the balance sheet if the investment advisor requires substantial prepayment of fees of more than $1,200 ($500 USA), 6 months or more in advance, or custody (USA) - Disclosure of material legal or disciplinary action within the past 10 years, including fines of $2,500 or more a. prompt amendment required for material changes

Social Media for Agents and IARs

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 mayor may not be required. For example, an "unscripted" participation in an interactive electronic forum (such as Twitter) generally does not require prior supervisory approval. On the other hand, a LinkedIn page would probably require pre-approval. - Specifically regarding Twitter, posts do not need supervisory pre-approval except for an agent's initial tweet. Look out for the red flags. Certain activities, such as linking to third-party sites or receiving 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.

Agency Cross Transactions

In an agency cross transaction, the adviser (or IAR acting on behalf of the firm) acts as 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 if: - The client executes a written consent prospectively (in advance) authorizing these transactions - Written disclosure must be given to the client before the completion of the transaction - Cannot recommend the trade to both parties.

Prohibited Investment Adviser Advertising

Included in the prohibition are advertisements: - 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 - implying extensive research when not a fact - that advertise gross performance data (i.e., 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 - implying approval by regulators - Use of abbreviation RIA or IAR - Use of titles not earned (MBA, JD, CPA, CFP, CFA) - lack of disclosure of outside data sources - charts and formulas must explain limitations and difficulties.

Disclosure of Capacity by Investment Advisers

Investment advisers acting as a principal or agent in purchase or sale of recommended securities must disclose this capacity - Full written disclosure to the client before the completion of the transaction (settlement date) - Must gain client's consent before completion of the transaction (consent can be both oral or written) - this is unlike broker-dealers who do not need consent - an adviser is not "acting as a broker" within the meaning of the acts if the adviser receives no compensation (other than its advisory fee) for effecting a particular agency transaction between advisory clients. It is primarily the incentive to earn additional compensation that creates the adviser's conflict of interest when effecting an agency transaction between advisory clients.

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 (e.g., 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 our previous example, if one more of the partners left, that would be 3 out of 5—a majority). 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

Broker-Dealer Conflicts of Interest

Must disclose if: - 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 - financial interest in a recommended security (sister is the CEO of the recommended security) - publishing a favorable research report after underwriting the issuer's stock offering - going public and placing shares of its own stock into discretionary accounts

Investment Adviser Conflicts of Interest

Must disclose if: - ownership in the recommended security - must disclose gifts or incentives associated with the recommended product - Advisers must notify clients if they are a representative of a broker-dealer and will recommend a purchase of products through that broker-dealer to receive commission - disclose if recommending products of only the broker-dealer or insurance company with whom they are associated - disclose that a client may execute through other broker-dealers. - disclose the amount of compensation when a. the transaction is through a broker-dealer with whom the adviser is associated and; b. compensation is received from an issuer or; c. compensation is received for the sale of non-security products. - disclose personal trades if a. inconsistent with the advice given or; b. investment adviser benefits from client acting on the recommendation

Past Performance can be used in advertising if....

Past Performance a. Can be used if the following disclaimer and disclosure are included: - No assurance of future results - Includes all gains and losses

Principal vs Agency Capacity

Principal - on the other side of the trade of a client - when a client is buying a security, they are buying out of the inventory of the BD - the firm's profit comes from a markup or markdown Agent - BD is putting the buyer and seller together - they earn a commission Broker Dealer must always indicate their capacity on the trade confirmation, sent no later than the settlement date. - must always disclose commission if working in agency capacity

Written Requirements; Initial and Renewal

Required under USA and Investment Company Act of 1940 Not required under the Investment Advisers Act of 1940

Static vs Interactive Content

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. Interactive content, as the name implies, has input from both the creator and the viewer. Common examples include Facebook, Twitter, Instagram, and LinkedIn. The most common way in which to distinguish whether social media content is static or interactive is the ability for others to change it.

Waiving Compliance Laws

The Model Rule is very clear that waivers of this type are never permitted—you just can't waive compliance with the laws.

Investment Adviser Advertising

The SEC has defined the term advertisement to include 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.

Investment Advisory Contracts: Three major differences between federal and state law

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. Another difference concerns the amount of the fees. The USA requires that fees be competitive while federal law only requires that they be reasonable in view of the services rendered. Finally, the 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.

Disclosure of Material Information

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. 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 - 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

Updating the Brochure

The brochure must be updated: - each year at the time of filing the annual updating amendment; and - promptly, whenever any information in the brochure becomes materially inaccurate.

Cover page of the brochure must contain:

The cover page of the brochure must state the name, business address, contact information, website address (if there is one), and the date of the brochure.

If an investment adviser does not maintain custody or receive substantial prepayment, what do they not have to disclose to clients?

They do not have to notify their clients about any financial situation that might impair their ability to meet contractual commitments to clients. I.e., if a civil lawsuit is filed against an adviser by one of its clients, this does not have to be disclosed unless the suit goes in favor of the client and the adviser is found guilty.

Broker-Dealer Disclosure of Fees

Typically disclosed when a customer account is opened - must be up to date Fee changes - typically at least 30 days in advance. - methods used include email, postal mail, or website. Disclosure method used - Chart - List - Table - Narrative NASAA Model Fee Disclosure Schedule - The template and guidelines make fee disclosure easily accessible for retail investors to use to understand and compare fees.

Wrap Fee

When a broker-dealer takes all of its services and wraps it into a package It is generally agreed that "buy and hold" clients are not suitable for a wrap fee account because they don't do enough trading to benefit from the fact that commissions are included in the program fee. The required disclosure statement for wrap fee programs must contain at least the information in Appendix 1 of Form ADV Part 2A, but duplicates need not be provided to clients who have already received the required disclosure on that program from another adviser.

Does an investment adviser have to deliver a brochure if they do not have custody or discretion?

Yes Unless there have been no material changes, a copy of the adviser's brochure or brochure supplement must be delivered to all current clients [except those who are exempt from the brochure delivery requirements (impersonal advise costing less than $500 per year and investment companies registered under the Investment Company Act of 1940)] within 120 days of the end of the adviser's fiscal year.

Anytime you see a question dealing with advertising a charting system (or investment formula, etc.), always look for.....

limitations and difficulties in the answer.