Section 3: Understanding Trading, Customer Accounts and Prohibited Activities

Buybacks

(AKA share repurchase) A company buys its share back on the open market using company funds. These buybacks are known as treasury stock.

Simplified Employee Pension (SEP)

A cost-effective IRA that allows employers to make discretionary contributions towards their own retirement—as well as their employees'—and receive tax deductions for those contributions. SEP IRAs can be considered traditional IRAs with a few key differences, namely employers being able to contribute. Additionally, employers can often contribute significantly more to a SEP IRA than a traditional IRA but are still limited to the lesser of 25% of an employee's compensation or $58,000 (as of 2021). Like traditional IRAs, account owners who turn 72 have until April 1 of the following year to take their first required minimum distribution. -- Retirement Account

Tender Offers

A method by which a hostile acquirer renders an offer to the shareholders of a company in an attempt to gather a controlling interest in the company. Generally, the potential acquirer will offer to buy stock from shareholders at a much higher value than the market value.

Defined Contribution Plan

A plan that generally permits an employee to make pre-tax contributions which can be partially matched by their employer. In traditional accounts, investment gains grow on a tax-deferred basis up until retirement, when they are then taxed as income withdrawals are made. (Most commonly a 401 (k)) -- Unlike defined benefit plans, these plans are voluntary for employees and the retirement income is NOT guaranteed by employers. -- Required minimum distributions start for defined contribution plans at the age of 72. -- Retirement Account

Solicited Order

A registered representative (RR) contacts client making a recommendation that results in a transaction. (All order must be marked as solicited or unsolicited)

Individual Retirement Account (IRA)

A tax-advantaged savings account available to any individual with earned income (several different IRAs such as traditional, Roth IRAs, Payroll Deduction IRAs, SEP IRAs and SIMPLE IRAs). --On an annual basis, individuals can contribute the lesser of: (1) $6,000, or $7,000 for those 50 years or older by the end of the year; or (2) taxable compensation for the year. -- Retirement Aaccount

Custodial Account

Account that is created for a minor, usually at a bank, brokerage firm, or mutual fund. Minors cannot make securities transactions without the approval of the custodian, who manages cash and other property gifted to minors under the UNIFORM GIFTS TO MINORS ACT or the Uniform Transfers to Minors Act.

Trust Accounts

Accounts that transfer assets to one or more beneficiaries upon the death of the owner(s). --Revocable trusts: can be revoked or modified by the creator-grantor-of the trust. --irrevocable trusts cannot be modified w/o beneficiary consent.

Corporate Record

All publicly traded corporations are required by law to keep and maintain an accurate list, updated every business day, of who owns its shares/bonds). Record is kept by Transfer Agent (typically a bank or trust).

Cash Account

All transactions must be paid in full with cash or investments (investments must be sold the same day) (no credit is permitted).

Individual Account

An account that has only one holder and no named beneficiaries (checking, savings, market deposit accounts)

Anti-Money Laundering (AML)

An employee benefit plan that is set up as a trust fund and provides employees with the option to acquire ownership interests in the form of company stock. Money laundering typically follows three steps known as placement, layering, and integration. 1. Placement: illegitimate money is entered into the legitimate financial system. 2. Layering: money source is disguised through a series of sophisticated transactions. 3. Integration: when the now-legitimatized money is withdrawn by the criminal(s) to be used as they wish.

Employee Stock Ownership Plan (ESOP)

An employee benefit plan that is set up as a trust fund and provides employees with the option to acquire ownership interests in the form of company stock. An employee benefit plan that is set up as a trust fund and provides employees with the option to acquire ownership interests in the form of company stock. -- Retirement Account

Defined Benefit Plan

An employer-sponsored plan that provides a specified monthly benefit or lump-sum payment to the employee upon retirement. Employer is responsible for all the investment decisions in the account and thus bears all the risk. Taxable as normal income. --Retirement Account

Improper use of Customers' Securities or Funds

Applied broadly, member firms and registered reps are prohibited from making improper use of customers' securities or funds. There are many examples of what "improper use" could mean, but the most common violation of this rule is theft. -- Borrowing from customers: Member firms and associated persons are prohibited from lending money to or borrowing money from their customers unless the member firm has written policies in place that authorize their associated persons and customers to engage in borrowing or lending. -- Sharing in customer accounts: Generally, member firms and associated persons are prohibited from sharing directly or indirectly in a customer's gains or losses. However, they are able to do so if three conditions are met: 1. The associated person receives prior written authorization from their member firm; 2. The associated person receives prior written authorization from the customer; and 3. The associated person or member firm's share in the customer's gains or losses is directly proportional to their own financial contributions.

Use of Manipulative, Deceptive or other Fraudulent devices

Applied broadly, member firms are prohibited from effecting any transaction, purchase, or sale of a security by any manipulative, deceptive, or other fraudulent means.

Principal Capacity

Broker-dealer sells directly to a buying customer out of the firm's inventory.

Agency Capacity

Broker-dealers acting as intermediary between a buying customer and a selling customer.

FINRA Rule 2111

Broker-dealers and associated persons are required to have a reasonable basis to believe a recommended securities transaction (or investment strategy involving securities) is suitable for the customer. 3 main suitability Obligations 1. Reasonable-basis Suitability: Broker must have a reasonable basis to believe that the recommendation is suitable for at least some investors. The firm or associated person must also have an understanding of the potential risks and rewards of the recommended product. 2. Customer-specific Suitability: Based on a customer's investment profile, the broker must have a reasonable basis to believe that the recommendation is suitable for that specific customer. The broker must also be able to support this determination. 3. Quantitative Suitability: A broker with actual (or de facto) control over a customer's account must have a reasonable basis to believe that a series of recommended transactions is not excessive nor unsuitable for the customer in consideration of their investment profile.

SEC's Regulation Best Interest (Reg BI)

Broker-dealers and associated persons must follow a "best interest" standard of conduct when making a recommendation of a certain type to a retail customer. One requirement of the rule is for broker-dealers and investment advisers to provide retail investors with a brief relationship summary known as Form CRS, which includes information such as types of services the firm can provide to retail investors, fees/costs, conflicts, and more.

Options Account

Broker-dealers are required to formally approve investors for options trading by having them complete an options agreement, which will assess the investor's general investing knowledge as well as their knowledge of options, trading strategies, and the risks associated with options transactions. They may also need to provide information such as investment objectives, trading experience, and personal financial details. In addition to the options agreement, broker-dealers are required to furnish all potential options investors with certain disclosures. Once approved, the broker-dealer will decide which option trading level the investor qualifies for (typically one of five levels varying in risk).

Fee-Based Advisors

Charge their clients annual, hourly, or flat fees and required to operate under a fiduciary duty (meaning they always prioritize their clients' best financial interest over their own).

Unsolicited Order

Client contacts Registered Representative (RR) on stock they want to purchase or sell. (All order must be marked as solicited or unsolicited)

FINRA Rule 2210

Communications w/ the public. Cold Calling: cannot be done before 8 AM or after 9 PM in the prospects timezone Unless (1) an established business relationship exists (2) the prospects has provided permission or (3) the prospect is a broker dealer. National Do-Not-Call list: No cold calls can be made to any person who has registered their phone # on the Federal Trade Commission's national do-not-call registry.

Dividends: Declaration Date

Company announces the type and size of the dividends as well as the record date and payment date.

Corporate/Institutional Account

Corporations often open brokerage accounts as do large institution (banks, insurance companies, pensions plans etc)

Discretionary Vs. Non-Discretionary Accounts

Discretionary accounts authorize brokers/advisors to trade securities on behalf of their clients w/o consent. Opposite is true for non-discretionary accounts.

Commission-Based Advisors

Earn their compensation from selling certain investment products or opening accounts. Fiduciary duties are optional.

Dividends

Earnings distributed to stockholders. Cash Dividends: cash given stockholders (based on well the company does) Stock Dividends: common stock given to stockholders (share price will decrease due to additional shares)

Backing Away

Failure to honor bid/ask price firm quotes. This is a FINRA rule (5220) and is a serious violation. -- Bid price indicates the max price of a security that a buyer is willing to pay. -- Ask price indicates the min price of a security that a seller is willing to accept.

Educational Accounts

Families wishing to save up for qualified postsecondary educational expenses can open a 529 college savings plan account. These plans are popular with investors for their tax benefits.

Account Compliance

Federal Reserve Board Regulation T (Reg T) governs all account types. Main two are cash account and margin account.

Partnership Account

Held by two or more people who are held equally liable. Similar to joint accounts but are mostly use by business partners.

Bearish

Investor expect prices to decline. Bear market = prolonged 20% decline in securities prices.

Bullish

Investor expects prices to rise. Bull market = prolonged rise in securities price.

Capital Gains -- Realized vs Unrealized

Investor purchases ABC stock at $80 and it rises to $110. The investor has an unrealized gain of $30. Once the investor sells the stock, they have a realized gain of $30.

Naked Call Writing

Investor sells a call option w/o owning the underlying security (believes price of stock will trade below strike price, thereby collecting premium [If price of stock trades above strike, max potential loss is unlimited]).

Naked Put Writing

Investor sells a put option w/o owning the stock (believes price of stock will trade above strike, thereby collecting the premium [IF it trades below the strike, max potential loss is unlimited]).

Long-Short Equity

Investor takes long positions in stock they expect to rise (owning the stock) and short positions in they expect will drop (borrowing stock).

Margin Account

Investors can borrow upto 50% of the cost of securities referred to as buying on margin and investors are charged interest (loan must be paid off when securities are sold). -- Increase purchasing power of investor but are riskier and come with more requirements.

Front Running

Jims client calls and asks to buy 600,000 shares of ABC, knowing this is a large order and will drive the price up, jim buys ahead of the clients order to turn a profit.

Unsuitable Recommendations

Making recommendations which DO NOT match the client's investment goals and needs is unsuitable and can lead to disciplinary action.

Activities of Unregistered Persons

Member firms and associated persons are prohibited from paying compensation, fees, concessions, discount, or commissions to unregistered persons. Unregistered persons are prohibited from discussing firm investment products or services, pre-qualifying firm customers, or soliciting new customer accounts or orders.

Mergers and Acquisitions (M&A)

Merger: Two companies combine under a new single entity with new ownership and a new management team (occurs less often). Acquisition: One company (often large) takes over a smaller company. Typically a financial buyer (i.e. private equity firm) or a strategic buyer (operates in the same industry).

Commingling

Mixing client assets with registered rep or firm assets is called commingling. Customers' money and securities are to be segregated from those of the brokerage firm and/or their rep.

Trade Capacity

Most securities firms are required to register w the SEC and join a self-regulatory organization (SRO) like FINRA, thereby becoming member firms and agreeing to abide by all rules and regulations set forth by the SRO. Two such examples are brokers and dealers, with many acting in both capacities (known as broker-dealers).

Trade Settlement

Most securities transactions are required to settle within 2 business days (T+2). T: Transaction date. T + 1: For U.S. gov bonds and gov agencies (1 business day after transaction) T + 2: For stocks and most mutual funds (2 business days after transaction). Regulation T --> 2 days is the max amount of time has to pay for a stock after it has been purchased. Transfer of ownership of a stock or bond certificate is done by 1. Book Entry: Tracking securities ownership electronically (majority of casses and are processed by the Depository Trust Company) OR 2. Physical Entry: certificates are physically delivered to the buyer and ownership is kept on the books of the securities issuer.

AML Compliance Program

Must satisfy the following conditions: 1. Have policies, procedures, and internal controls reasonably designed to achieve compliance with the BSA. 2. Appoint an AML Compliance Officer (AML Officer), with subsequent notification to FINRA 3. Provide ongoing training to personnel 4. Implement risk-based procedures for conducting ongoing customer due diligence 5. Conduct independent testing of the firm's AML program (done annually for most firms). Financial Institutions are required to file a suspicious activity report (SAR) with the Financial Crimes Enforcement Network (FinCEN) whenever it knows, suspects or has reason to suspect a transaction (of at least $5000). Banks are required to file currency transaction report (CRT) with FinCEN whenever a customer completes a transaction (deposit, withdrawal, or other payment or transfer) in currency of more than $10,000. They may also file a CTR whenever a customer appears to be intentionally avoiding the $10,000 threshold by effecting a series of smaller transactions (Known as structuring). --- NOTE: NOT required to be reported for banks, government agencies, or public companies whose shares trade on the NYSE (Exempt Persons).

Joint Account

Opened by 2 or more people. Joint Tenants with Rights of Survivorship (JTWROS) commonly used by spouses while Tenants in Common are more commonly used by friends/relatives.

Exchange Offers

Optional events directly targeting company shareholders. They are given the option to exchange one type of security, such as common stock, for another type of security such as preferred stock or debt.

Good-til-Canceled Order (GTC)

Order to buy or sell at a specified price that remains in effect until it is executed by the broker or canceled by the investor (AKA a limit order w/o time limitation)

Purchasing Initial Public Offerings

Registered reps are prohibited from purchasing a new issue of an equity security (initial public offering or IPO). They are also prohibited from selling a new issue of an equity security to other broker-dealers and their affiliates.

FINRA Rule 2090, Know-Your-Customer (KYC)

Require firms to "know their customer" by conducting reasonable diligence on customers each time a new account is opened as well as to know, verify, and retain each customer's essential facts.

FINRA Rule 4370

Requires firms to and maintain a written business continuity plan (BCP) that addresses an emergency or serious business disruptions and how the firm plans to respond to such. Should include at min: -- Data backup and recovery (hard copy and electronic) -- All mission critical systems -- Financial and operational assessments -- Alternate communications btwn CU and the firm, and btwn the firm and employees -- Alternate phyical location of employees -- Critical business constituent, bank, and counterparty impact -- Regulatory reporting -- Communications w regulators And -- How the firm will assure customers' prompt access to their funds and securities in the event that the firm determines that is is unable to cont. business

SEC Regualtion S-P

Requires firms to have policies and procedures in place addressing this protection and safeguarding of customer information and records. -- Additional requirement of the rule is that firms must provide their customers with initial and annual privacy notices that contain firm policies as well as inform customer of their rights (ie opting our of their nonpublic personal information being shared w nonaffiliated 3rd parties).

Financial Exploitation of Seniors

Seniors are one of FINRA's top prioritized groups of investors due to the increasing problem of financial exploitation. A senior is defined as (1) a natural person age 65 and older or (2) a natural person age 18 and older w a reasonably believed mental or physical impairment that leaves them unable to protect their own interests. --Under FINRA rules member firms are allowed to place a temporary hold on fund or security disbursements from a "specified adult" if they believe financial exploitation has occurred.

Falsifying or Withholding Documents

Signatures of convenience: Registered reps are prohibited from creating blank template forms that contain signatures. Responding to regulatory requests: Regulatory requests should be responded to promptly.

Naked Options

Sophisticated investor sells options contract w/o owing the underlying security (IF exercised the seller will have to purchase the stock at market price in order to meet the obligation).

Market Rumors

Spreading of misinformation with the intent of manipulating the price of a security. (Ex Jim holds ABC stock and spreads a false rumor to inflate the price, and then sells.)

Theft/Embezzlement/Similar Criminal Behavior

Stealing from clients is both unethical and illegal and can lead to incarceration and/or loss of career.

Books and Records and Privacy Requirements

The SEC, the MSRB and FINRA all have specific record-keeping rules for registered broker-dealers. At a min, broker-dealers must retain the following records: Communications with the Public: Retained for 3 yrs (at least 2 yrs easily accessible). Organizational Documents: Retained for the lifetime of the firm. Special Reports: Retained for 3 yrs after the report. Compliance, Supervisory & Procedures Manuals: Retained for 3 yrs after the manual's termination of use. Exception Reports: Retained for eighteen months after the date the report was generated. Brokerage Account Statements: Retained for 6 years and they are sent on a quarterly basis. Trade Confirmations: Retained for 3 yrs and are written at or prior to transaction completion. Customer Mail: Member firms are permitted to hold CU mail as long as the CU provides written instructions on how long it is to be held (if longer than 3 months the CU is responsible for providing acceptable reason such as security concerns).

Dividends: Record Date

The date a shareholder must be on the company's books in order to receive the dividend (on or before the date).

Stop Order

The investor already owns a stock sets a price if the stock declines past that price then the stock is sold (Originally called stop loss order).

Non-Discretionary Order

The investor makes the trade.

Office of Foreign Assets Control (OFAC)

U.S. Treasury Department agency tasked with enforcing sanctions against terrorists, narcotics traffickers, and other threats to national security. They keep the public informed in part by publishing the Specially Designated Nationals (SDNs) List which contains individuals and companies owned or controlled by, or acting for or on behalf of, targeted countries. Assets of those found on the SDNs list are blocked (frozen) and U.S. persons are generally restricted from doing business with them.

Rights Offerings

When a company offers its existing shareholders the right to buy additional new shares (typically at a discount) in the company, proportional to their current holdings. These are similar to options in that participating shareholders own the right—but not the obligation—to purchase new shares. Additionally, if the rights are transferable, then participating shareholders can also freely trade them in the open market like any other securities.

Discretionary Order

When a registered representative (RR, like a brokerage) makes a trade on behalf of their client (w/o their express permission).

Corporate Actions

When publicly-traded companies undergo events that have material impacts on the company and/or its shareholders. - Stock Splits - Buybacks - Tender Offers - Exchange Offers - Rights Offerings - Mergers & Acquisitions (M&A)

Freeriding

When securities are purchased and then sold before making payment for the purchase. May result in their account being frozen for 90 days.

Pump and Dump Scheme

When someone holding a stock artificially drives its share price up by floating exaggerated or false reports of its value through Web sites, online postings, or e-mail, this is known as

Insider Trading

When someone trades a security having nonpublic information (ie. Impending mergers & acquisitions, legal proceedings, loan defaults or development of patents). -- Individuals: Up to 20 yrs of imprisonment; and/or Fines up to $5 M. -- Business Entities (corporations): Fines up to $25 M.

Dividends: Payment Date

When the dividend actually gets paid.

Stock Splits

When the price of a share begins to rise too much or fall too much a company may opt to increase the number of shares (i.e. 3 for 1) or if the price per share falls too much a company may opt for decrease the number of shares (i.e. 1 for 2).

Limit Order

a request to buy or sell a stock at a specified price (If the price is never reached the order is canceled).

Market Order

a request to buy or sell a stock at the current market value.

Marking the Open

entering orders before the opening for a stock or falsely reporting trades that never occurred to influence the opening price of a stock. If done the same thing prior to market close it is called marking the close.

Excessive Trading (Churning)

excessive trading in a customer's account to generate commissions rather than to help achieve the customer's stated investment objectives

Exchange Act Rule 15c3-3

firms are required to protect customer funds and securities by segregating these assets from the firm's own business activities as well as promptly delivering these assets to their owner upon request. To satisfy this requirement, firms can either hold the customer's assets (1) in the firm's physical possession; or (2) in a location through which the firm can direct their movement, such as a clearing corporation.

Bond Interest

is the interest earned on a bond called return on investment (ROI).

Covered Options

writer owns the optioned securities. Loss exposure is limited to the price originally paid for the securities.