CHAPTER 11: Regulation of Securities - Introduction

Look Out! The term "security" is vitally important to theUSA; therefore, you will find the exactdefinition from the USA below. You arestrongly encouraged to memorize this definition for the exam.

Definition: Stock As defined by the Uniform Securities Act, asecurity is any of the following: a note; stock; treasury stock; security future; bond; debenture; evidence of indebtedness; certificate of interest or participation in a profit-sharing agreement; collateral trust certificate; pre-organization certificate or subscription; transferable share; investment contract; voting trust certificate; certificate of deposit for a security; fractional undivided interest in oil, gas, or other mineral rights; put, call, straddle, option, or privilege on a security, certificate of deposit, or group or inde of securities, including an interest therein or based

on the value thereof; put, call, straddle, option, or privilege entered into on a national securities e change relating to foreign currency; or, in general, an interest or instrument commonly known as a !security!; or a certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase any of the foregoing"

Regulation of Securities - Stock Term Specifics

includes both certified and uncertified securities; does not include an insurance or endowment policy or fi ed annuity contract; does not include an interest in a contributory or noncontributory pension or welfare plan sub#ect to the $mployee %etirement &ncome Security Act of '()*; includes an investment in a common enterprise with the e pectation of profits to be derived primarily from the efforts of a person other than the investor and a !common enterprise! meaning an enterprise in which the fortunes of the investor are interwoven with those of either the person offering the investment, a third party, or other investors; and includes, as an !investment contract!, an interest in a limited partnership and a limited liability company and, an investment in a viatical settlement or similar agreement" o +iatical Settlement is an arrangement in which someone with a terminal disease sells his or her life insurance policy at a discount from its face value for ready cash" ,he buyer cashes in the full amount of the policy when the original owner dies"
Look Out! The factor that determines if something is a security is whether the item is some sort of venture that could possibly return additional income. For example, if you were to purchase a portion of a contractual interest related to buying homes - in which you were not the direct owner of the home - you would have purchased a security. If you owned a collection of stamps, you would not have a security. However, if you owned a salable or tradable interest in the stamps, but not the stamps themselves, you would have a security. Lastly, domestic currency is not a security.

Example -ob owns a fancy set of ties, which he considers e tremely valuable" .e decides to sell the ties on e-ay/, putting them up for auction starting at 0'1,111" .as he created a security by initiating an electronic auction2 Answer No, because the purchaser of the ties will receive them directly, and as far as we know, no third party benefited from the transaction - eBay

only benefited bycharging a fee, which does not qualify it as a brokerdealer.

Regulation of Securities - Definition: Sale and ffer to Sell

,he USA defines a sale and an offer to sell as follows: Sale includes: every contract of sale, contract to sell, or disposition of, a security or interest in a security for value" Offer to sell includes: every attempt, or offer to dispose of, or solicitation of an offer to purchase, a security or interest in a security for value" Both terms include:

a security given or delivered with, or as a bonus on account of, a purchase of securities or any other thing constituting part of the sub#ect of the purchase and having been offered and sold for value;

a gift of assessable stock involving an offer and sale; and a sale3offer of a warrant3right to purchase3subscribe to another security of the same or another issuer, and a sale3offer of a security that gives the holder a present or future right or privilege to convert the security into another security of the same or another issuer, including an offer of the other security"

Regulation of Securities - t!er Definitions

,he USA also defines the following terms:

A non-issuer transaction or non-issuer distribution is a transaction or distribution that is not directly or indirectly for the benefit of the issuer"

,he term guaranteed means guaranteed as to payment of all principal and all interest"
Exam Tips and Tricks The following is a list of additional securities-related information, mostly pertaining to issuers. Much of this will be on the test, so make sure you do not skip this section!

Unlawful sale - ,he USA clearly mentions that it is !unlawful for a person to offer or sell a security! in a state unless:
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!the security is a federal covered security!" !the security, transaction, or offer is e empted from registration!" !the security is registered under! the USA"

Initial registration - -efore an offer to sell a security can be made, a registrant4the issuer, insider or broker-dealer5 must file a registration with the state Administrator"

Filing fees - &ssuers are re6uired to pay filing fees at both initial registration and annual re-registration" 7iling fees fluctuate from state to state" &f a filing fee is not paid 4or an issuer fails to comply with a notice5, the Administrator may issue a stop order !suspending the offer and sale of a federal covered security!"

General filings - ,he registrant must supply general information regarding the securities to the Administrator, including the following:
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,he states where the securities will be solicited3offered Amount of securities that will be issued Any guidelines3#udgments re6uired by the S$8 or other administrative or #udicial entity

egistration records - ,he USA specifically states that, along with the initial registration statement, offerings must be accompanied by these:
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A copy of the latest form of prospectus filed under the Securities Act of '(99 A copy of the articles of incorporation and bylaws, or their substantial e6uivalents currently in effect

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A copy of any agreement with or among underwriters A copy of any indenture or other instrument governing the issuance of the security to be registered 8opies of any other information or any other records filed by the issuer under the Securities Act of '(99 re6uested by the Administrator

Effecti!e date - :nce an offering is accepted by the Administrator, it is valid for one year after the date of approval 4the effective date5" :fferings may be renewed the following year, if the entire issue was not sold"

Effecti!eness of registration statement - ,he USA states: !&f the federal registration statement becomes effective before each of the conditions is satisfied or is waived by the Administrator, the registration statement is automatically effective """! ,he conditions are those of registration records, above"

"eriodic reports - &ssuers may be re6uired to file reports !to keep the information or other record in the registration statement reasonably current and to disclose the progress of the offering"! ,he Administrator cannot re6uire the reports to be filed more often than 6uarterly"

"ost-effecti!e amendments - A !registration statement may be amended after the effective date! to alter information, or to increase the number of securities to be offered" :f course, on amendment, an issuer may be re6uired to pay a registration fee"

Form of su#scription - &t may be re6uired that an offering !be sold only on a specified form of subscription or sale contract and that a signed or confirmed copy of each contract be filed! with the Administrator"

Escrow and impoundment o

$scrow may be re6uired if the offering:

is issued within the last five years; is !to be issued to a promoter for a consideration substantially less than the public offering price!; or is to be issued !to a person for a consideration other than cash!"

Impoundment simply means that proceeds from the sale

must be put in escrow until !the issuer receives a specified amount from the sale of the security!"

Offering outstanding - !Unless the Administrator determines otherwise, a registration statement cannot be withdrawn until one year after its effective date if any securities of the same class are outstanding """!

Regulation of Securities - Registration of Securities

Under the Uniform Securities Act, all securities sold in a particular state must be registered in that state, unless they meet one of the following e emptions:

$ertain issuers - ,he securities associated with the following issuers are e empt from state registration: government and municipal issuers, issuers regulated under other laws 4banks, credit unions, insurance companies, railroads, public utilities5, and nonprofit organizations such as cooperatives and employer benefit plans"

Federal co!ered securit% - ,his includes investment company shares, &;:s and e change-listed securities" Exempt transactions - ,hese are transactions that do not involve the public, including the following: 7iduciary transactions Unsolicited transactions %eal estate transactions secured by a mortgage &solated non-issuer transactions ,ransactions between issuers and underwriters ,ransactions with financial or institutional investors ;rivate placements Sales where no commissions or fees are involved <on-issuer transactions in outstanding securities registered under either the Securities Act of '(9* or the &nvestment 8ompany Act of '(*1

$ach of these issues is covered in more detail in the sections below"

&otice Filing &f an issuer deals in federally e empt securities, the person3entity is only re6uired to file the federal forms with the state Administrator" ,his method is used by established companies who are permitted to use the prospectus filed with the S$8 under the Securities Act of '(99 as the filing document for the state" :f course, all fees must be paid" <otice filing may be referred to on the e am as !registration by filing!" ,he article !A <ew Uniform Securities Act! by %ichard -" Smith defines notice filing as follows" "Notice filing under the !! "niform #ct is for federal covered securities other than listed securities. $his filing consists of a consent to service of process, a filing fee, and %depending on the state securities administrator&s requirements' can include copies of material filed with the ()*. $he !! "niform #ct provides a platform for eventually effectuating one-stop filing, whereby documents filed with the ()* can be electronically filed with states within which offerings are to be made."

Regulation of Securities - Registration "# Coordination

&n the article !A <ew Uniform Securities Act! by %ichard -" Smith, registration by coordination is outlined as follows: "$he ob+ective of coordination is the simultaneous registration of the offering at the ()* and in the states where the offering is to be made. ,n order to facilitate coordinated registration, the state securities administrators association has implemented a system for coordinated review of these offerings by the states." Under the USA, registration by coordination is for securities that are registered with the S$8 but are not federal covered securities" Securities that may fall into this category include those that do not meet the listing standards of e changes and3or are upgrading"

Look Out! The term "coordination" describes registration, as the securities are to be registered with the SEC and with individual states where they will be offered and/or sold.

Under registration by coordination, the issuer, offeror or broker-dealer of the security generally needs to supply the Administrator with a long laundry list of items regarding the security" ,he USA states that registration by coordination is for a !security for which a registration statement has been filed under the Securities Act of '(99 in connection with the same offering!" Along with a registration application, the USA states that issuers must also file the following: A copy of the latest form of prospectus filed under the Securities

Act of '(99 A copy of the articles of incorporation and bylaws or their substantial e6uivalents currently in effect A copy of any agreement with or among underwriters A copy of any indenture or other instrument governing the issuance of the security to be registered A specimen, copy or description of the security 8opies of any other information or any other records filed by the issuer under the Securities Act of '(99 and re6uested by the Administrator An undertaking to forward each amendment to the federal prospectus, other than an amendment that delays the effective date of the registration statement, promptly after it is filed with the Securities and $ change 8ommission

A registration #ecomes effecti!e su#se'uent to t(e federal registration if: a stop order or proceeding is not pending" the registration statement has been on file for at least =1 days, 4or less, depending on the rule adopted or order issued under the USA"5 &f federal registration is met 4before all the aforementioned conditions are met5, the issuer is obligated to notify the Administrator immediately"

Regulation of Securities - Registration "# $ualification

%egistration by 6ualification pertains to all other offerings 4that are not federally e empt5 that are made within a state" $ amples of such include offerings that are intrastate and3or are S$8 e empt, based on their smaller size" ,he registration period is usually one year, and all persons registering a security must pay the applicable fee" &n the resources portion of the te t, you will find a link for a sample registration by 6ualification application for the state of Utah" Utah was chosen randomly and does not constitute what you will see in all states" .owever, on the front page of the application website, the site mentions: !Any security may be registered by 6ualification" Securities should be registered by 6ualification when no other method is available"! >hile this point is not specifically highlighted in the USA, it is important to recognize" %egistration by 6ualification is generally the final method of registration if a security cannot be registered another way" ?ualification entails submitting the following information to the Administrator: >ith respect to the issuer and an% significant su#sidiar% : o ,he issuer@s name, address and form of organization o ,he State or foreign #urisdiction and date of its organization o ,he general character and location of its business o A description of its physical properties and e6uipment o A statement of the general competitive conditions in the

industry or business in which it is or will be engaged >ith respect to each director and officer of t(e issuer, and ot(er person having a similar status or performing similar functions: o ,he person@s name, address and principal occupation for the
o

previous five years ,he amount of securities of the issuer held by the person as

of the 91th day before the filing of the registration statement ,he amount of the securities covered by the registration statement to which the person has indicated an intention to subscribe A description of any material interest of the person in any material transaction with the issuer or a significant subsidiary effected within the previous three years or proposed to be effected ,he aggregate sum of the remuneration paid to those persons during the previous '= months and estimated to be paid during the ne t '= months, directly or indirectly, by the issuer and all predecessors, parents, subsidiaries and affiliates of the issuer" All above information for a person owning on record or owning beneficially, if known, '1A or more of the outstanding shares of any class of e6uity security of the issuer >ith respect to a promoter, if the issuer was organized within the previous three years, all information listed in the first five bullet points above and any amount paid to the promoter within that period, or intended to be paid to the promoter, and the consideration for the payment

Summar% Benerally speaking, an issuer must provide the following: -asic information: name, address, type of business and description %ecords of officers, directors and owners with a stake of '1A 4or

more5 Cescription of issuer@s long-term debt and capitalization ,ype and amount of securities to be offered Any3all stock options to be created in regards to the offering $stimated proceeds 8opy of all red herrings, investment circulars or pamphlets for the offering Sample copy of the security Audited balance sheet of the issuer as of a date within four months before the filing of the registration statement An income statement and statement of cash flows for three years

prior to the balance sheet A signed or confirmed copy of an opinion of counsel concerning the legality of the security being registered

Regulation of Securities - E%empt Securities

7irst, it is important to make this clear: there are two different types of e emptions, according to the USA" ,hey aresecurities e empt from registration and transactionse empt from registration" ,his may get a little confusing, as there can be both securities and transactions that are e empt, or either can be e empt individually" A security that is non-e empt must be registered" 7urthermore, all transactions that are e empt are generally known to be e empt before the transaction ever takes place" Securities Section =1' of the USA lists nine types of e empt securities" As a general rule, any security backed by or insured by a government, or government institution, is usually e empt" ,hough it is important to remember the following nine items, if you retain nothing else, #ust remember that anything that has some sort of federal or municipal ta -e empt status is probably e empt" ,he following nine items are specified as !e empt! by the USA: o Go!ernment securities - Any securities that are guaranteed by the U"S"government, a state or !a political subdivision of a state! )egitimate foreign go!ernments - Any security issued by a foreign government - with which the U"S" maintains a diplomatic relationship *anks and depositor% institutions - A security that will represent an interest in, or a direct obligation of, or guaranteed by: an international banking institution" a depository institution that is a member of the 7ederal %eserve system, or organized in relation to the state in 6uestion" any other depository institution, unless specified

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as not e empt by the Administrator" Insurance - A security issued3representing 4guaranteed by5 an insurance company authorized to do business in the state ailroads and pu#lic utilit% securities - A security issued, or guaranteed by a railroad, other common carrier, public utility, or other public holding company that is: regulated in respect to the issuance or guarantee, and3or rates, and charged of the security by the United States, a State, 8anada, or a 8anadian, or a public utility holding company registered under the ;ublic Utility .olding 8ompany Act of '(9D" Options or warrants - A put or a call option contract; a warrant; a subscription right on or with respect to such securities; or an option or similar derivative security on a security or an inde of securities of foreign currencies issued by a clearing agency registered under the Securities $ change Act of '(9* and listed or designated for trading on a national securities e change &onprofits - A security issued by a person organized and operated e clusively for religious, educational, benevolent, fraternal, charitable, social, athletic or reformatory purposes, or as a chamber of commerce, and not for profit Emplo%ee #enefit plans - Securities sold to employees of a company in connection to stock, savings or pension plans E'uipment trust certificates - An e6uipment trust certificate with respect to e6uipment leased or conditionally sold to a person - i"e" e6uipment lease financing through leveraged leases, conditional sales and other devices

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Regulation of Securities - E%empt Transactions

,he USA e empts certain transactions from registration - usually transactions in securities that are already registered on a federal level, have some sort of federal association, or in some way are not transacted among the public at large" After you read the following list, the best bet for the test is simply to try to use common sense" &f an issuer is effecting a transaction for an average person or purchasing the security for his or her portfolio, the transaction is most likely not e empt"

,he Administrator has the power to e empt any transaction he or she deems not necessary of registration" ,he Administrator can also deny an e emption, if he or she deems that state registration is necessary" &f an Administrator feels that an e empt security falls under a state provision 4like anti-fraud5, he or she may re6uire that thefederally e empt security be registered with the state"According to the USA, e empt transactions include the following:

Isolated non-issuer transactions - An isolated non-issuer transaction, whether or not it is affected by or through a brokerdealer"

&on-issuer transactions - A non-issuer transaction by or through a broker-dealer registered 4or e empt from registration5, in a security of a class that has been outstanding in the hands of the public for at least (1 days, if, at the date of the transaction: o the issuer of the security is engaged in business, is not in bankruptcy, and is not in any type of merger and the security is: sold at a reasonable price" not representative of an unsold allotment of the underwriter" nationally recognized" +ransaction in a securit% of a foreign issuer - A non-issuer transaction by or through a broker-dealer registered or e empt from registration under this EActF in a security of a foreign issuer that is a margin security" &on-issuer transaction in!ol!ing t(e SE$ - A transaction where the issuer of the security files a report with the Securities and $ change 8ommission" &on-issuer transaction #% or t(roug( a #roker-dealer &t is vitally important that these transactions are e empt only if they are by or through a broker-dealer registered or e empt from registration in a security that: o is rated at the time of the transaction by a nationally recognized statistical rating organization in one of its four highest rating categories has a fi ed maturity or a fi ed interest or dividend, if:

a default has not occurred during the current fiscal year or within the three previous fiscal years or during the e istence of the issuer; the issuer is engaged in business, is not in the organizational stage or in bankruptcy or receivership, and is not and has not been within the previous '= months a blank check, blind pool, or shell company that has no specific business plan or purpose" &on-issuer unsolicited - A non-issuer transaction by or through a

broker-dealer registered or e empt from registration affecting an unsolicited order or offer to purchase" &on-issuer transaction t(roug( pledge - A non-issuer transaction e ecuted by a bona fide pledgee without the purpose of evading the USA" &on-issuer transaction #% a federal co!ered in!estment ad!isor - A non-issuer transaction by a federal covered investment advisor with investments under management in e cess of 0'11,111,111 acting in the e ercise of discretionary authority" Securit% exc(ange - A transaction where no cash, or partial cash, is e changed - this type of transaction is only valid after a hearing with and approval from the Administrator" +ransaction #etween Issuer and Underwriter Secured transactions - ,ransactions secured by a note, bond, mortgage or security agreement, if: o a general solicitation of the transaction is not made" o a commission or other remuneration is not made" Fiduciar% transactions - A transaction by an e ecutor, administrator of an estate, sheriff, marshal, receiver, trustee in bankruptcy, guardian or conservator Sale or offer of sale to: o an institutional investor o federally covered investment advisor o any other e empt person Sale #% or on #e(alf of an issuer if: o no more than =D people purchase the security in the state
o

registered, in a '=-month period a general advertisement or solicitation is not made in connection to the offer

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commission is not paid the issuer believes that purchasers@ interest is purely for

investment +ransaction to existing owners Offer to sell, #ut not a sale: o :f a security that is not e empt from registration under the Securities Act of '(99 a registration has not been filed with the state, but is effective at a federal level a solicitation of interest is provided a stop order has not been issued by the Administrator escission offers - :ffers of rescission are defined under civil liabilities" Offer of sale to a person from anot(er state +ransactions of emplo%ee stock plans including: o stock purchase, savings, option, profit-sharing, pension, or other benefit plans for: directors, general partners, trustees, officers, consultants and advisors family members who ac6uire securities though gifts or domestic relations orders former employees, who were providing services when the securities were offered insurance agents, who are the e clusive agent of the issuer +ransactions in!ol!ing: o a stock dividend o a #udicially approved reorganization
Exam Tips and Tricks A common "trick" question on the exam involves the "certain issuers" exemption from securities registration. Some of the incorrect options may include securities issued by bank holding companies (only banks themselves are exempt) and airlines (only railroads are exempt).

Regulation of Securities - &ederal Co'ered Securities

7ederal covered securities are e-empt from state registration" ,he USA defines a federal covered security as follows: !A security that is, or upon completion of a transaction will be, a covered security under Section 'G4b5 of the Securities Act of '(99 4'D U"S"8" Section ))r4b55 or rules or regulations adopted pursuant to that provision"! Hore specifically, a federal covered security, also known as a !covered security!, is defined as follows:

Securities issued by an open-end mutual fund, closed-end mutual fund, unit investment trust, or face amount certificate company, that is registered under the &nvestment 8ompany Act of '(*1

Securities offered pursuant to the provisions of %ule D1I of %egulation C under the Securities Act of '(99 Securities offered by a municipal3governmental issuer, unless the issuer is located in the state in which the securities are being offered Securities offered by an issuer e clusively to its e isting security holders where no commission or other remuneration is paid directly or indirectly for soliciting the e change

Federal co!ered securities include:

Securities either listed, or authorized for listing, on the <ew Jork Stock $ change, <asda6 <ational Harket System, American Stock $ change, 8hicago -oard :ptions $ change, ,ier ' of the ;acific $ change, and ,ier ' of the ;hiladelphia Stock $ change, or any other national e change determined by the S$8 to have proper listing standards

Securities issued by an investment company registered under the &nvestment 8ompany Act of '(*1 Securities !offered or sold pursuant to most e emptions contained in the Securities Act of '(99, intrastate e emptions, non-profit e emptions, and any3all municipal3government securities sold in the state where the issuer is located!"

Exam Tips and Tricks Please note that Nasdaq small-cap securities are not federal covered securities. This could easily show up on the exam.

Exam Tips and Tricks Questions about securities registration tend to be very straightforward. Remember that only two questions involving securities registration are scheduled to be on the exam. Here are two likely questions on the topic of exempt securities or transactions:

-. A*$ $orporation (as ne!er pre!iousl% issued securities registered #% t(e SE$. It can register in t(e State #% w(ic( met(od/s01 I. egistration #% filing II. egistration #% coordination III. egistration #% 'ualification I2. egistration #% administration a" b" c" d" & only && only && K &&& &, &&& K &+

$he correct answer is "c". registration by filing is only available to companies that have previously registered securities with the ()*, and registration by administration is not a valid registration method. 3. 4(ic( of t(e following securities are not exempt under t(e Uniform Securities Act1 a" Limited partnerships b" 8onvertible bonds of a <JS$-listed company c" U"S" ,reasury bonds d" Stock issued by a non-profit organization $he answer is "a", since all the other options listed are specifically e-empted.

CHAPTER 1(: Remedies and Administrati'e Procedures -

Introduction
$ach state has an Administrator, who has certain #urisdiction and powers related to the offer and sale of securities in his or her state" Benerally, an Administrator will simply issue a cease and desist order if he or she finds a problem" .owever, the Administrator can also have a court order an in#unction or deny, revoke or suspend registration" ,he following section outlines an Administrator@s ability to regulate - that is, the enforcement aspect of the USA"

Remedies and Administrati'e Procedures - Administrator Aut!orit#

In!estigate At any time, the Administrator can conduct public or private investigations, within or outside of a state, which the Administrator considers necessary or appropriate to determine whether a person has violated, is violating, or is about to violate a rule, or to aid in the enforcement of regulations of the USA"
o

&n conducting an investigation, the Administrator can at any time re6uire 4or permit5 a person to testify, file a statement, or produce a record regarding facts or circumstances of a situation" ,he Administrator can also publish a record that is of direct concern to an action, proceeding, or investigation"

&n general, the Administrator has the ability to inspect records within 4and outside of5 his or her state" ,he Administrator can also re6uire those being investigated to provide written statements under oath"

Issue Su#poenas At any time, the Administrator may issue a subpoena for investigation-related information, if he or she has #urisdiction over the transaction or security in 6uestion"

Ot(er "ro!isions &n addition to those already listed, the Administrator has the following powers:

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,o cooperate in S$8 investigations ,o publish information concerning a violation ,o compel testimony regarding a violation, even if such testimony might incriminate the individual

5urisdiction Murisdiction comes down to where a securities transaction was made and whether a state Administrator has the authority to regulate the activity" Murisdiction includes any offer, or offer to sell that: o originates or takes place in the state" o is directed to the state and received !at the place which it is
o

directed!" is accepted in a state:

if the offeree reasonably believes the offeror to be present in the state" and has not been previously communicated to the offeror outside the state" 5urisdiction as applied to pu#lications or radio An Administrator does not have #urisdiction over the following: o a publication that is a bona fide newspaper or other print media - if the publication has two-thirds of its circulation outside of the state in which it is published, or is circulated outside of the publication state" a television or radio broadcast that is syndicated from outside the state" any electronic communication originating from outside the state" any electronic communication that comes from within the

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state, but is not intended for distribution within the state" 5urisdiction as applied to in!estment ad!ice and misrepresentation ,he Administrator has #urisdiction if an individual3entity attempts to commit fraud in the Administrator@s state, whether or not the individual3entity in 6uestion is in the state or not" 5urisdiction as applied to securities >hen it comes to e empt securities transactions, the Administrator is permitted to deny or revoke any specific transaction or security e emption, but cannot enter the order to do so unless prior notice

is given to all parties, an opportunity is given for a hearing, and written findings are provided" &f the Administrator issues a summary order to deny or revoke pending final determination, he or she must notify all interested parties of the reasons for entering the order and inform them that a hearing will be granted within 'D days of a written re6uest"
Exam Tips and Tricks An Administrator generally has jurisdiction if a transaction is originated or accepted in his/her state, or if it is directed to the state.

Remedies and Administrati'e Procedures - Administrati'e Actions

,he Administrator has the power to deny, revoke or suspend registrations or licenses at any time, if the Administrator feels he or she is acting for the benefit of the public" Horeover, the Administrator has an obligation to not misuse his or her powers for personal gain" ,he USA gives the Administrator very broad powers and applies to offers made either verbally or in writing" ,he powers apply to broker-dealers, agents, investment advisors and investment advisor representatives" ,he Administrator can deny, suspend, or revoke registration if it is in the public interestand if the registrant: files a materially false, incomplete or misleading application" willfully violates any provision of the Uniform Securities Act" is prohibited by court order from engaging in the securities

industry" becomes insolvent" fails to pay re6uired fees" is convicted of any felony, or any misdemeanor involving the securities industry" engages in unethical or dishonest business practices" is un6ualified due to lack of e perience, training or knowledge" fails to properly supervise employees"

.owever, the Administrator cannot deny, suspend or revoke a registration solely based on a lack of e perience if the applicant is otherwise 6ualified by training or knowledge"
Look Out! While this list of potential reasons to deny a registration application includes the item "is unqualified due to lack of experience, training or knowledge", note that the paragraph that follows states that the Administrator cannot deny or revoke a registration based on "lack of experience if otherwise qualified by training or knowledge". You\'re likely to be tested on that distinction, so watch for answers such as "the Administrator can deny registration if it is in the public interest and an Investment Advisor (IA) has a degree in finance but no investment advisory experience". That answer would be incorrect, since the IA does have training or knowledge.

Exam Tips and Tricks If, for any reason, an Administrator decides to take any one of the following three actions (denial, revocation or suspension), he/she must expressly detail the reasoning behind the injunctive act and give the person/entity in question a chance for appeal.

Remedies and Administrati'e Procedures - Additional Administrati'e Po)ers

&n addition to the following items 4initiated by the Administrator5, a broker-dealer may withdraw its own registration at any time, and this withdrawal is effective 91 days after an initial withdrawal application is filed" Lastly, if a broker-dealer withdraws its registration, and then 4within one year5 the Administrator finds a wrongdoing, the Administrator may still commence disciplinary proceedings"

Denial ,he Administrator may deny an application if:

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it is incomplete, contains any misleading information or omits vital facts" within the last '1 years, the applicant was convicted of a securities-related misdemeanor or any felony whatsoever regardless of whether or not it was securities related"

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another Administrator already denied registration, or another suspension or revocation order is already in effect" the Administrator finds that the applicant is not financially solvent and3or is in a state of bankruptcy" a court order e ists barring the registrant from working in the securities industry" the Administrator deems that the registrant is not 6ualified

for the type of business he or she intends to pursue" /owever, an Administrator cannot suspend registration if the registrant can give material proof that he or she is 6ualified" e!ocation o An Administrator may revoke registration at any time, if any one of the above si items listed under Cenial is found to be true" &n addition, the Administrator may revoke the registration of an officer or partner of a firm without crippling the entire firm, although such action could also be grounds for revoking the registration of the firm as a larger entity" %egistration may be revoked from an agent without being

revoked from the broker-dealer, if it is found that the brokerdealer was competently supervising the agent but was nevertheless unable to prevent the agent from committing some sort of fraudulent activity" .owever, if the agent@s fraudulent activity was the direct result of a broker-dealer@s incompetent supervision, then the broker-dealer@s registration is at risk as well" Suspension Suspension can occur for the same reasons as Cenial, though registration may be reinstated pending a hearing" .earings are usually held within 'D days of the initial re6uest" $ancellation o An Administrator may cancel an agent@s registration if the agent is found to be deceased, or not able to perform his or her duties" &n short, if for any reason the agent becomes incompetent, the Administrator may cancel registration" &f an agent disappears and cannot be found after a reasonable search 4e"g" Mane@s lounging on an e otic beach

somewhere and her firm can@t find her for a month5, the Administrator may revoke registration" $ease and Desist ,he Administrator may issue a cease and desist order, if it has determined that a particular action is in violation of the USA" &f the cease and desist order is ignored, the Administrator may have a court intervene and issue an in#unction against the party in 6uestion"

Remedies and Administrati'e Procedures - t!er Penalties and *ia"ilities: Ci'il

8ivil liabilities arise when a violation of the USA has occurred and the person harmed wishes to recover any losses incurred" All securities professionals are liable for civil penalties if the USA is violated" >here there is an infraction of the USA, purchasers of securities can sue for recovery of losses" 4(en a client can sue: A direct violation of the USA occurred, where a securities

transaction ensued" An agent, broker-dealer or investment advisor sold securities in violation of a direct rule of the Administrator" Securities were sold by an unregistered person" Hisleading statements, or omitted facts, led to the sale of a security" ,he securities sold were either misrepresented as being approved 4recommended5 by the Administrator or another governing body, or misrepresented as being listed 4or to be listed5 on an e change, when in fact the information was false" ,here was a violation of the state@s sales literature re6uirements"

&f a violation occurs, a purchaser can then sue for damages" ,he formula relating to recovery is fairly simple" ;urchasers can sue for: easonable attorney fees, and other costs N Interest

N +he purchase price of the securities - Any income 4dividend or interest5 received O Camages
Exam Tips and Tricks You will notice that this formula can be summed up by the acronym RITA. When you write the test, it may be helpful to think, "RITA\'s a little upset with her broker, and she\'s ready to sue!" Although civil penalties are no laughing matter in real life, the humor should help you remember the damages formula for the exam.

Example -ob@s broker lied to him about a stock, telling him the state Administrator had approved 4and recommended5 the stock for purchase" -ob@s broker further suggested that -ob should buy the stock, since the Administrator@s listing endorsement made it a sure thing" 8onse6uently, -ob bought 0',111 of the stock" ,hree weeks after his investment, he received a dividend payment for 0'D, which pleased him greatly" Shortly after, the company released a negative press release" ,his triggered a sharp sell-off, and the stock@s price was cut in half" -ob sold the stock to retain 0D11 of his initial investment" Soon after, -ob decided to sue his broker, even though the legal costs would be around 0911" >hat can -ob sue his broker for2 Answer
Reasonable attorney fees, and other costs + Interest + The purchase price of the securities - Any income (dividend, or interest) received = Damages $300 $0.00 $500 $15.00 $775

P,he original purchase price is 0D11 because -ob sold the investment holding on to 0D11 4half5 of his original investment"

Remedies and Administrati'e Procedures - t!er Penalties and *ia"ilities: In'estment Ad'ice and Rescission
In!estment Ad!ice

Any investment advice in violation of the USA is also liable for civil penalties, as long as the advice was dispensed for a fee" ,hose sub#ect to fraudulent investment advice can sue for: N $ost of the advice N )oss resulting from the advice N Attorney fees 4reasonable5, and other costs N InterestQQQQQQQQQQQQQQQQQQQQ Q - 6oney 4dividend or interest5 received O Camages
Exam Tips and Tricks In this case, remember the acronym CLAIM. If investment advice was in violation of theUSA and was dispensed for a fee, an investor can CLAIM damages.

Statute of )imitations :nce a person discovers a violation of the USA, he or she has two years to sue, or three years from the date of the initial transaction" escission &f an agent3person discovers a violation of the USA, a letter of rescission containing an offer to buy back the security in 6uestion - may be tendered" :f course, the letter of rescission must also take into consideration 4and make an offer for5 any interest potentially gained or lost" &n short, the formulas given for civil losses apply e6ually for a letter of rescission - with the e ception that the party issuing the letter of rescission is generally trying to avoid legal fees" 7urthermore, it is important to note that once a rescission offer is tendered, the buyer of the securities must respond within 91 days, or he or she gives up all rights to take legal action at a later date" Example -illy, an agent of -ad -oy -rokers, &nc, discovers that he has violated the USA by mis6uoting dividend information which led to the purchase of a security by a customer" ,hough -illy@s firm has had a few run-ins with the Administrator in the past, he@s trying to reestablish the firm@s reputation as a reliable business" .e realizes that his client invested

0',111, e pecting a '1A dividend" -illy immediately writes a letter of rescission, offering to repurchase the securities" &n the time it takes for -illy to send the letter and for his client to agree to sell the securities 4three days5, the stock appreciates 0D" -illy@s client sells the securities to -illy for a 0D profit 4assuming, hypothetically, that no commissions are paid5" >hat is the total amount -illy owes his client2 Answer 0irst, Billy owes his client 1223, as the client already received 13 in capital appreciation. (econd, Billy rescinded the offer in three days, but had guaranteed 4!5, which would equate to 16.73 a day. (o, Billy also owes his client 14!.23 in interest. Billy&s total tally is 1223 8 14!.23, working out to 14,!!3.23 %assuming the client already received an additional 13'.

Remedies and Administrati'e Procedures - t!er Penalties and *ia"ilities: Criminal

8riminal penalties arise when a person or an entity is proven guilty of consciously and willingly conducting a fraudulent securities transaction 4in violation of the USA5"
Look Out! The key word in criminal liabilities is "fraudulent", meaning the violation was deliberate.

:nce the Administrator makes an order 4which can lead to fines and3or imprisonment5, the person or entity affected may retort with a written petition of appeal within I1 days" At the same time, the affected member 4agent or broker-dealer5 must serve the Administrator as well" 7ollowing this, the Administrator is obligated to provide the appropriate court with all evidence" Unlike the normal #udicial process, once the Administrator makes an order, it remains in effect until a court of law overturns it" >hatever the court decides in appeal is final, and the court has the right to change any

part of the order" $on!iction &f the offender is convicted, he or she may not be imprisoned for more than three years, or pay more than 0D,111 in fines 4per violation5" Statute of )imitations ,he statute of limitations for criminal penalties is five years"
Exam Tips and Tricks It is crucial to remember that there can be no prison time if a person can prove that he or she had no knowledge that the USA was being violated.

Exam Tips and Tricks You should be very familiar with the specific powers of the Administrator and the differences between civil and criminal penalties. Here are two questions that could come up on the exam:

-. Of t(e following statements regarding t(e state Administrator7s powers, w(ic( are + UE1 I. +(e Administrator ma% re!oke a registration for t(e sole reason t(at it is 8for t(e pu#lic good8. II. If an IA7s registration is suspended, an% IA s w(o work for t(e IA will (a!e t(eir licenses suspended as well. III. If an IA 7s registration is suspended, t(e license of t(e IA (e9s(e works for is suspended as well. I2. IAs, #ut not IA s, ma% (a!e t(eir registration re!oked for failing to properl% super!ise emplo%ees. a" b" c" d" & K && only & K &+ only &, && K &&& only && K &+ only

$he correct answer is "d". if the ,# license is suspended, there can be no active ,#9 registrations, and ,#s are responsible for supervising employees %,#9s have no such responsibilities'.

3. A state Administrator can do all of t(e following E:$E"+: a" re6uire a witness to testify at a hearing" b" inspect a broker-dealer who does business in the state, even if the broker-dealer is located in another state" c" suspend the constitutional privilege against self-incrimination" d" coordinate inspections with the S$8" $he correct answer is "c". while the #dministrator can compel incriminating testimony, the privilege against self-incrimination is a constitutional one, and federal law must supercede state laws.

Remedies and Administrati'e Procedures - t!er Pro'isions

,he Uniform Securities Act states that an Administrator may re6uire a firm to !re6uire the filing of any prospectus, pamphlet, circular, form letter, advertisement, or other sales literature or advertising communication addressed or intended for distribution to prospective investors, including clients or prospective clients of an investment adviser, unless the security or transaction is e empted"! Exempted securities include t(e following: 7ederal covered securities Any security issued or guaranteed by 8anada Any security issued or guaranteed by a bank, savings institution or

trust company Any security issued or guaranteed by any federal credit union or any credit union Any security issued or guaranteed by any railroad or other common carrier, public utility, or holding company Securities issued or guaranteed by non-profits Any investment contract issued in connection with an employees@ stock purchase, savings, pension, profit-sharing or similar benefit plan
Exam Tips and Tricks You can expect a question on the test regarding the Telephone Consumer Protection Act of 1991, which states that organizations must do the following:

Maintain do-not-call lists. When a prospective recipient of a call asks to be put on the list, the firm must keep his or her name on record for 10 years. Make sure that reps understand how to use the list and immediately record any names and phone numbers of people who wish to be on the do-not-call list. Only call homes of prospective clients between the hours of 8:00 AM and 9:00 PM in the customer\'s time zone.

CHAPTER 1+: Client Communication and Compensation Issues - Introduction

Disclosure - +(e *roc(ure ule &nvestment advisors must disclose the nature of the relationship between the client and the &A" &As cannot participate in, nor be compensated by, any percentage gains of a client@s portfolio" ,hese terms must be included within the investment advisor@s contract" ,he most important rule regarding disclosure is the brochure rule, which re6uires an &A to provide a written disclosure document to each investment advisory client or potential client" ,he &A can simply provide a copy of the 7orm AC+ ;art &&, or create a brochure with substantially the same content" ,he document must include all of the following information:

-ackground information of the &A and any &A%s Services available and the fees for those services Cisclosure of any compensation received from third parties 4such as commissions or referral fees5 >hether the &A e ercises discretion over client funds ,ypes of clients for whom advisory services are provided, including any minimum dollar amount for assets to be managed Cisclosure of any affiliation with a broker-dealer Any material legal or disciplinary action that occurred within the last '1 years Any financial condition of the &A 4such as bankruptcy5 that might impair its ability to meet client commitments must also be disclosed

if the &A: o has discretion over client accounts" o has custody of client monies or securities" o re6uires prepayment of more than 0D11 in fees, more than si months in advance" ,he brochure must be provided at least *G hours before entering into an advisory contract, or at the time of entering into a contract, if the client has the right to terminate the contract without penalty within five business days" $ach year, the &A must deliver 4or offer to deliver5 its disclosure document to e isting clients" 7ailure to meet disclosure re6uirements is considered fraudulent behavior"
Look Out! It is crucial for you to know when the brochure must be given; the timing of this disclosure is frequently tested on the exam. Remember, it is not true that a brochure must be provided prior to entering into the contract; however, the contract must then explicitly offer the right to terminate without penalty within five business days. If this offer is not part of the contract, the brochure maynot be provided at the time of signing the contract. Watch for answers such as "...if the IA states he/she has a right to terminate within five business days..." - this is incorrect, since a verbal statement is not sufficient.

Under the USA, an additional disclosure is re6uired if the &A acts as principal for its own account or as broker for both an advisory client and another person on any securities transaction" &n these instances, the &A must disclose 4prior to completion of the transaction5 in what capacity it is acting, and it must receive the client@s written consent" >rap fee 4or wrap account5 programs re6uire a special disclosure form instead of the 7orm AC+ ;art &&" 7or these purposes, the S$8 definition of wrap accounts does not include:

Hanaged account programs - ,raditional portfolio management services offered by money managers

6utual fund asset allocation programs - -undled programs that charge a percentage of assets fee to manage a portfolio of no-load

4or load-waived5 mutual funds ,he wrap fee disclosure must include the following information 4where applicable5: ,he amount of the wrap fee, the services that are included, and

whether the fees are negotiable Any additional fees that might be re6uired >hat methods are used to select portfolio managers >hat compensation is paid to the person who recommended the program
Exam Tips and Tricks Be prepared to answer a number of questions on the "brochure rule", and be familiar with what must be included on Form ADV Part II. Here are two questions you might encounter on the exam:

-. +(e #roc(ure rule applies to: a" only discretionary advisory contracts" b" only written advisory contracts" c" only oral advisory contracts" d" both oral and written advisory contracts" $he correct answer is "d". $he brochure rule applies to all investment advisory contracts. 3. Under t(e #roc(ure rule, t(e IA clients /or potential clients0 must recei!e a cop% of t(e #roc(ure: a" at least *G hours prior to entering into an advisory contract" b" within =* hours of entering into an advisory contract" c" at the time of entering into an advisory contract, as long as the client can terminate the contract without penalty within three days" d" within five days of entering into an advisory contract" $he correct answer is "a". "c" is wrong because this provision only applies if the client can terminate within five days.

Client Communication and Compensation Issues In'estment Ad'isor Contracts

>hile state laws re6uire that contracts between state registered &As and

clients be in writing, the &nvestment Advisers Act of '(*1 does not"

Exam Tips and Tricks Although the NASAA Model Rule on Unethical Business Practices does state that written contracts are required, the questions on the exam do reference oral contracts.

.owever, most &As put their contracts in writing to avoid misunderstandings" Also, S$8rules do impose the following conditions on a written investment advisory contract:

;erformance-based fees are generally prohibited 4learn more in the ne t section5"

8ontract language must not lead clients to believe they have waived rights to take legal action against the advisor" ,here must be no provisions that force the client to waive compliance with any of the rights or rules within the &nvestment Advisers Act of '(*1" 8ontract must prohibit the &A from assigning the contract without the client@s consent"

Under t(e USA, IA contracts must:

disclose all material information regarding the services to be provided and the fees to be charged"

disclose conditions under which the contract may be assigned to another party" re6uire client consent prior to the &A assigning the contract" re6uire the &A 4if a partnership5 to notify the client of any change in the membership of the partnership" not permit the &A to be compensated on the basis of sharing in capital gains or capital appreciation of the client@s accounts 4however, fees based on the total value of the account, such as an assets under management fee, are allowed5"

"erformance Guarantees ;erformance guarantees are generally considered a conflict of interest"

,he hallmark of an investment advisor is ob#ectivity, so there must be no personal interest in the outcome of any specific investment recommendation" Also, guaranteeing a client@s account against loss is specifically cited as an unethical business practice under the USA"
Look Out! Guaranteeing a client\'s account against loss is a type of performance guarantee. The Series 66 exam is not likely to test you on any distinction between these two concepts.

&f any change within a partnership firm is made 4i"e" change in partners5, clients must be made aware of the change in reasonable time" &t is important to note that this act of notification only applies to partnerships, not corporations"

Client Communication and Compensation Issues Ad'ertising

,he &nvestment Advisers Act of '(*1 defines advertising as any letter, notice, circular or other written communication addressed to more than one person, as well as any notice in a publication or by radio or ,+ that contains the following: Braphs, charts, formulas or other devices used to determine how to

choose a security or when to buy or sell a security &nformation that offers analysis, reports, or publications concerning securities or when to buy or sell a security Any other investment advisory service that relates to securities

,he following media have also been identified by the S$8 as forms of advertising: 7orm letters and other mass mailings ;ress releases <ewsletters Harketing brochures ,elemarketing scripts Slides or audio3videotapes used in marketing presentations $-mail messages sent to more than one person Ad!ertising standards

&A advertising is not permitted to:

refer 4directly or indirectly5 to testimonials about the advisor" refer to specific past recommendations that were profitable" .owever, an &A may advertise a list of all recommendations made within the immediate past year 4or longer5, as long as all pertinent information is included 4date of recommendations, market price at time of buy, sell, and current5, along with a disclaimer on the first page stating: !&t should not be assumed that recommendations made in the future will be profitable or will e6ual the performance of the securities in this list"! advertise that any report, analysis or other service is free of charge if that is not completely true - there must be no obligation or condition of any kind" represent that a graph, chart, formula or other device can 4by itself5 be used to determine which securities to buy or sell, without disclosing the limitations in doing so"

"erformance ad!ertising &n a guidance statement called the 8lover 8apital letter, the S$8 clarified that advertising of actual performance data would be prohibited if the advertising:

included results that didn@t reflect the impact of brokerage commissions, advisory fees and other client-paid e penses"

failed to disclose the effect that market or economic conditions had on the results" failed to disclose whether or not the results shown reflected reinvestment of dividends and capital gains" made claims about the future potential for profit without also mentioning the possibility of loss" failed to disclose 4if applicable5 that performance results related only to a select group of the &A@s clients" compared results to an inde without disclosing all material facts relevant to the comparison" failed to disclose any material conditions, ob#ectives or investment strategies used to obtain the results"

Exam Tips and Tricks One question you can expect to see involves performance advertising. In particular, one type of answer that appears to be correct is "IAs cannot use performance advertising that promotes results received by only a small group of the portfolios under management." But the requirements listed above state that it is only prohibited to not disclose that only asmall group was used, so the answer above isactually incorrect.

Client Communication and Compensation Issues Solicitation

,he &nvestment Advisers Act of '(*1 permits an &A to pay a fee to a person who solicits advisory clients only if these two conditions are met:

,he &A is registered with the S$8" ,he solicitor has never been suspended, e pelled, limited or barred from associating with an investment advisor by the S$8"

&f solicitation is permitted, the following rules apply:

,here must be a written agreement between the &A and the solicitor, which must re6uire compliance with the &nvestment Advisers Act of '(*1"

,he solicitor must provide a copy of the &A@s disclosure document to the potential client at the time of solicitation" ,he solicitor must provide a separate disclosure document to the potential client that spells out the names of the solicitor and the &A, the nature of the relationship between the two, a statement that the &A will pay the solicitor, and the amount above the regular advisory fee that the client will be charged due to the use of the solicitor" ,he &A must obtain a signed and dated acknowledgement from the client stating that he or she has received both the &A@s and the solicitor@s disclosure documents by the time the advisory contract is entered into"

Exam Tips and Tricks It is important to know the rules for both general advertising and performance advertising. You can expect fewer questions on advisory contracts and solicitations. Here is a question you might encounter on the exam:

-. 4(ic( of t(e following statements a#out IA ad!ertising is FA)SE under t(e In!estment Ad!isers Act of -;<=1 a" A performance record may only be used if it contains a disclaimer on the first page that states there is no assurance that future results will be as good as the reported results" b" ,he &A may not advertise a formula without a disclaimer that refers to the limitations and difficulties of relying on any one formula or system" c" ,estimonials may be used only if written consent has been obtained from the client and the testimonial is not misleading in any way" d" A performance record may be used only if the results are for at least one year" $he correct answer is "c". testimonials may not be used in ,# advertising.

Client Communication and Compensation Issues Compensation

,here are few specific restrictions on fees within either the &nvestment Advisers Act of '(*1 or the USA" ,he advisory fee must not be !unreasonable!, which means that it should be in line with what other advisors charge" Under the USA, the following types of fee arrangements are permitted: 7ees based on a percentage of assets under management 7lat annual dollar amount for services agreed upon -rokerage fees on trades made for clients >rap fees that cover all services 4asset management and transactional fees5 in one single annual fee
Look Out There are a few exceptional cases in which an investment advisor can benefit from portfolio gains. Advisors can participate in

capital gains (receive a performance-based fee) if the client: 1. is an institutional investor. 2. is a private client with a minimum net worth of $1.5 million. 3. is a private client with a minimum of $750,000 invested with the IA.

As mentioned above, performance-based fees are generally prohibited" :nly two types of clients may be charged such a fee:

%egistered investment companies 4mutual funds5 An individual with an account value in e cess of 0' million 4Uniform Securities Act5, :% An individual with an account value in e cess of 0)D1,111 and a net worth of at least 0',D11,111 4&nvestment Adviser Act5

&n these cases, a performance-based fee known as a !fulcrum fee! is permitted" A fulcrum fee provides for a base fee to be paid to the advisor, with additional fees permitted for performance above a specific benchmark" .owever, this is allowed only if the base fee would be reduced e6ually for inferior performance beneath the benchmark"
Look Out! Don\'t confuse performance-based fees with performance guarantees - read the exam questions carefully. Remember that performance guarantees are alwaysprohibited, while performancebased fees aregenerally prohibited, with the exceptions discussed above.

Exam Tips and Tricks Here is a question you might encounter on the exam:

-. IAs ma% enter into ad!isor% contracts t(at allow compensation: a" based on the level of trading activity" b" based on a percentage of the value of all assets under management" c" based on a percentage of capital gains or losses in the

account" d" based on any of the above $he correct answer is "b". options "a" and "c" are specifically prohibited.

CHAPTER 1,: Handling Client &unds - Introduction

$ustod% 8ustody is defined as having physical possession of funds or securities" 7unds and securities can be placed in custodian accounts, though an Administrator may re6uire that an advisor post a bond for such" &nvestment advisors that have the ability to withdraw money from a client@s account are considered to have custody of these funds" &n that case, the &nvestment Advisers Act of '(*1 re6uires the &A to do the following: Reep each client@s securities segregated and held in safekeeping <ot commingle client funds with the &A@s funds Haintain client funds in accounts that name the &A as trustee or

agent Reep records showing deposits and withdrawals for each client account <otify clients in writing of how the funds are maintained and when accounts are changed Send a 6uarterly 4or more fre6uent5 itemized statement to each client Arrange an annual unannounced visit from an independent public accountant, who must then file a report with the S$8 verifying the amount of client funds and securities

,hese rules do not apply if the &A is also a broker-dealer, since brokerdealers are sub#ect to similar rules at the federal level" Under the USA, &As must notify the Administrator if they currently have custody of client funds and securities 4or plan to in the future5" :therwise, the custody re6uirements are the same as those stated by the &nvestment Advisors Act of '(*1 4e cept that the state Administrator receives the annual accountant report, rather than the S$85"

Handling Client &unds - Discretion

As is the case with registered representatives of broker-dealers, an &A must not e ercise discretionary power over securities transactions without first obtaining the proper discretionary authority from the client" :nly oral discretionary orders are re6uired in the '1 days following the first transaction in a client account" ,hereafter, specific written discretionary authority is re6uired" As with registered representatives of brokerdealers, an &A may use discretion as to time and price of an e ecution without having discretionary authority"
Look Out! The time and price question is sure to be tested and is easy to recognize. But expect additional questions on discretionary powers, particularly regarding situations where a client is unavailable and the client\'s spouse may want to place orders or give approval to an IA\'s suggestion of a buy or sell order. If the spouse has not been given written power of attorney on the account, it is always incorrect to choose an answer involving the spouse. In particular, watch out for an answer stating the spouse can give approval as long as the client signs a power of attorney within 10 days following the trade: the 10-day rule only applies following the first transaction to occur in a new account.

Exam Tips and Tricks Custody questions tend to focus on the Investment Advisers Act standards. Consider this sample question:

-. +(e following statements a#out IAs t(at take custod% of client funds are true, E:$E"+: a" each client must receive a statement of transactions in the account at least 6uarterly" b" the &A must be audited at least annually" c" each client@s funds must be segregated from other client@s funds" d" client funds must not be commingled with the &A@s funds" $he correct answer is "c" - while the funds must not be commingled with the ,#&s funds, there is no requirement that they not be commingled with

other client&s funds.

Handling Client &unds - Suita"ilit#

&f at any time you knowingly recommend an unsuitable investment to a client, with the intention to defraud, you are liable for both civil and criminal penalties" Suitability is defined in many ways, a few of which will be discussed here"
Look Out! The SEC specifically defines suitability as follows: When your broker recommends that you buy or sell a particular security, your broker must have a reasonable basis for believing that the recommendation is suitable for you. In making this assessment, your broker must consider your risk tolerance, other security holdings, financial situation (income and net worth), financial needs, and investment objectives.

,he USA re6uires &As to determine the suitability of investment recommendations given each client@s circumstances" 7ailure to do so is considered an unethical business practice and is sub#ect to penalties" ,he following practices are e amples of violations of the suitability rules: %ecommending securities without having a reasonable basis for the

recommendation %ecommending securities without taking the client@s financial situation, needs and ob#ectives into account %ecommending the same security to all clients 7ailing to describe important facts and risks about the security to each client Haking trades of e cessive size in a client@s account 8hurning in a client account 4making trades too fre6uently5 ;roviding services that are not appropriate to the client@s situation and needs 7ailing to in6uire into client@s ta situation, risk tolerance and other assets

,he &nvestment Advisers Act of '(*1 also defines failure to meet suitability standards as an unethical practice" An &A who does not make reasonable in6uiry, or suitable recommendations given the information

from such an in6uiry, is guilty of violating the suitability re6uirements"

Handling Client &unds - Prudent In'estor Standards

7or many years, the !;rudent ;erson %ule! stood as a guide for fiduciary investing" >hile it was designed to limit unsuitable investing by third parties, it basically placed a higher emphasis on preservation of capital than on income or growth" 7urthermore, the rule re6uired looking at each investment to see if it was suitable" &n '((*, the Uniform ;rudent &nvestor Act was created as a model law for states to enact" &t essentially updated the old !prudent investing! standards to take modern portfolio theory into account" As a result, fiduciary investors can take advantage of diversification and risk-reward tradeoffs and can manage a portfolio as a whole"
Look Out! While the Uniform Prudent Investor Act permits an IA to include growth investments if they are appropriate to the needs of the client, remember that the client\'s specific situation is the key consideration. Look out for questions that imply that, under the Act, stocks would be appropriate for any client account.

>hile the fiduciary role of &As and &A%s was discussed earlier in the section, it is important to understand that all topics discussed in this section must be considered in all dealings with the client, from investment recommendations to choice of trustees 4for retirement accounts and other trusts5 and investment managers"
Exam Tips and Tricks Suitability is one of the primary concerns of an IA. Questions could focus on either the practices that violate suitability standards or the consequences of such violations. Consider this sample question:

-. An IA is working wit( a new ad!isor% client w(o is anxious to get a large sum of cas( in!ested. 4(en t(e IA tries to take t(e time to understand t(e client7s financial o#>ecti!es and ot(er assets, t(e client tells (er, 84e7ll do t(at later, >ust get m% account in!ested first.8 4(ic( of t(e following

statements is + UE1 a" ,he &A should e plain that it is unethical to make investment recommendations without first obtaining this information" b" ,he &A can make investment recommendations as long as the financial ob#ectives are obtained within '1 days of investing the funds" c" ,he &A must cancel the client@s advisory contract" d" ,he &A can make investment recommendations once she receives the client@s other investment account statements" $he correct answer is "a". $he ,# must not invest the client&s money until sufficient information is gathered to make suitable recommendations, and she should e-plain to the client why failure to follow this rule is unethical and inappropriate.

CHAPTER 1-: Conflicts of Interest - Introduction

-oth the &nvestment Advisers Act of '(*1 and the Uniform Securities Act spell out a number of potential conflicts of interest and unethical behaviors"

Conflicts of Interest - E%cessi'e Trading and Insider Trading

Excessi!e +rading $ cessive trading has already been mentioned in the!Suitability! section" -y definition, e cessive trading is also a conflict of interest, since in most cases an &A who engages in this behavior also receives commissions from such trades" ,his is a clear case of conflict of interest, since an &A must always put his or her client@s interests first" Any time you trade 4on a discretionary basis5, or recommend trading e cessively in or for a client@s account, for the sake of generating commissions, you are committing fraud" Legally, the term associated with this action is known as churning" ,he S$8 defines churning as follows: 8hurning refers to e cessive buying and selling in your account by your broker" 7or churning to occur, your broker must e ercise control over the investment decisions in your account, either through a formal written

discretionary agreement or otherwise, and must engage in e cessive trading in light of the financial resources and character of the account for the purpose of generating commissions" Insider +rading As the S$8 site makes clear; there are actually two types of insider trading, the legal kind and the illegal kind" ,his clarification is needed because many people associate the term with solely illegal activities" According to the S$8, legal insider trading occurs when insiders 4officers, directors and employees5 trade their own securities and report any3all transactions to the S$8"
Look Out! According to the SEC, illegal insider trading occurs when insiders buy or sell securities"in breach of a fiduciary duty or other relationship of trust and confidence, while in possession of material, nonpublic information about the security. Insider trading violations may also include \'tipping\' such information, securities trading by the person \'tipped,\' and securities trading by those who misappropriate such information."

$ amples of insider trading listed by the S$8 include:

corporate officers, directors and employees who traded the corporation@s securities after learning of significant, confidential corporate developments;

friends, business associates, family members and other !tippers! of such officers, directors and employees, who traded the securities after receiving such information; employees of law, banking, brokerage and printing firms who were given such information to provide services to the corporation whose securities they traded"

$ amples of insiders listed by the S$8 include: government employees who learned of such information because of

their employment by the government; and other persons who misappropriated, and took advantage of, confidential information from their employers"

Conflicts of Interest - Selling A)a#. Client *oans and Confidentialit#

Selling Awa% >hen a broker solicits you to purchase securities not held or offered by the brokerage firm" As a rule, such activities are a violation of securities regulations" ,ypically, when a broker is selling away, the investments are in the form of private placements or other non-public investments"
Look Out! The basic idea here is that if you are selling away, as a broker, you are attempting to sell something that you do not have rights to, or have not been authorized to sell. Such activity is considered fraudulent.

$lient )oans &t is usually considered unethical to borrow money from or loan money to a client" Since the advisory relationship allows the &A to know confidential information about the client@s income and assets, it is a breach of confidentiality 4see below5 to borrow money from the client" 7urthermore, loaning money in either direction is likely to influence the advice given, thus making it almost impossible for the &A to give ob#ective advice" $ ceptional circumstances in which it would be allowable for an &A to borrow money from a client are these: if the client is in the business of lending money if the client is an affiliate of the investment advisor if the client is a broker-dealer" $ ceptional circumstances in which it would be allowable for an &A to lend money to a client are these: if the &A is a financial institution that normally engages in lending

money if the client is affiliated with the &A, such as an employee of the &A"
Look Out! Remember, it is OK to borrow from or lend to someone who is an affiliate of the investment advisor or broker-dealer. On the exam, this is usually referred to simply as "an affiliate". his can be confusing, but these answers are considered correct.

$onfidentialit% 8onfidentiality is re6uired for all aspects of client information, unless the client specifically authorizes disclosure of information in writing" 8onfidentiality rules cover information on the client@s: identity; investments; transactions; trust arrangements; legal affairs; ta information" .owever, disclosure that may be re6uired by governmental authorities 4e"g" S$8, &%S, 7&<%A5 is permitted, since the disclosure is re6uired under law"
Exam Tips and Tricks You are sure to be tested on the topic of "arm\'s length" transactions such as borrowing money from or loaning money to a client. Consider this sample question:

-. An in!estment ad!isor cannot #orrow mone% from: a" an affiliated investment advisor" b" an affiliated broker-dealer" c" an accredited investor" d" an unaffiliated bank" $he correct answer is "c". an ,# cannot borrow money from an advisory client.

Conflicts of Interest - Antifraud Pro'isions and /arket /anipulation

Antifraud "ro!isions

$omplaints and ?our $ompliance Officer &f a customer brings forth a formal complaint, you must bring the complaint to the attention of your compliance officer, and3or broker-dealer"

Guarantees &t is considered fraudulent to guarantee any returns to any client" $ommingling funds &t is considered fraudulent to commingle funds in an account, unless: o written authorization is granted by the firm" o an agent contributes e6ually 4monetarily5 to the account" "rofit s(aring &t is considered fraudulent to share in the profits of a client@s account - unless the account is dually owned with proportionate funds" 7urthermore, if an account is proportionately owned, written notice must be supplied 4and approved5 by the broker-dealer"

Antifraud is always hot topic with the 7&<%A, especially with regards to Anti-money laundering" e am" 6arket 6anipulation

Front running 7ront running is an unethical practice that occurs when a broker trades e6uity based on information from the analyst department before his or her clients have been given the information"

+ailgating ,ailgating occurs when a broker or advisor is purchasing or selling a security for his or her client4s5, and then immediately making the same transaction in his or her own account" "ainting t(e tape ;ainting the tape is an illegal action that occurs when a group of market manipulators are buying and3or selling a security among themselves to create artificial trading activity, which, when reported on the ticker tape, lures unsuspecting investors as they perceive an unusual volume",his behavior is similar to matching orders"

Conflicts of Interest - &iduciar# Duties

A fiduciary is re6uired to act in the best interests of the person he or she is working with" 7iduciaries have been legally appointed and authorized to

hold assets in trust for another person" ,he fiduciary manages the assets for the benefit of the other person rather than for his or her own profits" ,rustees, pension administrators, custodians and investmentadvisors are all prohibited from engaging in any fraudulent, deceptive or manipulative behaviors when working with beneficiaries or clients" All securities professionals have fiduciary responsibility to handle client funds and advice in a professional, ethical and responsible manner" &f you are a securities professional, you are a fiduciary" ,his means you are held to a higher standard of ethical responsibility than the average person is" Simply put, fiduciaries must put the interests of their clients above their own" 7iduciary duty covers agents, investment advisors, investment advisor assistants, issuers and broker-dealers"
Look Out! It is very important to know that under no circumstances can an agent ask a client to sign an affidavit of liability waiver - better known as an Exculpatory Clause - which says that the agent is not responsible for any losses that may occur in the account.

>hen it comes to working with clients, investment advisors and investment advisor representatives have a much stronger fiduciary responsibility than broker-dealers and their registered representatives" Under the &nvestment Advisers Act of '(*1, the &A@s obligations in the role of fiduciary include the following: ,he duty to be loyal to the client ,he duty to have a reasonable and ob#ective basis for investment

recommendations ,he duty to make sure that any investment recommendations are appropriate considering the client@s financial ob#ectives, needs and situation ,he duty to ensure best e ecution for securities transactions, if the &A can direct such transactions

Look Out! The IA\'s primary fiduciary obligation is to put the client\'s (or the beneficiary\'s) needs before his or her own. When faced with an exam question on this topic, answers such as "ensuring the account does not lose money" or "investing in a fund desired by the trustee" are incorrect, since performance guarantees are prohibited, and the IA\'s obligation is to the beneficiary, not the trustee.

Conflicts of Interest - t!er Pro!i"ited 0e!a'iors

Actions that are considered either unethical behavior or conflicts of interest include the following:

Hisrepresentations - &A cannot misrepresent his3her 6ualifications, services or fees to clients or potential clients

,hird-party research - &A cannot use or rely on third-party research for investment recommendations or reports without disclosing this fact to the client Advertisements - &A cannot use an advertisement that does not comply with the guidelines of the &nvestment Advisers Act of '(*1 7ailure to state important facts - for e ample, failing to state the ta implication of a transaction 7ailure to follow a client@s instructions Haking misleading or untrue statements, including the following: o Stating or implying that either the state Administrator or the
o o o o o

S$8 approves or endorses the &A Haking e aggerated claims about investment performance Stating or implying that either the Administrator or the S$8 approves of a specific investment Haking inaccurate statement regarding commissions or markups Biving inaccurate market 6uotations Hisrepresenting the client@s account status
Exam Tips and Tricks The exam is likely to contain a number of questions on prohibited behaviors such as misleading statements and misrepresentations.

Consider this sample question:

-. All of t(e following are unet(ical #e(a!iors pro(i#ited under t(e Uniform Securities Act E:$E"+: a" deliberately failing to follow a client@s instructions" b" e ecuting a trade the &A believes to be unsuitable at the client@s orders" c" telling a client that the &A is a %egistered &nvestment Advisor and has therefore been approved by the state Administrator" d" failing to tell a client that making trades recommended by the &A will sub#ect the client to a large ta liability" $he correct answer is "b". the ,# must follow client orders. ,t would be unethical only if the ,# recommended the inappropriate trade.