State securities law, in nine chapters.

The Series 63 centers on the Uniform Securities Act, the model statute that each U.S. state adapts into its own "blue sky law." But the 2023 exam outline adds a federal and FINRA component: Regulation Best Interest, communications, recordkeeping, options, margin, SIPC. So you need definitions, exceptions, ethics, and a little arithmetic.

What the exam weighs

Official NASAA breakdown of the 60 scored questions (outline in effect since June 2023). Click a row to open the chapter. Communications and ethics are worth 45% between them: do not leave them for the end.

The remaining 5 questions are unscored pretest questions, and nothing sets them apart from the others: treat all 65 with the same care.

What can be tested

How to use this course

1. Read the chapters in order. Chapter 1 sets out the vocabulary that everything else depends on.
2. Do the quiz sets at the bottom of each chapter right after reading it. The questions are written in the format you will see on exam day; the explanations also tell you why each wrong answer is wrong.
3. Review with the flashcards, the glossary, and the "Key numbers" page: deadlines and thresholds are the easiest points to earn.
4. Finish with the practice exams: three separate exams of 65 questions, none of them seen in the quizzes, in 75 minutes, scored out of 60 with the passing mark of 43. Aim for 80% before you book your date.

Three-week study plan

The exam in practice

How you enroll, what happens at the test center, how to read a NASAA question, and the signs that tell you that you are ready.

Enrolling

1. With a firm. If you are hired by a broker-dealer, the firm enrolls you by filing your Form U4 in the CRD system. You have nothing to do yourself.
2. Without a firm. You open an exam window yourself through FINRA's Test Enrollment Services System (TESS), at finra.org, and you pay the fee ($147). No prerequisites: no SIE, no Series 7, no sponsorship.
3. The window. Once the request is processed, FINRA opens a 120-day window for you. You must book your date and take the exam within it. If it expires, you have to enroll again and pay again.
4. The appointment. You choose a Prometric center and a time slot on Prometric's website. Make sure the name on the enrollment is exactly the one on your ID.

The exam is given in English at a Prometric center. The online exam is offered only as an approved accommodation: NASAA's FAQ reserves it for immunocompromised candidates at risk of serious illness.

If you live outside the United States. NASAA's FAQ confirms that its exams are also given at centers located outside the United States, and refers to FINRA's website for the list of locations. FINRA states that the process there is essentially the same as in the United States, that a consent form for the processing of personal data must be signed on site, and that a $15 surcharge is charged for a session taken abroad. The list of cities changes and is not reproduced here: before you pay for enrollment, check on Prometric's booking site that a center you can get to does offer the Series 63, and on which dates.

Exam day

• Arrive 30 minutes before your appointment time. Being more than 30 minutes late can cost you the session and the fee.
• Identification: one currently valid government-issued ID with a photo and a signature (passport, driver's license). The name must match the name on the enrollment exactly.
• Personal belongings: everything goes in a locker, including your phone, watch, wallet, and notes. You will be asked to show that your pockets are empty. The room is video-recorded.
• Provided by the center: a basic four-function calculator, erasable boards with markers for scratch work, noise-reducing headphones. You bring neither a calculator nor paper.
• Time: 75 minutes for 65 questions. The appointment also includes a 30-minute block for the computer tutorial and the end-of-session survey: that time cannot be used for the exam and does not count toward the 75 minutes. A restroom break is possible, but the clock does not stop.
• During the exam: one question at a time; you can mark a question and come back to it; you can change an answer as long as you have not finished. There is no penalty for a wrong answer: do not leave any question unanswered.
• The result appears on screen shortly after you finish, and you are handed a printed report: pass or fail. If you fail, you receive your result by section, which tells you what to rework. No certificate is sent afterward.

How to approach a NASAA question

The questions do not reward reading speed; they reward precision. Almost every one contains a word that decides the answer. Make this routine a habit on every quiz question, so that it is automatic on exam day:

1. Read the last sentence first. It is the one that asks the question. You will then read the scenario knowing what you are looking for.
2. Spot the word that reverses the question: EXCEPT, NOT, LEAST, false. In an EXCEPT question, three answers are true and you are looking for the false one. Write "T / F" on your board next to each letter if you need to.
3. Identify who is who. Agent of a broker-dealer or of an issuer? State-registered adviser or federal covered? Retail or institutional client? With or without an office in the state? The same situation gets a different answer depending on these roles.
4. Identify the source being tested. "Under the Uniform Securities Act" or "under NASAA's Statement of Policy" calls for the state rule; "under FINRA rules" or "under Regulation Best Interest" calls for the federal rule. When the two differ (borrowing from a customer, the length of a hold on a disbursement), that wording decides. The exam does not always name the exact source: "under the Uniform Securities Act" may refer to the Act itself or to a NASAA model rule, and "pursuant to the Securities Exchange Act" may refer to an SEC rule. This course gives the source of each rule so that you know which level it belongs to.
5. Answer before you read the choices, in your head, then look for your answer among them. You will be less tempted by a well-phrased distractor.
6. Eliminate. Two choices are usually clearly wrong. Between the two that remain, be wary of absolutes (always, never, automatically, under any circumstances): they are often wrong, except for antifraud and guarantees, where the absolute is the rule.

Questions with statements I, II, III, IV

These give four numbered statements, and the choices are combinations ("I and III only," "II, III and IV only"). Do not look for the combination: judge each statement separately, true or false, then see which combination matches. Tip: as soon as you are sure that a statement is false, cross out every choice that contains it; often only one or two are left.

Managing the 75 minutes

• 75 minutes for 65 questions: a little under 70 seconds per question. Definition questions take 20 seconds; save the time for the scenarios and the calculations.
• Checkpoints: question 22 at about the 25^th minute, question 44 at about the 50^th. If you are behind, speed up on the definitions, not on the scenarios.
• If a question holds you up for more than a minute and a half: pick the most likely answer, mark it, move on. You will come back to it if there is time left.
• Change an answer on review only if you have found a specific reason (a word you misread, a rule you remembered). A mere doubt is not enough.
• Five questions do not count, and you do not know which ones. A question that seems strange or off the outline may be one of them: do not let it throw you.
• For calculations (options, margin, SIPC), write the data on the board before you calculate. Mistakes almost always come from a forgotten piece of data (the factor of 100 in an option contract, the SIPC limit on cash).

How to know you are ready

The actual passing mark is 43 out of 60, or 72%. Aim higher in practice, because the real questions will be worded differently from the ones you know, and stress costs a few points.

The distinctions you must be able to explain without hesitating. This list is an end-of-course check: if you have not read the course yet, these words are unfamiliar to you, and that is normal. Come back to it after chapter 9.

• exclusion and exemption; exempt security and exempt transaction;
• agent of a broker-dealer and agent of an issuer;
• the adviser's de minimis, and the absence of one for the broker-dealer and the agent;
• registration and notice filing; state-registered adviser and federal covered adviser; where the IAR of each one registers;
• filing, coordination, qualification;
• deny, suspend, revoke, cancel, withdraw; cease and desist and injunction;
• criminal and civil; the two cases for an offer of rescission;
• where an offer is made and where it is accepted;
• retail communication and correspondence; static and interactive content;
• the agent's discretion and the adviser's discretion; Reg BI and fiduciary duty;
• what the NASAA list says and what FINRA says about borrowing from a customer and about vulnerable adults.

Foundations: who regulates what

Almost every question on the exam comes down to: "does this person or this product fall within the definition?" Master the definitions and half the work is done. This chapter is not a separately scored section: its concepts are tested in the "Securities and Issuers" and "Remedies" sections.

Why these laws exist

In the early 20^th century, anyone could sell a Kansas farmer shares in an imaginary gold mine. Nothing required the seller to prove that the mine existed, or to say what he was keeping for himself. In 1911, Kansas passed the first law requiring securities and salespeople to be registered with the state. These laws came to be called blue sky laws, because they targeted speculative schemes that had, in the words of a Supreme Court justice in 1917, no more basis than "so many feet of blue sky." The other states followed, each with its own statute.

After the crash of 1929, Congress added a federal layer: the Securities Act of 1933 for securities offerings, the Securities Exchange Act of 1934 for markets and intermediaries, then the Investment Advisers Act of 1940 for advisers. The state laws did not go away, however. A U.S. securities professional therefore lives under two regulators at once: the federal regulator and the regulator of each state where he or she works. The Series 63 covers the second, with as much of the first as you need to understand where the boundary lies.

Because each state had written its own law, a broker active in twenty states had to know twenty statutes. In 1956, a commission of lawyers (the Uniform Law Commission) drafted a model statute, the Uniform Securities Act, which the states could adopt. That text, with NASAA's additions, is what the exam tests: it will never ask you for the particular rule of Texas or California.

The whole Act rests on three tools. Keep them in mind, because every chapter of the course develops one of them:

1. Register the persons who sell securities or give advice about them (chapters 2 to 5). The regulator knows who they are, checks their background, and can take away their right to do business.
2. Register the securities offered to the public (chapter 6). The investor has verifiable information before buying.
3. Prohibit fraud (chapters 7 to 9). This tool applies to everyone and to all securities, including when the first two do not apply.

The person protected is the ordinary investor, the one who has neither the means nor the knowledge to investigate on his or her own. That is why you will see the same logic everywhere: the more able the buyer is to fend for itself (a bank, an insurer, a pension fund), the fewer formalities the law requires; the more vulnerable the buyer, the more it requires. When you are unsure about a question, ask yourself which answer best protects the small investor: it is often the right one.

The market concepts you need to know

The exam assumes that you know the products and the players. Here is the minimum, to read once if you have never worked in U.S. finance.

The products

• Equity securities (stock, share, equity): an ownership interest in a company (corporation). The shareholder receives a dividend if the company pays one, votes at shareholder meetings, and gains or loses with the share price. Common stock is the ordinary share; preferred stock carries a fixed dividend paid before the dividend on common stock, usually without voting rights. Treasury stock is stock that the company has bought back and holds itself.
• Debt securities (bond): a loan made to the issuer. The holder receives interest (the coupon) and repayment of the principal at maturity. A debenture is a corporate bond with no specific collateral; a note is a debt security with a shorter maturity. A municipal bond is issued by a state or a local government; Treasury securities are issued by the federal government.
• Funds (investment company): a company that pools the money of many investors to invest it in a portfolio of securities. A mutual fund (open-end investment company: "open-end" because it creates new shares with every purchase) issues and redeems its shares every day at their net asset value. A closed-end fund issues a fixed number of shares, which then trade on an exchange. An exchange-traded fund (ETF) is a fund whose shares trade on an exchange during the trading day, like a stock; it most often tracks an index. A unit investment trust (UIT) is a fund with a fixed portfolio that no one manages once it has been set up. Fees and share classes are explained in chapter 9.
• Derivatives: an option gives the right to buy (call) or to sell (put) a security at a set price for a limited time (chapter 8). A warrant is a long-term right, issued by the company itself, to buy its stock at a set price. A right (subscription right) is a short-term right given to existing shareholders to subscribe to a new issue.
• Insurance products: an annuity is a contract under which an insurer pays out a stream of income in exchange for a premium. In a fixed annuity, the insurer guarantees the amount; in a variable annuity, the amount depends on funds chosen by the customer. Traditional life insurance comes in three forms: whole life (coverage for the insured's entire life, with a fixed premium and death benefit), term life (death coverage limited to a set period), and endowment (a fixed sum, paid on a set date or at death). In all three, the insurer bears the risk.
• Bank products: the savings account and the certificate of deposit (CD), a fixed-rate deposit for a set term. They are insured by the FDIC, the federal deposit insurance agency, up to the legal limit.
• Retirement accounts: the IRA (individual account), the 401(k) (employer plan), and the Keogh (plan for the self-employed) are tax-advantaged wrappers. Securities are held inside them, but the wrapper is not a security. A Roth IRA is an IRA funded with contributions that have already been taxed, from which withdrawals are then tax-free. A rollover is the transfer of assets from one plan to another, for example from a 401(k) to an IRA when leaving an employer.
• Partnerships: in a partnership, partners run a business together. In a general partnership, all of them manage and all of them are liable for the debts. In a limited partnership, a general partner manages and is liable for the debts without limit, while the limited partners contribute capital, do not manage, and risk only what they put in. A limited partner's interest is a passive investment: that is what will make it a security.

The markets

• Primary market: the issuer sells new securities and receives the money. The first sale of stock to the public is called an initial public offering (IPO). The investment banks that organize the sale are the underwriters (chapter 6).
• Secondary market: investors trade already-issued securities among themselves, on a stock market (exchange: NYSE, Nasdaq) or directly through dealers (over-the-counter, OTC). The issuer receives nothing.

The intermediaries

Two professions share the customers, and the law treats them differently because the way they are paid does not create the same temptations.

• The broker-dealer executes transactions. When it acts as a broker, it finds a counterparty for the customer's order and earns a commission. When it acts as a dealer, it sells the customer a security that it owns (or buys the customer's security) and earns the price difference, the markup or markdown. It is paid per trade: the risk is that it pushes for too many trades.
• The investment adviser sells advice. It is paid by fees, most often an annual percentage of the assets it manages. It has an ongoing relationship with the client: the law imposes a fiduciary duty on it, the most demanding duty there is.

In practice, the same firm often holds both registrations, and the same person can be both an agent (for the brokerage side) and an IAR (for the advisory side). The exam checks that you know which hat that person is wearing in the situation described.

The framework

• Uniform Securities Act (USA): a model statute, not a federal law. Each state adopts it with its own variations. These laws are called blue sky laws. The exam tests the 1956 version as amended by NASAA.
• Administrator: the state's securities regulator (sometimes called the Commissioner). This is the central figure of the exam.
• NASAA: the association of Administrators. It writes the exam, the model rules, and the statements of policy, which have the force of law only where a state adopts them.
• NSMIA (National Securities Markets Improvement Act, 1996): the federal law that divided the roles between the SEC and the states, and created federal covered securities and federal covered advisers.

Who does what

The CRD (Central Registration Depository) is the shared database where the registration forms of broker-dealers and their agents are filed; the IARD is its counterpart for advisers. A single electronic filing serves the SEC, FINRA, and the states. BrokerCheck is its public window.

NSMIA: how the federal government and the states divide the territory

Until 1996, a company launching a nationwide offering had to register its securities with the SEC and in every state, and a large adviser was subject to fifty sets of rules. Congress found this duplication unnecessary for players already supervised at the federal level. NSMIA therefore took three main powers away from the states:

1. requiring the registration of securities already covered at the federal level, the federal covered securities (exchange-listed securities, investment company shares, certain private placements);
2. requiring the registration of advisers registered with the SEC, the federal covered advisers;
3. imposing on broker-dealers capital, margin, and recordkeeping requirements that differ from the federal requirements.

What NSMIA left to the states fits in one sentence that you must know by heart: the state can still require a notice filing and fees (a simple filing of information, with no approval to obtain; details in chapters 4 and 6, where you will also see that exchange-listed securities are excused from it), register broker-dealers, agents, and IARs, and above all pursue fraud, whatever the security and whoever the person.

Person

The Act constantly says "any person." The word does not refer only to a human being: it covers any entity capable of having rights and obligations. When the Act means a human being, it says individual. The nuance matters: a broker-dealer is a person (most often a company), whereas an agent is necessarily an individual.

USA § 401(j): a person is an individual, a corporation, a partnership, an association, a joint-stock company (an old form of company with shares, whose members remain liable for its debts), a trust where the interests of the beneficiaries are evidenced by a security, an unincorporated organization, a government, or a political subdivision of a government.

Security

The entire scope of the Act depends on this word. If the product being sold is a security, you have to ask whether it is registered, whether the seller is registered, and the antifraud provisions of the securities law apply. If it is not one, the Administrator has no jurisdiction under this Act (other laws, on insurance or banking, take over). Promoters have therefore always tried to dress up their products to escape the definition, and the law has responded with a very broad definition.

USA § 401(m) gives a list (note, stock, treasury stock, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, certificates of interest in oil, gas, or mining) and includes warrants and subscription rights on those securities. For unusual instruments, the Howey test (SEC v. W.J. Howey Co., 1946) defines the investment contract with four elements:

1. an investment of money,
2. in a shared venture (common enterprise),
3. with an expectation of profit,
4. coming from the efforts of a third party (promoter, manager).

Options: the federal definition (Securities Act § 2(a)(1)) expressly lists puts, calls, straddles and other options on a security or an index of securities, as well as options on foreign currency entered into on a national securities exchange. Series 63 practice questions follow this reading: an exchange-traded option on the Swiss franc is a security; the currency itself, bought for cash, is not.

Indexed annuities (fixed indexed or equity-indexed annuities), whose return tracks an index with a guarantee of principal, are in principle treated as insurance products and not as securities when they meet the conditions set by federal law (the Harkin amendment, Dodd-Frank Act of 2010, § 989J). Do not confuse them with the variable annuity, which is always a security.

Form does not matter: rows of orange trees sold with a management contract, or interests in cattle or vineyards managed by a promoter, are securities if the investor remains passive. No written document is necessary.

The original case helps you remember the test. The Howey company owned orange groves in Florida and sold plots of them to guests of its hotel, tourists who knew nothing about farming. With each plot, it offered a service contract: it cultivated, harvested, sold the oranges, and paid over a share of the profit. Howey argued that it was selling land, not securities. The Supreme Court answered that economic reality counts, not the label: the buyers put in money, their funds were pooled in a single operation, they hoped for a profit, and that profit depended entirely on Howey's work. It was an investment contract, and therefore a security, which should have been registered.

The question to ask is always the same: does the expected profit come from the efforts of a third party? If so, it is a security, subject to registration (unless exempt) and to antifraud, whatever its form or its technology.

A whiskey warehouse receipt is a warehouse receipt representing barrels of whiskey that are still aging, sold as an investment: the buyer will never touch the barrels and is counting on the distiller to age them and resell them. It is the classic example of a product that does not look like a security and is one. A pre-organization certificate is a commitment to subscribe to the securities of a company that has not yet been formed.

The right-hand column of the table is explained by a single idea: who bears the investment risk? In a fixed annuity or traditional life insurance, the insurer promises an amount and owes it whatever happens in the markets; the customer does not need the protection of the securities law, because insurance law is enough. In a variable annuity, the premiums are invested in funds and the customer receives whatever those funds are worth: the customer bears the risk, like a shareholder. It is a security, and whoever sells it must have both an insurance license and a registration as an agent.

The same logic applies to the rest of the column. An ounce of gold, a house, a painting, euros: their value does not depend on the work of a promoter. A bank deposit is protected by federal deposit insurance (FDIC). A retirement account is a wrapper: the IRA is not a security, but the stock held inside the IRA is one.

Offer and sale

Registration and antifraud are triggered as soon as there is an offer or a sale. Both definitions turn on the same words: in exchange for something of value (for value). Without consideration, there is neither an offer nor a sale: a true gift is not regulated. But the law knows that promoters disguise sales as gifts, and it recharacterizes sham gifts. Remember too that an offer is enough: an unregistered agent who proposes a security violates the Act even if the prospect says no.

• Sale: every contract of sale or disposition of a security for value (USA § 401(k)(1)).
• Offer: every attempt to dispose of a security, or solicitation of an offer to buy one, for value.
• A security given as a bonus with a purchase (of securities or of anything else) is considered to be offered and sold for value.
• A purported gift of assessable stock (stock on which the issuer can demand money later) is an offer and a sale.
• Selling or offering a warrant, a right, or a convertible security is also offering the underlying security.
• The following are not sales: a genuine pledge or loan (bona fide pledge or loan), a stock dividend for which nothing is paid, acts incident to a shareholder vote on a merger or a reclassification, a court-approved reorganization.

A few explanations of these cases. Assessable stock is stock on which the company can make a "call": it has the right to demand an additional payment from the shareholder later. Whoever receives it as a gift therefore receives a potential debt; the law treats that gift as a sale so that the recipient has the same protections as a buyer. A stock dividend is a dividend paid in new shares instead of cash: the shareholder pays nothing and decides nothing, so there is no sale. A pledge is the use of securities as collateral: the customer hands securities over to a bank to secure a loan; ownership does not change hands.

When does the Administrator have jurisdiction?

First, what a "State" is under the Act (USA § 401): any state, territory, or possession of the United States, the District of Columbia, and Puerto Rico. A Canadian province is not one.

An agent in Chicago calls a customer in Florida: which state can sanction him if he lies? The Act looks at neither the nationality nor the residence of the parties. It looks at the path of the offer: where it starts, where it arrives, and where the acceptance is received. Every state touched by that path has jurisdiction, because each has an interest in acting: the state where the offer starts does not want to serve as a base for questionable sellers, and the state where it arrives wants to protect the people who are there.

USA § 414. A state's law applies when an offer to sell is made in that state, or when an offer to buy is made and accepted there.

• An offer is made in a state when it starts there (originates), or when it is directed there by the offeror and received at the place to which it is directed. Neither party needs to be physically present there.
• An offer is accepted in the state where the acceptance is communicated to the offeror, not in the state from which it is mailed.
• Several Administrators can therefore have jurisdiction over the same transaction.

The practical consequence for you: since an offer is "made" in the state where it is received, an agent who telephones a prospect in another state is making an offer there, and must be registered there before calling (chapter 3). And if the offer contains a lie, both states can act independently, without either one waiting for the other.

The reason for this exception: the advertiser does not control the circulation of a newspaper or the reach of a station. Without it, an advertisement in a national daily would be an offer in fifty states, and the issuer would have to register everywhere before publishing. The exception protects only the advertisement itself: if a reader in another state responds and the agent calls back to propose the security, that call is an ordinary offer, directed to the reader's state.

Consent to service of process: every applicant for registration irrevocably appoints the Administrator to receive, on the applicant's behalf, legal papers in noncriminal proceedings. Anyone who acts in the state without having filed one is considered to have done so (§ 414(h)).

Why this document? To start a lawsuit, the summons has to be formally delivered to the defendant (service of process). An injured customer in Iowa would have trouble serving papers on a firm based in New York, or on a salesperson who has left the state. Thanks to the consent, it is enough to deliver the papers to the Iowa Administrator, and the firm is considered to have received them. The consent applies only to civil and administrative proceedings, not to criminal prosecutions.

The four professionals

And the issuer: any person who issues or proposes to issue a security. An issuer transaction benefits the issuer (primary market); a non-issuer transaction benefits the issuer neither directly nor indirectly: it takes place between investors (secondary market).

The table reads in both directions. By row: brokerage on one side, advice on the other. By column: the firm, which bears the responsibility and the financial obligations, and the individual, who talks to the customer. The vocabulary rule is strict: an agent and an IAR are always individuals; a broker-dealer and an investment adviser are persons, almost always companies, sometimes an individual doing business in his or her own name (sole proprietor). An individual therefore cannot be "both the broker-dealer and its agent" within the meaning of the Act: an individual who is the firm is a broker-dealer.

The issuer / non-issuer distinction comes up often in chapter 6: several exemptions apply only to non-issuer transactions, because a resale between investors presents less risk than a capital raise by an issuer that has every reason to make its situation look better than it is.

Exclusion, exemption: two words, two effects

This is the distinction that pays off the most on the exam. The two words lead to the same practical result (no registration), but by two different routes. An exclusion operates at the level of the definition: the law says "this is not a broker-dealer," "this is not a security." An exemption operates at the level of the obligation: the law says "this is indeed a security, but we do not require it to be registered." The questions play on the wording: "is not defined as," "is excluded from the definition" on one side; "is exempt from registration," "need not register" on the other.

The four-question method

Faced with an exam situation, always ask the same questions, in this order:

1. Is it a security? If not, the Act does not apply.
2. Does the person fall within a definition (broker-dealer, agent, investment adviser, IAR)? Look for the exclusions.
3. Does an exemption from registration apply, to the person, to the security, or to the transaction?
4. Is there deception? Antifraud applies whatever the answers to questions 2 and 3.

Chapter quiz

Broker-Dealers

A person (a firm, or an individual operating in their own name) engaged in the business of effecting transactions in securities, for the account of others (broker) or for its own account (dealer). USA § 401(c).

What a broker-dealer is, and why it is registered

The broker-dealer is the firm through which the investor's money flows. It opens the account, receives the funds, executes the orders, holds the securities and sends the statements. The client therefore entrusts it with two things: their assets, and their confidence that the order will be executed honestly. The dangers are of three kinds: the firm can go bankrupt while holding clients' assets, one of its salespeople can steal or deceive, and the firm can push its clients into trades that enrich the firm itself.

Registration answers each of these dangers. It lets the regulator check the background of the firm and its principals before it opens, impose financial requirements on it (a capital cushion), require it to supervise its agents, and take away its right to do business if it abuses that right. An unregistered firm escapes all of this: that is why doing business without registration is a violation in itself, even if no client has lost a dollar.

Broker or dealer: two ways to execute the same order

The same firm can play two roles, and must tell the client which one it played in each trade (its capacity, shown on the confirmation).

Two other terms you will come across. An introducing firm handles the client relationship but hands off execution, settlement and safekeeping of the securities to a clearing firm (or carrying firm), which actually holds the assets; the agreement between the two is the clearing arrangement disclosed on Form BD. And a place of business is an office, or any location held out to the public as one (for example, an address on a business card); the written definition comes from the SEC rule on IARs, see Chapter 5.

Who is not a broker-dealer

The definition is broad: any person engaged in the business of effecting transactions in securities. The Act then removes five categories from it. For each one, ask yourself why: either the person is already regulated elsewhere, or is regulated under another name, or its clients do not need this state's protection.

• Agents (they are individuals who represent the firm).
• Issuers.
• Banks, savings institutions, trust companies.
• A firm with no place of business in the state that deals there exclusively with: the issuers of the securities involved, other BDs, or financial institutions (banks, insurance companies, investment companies, pension funds, other institutional buyers).
• A firm with no place of business in the state, licensed in the state where it has its office, that deals with an existing client whose residence is not in the state: the client on vacation, the "snowbird" (§ 401(c)(4)(B)).

The first three lines are exclusions based on status. The agent is an individual, regulated as an agent. The issuer that sells its own securities is regulated through the registration of those securities. The bank is supervised by the banking regulators. The last two lines are exclusions based on situation, and they are the ones the exam tests. They have two cumulative conditions: no office in the state, and a certain type of client. The idea is that the state has no need to register a distant firm that, within its borders, touches only professionals able to protect themselves, or a visitor who is already protected by their home state.

The order of the questions to ask is therefore: does the firm have an office in the state? If so, registration, end of analysis. If not: does it have a client in the state who is neither an institution, nor an issuer, nor another broker-dealer, nor an existing client passing through? If so, registration.

Two levels of registration

A broker-dealer that does business beyond a single state, which means almost all of them, registers first at the federal level, then in each state where it does business. The two registrations do not duplicate each other. The federal level oversees financial soundness and market rules, through the SEC and through FINRA, which the firm must join. The state oversees who sells to its residents. The same form, Form BD, serves both: the firm files it once in the CRD and checks the states it wants.

Federal registration does not replace state registration. NSMIA only limits what the state may require (see below). A person subject to a statutory disqualification (certain convictions, injunctions, bars) cannot associate with a member without permission.

Form BD

• Contents: legal form, direct and indirect owners, control persons, types of business, clearing arrangements, and the criminal, regulatory, civil and financial history of the firm and its control affiliates.
• Any information that has become inaccurate is corrected promptly (without delay, with no number of days set by the Act; the word is explained in Chapter 3) by an amendment (USA § 203(d)); the filing rules set 30 days.
• It contains no client information.

The application to the state

• Application, filing fee, and consent to service of process: it appoints the Administrator as the applicant's agent to receive legal papers in noncriminal proceedings. It is irrevocable, is filed once and does not have to be renewed.
• The Administrator may require publication of a notice of the application in newspapers in the state.
• The Administrator may set an earlier effective date, or defer it to noon of the 30^th day after an amendment.
• Registration of the BD automatically registers as agents those of its partners, officers and directors who act as agents.
• Successor firm (reorganization, change of legal form): application filed for the rest of the year, with no fee.
• Unpaid fees: the Administrator may only enter a denial, lifted as soon as the deficiency is corrected.
• Withdrawal under investigation: if a proceeding is pending or is instituted within the 30 days, the withdrawal becomes effective at the time and on the conditions set by the Administrator.

Qualification and examinations

• The Administrator may require an examination that is written, oral or both for any class of applicants, and may waive it.
• Lack of qualification can be held only against the BD itself (if it is an individual) or against its agents, not against a partner or director who merely contributes capital.
• A BD is not automatically qualified as an investment adviser: the Administrator may condition its registration on its not acting as an investment adviser.

Financial requirements and records: the federal limit

Exchange Act § 15 (from NSMIA): for a BD registered with the SEC, a state may not impose any capital, custody, margin, financial responsibility, recordkeeping, bonding or financial reporting requirement that differs from or is in addition to federal requirements.

A few definitions before the list. Net capital is the firm's safety cushion: its liquid assets minus its debts, computed under an SEC formula. It ensures that a firm in trouble can still return clients' assets to them. A surety bond is a guarantee: an insurance company undertakes to compensate clients, up to a set amount, if the firm causes them harm. Custody means holding clients' funds or securities; discretion is the power to decide on trades in their place. These are the two situations in which a professional can most easily do harm, hence the requirement of a guarantee.

• Net capital: at most the federal level.
• Surety bond: may be required of BDs (and agents, and advisers) that have custody or discretion; a deposit of cash or securities is always accepted instead; no bond if net capital exceeds the amount set by the Administrator.
• Records: those of SEC Rules 17a-3 and 17a-4, detailed in Chapter 8. The state cannot require more.
• The Administrator may examine the records at any time, inside or outside the state, without a subpoena, and may cooperate with the SEC and other states to avoid duplication (§ 203(e)).

What the state keeps: registration of the firm and its agents, fees, examinations, antifraud authority and sanctions.

Supervision: FINRA Rule 3110

Each firm must establish and maintain a supervisory system reasonably designed to achieve compliance with the laws and rules. The standard is reasonableness, not the outcome.

Why is supervision on the outline of an agent's exam? Because the regulator cannot stand behind every salesperson. It therefore delegates that oversight to the firm: the firm is the one that must read the emails, review the orders, and spot the account that is turning over too fast. A principal is a manager who has passed a supervisory examination and who signs off on behalf of the firm: the principal approves new accounts, advertising, and options accounts. You will always have a designated principal above you, and many rules in Chapters 8 and 9 boil down to "not without a principal's approval".

• Written supervisory procedures (WSPs), kept current and available in each supervisory office.
• Registered principals designated as responsible; each representative is assigned to a supervisor.
• Office of supervisory jurisdiction (OSJ): an office where order execution, market making, custody of funds and securities, approval of new accounts, review of orders, approval of advertising, or supervision of other offices takes place.
• Internal inspections: each OSJ and each branch office that supervises other locations, at least once a year; non-supervisory branch offices, at least every 3 years; other locations, on a regular periodic schedule. A written report is kept.
• Annual compliance meeting: each representative and principal takes part at least once a year in a compliance interview or meeting.
• Review by a principal of transactions and of incoming and outgoing correspondence, written and electronic.
• Investigation of applicants' good character, qualifications and experience before applying for their registration (including a review of their prior Form U5).

Selling securities in a bank

NASAA, Model Rules for Sales of Securities at Financial Institutions (1998). They apply to a BD that does business on the premises of a financial institution where retail deposits are taken (networking arrangement). The risk targeted: that the client believes they are buying an insured bank product.

To understand the rule, you need to know the FDIC (Federal Deposit Insurance Corporation): this federal agency insures bank deposits, so that a depositor loses nothing if their bank fails, up to a ceiling. A client who walks into their bank therefore associates the place with safety. If, next to the teller window, a salesperson offers them a stock fund, they may believe that the fund is as safe as their savings account. All of the rules below serve to break that confusion.

• Location: wherever practical, physically distinct from the deposit-taking area; the BD's name is clearly displayed.
• Written agreement between the BD and the institution, setting out responsibilities and compensation, and giving the BD's supervisors and state authorities access for inspection.
• At or before the opening of the account, oral and written disclosures: the securities are not insured by the FDIC; they are neither deposits nor obligations of the institution, which does not guarantee them; they involve risk, including possible loss of principal. The BD makes reasonable efforts to obtain a written acknowledgment from the client.
• Advertising: the same disclosures, or the short form Not FDIC Insured · No Bank Guarantee · May Lose Value.
• Confirmations and statements clearly indicate that the service is provided by the BD.
• The BD notifies the institution if one of its agents, who is an employee of the institution, is terminated for cause.

A bank employee who is not registered may neither make recommendations nor take orders; federal banking law tolerates only a nominal, fixed fee for referring a client, unrelated to any transaction.

Canadian broker-dealers: limited registration

USA § 201-A. A BD resident in Canada, with no office or physical presence in the state, may obtain a limited registration to serve:

• a person from Canada who is temporarily resident and with whom it had a brokerage relationship before the person entered the United States;
• a person from Canada who is a resident of the state, for their self-directed, tax-advantaged Canadian retirement account.

Conditions: application on the form of its home jurisdiction, consent to service of process, registration in good standing in Canada, membership in a Canadian SRO or stock exchange. Effective on the 30^th day. It informs its clients that it is not subject to the full requirements of the Act; it is bound only by the antifraud provisions and by this section. Its agents follow the same regime.

The reason for this regime: many Canadians spend the winter or work for a few years in the United States while keeping their broker and their retirement account in Canada (an RRSP, the Canadian equivalent of the IRA). Without this provision, their Canadian broker would violate the state's law with every call. Limited registration lets it keep serving those clients, and only them.

Chapter quiz

Agents of Broker-Dealers

This is you. An agent is an individual, other than a broker-dealer, who represents a broker-dealer or an issuer in effecting or attempting to effect purchases or sales of securities. USA § 401(b).

Why register the individual, and not just the firm

The client does not talk to "the firm": they talk to a person, who recommends a security to them, takes their order and sometimes decides for them. That person is the one who can lie, steal or push a sale. The law therefore wants to know every individual who stands between an investor and a security: their criminal and professional background, their competence (hence the exam you are preparing for), and the firm that answers for them. Registration also gives the Administrator a simple lever: taking away the individual's right to work.

A point of vocabulary. State law says agent. FINRA and federal law say registered representative or associated person for the same person; they are also called a stockbroker or account executive. On the exam, these words all refer to the individual salesperson associated with a broker-dealer. And "agent" has a precise legal meaning here: it has nothing to do with the firm acting "as agent" (in an agency capacity) in a transaction.

The definition has three elements: an individual; who represents a broker-dealer or an issuer; in effecting or attempting to effect transactions in securities. The third element is the broadest: the attempt is enough. Someone who solicits without selling anything is already an agent. Neither the job title, nor the method of compensation, nor the hours worked matter: what matters is the function.

Agent of a broker-dealer

For someone who represents a broker-dealer, the rule has no nuance: if they take part in the sale, they are an agent, whatever security is sold and whoever the buyer is. The only caveat: if the firm itself is not a broker-dealer in the state (no office in the state, and institutional clients only or an existing client passing through, see Chapter 2), its representative is not an agent there, since the law defines the agent as someone who represents "a broker-dealer or issuer" (USA § 401(b)).

• Anyone who sells for a BD is an agent, even if the securities or the transactions are exempt.
• Clerical and administrative staff are not agents, unless they take orders, solicit accounts, pass on recommendations or receive compensation tied to sales.
• A partner, officer or director is an agent only if they otherwise fall within the definition: one who sells or solicits is, one who merely sits on the board is not.
• It is unlawful for a BD or an issuer to employ an unregistered agent (§ 201(b)).
• There is no de minimis for agents.

Agent of an issuer

A company can sell its own securities without going through a broker-dealer: its employees approach investors directly. These employees "represent an issuer in effecting transactions": in principle they are agents, and must register. But the law has decided that, in certain low-risk situations, this registration is unnecessary. It then removes the individual from the definition (this is an exclusion, not an exemption).

An individual who represents an issuer is not an agent when effecting transactions:

• in one of these five exempt securities: securities of the U.S. government, the states and municipalities; securities of Canada and of recognized foreign governments; securities of banks, savings institutions and trust companies; exempt commercial paper; investment contracts of employee benefit plans;
• in an exempt transaction (§ 402(b)), that is, a sale excused from registration because of its circumstances (list in Chapter 6);
• in certain federal covered securities: sales to qualified purchasers (very wealthy or institutional investors, a category defined at the federal level) and private placements under Rule 506 (Chapter 6);
• with employees, partners or directors of the issuer, if no commission or other remuneration is paid for the solicitation.

Registration: Form U4

You do not register on your own. The firm files Form U4 for you in the CRD, after checking your background, and pays the fees of each state requested. The form is a statement made under your own responsibility: you answer a series of questions about your history, and you commit to keeping it up to date. The logic is that of all securities law: you are not forbidden to have a past, you are forbidden to hide it. The content of Form U4 feeds BrokerCheck, which any client can look up.

• Form U4 (Uniform Application for Securities Industry Registration or Transfer), filed by the firm in the CRD system. Content: identity, 5 years of residential history, 10 years of employment history, exams, states requested, and the disclosure questions: criminal charges and convictions, regulatory actions, injunctions and civil litigation, customer complaints and arbitrations, terminations for cause, bankruptcies, unpaid judgments and liens. Fingerprints.
• Look-back windows of the disclosure questions, a classic trap: any felony, conviction or mere charge, with no time limit ("Have you ever…"), as well as misdemeanors involving investments or fraud; bankruptcies and compromises with creditors within the last 10 years; judgments and liens as long as they are unpaid. Do not confuse this with the ground for denial in USA § 204, limited to convictions within the last 10 years: a 15-year-old felony is disclosed on Form U4, but is no longer by itself a statutory ground for denial.
• Updating: any information that has become inaccurate is corrected promptly (USA § 203(d)); the filing rules set 30 days, shortened to 10 days for an event that results in a statutory disqualification.
• A false statement on Form U4 is a ground for denial or revocation (§ 204(a)(2)(A)) and a violation in itself (§ 404).
• Form U5 at the end of the relationship: filed by the firm within 30 days, with a copy to the individual.
• Effective at noon on the 30^th day, expiration on December 31, consent to service of process, fees: same rules as for the BD.
• The Administrator may require a bond from an agent who has custody of or discretion over client funds or securities.

Three terms from American criminal law come up in these questions. A felony is a serious crime, generally punishable by more than one year in prison. A misdemeanor is a less serious offense. Being charged (formally accused) is not the same as being convicted (found guilty): Form U4 asks about both for felonies. A lien is a creditor's (often the tax authority's) claim on a debtor's property for as long as the debt remains unpaid.

At the end of the relationship, whatever the cause (resignation, termination, retirement), the firm files a Form U5 that states the reason for the departure. That reason follows the agent: the next firm will read it before hiring them. This is why the agent receives a copy of it, and may dispute an entry they consider inaccurate.

Exams

• In practice: the SIE, a FINRA representative exam (Series 7 or Series 6), and the Series 63 (or the Series 66).
• Passing the Series 63 does not give you the right to do business: registration must be effective in each state concerned.
• Validity: under the NASAA model rule, the exam must have been passed within the 2 years preceding the application, unless the individual has been registered in a state during the last 2 years or participates in a continuing qualification program.
• An agent supervised by a registered BD does not have to show the same qualifications as a BD; lack of experience alone does not justify a denial.

Each exam has its purpose. The SIE (Securities Industry Essentials) tests general knowledge and can be taken without a firm. The Series 7 (all products) and the Series 6 (funds and variable annuities) are FINRA's representative exams: they cover products and federal rules, and require sponsorship by a firm. The Series 63 covers state law. The Series 65 is the IAR exam, and the Series 66 combines the Series 63 and 65 for those who already hold the Series 7.

Where must the agent be registered?

In every state where they effect or attempt to effect transactions: the state they call from, and the state to which their offer is directed and where it is received (§ 414). Calling a prospect in a state where you are not registered is a violation, even without a sale.

The principle is strict because it protects each state's jurisdiction over what happens within its borders. The federal exception exists for a practical reason: clients travel. Without it, an agent would have to refuse the sell order of a ten-year client because she is calling from a hotel in a state where he is not registered. But the exception is narrow: it covers a client the agent already has, never prospecting.

Association with the firm

An agent does not exist on their own. Their registration is always that of "the agent of such-and-such firm", because the firm is the one that supervises them and answers for them. The license is therefore not a diploma you take with you: it lives only as long as the link with a registered firm exists.

• The agent's registration is not effective during any period when they are not associated with a registered BD or an issuer. With no firm, or if the firm loses its registration, there is no longer an active license.
• Dual association with two unaffiliated BDs: only if the Administrator permits it by rule or order.
• Registration is personal: it cannot be transferred to another individual.

Who notifies the Administrator when an agent joins or leaves?

For the agent, the rule is "everyone notifies": the Administrator does not rely on any single party to know at all times who works for whom. The word promptly recurs throughout the law: it means without delay, without the text setting a number of days. When a question offers "promptly" against an invented numerical deadline, "promptly" is generally the right answer for a notification to the Administrator.

Accounts at another broker-dealer: FINRA Rule 3210

A firm monitors the trading of its own employees: an agent who buys for himself just before recommending the security to his clients, or who trades on confidential information, shows up in the records. But if the agent opens a personal account at a competitor, the employer no longer sees anything. Rule 3210 closes that door: no account elsewhere unless the employer knows about it and can receive the statements.

• Before opening an account that permits securities transactions at another member or another financial institution, the associated person obtains the prior written consent of their employer.
• They notify the executing firm in writing of their association with a member.
• Upon the employer's written request, the executing firm sends duplicate confirmations and statements.
• Account opened before hiring: the employer's written consent within 30 calendar days.
• The associated person is presumed to have an interest in the accounts of their spouse, their dependent children and relatives whose accounts they control.

Payments to unregistered persons: FINRA Rule 2040

If a firm could pay a commission to anyone, registration would be pointless: it would be enough to have unregistered recruiters sell and pay them by results. The rule therefore starts from compensation: being paid based on transactions is the sign that you take part in the sale, and anyone who takes part in the sale must be registered. Conversely, a fixed payment with no connection to a transaction (rent, accounting fees) does not raise this problem.

• No commission or other transaction-based compensation may be paid to a person who should be registered and is not. A "finder's fee" proportional to transactions, paid to an accountant or a friend, is prohibited.
• The retired representative exception: continuing commissions on their former accounts, under a bona fide contract signed while they were registered, provided they no longer solicit, open accounts or service those accounts.
• The exception for an unregistered foreign finder who refers foreign clients, subject to disclosure conditions.
• On the state side (NASAA, 1983): sharing commissions with a person who is not a registered agent of the same BD or of a BD under common control is a dishonest practice. Sharing between two agents of the same firm is permitted.

Agents of Canadian broker-dealers

The agent of a Canadian BD with limited registration (Chapter 2) obtains a limited registration himself: a form from his home jurisdiction, consent to service of process, registration in good standing in Canada. He may serve only the clients his firm is permitted to serve, and remains subject to the antifraud provisions.

Chapter quiz

Investment Advisers

Three scored questions, but the rules for advisers come back in the communication and ethics chapters. Above all, an agent must know where their job ends and where paid advice begins.

The advisory business, and why it has its own rules

The investment adviser does not sell securities: it sells its judgment. The client pays it to say what to buy and what to sell, or to manage the portfolio on the client's behalf. This relationship is more intimate than a brokerage one. The client relies on the adviser, often for years, and frequently gives it the power to decide alone. The danger is no longer the one trade too many: it is self-interested advice, advice the adviser gives because it gains something the client does not know about.

The law answers with the fiduciary duty. A fiduciary is someone who manages another person's affairs and who must, for that reason, put the other person's interest ahead of their own, in all circumstances, and disclose everything that could compromise their judgment. It is the highest standard of conduct in American law. Almost all the rules in this chapter flow from it: the written contract, the brochure, the ban on borrowing from clients, the restrictions on custody.

Advisers are paid in several ways: an annual percentage of assets under management (AUM), for example 1% per year; an hourly rate; a flat fee for a financial plan; a subscription to a newsletter. What, in principle, they may not do is be paid out of the client's gains (Chapter 8, performance fees), because that would push them to take too much risk with other people's money.

The ABC test

As with the broker-dealer, the law defines the adviser by its activity, not by its title. Three criteria, all required: if just one is missing, the person is not an investment adviser.

• Advice: gives advice about securities (direct advice, analyses, reports, publications).
• Business: is in the business of doing so, or holds itself out as such.
• Compensation: is paid for it, in any form.

All three criteria must be met (USA § 401(f)). The definition expressly includes financial planners and any person who, as part of other financial services, advises on securities for compensation: a retirement consultant, a sports agent who selects investments for a fee.

Details on each letter. Advice: the advice must concern securities. Advising someone to buy gold, a building or traditional life insurance does not count. But advising someone to sell stocks in order to buy gold does concern securities. General advice on the allocation between stocks and bonds is also enough. Business: the person does it on a regular basis, or holds themselves out to the public as an adviser (business card, website, advertising). A single piece of advice given to a friend does not make a business. Compensation: any economic benefit, whether it comes from the client or from a third party: a fee, a commission on the recommended product, a subscription. Free advice, with no benefit of any kind in return, does not make someone an adviser.

Who is excluded from the definition

These persons may meet all three criteria and yet not be investment advisers under state law. The reason is the same as for the broker-dealer: they are already regulated in another capacity, or their advice is only incidental to another profession. Each exclusion has a condition, and the loss of that condition is what the exam tests.

• LATE: Lawyers, Accountants, Teachers, Engineers, if the advice is solely incidental to their profession. One who holds themselves out as an investment adviser or bills separately for that advice loses the exclusion.
• Broker-dealers and their agents, if the advice is incidental to the brokerage business and without special compensation. A wrap fee is special compensation: the BD becomes an IA for that program.
• Publishers of bona fide newspapers, newsletters and financial publications, with no advice based on each client's situation.
• Banks, savings institutions, trust companies.
• IARs (they are individuals associated with the firm).
• Federal covered advisers.

Excluded from the definition does not mean free of all rules: the antifraud provisions of USA § 102 reach "any person" who is paid to advise on securities.

SEC or state? (Advisers Act § 203A, Rule 203A-1)

Unlike the broker-dealer, which registers at both levels, the adviser registers at only one: either with the SEC or with the states. NSMIA made this split in 1996, so that the SEC would focus on large firms and the states would oversee small ones, which are closer to their residents. The criterion is size, measured by assets under management. A 2010 federal law (Dodd-Frank) raised the threshold to $100M, which created the intermediate category of mid-size advisers.

• An adviser already registered with the SEC has to go back to the state only if its assets fall below $90M.
• Also federal covered, regardless of AUM: advisers to registered investment companies; pension consultants advising plans of at least $200M; advisers required to register in 15 states or more; internet advisers; newly formed advisers that expect to reach the threshold within 120 days.
• A federal covered adviser does not register with the state: it makes a notice filing (a copy of the documents filed with the SEC) and pays fees. The state keeps its antifraud authority over it, but may impose neither recordkeeping nor financial requirements on it.

Notice filing or registration

The notice filing is what the state has left when federal law has taken registration away from it: the right to be informed and to be paid. The firm does not have to ask for permission; it reports its presence.

The same term is used for securities: the issuer of a federal covered security also makes a notice filing (Chapter 6). In both cases, remember that it is not a registration and that it does not weaken the antifraud provisions.

State registration and the de minimis exemption

USA § 201(c). An IA (or an IAR) with no place of business in the state does not have to register there if its only clients in the state are institutions (investment companies, other advisers, BDs, banks, insurance companies, employee benefit plans with at least $1M in assets, governments), or if it has had no more than 5 clients other than institutions during the preceding 12 months.

This is the only numerical tolerance in the entire law for professionals, and it applies only to advice. Why advisers and not broker-dealers? An adviser follows its clients over time; when a few of them move to another state, it would be disproportionate to require full registration for them. The two conditions are cumulative: no office in the state, and a small number of clients. An office in the state requires registration from the first client.

The Form ADV is to the adviser what Form BD is to the broker-dealer, with one difference: part of it is written for the client. Part 1 is a check-the-box questionnaire for regulators. Part 2 is written in plain English and delivered to the client: it is the brochure, which tells the client, before signing, what the firm does, what it costs, what conflicts of interest it has and whether it has been disciplined.

• Form ADV: Part 1, data for regulators; Part 2A, the firm brochure (services, fees, conflicts, disciplinary history); Part 2B, the brochure supplement on the individuals who advise the client; Part 3, Form CRS, intended for retail investors. Withdrawal: ADV-W.
• Annual updating amendment within 90 days after the end of the fiscal year; material changes: promptly.
• Effective at noon on the 30^th day, expiration on December 31, consent to service of process, successor firm with no fee: as for BDs.
• Registration of the IA automatically constitutes registration as IARs of its partners, officers and directors who perform IAR functions.

Financial requirements (NASAA Model Rule 202(d)-1)

Net worth is the firm's net value: what it owns minus what it owes. The requirement rises with the power the adviser has over the client's money. One that only gives advice, without touching the funds or deciding alone, has no minimum. One that decides alone (discretion) can cause losses: $10,000. One that holds the funds (custody) can lose or misappropriate them: $35,000. And one that is paid long in advance must at least not be insolvent, since the client has extended it credit.

• Minimum net worth: $35,000 with custody; $10,000 with discretion but no custody. A surety bond can make up a deficiency.
• Fees of more than $500 per client collected 6 months or more in advance: positive net worth at all times, and a balance sheet provided in the brochure.
• Net worth deficiency: notice to the Administrator by the close of business on the next business day, then a financial report on the business day after that.
• An IA that meets the financial requirements of the state where it has its principal office cannot be made to meet more by another state.

Records (NASAA Model Rule 203(a)-2)

• Retention for 5 years from the end of the fiscal year of the last entry, the first 2 years in the principal office.
• Organizational documents: until 3 years after termination of the business.
• Content: journals and general ledger, order memoranda, bank statements, written communications received and sent relating to advice, a list of discretionary accounts, powers of attorney, contracts, advertisements, personal transactions of associated persons, brochures delivered, security and privacy policies.

Custody (NASAA Model Rule 102(e)(1)-1)

Custody: holding, directly or indirectly, client funds or securities, or having the authority to obtain possession of them. It exists in three cases: possession; any arrangement giving the authority to withdraw funds or securities on instruction to the custodian (including direct deduction of fees and a general power of attorney); any capacity that gives legal ownership or access (general partner of a limited partnership, trustee).

Custody is the most sensitive point of the business: an adviser who can get its hands on the client's money can also make it disappear. The law does not forbid it, but surrounds it with four protections that all serve the same purpose, having someone other than the adviser check that the money is really there: an independent custodian (the qualified custodian, a bank or a broker-dealer) that actually holds the assets; statements sent to the client by that custodian, not by the adviser; a certified public accountant (CPA) who comes to count without warning; and notice to the Administrator. Note that custody is defined by authority, not by physical possession: an adviser authorized to deduct its fees from the account has custody, even if it has never seen a single bill.

• No custody if funds or securities received inadvertently are returned to the sender within 3 business days, nor if a client's check made out to a third party is forwarded to that third party within 3 business days.
• With custody: written notice to the Administrator on Form ADV; a qualified custodian (bank, BD) holding the assets in separate accounts; written notice to the client about the custodian; statements at least quarterly sent by the custodian; an annual surprise examination by an independent CPA.
• Custody arising solely from fee deduction: the client's written authorization, an invoice sent to the custodian and an itemized invoice to the client with each deduction, notice to the Administrator. Under these conditions, neither a surprise examination nor the $35,000 net worth is required.
• USA § 102(e): custody is unlawful if the Administrator prohibits it by rule, or, absent a rule, if the adviser has not notified the Administrator of it.

Advisory contract (USA § 102(c), NASAA Model Rule 502(c))

The client chooses an adviser for its personal competence and integrity. The contract protects that choice: it must state clearly what is provided and at what price, and it cannot be transferred to someone else behind the client's back. The word assignment is broader than a formal transfer: if the owners sell control of the firm, the client in fact ends up being advised by other people, and the law treats that sale as an assignment of the contract.

• In writing, stating the services, the term, the fees and how they are calculated, the portion of prepaid fees refunded upon termination, and whether or not there is discretionary authority.
• No assignment (transfer, including by transfer of a controlling block of interest) without the client's consent.
• Partnership: notice to clients of any change in partners within a reasonable time. The departure or admission of minority partners is not an assignment.
• No compensation based on capital gains, except for qualified clients (figures in Chapter 8). No clause waiving the protections of the law: a hedge clause that purports to release the adviser from all liability or to make the client waive their rights is void (USA § 410(i)) and does not protect the adviser.

Unethical practices (NASAA Model Rule 102(a)(4)-1)

The adviser and the IAR are fiduciaries: they act first in the client's interest. The model rule lists, among other things:

• recommending without reasonable grounds to believe that the advice is suitable for the client;
• exercising discretion without written authorization obtained within 10 business days after the first transaction placed on oral authorization (discretion limited to price and timing does not require it);
• inducing excessive trading; placing an order without authorization, or on a third party's instructions without the client's written authorization;
• borrowing from a client, unless the client is a BD, an affiliate of the adviser or a financial institution in the business of lending; lending to a client, unless the adviser is a lending institution or the client is an affiliate;
• misrepresenting its qualifications, services or fees; presenting a report prepared by a third party as its own;
• charging an unreasonable fee;
• failing to disclose in writing, before any advice is given, a material conflict of interest (compensation from third parties, commissions earned on the transactions advised);
• guaranteeing a result; publishing misleading advertising;
• disclosing a client's identity or affairs without consent or a legal requirement;
• failing to comply with the custody rule; entering into a contract that does not comply with the rules;
• failing to have written procedures to prevent the misuse of material nonpublic information;
• accessing a client's account using the client's own login credentials;
• failing to establish or enforce a required policy; failing to pay an arbitration award or a fine.

The list looks long, but it applies the same principle throughout: the adviser must never be in a position to gain something at the client's expense without the client knowing it and accepting it. Borrowing from the client makes the client a creditor and distorts the advice. Earning a commission on the recommended product creates an incentive to recommend it. The disclosure must be written and made before the advice, so that the client can take it into account.

Information security (NASAA, 2019)

Investment Adviser Information Security and Privacy Rule. A state-registered adviser must:

• establish, implement and maintain written physical security and cybersecurity policies, appropriate to its size, that protect the confidentiality, integrity and availability of information;
• cover five functions: identify, protect, detect, respond, recover;
• review these policies at least once a year;
• deliver its privacy policy to the client at the start of the relationship, then annually, and promptly after any change.

Wrap fee programs

A single fee, as a percentage of assets and not based on transactions, covers advice, execution and custody. It is not a performance fee. The sponsor is an investment adviser (the wrap fee is special compensation for advice, even when the sponsor is a broker-dealer) and delivers a specific brochure (Form ADV Part 2A, Appendix 1) describing the fees and stating that the program may cost more than buying the services separately. A wrap fee is poorly suited to an inactive account: the client would be paying for transactions they do not make (reverse churning).

Chapter quiz

Investment Adviser Representatives

The IAR is to the investment adviser what the agent is to the broker-dealer: the individual who does the work. The Series 63 alone does not qualify you to be one.

Why an agent exam covers IARs

You are taking the Series 63 to become an agent, not an IAR. NASAA nevertheless puts three questions on this topic, and its reason is written in the exam outline: brokerage and advice sit so close together that an agent must know where the limits of an agent registration lie. In a firm that has both businesses, a small step is enough to move from one profession to the other: offering a client a fee-based managed account, receiving a share of those fees, holding yourself out as a "wealth management adviser." From that point on, the agent is performing the function of an IAR, and if the agent is not registered as one, the agent is violating the law.

The structure is the same as in brokerage: a firm (the investment adviser) and individuals who act for it (the IARs). The rules resemble those for agents, with a few deliberate differences that the exam exploits. Read this chapter with Chapter 3 in mind, and note every difference.

Who is an IAR

The definition works like the definition of an agent: it starts from the function. An IAR is anyone who, on behalf of an adviser, is involved closely or remotely in the advice itself or in selling it.

USA § 401(g). Any partner, officer, director, or individual employed by or associated with an IA, who:

• makes recommendations or gives advice regarding securities,
• manages accounts or portfolios,
• determines which advice or recommendations should be given,
• solicits, offers, or negotiates the sale of advisory services (the "solicitor"),
• supervises persons who do any of these things.

Purely clerical staff are not IARs. An agent of a BD who receives a share of advisory fees for recommending portfolios must also be an IAR: the two registrations are held together.

Let us go back over the five functions. The first two are obvious: the person who advises the client and the person who manages the client's portfolio. The third covers people the client never sees: the analyst or investment committee member who decides what the firm will recommend. The fourth is the biggest trap: the solicitor, paid to bring clients to the firm, is an IAR even though the solicitor gives no advice, because the solicitor sells the advisory service. The fifth covers the supervisor of all of these. By contrast, a person who prepares invoices, files records, mails statements, or schedules appointments performs none of these functions.

Agent and IAR side by side

Where the IAR registers

The answer depends on the firm, and this is the favorite subject of questions on this chapter. NSMIA took the registration of large advisory firms away from the states, but left them the registration of individuals: a state thus keeps control over the people who meet with its residents. To keep an IAR of a large national firm from having to register in fifty states because he or she has clients everywhere, federal law limited this power to the states where the IAR has an office. For the IAR of a state-registered adviser, there is nothing of the kind: the ordinary rule applies, with the de minimis exemption.

Even when the firm is regulated by the SEC, the individual registers with the state: the SEC does not register IARs. A place of business is an office where the IAR regularly provides services, solicits, or meets with clients, or any other location held out to the public as such (SEC Rule 203A-3).

And if you are asked who registers the IAR of a giant adviser, the answer is never the SEC. The SEC registers firms. Individuals in the advisory business are always under the states.

Beginning and end of the relationship: who gives notice?

The Administrator must know at all times which firm each IAR works for. The law assigns the duty to notify to whoever has a registration relationship with the Administrator. The state-registered adviser is registered with the Administrator: it is the one that gives notice. The federal covered adviser is not registered with the state; the only one who is registered is the IAR: so it is up to the IAR to give notice.

Formalities and exams

The procedure is the same as for the agent, with a few differences in detail. The IAR also files a Form U4, in the IARD system. The IAR's registration is tied to a firm and does not exist without it. What changes is the exam: the Series 63 tests state law from the brokerage point of view, whereas the work of an IAR also requires knowledge of analysis, investment strategy, and fiduciary duty, which the Series 65 and Series 66 test.

• Form U4, effective at noon on the 30^th day, expires December 31, consent to service of process.
• The registration is not in effect unless the IAR is employed by a registered IA (or associated with a federal covered adviser).
• Exam (NASAA Model Rule 202(a)-2): Series 65, or Series 66 with the Series 7, passed within the 2 years before the application.
• Waiver for holders in good standing of certain designations: CFP, ChFC, PFS, CFA, and CIC in the 2000 text (the rule was readopted in 2022; the version amended in 2024 lists CIMA instead). The CPA credential alone does not provide a waiver.
• An IAR supervised by a registered IA does not have to meet the same qualifications as an IA.
• Continuing education: the 2020 NASAA model rule (IAR Continuing Education) requires 12 credits per year (6 in ethics and professional responsibility, 6 in products and practice) in the states that have adopted it, a growing number. An IAR who does not complete them cannot renew the registration.
• The ethics rules for advisers (Chapter 4) apply to the IAR personally: no borrowing from a client, no guarantee of results, disclosure of conflicts.

The abbreviations in the waiver list are private professional designations, earned after demanding exams: CFP (Certified Financial Planner), ChFC (Chartered Financial Consultant), PFS (Personal Financial Specialist, available only to CPAs), CFA (Chartered Financial Analyst), CIC (Chartered Investment Counselor). The Administrator considers that the holder has already demonstrated the required knowledge. The CPA (Certified Public Accountant) is a licensed accountant: the credential shows competence in accounting, not in investments, which is why there is no waiver without the PFS. The waiver covers the exam only: the holder must still register.

The agent who drifts into advice

This is the scenario the exam likes best, because it concerns you directly. An agent of a broker-dealer gives advice every day: recommending a security is part of the job. As long as that advice is incidental to the brokerage business and is paid for only by the commission on the order, the agent remains an agent. The agent changes category when the client pays for the advice.

Chapter quiz

Securities and Issuers

Basic rule (USA § 301): to be lawfully offered or sold in a state, a security must be registered, exempt (the security or the transaction), or federal covered.

Why register a security

The seller of a security always knows more than the buyer. The issuer knows its financial statements, its debts, its pending lawsuits, what the founders paid for their own shares. The buyer sees only a brochure. Registration corrects this imbalance: before selling to the public, the issuer files with the regulator a set of documents describing the business, the security, and the use of the money, and the issuer is answerable if it lied. The regulator does not say that the investment is good. It checks that the required information is there, and the investor decides.

Before every sale, the agent must therefore be able to answer one question: through which door did this security lawfully enter the state? There are three, and one is enough.

1. The security is registered in the state, by one of the three methods below.
2. An exemption applies: either to the security itself (exempt security) or to this sale (exempt transaction).
3. The security is federal covered: federal law bars the state from requiring its registration.

If no door is open, the sale is unlawful and the buyer can demand that it be undone (Chapter 7), even if the security has gone up and even if no one lied. Selling an unregistered, non-exempt security is one of the two major "no-fault" violations of the Act, along with selling without being registered yourself.

The vocabulary of an offering

• Registration statement: the complete set of documents filed with the regulator (the SEC at the federal level, the Administrator at the state level).
• Prospectus: the part of that filing intended for the investor. It describes the issuer, its financial statements, its risks, the security offered, and the price. It is the document the buyer must receive.
• Effective date: the moment the registration takes effect. Before that, no sales can be made.
• Underwriter: the investment bank (a broker-dealer) that organizes the offering and places the securities with investors. The process is called an underwriting.
• Public offering: an offering open to any investor. Private placement: an offering limited to a small number of selected investors, without advertising.
• Interstate offering: an offering made in several states, which falls under the SEC. Intrastate offering: an offering limited to the residents of a single state by a company of that state, which escapes federal registration and falls under the state alone.

The three methods of registration

The three methods differ in only one respect: how much of the work the SEC has already done. If the issuer has filed with the SEC, the state relies on that filing and the state registration follows the federal timetable (filing, coordination). If there is no federal filing, the state does the entire review itself and alone decides the date (qualification).

Filing (§ 302)

• Main criteria: issuer in business in the United States for at least 36 months; class of securities registered under the Exchange Act and held by 500 or more persons; net worth of $4M (or $2M with earnings in 2 of the last 3 fiscal years); at least 4 market makers; offering price of at least $5 per share; underwriting commissions of no more than 10%; no recent payment default.
• Also available to funds (open-end investment companies, that is, mutual funds, and unit investment trusts, funds with a fixed portfolio) that have already registered their securities in the state within the last 24 months.
• Light filing: proof of eligibility, description of the issuer and the security, latest federal prospectus.

Coordination (§ 303)

• Filing: copies of the latest prospectus filed with the SEC and, on request, the articles of incorporation, underwriting agreements, other federal documents; an undertaking to forward amendments. The Administrator can require only what is filed with the SEC.
• Automatically effective at the moment of federal effectiveness if: (1) no stop order is in effect and no proceeding is pending; (2) the registration statement has been on file with the Administrator for at least 10 days; (3) the maximum and minimum prices and the maximum underwriting commissions have been on file for 2 full business days. The Administrator may waive conditions (2) and (3).
• Afterward, the registrant promptly notifies the Administrator of the date and time of federal effectiveness and the content of the price amendment, and files a post-effective amendment. Failing that: a retroactive stop order is possible, without prior notice.

Qualification (§ 304)

• Full filing: issuer and subsidiaries, officers and directors and their compensation, 10% shareholders, promoters, capitalization, kind and amount of securities, price, underwriters' compensation, use of proceeds, outstanding options, material contracts, litigation, sales literature, specimen of the security, legal opinion, balance sheet less than 4 months old, and income statements for 3 years.
• The Administrator may require that a prospectus be delivered to each person to whom an offer is made, before the sale.

Common rules (§ 305)

• Who files: the issuer, any other person on whose behalf the offering is made (non-issuer distribution), or a registered BD.
• Filing fee; consent to service of process; statement of the amount offered in the state and of the other states where the offering is filed.
• Duration: 1 year from the effective date, or longer as long as the distribution is not completed. During that time, all outstanding securities of the same class are deemed registered for non-issuer transactions.
• No withdrawal for 1 year if securities of the same class are outstanding.
• Periodic reports may be required: no more often than quarterly.
• In a registration by qualification or coordination, the Administrator may require that securities issued to promoters at a price well below the public price or for something other than cash (cheap stock) be placed in escrow (escrow), and that the proceeds be impounded (impound) until a minimum amount is raised. The Administrator may also prescribe the form of the subscription agreement.

Two of these rules call for an explanation. The one-year duration must not be confused with December 31: registrations of persons all expire at the end of the calendar year, whereas the registration of a security lasts one year from its own effective date. A security registered on March 1^st remains registered until the following March 1^st, and beyond that if the distribution is not finished.

Escrow and impound protect the first subscribers of a young company. Suppose the founders issued themselves their shares at $0.50 each, and the public pays $5.00. If the founders could resell immediately, they would pocket ten times their stake at the expense of the new shareholders: the Administrator may require that these low-priced shares be held in escrow by a third party for a period of time. Likewise, if the project needs $2M to get started and the offering raises only $300,000, the money would be spent for nothing: the Administrator may require that the funds remain impounded until the minimum is reached, and returned to the subscribers if it is not.

Do not confuse the orders. The stop order is aimed at a security: it denies, suspends, or revokes its registration, and no one can sell it in the state any longer. The cease and desist order (Chapter 7) is aimed at a person and orders that person to stop a course of conduct. The sanctions of § 204 (deny, suspend, revoke) are aimed at the registration of a securities professional. Note also what the Administrator cannot do: deny a security solely because the Administrator considers the investment risky. One of the grounds on the list is needed, plus the public interest.

Federal covered securities and notice filing

This is the third door, opened by NSMIA in 1996. Certain categories of securities are already closely supervised at the federal level, or sold to buyers who do not need the state's protection. Requiring fifty state registrations on top of that was expensive and added nothing. Congress therefore "covered" these securities: the state can no longer require their registration.

NSMIA (Securities Act § 18) takes away the state's power to require registration of:

• securities listed on the NYSE, Nasdaq, and other national exchanges, and securities of the same issuer of equal or senior rank;
• securities of registered investment companies (mutual funds, exchange-traded funds or ETFs, unit investment trusts or UITs);
• sales to qualified purchasers: very wealthy or institutional buyers, a category that federal law directs the SEC to define. Not to be confused with the accredited investor of Regulation D or with the qualified client for performance fees;
• private placements under Rule 506 of Regulation D, and certain other offerings exempt at the federal level.

By contrast, a stock that trades only over the counter (OTC, for example on the OTC Pink market, formerly the Pink Sheets) is not federal covered on that ground: unless an exemption applies, it must be registered in the state.

Notice filing (USA § 307): this is not a registration. The Administrator may require the documents filed with the SEC, a consent to service of process, and a fee. For Rule 506: notice on Form D no later than 15 days after the first sale in the state. If the filing is not made, the Administrator may issue a stop order suspending the offering (except for listed securities). For listed securities (and securities of the same issuer of equal or senior rank), the state can require neither a filing nor a fee: in practice, notice filing concerns funds and Rule 506 (Securities Act § 18(c)(2)(D)). Antifraud authority remains intact.

Exempt securities (§ 402(a))

Second door. Certain securities do not have to be registered because their issuer already offers safeguards: it is a government, which levies taxes; or an entity supervised by another regulator (bank, insurer, rate-regulated public utility); or an entity whose purpose is not profit. The exemption attaches to the security: it follows the security in all its sales, primary or secondary, whoever the seller is.

The exemption belongs to the security itself, whoever the seller is and whatever the transaction:

• US government and municipal securities (states, political subdivisions, agencies);
• Canada, Canadian provinces, and their subdivisions; other foreign governments with diplomatic relations, at the national level only;
• banks, savings institutions, trust companies; savings and loan associations; credit unions. The exemption covers the bank itself: the securities of its parent, the bank holding company, are not exempt on this ground;
• insurance companies (their stocks and bonds, not variable annuities);
• railroads, common carriers, public utilities whose rates or securities issuances are regulated;
• securities listed on the major exchanges, and securities of the same issuer of equal or senior rank (in practice, they are now federal covered);
• nonprofit organizations (religious, educational, charitable, fraternal, chambers of commerce);
• commercial paper: maturity of 9 months (270 days) max, denominations of $50,000 minimum, rated in the top 3 categories;
• investment contracts issued in connection with employee benefit plans (with written notice to the Administrator 30 days before the plan begins);
• cooperatives, where the state so provides.

A few terms from the list. A savings and loan association and a credit union are savings and lending institutions, similar to banks and supervised like them. A common carrier is a public transportation company (railroad, transport company) and a public utility is a provider of essential services (electricity, gas, water): their rates and their securities issuances are controlled by an authority. Commercial paper is very short-term debt issued by a large corporation to finance its day-to-day operations. The three conditions (maturity, denomination, rating) ensure that it is a high-quality product sold to large buyers, not a risky borrowing placed with retail investors.

Exempt transactions (§ 402(b))

Here, there is nothing special about the security: it is ordinary stock of some company, which would have to be registered to be sold to the public. But the circumstances of this particular sale make registration unnecessary. The exemptions can be sorted into four families, which helps you remember them:

• The buyer can fend for itself: institutions, underwriters.
• The seller is not in the business of selling securities: isolated sale between individuals, forced sale by an executor, a sheriff, a trustee in bankruptcy, a pledgee.
• The initiative comes from the buyer: unsolicited order.
• The offering is too limited to be "public": private placement, pre-organization certificates, offering to existing security holders.

The exemption belongs to the way the sale is made. The security itself remains non-exempt: another sale of the same security may require registration.

• Isolated non-issuer transactions, whether or not effected through a BD;
• Manual exemption: non-issuer transaction by a registered agent of a registered BD, in a security that has been outstanding in the hands of the public for at least 90 days, whose issuer is an operating business (neither a blank check company, a company with no specific plan formed to merge with a target not yet identified, nor a shell company, a shell with no real operations) and whose financial information appears in a recognized securities manual or on EDGAR, the SEC's public database where issuers file their documents;
• Unsolicited non-issuer orders effected by a registered BD (the Administrator may require the client to acknowledge in writing that the order was unsolicited);
• transactions between the issuer and underwriters, or among underwriters;
• bonds secured by a mortgage or deed of trust, if the entire issue is offered and sold as a unit;
• sales by fiduciaries: executor, administrator, sheriff, marshal, receiver, trustee in bankruptcy, guardian, conservator;
• sale by a bona fide pledgee (the creditor liquidating pledged collateral);
• sales to institutional investors (banks, insurers, investment companies, pension funds, BDs);
• private placement: no more than 10 offers to non-institutional persons in the state in 12 months, purchase for investment, no commission for soliciting non-institutional buyers;
• pre-organization certificates: 10 subscribers max, no commission, no payment;
• offers to existing security holders (including holders of convertible securities and of warrants exercisable within 90 days of their issuance), with no commission other than a standby commission, or after a notice that the Administrator does not disallow within 5 business days;
• offer, but not sale, of a security for which registration statements have been filed with both the state and the SEC, with no stop order in effect.

More detail on the most heavily tested ones. A transaction is isolated when it is occasional: an individual who sells his or her stock in an unlisted company once to a neighbor. As soon as the sales are repeated, they are no longer isolated. An order is unsolicited when the idea comes from the client, with no recommendation from the agent: the client is the one who calls and names the security. The exemption requires a registered broker-dealer, and since everyone has an interest in claiming after the fact that the order was unsolicited, the Administrator may require a written acknowledgment from the client. The pledgee is the secured creditor: the bank that received securities as collateral and sells them because the borrower has stopped paying; the exemption requires a bona fide pledge, not an arrangement designed to evade registration. A pre-organization certificate is a commitment to subscribe for the shares of a company that does not yet exist.

Two reminders that hold for both columns. An exemption relates to the registration of the security; it says nothing about the registration of the person who sells. The agent of a broker-dealer who effects an unsolicited order, or who sells a municipal bond, must be registered. And an exemption is not obtained by default: the person who relies on it must prove that all its conditions were met.

The federal offering process (Securities Act § 5)

When a company sells securities to the public in several states, it goes through the SEC. The Securities Act of 1933 lays down a simple rule: no sale before the registration statement is effective, and no sale without a prospectus. Time is divided into three periods, and what an agent may say or do changes at each boundary.

How it works in practice: the company chooses an investment bank, which forms a syndicate of underwriters with others. Together, they prepare the registration statement and file it. While the SEC reviews it, the agents of the syndicate's broker-dealers gauge their clients' interest, without being able to take a firm order. When the SEC declares the registration effective, the final price is set, the sales are confirmed, and each buyer receives the final prospectus.

• Effectiveness is not an approval: the SEC passes neither on the merits of the security nor on the accuracy of the prospectus. Same rule for the Administrator (USA § 405).
• Tombstone ad: an announcement with limited content (issuer, security, quantity, price, names of the underwriters, where to obtain the prospectus). It is neither an offer to sell nor a prospectus, and it says so.
• Firm commitment: the underwriters buy the issue and bear the risk of unsold securities. Best efforts: they act as agents and return what is unsold; all-or-none and mini-max variations, with funds held in escrow until the threshold is reached.
• The syndicate is led by a managing underwriter; members of the selling group sell without any commitment to purchase. The underwriters conduct due diligence on the issuer; stabilization of the price during the offering is the only permitted intervention, disclosed in the prospectus. Unreasonable underwriting compensation is a ground for a stop order (§ 306).
• Primary offering: the proceeds go to the issuer. Secondary offering: they go to the selling shareholders.

The preliminary prospectus owes its nickname, red herring, to the legend printed in red on its cover, which warns that the registration statement is not yet effective and that the document may change. It contains everything except the final price and the date. An indication of interest is the response of a client to whom the offering is presented during the cooling-off period: "I would be interested in 500 shares." It binds neither the client nor the firm. The agent cannot turn it into an order, or accept a check.

Antifraud and securities: what the state always keeps

The exam outline places the state's antifraud authority in this section: all the doors described above (exemption of the security, exemption of the transaction, federal covered) concern registration; none concerns fraud. Lying while selling a Treasury security, a Rule 506 placement, or a listed stock is still fraud under USA § 101; the Administrator's powers are detailed in Chapter 7.

Regulation D and the broker-dealer's duty to investigate

A registered public offering is expensive and takes months. The Securities Act therefore allows an issuer to raise money without federal registration if it does not address the public: this is the private placement, whose conditions are set by Regulation D. The idea is the same as for the USA's exempt transactions: wealthy or sophisticated buyers can demand for themselves the information they need and can bear a loss. The central concept is the accredited investor, defined by wealth or professional status. The disclosure document for a private placement is called a private placement memorandum (PPM): it is written by the issuer and is not reviewed by any regulator.

• Accredited investor (Rule 501): a natural person with income over $200,000 ($300,000 with a spouse) in each of the last 2 years, or a net worth over $1M excluding the primary residence; banks, insurers, investment companies, BDs; entities with more than $5M in assets; officers and directors of the issuer; holders in good standing of the Series 7, 65, or 82.
• Rule 506(b): no general solicitation; unlimited accredited investors, plus no more than 35 non-accredited purchasers, who must be sophisticated and who receive detailed disclosure.
• Rule 506(c): general solicitation permitted; all purchasers are accredited, and the issuer takes reasonable steps to verify it.
• Form D: filed with the SEC within 15 days of the first sale. The securities are restricted securities: purchased outside a public offering, they cannot be freely resold to the public before a holding period has run. Disqualification of bad actors: the exemption is lost if the issuer, one of its officers or directors, or a compensated intermediary has previously been convicted or sanctioned for a securities-related offense (Rule 506(d)).
• FINRA Regulatory Notice 10-22: a BD that recommends a private placement must conduct a reasonable investigation of the issuer and its management, its business prospects, its assets, its claims, and the intended use of proceeds. It cannot blindly rely on the issuer's memorandum. The exemption from registration does not dispense with either the antifraud provisions or suitability.

The duty to investigate in Regulatory Notice 10-22 responds to a specific problem: in a private placement, no one has reviewed the documents. The client who buys on an agent's recommendation assumes that the firm, at least, has checked. So the firm must have done so. The warning signs (red flags) the firm cannot ignore: promised returns far above the market, unaudited financial statements, an officer who has already been sanctioned, a vague use of proceeds.

Chapter quiz

Remedies and Powers of the Administrator

What the regulator can do, what it cannot do, what a person who violates the Act risks, and what the client can recover.

Three paths for the same misconduct

A law is worth only what happens to those who violate it. The Uniform Securities Act provides three responses, which pursue three different purposes and can all apply to the same facts. Nearly every question in this chapter asks you, at bottom, not to attribute to one what belongs to another.

An agent who sells an unregistered security while lying about its risks can thus, for that single sale, lose his or her registration (administrative), have to repay the client (civil), and be convicted (criminal). The Administrator acts directly only on the first path. On the other two, the Administrator can help (go to court, refer a case to the prosecutor), but does not decide.

A little procedural vocabulary. An order is a decision directed at a specific person. A hearing is a proceeding at which the person concerned can present a defense. A subpoena is a compulsory demand to testify or to produce documents. An injunction is an order from a court to do or not to do something, and violating it is punished as contempt of court (contempt). A receiver is a person appointed by the court to take control of the defendant's assets. Rescission undoes the sale: each side gives back what it received. Restitution returns to the victims what they lost; disgorgement takes away from the wrongdoer the profit made from the violation.

Antifraud: the rule with no exception

This is the heart of the Act, and its broadest provision. Registration has dozens of exclusions and exemptions; antifraud has none. The reason is easy to see: one can accept that a bank or a Treasury security does not need to be registered; one cannot accept that anyone has the right to lie.

• USA § 101: it is unlawful for any person, in connection with the offer, sale, or purchase of any security, to employ a scheme to defraud, to make an untrue statement of a material fact or to omit a material fact necessary to keep what was said from being misleading, or to engage in a practice that operates as a fraud. No exemption: exempt securities, exempt transactions, federal covered securities, unregistered persons, everything is covered. The buyer who deceives a seller is covered just like the seller who deceives a buyer.
• USA § 102: same prohibition for anyone who is compensated for giving advice about securities, including persons excluded from the definition of investment adviser and federal covered advisers.
• Fraud, deceit, defraud are not limited to common-law deceit (§ 401(d)): there is no need to prove intent to harm or a loss.

Three concepts to master. A material fact is a fact that a reasonable investor would consider important in making a decision: the issuer's financial condition, a lawsuit, an unusual commission, the fact that the firm is selling from its own inventory. The color of the issuer's offices is not one. An omission is silence about such a fact, when that silence makes what was said misleading: the half-truth is fraud. Finally, fraud within the meaning of this Act requires neither intent to harm nor that the victim lost money: a false statement made without checking is enough.

What the Administrator can do

The Administrator combines three functions that are kept separate elsewhere: writing rules, investigating, and judging the misconduct of the professionals he or she has registered. The Administrator's powers are broad as long as they remain in the administrative sphere. They stop where the powers of the courts begin: compelling by force, punishing, awarding compensation.

• Make, amend, and rescind rules, forms, and orders (§ 412). A rule is general; an order is directed at specific persons. The Administrator cannot change the Act itself. Rules are published.
• Conduct investigations, public or private, inside and outside the state, and publish information about violations (§ 407).
• Issue subpoenas, take testimony under oath, require documents, including at the request of another state's Administrator.
• Issue a cease and desist order, with or without a prior hearing (§ 408).
• Deny, suspend, revoke a registration; bar, censure, restrict, or limit the activities of a registrant (§ 204).
• Go to court to obtain an injunction, the appointment of a receiver or conservator, and orders of rescission, restitution, or disgorgement. The court cannot require the Administrator to post a bond.
• Issue interpretive opinions and no-action determinations, for a fee (§ 413).
• Refer evidence of a violation to the prosecutor for criminal prosecution (§ 409).
• Cooperate with other states, the SEC, the CFTC, SIPC, and the SROs (§ 420).

What the Administrator cannot do: arrest someone, impose a prison sentence, issue an injunction himself or herself, award damages to a client. The Administrator and his or her staff cannot use for their own benefit nonpublic information obtained in the course of their duties (§ 406).

Other administrative rules: hearings are public, unless all the parties concerned request a private hearing; the Administrator keeps a public register of applications, registrations, and orders; a document is "filed" when the Administrator receives it; no one is liable for an act done in good faith in conformity with a rule or order, even if it is later rescinded (§ 412(e)).

Deny, suspend, revoke (§ 204)

Two conditions are required: the order must be in the public interest, and there must be a ground provided by the statute, concerning the applicant or, for a firm, one of its partners, officers, directors, or controlling persons:

• application for registration false or incomplete in a material respect;
• willful (willful) violation of the state Act, a rule, or an order, or of the federal securities laws;
• conviction within the past 10 years of a securities-related misdemeanor or one involving the securities business, or of any felony;
• court injunction in effect relating to the securities business;
• denial, suspension, or revocation order of an Administrator; decision of another regulator within the past 10 years; sanction by a foreign regulator within the past 5 years;
• dishonest or unethical practices in the securities business;
• insolvency;
• lack of qualification (training, experience, knowledge);
• failure to reasonably supervise;
• unpaid fee (denial only, vacated as soon as the fee is paid).

Procedure. Before a final order, the person concerned (and the employer, if the person is an agent or IAR) is entitled to: prior notice, an opportunity for a hearing, and written findings of fact and conclusions of law. The Administrator may suspend summarily in the meantime; if a hearing is requested in writing, it is held within 15 days. Appeal to a court: within 60 days, and the appeal does not stay the order, unless the court so decides (§ 411). The person who brings the appeal is the person harmed by the order (aggrieved); the suspension of the order, if granted, is called a stay. The court may affirm, modify, or set aside the order, in whole or in part; the Administrator's findings of fact are binding on the court if they are supported by sufficient evidence (competent, material and substantial evidence).

The two conditions are cumulative, and the exam likes to separate them. A statutory ground without the public interest is not enough; neither is the public interest without a ground from the list. The Administrator therefore cannot deny an applicant because he or she finds the applicant unpleasant, or because the local market already has too many agents. And the procedure protects the person concerned: taking away someone's profession is serious, so the law requires that the person be notified, heard, and given the reasons for the decision in writing. The only departure is the summary suspension, which responds to urgency; it is offset by the right to a prompt hearing.

Five words not to confuse

To tell them apart, ask two questions. Who takes the initiative? If it is the registrant, it is a withdrawal. Is there any wrongdoing alleged? If there is none, it is a cancellation: the Administrator is updating the records, nothing more. If there is, it is a sanction: denial if the registration has not yet been granted, suspension if it is taken away for a time, revocation if it is taken away for good. The distinction has lasting consequences: a revocation must be disclosed on all future forms and is a ground for denial in other states; a cancellation leaves no mark.

Criminal and civil penalties

The two columns of the table below do not answer the same question. The criminal side asks: does this person deserve to be punished? It therefore requires that the person acted willfully, and the penalty is imposed by a judge. The civil side asks: should this investor get the money back? For that, it is enough that the sale was unlawful or misleading, even through mere negligence on the seller's part.

• A person who proves that he or she had no knowledge of the rule or order violated cannot be imprisoned, but can be fined. Ignorance of the Act itself is no excuse.
• A buyer who no longer owns the security recovers damages: what the buyer would have recovered, less the value of the security when it was resold, with interest.
• The seller escapes liability for a misstatement by proving that he or she did not know of the untruth and could not have known of it with reasonable care; a buyer who knew the truth cannot sue.
• Joint and several liability (§ 410(c)): every person who controls the liable seller, its partners, officers, and directors, its employees who materially aid in the sale, and every BD or agent who materially aids in it, unless they prove they did not know of the facts through no fault of their own. Those who are jointly liable have a right of contribution among themselves.
• For unlawful or fraudulent advice: refund of the fees + losses caused by the advice + interest + costs, less income received from the advice.
• The cause of action survives the death of the plaintiff as well as of the defendant.
• A person who made a contract in violation of the Act cannot sue to enforce it.
• A provision by which the client waives rights under the Act (waiver) is void.
• These remedies are in addition to those available under general law; the Act provides for neither punitive nor multiple damages.

Joint and several liability (joint and several liability) means that the client can claim the entire amount from any one of the liable persons: from the agent, from the firm, from the executive who controls it. The one who paid then turns to the others for their share (this is contribution). For the client, the benefit is obvious: the agent at fault is often insolvent, the firm is not.

The rescission offer is the way for a seller who realizes the mistake to settle the problem before a lawsuit. The law encourages it, because the investor is repaid quickly and without cost. In exchange, it gives the seller certainty: after 30 days, the seller knows where things stand. The difference between the two cases comes down to what the buyer can still do. If the buyer has the security, a true unwinding of the sale is on offer: the buyer has only to accept, and silence counts as giving up the claim. If the buyer no longer has it, a sum of money is on offer: the buyer must say no in writing to keep the right to dispute the amount before a judge.

Federal remedies and arbitration

• SEC Rule 10b-5: general prohibition of fraud in the purchase and sale of securities; it is the basis for SEC actions and for a private action by investors. USA § 101 is its copy at the state level.
• Securities Act § 11 and § 12: liability for an inaccurate registration statement or prospectus.
• Insider trading: civil penalty of up to three times the profit; federal criminal penalties (Chapter 9).
• FINRA arbitration: account agreements generally contain an arbitration clause; the award is final and binding, with very limited judicial review.

These federal remedies exist alongside the state remedies: the same lie violates both USA § 101 and Rule 10b-5, and both the SEC and the Administrator can act. Arbitration is a private form of dispute resolution: instead of going to court, the client and the firm submit their dispute to arbitrators, under a procedure run by FINRA. The client agreed to this by signing the account agreement. Remember the link with what came before: an arbitration clause changes the forum where the dispute is decided; it does not take away the rights the law gives the client; a clause that made the client waive those rights would be void.

SIPC

The last safety net concerns neither fraud nor sanctions, but a simpler risk: that the broker-dealer holding your securities goes bankrupt and they are no longer there. SIPC was created by a 1970 federal statute (the Securities Investor Protection Act) so that the failure of a firm would not ruin its customers. Its role is to return to the customer what was in the account, up to a limit, not to protect the customer against a bad investment.

The Securities Investor Protection Corporation is a nonprofit organization, funded by its members, the registered broker-dealers. It steps in when a member BD fails and customers' securities or cash are missing.

• Limit: $500,000 per separate customer, of which no more than $250,000 for cash.
• Separate capacity: an individual account, a joint account, an IRA, a Roth IRA, a trust account are covered separately. Two accounts held in the same capacity (a cash account and a margin account in the same name) are combined.
• Covered: stocks, bonds, fund shares (money market funds count as securities), cash held for the purchase of securities.
• Not covered: the decline in value of securities, bad advice, fraud by an issuer, commodity futures contracts, currencies, unregistered investment contracts.
• A trustee liquidates the firm; positions are valued as of the filing date of the proceeding; securities are returned when possible.
• SIPC is not the FDIC: the FDIC insures bank deposits; SIPC does not guarantee the value of any security. An agent cannot say that an account is "insured against losses."

The calculation method takes three steps: (1) combine the accounts held in the same capacity; (2) for each group, cap the cash at $250,000; (3) add the securities and the cash allowed, and cap the total at $500,000.

Chapter quiz

Communication with Customers and Prospects

Everything you say, write, publish, have signed, keep on file, or leave out. The general rule: never mislead anyone about a material fact, meaning a fact that a reasonable investor would consider important. This section also covers customer agreements (new account, margin, options), books and records, and privacy.

Why what an agent says is regulated

A security cannot be seen or tried out. The customer cannot judge a stock or a bond for himself the way he would judge a car: he buys what he is told about it. In this business, information is the product. That is why one fifth of the exam deals with communication, and why the rules are so detailed. Yet they boil down to four ideas, which organize the whole chapter:

1. Say nothing false or misleading, including by omission (prohibited statements, content standards for advertising).
2. Say what must be said, at the right time and in the right form (confirmation, prospectus, risk disclosure documents for options and margin, the adviser's brochure).
3. Have the firm review whatever goes to the public (approval by a principal, supervision of correspondence).
4. Keep a record of everything (books and records, message archiving) and protect what the customer has entrusted to you (privacy).

Most questions describe a sentence spoken by an agent, a message sent, or a document delivered, and ask whether it is permitted. When you are unsure, apply these four ideas in order: is it accurate and complete? Did the customer receive the required document? Did a principal approve it if approval was needed? Does the firm have a copy?

Prohibited statements

Three of these prohibitions are named in the exam outline: false claims about registration, performance guarantees, and more broadly anything that misleads about the product.

• Saying that the registration of a security or of a professional, or an exemption, means that the Administrator has approved it, recommended it, or passed on its merits (USA § 405). You may say you are "registered," never "approved."
• Guaranteeing a return or the absence of loss. A security may be called "guaranteed" only if a third party guarantees payment of principal, interest, or dividends (§ 401(e)).
• Promising that a security will be listed on an exchange with no real basis.
• Omitting a material fact, or presenting a half-truth.
• Giving fictitious quotations or prices that are not bona fide.
• Presenting projections as facts, hiding the risks, using a presentation based on conjecture.
• Making a false statement in a document filed with the Administrator (§ 404).

These rules apply to oral and written statements alike, and to any security, exempt or not. A disclaimer does not cure a misleading statement.

Why "registered" but never "approved." Registration is a check of form: the file is complete, the fees are paid, nothing stands in the way. The Administrator has not verified that the security is a good investment, or that the agent is competent or honest. If an agent could say "the state has approved me," the customer would believe there was an official endorsement and would lower his guard. The law therefore prohibits any statement that turns registration into a seal of quality. Saying "I am registered in this state" is an accurate fact, and permitted. Saying "I am registered, so the state vouches for my reliability" is illegal, even if the registration is in fact in effect.

Why no guarantees. No one can guarantee the price of a security. Anyone who promises it is lying, or else is committing to reimburse the customer out of his own pocket, which is another violation. The word guaranteed does, however, have a legitimate and narrow use: when a person other than the issuer has undertaken to pay the principal, interest, or dividends if the issuer does not. A subsidiary's bond guaranteed by its parent company is a "guaranteed bond." The guarantee covers the payments, not the market price of the security, and the agent must say so.

Filing of sales literature (USA § 403)

The Administrator may require, by rule or order, the filing of any prospectus, pamphlet, circular, form letter, advertisement, or other sales literature intended for prospective investors, including clients of an adviser, unless the security or transaction is exempt (§ 402) or the security is federal covered.

In other words, the state may ask to see advertising before it circulates, for the securities it registers. For exempt securities and federal covered securities, it cannot require this. In every case, misleading advertising remains fraud: the fact that no filing was required does not protect its author.

Required disclosures

Not lying is not enough: some information must be given without the customer having to ask for it. It answers questions he would not think to ask. How much did I pay, and to whom? Was my firm my intermediary or my seller? Does it have an interest in this security? The exam outline calls these required product disclosures.

• Confirmation (SEC Rule 10b-10), no later than completion of the transaction (at or before completion, meaning payment and delivery): date, security, quantity, price, capacity (the firm acted as agent, paid by a commission, or as principal, paid by a markup or markdown), and the amount of the commission in an agency trade.
• Account statements (FINRA Rule 2231): at least once every calendar quarter for any account with a position, a balance, or activity.
• Conflicts of interest: the firm is a market maker, holds the security, is participating in the distribution, or is linked to the issuer by a control relationship. To be disclosed before the transaction; if the disclosure is oral, it is supplemented in writing at or before completion of the transaction.
• Fees: any service charge must be reasonable and disclosed.
• Prospectus: delivered no later than the date the confirmation of a new issue is sent.
• New or complex products: features, costs, and risks presented in a fair and balanced way.
• Performance: no projections; return shown net of fees and accompanied by standardized total return for funds.
• Holding of mail (FINRA Rule 3150): only on the customer's written instructions stating the time period; beyond 3 consecutive months, an acceptable reason (safety or security) is required. Confirmations and statements are never held at the agent's initiative.

The confirmation is the trade notice: the document sent after each transaction, which sets out its terms. The account statement (or simply statement) periodically summarizes positions and activity. These two documents are the customer's main way of checking what is happening in his account; an agent who intercepts them, has them sent to his own address, or "holds them for the customer" deprives the customer of that check, and this is often the sign of a fraud.

Opening an account: FINRA Rule 4512

The exam outline places account opening among the customer agreements, along with margin and options. There are two reasons for all this information. The firm must know who it is dealing with (identity, legal age, capacity to contract), and it must know enough for its recommendations to be suitable for the customer (chapter 9). The new account form is completed by the agent with the customer, then accepted by a principal, who commits the firm.

The main types of accounts: the cash account, where the customer pays for each purchase in full; the margin account, where the firm lends him part of the price; the individual account, with a single owner; the joint account, with several owners, each of whom may give orders; the custodial account, held by an adult for a minor; the discretionary account, where the customer has authorized someone in writing to make decisions for him.

• To be kept for each account: the customer's name and residence; whether the customer is of legal age; the associated person responsible for the account; the signature of the partner, officer, or manager who accepts the account; for an entity, the persons authorized to act.
• For a non-institutional account, reasonable efforts to obtain, before settlement of the first transaction: tax identification number or Social Security number, occupation and employer, and whether the customer is an associated person of another member.
• Trusted contact person: the firm makes reasonable efforts to obtain the name and contact information of a trusted person age 18 or older. The absence of one does not prevent the account from being opened. The firm informs the customer in writing that it may contact that person and disclose information to him or her to address possible financial exploitation, or to confirm the customer's contact information, health status, or the identity of a guardian, executor, trustee, or holder of a power of attorney. The trusted contact has no authority over the account.
• Discretionary account: the firm keeps the dated signature of each associated person authorized to exercise discretion.

The trusted contact is a recent invention, tied to the aging of customers. When the firm suspects that an elderly customer is being manipulated, or can no longer reach him, it needs someone to call. But its duty of confidentiality in principle forbids it from discussing the account with a third party. The rule solves the problem in advance: at account opening, the customer is asked to name a person the firm may contact in those situations. That person cannot place orders, withdraw money, or view the account: he or she is only someone to talk to.

Broker-dealer books and records: SEC Rules 17a-3 and 17a-4

A regulator who walks into a firm can reconstruct what happened only from the documents. The firm must therefore record everything as it happens, and keep it. The logic behind the retention periods: what describes the accounting and the accounts (who owns what, what came in and went out) is kept the longest, 6 years; what describes day-to-day dealings (orders, confirmations, messages, advertising) is kept 3 years; what describes the very existence of the firm is kept as long as the firm exists. In every case, for the first 2 years, the documents must be immediately available.

Rule 17a-3 says which records to make; Rule 17a-4 says how long to keep them. NASAA has no model rule on this subject: federal law prohibits the states from requiring more.

• Account record (Rule 17a-3(a)(17)): a copy sent to the customer within 30 days of account opening, then at least every 36 months, and within 30 days of a change.
• Electronic storage: non-rewriteable, non-erasable format (WORM), or a system that keeps a complete time-stamped audit trail.
• On the USA side (§ 203): the Administrator may require records within the federal limit and examine them at any time.

A few terms. A blotter is the chronological record of all of the day's transactions. A ledger is a book of accounts: the firm's general ledger, or each customer's account. An order memorandum (or order ticket) is the record of each order: security, quantity, buy or sell, time of receipt and of execution, and whether the order was solicited or discretionary. An agent who marked "unsolicited" on an order he had recommended would be falsifying a record of the firm.

Communications with the public: FINRA Rule 2210

The exam outline calls this part correspondence and advertising. FINRA classifies every written communication by its audience, and the level of review follows the risk: the more retail investors a message reaches, the more it must be reviewed before it goes out. A message to a few customers is reviewed afterward, by sampling. A mass message is approved beforehand. A message limited to professionals falls under internal procedures. Note that the rule covers only written material, on paper or electronic: a telephone conversation is not a "communication" within the meaning of Rule 2210, even though everything the agent says in it remains subject to the antifraud provisions.

• Content standards, for all categories: fair dealing and good faith; a fair and balanced presentation that gives a sound basis for evaluating the facts; no omission that makes the message misleading; no false, exaggerated, or promissory claims; no prediction or projection of performance (a hypothetical illustration of mathematical principles is permitted).
• Testimonials: disclose that they may not be representative, that they guarantee nothing, and that they are paid if the value given exceeds $100.
• Filing with FINRA: during a new member's first year, at least 10 business days before first use; for retail communications about funds, within 10 business days after first use.
• Retention: 3 years, with the name of the principal who approved and the date.
• Each of the firm's websites carries a prominent link to BrokerCheck.

Social media, email, messaging

• It is the content that counts, not the device or the account: a business message is a communication of the firm, to be supervised and archived (Rule 17a-4), even when sent from a personal phone.
• Static content (a profile, a page, a post that stays up): retail communication, so prior approval by a principal.
• Interactive content in real time (forum exchanges, comments): no prior approval, but supervision like correspondence.
• Third-party content: the firm is responsible for it if it took part in preparing it (entanglement) or if it approved or endorsed it, for example by liking or sharing it (adoption).
• Using an application or account that is not approved and not archived to discuss business is a violation, whatever the content.
• A recommendation posted on social media remains subject to suitability and to Regulation Best Interest.

The rules were not rewritten for the internet: FINRA applies the existing categories to the new tools. The useful distinction is between static and interactive. A profile page or a post that stays online resembles an advertisement: there is time to have it approved beforehand. A live exchange resembles a conversation: prior approval is impossible, so the firm reviews afterward. In both cases, the firm must be able to archive: that is why messaging apps it cannot record are prohibited for business, even if the customer prefers them.

Options: rights, obligations, and valuation

The exam outline includes options under two headings: the options account agreement (a customer agreement) and options valuation. So you need to understand the product before its rules. The calculations are simple once you have the mechanics down, and they are sure points.

What an option is

An option is a contract between two people on a stock (the underlying). The buyer pays a sum, the premium (the option's price), and receives in exchange a right: the right to buy or sell the stock at a price agreed in advance, the strike price (also called the exercise price), up to a deadline, the expiration. The seller collects the premium and accepts the corresponding obligation: if the buyer exercises the right, the seller must perform. The buyer is never required to exercise: if the trade is not favorable to him, he lets the option expire and loses only the premium.

• A call gives the right to buy. You buy one when you think the stock will go up: you will be able to buy it at the strike, cheaper than the market.
• A put gives the right to sell. You buy one when you think the stock will go down: you will be able to sell it at the strike, higher than the market. You also buy one to protect stock you own.
• The buyer is called the holder or is said to be long; the seller, the writer or short. To exercise is to use your right; to be assigned is, for the seller, to be designated to perform.
• An option is read like this: "1 XYZ October 50 call at 3" = one contract, on XYZ stock, expiring in October, strike 50, a call, premium of 3 dollars per share. Because the contract covers 100 shares, it costs 3 × 100 = $300.

Why sell an option, since you take on an obligation? To collect the premium. The seller is betting that the option will not be exercised: if he is right, he keeps the premium without delivering anything. If he is wrong, his loss can be far greater than the premium, which explains the special rules on uncovered writing. A call is covered when the seller owns the shares he would have to deliver; it is uncovered (or naked) when he does not own them and would have to buy them at the market price, whatever it is.

• One contract covers 100 shares. The premium is quoted per share: a premium of 3 costs $300.
• Premium = intrinsic value + time value. Intrinsic value is the amount by which the option is in the money; time value depends on the time remaining, volatility, and interest rates, and falls to zero at expiration.
• Direction of the effects on time value: more time remaining or more volatility, higher premium, for calls and puts alike; time value erodes as expiration approaches (time decay); an option that is out of the money or at the money has only time value. Intrinsic value is never negative.
• Call in the money: market price > strike. Put in the money: market price < strike. At the money: market price = strike. Otherwise out of the money: zero intrinsic value.
• Breakeven at expiration: call = strike + premium; put = strike − premium (for the buyer and the seller alike).
• Covered call (stock owned + call sold): max gain = (strike − purchase price) + premium; breakeven = purchase price − premium.
• Protective put (stock owned + put bought): max loss = (purchase price − strike) + premium; breakeven = purchase price + premium.

To understand where these formulas come from, follow a position to expiration while varying the stock price. The method is always the same: (1) what is the right worth at expiration? (2) subtract or add the premium; (3) multiply by 100.

The options account: FINRA Rule 2360

• Options Disclosure Document (ODD, "Characteristics and Risks of Standardized Options"): delivered at or before the time the account is approved for options.
• Due diligence on the customer (objectives, employment, income, net worth, liquid net worth, marital status, age, experience), then written approval by a Registered Options Principal (or a qualified principal) before the first order.
• Within 15 days after approval: the information collected is sent to the customer for verification, and the firm obtains the signed options agreement, in which the customer agrees to abide by the rules and by the position and exercise limits.
• Position and exercise limits: the maximum number of contracts on the same side of the market (long calls + short puts, or long puts + short calls) on the same underlying.
• Uncovered option writing requires specific procedures and approval, and a special risk disclosure statement.
• The Options Clearing Corporation (OCC) issues and guarantees listed options; on exercise, it assigns a member firm that is short, which in turn assigns one of its customers by a fair method.

Options are a leveraged product, in which you can lose your entire stake in a few weeks, and more if you write uncovered. An ordinary account therefore does not allow options trading: a separate approval is required, preceded by a risk document and followed by a signed agreement. The order of the steps is what the exam tests.

Margin: Regulation T and FINRA Rule 4210

Buying on margin means buying securities with money borrowed from your broker-dealer. The customer puts up part of the price; the firm lends the rest and holds the securities as collateral. The loan bears interest. The appeal is leverage: with $10,000, the customer controls $20,000 of stock, and his gains and his losses alike are doubled. If the stock rises 20%, to $24,000, he gains $4,000 on a stake of $10,000, or 40%. If it falls 20%, to $16,000, he loses 40% of his stake, and he still owes the firm $10,000.

Three levels of rules are stacked on top of one another, and the exam asks you to know who sets what:

Three terms to know. The debit balance is what the customer owes the firm. Equity is what truly belongs to the customer: the value of the securities minus his debt. A margin call is the firm's demand that the customer restore the equity when it has fallen too low, by depositing funds or securities; if the customer does not, the firm sells.

• Regulation T (Federal Reserve Board): initial deposit of 50% for the purchase of marginable stock. Payment is due within a payment period: the standard settlement cycle plus 2 business days. Otherwise, the position is liquidated and the account is frozen for 90 days.
• FINRA Rule 4210: minimum equity of $2,000 to buy on margin (or the full purchase price if it is less); maintenance margin of 25% of market value for long positions, 30% for short positions. Firms often set higher "house" requirements.
• Equity (long account) = market value − debit balance. The debit does not move when the price falls; it is the equity that absorbs the loss.
• Maintenance call threshold (long account) = debit balance ÷ 0.75.
• Short account (short sale): equity = credit balance − market value of the securities sold short. The credit balance (sale proceeds + deposit) does not move; equity falls when the price rises. Maintenance call threshold (30%) = credit balance ÷ 1.30: above that market value, equity drops below 30%.
• Documents: credit agreement (terms of the loan) and hypothecation agreement (the securities serve as collateral), both mandatory; loan consent (lending the securities to third parties), optional. NASAA requires the written margin agreement promptly after the first transaction.
• Margin disclosure statement (FINRA Rule 2264), delivered no later than account opening: you can lose more than your deposit; the firm can sell the securities without notice; the customer does not choose which securities are sold; the firm can raise its requirements without notice; no extension of time is owed.
• The firm may not re-pledge (rehypothecate) more than 140% of the customer's debit balance; the excess must be segregated.
• Not marginable at purchase: options (premium paid in full), new issues for 30 days.

Selling short (a short sale) is the opposite bet. The customer thinks a stock will fall: he borrows it through his firm, sells it right away, and will have to buy it back later to return it. If the price has fallen, he buys it back for less and keeps the difference. If the price has risen, he buys it back for more and loses, without limit since a price can rise indefinitely. A short sale is always made in a margin account. The sale proceeds stay locked up at the firm, together with the customer's deposit: this is the credit balance, which does not move. What moves is the cost of buying the stock back.

Two more concepts from the list. Hypothecation is the pledge: the customer gives his securities as collateral for the loan, through the agreement he signs. Rehypothecation is the firm, in turn, pledging those securities to a bank to finance the loan it is making. The 140% limit prevents the firm from pledging more of the customer's securities than necessary: for a debit of $12,000, it may rehypothecate at most 12,000 × 1.40 = $16,800 of securities; the rest is set aside. As for the payment deadline: since May 2024, stock trades settle on the next business day (T+1); a purchase made on a Monday must therefore be paid for no later than Thursday, that is, T+3.

Privacy: SEC Regulation S-P

To open an account, the customer has handed over his most sensitive information: his identity, his Social Security number, his income, his net worth. Regulation S-P (the "P" stands for privacy) governs what the firm does with that data, around three obligations: tell the customer what it does with it (the notices), let him refuse to have it passed on to outside third parties (the opt-out), and protect it against theft, from collection through disposal. An affiliate is a company in the same corporate group; a nonaffiliated third party is an outside company, for example a loan broker or a marketing company.

• Nonpublic personal information: financial information that can identify a person (balances, transactions, account number, customer lists), excluding what is publicly available.
• Consumer: an individual who obtains a financial product or service for personal purposes. Customer: a consumer with whom the relationship is ongoing.
• Initial notice (the initial privacy notice) to the customer, no later than when the relationship is established; annual notice during the relationship, with an exception when the firm shares only in the permitted cases and has not changed its practices.
• Opt-out: before sharing with an outside company (a nonaffiliated third party), the firm gives notice and a reasonable period in which to refuse (the rule's example: 30 days). Exceptions: carrying out a requested transaction, service providers under a confidentiality agreement, legal obligations and regulators.
• Safeguards rule: written policies that include administrative, technical, and physical safeguards.
• Disposal rule: disposal of information by means that prevent any unauthorized access.
• 2024 amendments: a written program for responding to incidents (incident response), and notification of individuals whose sensitive information was, or is reasonably likely to have been, accessed without authorization, as soon as practicable and no later than 30 days after becoming aware of it. Service providers notify the firm within 72 hours.

Investment adviser communications

The adviser has its own disclosure obligations, heavier than the broker-dealer's because it is a fiduciary. The client must know before committing who the firm is, what it charges, and where its conflicts of interest lie: that is the purpose of the brochure. The 48-hour rule gives the client time to read it; the 5-day alternative gives the client the right to change his mind after reading it.

Brochure rule

• The IA delivers Form ADV Part 2 at least 48 hours before the contract is signed, or at signing if the client can terminate without penalty within 5 business days.
• Update delivered or offered each year, within 120 days after the end of the fiscal year.
• Not required for clients that are investment companies, or for impersonal advice costing less than $500 per year.

Performance fees

A fee tied to gains puts the adviser in the position of a gambler betting someone else's money: if the bet pays off, he takes his share; if it fails, only the client loses. He is therefore tempted to take too much risk. The law prohibits this form of compensation for the ordinary client, and allows it only for clients wealthy enough to understand the incentive and bear the loss.

• Compensation based on a share of capital gains is prohibited (USA § 102(c)), except for qualified clients (Advisers Act Rule 205-3).
• Thresholds in effect since June 29, 2026: at least $1.4M under the adviser's management, or a net worth of more than $2.7M, excluding the primary residence. Previous thresholds (2021 to 2026): $1.1M and $2.2M. The SEC adjusts them every five years; an exam question may still cite the old ones. Above all, remember the principle.
• A fee that is a percentage of assets under management, or that is based on the average value of the account over a period, is not a performance fee.

Adviser advertising

• No misleading testimonials, no cherry-picking of only the winning recommendations (a complete list covering at least one year is permitted, with a disclaimer), no tool presented as infallible, no "free" service that is not actually free, no reference to approval by the Administrator.

Chapter quiz

Ethical practices and obligations

Fifteen questions, the largest section. Most describe a situation and ask whether it is permitted. Learn the exact conditions that make each practice acceptable, and the source of each rule: state (NASAA) or federal (SEC, FINRA).

What "ethics" means here

The word does not refer to morality in general. It refers to a specific list of behaviors that, once established, allow the Administrator to suspend or revoke a registration on the ground of "dishonest or unethical practices" (USA § 204). The agent is in a permanent position of conflict: he is paid when the customer buys or sells, he has access to the customer's money and information, and he knows more than the customer does. Each rule in this chapter closes off one of the ways to abuse that position. The exam outline sorts them into three families, which the chapter follows:

1. Compensation: fees, commissions, markups, and their disclosure. The agent must neither overcharge nor hide what he earns.
2. Customer funds and securities: custody, discretion, authorizations, standard of care. The agent must neither help himself to the customer's assets nor decide for the customer without being authorized to.
3. Conflicts of interest and unlawful activities: excessive trading, loans, sharing in profits, insider trading, selling away, manipulation, outside accounts, exploitation of vulnerable persons.

For each practice, ask three questions. Is it always prohibited (guaranteeing against loss, manipulating a price)? Is it permitted on a condition, and exactly which one (a writing? from whom? before or after?)? Or does it simply have to be disclosed? Most wrong answers on the exam offer the right practice with the wrong condition: oral consent instead of written, the customer's consent without the firm's, notice after the fact instead of before.

Regulation Best Interest (SEC Rule 15l-1)

This is the standard of care, the level of conduct a broker-dealer owes to retail customers, in effect since 2020. Before it, a recommendation only had to be suitable, meaning appropriate for the customer. Between two suitable products, the agent could therefore pick the one that paid him more. Reg BI closed that gap: the recommendation must be in the customer's best interest, and the agent cannot put his compensation first. It does not go as far as the adviser's fiduciary duty: it applies at the time of the recommendation, with no obligation to monitor the account afterward, and it accepts that the agent is paid by commission.

When a broker-dealer or its agent recommends to a retail customer a transaction, a strategy, or a type of account (including a rollover, the transfer of an employer retirement plan into an IRA), it must act in the customer's best interest at the time of the recommendation, without placing its financial or other interest ahead of the customer's. A retail customer is a natural person (or that person's legal representative) who uses the recommendation for personal, family, or household purposes.

• Form CRS (relationship summary): a short summary delivered to retail customers no later than the first recommendation, the first order, or the opening of the account: services, fees, conflicts, standard of conduct, disciplinary history.
• A BD that is not also an investment adviser, and its agents, must not hold themselves out under the title "adviser" or "advisor": this is presumed to violate the obligation to disclose their capacity.
• Reg BI creates no obligation of ongoing monitoring of the account and does not apply to institutional customers.

Suitability: FINRA Rule 2111

Suitability remains the standard for customers who are not retail customers, and its three-tier logic also structures the care obligation of Reg BI. Each tier answers a question: is this product suitable for anyone? Is it suitable for this customer? And are the transactions, taken together, suitable for this customer?

• Reasonable-basis: after reasonable diligence, understand the product and believe it is suitable for at least some investors. Recommending a product you do not understand already violates the rule.
• Customer-specific: a blanket recommendation, the same recommendation sent to every customer without regard to their situation, violates this obligation. The firm must believe that the recommendation is suitable for this customer, given the customer's investment profile: age, other investments, financial situation and needs, tax status, objectives, experience, time horizon (how long before the customer needs the money), liquidity needs (what the customer must be able to turn into cash quickly), and risk tolerance.
• Quantitative: a series of transactions, even if each is suitable on its own, must not be excessive. Indicators: turnover rate, cost-equity ratio, in-and-out trading.
• Institutional customer: the customer-specific obligation is satisfied if the firm reasonably believes the customer can evaluate the risks independently and the customer states that it is exercising independent judgment.
• At the state level (NASAA 1983): recommending without reasonable grounds, after reasonable inquiry into the customer's objectives, financial situation, and needs, is a dishonest practice.

Two clarifications. In-and-out trading means buying a security and quickly selling it, then reinvesting the proceeds in another security, and so on: it is the usual signature of churning. And the customer's consent does not protect the agent: a customer who "approved" each trade on the agent's recommendation may still have been the victim of excessive trading.

Prices and commissions: FINRA Rule 2121

This is the first family in the exam outline: compensation. A broker-dealer is paid in two ways depending on its role (chapter 2): a commission when it acts as agent, a markup (on a sale) or a markdown (on a purchase) when it acts as principal. In both cases, the rule is the same: the price must be fair. The commission is visible on the confirmation. The markup, by contrast, is buried in the price: that is where the risk of abuse is greatest, hence a dedicated policy.

• The price of a principal transaction must be reasonably related to the prevailing market price; the commission on an agency transaction must be reasonable.
• The 5% policy is a guide, not a rule: a markup of 5% or less may be unfair, and a higher markup may be justified.
• The markup is measured from the market price; absent other evidence, the dealer's contemporaneous cost is the best indication of it.
• Relevant factors: type of security, availability in the market, price of the security, amount of the transaction, disclosure, the firm's usual pattern of markups, the nature of its business. Disclosure alone does not justify an excessive price.
• The policy does not apply to securities sold at the public offering price of a prospectus (new issues, fund shares).

The customer's account

Second family: what the agent may do in the account. The principle is that the account belongs to the customer and that each transaction comes from the customer's decision. The agent proposes, the customer decides. All the rules in this section organize the exceptions: when, and on what conditions, someone other than the customer may decide.

Discretion is the power to decide without consulting the customer before each order. You recognize it by the three "A"s: the agent chooses the Asset (which security), the Amount (how much), or the Action (buy or sell). If he chooses only the time or the price, while the customer has set the three A's, it is not discretion. A trading authorization (in everyday English, a power of attorney) is the document by which the customer authorizes a third party to place orders in the account: limited (orders only) or full (orders and withdrawals).

The customer's money and securities

The agent is within arm's reach of his customers' assets and has a relationship of trust with them: it is the ideal position from which to ask them for a favor, and that is why the law prohibits almost any mixing of his personal affairs with theirs. The logic common to this table: the customer's money and securities go to the firm, never to the agent; they stay separate from the firm's; and the agent has no personal financial interest in a customer's account, except with the written consent of the two parties who watch over it.

Vocabulary: commingling is mixing customers' assets with those of the firm or the agent in the same account or the same vault; fully paid securities are those the customer has paid for in full, which the firm may neither use nor pledge. A stock power is the signed document that allows ownership of a stock certificate to be transferred: an agent who holds one signed in blank can sell the customer's securities.

The 1983 NASAA list

Statement of Policy on Dishonest or Unethical Business Practices of Broker-Dealers and Agents. It underlies the "dishonest or unethical practices" ground for sanctions (USA § 204). In addition to the above, it covers, for the broker-dealer:

• a price not reasonably related to the market, or an unreasonable commission or profit;
• failing to deliver the prospectus no later than the date of the confirmation;
• unreasonable and inequitable service charges (transfer, safekeeping, collection);
• offering to buy or sell at a stated price without being prepared to do so;
• saying a security is offered "at the market" when no market exists other than the one made or controlled by the firm;
• any manipulation (see below);
• publishing a transaction or a quotation that is not bona fide;
• misleading advertising or sales presentations;
• failing to disclose that the firm controls the issuer, is controlled by it, or is under common control with it, before the transaction, in writing no later than the completion of the transaction (at or before completion);
• failing to make a bona fide public offering of all the securities allotted to it: keeping part of a hot issue for itself or for insiders (free-riding and withholding);
• failing to furnish information owed to the customer, or failing to respond to a written complaint.

For the agent, the list adds: borrowing from, lending to, or holding the assets of a customer; selling away (transactions not recorded on the books of the BD, without its prior written authorization); fictitious accounts; sharing in an account without both written authorizations; splitting commissions with a person who is not a registered agent of the same BD or of a BD under common control. The list is not exhaustive: forgery, embezzlement, nondisclosure, or any deceptive practice are also grounds.

Selling away deserves an explanation, because it is one of the most common violations in real life. An agent may sell securities only through his firm, which supervises the transaction and records it on its books. If he sells his customers, "on the side," an investment his firm knows nothing about (shares in a friend's company, a promissory note, a structured real estate investment), nobody is checking anything, and yet the customer believes he is dealing with a supervised professional. It does not matter that the agent is not paid, that the investment is honest, or that the customer is delighted: without the firm's prior written authorization, it is a violation.

Market manipulation

A market price is supposed to result from real buyers meeting real sellers. To manipulate is to fabricate a false picture of that meeting (volume that does not exist, demand that does not exist, a price that is not the market's) in order to lead others to buy or sell. What all the techniques in the table have in common is the intent to deceive about activity or price: the trades themselves may look ordinary.

The following are not manipulation: arbitrage, lawful short selling, a good-faith agency cross, and regulated stabilization during a public offering. Front running: trading for yourself or for the firm ahead of a large customer order you know about; prohibited.

Insider trading

The market rests on the idea that all investors have access to the same information at the same time. Someone who trades knowing a decisive fact that others do not know, and that he obtained through a position of trust, is stealing from his counterparties: they would not have sold, or not at that price, had they known. The rule is summed up as disclose or abstain: as long as the information is not public, you refrain from trading on it and from passing it on.

• Elements: information that is material (a reasonable investor would consider it important) and nonpublic (not yet disseminated to the market), used to trade or passed on in breach of a duty of trust.
• Those liable: the classic insider (officer, employee, outside adviser such as a lawyer or accountant); the tipper who passes the information on and the tippee who trades knowing where it came from; a person who misappropriates information entrusted to him (misappropriation theory), even with no connection to the issuer.
• Federal sanctions: a civil penalty of up to three times the profit gained or the loss avoided; criminally, up to 20 years in prison and a $5 million fine for an individual ($25 million for an entity). Investors who traded at the same time on the opposite side (contemporaneous traders) have a private right of action. A firm that failed to prevent the fraud may also be sanctioned.
• BDs and advisers must have written procedures to prevent the misuse of inside information: information barriers between departments; a restricted list, the list circulated within the firm of securities that no one may trade or recommend any longer; a watch list, the confidential list, known only to compliance, of securities whose trading is being monitored.
• Conduct expected of the agent: do not trade, do not pass it on, report to the supervisor or to compliance.

Fund shares: the 1997 NASAA list

Statement of Policy on Dishonest or Unethical Business Practices … in Connection with Investment Company Shares.

How a fund works, and what it costs

A mutual fund pools the money of thousands of investors and invests it in a professionally managed portfolio. Every evening, the value of the portfolio per share is calculated: this is the net asset value (NAV). The fund issues new shares on each purchase and buys them back on each sale (redemption), always at NAV. It is the product most widely sold to retail investors, and its difficulty lies in its charges, which take several forms:

• Sales load: the commission that compensates the seller. Paid at purchase, it is a front-end load: the price paid, the public offering price, is NAV plus the load. Paid at redemption if that occurs in the first few years, it is a back-end load or contingent deferred sales load (CDSC), which declines over time.
• 12b-1 fee: an annual charge taken from the fund's assets to pay for its distribution and marketing. The investor does not see it go by, but it reduces the return every year.
• Breakpoint: a dollar threshold at which the front-end load goes down.

The following are dishonest practices under the 1997 list:

• failing to disclose all sales charges, including asset-based charges and deferred sales charges;
• saying a fund is "no-load" if it has a front-end load, a contingent deferred sales load (CDSC), or 12b-1 and service fees that together exceed 0.25% of average net assets per year;
• failing to point out a breakpoint (a reduction of the load starting at a certain amount) or a letter of intent (a commitment to invest the amount over 13 months); rights of accumulation also allow the threshold to be reached by adding in holdings already owned; selling just below the threshold is a breakpoint sale;
• recommending a share class (A, B, C) without reasonable grounds to believe that its fee structure is suitable for the customer;
• having the customer hold several funds with similar objectives, or recommending a switch from one fund to another similar one, without justification in view of the charges;
• quoting the current yield without giving the average annual total return for 1, 5, and 10 years and explaining the difference;
• comparing a fund to a savings account or a CD (certificate of deposit, a bank time deposit) without stating that there is no FDIC insurance and what the differences in risk are;
• pointing to insurance or to the quality of the portfolio securities without explaining the other risks (interest rate, market, liquidity, currency);
• selling dividends: presenting a purchase just before the ex-dividend date as advantageous; or presenting a capital gains distribution as yield;
• projecting future performance, or relying on nonpublic information.

Delivering the prospectus is necessary, but it is not enough to prove that the customer was fully informed.

Protecting vulnerable adults

NASAA, Model Act to Protect Vulnerable Adults from Financial Exploitation (2016).

Older people hold a large share of savings and are the target of scams and abuse, often committed by someone close to them. The agent is well placed to notice: an unusual withdrawal, a new "friend" who speaks for the customer, a sudden change of beneficiary. In the past, he could do nothing: carrying out the instruction was his duty, and talking about the account to a third party breached confidentiality. The Model Act gives him three tools and protects him when he uses them in good faith: reporting (an obligation), notifying a third party (an option), and delaying the disbursement (an option for the firm). Financial exploitation covers wrongfully taking or using a person's funds, including by abusing a power of attorney or a guardianship.

• Eligible adult: a person age 65 or older, or an adult covered by the state's adult protective services statute.
• Qualified individual: an agent, an IAR, or a person serving in a supervisory, compliance, or legal capacity for a BD or an IA.
• Mandatory reporting: as soon as he reasonably believes that financial exploitation has occurred, has been attempted, or is being attempted, the qualified individual promptly notifies the Administrator and Adult Protective Services (APS).
• Third party: he may also notify a third party previously designated by the customer, unless that third party is himself suspected.
• Delay of disbursement: the firm may delay a disbursement if, after initiating an internal review, it reasonably believes that the disbursement would result in exploitation. It must then, within 2 business days, notify in writing all persons authorized on the account (except a suspect) and both agencies, then report on its review within 7 business days.
• Duration: 15 business days at most; extended to 25 business days in total if the Administrator or APS requests it; beyond that, by court order.
• Administrative and civil immunity for the report, the third-party notice, and the delay, if the person acted in good faith and with reasonable care. No criminal immunity.
• Records: the firm gives APS and law enforcement access to the relevant records.

Uniform Prudent Investor Act

A trust is property entrusted to a trustee, who manages it for beneficiaries. For a long time, the law judged the trustee investment by investment and imposed lists of "safe" securities: a single risky stock that fell exposed him to liability. This model law replaced that approach with modern portfolio theory: what matters is the balance of the whole, and a risky security can have its place in it if it is offset by the rest. An agent encounters it when his customer is a trustee.

A model law of the Uniform Law Commission, applicable to trustees and to fiduciaries who invest for others.

• Prudence is judged on the portfolio as a whole and the overall strategy, not security by security.
• The tradeoff between risk and return is central: objectives suited to the trust.
• The circumstances to consider, which the text lists: general economic conditions; the possible effect of inflation or deflation; the expected tax consequences of decisions; the role of each investment within the overall portfolio; the expected total return (income and appreciation of capital); the beneficiaries' other resources; needs for liquidity, regularity of income, and preservation or appreciation of capital; an asset's special relationship to the purposes of the trust or to a beneficiary. A question that offers these items expects "all of them."
• Diversifying is a duty, absent special circumstances.
• No type of investment is prohibited in itself; no more legal list (the old list of investments permitted to trustees).
• Delegation of management is permitted, with care in selecting the agent, defining the scope of the delegation, and monitoring it.
• Duties of loyalty, of impartiality among beneficiaries, and of keeping costs to what is reasonable. A fiduciary with special skills must use them.
• Compliance with the rule is judged at the time of the decision, not in hindsight based on results.

Soft dollars: Exchange Act § 28(e)

An adviser who manages accounts chooses the broker-dealer that executes his clients' orders, and it is the clients who pay the commissions. Some broker-dealers offer the adviser research services in exchange for that order flow. The adviser is therefore paying for his research with his clients' money: hence the name soft dollars, as opposed to the hard dollars he would pay out of his own funds. It is an obvious conflict of interest. The law tolerates it within a precise limit: what the adviser receives must serve to manage the clients' accounts better, not to run his business.

• A money manager who exercises discretion may have his clients pay a commission higher than the lowest available without breaching his fiduciary duty, if he determines in good faith that it is reasonable in relation to the brokerage and research services received. This is a safe harbor. The determination is made on the transaction or on all the accounts the manager manages with discretion: the research may benefit all his accounts, not only the one that paid the commission. A client therefore cannot object that his own account does not hold the securities studied.
• Inside the safe harbor: research reports, analyses, portfolio analysis software, market data, registration fees for a research conference.
• Outside the safe harbor: rent, furniture, general office equipment, salaries, travel, hotel, meals, marketing costs.
• Mixed-use product: only the research portion is paid for with soft dollars; the rest is paid by the adviser.
• The arrangement is a conflict of interest: it is disclosed in the brochure (Form ADV Part 2A).

Conflicts of interest and compensation

A conflict of interest exists whenever the agent or the firm has a personal reason to prefer one solution over another. It is not always prohibited: it must be known. By the firm first, which must be able to monitor it; then by the customer, who must be able to take it into account. Hence the words that recur throughout this section: prior written notice.

• Disclosure of compensation: commission or markup on the confirmation; account fees; fund charges (loads, 12b-1); third-party payments that create an incentive to recommend (revenue sharing, differential commissions). Under Reg BI, these conflicts are disclosed in writing and mitigated.
• Outside business activity (FINRA Rule 3270): requires prior written notice to the firm of any compensated activity outside the firm, or any position as an employee, independent contractor, sole proprietor, officer, director, or partner of another entity, even if unpaid. The two cases are joined by "or": either one is enough. A purely passive investment is not covered.
• Private securities transaction (FINRA Rule 3280): detailed prior written notice; if the associated person is compensated, the firm approves or disapproves in writing, and if it approves, it records and supervises the transaction. Without that, it is selling away.
• Gifts (FINRA Rule 3220): no more than $300 per person per year in relation to the business of the recipient's employer (limit raised on March 30, 2026; it was $100 before).
• Written complaints: to be forwarded to the firm without delay; the firm records them and responds to them.
• Confidentiality: disclose a customer's information only with the customer's consent or when required by law (details of Regulation S-P in chapter 8).

Conflicts specific to advisers

• Principal transaction (the IA sells to the client from its own inventory, or buys from the client): written disclosure of the capacity and consent of the client before the completion of the transaction (USA § 102(a)(3)).
• Agency cross (the IA advises one side and acts as broker for both): prior written consent, a confirmation for each transaction, an annual statement, and the IA may not recommend the transaction to both sides.
• Fiduciary duty: the IA always puts the client's interest ahead of its own and discloses any conflict in writing before giving advice.

Cybersecurity and data protection

• Written policies to protect customer information (Regulation S-P for BDs; the 2019 NASAA rule for state-registered advisers).
• Expected good practices: multi-factor authentication, encryption of data and portable devices, individual passwords that are never shared, software updates, control of remote access, call-back verification of wire instructions received by email (phishing), staff training.
• Lost device or suspicious access: immediate report to the firm, which applies its incident response plan and notifies the persons affected.
• Identity theft: a program to detect warning signs (red flags) at account opening and throughout the life of the account.
• Never log in to a customer's account with the customer's credentials.

Chapter quiz

Key numbers

Every deadline and threshold in the course on one page, grouped by topic. The right-hand column gives the source, so you know which level (state or federal) a question is aiming at.

The exam

Registration of persons

Securities

Procedure and penalties

Communications, accounts, records

Ethics

Flashcards

Say the answer out loud before you flip the card. Filter by chapter, or keep only the cards you don't know yet.

Glossary

The terms you will read on screen on exam day, each with a plain-English definition. Type a few letters to filter.

Practice exams

To review

Every question you miss in a chapter quiz or a practice exam lands here and comes back in a loop, in random order. A missed question returns a few questions later; a question leaves the list once you get it right twice in a row, here or anywhere else.