General Securities Principal Exam€¦ · SERIES 24 GENERAL SECURITIES PRINCIPAL EXAM LICENSE EXAM...

General Securities Principal Exam

9th Edition Revised

Series 24

Securities License Exam Manual

Series_24_9e_Rev_LEM.indb 1 5/27/2015 7:37:58 AM

At press time, this edition contains the most complete and accurate information currently available. Owing to the nature of license examinations, however, information may have been added recently to the actual test that does not appear in this edition. Please contact the publisher to verify that you have the most current edition.

This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional services. If legal advice or other expert assistance is required, the services of a competent professional should be sought.

SERIES 24 GENERAL SECURITIES PRINCIPAL EXAM LICENSE EXAM MANUAL, 9TH EDITION REVISED©2015 Kaplan, Inc.

The text of this publication, or any part thereof, may not be reproduced in any manner whatsoever without written permission from the publisher.

If you find imperfections or incorrect information in this product, please visit www.kfeducation.com and submit an errata report.

Published in May 2015 by Kaplan Financial Education.

Printed in the United States of America.

ISBN: 978-1-4754-3310-4

PPN: 3200-6477


iii

Contents

1 Supervision of Registration of the Broker-Dealer and Personnel Management Activities 1

1.1 Registration of a Broker-Dealer and Personnel Management Activities 3Registering as a FINRA Member ■ Registration of Representatives (NASD Rule 1030) ■ Registration of Principals (NASD Rule 1020) ■ Persons Exempt

from Registration with FINRA (NASD Rule 1060) ■ Form U-4 ■ Fingerprinting of Securities Industry Personnel (SEC Rule 17f-2) ■ Form U-5 ■ License and Jurisdictional Retention ■ Active Military Service ■ Continuing Education

2 Supervision of General Broker-Dealer Activities 37

2.1 General Supervision of Employees 39Supervision ■ Supervisory Controls ■ Supervision of Supervisors ■ Specific Policies and Procedures ■ Internal Inspections ■ Tape Recording of Registered Persons by Certain Firms (FINRA Rule 3170) ■ Supervisory Control System/Branches (FINRA Rules 3110 and 3120) ■ Annual Compliance Meeting ■ Independent Review ■ Networking Arrangements (FINRA Rule 3160)

2.2 Member Conduct Rules 49 Recommendations to Noninstitutional Accounts ■ Recommendations to Institutional Accounts ■ Private Securities Transactions of AP’s (NASD Rule 3040) ■ Outside Business Activities (FINRA Rule 3270) ■ Member Acting in a Fiduciary Capacity ■ Influencing or Rewarding Employees of Others (FINRA Rule 3220) ■ Borrowing From or Lending to Customers (FINRA Rule 3240) ■ Customer Complaints ■ Transactions for Associated Persons (NASD Rule 3050) ■ Prohibitions Against Sharing in Customer Accounts and Guarantees Against Loss (FINRA Rule 2150) ■ Information Obtained as Fiduciary (FINRA Rule 2060) ■ Procedures for Exemptions


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2.3 Procedural Rules 58Investigations ■ Code of Procedure

2.4 Dispute Resolution 62Uniform Code of Arbitration (UCA) ■ Initiation of Proceedings ■ Selection of Arbitrators ■ Panel Composition ■ Simplified Arbitration ■ Awards ■ Failure to Act ■ Statute of Limitations ■ Investor Complaint Center/Office of the Whistleblower ■ Mediation

2.5 FINRA Rules 66Annual Certification of Compliance (FINRA Rule 3130)Business Continuity Plans and Emergency Contacts (FINRA Rule 4370) ■ Control Relationships ■ Direct Participation Programs (DPPs) ■ Nonconventional Investments (NCIs) ■ Registration and Delivery

2.6 Types of Accounts 70Accounts for Investment Advisers ■ DVP Accounts (Delivery Versus Payment) ■ Fee-Based Accounts ■ Prime Brokerage Accounts

2.7 Margin Transactions/Extensions of Credit 72Federal Reserve Board Regulation ■ Margin Agreement ■ Margin Risk Disclosures (Rule 2264) ■ Margin Requirements (FINRA Rule 4210) ■ Restricted Account ■ Special Memorandum Account ■ Minimum Maintenance Margin Requirement ■ Meeting Fed and Maintenance Calls

2.8 Short Selling 79Borrowing ■ Rule 10b-21 ■ Lender’s Privileges ■ Marginable Securities ■ Other FRB Rules ■ Pattern Day Traders ■ Portfolio Margin Accounts ■ Exchange-Traded Funds (ETFs)

2.9 Securities Investor Protection Corporation (SIPC) 86Protection of Customers ■ Account Transfer ■ Customer Account Coverage ■ Corporate and Partnership Accounts ■ Cash and Margin Accounts ■ Excess Coverage ■ Advertising SIPC Membership

2.10 Insider Trading Regulations 89Insider Trading and Securities Fraud Enforcement Act of 1988 ■ Trade Review and Investigation ■ Electronic Blue Sheets System ■ Penalties for Trading on Inside Information ■ Contemporaneous Traders ■ Misappropriation Theory


vContents

2.11 Financial Responsibility Rules 93SEC Uniform Net Capital Rule 15c3-1 ■ Carrying Firms ■ Introducing Firms (Fully Disclosed Firms) ■ Dealers ■ Member Offering Mutual Fund Shares ■ Market Makers ■ Basic Net Capital Computation Method ■ Nonallowable Assets ■ Haircuts ■ Undue Concentration ■ Aged Fails to Deliver ■ Joint Back Office Arrangements ■ Alternative Net Capital Method ■ Guarantees by Members ■ Aggregate Indebtedness (AI) ■ Effect on Net Capital ■ Subordination Agreements ■ Debt/Equity Ratio

2.12 Financial Reporting 105SEC Rule 17a-5 ■ Audited Reports ■ Statements to Customers ■ Trial Balances ■ Termination of Independent Accountant

2.13 Notification Provisions for Broker-Dealers 109Early Warning Reports

2.14 Reporting and Inquiry—Lost, Stolen, Missing Securities 110

2.15 Recordkeeping and Retention of Books and Records 110SEC Rules 17a-3 and 17a-4 (FINRA Rule 4511)

2.16 Customer Protection Rule (SEC Rule 15c3-3) 114Reserve Requirement

2.17 Fidelity Bond Requirements (FINRA Rule 4360) 117

2.18 Curtailment on Member Activity (FINRA Rule 4120) 118

2.19 Withdrawal of Equity Capital 119

2.20 Clearing Agreements 120

2.21 Trust Indenture Act of 1939 (TIA) 121

2.22 Investment Companies 121Investment Company Act of 1940 ■ Management Companies ■ Unit Investment Trusts ■ Diversified versus Non-Diversified Investment Companies ■ Registration of Management Companies ■ Affiliated Person ■ Interested Person ■ Principal Underwriter ■ Redeemable Security ■ Separate Account ■ Requirements Under the Investment Company Act of 1940 ■ Unlawful Representations and Names ■ Real Estate Investment Trusts (REITs)

2.23 Variable Annuities 135Rule 2330: Members’ Responsibilities Regarding Deferred Variable Annuities ■ Investment Advisers Act of 1940


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3 Supervision of Retail and Institutional Customer-Related Activities 159

3.1 Supervision of Account Opening/Existing Accounts 161Customer Information ■ Account Verification/USA Patriot Act ■ Charges for Services ■ Holding Customer Mail (FINRA Rule 3150) ■ Third-Party Trading ■ Customer Trade Confirmations (FINRA Rule 2232) ■ Electronic Delivery of Information ■ Customer Account Transfer Contracts ■ Death of a Customer ■ Components of Suitability Obligations (FINRA Rule 2111) ■ Suitability Information ■ Unique Suitability Issues ■ Regulation S-P ■ Regulation S-AM Limitations on Affiliate Marketing ■ Fair and Accurate Credit Transactions Act of 2003 (FACT Act) ■ Customer Account Statements ■ Offer of Rescission ■ Forwarding of Proxy Materials ■ Fair Prices and Commissions (FINRA Rule 2121) ■ Fair Dealing ■ Breakpoint “Sales” ■ Net Transactions with Customers (FINRA Rule 2124)

3.2 Anti-Money Laundering Regulation (FINRA Rule 3310) 190Currency Receipt ■ Suspicious Activity Reports ■ Stages of Money Laundering ■ Red Flags ■ Section 314(a) Request

3.3 Dealing with Nonmembers & Continuing Commissions 195Dealings with Nonmembers ■ Continuing Commissions

3.4 Communications with the Public (FINRA Rule 2210) 196Written Procedures, Education, and Training ■ Institutional Communications ■ Retail Communications ■ Filing Requirements ■ Public Appearance ■ Independently Prepared Reports ■ Instant Messaging (IM) ■ Specific Standards ■ Social Networking

3.5 Telemarketing (FINRA Rule 3230) 209


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4 Supervision of Trading and Market Making 221

4.1 Securities Trading Markets 223Market Centers ■ Agency versus Principal

4.2 New York Stock Exchange 225NYSE Listing Requirements ■ Trading Floor Participants ■ Order Types

4.3 Trading Halts, Limitations, and Errors 232Trading Halts and Limitations ■ Limit Up-Limit Down (LULD) ■ SEC Rule 201 ■ Erroneous Reports ■ Order Audit Trail System (OATS)

4.4 Nasdaq 236Introduction to the Nasdaq Stock Market ■ Nasdaq Listing Requirements ■ Registration as a Nasdaq Market Maker ■ Levels of Nasdaq Service ■ Types of OTC Transactions ■ VWAP

4.5 Nasdaq Trading Rules 243Character of Quotations ■ Customer Limit Order Protection Rule (The Manning Rule) ■ Manning Order Exemptions ■ Order Priority Method ■ Price Protection of Customer Limit Orders ■ Information Barriers ■ Price Improvement ■ SEC Limit Order Display Rule (SEC Rule 604) ■ Front Running (FINRA Rule 5270) ■ Trading Ahead of Research Reports ■ Manipulative Quotations ■ Nasdaq Trading Halts ■ Trading Halt Codes ■ Best Execution and Interpositioning (FINRA

Rule 5310) ■ Regulation NMS ■ Trades for Managed Accounts ■ Anticompetitive Practices ■ Time Synchronization ■ FINRA Rule 5290

4.6 Non-Nasdaq OTC 267Over the Counter Bulletin Board (OTCBB) ■ Registration as OTC Market Maker

4.7 The Third Market 273Consolidated Quotation System (CQS) ■ Consolidated Tape System (CTS)

4.8 Trading Systems, Processes 274Levels of Nasdaq Service ■ Time Stamp ■

Decrementation ■ Nondirected, Preferenced, and Directed Orders ■ Execution Algorithms ■ Time in Force Orders (TIF)/Designations ■ Locked/Crossed Market During Normal Market Hours ■ Price Deviation ■ Anti-Internalization Qualifier (AIQ) ■ ADF (Alternative Display Facility) ■ Opening Cross ■ The Cross Process ■ Closing Cross (Nasdaq) ■ ACES (Advanced Computerized Execution System)


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4.9 Weblink ACT 285Securities Reported ■ Reporting Participants ■ Transaction Reporting by TRF Participants (FINRA Rule 6380A) ■ Reporting Responsibilities ■ Clearing Firm Obligations to a FINRA Reporting Facility ■ Trade Input Symbols ■ Prices Reported to the TRF ■ Trade Reporting Rules ■ Late Reports (“As/Of” and T+N) ■ Trade Reporting ■ Common Modifiers ■ Locking in Trades—The 20 minute Rule ■ Reporting Canceled Trades ■ Nasdaq Risk Management ■ Exempt Transactions ■ Other Reporting Rules ■ OTC Equity Reporting (FINRA Rule 6400)

4.10 Nasdaq International Service 300

4.11 Opening Price of Nasdaq IPOs 301

4.12 Nasdaq MarketWatch 301Temporary Trading Halts

4.13 Uniform Practice 303Exclusions ■ Settlement Dates ■ Ex-Clearing Trades ■ When-Issued Contracts ■ Stock Borrowed ■ Clearly Erroneous Trades

4.14 Good Delivery Rules 306Unit Delivery Rule ■ Bond Deliveries ■ Computation of Accrued Interest ■

Assignments ■ American Depositary Receipts (ADRs) ■ Foreign Internal Securities ■ Rejection and Reclamation ■ Dividends and Distributions ■ Ex-Dates ■ Due Bills ■ Open Order Adjustments ■ Close-Out Requirements—Buy-In ■ Close-out Requirements—Sell Out ■ Order Entry ■ Completion of a Transaction ■ Completion of a Customer Sell Order

5 Supervision of Investment Banking and Research 335

5.1 Legislative Overview 337Securities Act of 1933 ■ Definition of a Security ■ Securities Exchange Act of 1934

5.2 Types of Underwritings 338Primary Offerings ■ Secondary Offerings ■ Split Offerings ■ Shelf Registration (Rule 415) ■ At-the-Market Offerings ■ Negotiated versus Competitive ■ Alternative Public Offering (APO)

5.3 Types of Underwriting Commitments 341Firm Commitment ■ Best Efforts ■ Standby Underwritings

5.4 Organizing the Underwriting 343Underwriter Engagement ■ Syndicate Formation ■ Selling Group Formation ■ Agreement Among Underwriters (AAU) ■ Underwriting Compensation ■ Liability for Unsold Securities


ixContents

5.5 The Registration Process 350Filing the Registration Statement ■ Uniform Securities Act (USA) ■ Delivery of Prospectus ■ Public Communications ■ SEC Offering Reforms

5.6 Gun Jumping 361

5.7 Restrictions on Sales of Initial Equity Public Offerings and New Issue Allocations 362FINRA Rules 5130 and 5131 ■ Restricted Persons ■ De Minimis Rule ■ Spinning ■ Quid Pro Quo Allocations ■ Flipping ■ Carve-Out Procedures ■ Representations ■ Restrictions on the Purchase and Sale of Initial Equity Public Offerings ■ Standby Purchasers ■ Issuer-Directed Sales ■ Tie-In Arrangements ■ “Reduced Pricing” Prohibition ■ Public Offerings of Securities with conflicts of interest (FINRA Rule 5121)

5.8 Regulation M 367■ Regulation M Rule 101 ■ Regulation M Rule 102 ■ Regulation M Rule 103 ■ Regulation M Rule 104 ■ Regulation M Rule 105

5.9 Exempt Securities and Transactions 372Exempt Securities ■ Exempt Transactions

5.10 SEC Rule 144 380Rule 144—Selling Restricted and Control Securities ■ Rule 144A ■ 144A Trades by QIBs Report Through ORF

5.11 Tender Offers and Corporate Buy-Backs 385Tender Offers by Issuers (Self Tender) ■ Short Tender Rule ■ Issuer Buying Its Own Securities

5.12 Public Distribution of Securities With Conflicts of Interest 387FINRA Rule 5121

5.13 Corporate Financing Rules/Notification Requirements (FINRA Rule 5110 and 5190) 388Offerings Subject to Rule 5110

5.14 Securities Exchange Act of 1934 Reporting Requirements 391Filings by Issuers ■ Filings by NonIssuers

5.15 Fair Disclosure (Regulation FD) 394

5.16 Regulation FD Compliant Methods of Disclosure 394

5.17 Sarbanes-Oxley Act 395

5.18 Fairness Opinions (FINRA Rule 5150) 395

5.19 Hart Scott Rodino (HSR) 396


x Contents

5.20 Research Reports 397Investment Analysis Tools (FINRA Rule 2214) ■ Research Analyst Conflicts of Interest ■ Contact Between Research Analysts and Investment Banking Personnel ■ Limitations on Contacts Between Research Analysts and Issuers ■ Quiet Periods ■ Required Disclosures in Research Reports and Public Appearances ■ Restrictions on Personal Trading by Analysts and Related Persons ■ Booster Shots ■ Termination of Coverage ■ Supervisory Procedures ■ Third-Party Research ■ Analyst Certification (SEC Regulation AC) ■ Investment Banking Quarterly Reports

Appendix A 413

Appendix B 419

Glossary 421

Index 447


xi

Introduction

❚ INTRODUCTION

Thank you for choosing this exam preparation system for your educational needs, and welcome to the Series 24 License Exam Manual. This manual has applied adult learning prin-ciples to give you the tools you’ll need to pass your exam on the first attempt.

Some of these special features include: ■ exam-focused questions and content to maximize exam preparation; ■ an interactive design that integrates content with questions to increase retention; and ■ integrated SecuritiesProTM QBank exam preparation tools to sharpen test-taking skills.

Why Do I Need to Pass the Series 24 Exam?

FINRA and other self-regulatory organizations require certain employees of its members to pass a qualification exam to become registered as a General Securities Principal. You must pass the Series 24 exam to be qualified to supervise most activities of a member firm including trading, market making, investment banking, sales, and approval of communications with the public.

Are There Any Prerequisites?

You must pass the Series 7, or any of the Series 17, Series 37, Series 38, Series 62, Series 79, or Series 82 exams before sitting for the Series 24.

What Is the Series 24 Exam Like?

The Series 24 is a 3¾-hour, 150-question exam administered by FINRA. It is offered as a computer-based exam at Prometric or Pearson VUE testing centers around the country. Each examination includes 10 additional, unidentified “tryout” questions that do not count toward your score. Those questions are randomly distributed. You will, therefore, be asked a total of 160 questions, of which 150 questions are scored. Series 24 questions come in three types: closed-stem (i.e., those questions that end with a question mark), open-stem (i.e., those ques-tions that end in a colon), and “except” or “not” questions. Furthermore, the test points to supervisory and management issues rather than those topics seen on the Series 7 examination. For instance, the characteristics of a defined-benefit retirement plan or the rights that accrue to stock owners is not directly tested, but you are expected to know.

What Score Must I Achieve to Pass?

You need a score of at least 70% on the Series 24 exam to pass and become eligible for registration as a General Securities Principal.


xii Introduction

What Topics Will I See on the Exam?

The questions you will see on the Series 24 exam do not appear in any particular order. The computer is programmed to select a new, random set of questions for each exam taker according to the preset topic weighting of the exam. Each Series 24 candidate will see the same number of questions on each topic but will see a different mix of questions. The Series 24 exam is divided into five areas of supervision and compliance:

Number of Questions

1. Supervision of Registration of the Broker-Dealer and Personnel Management Activities

9

2. Supervision of General Broker-Dealer Activities 45

3. Supervision of Retail and Institutional Customer-Related Activities 32

4. Supervision of Trading and Market Making Activities 32

5. Supervision of Investment Banking and Research 32

When you complete your exam, you will receive a printout that identifies your perfor-mance in each area.

❚ PREPARING FOR THE EXAM

How Is the License Exam Manual Organized?

The License Exam Manual consists of Units and Unit Tests. In addition to the regular text, each Unit has some unique features designed to help you with quick recognition of the material. When an additional point will be valuable to your comprehension, special notes are embedded in the text. Examples of these are included below.

✓T A K E N O T EThese highlight special or unusual information and amplify important points.

!T E S T T O P I C A L E R T Each Test Topic Alert! highlights content that is likely to appear on the exam.

*E X A M P L E These give practical examples and numerical instances of the material just cov-ered and convert theory into practice.


xiiiIntroduction

QQ U I C K Q U I Z Quick Quizzes are an interactive review of what you just read. These ensure you recognize and retain the material. Quick Quizzes are not indicative of those questions you will see on the actual examination. Answers and rationales for the Quick Quizzes can be found at the end of each Unit.

Additional Study Resources

To accompany and supplement your License Exam Manual, your study package may con-tain additional study resources. Be sure to spend some time on your homepage, view the best practices video, and understand all that is available to help you study.

SecuritiesPro™ QBank

Coordinating with the LEM, the SecuritiesProTM QBank includes a large number of ques-tions that are similar in style and content to those you will encounter on the exam. You may use it to generate tests by a spe cific unit or combination of units. The QBank also allows you to create Weighted Mock Exams that mimic your test. There is no limit on the number of QBank exams you can create.

Practice and Mastery Exams

Depending on the study package purchased, you may also have a fixed Practice Exam or a fixed Practice and Mastery Exam. These exams are designed to closely replicate the true exam experience, both in terms of the degree of difficulty and topical coverage. They provide scores and diagnostic feedback, but you will not be given access to, or be able to obtain from Kaplan, correct answers or question explanations. The Practice and Mastery Exams are sound indica-tors of potential actual exam scores—the better you do on these exams, the more likely you are to pass your actual exam. These may be taken just once each.

Video Library

You may also have access to various topics from our video library. These short, engaging videos cover key topics from your manual. If your package includes access to our video library, please review the topics as you complete your reading assignments in the study manual.

Exam Tips and Content Updates Link

Don’t forget to monitor your Exam Tips and Content Updates (located on your homep-age). When rules and regulations change, or we want to share new information regarding your exam, it’s posted there.

An important part of a principal-level exam is to identify the terms of art that abound in the securities industry. Often overlooked, the Glossary found in the back of this volume is a study tool that will help clarify jargon, rules, acronyms, and the technical language of “the Street.”


xiv Introduction

What Topics Are Covered in the Course?

The License Exam Manual consists of 5 Units, each devoted to a particular area of study that you will need to know to pass the Series 24 exam. Each Unit is divided into study sections devoted to more specific areas with which you need to become familiar.

How Much Time Should I Spend Studying?

Plan to spend approximately 60–80 hours reading the material and carefully answering the questions. Spread your study time over the 3–4 weeks before the date on which you are scheduled to take the Series 24 exam. Your actual time may vary depending on your reading rate, comprehension, professional background, and study environment.

What Is the Best Way to Structure My Study Time?

The following schedule is suggested to help you obtain maximum retention from your study efforts. Remember, this is a guideline only, because each individual may require more or less time to complete the steps included.

Step 1. Read a Unit and complete the Unit Test. Review rationales for all questions whether you got them right or wrong.

Step 2. In the SecuritiesProTM QBank, create a minimum of two 40-question exams for each unit as you go. Carefully review all rationales. Use the reference number to locate addi-tional or related information on the test topic in your LEM, if needed (2–3 hours per Unit).

■ Do not become too overwhelmed or bogged down in any one unit. You don’t want to lose sight of the finish line because you’re having trouble with one hurdle. Keep moving for-ward. It’s a steady pace that wins the race.

■ View rationales after each question initially and spend time studying each rationale in order to learn the concepts. Later, you will want to create exam scenarios in which scores and rationales are viewed at the end of each exam.

■ Perfection is not the goal during the reading phase; scores in the mid- to high-60s is good initially.

Step 3. When you have completed all the Units and their Unit Tests in the License Exam Manual, using the Securities ProTM QBank, concentrate on comprehensive exams covering all the material. With your comprehensive testing, it is best to view correct answers and rationales only after the test is completed. Plan to spend at least one week testing prior to a scheduled class (~2 hours for every 100 questions).

■ You should complete at least 10 Weighted Mock Exams prior to class. Review your answers and rationales. Also, review your LEM and video library as needed.

■ Your goal is to consistently score in the 80s.

Step 4. Complete online Practice and Mastery exams. You should complete each exam while observing the time limits for the actual exam. Upon completing the exam, you will receive a diagnostic report that identifies topics for further review (3–4 hours per exam). We recommend taking the Practice Exam prior to a scheduled class and taking the Mastery Exam afterward.


xvIntroduction

Step 5. Rules change continually. On the Kaplan website, there are a number of impor-tant tools to keep you current. The Exam-tips, Content Updates, and Corrections links are valuable assets that should be checked often.

How Well Can I Expect to Do?

The exams administered by FINRA are not easy. You must display considerable knowledge of the topics presented in this course to pass the exam and qualify for registration.

If you study diligently, complete all sections of the course, and consistently score in the 80s on the tests, you should be well prepared to pass the exam. However, it is important for you to realize that merely knowing the materials will not enable you to pass unless you can apply your knowledge to the questions you are given and comprehend and interpret the essence of the information behind the question.

Test-Taking Tips

Passing the exam depends not only on how well you learn the subject matter but also on how well you take exams. You can develop your test-taking skills—and improve your score—by learning the following test-taking techniques:

■ Read the full question ■ Avoid jumping to conclusions—watch for hedge clauses ■ Interpret the unfamiliar question ■ Look for key words and phrases ■ Identify the intent of the question ■ Memorize key points ■ Use a calculator ■ Avoid changing answers ■ Pace yourself

Each of these pointers is explained in the following subsections, including examples that show how to use them to improve your performance on the exam.

Read the Full Question

You cannot expect to answer a question correctly if you do not know what it is asking. If you see a question that seems familiar and easy, you might anticipate the answer, mark it, and move on before you finish reading it. This is a serious mistake. Be sure to read the full question before answering it—questions often are written to trap people who assume too much.

Avoid Jumping to Conclusions—Watch for Hedge Clauses

The questions on FINRA exams often are embellished with deceptive distractors as choices. To avoid being misled by seemingly obvious answers, make it a practice to read each question and each answer twice before selecting your choice. Doing so will provide you with a much better chance of doing well on the exam.


xvi Introduction

Watch out for hedge clauses embedded in the question. (Examples of hedge clauses include the terms if, not, all, none, and except.) In the case of if statements, the question can be answered correctly only by taking into account the qualifier. If you ignore the qualifier, you will not answer correctly.

Qualifiers are sometimes combined in a question. Some that you will frequently see together are all with except and none with except. In general, when a question starts with all or none and ends with except, you are looking for an answer that is opposite to what the ques-tion appears to be asking.

Interpret the Unfamiliar Question

Do not be surprised if questions on the exam seem unfamiliar at first. If you have studied your material, you will have the information to answer all of the questions correctly. The chal-lenge may be a matter of understanding what the question is asking.

Very often, questions present information indirectly. You may have to interpret the meaning of certain elements before you can answer the question. Be aware that the exam will approach a concept from different angles and will often expect you to make decisions from scant and imperfect information in similitude of the day-to-day work life of a General Securities Principal of broker-dealers.

Look for Key Words and Phrases

Look for words that are tip-offs to the situation presented. For example, if you see the word prospectus in the question, you know the question is about a new issue. Sometimes, a question will even supply you with the answer if you can recognize the key words it contains. Few ques-tions provide blatant clues, but many do offer key words that can guide you to selecting the correct answer if you pay attention. Be sure to read all instructional phrases carefully.

Take time to identify the key words to answer this type of question correctly.

Identify the Intent of the Question

Many questions on FINRA exams supply so much information that you lose track of what is being asked; this is often the case in story problems. Learn to separate the story from the question.

Take the time to identify what the question is asking. Of course, your ability to do so assumes you have studied sufficiently. There is no method for correctly answering questions if you don’t know the material.

Memorize Key Points

Principal-level examinations demand careful reasoning and logic to answer many ques-tions, but you also will have to memorize a good deal of information. Keep in mind, however, that this test values your skill as to how to apply a variety of rules and how they work together to solve supervisory and compliance issues. Industry regulators are concerned that principals recognize the importance of building a culture of compliance and are able to establish and test policies and procedures that will reasonably assure compliance with the securities laws and SRO regulations.


xviiIntroduction

Use a Calculator

For the most part, FINRA exams will not require the use of a calculator. Most of the ques-tions are written so that any arithmetic required is simple. However, if you have become accus-tomed to using a calculator, you will be provided with a basic one by the testing center staff.

Avoid Changing Answers

If you are unsure of an answer, your first hunch is the one most likely to be correct. Do not change answers on the exam without good reason. In general, change an answer only if you:

■ discover that you did not read the question correctly; or ■ find new or additional helpful information in another question.

Pace Yourself

Some people will finish the exam early, and some do not have time to finish all of the questions. Watch the time carefully (your time remaining will be displayed on your computer screen) and pace yourself throughout the exam, because it is important to finish the exam. It is a common experience that the easier questions appear at the beginning and at the end of the examination.

Do not waste time by dwelling on a question if you do not know the answer. Make the best guess you can, mark the question for Record for Review, and return to the question if time allows. Ensure that you have time to read all of the questions so that you can record the answers you do know.

❚THE EXAM

How Do I Enroll in the Exam?

To obtain an admission ticket to a FINRA exam, your firm must file an application form and processing fees with FINRA. To take the exam, you should make an appointment with a Prometric Testing Center as far in advance as possible of the date on which you would like to take the exam.

You may schedule your appointment at Prometric, 24 hours a day, 7 days a week, on the secure Prometric Website at www.prometric.com or Pearson VUE at www.vue.com/finra. You also may use these sites to reschedule or cancel your exam, locate a test center, and get a printed confirmation of your appointment. To speak with a Prometric representative by phone, please contact the Prometric Contact Center at 1-800-578-6273 or Pearson VUE at 1-866-396-6273. You must have your Central Registration Depository (CRD) number available when scheduling an exam. This unique personal identification number should be provided to you by your member firm.


xviii Introduction

What Should I Take to the Exam?

Take one form of personal identification with your signature and photograph as issued by a government agency. You cannot take reference materials or anything else into the testing area. Basic calculators, along with a small dry erase board and marker, will be provided by the testing center proctors.

Exam Results and Reports

At the end of the exam, your score will be displayed, indicating whether you passed. The testing center will print your results and affix their stamp as physical evidence of your passing. The next business day after your exam, your results will be emailed to your firm and to the self-regulatory organization and state securities commission specified on your application.


1

u n i t

1Supervision of Registration of the Broker-Dealer and Personnel Management Activities

This Unit focuses on the regulatory functions of FINRA and the rules pertinent to the qualification and registration of a broker-dealer, its branch offices, and representatives, which account for nine questions

of the Series 24 exam.


O B J E C T I V E S

2

When you have completed this Unit, you should recognize and explain the following:

■ The difference between SEC, SRO, and state requirements, including information about registration requirements and exemptions

■ Form BD, Form BDW, and Form BR

■ The difference between Registered Investment Adviser (RIA), Broker-Dealers (BD), and required registrations


3Unit 1 Supervision of Registration of the Broker-Dealer and Personnel Management Activities

1. 1 REGISTRATION OF A BROKER-DEALER AND PERSONNEL MANAGEMENT ACTIVITIES

On July 26, 2007, the SEC approved the consolidation of NASD and NYSE Regulation, Inc., into a single self-regulatory organization (SRO) known as Financial Industry Regulatory Authority, or FINRA. The purpose of the regulatory consolidation was to:

■ eliminate duplicate regulation by NASD and NYSE; and ■ strengthen the competitiveness of U.S. markets.

Although securities licensing exams may refer to FINRA when speaking of the industry’s SRO, you will see exam questions that point to both continuing NASD or incorporated NYSE rules. It is expected that this will continue until all of the individual rules of NASD and NYSE have been consolidated; this process has been going on for years and will likely go on for many more. Each rule change must be vetted and approved by the Securities and Exchange Commission (SEC, or simply Commission).

NYSE Regulation, Inc. continues to operate but focuses principally on uniquely NYSE listing and trading floor issues, such as listed-company corporate governance and trading floor integrity (such as tracking and monitoring handheld E-Broker devices). NYSE Regulation also monitors the performance of the regulatory services allotted to FINRA.

FINRA has a huge role to play. They work to provide an environment where investors feel safe and confident in going into orderly markets where risk is managed. It regulates about 4,200 brokerage firms and 630,000 registered representatives. One way that FINRA looks to achieve its aims is to ensure that those persons entering the securities business are quali-fied. This unit of the Licensing Exam Manual (LEM) covers the registration and qualification processes, and the follow-up supervisory issues that come with ensuring that firms and their principals look to build a culture of compliance.

FINRA operates under the oversight of the United States Securities and Exchange Commission (SEC), which is a government agency. FINRA is not a government agency and receives no government funding. The following list outlines some of the important parts of FINRA’s mission.

FINRA has the obligation or authority to: ■ establish and interpret rules regulating the over-the-counter markets; ■ take appropriate steps to ensure compliance with these rules; ■ examine and investigate members and their associated persons to determine if they have

violated FINRA or MSRB rules, federal securities law, or state regulations; ■ dispute resolutions; ■ administer qualification exams and continuing education programs; ■ operate the Central Registration Depository (CRD); ■ determine if applicants for membership meet FINRA guidelines; ■ determine whether persons seeking to register are subject to statutory disqualification; ■ establish fees and other assessments to be levied on member firms; ■ own both quote and trade reporting facilities (TRF), such as the Over the Counter Bul-

letin Board (OTCBB), OTC Reporting Facility (ORF), TRACE, the Alternative Display Facility (ADF), FINRA/NASDAQ TRF, and the FINRA/NYSE TRF;

■ market data; ■ educate industry professionals and investors; and ■ oversee investor protection services, such as BrokerCheck®. (FINRA member firms that

hold customer funds or securities must supply FINRA’s BrokerCheck® hotline number and FINRA’s website address.)


4 Unit 1 Supervision of Registration of the Broker-Dealer and Personnel Management Activities

1. 1. 1 REGISTERING AS A FINRA MEMBER

With limited exceptions, broker-dealers must be registered with the SEC, FINRA, and the states (and U.S. territories such as Puerto Rico, Guam, etc.) in which it operates. The registra-tion process begins by an online filing with FINRA of a new membership application (Form NMA) through the FINRA Firm Gateway. Filing the Form NMA opens a 180-day application review period. This undertaking should not be taken lightly. As you will see, the application process, including changes to existing membership agreements, is challenging and demands a great deal of preparation and disciplined, robust thinking.

✓T A K E N O T EThe term broker means any person engaged in the business of effecting transac-

tions in securities for the accounts of others. Those persons acting on behalf of their own proprietary trading account are acting as dealers. In most cases, broker-dealers register with the SEC, the states where they operate, and the appropriate designated examining authority (DEA), such as FINRA. The expression broker-dealer is often ab-breviated as BD on the exam.

✓T A K E N O T EAn investment adviser is a person who, for compensation, advises others directly

or through publications or writings, as to the value of securities or as to the advis-ability of purchasing or selling securities, or who, for compensation and as part of a regular business, issues or promulgates analyses or reports concerning securities. They may be registered with the Securities and Exchange Commission or the states subject to certain conditions. Unlike broker-dealers, investment advisers do not register with FINRA. There is no SRO for IAs. Form ADV is used by investment advisers to register with both the SEC and state securities authorities.

To satisfy the requirement to apply online, the applicant must be “entitled.” To become entitled, the applicant must complete and submit certain hardcopy forms. This includes an email notification contact form and a notarized Form BD. Form BD is the Uniform Application for Broker-Dealers to register with the SEC, SROs, and states through the Central Registration Depository (CRD) system, operated by FINRA. Broker-dealers are required to promptly (no later than 30 days) update Form BD whenever the form becomes inaccurate or incomplete. If a member firm has a change in ownership, control, or business operations, it must electronically submit a Form CMA.

✓T A K E N O T EA fictional name for “doing business as” or DBA, is acceptable provided the

name is filed with FINRA and the Commission.

!T E S T T O P I C A L E R T FINRA regulates the trading of over-the-counter (OTC) nonexempt securities. Firms that transact business in nonexempt securities must register with FINRA and the SEC. Other regulatory bodies, such as the Municipal Securities Rulemaking Board (MSRB) provide registration and operating rules, as well as reporting transparency ser-vices for those brokers and dealers who operate in the municipal fixed income space.



1. 1. 1. 1 Standards for Admission to Membership

The broker-dealer applicant must file supporting information or statements regarding its ability to meet the standards for admission under NASD Rule 1014, including its:

■ business plan; ■ organization chart; ■ financial projections, including a trial balance, balance sheet, and net capital computa-

tion; ■ supervisory system, including a copy of its written supervisory procedures; ■ statement that the applicant and its associated persons are capable of complying with

federal and state law as well as FINRA rules, including observing high standards of com-mercial honor and just and equitable principles of trade;

■ clearing and banking arrangements; ■ business facilities; ■ communications and operational systems; ■ ability to maintain adequate net capital to support intended business operations on a con-

tinuing basis; ■ proposed recordkeeping system; ■ financial controls; ■ a list of all associated persons, including those to be designated as principals (all appli-

cants, except for sole proprietorships, must have at least two officers qualified to become registered as principals);

■ training needs assessment and a written training plan that complies with FINRA rules; ■ Form BD (as amended if a change); ■ Form U-4 (see below); and ■ registration fees (electronic funds transfer—no checks).

✓T A K E N O T EAll applicants, except for sole proprietorships, must have at least two officers

register and qualify as appropriate principals; for a general securities firm, that means two Series 24-qualified people. For firms whose line of business is limited solely to the sale of investment company products, the minimum licensing qualification is two Series 26-qualified people.

This information is filed with the Department of Member Regulation (DMR) at the dis-trict office in the district in which the applicant has its main office. There, the information is reviewed and, if there are no deficiencies, a premembership interview (PMI) is arranged. During the interview, the DMR reviews the applicant’s capital, the scope of its intended busi-ness, familiarity with FINRA rules, and its capability to conduct securities business in har-mony with the public interest and the protection of investors.

The DMR issues a written decision on the application within 30 days of the premember-ship interview. The decision will be to:

■ grant the application; ■ grant the application with certain restrictions; or ■ deny the application.



Once registered, a broker-dealer needs to remain operationally healthy. It may not affect any transaction or induce a trade in a security unless it maintains acceptable standards of operational capability. All their associated persons must likewise meet acceptable standards of training, experience, and competence to operate in the public interest.

In a fashion similar to the Form BD being used to register a broker-dealer, the Form BR (Uniform Branch Office Registration Form) is used specifically for branch office registration.

Broker-dealers and investment advisers must use this form to register or notice file their branch offices in the appropriate jurisdictions and/or with SROs. Access to the Form is gained electronically through the FINRA Firm Gateway.

Information that must be entered into the form includes the following: ■ Supervisor/person-in-charge CRD number ■ Whether the person-in-charge is physically located at the branch ■ The branch location ■ OSJ, non-OSJ, branch telephone number ■ Type of branch registration (i.e. broker-dealer or investment adviser) ■ Jurisdiction (i.e. FINRA, NYSE or both)

Providing this information gives FINRA and/or the NYSE accurate data regarding branch operations, lines of business, supervisory capability, et cetera.

A branch office may be a private residence. FINRA policy is that private residences regis-tered as branch offices have their addresses disclosed through BrokerCheck®.

If a member firm’s management chooses to close/withdraw a branch, it uses the exact same Form BR. This is unlike the Form BDW, which is filed when the entire firm chooses to cease doing business and/or withdraw from registration with the SEC, FINRA, and the states.



Sample Page 1 of Form BR

✓T A K E N O T EFINRA requires that there be at least one resident principal at each Office of

Supervisory Jurisdiction. (See Unit 2 for more about OSJs.) The rules do not require the “person-in-charge” to be a principal at all non-OSJ branch offices. A properly qualified registered representative can manage the branch, but the location must be under the supervision of an OSJ or supervising branch. Note that FINRA must be notified within 30 days of the relocation or opening of a new branch and the filing of Form BR.



✓T A K E N O T EFINRA (or appropriate SRO) is required by the SEC to conduct an inspection of

the newly registered member firm within six months of the member’s registration with the Commission to ascertain whether the member is operating in conformity with financial responsibility rules.

1. 1. 1. 2 Statutory Disqualifications

Disciplinary sanctions within the previous 10 years by the SEC, another SRO, a foreign financial regulator, or a state or federal law enforcement agency can be cause for statutory dis-qualification (SD) from FINRA membership indefinitely.

The Firm. The firm will be denied membership if the applicant or any associated person: ■ has been expelled or suspended by another SRO or from the foreign equivalent of an SRO; ■ is subject to an SEC order denying, suspending, or revoking registration as a broker-dealer;

or ■ has willfully filed a false or misleading application or has failed to disclose material facts.

Individuals. An individual will be disqualified as an applicant for registration if the individual:

■ has made willful misstatements or omissions of fact in an application for membership or registration as an associated person (e.g., willful failure to disclose on the Form U-4 the receipt of a Wells Notice);

■ has been subject to a felony conviction (domestic or foreign), or a misdemeanor convic-tion involving securities or money, within the past 10 years;

■ is under court injunctions prohibiting the individual from acting as an investment adviser, underwriter, or broker-dealer or in other capacities aligned with the securities and finan-cial services industry;

■ has been suspended or expelled from membership or participation in another SRO or from the foreign equivalent of an SRO;

■ is under an SEC order or an order of a foreign financial regulator denying, suspending, or revoking his registration or barring him from association with a broker-dealer; or

■ is the cause of another broker-dealer’s or associated person’s expulsion or suspension from another SRO, the SEC, or the foreign equivalent of an SRO.

A member firm that wishes to sponsor a person who, for example, was permanently barred or convicted of a felony, to enter or be retained as an associate must apply to FINRA on Form MC-400. FINRA then may propose to admit or allow a person to continue as an associate with a member regardless of a statutory disqualification. When that happens, the SRO must file a notice with the Securities and Exchange Commission. A statutory disqualification now includes non-securities-related felonies, such as DUI or assault (often referred to as “other felonies”); and although it is a felony conviction, it does not pose a risk to investors and does not necessarily therefore preclude someone from working in the securities industry. Subject to review requirements of SEC Rule 19h-1, they may be able to work in the industry.

Another option for continued employment in the securities industry is available for statu-torily disqualified persons. As previously stated, the member firm may pay a fee and file Form MC-400 with FINRA’s Department of Registration and Disclosure (RAD) requesting a statu-torily disqualified person to remain in the industry.



This application is reviewed and then submitted to The Department of Member Regulation for further review. The Department may itself make the decision, depending on the nature of the disqualification or the position for which the applicant is applying, or may refer the matter to the NAC. In the event of an adverse decision by the Department of Member Regulation, the firm may request a hearing by the Statutory Disqualification Committee and then may appeal to the NAC. Member firms that are successful in their petition to permit an otherwise disqualified person to remain employed as an associated person must pay to FINRA a fee of $1,500 annually when such person or individual is classified as a Tier 1 statutorily disqualified individual (most serious offender), and an annual fee of $1,000 when such person or individual is classified as a Tier 2 statutorily disqualified individual.

!T E S T T O P I C A L E R TIf FINRA or the SEC issues an order that suspends, revokes, or cancels an associ-

ated person’s registration or bars the person, no member can permit the person to remain associated with it in any capacity, including a clerical or ministerial capacity.

If FINRA or the SEC suspends an AP, the member cannot pay any salary, com-mission, profit, or any other remuneration that results directly or indirectly from any securities transaction that the AP may have earned during the suspension.

✓T A K E N O T EUnder FINRA Rule 9522, the Department of Member Regulation has the author-

ity to approve an application on behalf of a statutorily disqualified person to become or remain associated with a member firm in a purely clerical and/or ministerial capac-ity. If Member Regulation does not approve an application, the sponsoring firm has the right to have the matter decided by the National Adjudicatory Council (NAC). The NAC is a FINRA committee authorized to review disciplinary and membership proceedings as well as applications for relief from statutory disqualifications.

✓T A K E N O T EThe exam may pose a question about an SD individual wondering if a clerical po-

sition may be offered instead of a sales job. Remember that, even in this case, where the Department of Member Regulation is authorized to approve the application with-out a hearing, a Form MC-400 must be filed requesting permission to employ.

1. 1. 1. 3 FINRA Membership Agreement

Once the 12 standards for admission under NASD Rule 1014 have been satisfied and a membership application is approved by the DMR, applicants must sign an agreement stating that they will abide by FINRA rules, pay any fees and assessments levied by FINRA, and limit its lines of business to those activities outlined in the restriction agreement. Additional lines of business may be added later by electronically submitting Form CMA pursuant to NASD Rule 1017. Form CMA is a useful tool to help firms articulate with specificity why a restric-tion should be modified or lifted. The form helps applicants capture each of the 12 standards required to be satisfied under Rule 1014. Form CMA also is used for changes in ownership or control of the business.



The applicant also agrees to provide written notice to FINRA at least 30 days before the occurrence of a(n):

■ merger with another member; ■ acquisition by another member; ■ acquisition or merger with a nonmember; ■ material change in the member’s business; or ■ change in the equity ownership that results in one person or entity controlling 25% or

more of the firm’s equity.

The reporting requirements of FINRA Rule 4530 demand that a member firm must promptly report to FINRA, but in any event not later than 30 calendar days, after the member knows (or should have known) of the existence of any of the following:

■ have been found to have violated federal securities law; ■ are subject to a customer complaint alleging theft, misappropriation of customer assets, or

forgery; ■ have been suspended or expelled by another SRO; ■ are indicted, convicted, or plead guilty or no contest to any criminal offense (other than

traffic violations); ■ become a defendant or respondent in any securities- or commodities-related litigation or

arbitration settled for an amount in excess of $15,000 ($25,000 if the defendant/respon-dent is the member firm itself);

■ become subject to a statutory disqualification; or ■ are the subject of in-house disciplinary action involving suspension, termination, with-

holding of commissions, or fines in excess of $2,500.

Once admitted to membership, a firm must ensure that its Form BD remains current. Amendments to this form (e.g., change in address, phone numbers, ownership, officers, branch openings or closings) must be made within 30 days.

Each member must designate to FINRA an executive representative who is a senior offi-cer entitled to represent, vote, and act for the member in all the affairs of FINRA. The execu-tive representative must be a registered principal and maintain an internet email account for communication with FINRA. The “ER” does not need to be the principal executive officer.

New members may feel relief from the burden of the application process. That relief is generally short lived, as FINRA examiners will regularly visit the firm to ascertain whether the firm is in compliance with all applicable rules. Examiners generally ask the compliance department of the firm for a list of items to be prepared prior to their arrival. Firms are obli-gated under FINRA Rule 8210 to provide any requested documents; failure to do so could lead to serious consequences. The rule also requires that any information provided to examiners on a portable media device be encrypted (256-bit or higher). The process or key must then be provided to FINRA staff in a separate email, fax, or letter.

The Form BDW is used to withdraw from registration as a broker-dealer. Prior to filing a BDW, the firm is obligated to update Form BD for any inaccurate information. The notice of withdrawal becomes effective generally on the 60th day from filing unless the SEC imposes terms and conditions it deems necessary to the public interest.



1. 1. 1. 4 Restriction Agreement

Most new membership approvals are granted with restrictions imposed. Over time, mem-bers may seek to have restrictions from their membership agreements removed if the circum-stances giving rise to particular prohibitions have changed.

*E X A M P L E If an applicant does not have a registered options principal, it will be prohibited from engaging in any options business. Likewise, if the applicant’s level of capital is not high enough, it will be prohibited from engaging in certain types of underwrit-ings. In both cases, the member was unable to satisfy one or more of the standards for admission in NASD Rule 1014.

1. 1. 1. 5 Fees and Assessments

In addition to annual dues, members pay an annual fee to FINRA based on the number of branch offices registered and the number of representatives and principals registered with the member. Firms also pay an annual assessment on their gross income from securities transac-tions, which is determined from information provided by the member’s FOCUS report.

For assessment purposes, gross income can be reduced by monies paid to other members in connection with the execution and clearance of trades. Should a member fail to pay fees and assessments (including arbitration awards) on a timely basis, its membership can be revoked or suspended upon 15 days’ written notice from FINRA.

QQ U I C K Q U I Z 1 . A True or False?

—— 1. After being expelled by the NYSE, a firm may be granted membership in FINRA if it files Form BD and Form U-4 for each associated person.

—— 2. A restriction agreement prohibiting certain activities of a member firm remains effective throughout the life of the firm.

—— 3. In a membership agreement, a firm agrees to notify FINRA promptly after merging with or acquiring another member firm.

—— 4. In the membership agreement, a firm agrees to notify FINRA within 30 business days if one of its associated persons is subject to a customer complaint alleging theft.

—— 5. If a member firm fails to pay fees and assessments in a timely manner, its membership may be revoked or suspended upon 15 days’ written notice from FINRA.

Quick Quiz answers can be found at the end of the Unit.



✓T A K E N O T EQuick Quizzes found in this text are useful for locking in facts. They are not

meant to be viewed as written in the same fashion as the actual text questions.

1. 1. 2 REGISTRATION OF REPRESENTATIVES (NASD RULE 1030)

Any person associated with a FINRA member firm that intends to engage in the invest-ment banking or securities business must be registered with FINRA as an associated person. Anyone applying for registration with FINRA as an associated person must be sponsored by a member firm and complete a questionnaire (Form U-4). A principal must verify the applicant’s employment for the past three years, and investigate and attest to the character and reputation of the applicant. This includes reviewing the termination Form U-5, which is discussed later. If the applicant was previously registered with the National Futures Association (the futures industry equivalent to FINRA), the member firm is obligated to review the NFA’s version of the Form U-5, which is known as the Form 8-T.

A representative is defined as any person, other than a principal, who solicits or conducts business in securities for the member. Foreign associates who are noncitizens and conduct all of their securities business outside the United States must be registered with FINRA but are exempt from having to pass a qualification exam administered by FINRA.

Note that principals, such as you, act in a supervisory role. You are the first line of defense in assuring that your firm and its people are adhering to the laws, rules, and regulations of the SEC, FINRA, the States, and all other applicable regulatory bodies. With that in mind, the failure of any member to register an employee, who should be registered, is conduct inconsis-tent with just and equitable principles of trade. When discovered, it could likely lead to severe disciplinary action.

Another important part of a principal’s job is to ensure that people are not only properly registered but also qualified by passing the appropriate FINRA-administered examination. As a principal, you have an obligation to protect the confidentiality of qualification examinations and to support FINRA’s mandate to provide evidence of qualification by testing. These qualifi-cation measures add confidence and serve to assure market participants that securities industry professionals have the requisite knowledge to operate in an often complex and demanding job.

A person returning to the office following an examination may be asked by colleagues who are currently studying for the same exam, what questions were seen. Although a high-level, outline discussion of general topics may be permissible, to disclose specific questions could compromise the effectiveness of the examination and violate NASD Rule 1080 requiring qualification examinations be held confidential. Lastly, each representative must certify to the Board that no assistance was received during the examination.

From time to time and in exceptional cases, FINRA may waive the examination require-ment and accept instead some other standard as evidence of qualification. The request for a waiver is made through the FINRA Firm Gateway. Advanced age or physical infirmity does not constitute sufficient grounds for a waiver. There are a variety of avenues to approach a waiver request, such as based on educational achievement, regulatory, or industry experience. If a waiver is sought based on experience, FINRA considers many factors, including other examinations such as those for CFP and CFA. Those exams, along with significant, substan-tive experience, may be deemed sufficient for a waiver.



1. 1. 2. 1 Investment Company and Variable Products Representative—Series 6

The Series 6 license allows its holder to offer investment company products and variable contracts by prospectus. This includes mutual fund shares, unit investment trusts, and face amount certificates. It also includes closed-end investment company shares, but only during the initial public offering. In the realm of insurance products, the Series 6 representative may sell variable annuities and variable life insurance, provided the representative also holds an appropriate insurance license. To solicit or trade in stocks through NASDAQ or on the NYSE (secondary markets) requires a General Securities Representative license (Series 7).

!T E S T T O P I C A L E R TThe limited representative may sell closed-end funds only as a new issue; once

these funds trade in the secondary market, they are no longer sold with a prospectus. At this point, a Series 7 or 62 is required.

1. 1. 2. 2 General Securities Representative—Series 7

The Series 7 General Securities Representative allows the holder to offer all types of secu-rities subject to approved business lines of the representative’s broker-dealer. It is a prerequisite for many principal level exams, such as the Series 9/10 and Series 24, as well as the Series 55. Since November 7, 2011, it is not a satisfactory prerequisite for the Series 53, which requires an aspiring Municipal Securities Principal to first pass the Series 52. Those who passed the Series 7 prior to that date are grandfathered.

✓T A K E N O T ECommodity futures contracts, both physical or financial futures, are not securities.

A Series 3 or 31 registration is required to offer or trade futures contracts for public customers. The futures industry is regulated by the Commodity Futures Trading Com-mission (CFTC), with the National Futures Association (NFA).

1. 1. 2. 3 Registered Sales Assistant (Assistant Representative—Order Processing)—Series 11

Series 11 allows the holder to function as a registered sales assistant. The holder can, among other things, enter unsolicited orders and provide current quotations. The holder is prohibited from making recommendations or soliciting business. Compensation must be sal-ary or hourly—no commissions or commission sharing. No per-transaction compensation is permitted; however, a member may pay these persons a job performance bonus.

1. 1. 2. 4 DPP Representative—Series 22

Series 22 allows the holder to sell direct participation programs (DPPs), such as limited partnership interests.



1. 1. 2. 5 OTC Equity Trader—Series 55

Series 55 allows the holder to trade equities, as agent or principal, OTC equity and con-vertible debt securities. It is required for OTC market makers, agency, and OTC proprietary traders. A Series 55 candidate must have first passed either the Series 7 or Series 62 exam. It is not intended for those traders who execute orders for an investment company. Those traders are in the same position as buy-side traders.

A market maker is a member willing to accept the risk of holding a particular security in its own account to facilitate trading in that security.

✓T A K E N O T EThe Series 55 resulted from an SEC 21(a) report, which concluded that certain

Nasdaq market makers participated in collusive and manipulative market behavior.

1. 1. 2. 6 Corporate Securities Representative—Series 62

Series 62 allows the holder to sell corporate securities only. Corporate securities include common stock, preferred stock, bonds, and so forth. The holder can sell closed-end funds.

1. 1. 2. 7 Research Analyst—Series 86/87

Series 86/87 allows the holder to prepare research reports. Series 86 deals with analysis and valuation, while Series 87 focuses on rules and regulations. The Series 86/87 is for indi-viduals who prepare communications that analyze equity securities or individual companies/industry sectors with the view to provide reasonably sufficient information to base investment decisions. Analysts also are subject to both the regulatory and firm elements of continuing education, discussed later in this Unit.

1. 1. 2. 8 Operation Professional—Series 99

The Series 99 is required for those senior managers with direct responsibility to supervise or manage client on-boarding in addition to funds collection, maintenance, disbursement and re-investment (sweep accounts), margin, stock lending, the contributing to the process of preparing regulatory reports, trade confirmations and other back office functions. Those opera-tions professionals (OPs) having passed the Series 6, Series 7, or other rigorous exam, such as the Series 24, may register as OPs without having to pass the Series 99. There is no testing prerequisite to sit for this 100-question exam.

1. 1. 3 REGISTRATION OF PRINCIPALS (NASD RULE 1020)

A principal is defined as any person associated with a member who is actively engaged in the management of the member’s investment banking or securities business, including supervi-sion, solicitation, the conduct of business, or the training of associated persons. These persons include sole proprietors, officers, partners, and managers of offices of supervisory jurisdiction.

Although a member may not maintain a principal registration for anyone who is no lon-ger functioning as a principal, if that person is looking to perform internal audit, back-office operations, legal work, or similar jobs, the principal registration may be maintained.



✓T A K E N O T EIf a registered representative is given additional responsibilities, such as supervi-

sion, managing a department, or training representatives, this person is required to register as a principal within 90 days following a change in duties. If registration is not made within 90 days, the firm and the individual become subject to FINRA sanctions.

1. 1. 3. 1 General Securities Principal—Series 24

Series 24 qualifies an individual to supervise most activities of a member firm, including trading, market making, investment banking, and sales. General securities principals also may approve retail communication, including communications regarding municipal securities.

1. 1. 3. 2 Options Principal—Series 4

Series 4 qualifies an individual to supervise the member’s options business. All mem-bers engaged in options transactions for customers must have at least one qualified, registered options principal to make sure those customers benefit from strong supervisory procedures, which, among other things, provides for the distribution of the Options Disclosure Document (ODD) published by the Options Clearing Corporation (OCC).

1. 1. 3. 3 Investment Company/Variable Products Principal—Series 26

Series 26 qualifies an individual to supervise the member’s activities relating to sales of investment company products and variable products offered by insurance companies regulated under the Investment Company Act of 1940.

1. 1. 3. 4 Financial Principal—Series 27

Series 27 allows the holder to supervise the preparation of the firm’s financial and opera-tional reports, such as the FOCUS Part II and related filings with the SEC and FINRA. The “FINOP” is responsible to perform the weekly reserve computation and to ascertain whether the member firm is in compliance with net capital requirements and to notify regulators when it approaches or is in violation of financial and operational rules. Lastly, the FINOP is respon-sible for the maintenance of firm books and records, safekeeping, and the processing and clear-ing functions of the firm. This is one of the few principal-level examinations with no prereq-uisite examination.

1. 1. 3. 5 Investment Banking Representative—Series 79

Series 79 allows the holder to perform the functions of an investment banker, which include advising on or facilitating debt or equity offerings through a private placement or public offering; or to advise or facilitate mergers or acquisitions, tender offers, financial restruc-turings, asset sales, divestitures or other corporate reorganizations or business combination transactions.



1. 1. 3. 6 Municipal Fund Securities Principal—Series 51

Series 51 allows the holder to supervise activities in municipal fund securities, such as Section 529 college savings plans and local government investment pools. A Series 51 princi-pal is not permitted to supervise any other type of municipal security.

1. 1. 3. 7 Municipal Principal—Series 53

Series 53 allows the holder to supervise the purchase and sale of municipal securities. All members engaged in municipal business must have at least one municipal principal.

1. 1. 3. 8 General Securities Sales Supervisor—Series 9/10

Series 9/10 allows the holder to supervise the sales efforts of a member firm. Unlike a gen-eral securities principal, a Series 9/10 principal cannot oversee investment banking, trading, or market making, nor can this person approve retail communications. A small non-OSJ branch may have a “person-in-charge” who is physically located at and manages the people working there. The person-in-charge is not required to be registered as a principal.

1. 1. 3. 9 NYSE Supervisory Analyst—Series 16

Series 16 permits an analyst for a member firm of the New York Stock Exchange to approve research intended for the general investing public.

1. 1. 3. 10 Compliance Official—Series 14

The Series 14 exam is intended to ensure that the individuals designated as having day-to-day compliance responsibilities for their firm or who supervise 10 or more people engaged in compliance activities have the knowledge necessary to carry out the responsibilities of their job. As of publication, this test is only required for those applicable compliance officers at NYSE and CBOE member firms. That may change. FINRA is considering this test for compli-ance officers too.

Member firms are required to assign people (usually principals but not always) as FINRA’s contact person for a variety of important areas of supervision. In addition to knowing who exactly is the Executive Representative, the point person for AML compliance and alternate, business continuity emergency contact, primary and secondary, continuing education, and others need to be identified along with their contact information.

Other points of contact depend on the business practice. For example, if a firm trades equity and fixed-income securities, the firm would be obliged to add points of contact for those lines of business. In this case, who is the head of trading and equity trading and then fixed-income trading? There is the potential for a great many points of contact depending on the structure and size of the member firm.

NASD Rule 1160 requires firms to update contact information promptly, but in no event later than 30 days following any change. Furthermore, firms must review and, if necessary, update the information within 17 business days after the end of each calendar year.



1. 1. 4 PERSONS EXEMPT FROM REGISTRATION WITH FINRA (NASD RULE 1060)

Some people associated with a member firm are not required to be registered with FINRA. They include the following:

■ Persons whose functions are exclusively clerical or ministerial ■ Persons who are not actively engaged in the investment banking or securities business ■ Persons whose functions relate solely to the member’s need for nominal corporate officers

or for capital participation ■ Persons who effect trades on a national securities exchange, such as on the NYSE trading

floor, so long as they are members of the exchange ■ Persons whose functions are solely related to commodities ■ Persons who effect transactions in security futures provided they are registered with the

National Futures Association (NFA). The NFA serves a similar function to FINRA, but to the futures industry.

■ Persons who effect transactions in municipal securities. For example, a bank may be involved in the underwriting of municipal bonds, and although the bank need not register with FINRA, they are subject to regulation by banking authorities. If a bank dealer adds lines of business beyond municipal securities, such as corporate debt, that new activity would trigger the registration requirements.

Ordinarily, members and associated persons do not share commissions and other allow-ances with nonmembers. However, in the case of nonregistered foreign persons, they may receive transaction-based compensation generated on business effected by customers whom they direct to the member. This exception to the rule, however, is available only if the member firm is satisfied that the finder is not required to be registered in the US and that the compen-sation does not violate foreign law. In addition, the finders must be foreign nationals, and the customers likewise must be foreign nationals. The firm also is obligated to send the customers a descriptive document disclosing the finder’s compensation arrangement and what the finder is receiving. This is memorialized again on each trade confirmation, which discloses the finder’s fee for that transaction.

QQ U I C K Q U I Z 1 . B Match the following registrations with the appropriate descriptions.

A. Series 7B. Series 24C. Series 4D. Series 6E. Series 62F. Series 53G. Series 11H. Series 51I. Series 14J. Series 52



—— 1. Allows the holder to sell only corporate securities

—— 2. Allows the holder to enter unsolicited orders, provide quotes, fill out new account forms, and update client information but not make recommendations or solicit business

—— 3. Allows the holder to sell general securities but not commodities

—— 4. Allows the holder to supervise the member’s options business; all mem-bers engaged in option transactions must have at least one

—— 5. Allows the holder to supervise most activities of a member firm, includ-ing trading, market making, investment banking, and sales; also may approve public communications

—— 6. Allows the holder to sell investment company products sold with a prospectus

—— 7. Allows the holder to supervise transactions in municipal securities; all member firms engaged in municipal business must have at least one

—— 8. Allows the holder to supervise transactions in municipal fund securities only

—— 9. Allows the holder to act as a Compliance Official

—— 10. Allows the holder to act as a municipal securities representative and is an acceptable prerequisite test for the Municipal Securities Principal Exam

1. 1. 5 FORM U-4

Every broker-dealer must obtain, and every associated person must furnish, a completed questionnaire signed by a municipal or general securities principal containing the following information:

■ Name, address, and Social Security number ■ Birth date ■ 10-year history of business connections (employment) ■ Residence(s) for the last five years ■ Denial, suspension, revocation, or disciplinary actions by a state or federal regulatory

agency (e.g., SEC, FINRA, NFA, NYSE) ■ Record of permanent or temporary injunctions ■ Criminal disclosures (including charges) ■ Record of bankruptcies filed ■ Record of fidelity bond refusal ■ Record of any aliases

✓T A K E N O T EAny felony charge is reportable no matter the disposition. For example, a repre-

sentative was charged with felony driving while under the influence of alcohol. The charge was reduced to a misdemeanor. It is still reportable. Another example would



be a representative who faced a felony assault charge that was dismissed. It too is re-portable. Although a felony charge that is dismissed is not in itself a statutory disquali-fication, failure to disclose it could be.

Sample Cover Page of Form U-4

A person associated with a broker-dealer is any partner, officer, or director of the broker-dealer (or any person performing similar functions) or any person directly or indirectly con-trolling or controlled by the broker-dealer, including any employees of the broker-dealer. Any person associated with a broker or dealer whose functions are solely clerical or ministerial is not included in the meaning of the term.



A completed and signed Form U-4 and its Disclosure Reporting Pages (DRPs) satisfy these requirements. There may be no misleading information. Those people entering the securities business would be unwise to try to hide or mask those aspects of their lives that they perceive might limit their chances or opportunities in a business that prizes truth and transparency. Those who are found to be untruthful with regulators suffer harsh sanctions. Note that regula-tors look favorably upon those who willingly amend forms prior to the discovery of an omis-sion or error.

The information in these files must be kept up-to-date, and every broker-dealer must keep a copy of this information for a minimum of three years from the date the person ends employ-ment with the firm. In addition, the copy retained by the company must have original signa-tures of the initial U-4 and amendments to the DRPs. This must be made available to examin-ers upon request. Social Security numbers also are collected for regulatory purposes.

Broker-dealers must keep a record of each associated person with regard to whether that person has passed the appropriate qualification exams. This record also must be maintained for at least three years after termination of the person’s employment.

To verify this information, a broker-dealer must check the person’s references and contact each employer listed for the preceding three years regarding accuracy of the information given, the person’s record, and reputation. A municipal broker-dealer that has been contacted by a potential employer must furnish information to the new employer within 10 business days of receiving the request.

!T E S T T O P I C A L E R TInformation on marital status or educational background is not required on Form

U-4. However, original signatures must be obtained with the initial Form U-4 and each submitted amendment to the DRPs found in Section 14 of the U-4.

Before manually signing the form for submission to the CRD (Central Registration Depository), a principal must verify the applicant’s employment for the prior three years and attest to the character and reputation of the applicant.

Any changes to this information require filing an amended form with the CRD not later than 30 days after the member becomes aware of changes. If the amendment involved a statu-tory disqualification, an amended form must be filed within 10 business days.

Registration is not effective until the applicant passes the appropriate qualification exam(s). If an applicant fails, 30 days must elapse before a second attempt can be made. If an applicant fails a FINRA-administered exam three straight times, the person must wait 180 days before making a fourth or any subsequent attempt.

Lastly, member firms are required under Rule 2263 to provide an associated person who manually signs an initial or amended Form U-4 that the form contains a predispute binding arbitration clause and cautions the associated person (AP) to read the clause before signing. The AP should know that he or she is agreeing to arbitrate any dispute, claim, or controversy that may arise between the firm and the AP, or a customer. Essentially, the AP is giving up the right to sue a member (or another AP) or customer. Claims, however, alleging employment discrimination, which included sexual harassment claims, are not required to be arbitrated unless the parties agree to it. See Unit 2 for more information on dispute resolution.



*C A S E S T U D Y An RR willfully failed to disclose material information on Form U-4 Section 14 Disclosure Reporting Pages. The missing information included federal and state tax liens, three civil judgments, and two bankruptcies. He did this with 11 different firms over the course of seven years. The National Adjudicatory Council (NAC) found that he violated ethical standards and filed misleading information. He was suspended for two years, required to requalify by exam, and pay assessed costs. Because his be-havior was material and willful, he was also statutorily disqualified from the securities industry.

1. 1. 5. 1 Verification

Before approving and affixing his/her signature on the Form U-4 for submission to the CRD, a principal must verify the applicant’s employment for the prior three years and attest to the character and reputation of the applicant.

As part of the overall review of a candidate for registration with a firm, a principal may look at a person previously registered in a pre-registration search. Ordinarily, a representative must sign a written consent form authorizing the firm to perform a pre-registration search. However, when a representative submits a signed Form U-4, no other written authorization is required.

✓T A K E N O T EAlthough a chief compliance officer may have assistance from a wide number of

people in the compliance department, when an examination of the firm is undertaken by FINRA, the CCO may not abnegate the responsibility attendant to that important office and point to others to share in the blame for violative practices or behaviors. The designated registered principal charged with the duty to supervise the member’s electronic filings may delegate that duty to an AP (who need not be registered). The registered principal, however, may not delegate any of the supervision, review, and approval responsibilities associated with, for example, a Form U-4.

Member firms must adopt procedures to verify the accuracy and completeness of a broker’s registration information on Form U4. Both for new registrants and newly hired people, mem-ber firms must conduct a search of reasonably available public records, such as those pertaining to criminal history, bankruptcy, civil litigation, liens and business records. The background check must be completed within 30 days of a U4 being filed.

1. 1. 6 FINGERPRINTING OF SECURITIES INDUSTRY PERSONNEL (SEC RULE 17F-2)

SEC Rule 17f-2 requires that the following associated persons be fingerprinted: ■ Persons applying for registration. A fingerprint card must be promptly submitted. FINRA

may make a registration effective pending receipt of the fingerprint information. If finger-print information is not received within 30 days following FINRA’s receipt of Form U-4, the registration will be changed to “inactive-prints.” The individual must then cease doing business until such time as the fingerprint card is received and entered into the Web CRD.



■ Persons involved in handling customer funds or securities (this also applies to employees of transfer agents)

■ Persons involved in the preparation of the firm’s original books and records (blotters) ■ Persons who supervise any of these

Occasionally, a firm may submit fingerprint information for a non-registered person. For example, those people who are granted access to the books and records of the firm, such as an outside bookkeeper.

Making certain that those who work on the firm’s books and records carry no history of violating laws that would call into question their ability to provide faithful and truthful service is part of a robust supervisory effort. Web CRD maintains fingerprint cards for non-registered individuals through non-registered fingerprint (NRF) filings.

If fingerprints are illegible to the FBI scanners and it rejects the fingerprint card, the mem-ber firm is obligated to submit again, up to three sets. The firm may not submit all three sets at once.

Summer interns need not be fingerprinted unless they sell securities or have access to han dling or processing securities, money, or original books and records or access to those who supervise that activity.

✓T A K E N O T EIf a fingerprint card is submitted for an associated person on at least three occa-

sions and it is returned each time due to illegibility, that person is exempt from the fingerprinting requirement. Fingerprints must be rolled in black ink. The card must be signed by the person being fingerprinted and by the official taking the prints.

All fingerprint cards, records, and information required is to be maintained and retained for at least three years after termination of that person’s employment or relationship with the organization at the firm’s principle office. The SRO acting as the firm’s DEA may also maintain the fingerprint cards. This is the same retention requirement period as for Forms U-4 and U-5.

!T E S T T O P I C A L E R TEven outside directors or partners whose only connection to the firm is the contri-

bution of capital are considered associated persons (APs) of the broker-dealer.

1. 1. 7 FORM U-5

Should a person registered with a member resign or be terminated, the member has an obligation under FINRA by-laws to file Form U-5 with the CRD within 30 days of termination date. The member firm also must provide a copy of the Form U-5 to its terminated employee within the same time frame. Failure to file the form with the CRD within 30 days will result in a late filing fee being assessed against the member. The form requires the member to indicate the reason for termination and to provide an explanation, where appropriate.

A person, who has been terminated and is no longer associated with any member, remains subject to complaint filings based on conduct prior to the termination for at least two years. This means that a credible complaint may lead to a suspension of the former representative



from future association with any member firm. The suspension could be based, for example, on the person’s failure to comply with an arbitration award.

As a footnote, this two-year hold on people is strictly a FINRA by-law. If a complaint arises due to serious criminal activity, such as embezzlement, fraud or money laundering, the SEC and the criminal justice system could pursue the alleged perpetrator well beyond two years.

*E X A M P L E If the member checks the Discharged or Permitted to Resign box, all of the details surrounding the termination must be disclosed.

In the event that the member, after filing the form, learns of facts or circumstances that would cause the information filed to be inaccurate or incomplete, the member must file an amended Form U-5 within 30 days of learning of facts giving rise to the amendment. A copy of the amended filing must be sent to the former employee. There is no time limit on how long after termination an amended Form U-5 is required.

If a registered person resigns from one member firm to join another, the new employer, in addition to filing Form U-4, must get and review a copy of Form U-5 filed by the former employer within 60 days of the U-4 filing.

!T E S T T O P I C A L E R T The former employer is not required to provide a copy of Form U-5 to the new employing member firm. The new firm must get a copy from either FINRA’s Web CRD or from its new employee. Under FINRA Rules, the new employee, if asked, must provide a copy within two business days of the request. If the prior employer failed to provide the Form U-5 to the applicant, that person must promptly request the Form and provide it to the requesting member within two business days of receipt. The ap-plicant must promptly provide any subsequent amendments to a Form U-5 he or she receives to the requesting member.

✓T A K E N O T EFailure to submit reportable information compromises the CRD and BrokerCheck®.

Without timely and accurate reporting of specific complaints and DRP reportable events (e.g., a felony charge and/or conviction), investors and other members are hindered in their background checks when considering a representative or hiring decisions. Fur-thermore, failure by a firm and its authorized principals to accurately make termination disclosures would likely lead to sanctions if uncovered by regulators.



Sample Form U-5 DRP Page

1. 1. 8 LICENSE AND JURISDICTIONAL RETENTION

If a registered associated person leaves the industry and reaffiliates with a member firm within two years, that person’s registration will be effective without an exam. If reaffilia-tion occurs after two years, the individual must requalify by passing the appropriate exam(s). Similarly, when a registered person leaves the business, FINRA retains jurisdiction over that person for two years.

!T E S T T O P I C A L E R TA person whose association with a member has been terminated and is no longer

associated with any member, or a person whose registration has been revoked or canceled, shall continue to be subject to the filing of a complaint under FINRA Rules based upon conduct that commenced prior to the termination, revocation, or cancel-



lation, or upon such person’s failure, while subject to FINRA’s jurisdiction, to provide information requested by FINRA pursuant to its Rules as long as the complaint is filed:

■■ within two years after the effective date of termination of registration;

■■ within two years after the effective date of revocation or cancellation of registration; or

■■ in the case of an unregistered person, within two years after the date upon which such person ceased to be associated with the member.

License Parking Prohibited. A registered representative may wish to keep his license active during a period when he is not going to use it. For example, he may wish to pursue an educational degree and then return to his firm without having to reapply for his license. This is called parking the license and is prohibited by FINRA.

1. 1. 9 ACTIVE MILITARY SERVICE

If a registered person volunteers for or is called into active military service, that person will be placed in a specifically designated inactive status upon notification to FINRA. Because these persons are inactive, they may not perform any of the duties normally performed by registered representatives. However, member firms may make arrangements with another reg-istered representative to have the accounts of that person serviced and to provide for a sharing of the commissions such accounts generate. Furthermore, once placed in inactive status, that person will not be required to complete either the regulatory or firm element of continuing education.

In addition, the two-year license expiration period will be tolled beginning on the date the person enters active military service and will end 90 days after that person’s completion of active service. If the person does not reregister with a member within 90 days after completion of service, the amount of time in which the person must become reregistered with a member, without being subject to the two-year expiration period, will be the standard two-year period reduced by the period between the person’s termination of registration and beginning of active service.

1. 1. 10 CONTINUING EDUCATION

Registered persons must participate in continuing education (CE) programs. The CE requirement has two components: (1) regulatory element, and (2) firm element.

The regulatory element requires that all registered persons complete a computer-based training session within 120 days after the person’s second registration anniversary and every three years thereafter (i.e., within 120 days of the person’s 5th, 8th, 11th registration anni-versary, et cetera). The content of the regulatory element is determined by FINRA and is appropriate to either the registered representative or principal status of the person. The repre-sentative’s initial registration date also is referred to as the base date.

If a person fails to complete the regulatory element within the prescribed period, FINRA will inactivate that person’s registration until the requirements of the program have been met. An answer choice on the actual exam may point to actions, such as suspend or terminate; these are not correct choices. The correct language would be the registration of the individual is deemed inactive. From that point on, the representative would be prohibited from perform-ing any of the duties and functions requiring registration. Anyone who remains in this inactive



status for two years will be terminated by FINRA and can be reregistered only after submitting a new application (Form U-4) and passing the appropriate examination. As a supervisor, note that members may not maintain a registration for anyone who is no longer active and is look-ing only to avoid the examination requirement prescribed by NASD Rule 1030, which spells out the registration requirements of FINRA.

If someone can show good cause, FINRA may allow additional time to satisfy the Regulatory Element beyond the two-year period. The application for the extension should not be taken lightly. FINRA is unlikely to grant extensions for superficial reasons.

Any registered representative who terminated association with a member and who has, within two years of the date of termination, become reassociated with a member, must partici-pate in the Regulatory Element based on the initial registration anniversary date rather than the date of reassociation.

From time to time, “In-Firm” delivery of the Regulatory Element may be permitted if the firm implements a program acceptable to FINRA. Some of the requirements include, but are not limited to, having a principal/officer in charge, that the location is under control of the firm, that the environment be conducive to training, and that the technology be compliant with FINRA standards. Furthermore, an authorized person must proctor all sessions during the entire Regulatory Element session. A proctor must be present or must be able to view those people sitting for Regulatory Element through a window or by video monitor.

Registration Category

PC – Floor Clerk Conducting Public Business

SC – Specialist Clerk (S21)

TA – Trading Assistant (S25)

FP – Municipal Fund (S51)

IF – In-Firm Delivery Proctor

MM – Market Maker Authorized Trader-Options (S56)

FB – Floor Broker (S56)

MB – Market Maker acting as Floor Broker

There is no requirement for a proctor to pass a qualification examination, but the proctor does need to be registered. A person whose sole registration is that of proctor may not function in any other area requiring registration.

The principal executive officer (or executive representative) of the firm must sign a letter of attestation that the in-firm delivery of the regulatory element continuing education proce-dures, reasonably comply with FINRA’s requirements to deliver it.

The firm element requires member firms to prepare an annual training plan that takes into account such factors as recent regulatory developments, the scope of the member’s busi-ness activities, the performance of its personnel in the regulatory element, and its supervisory needs. This annual in-house training must be given to all registered persons who have direct contact with the public.

✓T A K E N O T EIf a registered person leaves the industry and reaffiliates within two years, the

regulatory element for this person will be based on that person’s initial registration anniversary date. If reaffiliation is made after two years, the regulatory element cycle will be based on the reassociation date.



QQ U I C K Q U I Z 1 . C 1. An amendment to Form U-4 involving possible statutory disqualification requires submission of an amended form

A. immediatelyB. within 2 business daysC. within 10 business daysD. within 30 days

2. If a member learns that information it filed on Form U-5 is inaccurate or incom-plete, it must file an amended Form U-5

A. immediatelyB. within 2 business daysC. within 10 business daysD. within 30 days

3. All of the following may be SROs in the securities industry EXCEPT

A. FINRAB. a registered stock exchangeC. the Securities Industry and Financial Markets Association (SIFMA)D. a registered clearing agency

4. A stock exchange member firm that wishes to join FINRA must submit Form BD to which of the following?

A. FINRA’s district office where the applying firm has its home officeB. The main office of the Financial Industry Regulatory AuthorityC. Application may be made only through the SECD. Stock exchange members may not belong to FINRA

5. Which of the following must FINRA member firms that hold customer funds or securities supply to their customers at least once per calendar year?

I. FINRA’s BrokerCheck® hotline number II. The telephone number of the nearest district office of FINRA III. The name of their firm’s FINRA executive representative IV. FINRA’s website addressA. I and IIIB. I and IVC. II and IIID. II and IV



U N I T T E S T

1. Foreign associates of a member firm who are noncitizens and who conduct business outside the United States mustA. be registered with FINRA but are exempt from

passing a qualification examinationB. be registered with FINRA and pass an

appropriate qualification examinationC. be registered with the appropriate regulatory

authorities of the native countryD. apply for an exemption from the qualification

examination requirements

2. Required information on Form U-4 includesA. a 5-year employment history and a 5-year

residency historyB. a 5-year residency history and 10-year

employment historyC. marital status D. level of eduction

3. If an individual fails a qualification exam 3 straight times, a 4th attempt may not be made forA. 30 daysB. 60 daysC. 90 daysD. 180 days

4. A member firm may grant discounts, concessions, or other allowances to A. a suspended memberB. a broker-dealer registered with the SEC onlyC. a foreign nonmember ineligible for FINRA

membershipD. none of these

5. A registered person leaves the industry and, 18 months later, reassociates with another member firm. Under FINRA rules, this person’s cycle for determining the dates for the regulatory element of continuing education is based onA. initial registration dateB. reassociation dateC. either A or BD. neither A nor B

6. Before signing Form U-4, a principal must verify the applicant’s employment history for the previ-ousA. 2 yearsB. 3 yearsC. 4 yearsD. 5 years

7. Under FINRA rules, amendments to Form BD must be made withinA. 15 days of any changeB. 30 days of any changeC. 45 days of any changeD. 60 days of any change

8. Under FINRA rules, which of the following must be registered as principals?A. Small branch office managersB. Managers of an OSJsC. ProctorsD. Sales assistants

9. An individual will be statutorily disqualified from registration with FINRA if convicted of money- or securities-related fraud within the previous A. 2 yearsB. 3 yearsC. 5 yearsD. 10 years

10. A Series 6 license holder is permitted to sell I. mutual funds II. closed-end funds as a new issue III. closed-end funds in the secondary market IV. unit trusts

A. I onlyB. I, II and IVC. I and IVD. I, II, III, and IV



11. A registered representative leaves BDA to join BDB. Which of the following statements regarding Form U-5 is(are) TRUE? I. BDA must file Form U-5 with FINRA. II. BDA must provide a copy to its former

employee. III. BDA must provide a copy to BDB.A. I onlyB. I and IIC. I and IIID. I, II, and III

12. A member firm may join with a nonmember inA. underwriting nonexempt securitiesB. underwriting exempt securitiesC. either A or BD. neither A nor B

13. A member firm, operating on the premises of a commercial bank, must advise new customers that securities purchased or sold are I. not insured by the FDIC II. not deposits or obligations of the bank III. subject to investment riskA. I onlyB. I and IIIC. II onlyD. I, II, and III

14. Under FINRA rules, a registered representative must complete the regulatory element of continu-ing education within how many days of a registra-tion anniversary date?A. 30B. 60C. 90D. 120

15. A member firm files Form U-5 with FINRA for a former employee. Two years later, the member learns of facts that would cause the information filed to be inaccurate. Under FINRA rules, the member must file an amended Form U-5 within A. 30 daysB. 30 days only if the former employee has

reassociated with another memberC. 60 daysD. 60 days only if the former employee has

reassociated with another member

16. Which of the following statements regarding the various forms that broker-dealers use in the securi-ties business are CORRECT? I. Form ADV is used to terminate an associated

person. II. Form MC-400 is used when employing a

statutorily disqualified individual. III. Form U-5 is used to register an investment

adviser with the SEC. IV. Form U-4 is used to register an associated

person.A. I and IIIB. I and IVC. II and IIID. II and IV

17. Investors wishing to investigate the registration history of the registered representative handling their account would do so by going to the Broker-Check® program atA. the SICB. the CRDC. the FBID. the SEC

18. A registered representative with your firm terminated her registration for personal reasons. Now, 16 months later, she wishes to return to work. Which of the following statements are CORRECT? I. She must requalify by passing the exam. II. She does not have to retake the exam. III. She must file a new Form U-4. IV. She must amend her old Form U-4.A. I and IIIB. I and IVC. II and IIID. II and IV

19. All of the following statements relating to a FINRA member firm’s executive representative are correct EXCEPTA. the individual must be a member of the firm’s

senior managementB. the individual must be registered as a principalC. changes to the executive representative must

be noted in writing to FINRAD. appointment of the executive representative is

made by the FINRA district office serving that member firm



20. You are interviewing a potential registered repre-sentative. She indicates that she previously was employed by another FINRA member firm. You ask for a copy of her Form U-5 and are told that she has lost it. You would be able to obtain a copy fromA. her previous employerB. the CRDC. the SECD. the FINRA district office

21. A registered principal voluntarily terminates his registration. Should a complaint surface relating to activity occurring while he was registered, FINRA would have jurisdiction for a period ofA. 30 daysB. 6 monthsC. 1 yearD. 2 years

22. A candidate for registration with your firm fails to indicate on Form U-4 that he was once arrested for embezzlement. The charges were eventually dropped when the guilty party admitted to the crime. Several months later, this matter is brought to your attention. You shouldA. ignore it, because the charges were droppedB. require the individual to file an amendment to

Form U-4C. determine whether the charges were within

the 10-year period before the filing of the Form U-4

D. discharge the individual and file a Form U-5 within 30 days

23. Jim, one of your registered representatives, wishes to pursue a financial degree at a nearby commu-nity college. Your firm has expressed willingness to rehire him when he returns with his degree. He worked very hard to obtain his Series 6 license and wants to know how to keep it current while he is in school. You tell himA. he need not terminate his license unless he

plans to be gone from the firm for more than 2 years

B. his license will terminate when he leaves the firm, but if he returns in 2 years or less, he need not retake the exam

C. keeping an inactive license on file is a service available only to supervisory personnel

D. there will be no problem keeping him on the books as a licensed salesperson until he returns from school, as long as he is willing to pay the requisite fees

24. You have just hired a new registered representative who is 21 years old. You must verify his employ-ment record for the last how many years?A. 1B. 2C. 3D. 5

25. A registered representative who does not complete the regulatory element of continuing education within the prescribed time frameA. may continue to function for a limited time as

a representative with the written permission of a principal

B. may not perform any of the functions of a representative until the Regulatory Element is satisfied

C. is limited to accepting unsolicited orders only until the CE requirement is met

D. is required to take a 120-day leave of absence

26. A registered representative leaves the industry to accept a position as a finance professor. The repre-sentative must requalify by examination to return to the industry if he is unaffiliated with a broker-dealer for more thanA. 2 yearsB. 3 yearsC. 5 yearsD. 10 years



27. The Code of Arbitration would handleA. settlement dates on securitiesB. disputes involving a member and the public if

brought by the public customerC. trade practice complaintsD. violations of the SEC rules

28. If a member wishes to merge with another mem-ber, FINRA must be notifiedA. at least 30 days prior to the closing dateB. at least 20 days prior to the closing dateC. at least 10 days prior to the closing dateD. on or prior to the closing date

29. Investors wishing to investigate the registration history of the registered representative handling their account would do so by going to the Broker-Check® program atA. the SICB. www.finra.orgC. the FBID. the SEC

30. You have hired a Tier I individual. This will in-volve an annual charge by FINRA ofA. $0B. $1,000C. $1,500D. $2,500

31. Your company has been designated as having hired an excessive number of licensed personnel from a disciplined firm. The company must arrange to monitor all sales efforts, including taping conver-sations between salespersons and the public. How long does the company have to install the required systems and procedures?A. 60 daysB. 120 daysC. A reasonable periodD. Before it is allowed to expand its business



A N S W E R S A N D R A T I O N A L E S

1. B. Foreign associates who are noncitizens and who conduct business outside the United States must be registered with FINRA but are exempt from having to pass a qualification exam.

2. B. Form U-4 requires an applicant to provide a 5-year residency history and a 10-year employment history.

3. D. If a qualification exam (e.g., Series 7) is failed 3 straight times, a 4th attempt may not be made for 180 days.

4. C. Members can only grant discounts, concessions, and other allowances to other members. An exception is made for foreign nonmembers ineligible for membership.

5. A. Provided reassociation occurs within 2 years, the cycle for determining the dates for the regulatory element of continuing education is based on the initial registration date. If reassociation occurs after 2 years, the cycle is based on the reassociation date.

6. B. A principal is required to verify an applicant’s 3-year employment history. Verification may be done in writing or over the phone.

7. B. Amendments to Form BD must be made within 30 days of any change.

8. B. FINRA rules require that managers of OSJs and officers be registered as principals. Persons-in-charge at a non-OSJ branch are not required to be registered as a principal.

9. D. If convicted of money- or securities-related fraud within the prior 10 years, FINRA will deny an applicant registration.

10. B. A Series 6 registration enables the holder to sell investment company products with a prospectus (e.g., mutual funds, unit trusts, and variable annuities). Closed-end funds, which trade in the secondary market, cannot be sold by a Series 6 license holder except as a new issue where a prospectus is required.

11. B. Form U-5 must be filed with FINRA and a copy provided to the terminated representative within 30 days. The new employer must secure a copy for its files from either their new employee or from FINRA (not from BDA).

12. B. Only FINRA members can be part of a group underwriting nonexempt securities. Nonmembers can join with members in underwriting exempt securities.

13. D. If a member is operating on the premises of a commercial bank, FINRA rules require that the member’s services be clearly distinguished from the bank’s retail deposit-taking activities. When a member opens a customer account, the firm must disclose to the customer that the securities purchased or sold are not FDIC insured, are not obligations of the bank, and are subject to investment risk.

14. D. The regulatory element requires that all registered persons complete a computer-based training session within 120 days of their second registration anniversary and every 3 years thereafter.

15. A. If facts come to light that would cause a Form U-5 filing to be inaccurate, the member must file an amended form within 30 days. FINRA rules do not specify a period following termination for which an amended form would be required.



16. D. Form ADV is used to register an investment adviser, and Form U-5 is used in terminating the employment of a registered person. Firms subject to statutory disqualification would use Form MC-400A. Broker-dealers apply for FINRA membership on Form BD.

17. B. The Central Registration Depository (CRD) keeps a registrant’s history. This is accessible through BrokerCheck®.

18 C. After termination, a person wishing to reenter the business is exempt from the qualification exam for a period of 2 years. Returning to work after termination is considered the same as a new registration, so a new Form U-4 is required.

19. D. The member firm makes the decision as to who will be its executive representative and then notifies the FINRA district office.

20. B. In most cases, the terminated employee will have a copy of the Form U-5 and, if requested, must deliver it within 2 days. Alternatively, the new employer can obtain a copy from the CRD. The former employer has no further obligation once it has supplied the terminated employee and CRD with the original Form U-5.

21. D. FINRA retains jurisdiction over previously registered individuals for a period of 2 years after the effective date of their termination.

22. B. Any arrest or charge for something of this nature must be reported on Form U-4, regardless of how long ago it happened or whether the ultimate result is innocence or guilt. A guilty charge could result in statutory disqualification. In this instance, because the case against the person was dropped, it is only necessary to file an amended Form U-4.

23. B. The practice of parking a license is prohibited in the securities industry. Jim’s license will terminate when he leaves the company and must be reapplied for when he returns. However, if less than 2 years has elapsed, he need not resit the exam.

24. C. Employment records for registered personnel must be verified for the most recent 3 years.

25. B. If a registered person does not complete the regulatory element of CE within the prescribed time frame, the representative’s license will be suspended by FINRA. Therefore, until the element is completed, the representative may not perform any of the functions of a registered representative. The regulatory element must be completed within 120 days of the representative’s second registration anniversary and every 3 years thereafter.

26. A. All securities licenses become null and void once an individual is unaffiliated for more than 2 years.

27. B. You should always associate the words dispute and arbitration.

28. A. The membership agreement between a broker-dealer and FINRA requires written notice to FINRA at least 30 days prior to merger with another member, acquisition by the member of another member, acquisition or merger with a nonmember, and a material change in the member’s business.

29. B. The Central Registration Depository (CRD) keeps a registrant’s history. This is accessible through BrokerCheck®.

30. C. Tier I requires a separate annual review and involves a charge of $1,500. Tier II is reviewed during the firm’s normal audit and involves a charge of $1,000.



31. A. Upon designation as having hired an excessive number of personnel from a disciplined firm, a member firm has 60 days to adopt monitoring procedures, including arrangements to record conversations between registered representatives and the public.



Q U I C K Q U I Z A N S W E R S

Quick Quiz 1.A

1. F. A firm will be statutorily denied membership if it has been expelled by another SRO.

2. T. A membership agreement remains in force, including any restriction agreements, unless the firm changes its lines of business and satisfies Rules 1014 and 1017.

3. F. The membership agreement stipulates that a firm must notify FINRA 30 days prior to an acquisition of, or merger with, another member firm. Other events require notification within 30 days (e.g., branch openings, change of address).

4. T.

5. T.

Quick Quiz 1.B

1. E.

2. G.

3. A.

4. C.

5. B.

6. D.

7. F.

8. H.

9. I.

10. J.

Quick Quiz 1.C

1. C. An amendment to Form U-4 involving possible statutory disqualification must be filed within 10 business days of the date the member became aware of the event. Other amendments to the form must be filed no later than 30 days after the member becomes aware of the changes.

2. D. A member firm must file an amended Form U-5 within 30 days of learning of facts giving rise to the amendment.

3. C. The SROs in the securities industry consist of FINRA, the Municipal Securities Rulemaking Board, the registered stock and option exchanges, and registered clearing agencies.

4. A. Application for membership in FINRA is made to the district office where the applying firm has its headquarters. Although FINRA member firms must also be registered with the SEC, application is not made through the SEC.

5. B. FINRA member firms that hold customer funds or securities must supply FINRA’s BrokerCheck® hotline number, FINRA’s website address, and access information regarding their investor brochure to their customers at least once per year.

Series_24_01.indd 35 6/16/2015 3:06:55 PM

37

u n i t

2Supervision of General Broker-Dealer Activities

T his Unit focuses on the supervision of general broker-dealer activities. It covers a broad swath ranging from accounts, compensation prac-tices, development, evaluation, delivery of products and services, and

disciplinary or corrective actions, to developing and maintaining policies, procedures, records retention, and financial responsibilities. This two-part unit, with an expected 45 questions of the Series 24 exam, covers nearly a third of the Series 24 exam.


O B J E C T I V E S

38

When you have completed this Unit, you should be able to recognize and explain the following:

■ Requirements to segregate customer securities and funds

■ Requirements to report short interest

■ Introducing and clearing arrangements

■ SEC requirements for extensions of credit and related disclosure

■ Reporting requirements of firm capital condition

■ Record retention requirements

■ Electronic records storage requirements

■ Proper handling and resolution of disputes

■ FINRA and SEC disciplinary processes

■ Reporting requirements for customer complaints

■ Products and their risk characteristics and appropriate accounts

■ Requirements to train associated persons concerning products and services

■ Requirements to conduct due diligence on new products and services and continue risk assessment of existing products and services

■ Ongoing risk assessment of listing products and services

■ Networking arrangements

■ Payments for referrals

■ Gifts

■ Regulatory requirements to manage conflicts of interest

■ Regulatory requirements related to personal trading, private securities transactions, and outside business and other activities

■ Requirement to conduct periodic inspections and reviews of activities of personnel located at the Office of Supervisory Jurisdiction (OSJ), branch offices, and associated office loca-tions

■ Appropriate testing of the firm’s procedures and controls, including the CEO Certification

■ Business and regulatory requirements for firm’s systems and technologies

■ Requirement that all activities and systems have proper controls

■ Requirements to implement and test the firm’s Business Continuity Plan (BCP)


39Unit 2 Supervision of General Broker/Dealer Activities

Part 12. 1 GENERAL SUPERVISION OF EMPLOYEES

2. 1. 1 SUPERVISION

Each member is required to establish, in writing, a supervisory system to manage the types of business in which it engages and the activities of its registered representatives and associ-ated persons. At minimum, the member must:

■ designate appropriately registered principals with the authority to enforce the firm’s writ-ten supervisory procedures;

■ identify to FINRA which of its offices are designated as offices of supervisory jurisdiction; and

■ identify to FINRA which of its principals are responsible for reviewing the firm’s supervi-sory system and taking action where required to achieve compliance with securities laws and FINRA rules.

The primary job of a supervisor of a brokerage firm is to ensure that the registered represen-tatives have a good working knowledge of, and adhere to, the firm’s written supervisory proce-dures. In addition, they work to assure full compliance with not only FINRA regulations but also state and Federal laws, such as the Securities Exchange Act of 1934 (SEA). Supervisors must take all reasonable steps to prohibit the use of any manipulative and deceptive device or contrivance whether the securities are nonexempt, such as IBM common stock, or exempt, such as a New York City municipal bond.

Some specific supervisory tasks include: ■ supervising the activities of APs; ■ ensuring all representatives are qualified by the proper examination and receive their con-

tinuing education; ■ reviewing sales-related activity; ■ reviewing transactions and communications; and ■ accept new customer accounts by signature.

Suitability of customer recommendations must rank high on a supervisor’s list of concerns. Are recommendations reasonable and specific to that customer? That is, did the representative consider the investor’s age, life stage, and liquidity needs? Can the representatives identify and explain the characteristics and risks associated with the products they are offering?

The following are just a few items that must be considered before reasonable recommenda-tions may be made, particularly to senior investors.

■ Is the customer still employed? ■ How much longer is the customer planning to work? ■ Does the customer have a mortgage?


40 Unit 2 Supervision of General Broker/Dealer Activities

■ What other income sources does the customer have, if any? ■ How much income is needed to meet fixed and anticipated expenses? ■ What are the customer’s personal goals?

Supervisors must always consider that firms and registered representatives are prohibited from making false, exaggerated, unwarranted, or misleading statements or claims in commu-nications with the public. This includes referencing nonexistent or self-conferred degrees or designations.

As part of any good supervisory system, the approval of materials used in seminars should figure high. It’s a supervisor’s responsibility to ensure that none of the following occur:

■ Inaccurate or exaggerated claims on the safety, liquidity, or expected returns of the touted investment or strategy

■ Misrepresentations or material omissions about the investment product or strategy ■ Material omissions around conflicts of interest ■ Misrepresentations of the credentials of the seminar’s sponsor and participant ■ Failure to reference the firm’s name in advertisements ■ Improper use of testimonials in ads

The following chart summarizes common investor objectives and appropriate recommendations.

Investor Objective Suitable Recommendation

Preservation of capital; safety Insured bank CDs, money market instruments or funds, T-bills

Growth ■ Balanced/moderate growth ■ Aggressive growth

Common stock or common stock mutual funds

■ Large-cap stocks, defensive stocks ■ Technology stocks, sector funds, or

cyclical stocks

Income ■ Greatest safety ■ Tax-free income ■ High-yield income ■ From a stock portfolio

Bonds (but not zero-coupons) ■ U.S. government bonds ■ Municipal bonds or municipal

bond funds ■ Corporate bonds or corporate

bond funds ■ Preferred stock and utility stocks

Liquidity Money market funds ■ (DPPs, real estate, and annuities

are not considered liquid)

Speculation Volatile stocks, high-yield bonds, stock/index options

✓T A K E N O T EIf a customer refuses to provide financial information, the member firm may use

whatever information is available to decide whether to open the account. Any recom-mendation made to a customer must be suitable, taking into account the customer’s investment objectives, financial situation, and any other relevant information. If the information is not provided, the account may be opened, but no investment recom-mendations may be made.



2. 1. 1. 1 Office of Supervisory Jurisdiction (OSJ)

Each member must identify to FINRA which of its offices have been designated as OSJs. An OSJ is any office at which one or more of the following functions take place:

■ Order execution or market making ■ Formation or structuring of public offerings or private placements ■ Custody of customer funds or securities ■ Final approval by a principal of new accounts on behalf of the member ■ Review and endorsement of customer orders ■ Final approval of retail communications, except for an office that solely conducts final

approval of research reports ■ Supervision of activities of persons at one or more of the member’s branch offices

FINRA requires members to identify other offices as OSJs, if needed, to properly supervise the activities of their registered representatives. In making this determination, the member should consider:

■ whether registered persons at a location have regular contact with the public; ■ the number of registered persons at a location; ■ whether the location is geographically distant from another OSJ of the firm; ■ whether the securities activities at a location are diverse and/or complex; and ■ whether the member’s registered persons are geographically dispersed (working remotely).

The significance of an OSJ is that the office is responsible for the activities of registered representatives (and other associated persons) housed not only in that office, but in other offices usually located within the same region.

The responsibilities of an OSJ, which must be managed by at least one resident general securities principal, are to:

■ enforce the written supervisory procedures of the firm; ■ periodically review customer accounts; ■ maintain copies of customer records (new account forms signed by a principal, order tick-

ets, confirmations, etc.), including customer complaints; and ■ periodically inspect the branch offices beneath it.

*E X A M P L E If a FINRA or an in-house auditor were to examine records maintained at an OSJ, the auditor would be reviewing not only the activities at that location, but also the activities of all of the non-OSJ branch office locations reporting to that OSJ.

A copy of the member’s written supervisory procedures and a copy of the FINRA Manual must be kept in each OSJ and at each location where supervisory activities are conducted. Further, a copy of the Manual must be made available to customers on request. Access to the FINRA Manual electronically also will satisfy this requirement.



2. 1. 2 SUPERVISORY CONTROLS

Member firms must designate one or more principals who will establish, maintain, and enforce supervisory control procedures that will test and verify that the firm’s supervisory pro-cedures are sufficient. At least once annually, the principal(s) designated must submit a report to senior management that summarizes the results of testing and details any amended proce-dures to be implemented.

These supervisory control procedures also must be designed to review on a day-to-day basis customer account activity conducted by producing branch office managers, sales managers, and regional or district sales managers. A person who is senior to or otherwise independent of a producing manager must perform these day-to-day supervisory reviews. Persons independent from the activities being performed at that location and from the person supervising that loca-tion must carry out office reviews.

Remember that a member firm’s policies and procedures in supervising sales managers who service accounts are expected to encompass all sales-related activities, including new account approval by the principal, ongoing review of account activity in search of unauthorized trans-actions, and prior approval of account name change or designation change, such as cancel and rebills.

A cancel and rebill transaction involves canceling a trade in one account and rebill-ing it to another account. The firm’s written supervisory procedures should require a supervi-sor’s approval of cancel and rebill transactions or, if done in a producing manager’s customer account, the approval of some other qualified person. Failure to properly supervise cancel and rebills allows registered representatives inordinate latitude, which could turn out to be disad-vantageous to customers of the firm.

A person who does not report to the producing manager, whose compensation is not deter-mined in any way by the producing manager, and who is not in the same chain of authority may be considered senior to the producing manager. This person also must have the authority to correct the activities of the producing manager and take any action, including termination, if and when necessary. This person must be situated in an office other than the office of the producing manager. This person must alternate review responsibility with another qualified person every two years or less.

✓T A K E N O T EFINRA provides a limited size and resource exception for firms that do not have

the personnel (i.e., principals who are senior to and otherwise independent from the producing manager) to review the activities of producing managers. These firms may continue to use principals who do not meet these criteria. To do so, a firm must notify FINRA within 30 days of the date on which the firm first relies on the exception and annually thereafter.

✓T A K E N O T EEach member must identify, on a separate record, which of its principals are

responsible for each of its various activities.

*E X A M P L E An options principal must be designated to supervise the firm’s options business; a municipal principal must be designated to supervise the member’s municipal busi-ness; a general principal to supervise the training of registered representatives; and so on.



The designation record, which is appended to the firm’s written procedures, must be retained for six years after any change.

2. 1. 3 SUPERVISION OF SUPERVISORS

Member firms must have procedures that are reasonably designed to provide supervision over the activities of managers.

If, for example, a firm includes new and complex securities in its product line, there is likely a need for heightened supervision while managers and representatives are learning to properly offer the securities.

Other examples could include a representative who has been sanctioned by FINRA for rule violations—a representative who breaches trading limits regularly or a branch manager that has a pattern of “looking the other way” when profitable but unauthorized trading is identified.

Each firm must have in place sound practices and internal controls to uncover any unau-thorized practices that may undermine confidence in the firm and the industry. Sound prac-tices could include mining trade data for red flags, such as transactions in which confirmation and settlement do not occur on a timely basis. Another example could include the establish-ment of a mandatory vacation policy for supervisors and those positions, including traders, with sensitive jobs. Although not possible for some firms, those firms that have mandatory vacation policies may look at the request of the trader or representative for an exemption from the policy as a red flag. During the vacation, supervising managers may look through the files and records of the vacationer to identify irregularities or attempts to conceal unauthorized activity such as “rogue” trading.

✓T A K E N O T EA firm’s procedures must prohibit supervisory personnel from supervising their

own activities or having their compensation or continued employment determined by a person they are supervising.

If the firm’s size or a supervisory personnel’s position within the firm makes com-pliance with these restrictions impracticable, the member firm is obligated to docu-ment the factors the firm used to make that determination and how supervision with respect to supervisory personnel otherwise complies with the rule. This situation might arise in instances where the broker-dealer is a sole proprietorship.

2. 1. 4 SPECIFIC POLICIES AND PROCEDURES

A member firm’s supervisory control policies and procedures must include specific review of the following activities:

■ All transmittal of funds or securities from customer accounts

— that would result in a change of beneficial ownership;

— to outside entities, such as banks or investment companies;

— to locations other than a customer’s primary residence; and

— to registered representatives, including the hand delivery of checks ■ Customer changes of address and the validation of such change ■ Customer changes of investment objectives and the validation of such changes



2. 1. 5 INTERNAL INSPECTIONS

FINRA Rule 3110 requires, among other things, that OSJs and the lines of business in which it engages be inspected and reviewed annually. Branches that supervise one or more nonbranch locations also must be inspected annually. Branches that do not supervise other locations must be inspected at least once every three years. Nonbranches must be inspected according to a schedule determined by the firm. Records relating to inspections must be kept for at least three years. Those locations that do nothing other than approve research reports are exempt from definition of an OSJ.

✓T A K E N O T EAlthough not strictly prohibited, there is a general presumption that a principal

will not be designated to be the on-site principal for more than one OSJ. However, if the firm deems it necessary, it may do so but must consider all of the other factors including, among other things, whether the on-site principal has the time to supervise the activities at the other locations.

2. 1. 6 TAPE RECORDING OF REGISTERED PERSONS BY CERTAIN FIRMS (FINRA RULE 3170)

If a member hires representatives who were previously associated with a disciplined firm, the member may be required to establish procedures for monitoring the telemarketing activi-ties of all of its registered persons. A disciplined firm is one that has been expelled from mem-bership in any SRO or is the subject of an SEC order revoking its registration as a broker-dealer.

The criteria used by FINRA are as follows.

LevelNumber of Registered

Representatives Employed

Number of Registered Representatives from

Disciplined Firms

A 5–9 40% or more

B 10–19 4 or more

C 20 or more 20% or more

*E X A M P L E If a member with 15 registered representatives has four or more who, within the prior three years, were associated with a disciplined firm, the member is required to monitor the phone calls of all of its registered persons. The member must record and review all phone conversations of its representatives with clients, existing and poten-tial (cold calls).

Once the member is advised by FINRA that special supervisory procedures are required, the firm has 60 days to implement them by tape recording all telephone conversations between the registered persons and both existing and potential customers.

These special supervisory procedures must be maintained for three years. In addition, the member must provide FINRA with quarterly reports on its telemarketing supervision. All recordings made, as well as the quarterly reports, must be maintained for three years.



✓T A K E N O T EIf a firm is notified by FINRA for the first time that it is subject to the record-

ing rule, it has a onetime opportunity to obtain relief by adjusting its staffing levels to below the threshold levels. It can only do so by terminating representatives from disciplined firms. It cannot do so by hiring additional representatives to fall below the stated thresholds. If a firm wants to avoid the taping rule by adjusting its staffing levels, or if it wants to seek an exemption from the rule, it must do so within 30 days of receiving written notice from FINRA.

2. 1. 7 SUPERVISORY CONTROL SYSTEM/BRANCHES (FINRA RULES 3110 AND 3120)

A branch office is defined as any location “held out” to be where one or more associated persons of a member regularly conduct the business of effecting transactions in or inducing the purchase or sale of any security. The definition excludes the following:

■ Any nonsales location, such as a back office ■ The primary residence of an associated person (to be exempt, the associated person may

not meet with customers at the location; customer funds and securities may not be han-dled at the location; the associated person must be assigned to a designated branch office, which must be reflected on all business cards, stationery, advertisements, and other public communications; and all orders must be entered through the designated branch or through an electronic system that is reviewable at that branch)

■ Any location, other than a primary residence, that is used for less than 30 business days annually for securities business (these locations would generally include vacation or sec-ond homes and are subject to the same rules applicable to primary residences)

■ Any location of convenience used occasionally and by appointment; if an office of con-venience is located on bank property, signage necessary to comply with applicable rules of the bank regulators, as well as FINRA, may be displayed at the location and it will not be deemed “holding out” as a branch office under Rule 3110

■ Any location used primarily for nonsecurities business (e.g., insurance sales) and from which less than 25 securities transactions are effected annually

■ The floor of an exchange ■ Any temporary location used as part of a business continuity plan

✓T A K E N O T EAny location responsible for supervising the activities of persons at one or more

nonbranch locations is considered to be a branch office—in this case, a supervising branch.

*E X A M P L E The home of a registered representative (from which the representative conducts business) is not a branch as long as no advertising or signage indicates that securities business is conducted on the premises.

Also, any business cards or letterhead must state the address and phone number of the branch office or OSJ responsible for supervising this person.



!T E S T T O P I C A L E R T FINRA rules require that there be at least one principal at an OSJ. FINRA rules do not require principals to be at branch offices. A properly qualified registered represen-tative can act as branch manager. However, the location must be under the supervi-sion of an OSJ.

In addition to each firm being required to designate and specifically identify to FINRA one or more principals who must establish, maintain, and enforce a system of supervisory control policies and procedures, those appointed must test and verify that the procedures are, in fact, reasonably designed to achieve compliance. If it turns out following testing and verification there is a need to create additional or amend supervisory procedures, those principals are obli-gated to make sure that happens.

The designated principals must submit to the member’s senior management annually a report detailing the system of supervisory controls, the summary of the test results and signifi-cant identified exceptions, and any additional or amended supervisory procedures created in response to a test.

Each report provided to senior management in the calendar year following a calendar year in which a member reported $200 million or more in gross revenue must include, when appli-cable to the member’s business, a tabulation of the reports pertaining to customer complaints and internal investigations made to FINRA during the preceding year and discussion of the preceding year’s compliance efforts, including procedures and educational programs, in each of the following areas:

■ trading and market activities; ■ investment banking activities; ■ anti-fraud and sales practices; ■ finance and operations; ■ supervision; and ■ anti-money laundering.

2. 1. 8 ANNUAL COMPLIANCE MEETING

FINRA rules require that all registered representatives (Series 6, 52, 7 and so forth) and registered principals participate, at least once each year, in a meeting or interview at which compliance matters relevant to the activities of the particular representative and principal are discussed. These meetings can be held individually or with a group and typically take place at a central location or at the representative’s or principal’s place of business. They may, however, be conducted by video conference, telephone, interactive classroom setting, or other elec-tronic means so long as certain safeguards are in place to assure full participation. For example, if the firm conducts the meeting via a webcast, the registered person would be issued a user ID and password to access the presentation with a click-as-you-go confirmation. Although FINRA does not require any specific method, whichever method the firm uses, it must be rea-sonably reliable at demonstrating compliance.



2. 1. 9 INDEPENDENT REVIEW

FINRA requires that a member designate one or more principals who will establish, main-tain, and enforce supervisory control procedures that will test and verify that the firm’s supervi-sory procedures are sufficient. At least once annually, the principal(s) designated must submit a report to senior management that summarizes the results of testing and details any amended procedures and controls to be implemented, including the CEO certification.

Firms must have procedures to prohibit supervisory personnel from supervising their own activities and reporting to (or having compensation or employment determined by) the per-son whom the supervisor is supervising. Office reviews must be carried out by persons inde-pendent from the activities being performed at that location and from the person supervising that location.

✓T A K E N O T EThe SEC deems exchanges, SROs, and member firms to be “gatekeepers” of

securities laws. If, for example, a customer somehow gained a head start on valuable trading information, an exchange that could have prevented the violation but did not have sufficiently robust processes in place to prevent it could be disciplined along with the offending customer.

Supervisory personnel at a broker-dealer who fail to prevent securities laws viola-tions by customers when they saw or should have seen the violative conduct may be held to account for failing to live up to their gatekeeper responsibilities.

Please take the time to carefully review the following supervisory requirements that prin-cipals should consider when creating a strong supervisory system. This is more than a mere list. As you go through this, you will be creating and strengthening your ability to build a culture of compliance.

■ Supervision of Multiple OSJs by a Single Principal—FINRA member firms are required to maintain at least one onsite principal with supervisory responsibilities, and a regular and routine physical presence, at each office of supervisory jurisdiction (OSJ). The rules contain a presumption that a principal will not be designated and assigned to be an onsite principal to supervise more than one OSJ. The presumption may be overcome if a member considers and documents its consideration of certain factors, such as the experience of the principal and the geographic proximity of each OSJ the principal will be supervising.

■ Internal Office Inspections—Inspections of non-branch offices are required, and there is a presumption that a non-branch office will be inspected at least every three years. Addi-tionally, other than compliance personnel, the rules prohibit an AP from inspecting the AP’s office.

■ Restrictions on Supervisory Personnel—Firms must have procedures to prohibit supervi-sory personnel from supervising their own activities and reporting to (or having compen-sation or employment determined by) the person whom the supervisor is supervising.

■ Risk-Based Reviews of Transactions—Firms may employ a “risk-based” review of transac-tions. Firms are not required to conduct a detailed review of each transaction and may prioritize for review certain transactions that pose a greater risk of potential violations of securities laws and rules.

■ Risk-Based Reviews of Correspondence and Communication—Similarly, with regard to the requirement to review all written (including electronic) correspondence and internal communication relating to a firm’s investment banking and securities, business firms may use risk-based principles for its review of communications.



■ Internal Supervisory Reports—In addition to the requirement that a member firm must submit an annual report to senior management summarizing the testing and verification of its supervisory procedures, FINRA Rule 3120 requires that a member with $200 million or more in gross revenue must include additional content in the annual report submitted, including information related to customer complaints, internal investigations, and the firm’s compliance efforts.

■ Customer Complaints—A member firm’s supervisory procedures must include procedures to capture, acknowledge, and respond to all written (including electronic) customer com-plaints. Although oral customer complaints are not touched per se by the rules, FINRA encourages firms to provide customers with a standardized form so that they could easily communicate their complaints in writing. Firms that fail to address any customer com-plaint, whether written or oral, may violate the “high standards” rule.

■ Review of Securities Transactions for Insider Trading—Member firms are required to have supervisory procedures to review securities transactions effected for a member’s or its asso-ciated persons’ accounts in order to identify insider trading and manipulative and decep-tive devices. This rule means that member firms must now implement processes designed to identify insider trading and manipulative practices for certain securities transactions.

■ Internal Investigations of Securities Transactions for Insider Trading—Related to the previous, in addition to reviewing certain securities transactions for insider trading and manipulation, firms must also conduct a prompt internal investigation into any such trade to determine whether a violation of the laws prohibiting insider trading and manipulative devices has occurred.

■ Written Reports for Firms Engaging in Investment Banking Services—Investment bank-ing firms must file written reports with FINRA in connection with the internal investiga-tions previously discussed. The written reports must be signed by a senior officer of the member firm and must provide details about the results of the internal investigation and any disciplinary action taken to correct the prohibited insider trading or manipulative conduct.

2. 1. 10 NETWORKING ARRANGEMENTS (FINRA RULE 3160)

It is not unusual for a broker-dealer and a financial institution such as a federal or state-charted bank, savings bank, or a credit union to have a networking arrangement, that is, a contract under which the member firm offers its services on (or off) the premises of the bank. That is an acceptable, well-accepted practice. However, there are certain steps that have to be taken to protect investors from inferring that securities and services being offered have the same safeguards and protections afforded to bank accounts.

A member that conducts broker-dealer services on the premises of a bank must clearly be identified. In other words, steps must be taken to distinguish broker-dealer services from that of services provided by the financial institution, such as in an area that clearly displays the member’s name, and to the extent practicable, a location physically separate from the routine retail deposit-taking activities of the bank.

The bank must unambiguously know and the agreement must clearly state in writing that the member firm’s supervisory personnel and representatives of the SEC and FINRA will be permitted access to the bank’s premises in order to inspect the books and records.

Customers must be made aware in writing at or prior to the time that a customer account is opened that the broker-dealer’s services are not being provided by the financial institution



but rather the member firm. Furthermore, customers must be made aware that the securities products purchased or sold in a transaction are:

■ not insured by the Federal Deposit Insurance Corporation (FDIC); ■ not deposits or other obligations of the bank and are not guaranteed by the financial insti-

tution; and ■ subject to investment risks, including possible loss of the principal invested.

These disclosures must be made orally as well.From that point on, all confirmations and statements must clearly indicate that the mem-

ber, not the bank, is providing the broker-dealer’s services. Furthermore, retail communica-tions, such as in radio or television broadcasts, Automated Teller Machine (ATM) screens, billboards, signs, posters, and brochures that announce the location of the financial institution where broker-dealer services are provided must include those disclosures. A simplified legend may be used provided they are displayed in a conspicuous manner:

■ Not FDIC Insured ■ No Bank Guarantee ■ May Lose Value

These disclosures need not be made for radio broadcasts of 30 seconds or less; electronic signs, including billboard-type signs that are electronic, time and temperature signs, and ticker tape signs, as well as banners and posters, when used solely as location indicators.

If a registered representative of a member form who is also employed by the bank (dual employee) terminates the employee for cause, the member must promptly notify the bank.

2. 2 MEMBER CONDUCT RULES

2. 2. 1 RECOMMENDATIONS TO NONINSTITUTIONAL ACCOUNTS

Before recommending a security transaction for a noninstitutional customer (retail account), registered representatives must have reasonable grounds for believing that the rec-ommendation is suitable in light of the customer’s:

■ financial situation, including income and net worth; ■ tax status; ■ investment objectives; ■ risk tolerance; and ■ other holdings.

The key is suitability. Implicit in all dealings with customers is the responsibility for fair dealing. Sales efforts, including recommendations, must be judged on the basis of whether they represent fair and ethical treatment for the customer to whom the recommendation is being made.

For example, a member (or AP) may not recommend that a customer buy or sell short any OTC equity security (non-NMS) unless the member has reviewed the issuer’s current finan-



cial statements and current material business information. Based on that information, the member must determine that the information provides a reasonable basis under the current circumstances for making the recommendation.

*C A S E S T U D Y Fraudulent Sale of Securities Situation:

Mr. Luu, the registered sales agent, knowingly omitted the fact that analysts of the broker-dealer recently joined other firms in downgrading their assessment of the company and that the company bonds were placed on a credit watch by one of the major credit rating agencies prior to selling a large number of shares to Mr. Chong. A month after the sale, the shares became worthless.

Analysis: Mr. Luu sold these securities to Mr. Chong in violation of the law because he deliberately or knowingly failed to mention material infomation—informa-tion that was important for Mr. Chong to know in order for him to make an informed investment decision. It was found that Mr. Chong has the right to recover the finan-cial losses that resulted from the sale.

When a representative changes firms, a major interest of the new firm is obtaining the representative’s book of business. A number of customers serviced may own mutual funds that the prior firm was authorized to sell pursuant to a dealer agreement. However, there may be impediments to the representative’s ability to continue servicing or selling these investments as well as receiving trailer commissions. For example, the issuer may hold the product or it may be proprietary to the prior firm. Even with non-proprietary products, the new firm might not have a dealer agreement with the sponsor.

In these situations, the transferring representative might be tempted to recommend to customers that they replace their existing funds with other investments without considering the suitability of these recommendations. In making a recommendation to liquidate an exist-ing fund, a firm may consider that it lacks a dealer agreement with the sponsor and, therefore, cannot provide the customer with the service expected.

To deal with these situations, a firm must have procedures in place that include the following:

■ When conducting due diligence concerning a prospective new representative, the new firm should learn the nature of the representative’s business and the extent to which the representative sells products for which the new firm would need a dealer agreement. The new firm should determine whether it would seek such agreements.

■ If the new firm is unable or unwilling to service a customer’s mutual fund, the new firm or the representative should advise the customer of this as well as the option to continue to hold the fund at the prior firm before recommending that the customer liquidate or sur-render the investment.

■ For a reasonable time period following the hiring of the new representative, the firm should review the replacements recommended by the new representative with a view to identify any recommendations to liquidate that may not be suitable.



2. 2. 2 RECOMMENDATIONS TO INSTITUTIONAL ACCOUNTS

With respect to institutional customers, a member can fulfill its suitability obligations by focusing on the:

■ institution’s capability to independently evaluate investment risk; and ■ extent to which the institution makes independent investment decisions.

When a member has reasonable grounds for concluding that the institution is making independent investment decisions (i.e., not depending on the member or others) and is capa-ble of independently evaluating risk, the member’s suitability obligation is fulfilled. In other words, the member can make virtually any recommendation, because the institution is sophis-ticated enough to know which recommendations make sense and which should be rejected.

2. 2. 3 PRIVATE SECURITIES TRANSACTIONS OF AP’S (NASD RULE 3040)

A private securities transaction is any securities transaction executed outside the scope of an associated person’s employment with a member firm. When done without the firm’s knowl-edge and approval, it is known as “selling away” a serious violation.

*E X A M P L E Unbeknownst to a member firm, one of its registered representatives, during the evening and weekends, helped a friend market a private placement of unregistered securities. In this case, the registered representative acted without knowledge and approval of the firm. This would likely lead to strong disciplinary procedures by the employer and may include severe sanctions from FINRA.

Before participating in a private securities transaction, a registered representative (or any other associated person) must:

■ provide written notice to the member describing in detail the proposed transaction, the person’s role, and compensation to be received; and

■ if no compensation, the member must provide the AP prompt written acknowledgment of the notice and may require the person to accept certain conditions placed upon his or her participation in the transaction.

If the member does approve in writing (such as a rep selling variable-like insurance outside the firm), the member must record the transaction on its books and records. Practically speak-ing, the member must supervise the person’s participation as if the transaction were its own. If a member disapproves in writing, the person’s participation is prohibited.

There is one circumstance in which no written notification and response is required: if the proposed private securities transaction is for the benefit of an immediate family member and the associated person is to receive no compensation, the notification requirements are waived.



2. 2. 4 OUTSIDE BUSINESS ACTIVITIES (FINRA RULE 3270)

If a registered person of a member wants to be employed by, accept compensation from, or reasonably expects to be compensated by any entity other than from the member (bartender, wedding photographer, tax preparer, etc.), that person must provide written notice to the member. Following notification by the associated person, the member must be satisfied that the activity will not compromise the registered person’s responsibilities to the firm or its cus-tomers or be viewed by customers as part of the member’s business.

Following an evaluation of the proposed outside business activity, the member may impose conditions or place limitations on the representative’s outside business activity. The member may, if warranted, prohibit the activity. A member also must evaluate and determine whether the activity should be handled as a private securities transaction and, therefore, be subject to NASD Rule 3040.

The firm must retain a record of each written notice received and must preserve this record for three years.

✓T A K E N O T EFINRA Rule 3270 does not require that the member provide written consent.

Written notification by the employee is all that is required.

The rule on outside affiliations specifically exempts from the notification requirement: ■ activities reported to the member as a private securities transaction under NASD Rule

3040; and ■ passive investments.

*E X A M P L E Written notification or permission is not required for passive investments. If a registered representative is a limited partner in a shopping mall and earns $4,500 per month in rental income, employer notification or permission is not required. However, if the representative were active in the management of the mall, employer notice would be required.

*C A S E S T U D Y A registered representative engaged in a business away from his member firm without providing the firm with prior written notice and failed to respond to FINRA’s requests for information until they filed a complaint against the representative.

For nearly three years, the representative was a sales associate for an identity theft protection service. The representative failed to provide prompt written notice to his member firm that he was employed in the other outside business activity.

FINRA concluded that the registered representative violated FINRA Rule 3270 and FINRA Rules 8210 (requests for information) and 2010 (ethical standards). FINRA suspended the representative for two years.



2. 2. 5 MEMBER ACTING IN A FIDUCIARY CAPACITY

When acting as a fiduciary on behalf of an issuer of securities, member firms may be given a list of shareholders.

Under FINRA rules, a shareholder list can only be used as directed by the issuer (e.g., to solicit proxies). It can be used for no other purpose.

*E X A M P L E In situations in which a member is asked by an issuer to solicit proxies on its be-half, the member will be given a list of the issuer’s shareholders for contact purposes. It would be tempting, but it is a violation of the member’s fiduciary responsibility to the issuer to use this list for cold calling purposes, knowing that every person on the list is a buyer of common stock.

2. 2. 6 INFLUENCING OR REWARDING EMPLOYEES OF OTHERS (FINRA RULE 3220)

No member firm or AP may give or permit to be given anything of value, including gratu-ities, in excess of $100 per individual per year to any employee of another person where the payment (gratuity) is related to the business of the employer of the recipient. A gift of any kind is considered a gratuity.

Rule 3220, however, does not preclude ordinary and usual business entertainment allot-ted to the member’s clients and their guests so long as it is occasional and not so frequent or extensive as to raise any question of propriety. There is an expectation that the AP would attend the event. Otherwise, the giving of tickets, for instance, would not be permitted if over $100. Note, however, that if sporting or theater tickets have been obtained with the view to attend and then the representative receives word that an accident or some other unfortunate event came up requiring the AP to abandon his entertainment plans, his guests could still use the tickets without it becoming a regulatory issue. Recordkeeping requirements are such that a pattern of abuse would be quick and easy to spot by supervisors, compliance officials, and FINRA examiners.

The prohibitions in Rule 3220 also do not apply to personal gifts (e.g., wedding, bereave-ment, or sympathy gifts) or to promotional items of de minimis value, such as pens or modest desk ornaments displaying the firm’s logo. Furthermore, FINRA does not apply this rule to Lucite tombstones or plaques given to commemorate business transactions, such as an under-writing, even when the cost of such items may well exceed $100.

Members are required to have systems and procedures in place to ensure that gifts given in relation to the business of the member are reported to the firm, are reviewed for compliance with the rule, and are maintained in the firm’s records.

A special case arises when, for example, a trader for a pension or mutual fund solicits sub-stantial charitable contributions from members with whom they conduct business. Member firms must act carefully and establish written procedures concerning their charitable giving, which may give rise to a conflict of interest. For example, the WSPs could require approval for charitable contributions that exceed a specific dollar threshold or frequency.

Any dollar thresholds should take into account the nature of the firm’s business and its customary practice of charitable giving. This next point is key. Under no circumstances should the threshold for charitable contributions be based upon the level of business done or antici-pated by the customer soliciting charitable contributions.



✓T A K E N O T EGifts given by a member to its employees are not covered by this rule.

2. 2. 6. 1 Contracts

The limitations of FINRA Rule 3220 do not apply to contracts of employment in which compensation is paid. For instance, a member could hire, on a temporary basis, administrative employees of another member firm as long as a written agreement that describes the nature of the employment and the compensation arrangement is in place between the member firm and the persons to be employed.

The written consent of each person’s employing firm also is required. Permission of FINRA to enter into contracts with employees of another member is not required. Records of these contracts, as well as of gifts made or received, must be retained for three years.

2. 2. 6. 2 Media

Similarly, FINRA prohibits member firms from giving anything of value to any person to influence the publication in any media of information intended to affect the market price of any security.

2. 2. 6. 3 Noncash Compensation

FINRA is concerned about the potential conflicts of interest created when program spon-sors, such as investment companies, provide incentives or rewards to representatives for selling the sponsor’s products. These incentives are in the form of noncash compensation, which is subject to the following rules: an occasional meal or a ticket to a sporting event or the theatre is acceptable as long as it is not conditioned on the achievement of a sales target. Payment or reimbursement by sponsors in connection with meetings held to train or educate representa-tives is acceptable as long as:

■ the representative obtains the member’s prior permission to attend; ■ the location of the meeting is appropriate to the purpose of the meeting (e.g., an office of

the sponsor or the member would be appropriate; a meeting held at the Atlantis Hotel in the Bahamas is not);

■ there is no payment or reimbursement for a guest (e.g., a spouse) of the representative attending the meeting;

■ payment or reimbursement is not conditioned on the achievement of a sales target; ■ there is no payment or reimbursement for certain expenses incurred in connection with

meetings, such as golf outings, cruises, tours, and similar types of entertainment; and ■ the member firm creates a record of all noncash compensation received by its representa-

tives as well as the details of the meeting.



2. 2. 7 BORROWING FROM OR LENDING TO CUSTOMERS (FINRA RULE 3240)

No one registered with a FINRA member firm may borrow or lend money to a customer unless the firm has written procedures allowing such arrangements. If permitted by the firm, the lending arrangement must fall within one of the following permissible types:

■ The customer is a member of the representative’s immediate family ■ The customer is in the business of lending money (e.g., a bank) ■ The customer and the representative are both registered with the same firm ■ The lending arrangement is based on a personal relationship outside of the broker-cus-

tomer relationship ■ The lending arrangement is based on a business relationship outside of the broker-cus-

tomer relationship

With the exception of the first two listed, registered persons who wish to borrow from or lend to customers are required to provide the firm with written notice and receive approval in writing. Members are required to preserve the written preapproval for at least three years after the date the borrowing or lending arrangement terminated, or for at least three years after the representative’s termination.

✓T A K E N O T EThe scope of the rule is limited to lending arrangements between registered per-

sons and their customers rather than any customer of the firm.

*C A S E S T U D Y For Example: Borrowing Money or Securities from Clients

Situation: On occasion, Mr. Thompson borrowed cash from his discretionary cli-ent, Mr. Bixby, when Mr. Bixby’s account was not fully invested. Mr. Bixby gave Mr. Thompson wide latitude, because Mr. Thompson managed the account well, and Mr. Thompson always repaid the money in time to reinvest Mr. Bixby’s funds in new secu-rities purchases. Mr. Thompson justified these borrowings as within the discretionary power Mr. Bixby granted him. The First National Bank also is a client of Mr. Thomp-son, but he did not borrow from the bank, because of unusually high interest rates.

Analysis: Mr. Thompson engaged in a prohibited practice, because securities professionals may not borrow from customers who are not in the business of lending money. Furthermore, Mr. Thompson violated the law in exceeding the specific discre-tionary authority that Mr. Bixby had authorized. Mr. Bixby authorized Mr. Thompson to trade in securities—not to take his money for personal use. Had Mr. Thompson decided to borrow from The First National Bank, it would have been permitted, because it is an entity engaged in the business of lending money.



2. 2. 8 CUSTOMER COMPLAINTS

A complaint is defined as a written (including electronic) statement by a customer (or a person acting on behalf of a customer) alleging a grievance arising out of, or in connection with, a securities transaction.

If a complaint is resolved to the satisfaction of both the member firm and the customer, no further action is needed.

If it cannot be resolved, it must be referred to the director of arbitration of FINRA (dis-cussed later in this Unit). If the complaint involves allegations of theft, misappropriation of funds or securities, or forgery, the member must promptly (not later than 30 days) report this to FINRA.

2. 2. 8. 1 Recordkeeping of Complaints

FINRA Rule 4513 states that copies of all customer complaints be maintained in a file at the supervising OSJ. However, the rule does permit a member to keep a complaint file at the office where a complaint originated, if it chooses, rather than keeping them all at the OSJ. Each complaint in the file must be accompanied by a statement of its resolution and be endorsed by a principal. Member firms must electronically file information on all customer complaints with FINRA. These filings must be made within 15 days of the end of each calen-dar quarter.

!T E S T T O P I C A L E R T Copies of customer complaints, as well as the quarterly filings, must be retained for four years.

2. 2. 9 TRANSACTIONS FOR ASSOCIATED PERSONS (NASD RULE 3050)

A member firm that knowingly executes a securities transaction for the account of a rep-resentative of another member firm (employer member), or for any account over which the representative has discretionary authority (limited power of attorney), must use reasonable diligence to determine that the trade will not adversely affect the interests of the employer member firm.

The executing member, at a minimum, must notify the employer member in writing, prior to the execution of a transaction in that type of account of the executing member’s intention to open or accept it.

Furthermore, upon written request by the employer member, the executing firm must send copies of confirmations, statements, or any other information with respect to the account and notify the representative of the executing member’s intention to provide the notice and infor-mation to the employer member.

✓T A K E N O T EUnder FINRA rules, consent of the employer member is not required to open

the account. The notifications under this rule also are applicable to the opening of any account over which an associated person of another member has discretionary authority.



If the executing member opens the account, it is required to use reasonable diligence to determine that trades in the account will not adversely affect the interests of the employer member. A member does this by making sure the employer member, requested or not, receives duplicate statements. If the employer member requests confirmations in writing, then the executing member must forward them.

The rule places obligations on the associated person as well. Before opening an account with another member, an associated person must notify both the employer member and executing member, in writing, of his association with the other member. If the account was opened before association with a member, the associated person must notify both members promptly in writing.

A representative who wishes to open a securities account at a nonmember institution (e.g., a bank or investment adviser) must notify her employer member in writing of the intention to open the account. Upon the written request by the employer member, the associated person must advise the nonmember institution to send duplicate statements and confirmations.

There is one exception to the notification rule: if an associated person wants to open an account with another member and limits transactions in the account to unit trusts, variable contacts, or mutual funds, no notification is required.

2. 2. 10 PROHIBITIONS AGAINST SHARING IN CUSTOMER ACCOUNTS AND GUARANTEES AGAINST LOSS (FINRA RULE 2150)

As a rule, associated persons are not permitted to share in the profit and loss in customer accounts unless the associated person:

(i) obtains prior written authorization from the member employing the associated person;(ii) obtains prior written authorization from the customer; and(iii) shares in the profits or losses in any account of such customer only in direct propor-

tion to the financial contributions made to such account by either the member or person associated with a member.

It is unlikely that a principal would approve such a sharing agreement, as it would be vir-tually impossible to monitor the proportionate test. However, if there is an immediate family relationship between the customer and the associated person, the proportionate test does not apply.

A member or associated person can never guarantee a customer against loss, in writing or otherwise. Members can, however, recommend the purchase of puts to hedge long stock posi-tions or the purchase of calls to hedge short stock positions in order to limit losses.

Members are prohibited, however, from using repurchase agreements in connection with nonexempt securities. A repurchase agreement is a loan made by the customer to a member firm, collateralized by an equal value of securities. The member, on or before an agreed-upon date, will repurchase the securities from the customer at a fixed (higher) price.

The difference is the interest earned by the customer. Repurchase agreements are only permitted in cases in which the underlying securities are exempt securities, such as U.S. gov-ernment or municipal bonds.

✓T A K E N O T ERepurchase agreements are permissible only if:

■■ they are in writing;

■■ they involve exempt securities; and

■■ the time and price of the repurchase are specified.



✓T A K E N O T EFirms cannot have joint accounts with customers. Representatives may have joint

accounts with customers only if the arrangement has been approved in writing by the member, and customer and account proceeds are shared in proportion to each party’s contribution.

2. 2. 11 INFORMATION OBTAINED AS FIDUCIARY (FINRA RULE 2060)

A member, who in the capacity of paying agent, transfer agent, trustee, or has received information as to the ownership of securities, may under no circumstances make use of the information for the purpose of soliciting business except at the request and on behalf of the issuer.

2. 2. 12 PROCEDURES FOR EXEMPTIONS

A member firm seeking an exemption from any of the Member Conduct Rules must file a written application with FINRA stating the rule or rules from which the member is seeking an exemption and a detailed statement of the grounds for requesting an exemption.

After consideration, FINRA will issue a written decision of its conclusions. If the mem-ber receives an adverse decision, the member, within 15 days, may appeal the decision to the National Adjudicatory Council (NAC). The NAC will then affirm, modify, or reverse the decision. At that point, the matter is closed.

2. 3 PROCEDURAL RULES

2. 3. 1 INVESTIGATIONS

In connection with any investigation, complaint, or examination, FINRA and/or the SEC can require a member firm or any person associated with a member to:

■ provide information orally, in writing, or electronically; ■ give testimony on the record and under oath; and ■ provide access to, or copies of, any books, records, or accounts (make certain anything

provided to examiners is encrypted).

If a member or associated person fails to comply, the National Adjudicatory Council (NAC), after providing 20 days’ written notice, has the right to suspend the member and revoke the registration of any associated person.

The NAC is responsible for the development of regulatory and enforcement policy and rule changes relating to the business and sales practices of member firms. It also is responsible for the oversight of the Department of Enforcement, which has the authority to file com-plaints against member firms and their associated persons.



2. 3. 2 CODE OF PROCEDURE

The Code of Procedure was created to address alleged violations of FINRA rules, MSRB rules, and federal securities laws. If, after an investigation or firm examination, FINRA believes cause of action exists, in that a member and/or its associated persons may have violated one or more rules or laws, the Department of Enforcement will issue a formal complaint. With the fil-ing of a complaint, the department will name a hearing officer to preside over the disciplinary proceeding (hearing) and also will appoint panelists to serve as a jury. All panelists in Code of Procedure hearings are from the industry.

The respondent has 25 days after receiving the complaint to respond to the hearing panel. Answers must specifically admit, deny, or state that the respondent does not have sufficient information to admit or deny. If the respondent does not answer within 25 days, the depart-ment will send a second notice requiring an answer within 14 days of receipt. This notice states that failure to reply allows the hearing officer to enter a default decision (guilty as charged).

If additional facts come to light that cause the Department to file an amended com-plaint, the time for filing an answer or amended answer is 14 days after receipt of the amended complaint.

✓T A K E N O T EIf a complaint is filed against a registered representative, it is not unusual for that

person’s designated supervisor (e.g., branch manager) to be charged as well for failure to supervise.

2. 3. 2. 1 Offer of Settlement

A respondent has the option of proposing a settlement. An offer to settle must be in writ-ing and must:

■ describe the specific rule or law that the member or associated person is alleged to have violated;

■ describe the acts or practices that the member or associated person is alleged to have engaged in or omitted;

■ include a statement consenting to findings of fact and violations contained in the com-plaint; and

■ propose sanctions consistent with FINRA’s sanction guidelines.

2. 3. 2. 2 Uncontested Offer

By submitting an offer of settlement, the respondent waives the right to a hearing and the right to appeal. If the offer is accepted by the Department of Enforcement, it is then sent to the NAC for review. If uncontested by the NAC, the offer is accepted and final.

2. 3. 2. 3 Contested Offer

If the Department of Enforcement opposes the offer, the offer is contested. At this point, the offer and the department’s written opposition are submitted to the hearing panel. The panel may order a settlement conference between the parties in an attempt to work out a compromise or may forward the offer and the department’s opposition to the NAC.



If the NAC rejects the offer (or compromise offer), the hearings begin. If accepted by the NAC, the offer (or compromise offer) is final. If an offer of settlement is ultimately rejected, it may not be introduced as evidence at the hearing.

2. 3. 2. 4 Acceptance, Waiver, and Consent (AWC)

If the respondent does not dispute the allegations, the Department of Enforcement may prepare and request that the respondent sign a letter accepting a finding of violation, consent-ing to the imposition of sanctions, and waiving the right to a hearing and the right to appeal.

If agreed to by the respondent, the letter is sent to the NAC and, if approved, becomes final. If opposed by the NAC, the next step is formal hearings. In actuality, if the Department of Enforcement felt there was a chance of opposition from the NAC, it would not have offered AWC in the first place.

2. 3. 2. 5 Minor Rule Violation (MRV)

If the complaint involves a minor violation and the respondent does not dispute the alle-gation, the Department of Enforcement may prepare and request that the respondent sign an MRV letter, accepting a finding of violation. An example of a minor rule violation would be the failure to file an amendment to Form U-5 on a timely basis.

Once the respondent signs an MRV letter, the settlement is final. The NAC, as a sanction, may impose a fine not to exceed $2,500.

2. 3. 2. 6 Prehearing Conference

Assuming the respondent does not make an offer of settlement (or, if made, it is rejected), and assuming the Department of Enforcement does not offer AWC or MRV as options, a pre-hearing conference is scheduled. Under Code of Procedure rules, it must be held within 21 days of receipt of the respondent’s answer to the complaint.

This conference addresses matters such as: ■ simplification and clarification of the issues; ■ witness lists and exhibit lists; ■ criteria for including and excluding certain evidence; and ■ the determination of a hearing date.

At the conference, parties to the dispute are warned that contemptuous or frivolous con-duct by any person (including attorneys) will result in sanctions imposed by the NAC.

2. 3. 2. 7 Hearing

At the hearing, which resembles a courtroom proceeding, the hearing panel (Department of Enforcement) goes first, calling witnesses, producing documents, and so forth. Cross-examination of witnesses is permitted. At the conclusion, panelists convene and, within 60 days, render a written decision reflecting the majority view.



✓T A K E N O T EIn extraordinary circumstances, a hearing panel has the authority to issue both

a temporary cease and desist order and a permanent cease and desist order. This will happen only if there is an extreme threat to the investing public.

2. 3. 2. 8 Sanctions

Sanctions against a member or associated person found in violation of securities laws and rules are included with the written decision. Under Code of Procedure, sanctions could include one or more of the following:

■ Censure ■ Fine ■ Suspension of the membership of a member or suspension of the registration of an associ-

ated person for up to two years ■ Expulsion of the member, cancellation of the membership of the member, or revocation or

cancellation of the registration of an associated person ■ Barring a member or associated person from association with all members ■ Any other fitting sanction

If an associated person is suspended, that person cannot remain associated with the member in any capacity, including a clerical or administrative capacity (during the suspension period, that person cannot remain on the member’s premises). The member is prohibited from paying a sal-ary, commission, or other remuneration that the person might have earned during the suspension period. The suspended person may be paid monies earned before the suspension period.

2. 3. 2. 8. 1 Effective Date of Sanctions

Other than a permanent cease and desist order, which is effective as of the decision date, sanctions imposed are effective on a date specified by the hearing officer, but no earlier than 30 days after the written decision of the hearing panel is handed down.

2. 3. 2. 9 Appeals

If either side is displeased with the decision, an appeal can be made to the NAC. Any appeal must be made within 25 days of service of the decision; otherwise, the decision is final. If no satisfaction is received from the NAC, the appealing party may take the case to the SEC. Again, if turned down, the appealing party has the right to continue the appeal process by tak-ing its case to the federal court system.

Appealing a decision stays the effective date of most sanctions other than a permanent cease and desist order.

2. 3. 2. 10 Release of Disciplinary Information

FINRA will release to the public through BrokerCheck® any disciplinary decision that imposes a suspension or expulsion of a member, suspends or revokes an associated person’s registration, suspends or bars an associated person, or imposes monetary sanctions of $15,000 or more.



2. 3. 2. 11 Investor Education and Protection

Member firms that hold customer funds and securities must, at least once every calendar year, provide in writing to each customer the following: the Public Disclosure Program hotline number, FINRA’s website address, and a statement as to the availability of an investor bro-chure that includes information describing the Public Disclosure Program. The hotline num-ber allows customers access to BrokerCheck®, which provides information on the disciplinary history of member firms and their registered persons. Those people who are not registered with FINRA or a national securities exchange, such as the NYSE or a state securities regulator, and have not been so within the last 10 years are not included in BrokerCheck®.

*C A S E S T U D Y A registered representative was instructed to complete a syndicate worksheet during an initial public offering to document compliance with the firm’s procedures for new offerings. The worksheet included columns to record the date and manner in which a preliminary prospectus was delivered. When the representative submit-ted order tickets for sales to 15 customers, it became clear that the representative did not deliver the red herrings. When asked about it by the branch office manager, the representative claimed the firm was responsible for delivery of the preliminary prospectuses. The branch office manager (BOM) suggested that the representative should note on the worksheet that the prospectuses were hand delivered. The office administrator relied upon that false information as part of the official records of the firm. The NAC found that the representative had violated ethical standards and books and records rules, and imposed a fine of $5,000.

2. 4 DISPUTE RESOLUTION

The Code of Arbitration was established to resolve principally money disputes. When a customer sends a written complaint, a record must be made. It must include the complain-ant’s name, address, and account number; the date it was received; the name of the associated person identified in the complaint, and a description and the disposition of the complaint. Arbitration is one method of resolving complaints.

2. 4. 1 UNIFORM CODE OF ARBITRATION (UCA)

Arbitration is an alternative to going to court to resolve disputes. Arbitration panels com-posed of one or three arbitrators weigh all the facts and then resolve the issue put before them. The decision is called an award, and it is binding. In some exceptional cases, it may be chal-lenged in court. Arbitration or mediation is mandatory in controversies involving a(n):

■ member against another member or registered clearing agency; ■ member against an associated person; or ■ associated person against another associated person.



Over time, customer complaints became subject to mandatory arbitration. In the absence of a signed arbitration agreement, a customer can still force a member to arbitration, but a member cannot force a customer to arbitration. Today, virtually all on-boarding forms contain a predispute arbitration agreement that must be signed by customers before account opening. Thus, unresolved customer disputes must be heard under the Code of Arbitration.

✓T A K E N O T EIf a customer requests a copy of the predispute arbitration agreement signed on

account opening, FINRA rules require firms to respond within 10 business days of the request.

Class action claims are not subject to arbitration. In addition, claims alleging employment discrimination, including sexual harassment claims, are not required to be arbitrated unless the parties agree.

The advantages of arbitration over suits in state or federal courts are that time and money are saved and all decisions are final and binding; there are no appeals.

2. 4. 2 INITIATION OF PROCEEDINGS

Any party to an unresolved dispute can initiate proceedings by filing a Statement of Claim with the director of arbitration of FINRA. The Statement of Claim must describe in detail the controversy in dispute, include documentation in support of the claim, and state the remedy being sought (dollar amount). The claimant must include a check for the required claim filing fee. The director will then send a copy of the claim to the other party (respondent).

The respondent then has 45 calendar days to respond to both the director and the claim-ant. The answer must specify all available defenses and any related counterclaim the respon-dent may have against the claimant. A respondent who fails to answer within 45 days may, in the sole discretion of the director, be barred from presenting any matter, arguments, or defenses at the hearing.

The claimant, after receiving the respondent’s answer, must provide each party (the respondent and the director) with a written reply within 10 calendar days. At this point, the initial discovery is over.

If the dispute involves irreparable injury to one of the parties, that party may seek an interim injunction or a permanent injunction. The party seeking relief must make a clear showing that its case is likely to succeed on its merits and that it will suffer permanent harm unless immediate relief is granted.

2. 4. 3 SELECTION OF ARBITRATORS

In general, arbitrators are classified as being either public or non-public. Currently, a non-public arbitrator is a person who is an investment adviser or associated with a mutual or hedge fund, or within the past five years was, associated with the securities or futures industry. Also included are professionals, such as attorneys or accountants who have devoted 20% or more of their work, in the past two years, to clients engaged in the securities business.

On the other hand, a public arbitrator is one who is not engaged in the securities business (including municipal and government debt and commodity futures) for a total of 20 years or more, is not an investment adviser, is not an employee of a bank, and is not an attorney or accountant whose firm derived 10% or more of its revenue in the past two years from the



securities business. FINRA, concerned that certain accountants or attorneys who fall below the 10% test might still realize significant revenue from their arbitration work, has added a revenue limitation to the definition of a public arbitrator. Attorneys, accountants, and other professionals whose firms have derived $50,000 or more in annual revenue in either of the past two years from arbitration work cannot function as public arbitrators. The definitions of public and nonpublic arbitrators are subject to change. Please check with your instructor or the Series 24 website.

2. 4. 4 PANEL COMPOSITION

Customers involved in a dispute requiring three arbitrators (more than $100,000) can directly choose from a list of public and nonpublic arbitrators. They can, for instance, select an all-public arbitration panel.

FINRA provides all parties with lists of 10 chair-qualified public arbitrators, 10 public arbitrators, and 10 nonpublic arbitrators. The parties in the dispute may strike four arbitra-tors on the chair-qualified public list and on the public list. However, any party could select an all-public arbitration panel by striking all of the arbitrators on the nonpublic list. In dis-putes in which the claimant is seeking more than $50,000 and up to $100,000, one arbitrator hears the case unless the parties agree in writing to three arbitrators. If the claim is for more than $100,000, whether industry disputes or customer disputes, the director of arbitration will appoint a panel of three arbitrators, unless both parties agree in writing to one. A panel chairperson always will preside, or if only one arbitrator is to hear a dispute, the arbitrator will be selected from the chairperson roster. A chairperson must be a licensed attorney, trained by FINRA in its rules, and served on at least three arbitrations.

In an arbitration between member firms, the panel composition is: ■ if the panel consists of one arbitrator, the arbitrator will be a non-public arbitrator selected

from the chairperson roster unless the parties agree in writing otherwise; or ■ if the panel consists of three arbitrators, all will be non-public arbitrators. One of the arbi-

trators will be selected from the chairperson roster.

In disputes between associated persons or between or among members and associated persons:

■ if the panel consists of one arbitrator, the arbitrator will be a public arbitrator selected from the chairperson roster; or

■ if the panel consists of three arbitrators, one will be a non-public arbitrator and two will be public arbitrators. Again, one of the public arbitrators will be selected from the chair-person roster unless the parties agree in writing otherwise.

The so-called mid-case referral rule allows an arbitration panel in unusual cases to alert FINRA during the course of a hearing of their serious concern of an ongoing fraud they reason-ably believe could lead to investor harm.

2. 4. 5 SIMPLIFIED ARBITRATION

Any small claim dispute involving a dollar amount of $50,000 or less is eligible for simpli-fied arbitration. For disputes with customers, a single, chair-qualified, public arbitrator reviews all the evidence and renders a binding decision within 30 business days. Both parties must agree to this procedure or a formal hearing is required. Disputes between industry parties may be heard by a single, chair-qualified, nonpublic arbitrator.



2. 4. 6 AWARDS

All monetary awards must be paid within 30 days of decision date. Any award not paid within this time will begin to accrue interest as of the decision date.

2. 4. 7 FAILURE TO ACT

It is a violation of FINRA rules for a member or an associated person to fail to: ■ submit a dispute for arbitration; ■ comply with any injunction order; ■ appear or produce any document as directed; ■ honor an award; or ■ comply with an executed collective agreement obtained as the result of mediation.

Action by members requiring associated persons to waive the arbitration of disputes is also a rules violation.

2. 4. 8 STATUTE OF LIMITATIONS

No claim is eligible for submission to arbitration if six years or more have elapsed from the event giving rise to the claim.

✓T A K E N O T ESecurities arbitrators may alert FINRA mid-way through a hearing if they have

serious concerns regarding a possible fraud that they reasonably believe could lead to investor harm, such as a Ponzi scheme.

2. 4. 9 INVESTOR COMPLAINT CENTER/OFFICE OF THE WHISTLEBLOWER

Regulatory complaints may be filed with FINRA through the Investor Complaint Center to alert FINRA to fraudulent or suspicious activities by broker-dealers or representatives. Investors also may notify FINRA’s Office of the Whistleblower if they have evidence of high-risk illegal or unethical activity to expedite the review.

✓T A K E N O T ECustomers have the right to request a written explanation as to why a claim was

granted or denied. The request for a written explanation must be made before the arbitration panel holds its first meeting. This is known as an explained decision. The parties must submit a joint request for an explained decision to require the arbitrators to provide one.



2. 4. 10 MEDIATION

An alternate dispute resolution process and a reasonable, inexpensive first step is media-tion. If both parties agree, prior to the opening of hearings, a meeting may be held in an attempt to work out a settlement. A mediator is selected to preside over the discussions and to assist the parties, if possible, in reaching their own solution. If mediation is unsuccessful, a hearing is conducted. A mediator is prohibited from serving on an arbitration panel regard-ing any matter in which that person served as mediator. Sometimes, parts of a dispute settle in mediation, leaving fewer differences to be settled in arbitration, which can translate into savings of time and money. The issue is settled when the Memo of Understanding (MOU) is signed.

✓T A K E N O T EOnce mediation begins, either party may withdraw at any time without the con-

sent of the mediator or the other party.

2. 5 FINRA RULES

2. 5. 1 ANNUAL CERTIFICATION OF COMPLIANCE (FINRA RULE 3130)

Member firms, under FINRA Rule 3130, are required to designate to FINRA on Form BD a principal to serve as chief compliance officer (CCO) and to have the Chief Executive Officer (CEO) certify annually that the firm has in place processes to establish, maintain, review, test, and modify its supervisory procedures. The CEO also must conduct one or more meetings with the CCO during the 12 months preceding certification and submit a report to the firm’s board of directors and audit committee within 45 days of the certification.

✓T A K E N O T EAny member who is a party to an open transaction or who has on deposit cash

or securities of another member must, on written request, provide the other member with a statement of its financial condition as disclosed in its most recently prepared balance sheet.

2. 5. 2 BUSINESS CONTINUITY PLANS AND EMERGENCY CONTACTS (FINRA RULE 4370)

FINRA Rule 4370 requires each member to create and maintain a business continuity plan (BCP) to address the possibility of a significant business disruption. Firms must designate a member of senior management who is also a principal to approve the plan and be responsible for updating the plan where appropriate and, at a minimum, conducting an annual review of the plan.



The plan must address, at a minimum, the following: ■ Data backup and recovery (hard copy and electronic) ■ Alternate communications between the firm and its customers ■ Alternate communications between the firm and its employees ■ Alternate physical location of employees ■ Communications with regulators ■ How the firm will ensure customers prompt access to their funds and securities in the event

the firm is unable to continue its business ■ All mission-critical systems

Further, a firm must disclose to its customers how it will respond to events of varying scope. This disclosure must be made, in writing, to customers at account opening, posted on the firm’s website, and mailed to customers on request.

FINRA Rule 4370 requires firms to report to FINRA, typically electronically, the emergency contact information for the member, which must include the designation of two associated persons as emergency contact persons. At least one of the emergency contacts must be a member of senior management and a registered principal. If the other emergency contact person is not a registered principal, he or she must be a member of senior management who is at least knowledgeable about the member’s business operations. Those members that have only one associated person must designate as a second emergency contact person an individual, either registered with another firm (such as in a JBO), or a nonregistered person who has knowledge of the member’s business operations (e.g., clearing firm contact, attorney, accountant).

As a reminder from Unit 1, NASD Rule 1160 requires firms to update the contact information promptly, but no later than 30 days following any change. Member firms must review the contact information within 17 business days after the end of each calendar year and make an electronic attestation that the annual review was accurately completed.

2. 5. 3 CONTROL RELATIONSHIPS

If a member controls or is controlled by an issuer of securities, a control relationship is said to exist between the two. If such a relationship exists, a member, before recommending the purchase (or sale) of the issuer’s securities, must disclose to the customer the existence of such control, and if the disclosure is not made in writing at that time, it must be disclosed on the customer’s confirmation.

These disclosure rules also apply to discretionary accounts. Before purchasing these securi-ties, the member must disclose to the customer the existence of the control relationship.

2. 5. 4 DIRECT PARTICIPATION PROGRAMS (DPPS)

A DPP, which is normally structured as a limited partnership, is a program that provides flow-through tax consequences to investors. These programs are high risk, illiquid, and long term in nature.

*E X A M P L E Oil and gas programs, real estate partnerships, and equipment leasing programs can all be DPPs.



Before participating in a DPP offering, member firms must have reasonable grounds for believing, based on the information provided in the prospectus, that all material facts are adequately disclosed and that these facts provide a framework for customers to evaluate the program.

Under FINRA rules, all DPPs must have clearly stated standards of suitability in the pro-spectus. In recommending a DPP to a customer, a member firm must be certain that the pro-gram is consistent with the customer’s objectives and that the customer:

■ is in a position to take full advantage of any tax benefits generated by the DPP; and ■ has a net worth sufficient to sustain the risks of the DPP, including loss of investment.

The member, after making a suitability determination, must maintain in its file documents that describe the basis on which the determination of suitability was made. In addition, no member is permitted to execute a DPP transaction in a discretionary account without the prior written consent of the customer.

2. 5. 4. 1 DPP Roll-Up

A roll-up is a transaction involving the combination or reorganization of one or more limited partnerships into securities of a successor corporation. The lure to investors is the pos-sibility of turning an illiquid DPP into a more liquid security.

Disclosure documents prepared in connection with a proposed roll-up transaction must: ■ disclose all the risk factors; ■ disclose the general partner’s belief concerning fairness of the transaction; and ■ include all reports, opinions, and appraisals received by the general partner in connection

with the transaction.

Failure to provide adequate disclosure of a negative opinion rendered by an investment banker or financial adviser concerning fairness constitutes fraud.

Under FINRA rules, members are prohibited from soliciting votes from limited partners in connection with a proposed roll-up unless any compensation to be received by the member:

■ is payable and equal in amount regardless of whether the limited partners vote affirma-tively or negatively; and

■ does not exceed 2% of the value of the securities to be received in the exchange.

2. 5. 5 NONCONVENTIONAL INVESTMENTS (NCIS)

NCIs are alternative investments that do not fit a common category. Examples include hedge funds, certain asset-backed securities, and distressed debt. Distressed debt is defined as corporate bonds of companies that have either filed for bankruptcy or appear likely to do so in the near future. The strategy involves first becoming a major creditor of the target company by acquiring the company’s bonds at pennies on the dollar. This gives these investors the neces-sary leverage and control during either the reorganization or the liquidation of the company. In the event of liquidation, distressed debt holders, by standing ahead of the equity holders, often recover a high percentage of the par value of the bonds, thus making the return on investment substantial.

However, the more desirable outcome is a reorganization that allows the company to emerge from bankruptcy protection. As part of the reorganization, distressed debt holders, in exchange for their bonds, often receive enough equity in the new firm to compensate them well for the risks taken.



FINRA is concerned that retail investors do not fully comprehend the risks associated with these NCIs. Accordingly, FINRA requires members that sell these products to:

■ conduct appropriate due diligence; ■ perform a reasonable-basis suitability analysis; ■ perform a customer-specific suitability analysis for recommended transactions; ■ ensure that promotional materials used are accurate and balanced; ■ implement appropriate internal controls; and ■ provide training to persons selling these products.

In performing due diligence, members must look at the liquidity of the product, the exis-tence of a secondary market, interest rate risk, credit risk, the tax consequences of the product, and the costs associated with purchasing and selling the product.

A reasonable-basis suitability analysis is necessary to ensure that an investment is suitable for some investors, as opposed to a customer-specific suitability determination, which is under-taken on a customer-by-customer basis.

An equity-linked note (ELN) is an example of a nonconventional investment. It is a debt instrument that differs from a conventional fixed income security in that the final payment at maturity is based, in part, on the return of the underlying equity, which can be a single stock, a basket of stocks, or an equity index. A typical ELN is principal protected; the investor is guar-anteed to receive, at maturity, 100% of the original amount invested but receives no interest along the way. The final payout, in cash, is the amount invested plus a portion of the gain on the underlying equity. If the underling equity remains flat or declines during the investment period, all the investor receives at maturity is the original amount invested. Also note that there is generally no secondary market for these products during the investment period, which can range up to five years. ELNs not listed on a national exchange must be reported to Trade Reporting and Compliance Engine (TRACE).

✓T A K E N O T EBefore purchasing a structured product, such as an equity-linked note for a

discretionary account, a member needs the prior written consent of the customer. Discretionary trades need approval from an authorized principal promptly following the transaction.

2. 5. 6 REGISTRATION AND DELIVERY

As part of the account opening process, the customer and the registered representative establish registration and delivery instructions. These instructions may be changed for indi-vidual transactions. For purchase orders, the customer must stipulate whose name is to be on the security and who will keep the security certificate.

Customers may select any of the following delivery instructions. ■ Transfer and ship. Securities are transferred into the name of the customer and shipped. ■ Transfer and hold in safekeeping. Securities are transferred into the customer’s name but

are held by the broker-dealer. ■ Hold in street name. Securities are transferred into the broker-dealer’s name and held by

the broker-dealer. Although the broker-dealer is the nominal owner of the securities, the customer is the beneficial owner.



■ Delivery versus payment. The customer instructs the representative to deliver any securi-ties purchased to an agent bank, which will pay the member upon delivery. The customer provides the member firm with the name, address, and account number on file with the agent bank.

✓T A K E N O T EMost powers of attorney are nondurable in that they are canceled if the grantor

becomes mentally incompetent or dies. A durable power of attorney, on the other hand, will be canceled on the death of the grantor but will remain in force if the grantor becomes mentally incompetent.


—— 1. A new account form requires the signatures of the customer, the regis-tered representative, and the principal approving the account.

—— 2. If a member firm is recommending an issuer’s securities to a customer and a control relationship exists between the issuer and the member, the relationship must be disclosed either in writing before the recommendation or on the customer’s confirmation.

—— 3. A discretionary trade is one in which the member chooses the action, the security, or the price.

—— 4. A principal must approve all discretionary order tickets before execution.

—— 5. A representative may distribute an “internal-use-only” memo to institu-tional customers that have a block-size position in the security covered by the memo.


2. 6 TYPES OF ACCOUNTS

2. 6. 1 ACCOUNTS FOR INVESTMENT ADVISERS

An investment adviser is one who, for an annual fee, manages customer assets. The adviser will open an account at a member firm to trade securities for each advisory client. Advisers with a small number of clients will open individual accounts with a member, and the client provides the adviser with third-party trading authority.

Confirmations of trades and customer account statements are sent by the member to the customer and the investment adviser.

If an investment adviser has a large number of clients, the adviser may open a special omnibus account with a member to hold securities purchased for each client. The account is a single master account in the name of the adviser. In opening a special omnibus account, the adviser must disclose to the member that the securities in the account are customer securities, and not those of the adviser.



✓T A K E N O T EWhen a broker-dealer offers a wrap fee program, it then loses its exclusion from

the definition of IA and must register as such. Stand-alone IAs don’t offer wrap fee programs, because they don’t execute trades.

2. 6. 2 DVP ACCOUNTS (DELIVERY VERSUS PAYMENT)

A DVP account is one in which payment for securities purchased or delivery of securities sold is to be made by an agent bank. Before accepting such accounts, a member must have on file the name and address of the agent and the account number of the customer on file with the agent. In such transactions, members must get assurances from the customer that proper instructions have been given to the agent bank (e.g., to receive securities against payment [COD] or to deliver securities against payment [POD]).

There is no requirement for the firm to contact the agent bank in advance of settlement to ensure the funds are available to pay, in the case of a purchase, or that securities are available for delivery, in the case of a sale.

These trades settle regular way (three business days after trade date). However, if deliv-ery is delayed due to the mechanics of the transaction and is not related to the customer’s willingness or ability to pay, the member has up to 35 calendar days from trade date to obtain payment.

One point about DVP accounts that might be raised on the exam is that, under NASD Rule 2340, if the customer’s account is carried solely for the purpose of execution on a DVP/RVP basis, and all transactions effected for the account are done on a DVP/RVP basis, it may not be necessary to send the customer quarterly statements. This is a major exception to the rule.

2. 6. 3 FEE-BASED ACCOUNTS

Fee-based accounts are those that are charged a fixed fee monthly or annually as an alter-native to traditional commission-based charges for brokerage services. Unlike wrap accounts, these accounts do not provide advisory services. They are generally appropriate for custom-ers with a moderate to high level of trading activity. They are not appropriate for customers with a buy-and-hold strategy. FINRA rules require firms to periodically review all fee-based accounts to determine if they remain appropriate. The practice of putting clients into fee-based accounts who trade infrequently is known as reverse churning.

2. 6. 4 PRIME BROKERAGE ACCOUNTS

A prime brokerage account is one in which a customer, generally an institution, selects one member firm (the prime broker) to provide custody and financing of securities while other firms, called executing brokers, handle all trades placed by the customer. Under SEC rules, prime brokerage customers must maintain a minimum of $500,000 in equity in the account.

To open a prime brokerage account for a customer, a member (the prime broker) must sign an agreement with the customer explaining the terms of the agreement as well as names of all executing brokers with whom the customer has contracted. The prime broker then enters into written agreements with each executing broker named by the customer.



The customer receives trade confirmations and customer account statements from the prime broker, while responsibility for compliance with the short sale rule rests with the execut-ing brokers. That said, the prime broker is often relied on for stock lending.

Route of Trade

Customer

Prime BrokerSends Reports

Executing BrokerA

Executing BrokerB

Executing BrokerC

CustomerTrades

2. 7 MARGIN TRANSACTIONS/EXTENSIONS OF CREDIT

2. 7. 1 FEDERAL RESERVE BOARD REGULATION

Purchasing securities on margin is like buying securities on credit. The customer provides a portion of the purchase price (initial margin requirement) with the balance loaned to the customer by the member firm. The firm becomes the customer’s creditor, so all securities pur-chased on margin are registered in street name.

Utilizing Regulation T, the Federal Reserve Board sets the initial margin requirements for nonexempt securities. Currently, the Regulation T requirement, also referred to as the Fed call, is 50% of the market value of the securities being purchased on margin.

*E X A M P L E A customer wants to buy 1,000 shares of XYZ at $30 per share. The customer meets the Fed call by depositing $15,000 (50% of $30,000) while the remaining $15,000 is loaned to the customer by the member.



✓T A K E N O T EBe sure to distinguish between the terms margin and marginable. Marginable

means it may be used as collateral for a loan (e.g., IBM stock is marginable). Margin is the money required for a transaction (e.g., to buy $10,000 worth of stock, the margin is $5,000).

✓T A K E N O T EAlthough the Series 24 requires some knowledge about supervision of margin

accounts, it is unlikely that you will have more than one or two questions that require a simple calculation.

2. 7. 1. 1 Requests for Extensions of Time Under Regulation T and SEC Rule 15c3-3 (FINRA Rule 4230)

Clearing firms that submit requests for extensions of time in their effort to satisfy Regulation T or the reserve requirements of the Customer Protection Rule (see 2.16.1), must submit the request to FINRA for approval. A member clearing firm must also file a monthly report denoting all broker-dealers for which it clears that have overall ratios of requests for extensions of time to total transactions for the month that exceed the percentage stipulated by FINRA (currently 2%). That report is due to FINRA within five business days following the end of the month. For those months when no broker-dealer for which it clears exceeds the extension-of-time ratio criteria, the clearing firm must also submit a report indicating that no extensions were requested.

2. 7. 2 MARGIN AGREEMENT

Before letting a customer trade on margin, the customer must sign a margin agreement, which has three basic components: (1) the hypothecation agreement, (2) the credit agree-ment, and (3) the loan consent agreement.

■ Hypothecation agreement. By signing, the customer allows the member to use the cus-tomer’s securities as collateral for a loan.

■ Credit agreement. This agreement explains how the member will compute the interest to be charged to the customer for the money borrowed to finance the purchase. The inter-est rate, which varies daily, is based on the call loan rate published each day in financial media.

■ Loan consent agreement. By signing, the customer allows the member to loan out the customer’s margin securities for short sales.

✓T A K E N O T EWhile hypothecation and credit agreements are required to open a margin ac-

count, the loan consent form is optional. If signed, the firm may loan out the custom-er’s margin securities for short sales by other customers.



At or before opening a margin account, members must deliver to noninstitutional custom-ers a disclosure document that addresses the risks associated with trading on margin. Further, a margin disclosure document also must be provided to margin customers on an annual basis.

It is deemed fraudulent and deceptive to offer to sell, or attempt to sell, a security where the broker-dealer offers to extend any credit or arrange for a loan unless the member firm first delivers a written statement stating the exact nature of the risks and charges associated with borrowing money for entering into securities transactions. In addition, the broker-dealer must obtain from the customer sufficient financial information as to enable the firm to make a reasonable determination as to whether the margin is suitable for a particular customer. The broker-dealer is obligated to maintain in its files a written statement setting forth the basis for the determination.

Those investors who choose to trade securities through a margin account face additional risks that must be disclosed to those opening such an account. No member firm is permitted to open a margin account for a non-institutional account without the firm furnishing the customer a margin disclosure statement. If the account is open online, or to execute transac-tions online, firms have the additional requirement to post the disclosure conspicuously on the member firm’s website.

✓T A K E N O T EMargin trading in a trust account is permitted only if it is specifically provided for

in the trust agreement.

2. 7. 3 MARGIN RISK DISCLOSURES (RULE 2264)

As previously stated, a member firm may not open a margin account for a non-institu-tional client without making the following risk disclosures prior to or at the time of account opening and annually thereafter:

■ You can lose more funds than you deposit in the margin account. A decline in the value of securities that are purchased on margin may require you to provide additional funds to the firm that has made the loan to avoid the forced sale of those securities or other securi-ties or assets in your account(s).

■ The firm can force the sale of securities or other assets in your account(s). If the equity in your account falls below the maintenance margin requirements, or the firm’s higher “house” requirements, the firm can sell the securities or other assets in any of your accounts held at the firm to cover the margin deficiency. You also will be responsible for any short fall in the account after such a sale.

■ The firm can sell your securities or other assets without contacting you. Some investors mistakenly believe that a firm must contact them for a margin call to be valid, and that the firm cannot liquidate securities or other assets in their accounts to meet the call unless the firm has contacted them first. This is not the case. Most firms will attempt to notify their customers of margin calls, but they are not required to do so. However, even if a firm has contacted a customer and provided a specific date by which the customer can meet a margin call, the firm still can take necessary steps to protect its financial interests, includ-ing immediately selling the securities without notice to the customer.

■ You are not entitled to choose which securities or other assets in your account(s) are liquidated or sold to meet a margin call. Because the securities are collateral for the margin loan, the firm has the right to decide which security to sell in order to protect its interests.



■ The firm can increase its “house” maintenance margin requirements at any time and is not required to provide you advance written notice. These changes in firm policy often take effect immediately and may result in the issuance of a maintenance margin call. Your failure to satisfy the call may cause the member to liquidate or sell securities in your account(s).

■ You are not entitled to an extension of time on a margin call. While an extension of time to meet margin requirements may be available to customers under certain conditions, a customer does not have a right to the extension.

These disclosures can be in paper or electronic form and in a separate document or con-tained by itself on a separate page as part of another document. If retail customers can open accounts or trade online, the margin disclosure statement must be posted on the firm’s website.

2. 7. 4 MARGIN REQUIREMENTS (FINRA RULE 4210)

Using the purchase of 1,000 shares at $30 per share as an example, the account would look like this:

Long market value – debit balance = equity %$30,000 – $15,000 = $15,000 50%

Keeping in mind that these numbers are for illustration, the equity represents the custom-er’s initial margin requirement, while the debit balance represents the money loaned to the customer by the member. The mechanics of financing the purchase are as follows: the member firm takes $21,000 worth of XYZ stock to a bank for a loan (the customer signed the hypoth-ecation agreement, which permits this). The bank then loans $15,000 to the member at the call loan rate. The member then reloans $15,000 to the customer at the call loan rate plus 2%.

The customer’s securities are being used as collateral for a loan being made to that cus-tomer. The bank is in good shape, because it has $21,000 of stock collateralizing a $15,000 loan. The member is in good shape, because it is borrowing and immediately relending, mak-ing two points in the process. It is the customer who is at risk.

2. 7. 4. 1 140% Rule

The amount of customer securities that can be pledged to a bank for a loan is limited to 140% of the customer’s debit balance (140% × $15,000 = $21,000). This is SEC Rule 15c2-1, which is designed to ensure that a member does not borrow more from a bank, using customer securities as collateral, than the member reloans to the customer.

!T E S T T O P I C A L E R TAlthough the firm can hypothecate 140% of the customer debit balance, the firm

can never borrow from the bank more than 100% of the debit balance. The firm can borrow no more than it reloans to the customer.



✓T A K E N O T ESecurities of one customer can be commingled with those of other customers.

The bank providing financing to the member is holding the securities of numerous customers in street name in one account. Customer securities, however, may never be commingled with proprietary securities (i.e., securities owned by the member firm).

2. 7. 5 RESTRICTED ACCOUNT

A restricted margin account is one in which the percentage equity (margin) in the account has fallen below the initial 50% requirement. This occurs if the market value of the securities falls.

*E X A M P L E In the prior example, a customer purchased $30,000 of stock on margin. If the market value of the stock fell to $27,000, the account would look like this:

LMV – DB = EQ %

$27,000 – $15,000 = $12,000 44%

The percentage equity in this restricted account is now 44% (12 ÷ 27). To de-termine by how much this account is restricted, ask this question: How much more equity is needed to bring the account back to 50%? With a current market value of $27,000, the account would need $13,500 in equity to be at 50%. Because there is $12,000 in equity currently in the account, the account is restricted by $1,500.

✓T A K E N O T ERegarding restricted accounts: First, there is no requirement for the customer to

provide additional money. This only occurs if the account falls below the minimum maintenance margin requirement of 25% (discussed later in this Unit).

Second, the customer is permitted to make additional purchases in a restricted account. All the customer has to do is put up 50% of any subsequent purchase. When securities are sold in a restricted account, at least half the proceeds must be retained in the account (the retention requirement) to reduce the debit balance. The other half may be removed by the customer.

2. 7. 6 SPECIAL MEMORANDUM ACCOUNT

If the market value of securities purchased in a long margin account rises above initial cost, a special memorandum account (SMA) is created. As a rule of thumb, for each dollar rise in market value above cost, $.50 of SMA is created.



*E X A M P L E Using the prior example, assume the market value of the stock rises to $34,000 from $30,000. The account would now look as follows:

LMV – DB = EQ SMA

$34,000 – $15,000 = $19,000 $2,000

The market value rose by $4,000, thereby creating $2,000 of SMA. The $2,000 of SMA is often referred to as excess equity (equity in excess of 50% of the current market value). 50% × 34,000 = $17,000, which, when compared to the current equity of $19,000, shows that the account has excess of $2,000.

Once SMA is created, the customer has two basic options. First, the customer can use SMA to buy additional securities in the account without putting up additional money. This is termed buying power, which is two times the SMA. The second option is to withdraw the SMA from the account, dollar for dollar, in cash.

With SMA of $2,000, the account has buying power of $4,000, which means the customer can purchase $4,000 of stock without putting up additional money. Keeping in mind that it is highly unlikely that you will need to compute anything on the Series 24, for illustration:

LMV – DB = EQ SMA$34,000 – $15,000 = $19,000 $2,000

If the customer bought $4,000 worth of stock, the account would look as follows:

LMV – DB = EQ SMA$38,000 – $19,000 = $19,000 0

The member purchased $4,000 of stock for the customer and financed the purchase by increasing the customer’s debit balance (amount borrowed by the customer) by $4,000 to $19,000. The customer paid for the stock indirectly by borrowing more money. At this point, the SMA balance becomes zero, because the $2,000 of SMA has been fully used.

✓T A K E N O T ESMA is not equity, nor is it cash. It is a line of credit created when market value

moves up. Using that line, either through buying power or withdrawal, increases the customer’s debit balance. While an increase in market value over original cost cre-ates SMA, a subsequent decline in market value has no effect on SMA. Once created, SMA remains in the account until used, regardless of what happens to market value.

SMA can always be used, even in restricted accounts, as long as the use, either through buying power or withdrawal, does not bring the account below minimum (25%).

2. 7. 7 MINIMUM MAINTENANCE MARGIN REQUIREMENT

As noted previously, the minimum maintenance margin requirement is 25% of the current market value of the securities in a long margin account.



A firm’s SRO sets minimum maintenance requirements. Once a customer meets the initial Fed call of 50%, the percentage equity in the account can fall all the way to 25% without a maintenance margin call being sent. Once the percentage equity falls below 25%, the member sends the customer a maintenance call for an amount sufficient to bring the account back to minimum.

*E X A M P L ELMV – DB = EQ %

$30,000 – $15,000 = $15,000 50%

$27,000 – $15,000 = $12,000 44%

$25,000 – $15,000 = $10,000 40%

$22,000 – $15,000 = $ 7,000 32%

$20,000 – $15,000 = $ 5,000 25%

$18,000 – $15,000 = $ 3,000 17%

The customer begins by depositing $15,000 to meet the Fed call. At that point, the account is at 50%. As the market value of the securities purchased begins to fall, so does the equity and the percent equity (margin). When the market value falls to $20,000, the account is at minimum.

Once the account falls below 25% equity, the member sends a maintenance call. The amount of the call will be $1,500. The customer must deposit enough to bring the account back to minimum, which is 25% of the current market value (25% × $18,000 = $4,500). The customer needs $4,500 in equity to support $18,000 in market value. As the customer has only $3,000 in equity, the call will be for $1,500. Maintenance calls must be met promptly.

A customer, after purchasing securities on margin, might ask the registered representative when a maintenance call will be sent if the value of the securities declines. The customer wants to know to what market value the securities would have to fall for the account to be right at minimum. This market value is termed maintenance market value.

✓T A K E N O T EA decline in market value has no effect on SMA.

2. 7. 8 MEETING FED AND MAINTENANCE CALLS

To meet a Fed call, the customer can deposit cash (i.e., a check) in the amount of the call or can deposit fully paid-for marginable securities with a market value equal to twice the call.

*E X A M P L E To meet a $12,000 Fed call, the customer can either deposit cash of $12,000 or deposit $24,000 of fully paid-for securities.



To meet a maintenance call, the customer can deposit cash in the amount of the call or can deposit fully paid-for marginable securities with a market value equal to four-thirds of the call.

*E X A M P L E A customer receives a maintenance call for $1,500. The customer can deposit a check for that amount or deposit $2,000 worth of fully paid-for securities (V\c × $1,500 = $2,000).

If the customer fails to meet a maintenance call, the firm will sell out securities to elimi-nate the deficiency (to bring the account back to minimum).

2. 8 SHORT SELLING

A short sale involves the sale of a security the customer does not own. In order to deliver the security to the buyer no later than the settlement date, the customer must borrow security, usually from a broker-dealer or an institutional investor. Essentially, a short sale is the sale of borrowed stock. The short seller may profit if the stock declines in value and has potentially unlimited loss if the stock appreciates.

✓T A K E N O T EIf the market value of the long position is declining, the equity will fall dollar-for-

dollar with the decline. If the market value of the short position is rising, the equity will fall dollar-for-dollar with the rise. In essence, both positions are moving against the customer.

As a supervisor, consider that, although short selling serves useful market purposes, selling short also may be done to drive down the price of a stock or to hasten a declining market in a stock. In some cases, short selling may be used to manipulate stock prices and subject the offender to criminal justice. In addition, selling short is completely unsuitable for some risk-averse investors. Explaining the risks associated with short selling is of critical importance to filling the role of a supervising principal and compliance officer.

2. 8. 1 BORROWING

Securities can be borrowed from several sources: the member firm executing the short sale on behalf of the customer; margin customers of that member firm; other member firms; and institutional investors, such as pension plans and custodial banks, like State Street Bank or Bank of New York Mellon, that rank among the biggest lenders of securities in the world. When opening a margin account, customers often sign a loan consent agreement that allows custodians to lend customer margin securities from the portfolio. Certain sophisticated inves-tors and institutional customers, such as pension funds, lend securities (this is especially use-ful for hard-to-find-securities) to generate additional income in their portfolios by collecting loans.



Often, retail investors are unaware that by lending securities to short sellers who are apply-ing downward pressure to the borrowed shares, they may be working against themselves. A supervising principal should be able to explain this inherent conflict of interest to inquiring retail customers.

2. 8. 2 RULE 10B-21

SEC Rule 10b-21 is an anti-fraud rule that addresses fails-to-deliver transactions associated with “naked” short selling. It is targeted at short sellers who purposely mislead a broker-dealer about their ability or intention to deliver securities by the settlement date, thereby causing a fail to deliver. In addition, it targets short sellers who deceive broker-dealers about their source of borrowable securities to satisfy the location requirement of Regulation SHO, as well as long sellers who falsify to their broker-dealers that they actually own the shares being sold.

2. 8. 3 LENDER’S PRIVILEGES

The stock lender retains certain privileges, such as the right to cash dividends on the loaned stock. Dividends are paid by the issuer to the owner of record—the person who bought the shares from the short seller. However, the short seller must make good to the lender for the cash dividends the lender is no longer receiving. To ensure compliance, the member firm, on dividend payment date, will debit the short seller’s account the amount of the cash dividend for credit to the stock lender.

Further, the lender retains the right to any stock dividends or stock splits. Again, these additional shares will be paid by the issuer to the owner of record. The short seller makes good to the lender when the stock is bought back for return to the lender. At this point, the short seller will return not only the number of shares originally borrowed, but the additional shares resulting from the distribution as well.

Whenever a customer effects a short sale of stock, the member firm must make a deter-mination that the shares can be borrowed (locate requirement). This determination must be noted on the order ticket. Member firms, rather than making a determination for each individual short sale, may rely on a blanket or standing assurance that the securities will be available for borrowing on settlement date.

The assurance generally takes the form of a list (paper or electronic) of securities available. Under FINRA rules, the list can be no more than 24 hours old (updated daily).

!T E S T T O P I C A L E R TTwo important test points regarding short sales include the following.

■■ A short seller is required to remit cash dividends paid by the issuer to the buyer of the stock to the stock lender.

■■ The locate requirement for short sales can be made from an available securities list if the list is updated once per business day. This list is sometimes referred to as an easy-to-borrow list.



*C A S E S T U D Y Regulation SHO requires a broker-dealer to have reasonable grounds to believe that the security could be borrowed and available for delivery before accepting or effecting a short sale. Furthermore, it requires a broker-dealer to mark sales of equity securities as long or short.

The OTC equity trading firm of TNT & Associates of Montauk, NY, a member of FINRA and SIPC, effected millions of short sales without reasonable grounds to believe the securities could be obtained. As a result, those short sale orders were ei-ther mismarked, placed to the market without reasonable grounds to believe that the securities could be borrowed and delivered, or both.

FINRA found that its Reg SHO supervisory system regarding locates and the marking of sale orders was significantly flawed and resulted in a systemic supervisory failure that contributed to serious Reg SHO failures across its equities trading business.

FINRA fined TNT $12.5 million for violating Reg SHO and for failing to properly supervise short sales of securities. It was deemed that the scope and volume of TNT’s locate and order-marking violations created the potential for significant harm to the integrity of the market.

2. 8. 3. 1 Cheap Stock Rule

For stock trading at less than $5 per share, the minimum margin required to short these cheap stocks is 100% of market value or $2.50 per share, whichever is greater.

*E X A M P L E If a customer wants to short 1,000 shares of WXYZ at $4 per share, the customer must deposit $4,000 (100% of the short market value) even though this is greater than the initial Regulation T requirement of 50%.

*E X A M P L E If a customer wants to short 1,000 shares of WXYZ at $2 per share, the customer must deposit $2,500.

2. 8. 4 MARGINABLE SECURITIES

The Federal Reserve Board sets the initial margin requirement for nonexempt securities and also determines which nonexempt securities can be purchased on margin. As a general rule, all National Market System securities are marginable. All other OTC equity securities are marginable only if they are on the Federal Reserve’s marginable securities list. This list is updated periodically.

In addition, exempt securities, such as U.S. government and municipal bonds, are margin-able. Margin requirements on exempt securities are set by the SROs, not the Fed.



✓T A K E N O T ENew issues cannot be purchased on margin. They must trade in the secondary

market at least 30 days before becoming eligible for purchase on margin. Similarly, mutual funds cannot be purchased on margin. After holding mutual funds fully paid for 30 days, a customer could use these shares to meet a Fed call on a subsequent purchase of stock.

Standardized nine-month put or call options are not marginable; these are expiring securi-ties that have no loan value. Customers buying options must pay the premium in full.

✓T A K E N O T ELEAPs options, which are long-term options, are marginable as long as there are

more than nine months to expiration. In this situation, the Regulation T requirement is 75% of the premium.

2. 8. 5 OTHER FRB RULES

When a customer buys stock, the member expects payment by regular way settlement date, which is three business days following trade date. Regulation T, however, allows custom-ers an additional two business days to pay for securities purchased. Under Regulation T, the customer must pay promptly, but no later than five business days from trade date.

If payment is not received by the fifth business day and the member has not applied for (or did not receive) an extension of time from the member’s DEA, the position must be sold out on the morning of the sixth business day, and the account is frozen for 90 days. This rule applies to both cash and margin accounts.

✓T A K E N O T EExtension requests for an introducing broker-dealer are made by its clearing firm.

To monitor extension requests, FINRA requires clearing firms to keep a daily record of required margin and extension of time requests and to file monthly reports, within five business days of month end, indicating which of its introducing firms requested extensions that exceeded 2% of their total transactions for the month. If an introduc-ing firm has a ratio that exceeds 3%, it will be prohibited from any further extension requests for a 90-day period if it does not reduce its ratio by the next monthly report-ing period.



Another Regulation T rule deals with freeriding. Member firms cannot permit customers to make a practice of buying stock for which the cost is met by the sale of the same securities. If a customer buys stock on Monday and sells on Tuesday prior to paying for the purchase, the member must enter the sell order and freeze the account. The account will be unfrozen if the customer’s check is received by the fifth business day from trade date.

Member firms are permitted to establish margin requirements—across the board or for selected securities—that are more restrictive than those of the regulatory authorities.

*E X A M P L E Most member firms have minimum maintenance margin requirements for long and short positions that exceed the 25% and 30% levels established by FINRA. Some firms have established initial requirements for volatile internet stocks in excess of the Regulation T 50% requirement. Often, the expression “house maintenance” is used to describe stricter limits imposed by broker-dealers.

All margin accounts are marked to the market daily, which means the member compares purchase price (or short sales proceeds) with current market price to determine whether there is any excess (SMA) or deficiency (restriction) in the account. The price used is last sale as of the prior business day.

✓T A K E N O T ERegulation X of the Federal Reserve requires that margin credit obtained out-

side the United States to purchase securities issued by a company incorporated in the United States be in compliance with Regulation T if the credit is obtained from a foreign branch of a member firm, or with Regulation U if the credit is obtained from a foreign bank. A firm or individual cannot circumvent Regulation T or Regulation U by borrowing outside the United States.

2. 8. 6 PATTERN DAY TRADERS

A day trader is one who buys and sells the same security on the same day to try to take advantage of intraday price movements. A pattern day trader is one who executes four or more day trades in a five-business-day period.

Under FINRA rules, the minimum equity requirement for pattern day traders is $25,000 (pattern day traders must have on deposit in the account equity of at least $25,000 on any day on which day trading occurs). The minimum maintenance margin requirement for pattern day traders is 25%, which is the same as for regular customers.

Pattern day traders also are treated differently when it comes to buying power. Buying power for day traders is four times the maintenance margin excess. Maintenance margin excess is defined as the equity in the account above the 25% minimum requirement. For regu-lar customers, buying power is two times SMA.

Margin rules also prohibit day trading accounts from using account guarantees that are otherwise permitted.

A cross guarantee is one in which another customer agrees, in writing, to the use of money or securities in his account to carry the guaranteed accounts (e.g., to meet any margin calls).



2. 8. 7 PORTFOLIO MARGIN ACCOUNTS

Portfolio margining is a different way to calculate margin requirements for an account. It is based on the net risks of a portfolio of securities as a whole rather than on standardized percentages applied to each position in a portfolio. Margin requirements based on net risk are generally lower than those calculated conventionally, thereby achieving higher leverage.

In order to offer portfolio margining to customers, the following rules apply: ■ A firm must file an application with, and receive approval from, its DEA. ■ Only customers that have been approved for uncovered option writing are eligible. ■ Portfolio margin customers must receive and acknowledge in writing a risk disclosure

statement at or prior to the initial transaction.

Firms must establish minimum equity requirements for portfolio margin accounts. FINRA’s guidelines are set at $100,000 for customers of firms that have real-time intraday monitoring systems, $150,000 for customers of firms without real-time intraday monitoring systems, and $500,000 for prime broker customers or introduced account customers where trades may be executed away from the clearing firm.

The NYSE requires that customers must have and maintain $5 million in those accounts with positions in unlisted derivatives.

Securities that are eligible for portfolio margining include equity securities; listed options including LEAPS, warrants, futures, and derivatives; and exchange traded funds. Debt securi-ties are subject to conventional margin rules. Further, margin maintenance calls must be met within three business days.

2. 8. 8 EXCHANGE-TRADED FUNDS (ETFS)

ETFs are typically registered as unit investment trusts (UITs) or open-end investment companies. Shares in an ETF represent an interest in a portfolio of securities that track an underlying index. There is little active management. Since 2008, the SEC does permit, on a limited basis, exemptive relief for some types of ETFs to permit a more active management effort. Unlike traditional UITs or mutual funds, shares of ETFs generally trade as any other stock on the floor of an exchange and are subject to market forces.

A few ETFs direct investment dollars to commodities and currencies. This type of ETF is not registered as an investment company.

2. 8. 8. 1. 1 Leveraged ETFs

A leveraged ETF is designed with the view to generate multiples of 200% or 300% of the underlying index it tracks. Leveraged ETFs use futures and swaps to amplify the daily returns on its benchmark. For example, a daily large cap bull 3× shares would attempt to provide daily returns amounting to 300% of the daily return on its target index. If that index, for example the Russell 1000, rises 1% for a single trading session, the shares in the leverage ETF should rise by about 3%. Because leveraged ETFs use options, swaps, and futures, they are inherently more volatile than their underlying index.



2. 8. 8. 1. 2 Inverse ETFs

Some leveraged ETFs are “inverse” or “short” funds. These ETFs look to deliver the oppo-site of the performance of the index or benchmark they track.

2. 8. 8. 1. 3 Margin Requirements for ETFs

Because leveraged ETFs experience higher volatility compared to their non-leveraged ETFs, higher margin requirements are placed on them.

2. 8. 8. 1. 4 Strategy-Based Margin Account

In a strategy-based margin account, the maintenance margin requirement for any long ETF was 25% of the market value, and for any short ETF, the maintenance margin require-ment was generally 30% of the market value.

Maintenance margin requirements are now a percentage commensurate with the leverage of the ETF, not to exceed 100% of the value of the ETF, as detailed in the following examples:

■ Long 100 shares ABC ETF @ 28.00 (200% leverage) market value: 2,800 Maintenance requirement: 2 × .25 = .50; 2,800 × .50 = 1,400

■ Long 100 XYZ ETF @ $50 (200% leverage) current market value: $5,000 ■ Maintenance requirement: 2 × .25 = .50; $5,000 × .50 = $2,500 ■ Short 100 shares DEF ETF @ $60 (300% leverage) market value: $6,000 ■ Maintenance requirement: 3 × .30 = .90; $6,000 × .90 = $5,400

2. 8. 8. 1. 5 ETF Net Capital Haircuts

An exchange-traded fund tracking high-capitalization, broad-based indexes, such as SPDRs, is subject to a 10% haircut. ETFs tracking the riskier, non-high-capitalization, broad-based and narrow-based or sector index, is subject to a 15% haircut against capital.

2. 8. 8. 1. 6 Exchange-Traded Notes (ETNs)

Although similar in some regards, don’t confuse ETFs with ETNs, which are a type of exchange-traded debt security offering a return linked to a market index or other benchmark. Unlike ETFs, they do not buy or hold the assets replicating the performance of the underlying index. Some of the indexes and investment strategies used by ETNs can be sophisticated and very complex, carrying many different risks. They should be offered only to people who are knowledgeable and comfortable with the risks. Those risks, in part, include:

■ credit risk (ETNs are unsecured debt obligations); ■ market risk; ■ liquidity risk (although exchange traded, a trading market may not develop); ■ call, early redemption, and acceleration risk (ETNs may be called at the issuer’s discre-

tion); and ■ conflicts of interest (the issuer may engage in trading activities that are at odds with note

holders [shorting, for instance]).



✓T A K E N O T EThere is a requirement under FINRA Rule 4560 to report short positions to FINRA

twice a month as of the 15th and the last business day of the month. Reports are made on those positions that have settled as of the reporting dates. Further, reports must be received by FINRA no later than 6:00 pm on the second business day after each reporting date.

QQ U I C K Q U I Z 2 . B True or False?

—— 1. A stock lender retains the right to cash dividends, stock dividends, and stock splits.

—— 2. If a member firm keeps a list of borrowable stock, the firm must update this list at least weekly.

—— 3. SMA in a short account is created when market value falls. In a long account, SMA is created when market value rises.

—— 4. New issues trading for less than 30 days in the secondary market are not marginable.

—— 5. Under Regulation T, a customer must make payment for purchased stock within three business days of trade date.

2. 9 SECURITIES INVESTOR PROTECTION CORPORATION (SIPC)

The Securities Investor Protection Corporation (SIPC), created under the Securities Investor Protection Act of 1970, is a nonprofit membership organization. SIPC members pay assessments into a general insurance fund that is used to meet customer claims in the event of a broker-dealer bankruptcy.

!T E S T T O P I C A L E R TAll broker-dealers registered with the SEC must be SIPC members except:

■■ banks that deal exclusively in municipal securities;

■■ firms that deal exclusively in US government securities;

■■ firms that deal exclusively in redeemable investment company securities (those firms that offer shares in closed-end funds require SIPC membership); and

■■ firms whose principal business is conducted outside the United States and its territories and possessions.



2. 9. 1 PROTECTION OF CUSTOMERS

If the SEC or any SRO finds indications that a broker-dealer is in financial difficulty (usu-ally this will entail net capital violations), SIPC will be notified immediately. If SIPC deter-mines that the member has failed or is in imminent danger of failing, it may petition a federal court to take action by appointing a trustee to liquidate the firm and protect its customers. A customer can be broadly defined as anyone who has cash or securities in the possession of a broker-dealer.

The court, upon receipt of SIPC’s petition, issues a protective decree if the broker-dealer is, in fact, insolvent and then promptly appoints a trustee for the liquidation of the broker-dealer’s business.

Once a trustee has been appointed, the member firm is prohibited from engaging in busi-ness as a broker-dealer. It also is prohibited from attempting to conceal assets, file false state-ments, or alter securities records to defraud the trustee or SIPC.

2. 9. 2 ACCOUNT TRANSFER

If the trustee determines it is in the best interest of customers to do so, it may transfer customer accounts directly to another member. If the failed firm is an introducing firm, the accounts automatically become accounts of the clearing firm, which is holding customer assets anyway.

2. 9. 3 CUSTOMER ACCOUNT COVERAGE

The basic coverage under SIPC is up to $500,000 per separate customer, not per separate account. Of that total, SIPC covers no more than $250,000 in unrecovered cash.

2. 9. 4 CORPORATE AND PARTNERSHIP ACCOUNTS

Each corporate and partnership account is entitled to separate customer status—separate from the accounts of its directors, partners, and owners.

2. 9. 5 CASH AND MARGIN ACCOUNTS

If a customer has both a cash and a margin account, these accounts would be combined for coverage purposes.

The following claims are not permitted under SIPC: ■ Claims of officers or partners of the failed firm ■ Claims of other member firms for proprietary accounts ■ Claims of subordinated lenders (their funds are at risk) ■ Claims of persons who own 5% or more of the equity of the failed firm



In addition, SIPC does not cover losses relating to currencies or futures contracts, as these are not securities. For amounts not covered in a SIPC liquidation, the customer becomes a general (unsecured) creditor of the failed firm.

There are customer accounts in which one person is related to each account, but each account is considered a separate customer for SIPC coverage purposes.

*E X A M P L E John has an individual account. Mary, his spouse, has an individual account, and John and Mary have a joint account. Though John and Mary are related to each of the accounts, each account is considered a separate customer for purposes of SIPC, and each is covered for up to $500,000.

2. 9. 6 EXCESS COVERAGE

It is not uncommon for members to provide, through private insurance companies, cover-age in excess of SIPC limits. If the member decided to reduce or eliminate the excess coverage, the member must advise its customers at least 30 days before the discontinuation or reduction of such coverage.

!T E S T T O P I C A L E R TThere are two key points regarding SIPC coverage. First, accounts are valued, for

coverage purposes, as of the filing date; this is the date on which an application for a protective decree is filed, not the date the customer actually files his claim form. Sec-ond, it is the equity in a margin account, not the long market value, which is used to determine coverage. For example, an account with a long market value of $700,000, a debit balance of $350,000, and equity of $350,000 would be covered for the entire equity.

2. 9. 7 ADVERTISING SIPC MEMBERSHIP

All firms that are SIPC members must place a sign in each office location indicating SIPC membership, and all advertising by a member must include the SIPC logo or a statement of SIPC membership.

All members, unless they are excluded from membership in SIPC, are required to advise all new customers that they may obtain information about SIPC, including the SIPC bro-chure, by contacting SIPC. Members also must provide SIPC’s website address and telephone number. Further, members must provide this information to new customers, in writing, at the opening of an account, and must provide customers with the same information, in writing, at least once each year.



2. 10 INSIDER TRADING REGULATIONS

Insiders are officers, directors, as well as any person or entity that beneficially owns more than 10% of a company’s voting shares. In addition to monthly reporting of changes in owner-ship, insiders are prohibited from doing the following:

■ Selling short their own company’s stock—however, they are permitted to sell short against the box at year-end to lock in a gain (and defer taxation) as long as the position is closed out within 20 days

■ Taking short swing profits—a short swing profit is a profit realized, in a six-month period or shorter, from trading their own company’s stock; any short swing profit must be dis-gorged (returned to the company)

■ Trading based on inside information (generally defined as nonpublic information which, if known, could reasonably be expected to affect the market price of a security)

For purposes of insider trading, the definition of insider has been expanded to include anyone who has access to material, nonpublic information.

2. 10. 1 INSIDER TRADING AND SECURITIES FRAUD ENFORCEMENT ACT OF 1988

Trading securities on the basis of material nonpublic information is a violation of the law. The Insider Trading and Securities Fraud Enforcement Act of 1988 formally expanded the definition of an insider and established penalties for the illegal use of nonpublic information. Insiders may be held liable for more than just transactions in their own accounts.

The act recognizes the fiduciary responsibility of the insider to the issuer, to the stockhold-ers, and to others who might be affected by trades made with insider knowledge. Investors who have suffered monetary damage because of insider trading have legal recourse against the insider and against any other party who had control over the misuse of nonpublic information.

Inside information is any information that has not been widely disseminated to, or is not readily available to, the general public. To determine whether information is nonpublic, the SEC considers the method by which information is released to the public and the timing of trades relative to when the information is available for public evaluation. A tipper is one who gives inside information, and a tippee is the recipient of inside information.

✓T A K E N O T ESimply giving someone inside information, while imprudent, is not a violation of

law. When the information is used to trade for profit or to avoid a loss, a violation oc-curs. In this event, both tipper and tippee are liable.

The key elements of insider liability under the insider trading rules follow. ■ Does the tipper owe a fiduciary duty to the company, its stockholders, and so forth, and has

this duty been compromised? ■ Does the tipper meet the personal benefits test (even something as simple as enhancing a

friendship or reputation)? ■ Does the tippee know or should the tippee have known that the information was inside

or confidential? ■ Is the information material and nonpublic?



Given these elements, a misstatement by a corporate insider could leave that person liable under the rules, and anyone who trades on that information could be liable as well.

*C A S E S T U D Y Using Inside Information

Situation: Mr. Thompson is a friend and neighbor of Mr. Cage, president and owner of more than half of First Tech’s securities. Mr. Cage discloses to Mr. Thompson that the company has just discovered a new technology that will double First Tech’s earnings within the next year. No one outside of the company, except for Mr. Thomp-son, knows of this discovery. On this basis, Mr. Thompson buys additional shares of First Tech for Ms. Gordon.

Analysis: The information on First Tech’s new technology is material inside information that has not been made public. It is material information that only Mr. Thompson and company officials know. Mr. Thompson violated the Insider Trad-ing Act of 1988 by acting on this information. Mr. Thompson should have communi-cated the possession of the information to his compliance officer and refrained from making recommendations on the basis of this information.

2. 10. 2 TRADE REVIEW AND INVESTIGATION

As a result of the act, FINRA required member firms to establish written supervisory pro-cedures reasonably designed to detect and prevent the misuse of inside information by persons affiliated with members. Member firms erect information barriers, segregating the information flow in departments that may have sensitive information (e.g., the investment banking depart-ment) from the rest of the firm. Member firms must subject trades in NYSE-listed securities effected for the account of the firm, or for the accounts of members or employees of the mem-ber or member organization and their family members, including Rule 407 trades (employee of member trades), to review procedures that are reasonably designed to identify trades that may violate the Securities Exchange Act or the rules prohibiting insider trading and manipulative and deceptive devices. In addition, firms must promptly conduct an internal investigation into trades that appear to have violated those laws and rules to determine whether they did violate those laws and rules.

✓T A K E N O T EThere are many ways to manipulate markets. An example is the untimely an-

nouncement of record dates. As we will cover in a another unit in the LEM, SEC Rule 10b-17 requires those companies with publically traded securities to notify FINRA no later than 10 days prior to the record date, the planned distribution of a dividend, stock split, or subscription rights offering. Failure to do so would be deemed a ma-nipulative or deceptive device or contrivance under the 1934 Securities Exchange Act. (See Unit 4 for discussion about dividends and distributions.)

The act of a public company purchasing back its own stock from the public mar-ketplace could be deemed manipulative unless it relies upon a safe harbor found in SEC Rule 10b-18. (See Unit 5 for a discussion on issuer buy backs.)



2. 10. 3 ELECTRONIC BLUE SHEETS SYSTEM

In initiating an investigation into a possible insider trading violation (e.g., insider trad-ing), the SEC, FINRA, or any Intermarket Surveillance Group (ISG), such as the NYSE, CBOE and so on, will send Blue Sheets (also known as Electronic Blue Sheets or EBS) to member firms that have customers who may be involved.

*E X A M P L E If, for instance, the Commission is investigating unusual trading patterns regard-ing ABCD common stock, the Blue Sheets will require members to provide the SEC with information on the:

■■ identity of customers who bought or sold the common stock during a certain period;

■■ number of shares bought or sold;

■■ exact timing of these purchases or sales;

■■ transactions in derivative securities, such as options; and

■■ home addresses and phone numbers of the customers making these transactions.

Firms will be required, when requested, to submit Blue Sheets with information such as: ■ account number and date; ■ account number, symbol, and date; or ■ date range and executing firm CRD number or entering firm MPID.

FINRA requires that member firms keep current their Blue Sheet contact person’s infor-mation in order to process Blue Sheet data in a timely fashion. Failure to provide this informa-tion to the SEC on a timely basis will subject the member firm to serious disciplinary action.

*C A S E S T U D Y In September 2012, NYSE member firm Van Winkle & Son, LLC, violated NYSE rules by:

■■ failing to submit accurate trading information through submission of Electronic Blue Sheets in response to requests for information;

■■ submitting inaccurate trading information on Electronic Blue Sheets in response to requests for information;

■■ failing to establish and maintain systems and procedures for supervision and control for complying with EBS reporting requirements; and

■■ failing to establish a separate system of follow-up and review to ensure compliance with NYSE rules appertaining to the preparation and submission of Electronic Blue Sheets.

The firm was subject to censure and $300,000 fine. This and all case studies in this LEM are closely based on actual violations and sanctions.



2. 10. 4 PENALTIES FOR TRADING ON INSIDE INFORMATION

The SEC may seek civil penalties against anyone it believes has violated the Insider Trading Act. The penalty for the controlled person who makes the trade can be up to three times the profit made or loss avoided (i.e., treble damages). The controlling person (i.e., as the name implies, someone like a member firm who controls the offender) can be fined $1 million or three times the amount of profit made or loss avoided, whichever is greater if it knew (or disregarded) that the controlled person (e.g., registered representative) was likely to violate the law and took no steps to prevent it.

In addition, willful criminal violations carry punishments up to $5 million and can send a violator to prison for up to 20 years for each violation. However, prison time is waiting only for those whose crime is willful. If a defendant can show that he had no knowledge of the inside nature of the information, only fines would be levied. If the violator is employed by a broker-dealer, which should have procedures in place to avoid this, the firm (i.e., the controlling person) can be fined up to $25 million or treble damages, whichever is greater.

When determining how much profit or loss was made or avoided, the SEC looks at the security’s market price after the information becomes public. The difference between this price and the price the trader obtained determines the profit or loss avoided.

✓T A K E N O T EAny fines levied for insider trading violations must be paid to the U.S. Treasury.

2. 10. 5 CONTEMPORANEOUS TRADERS

A lawsuit can be brought to court by anyone who, at the same time, bought (if the insider sold) or sold (if the insider bought) securities of the same class. The action against those who were in possession of material, nonpublic information and acted upon it, may be initiated up to five years after the date of the last transaction that is the subject of the violation. The total amount of damages imposed may not exceed the profit gained or loss avoided in the transaction(s) that are the subject of the violation.

The SEC, in its sole discretion, is permitted to pay bounties to informants in insider trad-ing cases. The total amount of the bounty that may be paid from a civil penalty cannot exceed 10% of that penalty.

2. 10. 6 MISAPPROPRIATION THEORY

Those who steal information and make trades based on that ill-gotten intelligence are deemed to be trading on inside information. For example, two capital markets people are imprudently speaking about a merger on a crowded elevator. If a representative, who does not know the people talking about the deal, exits the elevator and trades based on that new, mis-appropriated intelligence, he could, if this trading activity were uncovered, go to jail.

As soon as a representative hears this type of inside information, he should immediately notify the manager who should caution the representative to not act on the information and then escalate the incident to the firm’s compliance department. Under no condition is the representative permitted to act on the information either for himself or the benefit of his cli-ents. Even though his clients may have positions in their portfolios that could be substantially impacted by the new information, he may not act upon it.



Part 22. 11 FINANCIAL RESPONSIBILITY RULES

2. 11. 1 SEC UNIFORM NET CAPITAL RULE 15C3-1

The uniform net capital rule is the SEC’s primary means of assuring that registered securi-ties broker-dealers have enough money (capitalization) to deal responsibly with the investing public. In theory, net capital is the amount of money left over after every liability of a broker-dealer has been satisfied. It is critically important that principals of all FINRA member firms grasp the importance of maintaining sufficient capital to minimize the possibility of financial failure and to protect customer assets if they do fail. In short, account for all liabilities. Disallow all illiquid assets, and ensure that all eligible securities positions receive an applicable haircut.

*C A S E S T U D Y Broker-dealers are required to accurately make a record of expenses incurred relating to its business. From time to time, a broker-dealer may have in place an expense sharing agreement with another company, most often an affiliated company. For example, an expense agreement might state that for a flat monthly payment of $20,000 from the broker-dealer to its parent company for “management and other administrative expenses,” with no definition of what that actually means, a finan-cial and operations principal at the broker-dealer may feel justified in not recording utilities, rent, cable, telephone, et cetera, because management claims that all these expenses are included in the monthly payment. The SEC’s Division of Market Regula-tion (DMR) requires, in this case, that the actual expenses reduce the firm’s capital as though there was no expense sharing agreement. Such an agreement must clearly itemize the actual services provided to the broker-dealer with a reasonable cost appor-tioned to each in order to avoid the reduction in capital. The burden of proof that the third party is able to meet its obligations rests with the broker-dealer. The other party must be able and willing to provide sufficient written evidence of its wherewithal.

As you know, each member firm operates under an individualized membership agreement with FINRA (or other SRO). The membership agreement explains what lines of business the broker-dealer undertakes. Most firms choose to “introduce” their customers to another member firm known as a clearing or carrying firm to handle back office tasks, such as clearing trades, sending trade confirmations, settlement and reporting compliance, trade execution, and custody of customer funds and securities. An introducing firm may operate with more than one clearing firm. If, for example, a member firm executes trades on Canadian exchanges, it may wish to clear those trades through a firm that has Canadian experience and qualifications.

Because carrying firms have custody of customer assets, they are required by law to main-tain higher levels of net capital than introducing firms. They also are responsible for segregat-ing the customer funds and securities in their custody. Because their risk profile is higher than an introducing firm, their net capital requirement is higher. Let’s review the varying amounts of net capital required of various types of member firms.



2. 11. 2 CARRYING FIRMS

A carrying firm carries customer accounts and accepts funds and securities from custom-ers. These firms are very often self-clearing. A firm carrying customer funds and securities clearly has a line of business that is inherently risky. The minimum net capital requirement for carrying firms is $250,000 or 62/3% of aggregate indebtedness (AI), whichever is greater (AI is discussed later in the Unit). Firms that do a commission recapture business also are required to have that amount of net capital since they are deemed to carry customer funds.

Carrying and clearing firms typically rank among the larger broker-dealers. Those firms carrying more than $20 million in net capital must document their procedures for managing risk and maintaining liquidity.

2. 11. 3 INTRODUCING FIRMS (FULLY DISCLOSED FIRMS)

A fully disclosed firm is one that introduces its customers to a clearing firm. The clearing firm holds funds and securities of the introducing firm’s customers and performs related func-tions, such as sending confirmations and statements for its correspondent firms. Essentially, the clearing firm acts as the introducing firm’s back office. The minimum net capital require-ment for introducing firms is either $5,000 or $50,000, depending on how their business is conducted.

✓T A K E N O T EThe following chart highlights the differences between the two levels of

introducing firms.

Introducing Firms $5,000 $50,000

Receives customer securities for prompt forwarding to clearing firm

No Yes

Participation in a best efforts underwriting Yes Yes

Syndicate participation in a firm commitment underwriting No No

Participation as a selling group member in a firm commitment underwriting

No Yes

Receives customer checks made out to the clearing firm Yes Yes

Receives customer checks made out to the introducing firm No No

The two major differences are that a $50,000 introducing firm can receive (but not hold) customer securities in-house for prompt forwarding to its clearing firm and can participate in a firm commitment underwriting as a selling group member. A $5,000 firm is not permitted to do either.



✓T A K E N O T EIf a firm is, for whatever reason, unable to make a net capital computation

necessary to demonstrate that it is in compliance with the net capital rule, then it would be deemed insolvent. An insolvent broker-dealer must cease all securities operations.

2. 11. 4 DEALERS

Introducing firms ($5,000 or $50,000) are permitted to make occasional trades in their firms’ investment accounts. For net capital purposes, the concept of a dealer is any member that:

■ endorses (writes) over-the-counter options; or ■ effects more than 10 transactions per year in its investment account.

The minimum net capital requirement for a dealer is $100,000. This capital requirement only affects firms whose requirement is below $100,000 (e.g., introducing firms).

*E X A M P L E If an introducing firm effects more than 10 trades per year in its investment account, its minimum net capital requirement is $100,000, not $5,000 or $50,000.

2. 11. 5 MEMBER OFFERING MUTUAL FUND SHARES

For members that deal solely in the sale of mutual funds or other investment company products, such as unit trusts or variable annuities, the minimum net capital requirement is either $5,000 or $25,000. For firms that accept wire orders from fund customers, the minimum is $25,000. For firms that sell on a subscription basis only, the minimum is $5,000. For firms that do both, the minimum is $25,000.

✓T A K E N O T EA mutual fund broker-dealer subject to a $25,000 capital requirement is permit-

ted to sell stock for an investor as long as the proceeds are immediately reinvested in redeemable investment company securities.

2. 11. 6 MARKET MAKERS

For firms registered as market makers, the minimum net capital requirement is a function of the number of markets made, subject to a minimum of $100,000 and a maximum of $1 mil-lion. For each stock in which the firm makes a market, the requirements are:

■ bid price of $5 or less—$1,000 in net capital per security; and ■ bid price of more than $5—$2,500 in net capital per security.



*E X A M P L E Firm #1 makes a market in 30 stocks under $5 bid and 20 stocks over $5 bid.

30 × $1,000 = $30,000

20 × $2,500 = $50,000

$80,000

However, this firm’s minimum capital requirement is $100,000. The absolute minimum for a market maker is $100,000.

Firm #2 makes a market in 120 stocks under $5 bid and 420 stocks over $5 bid.

120 × $1,000 = $120,000

420 × $2,500 = $1,050,000

$1,170,000

However, this firm’s minimum capital requirement is $1 million. Based on market making alone, minimum capital requirements can never exceed $1 million.

Firm #3 makes a market in 70 stocks under $5 bid and 110 stocks over $5 bid.

70 × $1,000 = $70,000

110 × $2,500 = $275,000

$345,000

This firm’s minimum capital requirement is $345,000.

Firm #4 is an introducing firm that receives but does not hold customer securities and makes a market in one stock under $5 bid.

When there is more than one way to view a firm’s capital requirement, always go with the higher (or highest) requirement. Based on this firm’s fully disclosed status, its minimum would appear to be $50,000. However, based on its market-making status, the minimum requirement is $100,000. These are never additive. Firm #4 has a mini-mum net capital requirement of $100,000.

✓T A K E N O T EFirms engaged solely in merger and acquisition work or in the sale of limited part-

nerships have a capital requirement of $5,000.

Also note that the minimum net capital requirement for firms acting as prime brokers is $1.5 million, while that for executing brokers in a prime brokerage relation-ship is $1 million. Firms engaged in block positioning also have a requirement of $1 million.



QQ U I C K Q U I Z 2 . C Match the following dollar amounts to the appropriate description.

A. $5,000B. $25,000C. $50,000D. $100,000E. $250,000F. $500,000G. $1 million

—— 1. Minimum net capital required for an introducing firm that effects more than 10 transactions per year in its investment account

—— 2. Minimum net capital required for a firm that deals exclusively in invest-ment company securities and accepts customer wire orders

—— 3. Minimum net capital required for an introducing broker-dealer that cannot receive customer securities

—— 4. Minimum net capital required for a firm that carries customer accounts

—— 5. Minimum net capital required for a market maker that makes a market in 200 stocks over $5 bid

—— 6. Minimum net capital required for a market maker that makes a market in 400 stocks over $5 bid and 100 stocks under $5 bid

—— 7. Minimum net capital required for an introducing broker-dealer that receives customer securities and participates as a selling group member in a firm com-mitment underwriting

2. 11. 7 BASIC NET CAPITAL COMPUTATION METHOD

Net capital represents the liquid net worth of a firm as computed using generally accepted accounting principles (GAAP). It differs from net worth in that net worth includes the value of all of a member’s assets, including items deemed illiquid, such as goodwill exchange mem-bership; and equipment, such as computers, copiers, software, and so on.

Net worth = total assets – total liabilities

Net capital excludes the value of a member’s illiquid assets.

Net capital = liquid assets – total liabilities

In theory, if a member goes into liquidation, the amount realized after all assets are sold and all liabilities paid off is net capital.

To find the total available capital, start with net worth and then add any subordinated debt. If a subordinated loan has been approved by regulatory authorities, it can be added back in the net capital computation. Subordinated loans are covered in greater detail later in the unit.



At this point, the net capital computation is as follows:

Net worth+ Subordinated debt Total available capital

As you can see, subordinated debt receives favorable net capital treatment. Although you will not be required to compute net capital, hopefully, the illustration will help map the con-cept and terms in your mind.

2. 11. 8 NONALLOWABLE ASSETS

The next step is to reduce total available capital by the amount of the firm’s illiquid (non-allowable) assets.

*E X A M P L E Nonallowable assets include equity in real estate, exchange memberships, furni-ture and fixtures, goodwill, prepaid expenses, and other assets that cannot readily be sold for fair value.

After deducting all nonallowable assets, the computation is as follows:

Net worth+ Subordinated debt Total available capital– Nonallowable assets Tentative net capital

2. 11. 9 HAIRCUTS

The final step is to take haircuts (value reductions) on the firm’s inventory of securities (securities owned by the firm). After taking haircuts, the computation is complete:

Net worth+ Subordinated debt Total available capital– Nonallowable assets Tentative net capital– Haircuts Net capital

The standard haircut on actively traded common stock is 15%. If stock owned by the firm has a limited trading market, the haircut is 40%. A limited trading market is where there are only one or two independent (that excludes the computing member) market makers submit-



ting regular quotations in an interdealer quotation system for the securities. In that case, the haircut is 40% on both the long and short positions. In cases where there are three or more independent market makers submitting regular quotations, the haircut is the same as for com-mon stock (15%). A stock with a limited trading market is sometimes referred to as thinly traded. By contrast, a well-known stock like Apple, Inc. has over 50 market makers.

For stocks in which there is no ready market, or your firm is the only market maker, the haircut is 100%. Examples would include unregistered warrants and unregistered stock. Essentially, these securities are nonallowable assets. Remember, the principal idea behind net capital is how much money would be available after everything is promptly liquidated. So, even though your accountancy staff might apply a value of $1 million, for example, on certain securities, if there’s no way to unload those securities, then a haircut of 100% is applied for net capital purposes.

2. 11. 10 UNDUE CONCENTRATION

An additional haircut generally is required to be taken on a particular security if its value is too great relative to the firm’s tentative net capital (the firm has too many eggs in one bas-ket). If the value of any single nonexempt security exceeds 10% of tentative net capital, the firm must take an additional haircut at the same rate on the amount by which the position exceeds the 10% threshold. An exception to this additional haircut requirement is for U.S. government securities.

*E X A M P L E A firm has tentative net capital of $600,000 and the following inventory posi-tions:

$75,000 ABC stock$80,000 US Treasury bonds$50,000 XYZ stock$55,000 DEF stock

The only position in inventory subject to an undue concentration haircut is ABC stock (more than 10% of $600,000).

US Treasury securities are an exempt security, and therefore, are never subject to an additional haircut, no matter how large the position.

!T E S T T O P I C A L E R T Whenever you see the expression “tentative net capital” on the test, it will most likely have to do with undue concentration.

2. 11. 11 AGED FAILS TO DELIVER

A customer fail to deliver can arise when a customer sells stock and fails to deliver the securities by the settlement date. At that point, the member sets up on its books a fail to deliver in the amount of the sales proceeds. It is an allowable asset for capital purposes. However, the longer it remains, the greater the risk to the member.

On the fifth business day after settlement, the fail to deliver must be aged for capital com-putation purposes. The position is marked to the market, and a 15% haircut is taken on its



current market value. This has the effect of reducing its value for capital purposes. After being aged, it is still an allowable asset.

2. 11. 12 JOINT BACK OFFICE ARRANGEMENTS

With prior written notification to FINRA, two or more broker-dealers that wish to obtain special margin treatment pursuant to Regulation T may form a joint back office (JBO) arrange-ment for carrying and clearing accounts. Carrying and/or clearing members in a JBO arrange-ment must maintain a minimum tentative net capital of $25 million.

2. 11. 13 ALTERNATIVE NET CAPITAL METHOD

For members that elect to compute their net capital under the alternative standard, the minimum net capital requirement is $250,000, or 2% of debits in the reserve computation, whichever is greater. For those firms electing the alternative standard, early warning occurs when net capital is less than 5% of aggregate debit items computed using the reserve computa-tion. The reserve computation will be discussed later in this Unit.

2. 11. 14 GUARANTEES BY MEMBERS

Whenever a member firm guarantees the obligations or liabilities of another person, writ-ten notice to FINRA must be made at least 10 business days prior to entering the arrangement.

2. 11. 15 AGGREGATE INDEBTEDNESS (AI)

Aggregate indebtedness (AI) represents certain liabilities of a member firm. It is not important to know which balance sheet liabilities are AI and which are not. It is important, however, to identify and assess the ratio relationship between net capital and AI, as shown:

AI Net Capital

Established firm $15 $1 = 15:1

First-year firm $ 8 $1 = 8:1

For established firms, the ratio of AI to net capital cannot exceed 15:1 (for every dollar the firm has in computed net capital, it cannot have more that $15 in aggregate indebtedness). For firms in their first year of operation, the ratio cannot exceed 8:1. An alternative way of seeing the 15:1 AI:NC ratio for a clearing firm on the exam would be $250,000 or 62/3% of aggregate indebtedness, whichever is greater.

*E X A M P L E An established carrying firm has computed net capital of $600,000. The maxi-mum amount of AI this firm could have would be $9 million (15 × $600,000). If this were a first-year firm, the maximum AI amount would be $4.8 million (8 × $600,000).



2. 11. 16 EFFECT ON NET CAPITAL

The effect of the AI rule is to increase a firm’s minimum net capital requirement as aggre-gate indebtedness rises.

*E X A M P L E An established carrying firm has AI of $12 million. Its minimum net capital requirement is $800,000, which is computed by dividing $12 million by 15. Alterna-tively, $12 million x 6 2/3% ($12,000,000 x .06666).

To restate, the minimum net capital requirement for an established carrying firm is $250,000 or 1/15 of AI, whichever is greater. Therefore, as a firm expands, increasing its AI, its capital requirement increases to compensate for the additional risk.

2. 11. 17 SUBORDINATION AGREEMENTS

Subordinated loans, if approved by the regulatory authorities, can be added to net worth in computing net capital (i.e., approved subordinated debt is considered capital).

Subordinated loans are certain loans to a member for which the lender agrees to subordi-nate its claim to the claims of the member’s other creditors. Subordinated loans are typically long term in nature and are a major source of financing for many firms.

Subordination agreements are of two types: (1) subordinated loan agreements, and (2) secured demand note agreements.

■ In a subordinated loan agreement the lender gives the member cash in exchange for inter-est payments on the loan and repayment at some future date.

■ In a secured demand note agreement, the lender gives the member negotiable securities to pledge on its own behalf to a bank for a loan. The lender receives interest at an agreed-upon rate, all dividends on the pledged stock, and repayment at an agreed-upon date. Typically, common stock is pledged. The member then takes these marginable securities to

a bank for a loan. As a general rule, the bank will loan 70% of the value of the securities to the firm. If the value of the stock is $100,000, the bank will loan $70,000 to the firm. The result is an increase in the firm’s capital of $70,000.

Another way to look at this is that the haircut on securities underlying a secured demand note is 30%.

2. 11. 17. 1 Standards For Subordinated Loans

Subordination agreements are required to have the following features: ■ A minimum term of one year ■ In written form, valid and binding on all parties ■ For a specific amount ■ Lender’s claims must be subordinated to all other claims ■ Proceeds of the loan must be used in the business and are subject to the risks of the busi-

ness



When a member has a secured demand note agreement, the following additional rules apply.

■ Only fully paid securities can be pledged, and such securities must be in street name, bearer form, or in the name of the member. They cannot be subject to any restrictions regarding sale or transfer. Unregistered securities or securities subject to a Rule 144 filing are not acceptable collateral.

■ The agreement must be for a specific amount; the amount cannot vary with the value of the underlying collateral.

■ If the value of the underlying collateral declines sharply (below that of the loan amount), immediately notify FINRA.

2. 11. 17. 2 Temporary Subordinated Loans

Temporary subordinated loans are for short-term needs and are normally used in conjunc-tion with firm commitment underwritings. SEC rules require that member firms, when acting as a syndicate member in a firm commitment offering, haircut that commitment as of the close of business on the day before the effective date.

*E X A M P L E A firm has a 10% syndicate participation in a $60 million initial public offering of common stock. It is committed to purchasing $6 million of the stock for resale to the public. Even if the issue is presold (there are more indications of interest than shares to be sold), this firm is required to charge its net capital by $1.8 million (30% × $6 million).

The haircut on IPOs is 30%, while that on additional issue offerings is 15%. The haircut of $1.8 million can be reduced by the estimated profit to be made on the sale.

Nonetheless, this is a significant reduction in capital. To offset the charge, a firm can take on temporary subordinated debt. The firm does not need the money; it needs something to restore capital reduced as a result of the haircut. Member firms are permitted no more than three temporary subordinated loans in any 12-month period. The maximum duration of such loans is 45 days.

2. 11. 17. 3 Filing Of Subordination Agreements

File two copies of proposed subordinated loan agreements with FINRA at least 10 days before the anticipated effective date. FINRA then renders a written opinion as to whether these loans are approved for capital purposes.

Repayment of a subordinated loan at maturity is suspended if, after repayment, its AI-to-NC ratio exceeds 12:1 or if its net capital is less than 120% of its minimum requirement (5% of aggregate debit items using the alternative standard).

Prepayment of a subordinated loan is permitted as long as the agreement has been in force for at least one year and the prepayment will not cause its AI-to-NC ratio to exceed 10:1 or its net capital to fall below 120% of its minimum requirement. Further, prepayment requires prior written approval of its designated examining authority (DEA).

Prepayment of a subordinated loan is permitted as long as the agreement has been in force for at least one year and the prepayment will not cause its AI-to-NC ratio to exceed 10:1 or its net capital to fall below 120% of its minimum requirement. Further, prepayment requires



prior written approval of its designated examining authority (DEA). The one-year restriction on prepayment does not apply to temporary subordinated loans.

Sample Front Page of SL–31D



2. 11. 18 DEBT/EQUITY RATIO

The debt/equity ratio of a member firm is a capital ratio. It has nothing to do with con-ventional liabilities. It expresses the percentage of a member’s total available capital that is accounted for by subordinated debt.

*E X A M P L E A firm has a net worth of $600,000 and subordinated loans of $200,000.

Net worth $600,000

Subordinated debt $200,000

Total available capital $800,000

Its debt/equity ratio is 25% ($200,000 ÷ $800,00). Conversely, 75% of its total available capital comes from real equity.

QQ U I C K Q U I Z 2 . D True or False?

—— 1. Aged fails to deliver are considered nonallowable assets.

—— 2. A carrying broker-dealer in business for 8 months is in compliance with 15c3-1 if its net capital is $200,000 and its aggregate indebtedness is $1 million.

—— 3. Temporary subordination agreements must be filed with FINRA 30 days before their effective date.

—— 4. A firm with a net worth of $500,000 and subordinated debt of $500,000 has a debt/equity ratio of 50%.

—— 5. The haircut for a stock owned by a firm with no ready market is 40%.

—— 6. Government securities are never subject to undue concentration haircuts.

—— 7. If undue concentration exists, an additional haircut of 15% applies to the amount that exceeds the 10% threshold.

—— 8. A standard subordination agreement must have a minimum term of 3 years.



2. 12 FINANCIAL REPORTING

2. 12. 1 SEC RULE 17A-5

Member firms must file electronic FOCUS reports with the regulatory authorities. These reports show the financial condition of the member, include a net capital computation, and provide related operational information.

SEC Rule 17a-5 requires, among other things, that broker-dealers file monthly FOCUS Reports, Part II, and quarterly FOCUS Reports, Part II or IIA, within 17 business days after the end of the month or quarter. Carrying firms must file FOCUS II reports both monthly and quarterly. The quarterly FOCUS II report is more extensive than that filed monthly. Noncarrying firms must file FOCUS IIA quarterly unless FINRA notifies the firm in writing that it must file monthly. A fifth FOCUS report is an additional report that is due from those member firms whose fiscal year end is other than the calendar quarter.

Furthermore, the SEC rules require firms to file Schedule I, which deals with operational matters, within 17 business days after the end of the calendar year. FOCUS Reports, as well as Schedule I, must be filed electronically with FINRA no later than midnight ET on the due date.

Quarterly FOCUS reports are based on calendar quarter reporting. If a member’s year-end date does not coincide with the end of calendar quarter, its quarters are not calendar quarters. In this case, the firm must file a fifth quarterly FOCUS report within 17 business days of year-end date.

If a firm terminates its membership in any national securities exchange or withdraws from any self-regulatory organization, it must file a FOCUS II or IIA within two business days of termination.

2. 12. 1. 1 Supplemental FOCUS Information (FINRA Rule 4524)

A supplementary schedule under FINRA Rule 4524, known as the SSOI, contains addi-tional line items for more details of the revenue and expense line items that are on the state-ment of income (loss) page of the FOCUS Report Part II and Part IIA. The SSOI helps FINRA better deduce a firm’s revenue sources and expense composition on an ongoing basis. Each firm, as FINRA designates, is required to file the Form SSOI within 20 business days of the end of each calendar quarter.

Firms with a $100,000 minimum net capital requirement or more and that carry inven-tory positions (other than money market mutual funds) must file a Supplemental Inventory Schedule (SIS) within 20 business days of filing its FOCUS reporting period. Just like the FOCUS, it must be filed using the eFOCUS System through FINRA’s Firm Gateway.

If the term FOGS Report appears on the test, know that it is the same thing as a FOCUS report, but used by government securities brokers and dealers.

2. 12. 1. 2 Form Custody

The SEC has recently added to Rule 17a-5 a requirement to file “Form Custody” with the view to discover whether a broker-dealer maintains custody of customer and non-customer assets and, if so, how the assets are maintained. Form Custody must be filed quarterly, within 17 business days of the quarter’s end. If the broker-dealer’s fiscal year is not the same as the calendar year, the firm must also file an additional Form Custody 17 business days after its fis-cal year end.



Sample Schedule I Cover Page



Sample Cover Page of Focus Part II



✓T A K E N O T EFully disclosed firms that are classified as dealers for net capital purposes must

file, for each noncalendar quarter-ending month, an abbreviated FOCUS IIA within 17 business days of month end.

2. 12. 2 AUDITED REPORTS

All broker-dealers registered with the SEC are required to file audited FOCUS II or IIA reports within 60 days of year-end date with a FOCUS Part III facing page. If a firm needs an extension to file its audited financials, the request must be directed to the firm’s designated examining authority (e.g., FINRA). Similarly, if a firm wants to change its year-end date, this request also must be made to the firm’s designated examining authority, as well as the SEC in Washington and regional offices, along with an explanation as to why. The DEA then has to approve the request.

The annual audit report must be filed in hard copy as follows: two copies with the principal office of the SEC, one copy with the appropriate regional office of the SEC, and one copy with the principal office of FINRA.

A firm seeking an extension to file its audited report may seek a date not to exceed 90 days from year-end date. The maximum extension is 30 days. Requests for an extension of time must be received by FINRA at least three business days before the due date.

2. 12. 3 STATEMENTS TO CUSTOMERS

Carrying firms are required to provide their customers with a semiannual statement (an unaudited balance sheet and unaudited statement of net capital) and an annual statement (an audited balance sheet and an audited statement of net capital). Upon request, all firms must provide customers with a balance sheet.

2. 12. 4 TRIAL BALANCES

A trial balance is a report, taken from a firm’s general ledger, that includes the firm’s bal-ance sheet, income statement, and net worth accounts. From the information in the trial bal-ance, a firm can prepare a net capital computation. SEC rules require that members prepare trial balances at least monthly.

2. 12. 5 TERMINATION OF INDEPENDENT ACCOUNTANT

If a member’s independent accountant resigns or is fired, the member must electronically notify SEC and FINRA within 15 business days of termination date. The notice must include:

■ details surrounding the termination; ■ information on any accounting or auditing disputes; and ■ a letter from the former accountant presenting the other side.



In particular, the notice must address any accounting or auditing disputes between the firm and the accountant over the 24-month period before termination. The notice must address all disputes, regardless of whether they were resolved to the former accountant’s satisfaction.

2. 13 NOTIFICATION PROVISIONS FOR BROKER-DEALERS

SEC Rule 17a-11 requires that reports be made electronically to the SEC and FINRA if a member has violated the net capital rule, is close to violating the net capital rule, or is expe-riencing operational problems.

There are six situations that require notification under 17a-11.1. The firm’s net capital falls below its minimum requirement.2. The firm’s AI-to-NC ratio exceeds 15:1 (8:1 for a first-year member).3. The firm’s debt/equity ratio exceeds 70% for more than 90 days.4. The firm’s books and records are not current.5. The firm has material inadequacies in its accounting system.6. The firm has a total amount of money payable against all securities loaned or subject to

a repurchase agreement, or the total contract value of all securities borrowed or subject to a reverse repurchase agreement, exceeds tentative net capital by 25 times (2,500%). Government securities are excluded from the calculation.

Situations 1 and 2 are essentially the same. If a firm’s AI-to-NC ratio exceeds 15:1, its capital is below minimum.

If a firm is reporting 1, 2, 3, or 4, notification must be made immediately. If the member is reporting 5, notification must be made within 24 hours.

If a member is reporting that its computed capital is below its minimum requirement, the member, in its notification, must state both its minimum requirement and the amount of its computed net capital.

In addition, if a member is reporting either 4 or 5, it also must file a report within 48 hours of notification, detailing the steps being taken to correct the situation.

2. 13. 1 EARLY WARNING REPORTS

A member is in early warning if: ■ its capital falls below 120% of its minimum requirement; or ■ its AI-to-NC ratio exceeds 12:1.

*E X A M P L E An established carrying firm, subject to a $250,000 minimum net capital require-ment, would be in early warning if its computed net capital fell below $300,000 (120% × $250,000).

Early warning reports must be made within 24 hours. For first-year firms, there is no early warning standard regarding AI-to-NC ratios, because FINRA is already watching first-year firms closely.



2. 14 REPORTING AND INQUIRY—LOST, STOLEN, MISSING SECURITIES

SEC Rule 17f-1 calls for the SEC or its designee, currently the Securities Information Center (SIC), to maintain records of lost, counterfeit, missing, or stolen securities. This rule was created in an effort to reduce trafficking in lost, stolen, missing, and counterfeit securities. The database of securities maintained by the SIC can only be accessed by registered BDs and other financial institutions to ascertain if securities that have come into their possession have been reported as lost, stolen, missing, or counterfeit.

Upon discovery of the likely loss of a security, if no criminal action is suspected, a member has two business days to locate the missing security. If it is still missing on the third day, the loss must be reported to the SIC and the transfer agent.

If securities are missing and criminal action is suspected, a member has one business day to report the loss to the SIC and the transfer agent. In addition, the FBI must be notified promptly. If the securities are later recovered, those parties who were originally notified must be advised of the recovery within one business day. Only the party reporting the loss can make notification of the recovery.

Every member is required to inquire of the SIC regarding certain securities coming into its possession as to whether the security has been reported as lost, missing, counterfeit or stolen.

Exceptions are made to this inquiry rule if the security is: ■ received directly from the issuer; ■ received from another reporting institution (e.g., member firm); ■ received from an existing customer of the firm and registered in the customer’s name, or

was previously sold to that customer as verified by the member’s records; and ■ part of a transaction valued at $10,000 or less.

However, any member may inquire at any time as to the validity of any security delivered into the firm. In essence, the rule requires inquiry only if securities are received from a new customer in registered or bearer form, or from an existing customer in bearer form in which the record of the purchase is not available.

Broker-dealers that carry securities are required to make a count quarterly. If securities are discovered missing as the result of a quarterly securities count, the member has 10 business days to report to the SIC.

2. 15 RECORDKEEPING AND RETENTION OF BOOKS AND RECORDS

The Securities Exchange Act of 1934 requires that broker-dealers make and keep records in order for the Commission, SROs and state regulators to conduct meaningful and effective examinations. The integrity of a firm’s books and records are of paramount importance. Firms must store true, legible and accurate records and protect them. Any falsification, alteration (no matter how small) or destruction of books and records is a serious violation. When this sort of behavior is uncovered, it always leads to heavy sanctions.



2. 15. 1 SEC RULES 17A-3 AND 17A-4 (FINRA RULE 4511)

These rules cover which records must be prepared by members, when such records must be prepared, in what format they must be kept, and for how long records must be retained. As required under these rules and Rule 3110, each member firm is responsible for developing and maintaining policies, procedures, and controls relating to the creation and retention of its books and records and update them as often as necessary. (Firm policies and procedures cannot be updated too much. However, a record of each iteration must be maintained.) An example of a firm-specific issue is instant messaging. If a firm uses that form of communication, how will it capture and retain a record of those messages? Another example might include the firm’s policies on scanning devices and their proper use. If a representative scans new account forms and he destroys the originals, and the scanned images are later found to be inaccessible or for some reason unreadable, the firm will be in violation. There is a ripple effect to this. If the new accounts department needed the records, they may not be able to verify and process the customer’s account, thus creating not only a compliance risk but a business risk as well. A supervisor then has the responsibility to find out how this happened as soon as it is uncovered and the extent of the problem. The representative should be re-trained and closely supervised. In addition, the representative should obtain the new account paperwork—again.

Recordkeeping policies and procedures vary from firm to firm. Each firm must develop its own WSPs to be in compliance with the rules and to fit its unique circumstances.

For retention purposes, records are generally lifetime records, six-year records, or three-year records. That said, be on the lookout for variances, such as the four-year retention requirement for customer written complaints. When FINRA examiners ask for the most recent two years’ worth of records, they must be readily available.

✓T A K E N O T EIn lieu of maintaining paper records, firms may wish to use micrographic media,

such as microfilm or microfiche (so long as there is a reading device available) or elec-tronic storage media, such as DVDs. Such media must have the capability to maintain records in non-rewriteable and non-erasable format. A broker-dealer is obligated to notify FINRA at least 90 days prior to utilizing electronic storage for recordkeeping purposes.

✓T A K E N O T EThere are various recordkeeping rules imposed by different regulatory bodies. For

example, those broker-dealers that are subject to reporting and recordkeeping of cur-rency and foreign transactions may be subject to conflicting laws and rules. Whenever there is a differing recordkeeping requirement, the SEC’s view is to preserve the record for the longer period.

2. 15. 1. 1 Lifetime Records

Records that must be kept for the life of the firm are partnership articles if a partner-ship, articles of incorporation if a corporation, minute books (records of directors’ or part-ners’ meetings), stock certificate books, and organizational documents, such as Form BD and amendments.



2. 15. 1. 2 Six-Year Records

This list points to records that must be retained for six years. FINRA Rule 4511 also prescribes that where no specific retention period is mentioned in any rule or law, the default retention period is six years. Furthermore, if the books and records pertain to an account, the records must be maintained for six years after the date the account is closed.

Blotters. A blotter is a record of original entry. A member generally maintains blotters relating to the purchase and sale of securities, the receipt and delivery of securities, and the receipt and disbursement of cash. Blotters must reflect transactions as of trade date (or event date) and must be prepared no later than the following business day.

General Ledger. The general ledger contains accounting records of the firm’s assets, liabilities, and net worth accounts. From the general ledger, a firm prepares its financial statements. The general ledger must be prepared as frequently as necessary to determine compliance with the net capital rule, but in no event less frequently than monthly.

Stock Record. The stock record shows all securities held by the firm, the ownership of those securities, and where the securities are held. The stock record must be posted no later than the business day after settlement date.

Customer Ledgers. Customer ledgers are customer statements. Cash accounts and margin accounts are shown on separate ledgers. These ledgers must be posted no later than settlement date.

Customer Account Records. Customer account records are records that every mem-ber broker-dealer must preserve for not less than six years after the closing of any customer’s account and any records of the terms and conditions with respect to the opening and main-tenance of the account. Note that if there has been a report generated on this account due to unusual activity, all of these reports in customer accounts must be retained for 18 months after the report was generated. Customer account records might include the new account form and margin agreement, if appropriate.

The principal designation record must be retained for six years.

2. 15. 1. 3 Three-Year Records

Most other records are three-year records. Examples of these records include the following: ■ Communications with the public ■ Focus reports ■ Trial balances ■ Form U-4, U-5, and fingerprint cards for terminated personnel ■ Customer confirmations ■ Order tickets ■ Subsidiary ledgers, such as securities borrowed and securities loaned, monies borrowed and

monies loaned, securities failed to receive and failed to deliver, long and short securities differences, and dividends and interest received

■ A list of every office where each associated person regularly conducts business



■ Associated persons’ compensation records ■ The firm’s Compliance and Procedures manual ■ Recordings of telephone conversations of firms required to record calls ■ The names of all persons who are designated as supervisory personnel and the dates the

designation was effective

*E X A M P L E Before executing any customer order, place upon the order form, electronic or otherwise, for each transaction, the name or designation of the account. No change in the account name or designation may be made unless the change has been autho-rized by a qualified and registered principal designated by the member. That person must, prior to giving his or her approval of an account designation change, be person-ally informed of the essential facts and indicate approval of the change in writing. Es-sential facts being relied upon also must be documented in writing and preserved for a period of not less than three years, the first two years in an easily accessible place.

✓T A K E N O T ENo member or AP may submit for payment a check or other form of negotiable

paper drawn on a customer’s checking or savings account, without that person’s express written authorization, which may include the customer’s signature on the ne-gotiable instrument. Where the written authorization is separate from the negotiable instrument, the member is required to preserve the authorization for a period of three years following the date the authorization expires. This provision does not require members to preserve copies of negotiable instruments signed by customers.

2. 15. 1. 4 Four-Year Records

Maintain customer written complaints for four years.

✓T A K E N O T EWhether a record retention requirement is six years or three years, the most

recent two years must be in a readily accessible location.

Records for which there is a five-year retention period include: ■ Form 112 filings; ■ SAR filings; and ■ information obtained to verify a customer’s identity.

Exception reports ordered from a clearing firm must be retained for 18 months. These reports can be generated daily to review for unusual activity in customer accounts. The list of available exception reports available from a clearing firm is extensive. These reports are invaluable and can provide excellent supervision tools to help spot most any kind of irregu-larity in customer and proprietary accounts, such as high turnover rates, large debit balances, overconcentration, and much more.



2. 16 CUSTOMER PROTECTION RULE (SEC RULE 15c3-3)

SEC Rule 15c3-3, the Customer Protection Rule, was enacted in conjunction with SIPC legislation in response to a wave of broker-dealer liquidations in the late 1960s and early 1970s. The rule has two basic components: (1) possession or control requirements, and (2) the reserve requirement.

Carrying firms have the daily requirement to bring under possession (in-house) or control (in an account controlled by the firm), all fully paid-for customer securities and all excess mar-gin securities. Each day, from the prior day’s settlement records, a carrying firm must take steps to ensure that it has obtained physical possession or control over such securities. For example, securities due from customers to complete sell orders must be bought in promptly after 10 busi-ness days from settlement.

✓T A K E N O T EMargin securities are not subject to this requirement. The securities are at a bank

collateralizing customer debit balances. Excess margin securities, however, must be under the possession or control of the firm and may not be used as collateral.

Good control locations include securities depositories, such as Depository Trust Company (DTC), commercial banks, and other broker-dealers. DTC is the world’s largest securities depository. It provides custody services for virtually all securities except those subject to trans-fer or ownership restrictions. Securities eligible for DTC services are said to be on the approved list. Foreign depositories, foreign clearing agencies, and foreign custodian banks are acceptable control locations if approved by the SEC.

✓T A K E N O T ECredit unions and savings and loans are not good control locations.

2. 16. 1 RESERVE REQUIREMENT

Each week, as of the close of business on Friday (or on Monday for Friday), carrying firms make the following determinations:

■ Monies owed to the member by customers (debits) ■ Monies owed by the member to customers (credits)

If credits exceed debits, the firm, in theory, is using customer monies in the conduct of business. The rule requires that any excess of credits over debits must be deposited in a Special Reserve Bank Account for the Exclusive Benefit of Customers within one hour after the banks open on the second business day following computation (this generally means by 10:00 am, Tuesday). The only acceptable deposits into this account are cash and qualified securities; that is, those securities backed by the full faith and credit of the US government, such as Treasury bills, Treasury notes, Treasury bonds, and Ginnie Mae mortgage-backed securities.

Failure to make a required deposit into a special reserve account requires immediate elec-tronic notice to the SEC and FINRA. The member must promptly confirm the contents of the electronic notice in writing.



BANKSubject to Federal Supervision

Credits(Liabilities)

Money owed to customers by thebrokerage firm

$1,200,000

Debits(Assets)

Money owed to the brokerage firm by

customers

$1,000,000

$200,000 excesscredits must be

deposited into theSpecial Reserve

Account

2. 16. 1. 1 Special Reserve Account

In opening a special reserve account, a member must inform the bank that the monies on deposit are for the exclusive benefit of the member’s customers and that there can be no cross liens on this account (the bank cannot go after funds in this account if the member is delin-quent in meeting other obligations it may have with the bank).

A member is permitted to withdraw monies from the special reserve account as long as the withdrawal is supported by a computation indicating there is an excess on deposit.

2. 16. 1. 1. 1 Monthly Computation

A firm that has customer credits of not more than $1 million and its AI:NC ratio does not exceed 8:1 is permitted by the SEC to make the reserve computation monthly rather than weekly. Because the updates are not as frequent, these firms must deposit into the account 105% of the required amount. For example, if the computation proved that the firm needed to deposit $10,000, it would be required to deposit $10,500 instead.



2. 16. 1. 1. 2 Exemptions

Certain firms are exempt from the computation requirements of the Customer Protection Rule SEC Rule 15c3-3. These exemptions, which are available to noncarrying firms, are as follows:

■ The k(1) exemption applies to firms whose transactions are limited to the sale and redemptions of redeemable securities of registered investment companies, and it promptly transmits all funds and delivers all securities received.

■ The k(2)(i) exemption is available to firms that carry no margin accounts and promptly forward all customer funds and securities. In other words, they do not hold funds or secu-rities for, or owe money or securities to, customers and conduct all financial transactions with customers through a bank account designated as “Special Account for the Exclusive Benefit of Customers.”

This exemption often applies to firms that clear their business in an omnibus account. These firms engage a clearing firm to hold all of their customer securities in an omnibus (umbrella) account. The clearing firm does not know the identity of the beneficial owners of the stock. All the securities are held in the firm’s name. The member firm clearing this way (unlike an introducing firm) is responsible for sending statements and confirmations and maintaining ownership records.

■ The k(2)(ii) exemption is available to introducing broker-dealers that clear all customer transactions on a fully disclosed basis with a clearing firm. In addition, the introducing firm (correspondent firm) must promptly transmit all customer funds and securities to its clearing broker-dealer. The clearing firm also must carry all customer accounts for cor-respondent firms looking to claim this exemption. The clearing firm is responsible in this arrangement to keep the books and records related to its correspondents’ accounts required under SEC Rules 17a-3 and 17a-4.

The minimum net capital requirement for k(2)(i) firms clearing on an omnibus basis is $100,000. If a firm wishes to change its exemptive status, direct the request to a designated examining authority for prior written approval.

Rule 15c3-3 requires that any customer with a free credit balance with a broker-dealer receive a written statement of the amount due the customer by the broker-dealer. The state-ment must also indicate that the amount is payable upon the customer’s demand, but until then, the funds may be commingled with other customer’s funds and/or with the funds of the broker-dealer, and therefore, may be used by the broker-dealer in the course of conducting business. The written statement required under this rule must be sent to customers at least once every three months unless there is activity in the account.

Carrying broker-dealers also must perform a separate reserve computation for proprietary accounts of other brokers (PAB accounts) in addition to the customer reserve computation required by Rule 15c3-3. In addition, carrying firms must establish a separate reserve bank account for the benefit of PAB accounts and obtain and maintain physical possession or con-trol of non-margin securities carried for PAB accounts.



QQ U I C K Q U I Z 2 . E Match the following terms with the appropriate descriptions.

A. WeeklyB. 105%C. 6 yearsD. 3 yearsE. LifetimeF. MonthlyG. Settlement dateH. 45 daysI. Quarterly

—— 1. Term for which FOCUS reports must be retained

—— 2. Typical frequency of a firm’s customer reserve calculation

—— 3. Term for which customer account records must be retained

—— 4. Term for which minute books must be retained

—— 5. Amount of excess of credits over debits that must be deposited by monthly reserve account calculators

—— 6. Number of days after which unresolved short securities differences must be bought in

—— 7. Frequency with which trial balances must be prepared

—— 8. Date by which customer ledgers must be posted

—— 9. Frequency of securities counts

2. 17 FIDELITY BOND REQUIREMENTS (FINRA RULE 4360)

FINRA Rule 4360 requires all member firms (including one-man firms) to join SIPC and to secure fidelity bonding insurance to insure against employee theft or embezzlement, fraudu-lent trading, and forgery of securities or checks. The rule requires a member with a net capital requirement of less than $250,000 to maintain minimum coverage of 120% of the firm’s net capital requirement or $100,000, whichever is greater. Firms with net capital requirements of $250,000 or more must purchase an amount found on a FINRA table found in the rule. (Refer to the Fidelity Bonding Coverage Table and become familiar with the coverages.) The higher the minimum, the more the required bond. Members must review the adequacy of coverage annually, even if the firm buys multi-year policies. Firms that act solely as DMMs or floor bro-kers are exempt from this entire rule if they do no business with the public.



✓T A K E N O T EIn determining their fidelity bonding requirement, firms must use their highest net

capital requirement over the 12 months preceding the computation. The preceding 12-month period includes the 12-month period that ends 60 days before the yearly anniversary date of the bond. This allows sufficient time for a firm to determine its required amount of the fidelity bond by the anniversary date. Member firms must review coverage annually.

A deductible provision may be included in the bond up to $5,000 or 10% of the minimum required coverage, whichever is greater. If a member’s policy includes a deductible greater than this, the difference must be charged against net worth for capital computation purposes.

Member firms must immediately advise FINRA in writing if its fidelity bond is terminated, cancelled, or substantially modified.

Fidelity Bonding Coverage Table

Net Capital Requirement Minimum Coverage $

250,000 – 300,000 600,000

300,001 – 500,000 700,000

500,001 – 1,000,000 800,000

1,000,001 – 2,000,000 1,000,000

2,000,000 – 3,000,000 1,500,000

3,000,000 – 4,000,000 2,000,000

4,000,000 – 6,000,000 3,000,000

6,000,000 – 12,000,000 4,000,000

12,000,001 and above 5,000,000

✓T A K E N O T EMembers are required to promptly advise FINRA in writing if its fidelity bond is

substantially modified, cancelled, or terminated.

2. 18 CURTAILMENT ON MEMBER ACTIVITY (FINRA RULE 4120)

If a member firm is experiencing financial or operational difficulties, FINRA has the authority to prohibit expansion or require a reduction in the member’s overall level of busi-ness. The following guidelines are applied by FINRA.

A member may be prohibited from expanding its business if either of the following has existed for more than 15 consecutive business days:

■ Net capital is less than 150% of its minimum requirement ■ AI-to-NC ratio exceeds 10:1



A member may be required to reduce its business if either of the following have existed for more than 15 consecutive business days:

■ Net capital is less than 125% of minimum ■ AI-to-NC ratio exceeds 12:1

✓T A K E N O T EOther indications that a member may be approaching difficulty include the

following.

■■ A member has experienced a 25% reduction in excess net capital in the preceding two months, or a 30% reduction or more in the preceding three months.

■■ A member’s books and records are not current.

■■ A member is unable to settle and clear transactions promptly.

In imposing restrictions, FINRA may require the member to take one or more of the fol-lowing actions:

■ Promptly pay all free credit balances to customers ■ Promptly make delivery to customers of all fully paid securities in the member’s possession

or control ■ Reduce the size of its inventory of securities ■ Accept no new customer accounts ■ Restrict the payment of salaries ■ Accept only unsolicited customer orders ■ File special financial and operating reports ■ Postpone the opening of new branches or close one or more existing branches

In addition to having the authority to direct members either not to expand their business operations or to reduce their business operations, FINRA has the authority to direct members to suspend all business operations during any period when the member is not in compliance with the net capital rule. If a member’s capital is below its minimum requirement, FINRA can force a firm to shut down.

2. 19 WITHDRAWAL OF EQUITY CAPITAL

Capital may not be withdrawn by officers or partners of members, or by parent companies or subsidiaries if the effect would be to have the firm’s capital fall below 120% of minimum, or cause its AI-to-NC ratio to exceed 10:1.

Certain withdrawals of equity require that notification be made to the SEC. If the amount to be withdrawn in any 30-calendar-day period will exceed 30% of the firm’s excess net capital (capital in excess of its minimum requirement), notify the SEC two business days in advance of the withdrawal. The SEC has the right to restrict the withdrawal of equity capital if it appears that the financial integrity of the firm will be compromised.



Be mindful that the SEC believes that capital contributions to broker-dealers should not be temporary in nature. Therefore, any capital contributed under an agreement that gives the contributor the right to withdraw the capital, or that is intended to be withdrawn within one year, must be excluded from net capital. In other words, deduct the contribution during the calculation.

2. 20 CLEARING AGREEMENTS

Most broker-dealers rely on another member firm to provide clearing, custody, and execu-tion services. Where needed, a clearing firm may provide prime brokerage, exception reports, stock lending and borrowing, financing margin, risk monitoring, direct market access (DMA), and much more. In short, an introducing firm outsources many important jobs. By allowing other firms to perform these critical functions, a fully disclosed introducing firm can focus on its core activities while its clearing firm may look to providing its clients with good service, economies of scale, and expertise in technology.

All clearing agreements between an introducing firm and its clearing agent must, at a minimum, specify the responsibilities of each party with respect to:

■ opening, approving, and monitoring customer accounts; ■ extension of credit; ■ maintenance of books and records; ■ receipt and delivery of funds and securities; ■ confirmations and statements; and ■ acceptance of orders and execution of transactions.

If the agreement allows the introducing firm to execute away (enter orders through firms other than the clearing broker), this is a give up clearing arrangement. This means the intro-ducing firm, when executing away, gives up the name of its clearing broker to each firm with which it enters orders. This alerts these firms that payment for purchases and delivery of secu-rities sold will be handled by the clearing broker, not the introducing firm.

The agreement must require the clearing broker, if it receives a customer complaint con-cerning the introducing firm, to immediately forward the complaint to both the introducing firm and FINRA. The clearing firm must notify the customer that the complaint was received and forwarded.

A clearing firm, when it enters into a clearing agreement, must immediately, and annually thereafter by July 1 of each year, provide the introducing firm with a list of exception reports available to assist the introducing firm in supervising its business. The list of available excep-tion reports must be given to the introducing firm’s chief executive officer and its compliance officers as well as to FINRA.

✓T A K E N O T ETo function as a clearing firm, a broker-dealer must be a member of the Deposi-

tory Trust & Clearing Corp. (DTCC), along with its subsidiary, the National Securities Clearing Corp.



2. 21 TRUST INDENTURE ACT OF 1939 (TIA)

The Trust Indenture Act of 1939 was created to afford protection to purchasers of newly issued corporate debt securities by more precisely defining the role of trustees and their quali-fications and duties to bondholders. In addition to meeting the registration requirements of the Securities Act of 1933, a corporate bond issuer, prior to registration, must prepare a trust indenture, which calls for the appointment of a trustee, normally a commercial bank. The principal job of the trustee is to protect bondholders in the event of default.

The trust indenture also provides the trustee with the power necessary to enforce the issuer’s obligations and the debt holder’s rights.

In a shelf offering, an open-ended form of trust indenture may be used. This permits a series of debt securities to be offered from time to time with the disclosure of the interest rate, term et cetera, to be furnished as an exhibit to Form 8-K and “stickered” to the prospectus.

There are certain exemptions from the Act. One example includes an offering of a debt security issued with an equity security in a unit. In that case, the determination as to whether an exemption is available is based on the aggregate principal amount of the debt security and not the dollar amount of the equity security. If the aggregate amount of the debt security is less than $5 million, the offering is exempt from the TIA.

2. 22 INVESTMENT COMPANIES

2. 22. 1 INVESTMENT COMPANY ACT OF 1940

During the 1930s, Congress directed the SEC to study investment trusts and investment companies, their corporate structures, their investment policies, and their influence on the companies in which they invest. This study led to the passage of the Investment Company Act of 1940, providing for SEC regulation of investment companies and their activities.

The act was designed to protect investors from unfair dealings, to regulate borrowing by investment company management, and to provide investors with current information. The act does not regulate ethical sales practices, which are covered by the Securities Exchange Act of 1934, and various rules and regulations put forth by various self-regulatory organizations (SROs).

The act defines an investment company as an issuer that is engaged, or proposes to engage, in the business of investing, reinvesting, owning, holding, or trading in securities, and owns or proposes to acquire investment securities having a value exceeding 40% of the value of such issuer’s total assets (exclusive of Government securities and cash items). Furthermore, the act created three classifications of investment company:

■ Face amount certificate company ■ Unit investment trust ■ Management investment company

These companies are all portfolio intermediaries in the business of pooling the public’s money and investing it. You may see the term, “pooled investment vehicle” used to describe investment companies. An investment company that has at least $100,000 under manage-ment must register by submitting Form N-1A with the Commission.



The definition of investment company does not include a holding company or a variable annuity. This fact may be tested (it is the separate account that is the investment company).

As a principal, you will find that the products described in this act are most relevant to your job. As we have done with the previous federal laws, we’ll list some of the important terms and their definitions.

2. 22. 2 MANAGEMENT COMPANIES

Management companies are of two types: (1) open-end, and (2) closed-end. An open-end company (mutual fund) makes a continuous offering of shares to the public (i.e., it will sell as many shares to the public as there is demand). The monies acquired are invested in accor-dance with the fund’s investment objectives. Mutual funds are redeemable, which means there is no secondary market. When a shareholder wants to sell, the shares are redeemed by the fund or its agent.

A closed-end fund is a publicly traded fund. The fund makes a onetime issue of shares, which then trade in the secondary market. Shares of closed-end funds are said to be negotiable (not redeemable).

As mutual funds make a continuous offering of shares, each sale is essentially a new issue and must be sold with a prospectus. With publicly traded funds, only the initial offering is sold with a prospectus.

2. 22. 3 UNIT INVESTMENT TRUSTS

Unit trusts are of two types: (1) fixed, and (2) participating. A fixed trust is a trust that selects a portfolio of securities (usually bonds) and places the securities in a trust. Once in place, the securities are not traded (i.e., the portfolio is fixed). As the securities pay interest (or are called or mature), the proceeds are distributed, pro rata, to the unit holders. Over time, the trust self-liquidates. Fixed unit trusts are closed-end trusts, which means there are a fixed number of units outstanding.

A participating unit trust is a trust that, rather than purchasing specific securities, pur-chases shares of mutual funds. Buyers are indirectly purchasing mutual fund shares. This is the structure used for variable annuities. Both fixed and participating unit trusts are redeemable securities, and each is sold with a prospectus.

✓T A K E N O T EUnder the Investment Company Act of 1940, the board of directors of a mutual

fund are divided into classes with a term of office from one year to five years. At least one class must come up for re-election each year.



InvestmentCompanies

Closed-EndOpen-End

(Mutual Fund)

Fixed UIT

Diversified Nondiversified

Face-AmountCertificate

Company (FAC)

ManagementInvestmentCompany

UnitInvestmentTrust (UIT)

Diversified Nondiversified

Nonfixed UIT

Classification of Investment Companies

2. 22. 4 DIVERSIFIED VERSUS NON-DIVERSIFIED INVESTMENT COMPANIES

Management companies can be either diversified or nondiversified. Under the Investment Company Act of 1940, a diversified investment company is one that meets the requirements of the 75-5-10 test.

■ At least 75% of the fund’s total assets must be invested in securities issued by companies other than the investment company itself or its affiliates.

■ The 75% must be invested in such a way that:

— no more than 5% of the fund’s total assets are invested in the securities of any one issuer, and

— the fund may not own more than 10% of the outstanding voting securities of any one issuer.

!T E S T T O P I C A L E R TRemember, for testing purposes, the 5% and 10% limitations are part of the

75% invested. There are no conditions attached to the remaining 25%.



*E X A M P L E Assume a mutual fund has $200,000 total assets. To call itself diversified, at least $150,000 must be invested so no more than $10,000 may be invested in the securities of any one company (5% of the total $200,000); if a target company has $100,000 of outstanding common stock, the mutual fund could own no more than $10,000 of that stock (10% of $100,000).

A nondiversified investment company fails to meet the 75-5-10 test. An investment com-pany that specializes in a single industry is not necessarily a nondiversified company. Some investment companies choose to concentrate their assets in an industry or a geographic area, such as health care, technology, or mining companies. These are known as specialized or sec-tor funds. An investment company that invests in a single industry may still be considered diversified as long as it satisfies the 75-5-10 test.

✓T A K E N O T EBoth open- and closed-end companies can be diversified or nondiversified.

2. 22. 5 REGISTRATION OF MANAGEMENT COMPANIES

Management company securities are nonexempt, which means they must be registered with the SEC before public sale. The registration is made on Form N-IA. A management com-pany is not permitted to issue securities to the public unless it has capital of at least $100,000.

In addition to financial information, the company must provide the SEC with information on:

■ its investment objectives; ■ its policy on borrowing money; ■ its policy on issuing senior securities; ■ its policy on making loans; and ■ the names and addresses of all affiliated persons, including the investment adviser.

Open-end funds can only issue voting common stock but are permitted to borrow money from banks for short-term needs. Closed-end funds, in addition to issuing common stock, are permitted to issue senior securities, such as bonds and preferred stock. They are also permitted to borrow from banks.

If a management company is open end, the need for an underwriter, called the sponsor, to distribute shares is ongoing, because shares are continuously offered and sold. If the manage-ment company is closed end, the underwriting and distribution process is generally limited to a single offering.

A management company typically contracts with an investment adviser to invest the company’s assets, implement investment strategies consistent with the company’s investment objectives, and manage the day-to-day trading of the portfolio’s securities. Advisers are gener-ally compensated based on a percentage of assets under management.



2. 22. 5. 1 Prospectus updating

Because open-end investment companies continuously offer new shares, all sales must be made by prospectus. A mutual fund is required to periodically update its prospectus. The SEC requires that a prospectus in use for more than nine months cannot contain financial informa-tion more than 16 months old.

*E X A M P L E A prospectus dated February 1, 2014, contains financial information through September 30, 2013. At that point, the financial information is four months old. Nine months later, November 1, 2014, the information in the prospectus is 13 months old. At that point it can be used for another three months.

2. 22. 6 AFFILIATED PERSON

An affiliated person is any person who directly or indirectly owns, controls, or holds, with power to vote, 5% or more of the outstanding voting securities of a company; any officer, direc-tor, partner, copartner, or employee; or an investment adviser or member of the advisory board of an investment company.

2. 22. 7 INTERESTED PERSON

With respect to an investment company, an interested person includes any: ■ affiliated person of the company (previously defined, but excluding certain board mem-

bers); ■ member of the affiliate’s immediate family, defined as any parent, spouse of a parent, child,

spouse of a child, spouse, brother, or sister, and includes step and adoptive relationships; ■ person who has been a legal counsel to the company during the last two fiscal years; ■ broker-dealer registered under the Securities Exchange Act of 1934 who has, during the

last two years, maintained a business relationship with the company; or ■ person whom the SEC determines to be an interested person.

!T E S T T O P I C A L E R TYou must know that no person will be deemed to be an interested person of an

investment company solely by reason of his being a member of its board of directors or advisory board or an owner of its securities. Without this provision, there could be no “noninterested” members of the fund’s board.

With respect to an investment adviser or principal underwriter for any investment com-pany, interested person refers to any:

■ affiliated person of the investment adviser or principal underwriter; ■ member of the affiliate’s immediate family; ■ person who knowingly has a direct or indirect beneficial interest in any security issued by

the investment adviser or principal underwriter;



■ person, partner, or employee of the company who has acted as legal counsel for the adviser or underwriter for the last two years; or

■ broker-dealer or associated person who has engaged in portfolio transactions or retail transactions in shares of an investment company managed or distributed by this adviser or underwriter.

✓T A K E N O T EThe definition of an interested person is substantially broader than that of an af-

filiate (i.e., although all affiliated persons, other than certain board members described in the previous Test Topic Alert, are interested, not all interested persons are affiliates).

2. 22. 8 PRINCIPAL UNDERWRITER

The principal underwriter for an investment company or fund (sometimes referred to as the sponsor or distributor) is the fund’s chief salesperson. The principal underwriter is respon-sible for the distribution of the investment company’s shares.

2. 22. 9 REDEEMABLE SECURITY

A redeemable security is any security under the terms of which the holder, upon presenta-tion to the issuer, is entitled to receive his proportionate share of the issuer’s current net assets. When used on the exam, this definition always refers to mutual funds, variable annuities, and unit investment trusts.

2. 22. 9. 1 Sales Load

Sales load is the difference between the price of a security to the public and the net por-tion of the proceeds from its sale that is received and invested or held for investment by the issuer, minus any portion that is deducted for trustees’ or custodians’ fees, insurance premiums, administrative expenses, or fees that are not properly chargeable to sales activities.

2. 22. 10 SEPARATE ACCOUNT

A separate account is an account established and maintained by an insurance company in which income, gains, and losses—whether realized or not—from assets allocated to the account are in accordance with the applicable variable annuity or variable life insurance con-tract. In almost all cases, the separate account is registered as an investment company under the act.



2. 22. 11 REQUIREMENTS UNDER THE INVESTMENT COMPANY ACT OF 1940

A majority vote of the outstanding shares is required if the management company wishes to change:

■ its investment objectives; ■ its investment adviser; or ■ any of its policies.

✓T A K E N O T EFor funds that charge 12b-1 fees, a majority of directors must be unaffiliated with

the fund. For non-12b-1 funds, at least 40% of the directors must be unaffiliated.

2. 22. 12 UNLAWFUL REPRESENTATIONS AND NAMES

SEC Rule 35d-1, called the name test rule, requires that an investment company with a name suggesting that the company focuses on a particular type of investment have at least 80% of its assets in the type of investment suggested by its name. Some examples of terms used in the “name” of a fund that require compliance with the rule would be:

■ small-cap, mid-cap, or large-cap ■ global or international ■ tax-free

2. 22. 12. 1 Pricing and Sales Charges

The net asset value NAV per share of an investment company is its book value (net worth) per share (total assets less total liabilities divided by the number of shares outstanding). The primary determinant of NAV is the market value of the securities held by the company.

Rule 22c-1 promulgated under the 1940 Act provides that the net asset value of redeem-able securities (mutual funds and UITs) has to be computed no less frequently than once daily, typically after the major U.S. exchanges close (4:00 pm ET). The computation is then reported to FINRA and financial media. A closed-end fund, whose shares are not “redeem-able”, that is, not required to be repurchased by the fund, is not subject to this requirement.

Unless it is a no-load fund, redeemable investment company securities are sold with a sales charge. The sales charge (load) can be front-end loaded or back-end loaded. There may also be a charge against the average annual net assets of the company (12b-1).

A front-end load is charged when an investor purchases shares. It is added to the NAV of the company. A back-end load contingent deferred sales charge (CDSC) is taken out on redemption of company shares.

An asset-based charge, or 12b-1 fee, allows the company to charge certain selling and distribution expenses to its assets. These charges, which are computed on an annual basis but charged to the shareholder quarterly, are intended to result in the sale of additional shares.



*E X A M P L E 12b-1 charges include advertising, the printing and mailing of prospectuses to persons other than current shareholders, and compensation of sales personnel.

For companies without an asset-based sales charge, the maximum permissible sales charge under FINRA rules is 8½% of the public offering price. FINRA rules limit 12b-1 fees to .75% of the average annual net assets of the investment company.

Pricing of redeemable investment company securities is based on NAV per share. In a front-end-loaded company, the customer pays the public offering price (POP), which is NAV per share with a sales charge added.

In a back-end-loaded fund, the customer buys at NAV and redeems at NAV less a sales charge. Sales charges for back-end load funds decline over time. The longer the shares are held, the lower the sales charge on redemption.

Pricing of redeemable investment company securities is done on a forward basis. Orders to buy or redeem are filled based on the next computed NAV per share.

With closed-end (publicly traded) funds, the NAV has no direct bearing on the market price, because that price is determined by open market supply and demand. Unlike open-end funds, closed-end funds can, and frequently do, trade in the market at a discount to the NAV.

Under extraordinary circumstances (e.g., the markets are closed due to a precipitous decline in market averages), the SEC is empowered to suspend redemptions of redeemable investment company securities until the markets reopen and NAV per share can be computed.

*E X A M P L E After the events of 9/11 (a Tuesday), the U.S. stock markets were closed until the following Monday (September 17). During that period of 4 days, all redemptions were suspended.

2. 22. 12. 1. 1 Distribution and Repurchase of Securities by Closed-end Investment Companies (Section 23)

Unless one of several unusual situations exists, no registered closed-end company can sell any common stock of which it is the issuer at a price below the current net asset value of such stock. Although shares in the secondary market will frequently trade at a discount due to sup-ply and demand, issuance (primary) must always be at net asset value.

One other condition that applies to these companies deals with repurchase of shares. Unlike open-end companies, there is no redemption of shares. No registered closed-end com-pany can purchase any securities of any class of which it is the issuer except on a securities exchange or other regulated market. If the securities are stock (remember, close-end companies can issue debt securities), the company must, within the preceding six months, have informed stockholders of its intention to purchase stock of such class by letter or report addressed to stockholders of such class.

2. 22. 12. 2 12b-1 Fees

As a general statement, funds are prohibited from charging to stockholders any selling expenses of the fund; only operating expenses can be charged against investment income. However, under SEC Rule 12b-1, certain selling and distribution expenses can be charged to shareholders.



To charge an asset-based fee, the fund must have a majority vote of the shareholders, a majority vote of the board, and a majority vote of the outside (independent) directors. In addi-tion, 12b-1 fees must be reapproved annually. Once in place, 12b-1 charges must be reviewed quarterly by the BOD.

To terminate 12b-1 charges, a majority vote of the shareholders or a majority vote of the outside directors is needed.

2. 22. 12. 3 Sales Agreements

For a broker-dealer to sell redeemable investment company securities, there must be a written sales agreement between the company or its sponsor (principal underwriter) and the broker-dealer.

Both the sponsor and the broker-dealer must be FINRA members. The agreement, as well as the prospectus, must specify the sales concession to be received

from the sponsor for selling shares and must reiterate that all sales to the public be made at the public offering price—the member selling shares must maintain the POP not only to its customers but also to nonmember broker-dealers or to suspended member firms. Only FINRA members with written selling agreements with the sponsor can buy shares at a discount (less a concession) for sale at the POP.

If the sponsor offers special compensation to a particular member and not to all members distributing shares of the fund, the details of the arrangement, as well as the name of the mem-ber benefiting from the arrangement, must be disclosed in the prospectus.

2. 22. 12. 4 Placing Orders

Orders to buy or redeem must be promptly communicated to the investment company or its sponsor. Withholding a customer order so as to profit is a rules violation. Orders can be placed:

■ to fill an existing customer order; or ■ for the member’s investment account.

✓T A K E N O T EA member cannot buy shares for its inventory; this is to ensure that there is only

one market maker for the fund’s shares—the fund itself. Shares bought by members for investment cannot be resold to customers. They can only be redeemed with the fund.

Prompt Payment. Members must promptly transmit payments received from customers to the fund or its sponsor within three business days of trade date or within one business day of receipt, whichever is later.

Redemptions. FINRA rules require that if a customer redeems shares within seven busi-ness days of purchase, the member must forfeit the concession received to the fund or its sponsor. Repurchasing shares from a customer at a price less than the next computed NAV is a rules violation.



2. 22. 12. 5 Anti-Reciprocal Rule

The anti-reciprocal rule is designed to soften conflicts of interest between members that have selling agreements with a fund and to execute portfolio transactions for that fund.

FINRA prohibits its members from: ■ favoring one fund over another based on commissions received from executing portfolio

transactions for the fund; ■ soliciting portfolio transaction business from a fund based on the member’s sales of the

fund’s shares; and ■ circulating information on the amount of brokerage commissions earned from executing

portfolio transactions for a fund.

*E X A M P L E A member cannot have a fund direct portfolio trades to it and begin selling the fund’s shares, any more than a fund can have a member sell the fund and direct port-folio trades to the firm.

Further, a member may not sell the shares of, or act as underwriter for, a fund that follows a policy of considering sales of its shares as a factor in selecting firms to execute portfolio transactions. Similarly, funds are prohibited from compensating members for selling their shares by directing portfolio trades (directed brokerage ar-rangements) to that firm.

A member firm is not permitted to sell shares of, or act as underwriter for, any fund that the member knows, or has reason to know, engages in directing broker-age in consideration for the sale of shares of that fund. This prohibition applies even where a directed brokerage arrangement exists between the fund and a different member firm.

2. 22. 12. 6 Distributions

Under Section 19 of the Act, all dividends and capital gains distributions to shareholders must clearly be identified and accounted for separately at the time of the distribution. A state-ment or transmittal letter must provide an accounting of each distribution, indicating whether the distribution represents:

■ dividends (from accumulated undistributed net income or current income); ■ undistributed profits (capital gains); or ■ paid-in surplus (return of principal).

In addition, while portfolio income may be distributed to shareholder accounts as fre-quently as the fund sees fit, capital gains must not be distributed more than once every 12 months.

2. 22. 12. 7 Additional Disclosures

Funds that charge 12b-1 fees must disclose, in reports to shareholders, the amounts charged to net assets.



2. 22. 12. 8 Selling Dividends

Encouraging a customer to buy mutual fund shares just before the ex-date to receive the upcoming dividend is a FINRA rules violation. This is a violation, because the customer will receive the dividend, which is taxable, and the NAV per share will be reduced by the amount of the dividend—similar to receiving a return of capital that is being taxed.

In addition, no member can represent that distribution of long-term capital gains by a mutual fund if it is part of the current yield.

2. 22. 12. 9 Breakpoints

Breakpoints are quantity discounts: the greater the dollar amount of a purchase, the lower the sales charge. The following chart shows a sample of a chart of breakpoints.

A single mutual fund generally offers more than one class of shares to investors. Each class represents the same interest in the fund’s portfolio but has different fees and expenses. A typi-cal class structure is as follows.

■ Class A shares. These shares charge a front-end load on the initial purchase, which can be reduced or eliminated by breakpoint discounts. They may also charge 12b-1 fees that are typically lower than Class B or Class C shares.

■ Class B shares. These shares charge a back-end load that declines over time. They gener-ally charge 12b-1 fees that are typically higher than Class A shares. Most Class B shares convert to Class A shares, generally after the CDSL (conditional deferred sales load) has expired (6 – 8 years).

■ Class C shares. These shares typically charge a back-end load that is eliminated after one year. They also charge 12b-1 fees that are generally higher than Class A shares.

Mutual Fund Share Class Table

Class A Class B Class C No-Load

Front-end load Up to 8.5% No No No

Back-end load (CDSC) No Yes; expires after 6 to 8 years

1%; drops to 0 after 1 year

Low or 0; short time

12b-1 fee 0 to .25% up to .75%; expires after 6 to 8 years

up to .75%; for life of account

0 to .25%

Expense ratio Low High until shares convert

Medium Varies

Breakpoints,LOIs,rights of accumulation, combination privilege

Yes N/A N/A N/A

Converts No Converts to Class A after 6 to 8 years

No No

Investor Large amount; long time horizon

Small amount; long time horizon

Amount neutral; short time horizon

Amount neutral; time horizon neutral



Breakpoints are only available on the purchase of Class A shares. For large purchases, the front-end load can be reduced or eliminated. Class B shares do not impose a front-end load, but they may charge investors more over the lifetime of their investment than do Class A shares. Breakpoints also are available to investors who:

■ already hold other funds offered by the same fund family; ■ commit to regularly purchasing mutual fund shares; or ■ have family members (spouse and minor children).

✓T A K E N O T EFrequently overlooked when attempting to determine if a client qualifies for

a breakpoint, are holdings of shares in a retirement plan, such as an IRA or even a 401(k) plan.

Failure to properly grant breakpoint discounts when available led, in 2002, the staffs of NASD (FINRA’s predecessor), the SEC, and the New York Stock Exchange (NYSE) to con-duct examinations of broker-dealers to assess their ability to deliver breakpoint discounts. In March of 2003, they published a report on those examinations stating that most of the 43 broker-dealers examined failed to provide the appropriate breakpoint discount to customers in a significant number of cases. The group of firms examined in the sweep did not provide break-points in about 1/3 of the breakpoint-eligible transactions analyzed, and the average dollar amount of the discount not provided was $364. The Joint Report, however, noted that most breakpoint problems did not appear to be intentional failures to charge correct sales loads.

The ultimate result of the study was the 2004 enforcement actions brought by the SEC and the NASD against 15 prominent firms for failure to deliver mutual fund breakpoint dis-counts. The SEC’s actions at that time were intended to send a message that broker-dealers had to exercise due care to provide breakpoint discounts to mutual fund investors consistent with the promises made to customers. These firms agreed to pay more than $21.5 million in fines and over $86 million in “disgorged” profits to settle charges of denying breakpoint dis-counts to mutual fund customers.

*E X A M P L E What a Sample Breakpoint Schedule Looks Like

Breakpoint discounts usually start at investment levels of $50,000, but may begin at $25,000. The following is a sample breakpoint schedule.

Your Investment Your Sales Charge

Less than $25,000 5.00%

At least $25,000, but less than $50,000 4.25%




At least $500,000, but less than $1 million 2.00%

$1 million or more No sales charge



✓T A K E N O T EBreakpoints are not to be confused with “breakpoint sales,” which is a serious vi-

olation (see Unit 3). In the same vein, selling shares of one mutual fund to buy shares of another is known as switching and is a supervisory concern. Although the customer may have legitimate reasons for making the exchange, he may incur additional sales charges and tax liabilities.

2. 22. 12. 10 Letter of Intent

A letter of intent, which is nonbinding as to the investor, is good for 13 months and may be backdated for up to 90 days.

*E X A M P L E An investor wants to purchase $50,000 worth of a fund with a breakpoint schedule as previously shown. The investor, as of today, only has $20,000 available to purchase the shares. If the customer signs a letter of intent to purchase $50,000 worth, you can charge him 3.75% on his initial investment of $20,000. The extra shares purchased with the lower sales charge are placed in escrow and are released once the letter is met.

✓T A K E N O T ETo charge the maximum sales charge of 8.5%, the fund cannot impose 12b-1

fees and must offer breakpoints, rights of accumulation, and dividend reinvestment at NAV per share.

2. 22. 12. 11 Commission Sharing Arrangements

Soft dollars is a term used to describe payments made by institutional investors, such as mutual funds to broker-dealers in return for services, such as research. The difference between soft dollars and hard dollars is that instead of paying a broker-dealer with cash (hard dollars), the mutual fund will pay in-kind by directing brokerage business (soft dollars).

Under SEC guidelines, soft dollars may be used to pay for research reports, software that provides analyses of securities portfolios, services for the benefit of clients, and seminar reg-istration fees. The safe harbor for this kind of activity is found under Section 28(e) of the Securities Exchange Act of 1934. The safe harbor does not permit the use of soft dollars for computer hardware, telecommunications lines, office equipment, reimbursement of travel expenses to attend seminars, and other operational overhead, such as rent. Lastly, member firms that offer soft dollar commission sharing arrangements are not required to maintain a special reserve bank account for that reason alone.

2. 22. 13 REAL ESTATE INVESTMENT TRUSTS (REITS)

A real estate investment trust (REIT) is a company that manages a portfolio of real estate investments to earn profits for shareholders. Although there are exceptions, REITs are nor-mally publicly traded on exchanges and OTC and serve as a source of long-term financing



for real estate projects. A REIT pools capital in a manner similar to an investment com-pany, but they are not investment companies regulated under the Investment Company Act. Shareholders receive dividends from investment income or capital gains distributions. REITs normally:

■ own commercial property (equity REITs); ■ own mortgages on commercial property (mortgage REITs); or ■ do both (hybrid REITs).

For a company to qualify as a REIT, it must comply with certain provisions within the Internal Revenue Code. As required by the Tax Code, a REIT must:

■ be an entity that is taxable as a corporation; ■ be managed by a board of directors or trustees; ■ have shares that are fully transferable; ■ have a minimum of 100 shareholders; ■ invest at least 75% of its total assets in real estate assets; ■ derive at least 75% of its gross income from rents from real property or interest on mort-

gages financing real property; and ■ pay annually at least 90% of its taxable income in the form of shareholder dividends.

Remember that REITs are not considered “flow-through” investments (like DPPs), because losses do not pass through to the shareholders.

QQ U I C K Q U I Z 2 . F True or False?

—— 1. A participating unit investment trust purchases mutual fund shares.

—— 2. A change cannot be made to a mutual fund’s investment adviser without the approval of a majority vote of outstanding shares.

—— 3. Open- and closed-end funds must provide audited financial information to the SEC annually.

—— 4. Shareholders must receive quarterly financial reports from the investment company.

—— 5. A diversified mutual fund can own a maximum of 5% of the outstanding voting stock of any one company.

—— 6. Prospectuses cannot include financial information that is more than 12 months old.

—— 7. FINRA rules limit 12b-1 fees to .75% of the average annual net assets of the investment company.

—— 8. A 12b-1 charge can be terminated with a majority vote of the sharehold-ers or a majority vote of the outside directors.

—— 9. A mutual fund sponsor must be a member firm.



—— 10. Mutual funds are prohibited from all transactions involving short options.

—— 11. Member firms must transmit customer payments to the mutual fund within 1 business day of the trade or three business days of receipt, whichever is later.

—— 12. If shares are redeemed within seven business days of purchase, conces-sions received by the member must be forfeited to the fund or its sponsor.

—— 13. Capital gains distributions can be made no more frequently than once per year.

2. 23 VARIABLE ANNUITIES

An annuity is a contract between an individual and an insurance company, usually pur-chased for retirement income. Investors, called annuitants, contribute money to an annuity plan either in a lump sum or as periodic contractual payments. At some future time (specified in the contract), the owner of the annuity plan will either begin receiving regular income distributions or take a lump sum distribution.

A fixed annuity has a guaranteed rate of return. When the individual elects to begin receiving income, payout is determined by the value of the account and the annuitant’s life expectancy. Payment from a fixed annuity remains constant throughout the annuitant’s life. The sales representative and annuitant must be mindful that inflation can shrink purchasing power over time. Because the return in a fixed annuity is guaranteed by the insurance com-pany and no risk is borne by the annuitant, a fixed annuity is considered an insurance product. Because of this insurance aspect, a salesperson must have an insurance license to sell fixed annuities.

A variable annuity, on the other hand, does not guarantee a rate of return. The customer’s funds are at risk; however, there is a chance at beating inflation. Therefore, both an insurance license and a securities license (Series 6 or 7) are required to sell variable contracts.

Variable annuities, as retirement vehicles, are often nonqualified, which means that pay-ments made by annuitants are made with after-tax dollars. On withdrawal, only the earnings generated on the monies contributed to the annuity are taxable.

Fixed vs. Variable Annuity

Fixed Annuity Variable Annuity

Payments made with after-tax dollars Payments made with after-tax dollars

Payments are invested in the general account Payments are invested in the separate account

Portfolio of fixed-income securities/real estate Portfolio of equity, debt, or mutual funds

Insurer assumes investment risk Annuitant assumes investment risk

Not a security Is a security

Guaranteed rate of return Return depends on separate account performance

Fixed administrative expenses Fixed administrative expenses

Income guaranteed for life Income guaranteed for life

Monthly payment never falls below guaranteed minimum

Monthly payments may fluctuate up or down

Purchasing power risk Typically protects against purchasing power risk

Subject to insurance regulation Subject to insurance and securities regulation



2. 23. 1 RULE 2330: MEMBERS’ RESPONSIBILITIES REGARDING DEFERRED VARIABLE ANNUITIES

In light of the large number of cases involving variable annuities where there was failure to supervise and egregious unethical behavior, FINRA’s Rule 2330 evolved.

2. 23. 1. 1 Application

Before going into the specific details of this rule, it is necessary to know when the rule is and when it is not applicable. This rule applies to recommended purchases and exchanges of deferred (NOT immediate) variable annuities and recommended initial subaccount alloca-tions. On the other hand, this rule does not apply to reallocations among subaccounts made or to funds paid after the initial purchase or exchange of a deferred variable annuity. This rule also does not apply to deferred variable annuity transactions made in connection with any tax-qualified, employer-sponsored retirement or benefit plan that either is defined as a “quali-fied plan” or meets the requirements of Internal Revenue Code Sections 403(b) or 457. The exception to this is if a member or person associated with a member makes recommendations to an individual plan participant regarding a deferred variable annuity, in which case the Rule would apply as to the individual plan participant to whom the member or person associated with the member makes such recommendations.

2. 23. 1. 2 Suitability

The rule makes the obvious statement that no member or person associated with a mem-ber shall recommend to any customer the purchase or exchange of a deferred variable annuity unless the member or person associated with a member has a reasonable basis to believe that it is suitable.

✓T A K E N O T EA 1035 exchange is a tax-free exchange between like contracts. The IRS permits

annuity and life policyholders to exchange their policies without tax liability. For ex-ample, if a life policyholder wanted to exchange a policy to that of another company, he could transfer all values from the old policy into the new one without recognizing any tax consequences. However, Section 1035 exchanges have their limits. For ex-ample, clients can use the provision to exchange life insurance for annuities, life insur-ance for life insurance, and annuities for annuities. They cannot, however, exchange annuities for life insurance.

2. 23. 1. 2. 1 Specific Suitability Requirements

Although there are general suitability rules that always apply, this rule specifies that, in order to be considered suitable, there is a reasonable basis to believe that:

■ the customer has been informed, in general terms, of various features of deferred variable annuities, such as

— the potential surrender period and surrender charge,

— the potential tax penalty if customers sell or redeem deferred variable annuities before reaching the age of 59½,



— fees and charges, and

— market risk; or ■ the customer would benefit from certain features of deferred variable annuities, such as

tax-deferred growth, annuitization, or a death or living benefit; and ■ the particular deferred variable annuity as a whole, the underlying subaccounts to which

funds are allocated at the time of the purchase or exchange of the deferred variable annu-ity, and riders and similar product enhancements, if any, are suitable (and, in the case of an exchange, the transaction as a whole also is suitable) for the particular customer based on the information required by this rule.

2. 23. 1. 2. 2 Exchanges

If the recommendation is for an exchange of one deferred variable annuity for another deferred variable annuity, the exchange also is consistent with the suitability determination requirements previously stated, taking into consideration whether:

■ the customer would incur a surrender charge, be subject to the commencement of a new surrender period, lose existing benefits (such as death, living, or other contractual ben-efits), or be subject to increased fees or charges (such as mortality and expense fees, invest-ment advisory fees, or charges for riders and similar product enhancements);

■ the customer would benefit from product enhancements and improvements; and ■ the customer has had another deferred variable annuity exchange within the preceding

36 months. Under this provision, it must be determined whether the customer has made a VA exchange using the member and must make reasonable efforts to ascertain whether the customer has had an exchange at any other broker-dealer within the preceding 36 months. An inquiry to the customer as to whether the customer has had an exchange at another broker-dealer within 36 months would constitute a “reasonable effort” in this con-text. Members shall document in writing both the nature of the inquiry and the response from the customer.

The determination requirements previously stated must be documented and signed by the associated person recommending the transaction.

2. 23. 1. 3 Training

Members have to develop and document specific training policies or programs reason-ably designed to ensure that associated persons who effect, as well as the registered principals who review transactions in deferred variable annuities, comply with the requirements of this rule and that they recognize and explain the material features of deferred variable annuities, including those dealing with recommendations.

2. 23. 1. 4 Principal Review and Approval

Prior to transmitting a customer’s application for a deferred variable annuity to the issu-ing insurance company for processing, but no later than seven business days after an office of supervisory jurisdiction of the member receives a complete and correct application package, a registered principal must review and determine whether to approve of the recommended purchase or exchange of the deferred variable annuity. These determinations are to be docu-mented and signed by the registered principal who reviewed and then approved or rejected the transaction.



2. 23. 1. 5 Supervisory Procedures

In addition to the general supervisory and recordkeeping requirements of FINRA’s rules, a member must establish and maintain specific written supervisory procedures reasonably designed to achieve compliance with the standards set forth in Rule 2330. The member also must:

■ implement surveillance procedures to determine if any of the member’s associated persons have rates of effecting deferred variable annuity exchanges that raise for review whether such rates of exchanges evidence conduct inconsistent with the applicable provisions of this Rule, other applicable rules, or the federal securities laws (“inappropriate exchanges”); and

■ have policies and procedures reasonably designed to implement corrective measures to address inappropriate exchanges and the conduct of associated persons who engage in inappropriate exchanges.

2. 23. 1. 6 Handling Customer Funds and Checks

Since it is rare to find an investment company/variable contracts broker-dealer that is permitted to hold customer funds (most are exempt from the Customer Protection Rule, 15c3-3), how does FINRA view holding the customer’s check made out to the insurance company for up to seven business days? There are two FINRA rules that apply to this situation. One of them could consider that this would be making improper use of customer’s funds, and the other requires member firms to transmit applications and purchase payments for variable contracts promptly to issuers. To avoid violations, FINRA has provided limited interpretive relief from these rules to allow members to perform comprehensive and rigorous reviews of recommended transactions in deferred variable annuities under Rule 2330. Concerns have been expressed, however, regarding the breadth of the interpretive relief and the conditions that must be pres-ent for it to apply. FINRA has clarified that the interpretive relief applies only if the following conditions are present.

■ The reason that the firm is holding the application for a deferred variable annuity and/or a customer’s non-negotiated check payable to a third party is to allow completion of principal review of the transaction pursuant to FINRA Rule 2330.

■ The associated person who recommended the purchase or exchange of the deferred vari-able annuity makes reasonable efforts to safeguard the check and to promptly prepare and forward a complete and correct copy of the application package to an OSJ.

■ The firm has policies and procedures in place that are reasonably designed to ensure that the check is safeguarded and that reasonable efforts are made to promptly prepare and forward a complete and correct copy of the application package to an OSJ.

■ A principal reviews and makes a determination of whether to approve or reject the pur-chase or exchange of the deferred variable annuity in accordance with the provisions of FINRA Rule 2330.

■ The firm holds the application and/or check no longer than seven business days from the date an OSJ receives a complete and correct copy of the application package.

■ The firm maintains a copy of each such check and creates a record of the date the check was received from the customer and the date the check was transmitted to the insurance company or returned to the customer.

■ The firm creates a record of the date when the OSJ receives a complete and correct copy of the application package.



If these conditions are not present, FINRA’s interpretive relief will not apply, and it will enforce the previously referred to rules as appropriate.

✓T A K E N O T EThe idea of sharing office space and employees may arise. As Rule 2330 requires

principal review and approval prior to transmitting a customer’s application for a deferred variable annuity to the issuing insurance company for processing, in circum-stances where an insurance company and its affiliated broker-dealer share office space and/or employees who carry out both the principal review as well as the issuance pro-cess, the application is considered “transmitted” to the insurance company only after the broker-dealer’s principal, acting in that capacity, has approved the transaction, provided that the affiliated broker-dealer and the insurance company have agreed that the insurance company will not issue the contract prior to principal approval by the broker-dealer.

2. 23. 2 INVESTMENT ADVISERS ACT OF 1940

This act was passed to regulate the activities of persons giving customers advice about securities. An investment adviser is one who, for compensation, provides advice about invest-ing in securities.

The Investment Advisers Act of 1940 includes three characteristics of investment advis-ers under the federal definition of the term.

■ They provide investment advice, specifically on securities. ■ They hold themselves out to the public, or advertise, as investment advisers. ■ They receive compensation specifically for their investment advice.

There are exemptions from this definition—those that fit the definition but are exempt from the provisions. There are also exclusions—those that are deliberately left out of the definition.

2. 23. 2. 1 Exemptions ■ Advisers who maintain offices in only one state, whose clients are all in that state, and

who do not give advice on securities listed on any national exchange. ■ Advisers whose only clients are insurance companies.

✓T A K E N O T EAdvisers whose only customers are insurance companies, as well as those whose

clients are all in one state and who offer no advice on securities listed on national exchanges, are exempt from registering with the SEC. In addition, those whose in-vestment advice is incidental to their professions [e.g., lawyers, accountants, teachers, engineers (L.A.T.E.)] are excluded from the definition of an adviser.



2. 23. 2. 2 Exclusions

The definition of investment adviser does not include: ■ banks and bank-holding companies; ■ publishers of any bona fide newspaper or magazine or business or financial publication of

general and regular circulation (e.g., The Wall Street Journal or Business Week); ■ brokers or dealers (or their associated persons and registered representatives) whose invest-

ment advice is incidental to the conduct of the broker-dealer’s business and who receive no special compensation for the advice;

■ government Securities Advisers (this exclusion is available to persons and firms whose advice is limited to certain securities issued by or guaranteed by the U.S. government); or

■ persons whose investment advice is incidental to their professions (e.g., lawyers, accoun-tants, engineers, teachers).

✓T A K E N O T EAs previously mentioned, the exception granted to broker-dealers only applies

if the firm does not charge specifically for giving advice. If a member firm were to set up a financial planning operation and charge separately for this service, the firm would be considered an investment adviser. The most common example of losing the exclusion is when the member offers wrap fee programs.

2. 23. 2. 3 Registration of Investment Advisers

Any person included under the federal definition of an investment adviser must regis-ter with the SEC under the Investment Advisers Act of 1940, unless that person is exempt. SEC-registered investment advisers are known as federal covered advisers. That term origi-nated with the National Securities Markets Improvement Act of 1996, generally referred to as NSMIA. NSMIA split the responsibility of regulation of investment advisers between the states and the SEC on the basis of the amount of money the adviser has under management. In the same manner that broker-dealers register by completing Forms NMA and BD, investment advisers file a Form ADV. Although federal covered investment advisers do not register at the state level, they may still be required to pay state filing fees.

The following advisers must register with the SEC: ■ Persons with $110 million or more in AUM ■ Persons managing an investment company registered under the Investment Company Act

of 1940

An investment adviser that is not subject to federal registration requirements will gener-ally be required to register with the state(s) where it conducts business.



!T E S T T O P I C A L E R TInvestment advisers with under $100 million of assets under management (AUM)

register at the state level. There are a few exceptions to this, but they are not testable for the Series 24. Advisers managing at least $100 million, but not $110 million, have the option to register with either the state(s) or the SEC. Once registered at the fed-eral level, an adviser would not register at the state level unless AUM falls below $90 million. In essence, there is a $20 million buffer as advisers must register at the federal level with $110 million of AUM and may maintain federal registration until AUM falls below $90 million.

✓T A K E N O T EPerformance fees are prohibited unless the client has at least $1 million under

management with the investment adviser or a net worth of at least $2 million.



U N I T T E S T ( P A R T 1 )

1. When determining if a client qualifies for a break-point, mutual fund holdings in all of the following accounts may be aggregated EXCEPT A. a joint account with the client’s business

partnerB. the client’s IRAC. the client’s spouse’s IRAD. a UTMA account for the client’s minor,

dependent child

2. Sales charges are applicable to all of the following EXCEPTA. open-end fundsB. closed-end fundsC. variable annuitiesD. unit trusts

3. To qualify as a REIT, certain IRS requirements must be met. Which of the following is NOT one of those requirements?A. Flow through losses to shareholdersB. Invest at least 75% of its total assets in real

estate assetsC. Derive at least 75% of its gross income

from rents from real property or interest on mortgages financing real property

D. Pay annually at least 90% of its taxable income in the form of shareholder dividends

4. Rule 22d-1 of the Investment Company Act of 1940 stipulates certain persons who are eligible to purchase shares of an open-end investment company at prices below the public offering price. Included in that list would be I. officers of the fund’s investment adviser II. full-time employees of the fund’s custodian

bank III. full-time employees of the fund’s sponsor IV. non-member broker-dealersA. I and IV B. I and IIIC. II and IIID. II and IV

5. An order to redeem mutual fund shares is filled at the A. prior day’s closing NAVB. NAV computed at the time the order is

receivedC. next computed NAVD. next computed POP

6. Under FINRA Rule 2330, a potential “red flag” would beA. registered representatives selling deferred

variable annuities to clients under the age of 40

B. a client beginning annuity payments 24 months after the initial purchase of a deferred variable annuity

C. a 75 year old client taking a partial withdrawal from a deferred variable annuity

D. a client exchanging one deferred variable annuity for another 24 months after the initial purchase

7. Both open- and closed-end funds mayA. borrow from banksB. issue preferred stockC. issue debt securitiesD. make a continuous offering of common stock

8. A member may purchase variable contracts from an insurance company underwriter if I. there is a written sales agreement in place II. the insurance company is a member III. the member agrees to forfeit all concessions

if the contract is redeemed within 7 business days of acceptance

A. I onlyB. I and III C. II onlyD. I, II and III



9. A diversified investment company must invest at least ____ of its assets in such a way that no more than ____ of its assets are in any one company, and each investment represents no more than ____ of the target company’s voting securities.A. 75%; 5%; 10% B. 50%; 10%; 5% C. 75%; 10%; 5% D. 100%; 5%; 15%

10. All of the following terms apply to municipal unit investment trusts EXCEPTA. regulatedB. managedC. redeemableD. registered

11. Under FINRA rules, payments made to purchase variable contracts must be forwarded to the insur-ance company underwriterA. promptlyB. within 3 business days of receiptC. within 5 business days of receiptD. within 7 business days of receipt

12. Which of the following activities would require a member firm to register as an investment adviser?A. The firm provides advice to clients on the

purchase and sale of securities.B. The firm publishes research reports.C. The firm distributed a list of recommended

securities to clients.D. None of these

13. To register with the SEC on Form N-1A, an in-vestment company must have capital of at leastA. $25,000B. $100,000C. $250,000D. $500,000

14. FINRA Rule 2330 dealing with members’ respon-sibilities regarding variable annuities applies under which of the following circumstances? I. The initial purchase of a deferred variable

annuity II. The initial purchase of an immediate variable

annuity III. The initial sub-account allocations IV. Sub-account re-allocationsA. I and IIIB. II and IVC. I, II and IIID. I, II, III and IV

15. Rule 35d-1 (the “name” rule) would NOT apply to which of the following mutual funds?A. The GHI Global Equity FundB. The DEF Municipal Bond FundC. The ABC Income FundD. The JKL Small-Cap Fund

16. Which of the following would be deemed imper-missible under FINRA rules? A. Registered representative sharing in his

customer’s accountsB. Opening and sharing a special margin account

with a non-related customerC. Obtaining a personal loan from a bank that

happens to be a customerD. A registered representative sharing

disproportionately in her mother’s company’s trading account

17. Information on customer complaints must be elec-tronically filed with FINRAA. weeklyB. monthlyC. quarterlyD. semiannually

18. Under FINRA rules, the annual gift limit isA. $25B. $50C. $75D. $100



19. Which of the following statements is TRUE re-garding explained decisions by arbitrators?A. Arbitrators need to cite legal authorities and

explain decisions.B. Explained decisions have precedential value

for other arbitration cases.C. Any member of the arbitration panel may

write the explained decision.D. Parties must submit a joint request for

explained decisions to require arbitrators to provide one.

20. If a member wishes to appeal an adverse decision in a Code of Procedure hearing, the member must first appeal to the National Adjudicatory Council within how many days of the decision date?A. 25B. 30C. 40D. 45

21. Under the Code of Procedure, if a member re-ceives a formal complaint from the Department of Enforcement, the member must file an answer withinA. 10 daysB. 15 daysC. 25 daysD. 30 days

22. If a registered representative is suspended for 90 days as the result of a Code of Procedure decision, during the suspension period, that person may A. continue to work for the member in a clerical

capacityB. receive remuneration that might have been

earnedC. remain on the member’s premises but is

prohibited from receiving any remunerationD. be paid monies earned before the suspension

23. Under the Code of Arbitration, all monetary awards must be paid within how many days of the decision date? A. 15B. 30C. 45D. 60

24. Under FINRA rules, which of the following state-ments is TRUE if an associated person wishes to open an account at another member firm? A. Prior notification to the employer is required.B. Prior consent of the employer is required.C. Both A and B.D. Neither A nor B.

25. United Money Managers is under contract to manage the assets of the GEM Fund, an open-end investment company registered under the Investment Company Act of 1940. This fund is their only client. The GEM Fund currently has $106 million in net assets. Which of the following statements is CORRECT?A. United Money Managers is exempt from

registration as an investment adviser under the de minimis rules.

B. United Money Managers would have to register with the state.

C. United Money Managers would have to register with the SEC.

D. United Money Managers would have the choice of registering with either the state or the SEC.

26. A registered representative’s recommendations to a customerA. must be approved in advance by a principal

and must be suitable based on the facts the customer discloses regarding other holdings and investment objectives

B. must be suitable based on the facts the customer discloses regarding other holdings and investment objectives

C. must be approved in advance by a principalD. are not covered by any industry rules



27. A customer buys 100 shares of RFTQ at $10 per share. Several months later, the stock is trading at 4.60–5, at which time the registered representative offers to buy back the stock from the customer for his own account at $9 per share. This action isA. permitted, because it allows the customer to

sell at a price higher than the current marketB. prohibited, because FINRA does not allow

registered representatives to guarantee customers against loss

C. permitted with the written permission of a principal

D. prohibited, because it violates the Uniform Practice Code

28. Under Section 28(e) of the Securities Exchange Act of 1934, which of the following is allowable soft-dollar compensation from a broker/dealer to an investment adviser under the safe harbor provi-sions?A. Custodial services provided by the broker-

dealerB. Office rental paymentsC. Cell phones to rapidly communicate with

clientsD. Vacations

29. Rulings under the Code of ArbitrationA. are binding on members but not on customersB. are binding on all partiesC. may be appealed to the National Adjudicatory

CouncilD. may be appealed to the SEC

33. According to the Investment Advisers Act of 1940, which of the following is NOT defined as an investment adviser?A. A person who receives a fee for advising

others exclusively on Treasury securitiesB. A lawyer who charges a separate fee for giving

specific investment adviceC. A person paid to give advice on bank stocksD. A publisher of a newsletter that makes specific

securities recommendations based on market events




1. A Under the rules for determining breakpoint eligibility, any accounts owned directly by the client, including retirement accounts, or indirectly through a spouse or dependent child, may be aggregated. However, an account with a business partner, or any other non-spouse partner, would not be included.

2. B. Sales charges are only applicable to redeemable securities, such as mutual funds, unit trusts, and variable annuities. Closed-end funds trade in the secondary market with either a commission or a markup.

3. A DPPs are flow-through vehicles, and REITS are not.

4. B. This rule permits sales to directors, officers or partners of the investment company, its investment adviser or principal underwriter, or to the bona fide full-time employees of sales representatives of any of these (provided that the purchases are made for investment and not resale). Not included would be employees of other entities servicing the fund, and non-member broker-dealers must always be charged POP.

5. C. Mutual funds are bought and sold on a forward pricing basis. Orders to buy are filled at the next computed NAV per share (with a sales charge added to arrive at POP), and orders to redeem are filled at the next computed NAV per share.

6. D. The rule mandates examining any exchange of a deferred variable annuity made within 36 months of the initial purchase.

7. A. Mutual funds are only permitted to issue voting common stock, whereas closed-end funds, in addition to voting common, can issue senior securities, such as bonds and preferred stock. Only mutual funds make a continuous offering of shares. Publicly traded funds make a onetime issuance of shares, which then trade in the secondary market. Both may borrow from banks.

8. D. For a member to sell variable contracts, there must be a written agreement between the member and the insurance company underwriter. In addition, the subsidiary of the insurance company doing the underwriting also must be a member. The written agreement also must call for the forfeiture of any concessions earned by the selling member if the contract is redeemed by the customer within seven business days of acceptance.

9. A. A diversified investment company must invest at least 75% of its assets in a way that it invests no more than 5% of its assets in any one company, and no single investment represents more than 10% of another company’s voting securities. There are no restrictions on how the remaining 25% may be invested.

10. B. Unit investment trusts have a fixed portfolio that is not traded. As the bonds mature or are called, the proceeds are distributed pro rata to the unit holders. As a result, the trust has no investment adviser (i.e., it is not managed). Like other investment companies, a UIT is regulated if it distributes a minimum of 90% of its net investment income to unit holders.

11. A. FINRA rules require members selling variable contracts to promptly transmit payments to the insurance company underwriter.



12. D. A broker-dealer is generally exempt from having to register as an investment adviser, because giving investment advice is part of what a broker-dealer does. This exemption only applies if the firm does not charge separately for giving advice.

13. B. A management company is not permitted to issue securities to the public unless it has capital of at least $100,000.

14. A. This rule applies to recommended purchases and exchanges of deferred (NOT immediate) variable annuities and recommended initial sub-account allocations. On the other hand, this rule does not apply to reallocations among sub-accounts made or to funds paid after the initial purchase or exchange of a deferred variable annuity.

15. C SEC Rule 35d-1, the “name” rule, would not apply to the use of the term “income” where that term suggests an investment objective or strategy rather than a type of investment. When used by itself, the term “income” in a fund’s name generally suggests that the fund emphasizes the achievement of current income and does not suggest a type of investment. Similarly, the term “growth and income” does not suggest that a fund focuses its investments in a particular type of investment, but rather suggests that a fund invests its assets to achieve both growth of capital and current income. On the other hand, a term such as “Tax-Free Bond” suggests investment in a particular type of investment and would be covered by rule 35d-1.

16. D. Although a registered representative may open an account and share disproportionately with immediate family members with principal approval, the representative cannot share in this fashion with any other customer, such as a company’s trading account.

17. C. FINRA rules require members to electronically file information on customer complaints within 15 days of the end of each calendar quarter.

18. D. The annual gift limit is $100. This limit applies to gifts given to or received from customers, as well as to or from employees of other member firms.

19. D. The chairperson of the arbitration panel is required to write the explained decision and will receive an additional honorarium for the work. Awards with unexplained decisions must include the following language: “if the arbitrators have provided an explanation of their decision in this award, the explanation is for the information of the parties only and is not precedential in nature.” Arbitrators do not need to cite legal authorities or damage calculations and explained decisions. All parties, however, must submit a joint request for the explained decision.

20. A. If either side is displeased with a Code of Procedure decision, an appeal must be made within 25 days of the decision date.

21. C. After receiving a complaint from the Department of Enforcement, a respondent has 25 days to file a response.

22. D. If a registered representative is suspended, that person cannot be paid during the suspension period. In addition, that person cannot remain on the member’s premises during the suspension period. Performing any services for the member (including administrative or clerical) during this period is prohibited. However, the person may be paid compensation earned before the suspension period.

23. B. All monetary awards in a Code of Arbitration decision must be paid within 30 days of the decision date.



24. A. Under FINRA rules, if an associated person wishes to open an account at another member firm, the executing member must notify the employer member in writing. Note that, under FINRA rules, consent of the employer member is not required.

25. C. Even though United Money Managers has less than $110 million under management, any adviser under contract to a registered investment company must register with the SEC.

26. B. Recommendations made to a customer must be suitable for that customer. Individual recommendations do not require principal approval.

27. B. A representative may never guarantee a customer against a loss. This is specified in the Conduct Rules, not the Uniform Practice Code.

28. A. The use of a client’s commission dollars to purchase a broker/dealer’s custodial services is an allowable soft-dollar compensation. It is an investment benefit that accrues directly to the client and not to the adviser. Office rental payments, cell phones, and vacations are not allowable because their benefits do not accrue directly to the client. Other examples of permitted soft-dollar items are research and analytical software because they benefit the client whose commission dollars are, in effect, paying for them.

29. B. A customer who chooses to submit a claim or dispute to arbitration under the Code of Arbitration is bound by the arbitration decision.

33. A. The Investment Advisers Act of 1940 excludes from the definition of investment adviser anyone who advises only on U.S. government or agency securities. A lawyer who gives investment advice (if he offers the advice as part of his practice and receives compensation for it), a person who is paid to give advice on bank stocks, and a publisher of a newsletter that gives specific securities recommendations and is not published with regular frequency all are included within the definition under the act.




Quick Quiz 2.A

1. F. There is no requirement for the customer’s signature on the new account form. The only required signature is the principal approving the account.

2. T. These disclosure rules also apply to discretionary accounts.

3. F. Deciding the price at which to buy or sell a security does not require discretionary authority. Discretionary authority is required if the member chooses the action (buy or sell), the security, or the number of shares being bought or sold.

4. F. Discretionary order tickets must be reviewed by a principal promptly after execution. In addition, a principal must frequently review all discretionary accounts to detect potential abuses.

5. F. Internal-use-only means just that. By distributing the memo, the representative and firm could stand to be in violation of several rules and laws.

Quick Quiz 2.B

1. T.

2. F. Under FINRA rules, a list of borrowable securities for short sale purposes must be updated at least daily.

3. T.

4 T.

5. F. Regular way settlement requires payment within 3 business days following trade date. Regulation T, however, allows customers an additional 2 business days to pay for securities purchased. Under Regulation T, customers must pay promptly but no later than 5 business days from trade date.

Quick Quiz 2.C

1. D.

2. B.

3. A.

4. E.

5. F.

6. G.

7. C.

Quick Quiz 2.D

1. F. Aged fails to deliver are allowable assets after being marked to the market and a haircut taken on the 5th business day after settlement.

2. F. Regardless of the AI-to-NC ratio of 5:1, this new firm is not in compliance because its net capital is below the minimum requirement of $250,000.

3. F. All subordinated loan agreements must be filed with FINRA 10 days prior to their effective date.

4. T.

5. F. A security for which there is no ready market is a nonallowable asset. The haircut for securities with a limited market (less than 3 independent market makers total) is 40%.

6. T.

7. T.

8. F. A standard subordination agreement must have a minimum term of 1 year.



Quick Quiz 2.E

1. D.

2. A.

3. C.

4. E.

5. B.

6. H.

7. F.

8. G.

9. I.

Quick Quiz 2.F

1. T.

2. T.

3. T.

4. F. Shareholders must receive annual audited reports and semiannual unaudited financial reports from the management company.

5. F. The 5% (and 10%) limitations placed on a diversified investment company only apply to that 75% of the assets that must be diversified. There are no other restrictions on how to invest the remaining 75%. Therefore, as much as 30% of the company’s assets could be invested in the securities of a single issuer.

6. F. Prospectuses cannot include financial information more than 16 months old.

7. T.

8. T.

9. T.

10. F. As an example, mutual funds may write covered calls.

11. F. Member firms must transmit customer payments to the mutual fund within 3 business days of the trade or 1 business day of receipt, whichever is later.

12. T.

13. T.




1. FOCUS Part IIA reports must be submitted A. weeklyB. monthlyC. quarterlyD. annually

2. Under SEC rules, all of the following information must be on a customer confirmation EXCEPTA. whether the member acted as agent or

principalB. whether the member is a market maker in the

security bought or soldC. whether the trade was solicited or unsolicitedD. whether the member has a control

relationship with the issuer

3. A customer’s margin account is long 400 shares of XYZ currently trading at $18 per share. Under FINRA rules, the minimum maintenance margin requirement for this account isA. $1,800B. $2,000C. $2,160D. $3,600

4. Which of the following statements regarding joint accounts/tenants in common are TRUE? I. Each party specifies a percentage interest in

the account. II. Each party has an equal interest in the

account. III. The interest of a deceased tenant passes to the

estate of the decedent. IV. The interest of a deceased tenant passes to the

cotenant. A. I and IIIB. I and IVC. II and IIID. II and IV

5. A member firm maintains a list of borrowable securities for short sale purposes. Under FINRA rules, this list must be updatedA. twice dailyB. dailyC. every 48 hoursD. weekly

6. A customer purchases stock in a cash account and pays for the purchase on the following business day. Under FINRA rules, the purchase is completeA. on trade dateB. upon receipt of the customer’s checkC. upon the sending of the confirmation of saleD. when the securities are delivered into the

account

7. For which of the following investments does SIPC provide coverage to customers? I. Financial futures contracts II. Common stock III. Currencies IV. Municipal bonds A. I, II and III B. II onlyC. II and IV D. I, II, III and IV

8. A customer has a short margin account that has a credit balance of $39,000 and a market value of $26,000. The short market value at maintenance isA. $9,750B. $13,000C. $19,500D. $30,000



9. An established member firm discovers that its AI exceeds its net capital by more than 12:1. Under SEC 17a-11, which of the following statements are TRUE? I. Immediate notice is required. II. Notice within 24 hours is required. III. Notice must be made by US mail (certified

and registered). IV. Notice must be made electronically. A. I and IIIB. I and IVC. II and IIID. II and IV

10. A principal is required to approve discretionary order ticketsA. prior to order entryB. prior to the mailing of a confirmationC. prior to settlement of the transactionD. promptly after execution

11. The deposit of fully paid securities into a long mar-gin account increases all of the following EXCEPTA. market valueB. debit balanceC. equityD. SMA

12. The agreement that allows the member firm to use customer securities as collateral for a loan is the A. hypothecation agreementB. credit agreementC. loan consent agreementD. restriction agreement

13. A power of attorney is not required for a registered representative to choose which of the following order qualifiers? I. Security to be bought or sold II. Number of shares to be bought or sold III. Time of execution IV. Price of executionA. I and II B. II, III, and IV C. III and IV D. I, II, III, and IV

14. An order ticket, under FINRA rules, must be pre-pared beforeA. the execution of the orderB. 4:00 pm on trade dateC. mailing the confirmationD. settlement date

15. A stock lender retains all of the following rights EXCEPT A. the right to cash dividends on the loaned

stockB. the right to additional shares resulting from a

stock split on the loaned stockC. the right to additional shares resulting from a

stock dividend on the loaned stockD. the right to vote the loaned stock

16. A carrying firm must provide its customers, semi-annually and annually, with information on its I. balance sheet II. income statement III. net capitalA. I and II B. I and III C. II and III D. I, II and III

17. Which of the following statements regarding DVP transactions are TRUE? I. The customer must receive a confirmation at

or prior to completion of the transaction. II. The customer must receive a confirmation no

later than T+1. III. The member is required to receive assurance

from the agent bank that proper instructions have been given by the customer.

IV. The member is required to receive assurance from the customer that proper instructions have been given to the agent bank.

A. I and IIIB. I and IVC. II and IIID. II and IV



18. A customer sells stock and fails to deliver the secu-rities by settlement date to satisfy the sale. Under SEC rules, the member firm must buy in the posi-tion after how many business days from settlement date?A. 2 B. 3C. 5D. 10

19. If a member’s fidelity bond is modified, FINRA must be notifiedA. immediatelyB. within 5 business daysC. within 10 business daysD. within 20 business days

20. Under FINRA rules, a principal must review all discretionary accountsA. dailyB. monthlyC. periodicallyD. frequently

21. A customer’s margin account shows a market value of $13,200 and a debit balance of $8,400. The maintenance market value isA. $3,300B. $4,800C. $6,600D. $11,200

22. Under FINRA rules on account transfers, the carrying member must transfer the positions in the account to the receiving member within how many business days of validation? A. 3B. 4C. 5D. 7

23. If a firm terminates its independent accountant, it must notify the regulatory authorities withinA. 5 business daysB. 10 business daysC. 15 business daysD. 20 business days

24. Subordinated loan agreements must have a mini-mum term ofA. 45 daysB. 6 monthsC. 1 yearD. 3 years

25. Under the Customer Protection Rule, a carrying firm must reduce to possession or control fully paid-for customer securities and excess margin securities A. dailyB. weeklyC. monthlyD. quarterly

26. Who must sign a new account form for a cash account? I. Principal II. Registered representative III. Customer IV. Spouse of the customer A. I onlyB. I, II, and IIIC. II and IIID. I, II, III, and IV

27. A dealer must use special procedures whenever it opens a municipal securities account forA. a clerical employee of another dealerB. the spouse of a trader employed by another

dealerC. the minor child of an operations supervisor

employed by another dealerD. all of these

28. Which of the following would be considered discretionary?A. Order that specifies the size of the trade

and name of the security but leaves the choice of price and time up to the registered representative

B. Account in which the broker has the power to decide when and what to trade, without specific customer authorization for those trades

C. Joint account with right of survivorshipD. Joint tenants in common account



29. One of your clients dies. Upon notification of the death, you should immediately I. mark the account Deceased until proper

documents are received II. cancel all GTC orders for the account III. obtain a letter from the attorney representing

the estate with instructions for transfer IV. obtain the names and addresses of the

beneficiaries of the estateA. I onlyB. I and IIC. II and IIID. I, II, III, and IV

30. A member firm acting solely as a market maker makes a market in 20 stocks under $5 bid and 20 stocks over $5 bid. Under SEC rules, this firm has a minimum net capital requirement ofA. $50,000B. $70,000C. $100,000D. $250,000

31. The documents required to open a cash account for a customer and give a sibling trading authorization include I. a new account form II. a loan consent agreement III. a customer agreement IV. a limited power of attorneyA. I onlyB. I, II, and IVC. I and IVD. II, III, and IV

32. Under Sec 17a-11, a member is in violation of the net capital rule if its debt/equity ratio exceeds 70% for more thanA. 30 daysB. 60 daysC. 90 daysD. 180 days

33. Which of the following violations of the net capital rule require that the member making the notification file a report within 48 hours of noti-fication detailing the steps being taken to correct the situation? I. AI-to-NC ratio exceeds 15:1 II. Books and records are not current III. Material inadequacies in the member’s

accounting system IV. Debt/equity ratio at 80% for 100 days A. I and IIIB. I and IVC. II and IIID. II and IV

34. An employee of another broker-dealer would like to open an account with your firm. Under FINRA rules, all of the following statements regarding the employee and the account are true EXCEPTA. the employer must receive duplicate copies

of all transactions made in the account if requested

B. prior notice to the employer is needed for a cash account

C. prior notice to the employer is needed for a margin account

D. the broker-dealer holding the account must approve each transaction made by the person before entry of the order

35. All of the following records must be retained for 6 years EXCEPT A. blottersB. FOCUS reportsC. general ledgerD. stock record

36. All of the following information must be obtained from new customers EXCEPTA. employer name and addressB. date of birthC. educational backgroundD. citizenship



37. Unless otherwise directed by the SEC, carrying firms must perform a reserve computationA. dailyB. weeklyC. biweeklyD. monthly




1. C. Focus II and IIA reports are filed quarterly, within 17 business days of the end of each calendar quarter. Carrying firms file Focus II, while noncarrying firms file IIA. Carrying firms also must file the Focus II monthly. In addition, most firms also must file Form SSOI 20 business days following each quarter.

2. C. Under SEC Rule 10b-10, a customer confirmation must include whether the member acted as agent or principal, whether the member acted in a dual agency capacity, the commission in an agency trade, the markup or markdown in a principal trade of a Nasdaq security, if the member is a market maker in the security, if a control relationship exists between the member and the issuer, and the time of execution or a statement that it will be furnished upon request. Whether the trade was solicited or unsolicited is not a required disclosure (although many firms do disclose this information).

3. A. This account has a current market value of $7,200 (400 × $18). Minimum maintenance is 25% of market value (25% × $7,200 = $1,800).

4. A. In a TIC account, each party must specify a percentage interest in the account. If one party dies, his percentage ownership passes to his estate, not to the other party.

5. B. A list of borrowable securities for short sale purposes can be no more than 24 hours old.

6. D. If a customer pays for securities purchased before settlement date, the transaction is not considered complete until the securities are delivered into the account, which should occur on settlement date.

7. C. SIPC coverage only applies to cash and securities. Futures contracts and currencies are not considered securities.

8. D. The short market value at maintenance is the market value to which the short position could rise that would put the account right at minimum (30%). The easy way to compute this market value is to divide the credit balance in the account by 1.3.

CR – SMV = EQ %$39,000 – $26,000 = $13,000 50%

$39,000 ÷ 1.3 = $30,000. If the market value should rise to $30,000, the account would be $39,000 – $30,000 = $9,000 (30%).

9. D. Once a firm discovers that it is in early warning, notification must be made to the regulatory authorities within 24 hours. This notice must be made electronically.

10. D. All order tickets, discretionary or otherwise, must be reviewed promptly after execution.

11. B. The debit balance will not change, because the customer is not borrowing more money. The market value in the account will increase by the value of the securities deposited and equity will rise dollar for dollar with the deposit. SMA will increase by 50% of the value of the securities deposited.

12. A. The hypothecation agreement, signed when opening a margin account, allows the member firm to use customer securities to collateralize a loan to the member. The member in turn reloans the money to the customer to finance the debit balance.

13. C. If a registered representative chooses price or timing of an order, the order is a not-held order. To be discretionary, the representative must choose one or more of the following: the action (buy or sell), the security, or the amount (number of shares).



14. A. All order tickets must be prepared before order execution.

15. D. A stock lender retains the right to cash or stock dividends on the loaned stock. In addition, the lender retains the right to additional shares resulting from stock splits. Voting rights, however, belong to the person who bought the stock from the short seller.

16. B. Carrying firms must provide their customers with a semiannual statement (unaudited balance sheet and net capital computation) and an annual statement (audited balance sheet and net capital computation).

17. D. In a DVP account, a confirmation must be given to the customer no later than T+1. Also, the member is required to receive assurance from the customer that proper instructions have been given to the agent bank. The member is not required to, but may contact the agent bank.

18. D. If a customer fails to deliver securities to satisfy a sale by settlement date, a fail to deliver is created. Unless an extension of time is granted by the SRO, customer fails must be bought in after 10 business days from settlement date.

19. A. If a member’s fidelity bond is canceled or modified, FINRA must be notified immediately.

20. D. Under FINRA rules, discretionary accounts must be reviewed frequently by a principal to detect potential fair dealing abuses. Nondiscretionary accounts must be reviewed periodically.

21. D. The long market value at maintenance refers to the market value where the account would be at minimum maintenance (25%). The account is currently at 36% ($13,200 – $8,400 = $4,800). To compute long market value at maintenance, divide the debit balance by .75, which results in a market value of $11,200. If the market value falls to $11,200, the account will be $11,200 – $8,400 = $2,800.

22. A. The carrying firm must transfer the positions within 3 business days of validation.

23. C. The regulatory authorities must be notified within 15 business days of the termination date.

24. C. To be deemed good capital, subordinated loan agreements must be in writing, be for a specific amount, and have a minimum term of 1 year.

25. A. Each day, from the prior day’s settlement records, a carrying firm must take steps to ensure that it has obtained possession or control over fully paid-for customer securities and excess margin securities.

26. A. To open a cash account, only the signature of the principal accepting the account is required. For margin accounts, the signature of the customer is required on the margin agreement. The signature of the spouse is required only for a joint account.

27. D. The firm must follow special procedures whenever it opens an account for the employee of another broker-dealer. The firm must give the employing broker-dealer written notice that it is opening the account. Also, the firm must send copies of all confirmations to the employer.



28. B. An order is discretionary when it is placed by the member firm or its representative for a customer’s account without the customer’s express authorization for that order. Also, for the order to be considered discretionary, the firm must choose more than just the price or time of execution; that is, the size of the trade, whether to buy or sell, or the security must be chosen by the firm.

29. B. The account registered representative should cancel all open orders and mark the account Deceased. The firm should not permit any trades until proper documents are received from the estate representative. It is not the responsibility of the firm to contact the decedent’s attorney or the beneficiaries.

30. C. The minimum net capital requirement for market makers is based on the number of markets made. For stocks that have a bid price of $5 or less, a firm needs $1,000 in capital per security. For stocks that have a bid price of more than $5, a firm needs $2,500 in capital per security. The minimum requirement is $100,000 with a maximum of $1 million. The computation is:

20 × $1,000 = $20,000 20 × $2,500 = $50,000 $70,000

If the computation shows less than $100,000, the minimum is $100,000.

31. C. If one party wants to give discretionary privileges to a third party in a cash account, a member firm requires a new account form and a limited power of attorney. A limited power of attorney gives the third party trading authority but prohibits that party from withdrawing securities from the account.

32. C. If a firm’s debt/equity ratio (subordinated debt divided by total available capital) exceeds 70% for more than 90 days, immediate notification to the regulatory authorities is required.

33. C. If a member is reporting that its books and records are not current or that there are material inadequacies in its accounting system, the member must file a report detailing the steps being taken to correct the situation within 48 hours of giving notification.

34. D. The FINRA rule does not require prior approval of individual transactions by the broker-dealer at which the account has been opened.

35. B. The 6-year records include blotters, the general ledger, the stock record, customer ledgers, and customer account information. FOCUS reports are kept for 3 years

36. C. A customer’s educational background need not be ascertained when opening an account.

37. B. Reserve computations must be made weekly, after the close of business on Friday.


159

u n i t

3Supervision of Retail and Institutional Customer-Related Activities

T his Unit focuses on the supervision of retail and institutional custom-er-related activities. You may expect 32 questions about the supervi-sory activities found in this unit.


O B J E C T I V E S

160

At the end of this unit, you should be able to recognize and explain the following:

■ Suitability requirements

■ Requirement to recognize red flags, investigate and escalate potential issues

■ Commission and markup regulations

■ Requirements to provide disclosures concerning products, risks, services, costs and fees, Social media, and electronic communications guidelines

■ Differences among research, retail, and institutional communications and correspondence

■ Various approval and filing requirements

■ “Do Not Call” list requirements

■ Requirement to obtain specified customer information

■ Requirement to verify that accounts comply with the Customer Identification Program (CIP)

■ Bank Secrecy Act and USA PATRIOT Act

■ Office of Foreign Assets Control (OFAC)

■ Financial Crimes Enforcement Network (FinCEN)

■ Anti–Money Laundering regulations

■ Asset transfer processes

■ Required documentation for account changes

■ Privacy of customer information

■ Detect, prevent, and mitigate identity theft


161Unit 3 Supervision of Retail and Institutional Customer-Related Activities

3. 1 SUPERVISION OF ACCOUNT OPENING/EXISTING ACCOUNTS

3. 1. 1 CUSTOMER INFORMATION

The Know Your Customer rule, FINRA Rule 2090, along with Rule 2111 (suitability) requires registered representatives to be diligent in learning the essential facts about each account opened. In a broad sense, knowing about a customer is key to acting with high stan-dards of commercial honor and just and equitable principals of trade (FINRA Rule 2010). This customer information is recorded on the new account form and becomes subject to the record-keeping requirement of the firm once accepted by signature of a partner, officer, or manager.

It would be appropriate for a supervisor to return without his signature a new account form to a registered representative who failed to properly obtain key customer account information. A representative who developed a pattern of submitting for approval incomplete new account forms would be a source of concern to a diligent supervisor. Direction for the representative to go back to the customer and get all the information, as well as establishing a documented re-training program, would be wholly consistent with good supervisory practices and building a culture of compliance.

Generally, FINRA Rule 4512 requires the following information to be obtained: ■ Name, address, phone number, and occupation of customer ■ Name and address of employer ■ Whether the customer is an associated person of another member firm ■ Social Security number or tax ID number ■ Whether the customer is of legal age ■ Whether the account will be a cash or margin account ■ Whether the customer is employed by another broker-dealer ■ Whether the customer is an officer, director, or more than 10% shareholder of a publicly

traded company (See Control Stock in Unit 5) ■ Citizenship (U.S. or non-U.S.) ■ Annual income, net worth, and investment objectives ■ Investment experience ■ Investment time horizon ■ Liquidity needs ■ Risk tolerance ■ Investment objective ■ Registered representative responsible for the account

It is not unusual to have rules relaxed somewhat for certain classes of investors, such as institutional accounts, which comprise the following:

■ Banks, savings and loans, insurance companies, or registered investment companies ■ Investment advisers registered either with the SEC or the states ■ Any natural person, corporation, partnership, or trust with total assets of at least $50 mil-

lion.


162 Unit 3 Supervision of Retail and Institutional Customer-Related Activities

For some investments, a continuing financial commitment is needed. The firm must have a reasonable expectation that a customer will be able to satisfy that commitment.

No member may carry on its books an account in the name of a person other than that of the customer. However, an account may be designated by a number or a symbol, so long as the member firm has on file a written statement signed by the customer attesting the ownership of the account.

While it is clearly important to obtain information about the customer during the on-boarding process, it also is essential that investors, particularly non-institutional investors, be cautioned about the risks inherent in certain investment practices and strategies as well as accounts, such as day-trading and margin accounts.

New Account Form

TAXPAYER ID NUMBER

LEGAL NAME(S) AND MAILING ADDRESS

SSN

TAX ID

DIVIDENDS

BRANCH# RR# ACCOUNT#

SINGLE

WIDOWED

HOLD

MAIL

DUPLICATE

CONFIRMS?

YES

NO

ATTACH SPECIAL INSTRUCTIONS

TELEPHONE NO. HOME

BUS

TELEPHONE NO. HOME

BUS

EM

PL

OY

ME

NT

RE

FE

RE

NC

ES

PO

US

E

EMPLOYER'S NAME

ADDRESS

TYPE OF BUSINESS

BANK NAME AND ADDRESS

DOES CLIENT HAVE AN ACCOUNT

WITH ANOTHER BROKERAGE FIRM?

NAME

EMPLOYER

YEARS EMPLOYED

CLIENT'S OCCUPATION

YES

NO

IF YES, WITH WHAT FIRM?

CHECKING

SAVINGS

VERIFIED

NOT VERIFIED

OCCUPATION

ADDRESS

AGE

ANNUAL INCOME

BRANCH MGR APPROVAL DATE ROP SIGNATURE (OPTIONS APPROVAL)

AGENT'S NAME AND ADDRESS

INVESTMENT OBJECTIVES

GROWTHINCOMEGRO/INC

SPECULATIONRETIREMENTTAX

DOES CLIENT OR SPOUSE HAVE

ANOTHER ACCOUNT WITH US?

IF YES, LIST:

YES NO

IS CLIENT NOW OR HAS CLIENT

EVER BEEN A CORPORATE

OFFICER OR OWNER OF 10%

OF ANY CORPORATION'S

SECURITIES?

IF YES, NAME:

HOW WAS ACCOUNT ACQUIRED?

WALK INPHONE INOTHER

REFERRALPROSPECTACQUAINTANCE

INITIAL TRANSACTION

BUYSELLOTHER

DESCRIBE:

INITIAL DEPOSIT

OPTION TRADES ANTICIPATEDBUY ONLYCOV CALLSCOV PUTSUNC OPTS

STRADDLESSPREADSCOMBINSOTHER

IS CLIENT FAMILIAR WITHOPTIONS?

YES NO

HOME

BUS

MARRIED

DIVORCED

MARITAL STATUS

YES NO

HOME OWN RENT

HAS CLIENT RECEIVED OCCPROSPECTUS?

YESHAS CLIENT PREVIOUSLYTRADED OPTIONS?

YES NO

DATE

ARE OPTIONS SUITABLE?YES NO

DISCRETIONARY AUTHORIZATIONFULL LIMITED NONE

NO. OF DEPENDENTS

AGE

DOCUMENTATION

MARGIN AGR

JOINT ACCT

TRADING AUTH

CORP/PART AGR

RETIRE ACCT

SIG CARD

RCVDPEND

RCVDPEND

RCVDPEND

RCVDPEND

RCVDPEND

RCVDPEND

OTHER (DESCRIBE)

JTWROS

INV CLUB

PARTNER

OTHER

SINGLE

JTIC

CORP

RETIRE

ACCOUNT REGIS.

OPTION

COMMODITY

CASH

MARGIN

ACCOUNT TYPE

IS THE CUSTOMER OR SPOUSE EMPLOYED BY, OR RELATED

TO AN EMPLOYEE OF, ANY FINANCIAL INSTITUTION?

YES

NO

INVESTMENT EXPERIENCE

DATE

ANNUAL INC

NET WORTH

U.S.CITIZEN?

YES

NO



3. 1. 1. 1 Approval for Day-trading Accounts (FINRA Rule 2130)

Member firms that promote day-trading strategies must now implement procedures to approve day-trading accounts.

Before opening an account for a non-institutional customer, the member must: ■ provide the customer with a risk disclosure statement that outlines all the risks associated

with day trading (the statement can be furnished in writing or electronically); and ■ approve the account for a day trading strategy or receive from the customer a written state-

ment that the customer does not intend to engage in day trading.

To approve a customer account for a day trading strategy, the member must have reason-able grounds for believing that the day trading strategy is appropriate for the customer. In mak-ing this determination, a member must gather essential facts about the customer, including:

■ investment objectives, trading experience, and knowledge; ■ financial status (income, liquid net worth, etc.) and tax status; and ■ employment status, marital status, number of dependents, and age.

If a member who promotes a day trading strategy opens an account and receives written assurance that the customer does not intend to engage in day trading—and later determines that the customer is day trading—it must approve the account within 10 days.

A firm will not be deemed to be promoting a day trading strategy if it promotes lower execution costs based on multiple trades and has a website that allows multiple entry of intra-day trades of the same securities.

3. 1. 1. 2 Day-trading Risk Disclosure Statement (FINRA Rule 2270)

As previously mentioned, member firms that promote day-trading strategy are obligated to caution their non-institutional customers as to the risks involved. The firm must provide to each separate customer a disclosure statement as well as conspicuously posting it on the member’s website.



Sample Risk Disclosure Statement

You should consider the following points before engaging in a day-trading strategy. For pur-poses of this notice, a “day-trading strategy” means an overall trading strategy characterized by the regular transmission by a customer of intra-day orders to effect both purchase and sale transac-tions in the same security or securities.

Day trading can be extremely risky. Day trading generally is not appropriate for someone of limited resources and limited investment or trading experience and low risk tolerance. You should be prepared to lose all of the funds that you use for day trading. In particular, you should not fund day-trading activities with retirement savings, student loans, second mortgages, emergency funds, funds set aside for purposes such as education or home ownership, or funds required to meet your living expenses. Further, certain evidence indicates that an investment of less than $50,000 will significantly impair the ability of a day trader to make a profit. Of course, an investment of $50,000 or more will in no way guarantee success.

Be cautious of claims of large profits from day trading. You should be wary of advertisements or other statements that emphasize the potential for large profits in day trading. Day trading also can lead to large and immediate financial losses.

Day trading requires knowledge of securities markets. Day trading requires in-depth knowl-edge of the securities markets and trading techniques and strategies. In attempting to profit through day trading, you must compete with professional, licensed traders employed by securities firms. You should have appropriate experience before engaging in day trading.

Day trading requires knowledge of a firm’s operations. You should be familiar with a securities firm’s business practices, including the operation of the firm’s order execution systems and proce-dures. Under certain market conditions, you may find it difficult or impossible to liquidate a position quickly at a reasonable price. This can occur, for example, when the market for a stock suddenly drops, or if trading is halted due to recent news events or unusual trading activity. The more volatile a stock is, the greater the likelihood that problems may be encountered in executing a transaction. In addition to normal market risks, you may experience losses due to system failures.

Day trading will generate substantial commissions, even if the per-trade cost is low. Day trading involves aggressive trading, and generally you will pay commissions on each trade. The total daily commissions that you pay on your trades will add to your losses or significantly reduce your earnings. For instance, assuming that a trade costs $16 and an average of 29 transactions are conducted per day, an investor would need to generate an annual profit of $111,360 just to cover commission expenses.

Day trading on margin or short selling may result in losses beyond your initial investment. When you day trade with funds borrowed from a firm or someone else, you can lose more than the funds you originally placed at risk. A decline in the value of the securities that are purchased may require you to provide additional funds to the firm to avoid the forced sale of those securities or other securities in your account. Short selling as part of your day-trading strategy also may lead to extraordinary losses, because you may have to purchase a stock at a very high price in order to cover a short position.

Potential Registration Requirements. Persons providing investment advice for others or man-aging securities accounts for others may need to register as either an “Investment Adviser” under the Investment Advisers Act of 1940 or as a “Broker” or “Dealer” under the Securities Exchange Act of 1934. Such activities also may trigger state registration requirements.



3. 1. 1. 3 Margin Account Disclosure

Those investors who choose to trade securities through a margin account face additional risks that must be disclosed to those opening such an account. No member firm is permitted to open a margin account for a non-institutional account without the firm furnishing the customer a margin disclosure statement. If the account is open online, or to execute transac-tions online, firms have the additional requirement to post the disclosure conspicuously on the member firm’s website.



Sample Margin Disclosure Statement

Your brokerage firm is furnishing this document to you to provide some basic facts about purchasing securities on margin, and to alert you to the risks involved with trading securities in a margin account. Before trading stocks in a margin account, you should carefully review the margin agreement provided by your firm. Consult your firm regarding any questions or concerns you may have with your margin accounts.

When you purchase securities, you may pay for the securities in full or you may borrow part of the purchase price from your brokerage firm. If you choose to borrow funds from your firm, you will open a margin account with the firm. The securities purchased are the firm’s collateral for the loan to you. If the securities in your account decline in value, so does the value of the collateral supporting your loan; and, as a result, the firm can take action, such as issue a margin call and/or sell securities or other assets in any of your accounts held with the member, in order to maintain the required equity in the account.

It is important that you fully understand the risks involved in trading securities on margin. These risks include the following:

■ You can lose more funds than you deposit in the margin account. A decline in the value of securities that are purchased on margin may require you to provide additional funds to the firm that has made the loan to avoid the forced sale of those securities or other securities or assets in your account(s).

■ The firm can force the sale of securities or other assets in your account(s). If the equity in your account falls below the maintenance margin requirements, or the firm’s higher “house” requirements, the firm can sell the securities or other assets in any of your accounts held at the firm to cover the margin deficiency. You also will be responsible for any short fall in the account after such a sale.

■ The firm can sell your securities or other assets without contacting you. Some investors mistakenly believe that a firm must contact them for a margin call to be valid, and that the firm cannot liquidate securities or other assets in their accounts to meet the call unless the firm has con-tacted them first. This is not the case. Most firms will attempt to notify their customers of margin calls, but they are not required to do so. However, even if a firm has contacted a customer and provided a specific date by which the customer can meet a margin call, the firm can still take neces-sary steps to protect its financial interests, including immediately selling the securities without notice to the customer.

■ You are not entitled to choose which securities or other assets in your account(s) are liq-uidated or sold to meet a margin call. Because the securities are collateral for the margin loan, the firm has the right to decide which security to sell in order to protect its interests.

■ The firm can increase its “house” maintenance margin requirements at any time and is not required to provide you advance written notice. These changes in firm policy often take effect immediately and may result in the issuance of a maintenance margin call. Your failure to satisfy the call may cause the member to liquidate or sell securities in your account(s).

■ You are not entitled to an extension of time on a margin call. While an extension of time to meet margin requirements may be available to customers under certain conditions, a customer does not have a right to the extension.



In addition to the disclosure at the opening of a margin account, the member firm must at least annually (calendar year) deliver the disclosure again, or alternatively a somewhat truncated list of the following cautions, to non-institutional customers with an open margin account.

Securities purchased on margin are the firm’s collateral for the loan to you. If the securities in your account decline in value, so does the value of the collateral supporting your loan; and, as a result, the firm can take action, such as issue a margin call and/or sell securities or other assets in any of your accounts held with the member, in order to maintain the required equity in the account. It is important that you fully understand the risks involved in trading securities on margin. These risks include the following:

■ You can lose more funds than you deposit in the margin account.

■ The firm can force the sale of securities or other assets in your account(s).

■ The firm can sell your securities or other assets without contacting you.

■ You are not entitled to choose which securities or other assets in your account(s) are liqui-dated or sold to meet a margin call.

■ The firm can increase its “house” maintenance margin requirements at any time and is not required to provide you advance written notice.

■ You are not entitled to an extension of time on a margin call.

3. 1. 1. 4 Extended Trading Hours Risk Disclosure (FINRA Rule 2265)

Those investors seeking to trade during extended trading hours need to be cautioned about the risks associated with that trading practice. No member may permit a customer to trade in extended hours unless they have received a disclosure statement in the same fashion as previously stated.



Sample Trading Risk Disclosure Statement

You should consider the following points before engaging in extended-hours trading. “Extended-hours trading” means trading outside of “regular trading hours.” “Regular trading hours” generally means the time between 9:30 a.m. and 4:00 p.m. Eastern Time.

■ Risk of Lower Liquidity. Liquidity refers to the ability of market participants to buy and sell securities. Generally, the more orders that are available in a market, the greater the liquidity. Liquidity is important, because with greater liquidity, it is easier for investors to buy or sell securi-ties, and as a result, investors are more likely to pay or receive a competitive price for securities purchased or sold. There may be lower liquidity in extended hours trading as compared to regular trading hours. As a result, your order may only be partially executed, or not at all.

■ Risk of Higher Volatility. Volatility refers to the changes in price that securities undergo when trading. Generally, the higher the volatility of a security, the greater its price swings. There may be greater volatility in extended hours trading than in regular trading hours. As a result, your order may only be partially executed, or not at all, or you may receive an inferior price when engaging in extended hours trading than you would during regular trading hours.

■ Risk of Changing Prices. The prices of securities traded in extended hours trading may not reflect the prices either at the end of regular trading hours, or upon the opening the next morning. As a result, you may receive an inferior price when engaging in extended hours trading than you would during regular trading hours.

■ Risk of Unlinked Markets. Depending on the extended hours trading system or the time of day, the prices displayed on a particular extended hours trading system may not reflect the prices in other concurrently operating extended hours trading systems dealing in the same securi-ties. Accordingly, you may receive an inferior price in one extended hours trading system than you would in another extended hours trading system.

■ Risk of News Announcements. Normally, issuers make news announcements that may affect the price of their securities after regular trading hours. Similarly, important financial information is frequently announced outside of regular trading hours. In extended hours trading, these announce-ments may occur during trading, and if combined with lower liquidity and higher volatility, may cause an exaggerated and unsustainable effect on the price of a security.

■ Risk of Wider Spreads. The spread refers to the difference in price for which you can buy a security and for which you can sell it. Lower liquidity and higher volatility in extended hours trading may result in wider-than-normal spreads for a particular security.

Member firms may use the previous sample, but the firm also may create its own form if it covers at least these six risks.



3. 1. 2 ACCOUNT VERIFICATION/USA PATRIOT ACT

Under provisions of the USA PATRIOT Act, broker-dealers are required to: ■ verify the identity of any new customer; ■ maintain records of the information used to verify identity; and ■ determine whether the person appears on any list of known or suspected terrorists or ter-

rorist organizations.

These rules are designed to prevent, detect, and prosecute money laundering and the financing of terrorism.

✓T A K E N O T EUnder the USA PATRIOT Act, records relating to the verification of customers’

identity must be retained for five years.

As part of its customer identification program (CIP), a broker-dealer must, before opening an account, obtain the following information at a minimum:

■ Customer name ■ Date of birth ■ Address ■ An identification number (e.g., SSN)

An exception is granted to persons who do not currently have, but who have applied for, a Social Security number. The firm, in this instance, must obtain the number within a reason-able time.

The firm also must verify the identity of each new customer. Obtaining a copy of the person’s unexpired drivers license, a copy of a valid passport, or a military ID suffices. For non-U.S. citizens, an alien registration card or passport will suffice. Further, the firm must determine whether the customer’s name appears on any list of known or suspected terrorists by contacting the Office of Foreign Assets Control (OFAC).

New customers must be advised, before the account is opened, that the firm is requesting information to verify their identities. This notification may be placed on the firm’s website, delivered verbally, or placed on the new account form.

For a person other than an individual (corporation, partnership, trust, et cetera) a member must obtain documents showing the existence of the entity, such as articles of incorporation, a partnership agreement, a trust instrument, or a government-issued business license.

Note that a birth certificate is not a valid means to verify an individual’s identity, because it does not contain a photograph or address. In addition, the name on the certificate may have changed due to marriage or otherwise.

✓T A K E N O T EFirms must verify a customer’s identity within a reasonable time before or after

the account is opened. The SEC does not proscribe what firms must do if they are unable to verify identity. The SEC does say, however, that a firm’s written supervisory procedures must state what it will do in this situation.



In addition, each retail customer who opens a new account must, within 30 days of the opening of the account, be furnished with a copy of the account record. This is to ensure that the information obtained by the firm, particularly suitability information, is correct. The firm must send a copy of the account record to customers at least every 36 months thereaf-ter. Supervisors always must, however, look for red flags, which may indicate something has changed in the circumstances of the customer.

If the customer should notify the firm of any changes to the account record, such as change in name, address, or investment objectives, the firm must send a copy of the updated account record within 30 days of receiving notice of the change.

A broker-dealer is required to retain records of all of the identification information obtained from the customer for five years after the account is closed.

By contrast, records made about the information actually verifying a customer’s identity have to be retained for only five years after the record is made.

In every other respect, records of the customer’s account must be maintained pursuant to the provisions of SEC recordkeeping rules 17a-3 and 17a-4.

✓T A K E N O T EAccounts that are acquired through acquisition of another member firm are not

subject to customer identification procedures. It can be presumed that the other member fulfilled its obligation.

*E X A M P L E Verification of signatures is critically important with regard to third-party wire orders. For instance, if a customer sends an email seeking a wire transfer of funds to a third party in Mumbai, India that contained a signed wire transfer form, the represen-tative or his assistant should witness the customer affixing his signature and examine the customer’s government-issued ID to authenticate the customer’s signature. Failure to do so, or something equally convincing, could leave the firm and customer greatly exposed. If the customer’s account was hacked, the funds sent to the third party are likely gone forever. The careful monitoring of third-party transfers of funds or securi-ties is an important part of a firm’s written supervisory procedures and best practices. Failure to do so could lead to sanctions for failure to enforce WSPs, as well as violat-ing 2010, 3120, and recordkeeping rules.

3. 1. 3 CHARGES FOR SERVICES

Charges for services—including miscellaneous services, such as the collection of interest or dividends, safekeeping or custody of securities, and the exchange or transfer of securities—must be reasonable and cannot be discriminatory among customers.

There are two services for which members cannot charge customers. First, a member may not charge a customer for research. Providing research for a price would force the member to register as an investment adviser with the SEC for those who manage $110 million or more (with a state securities agency if it is less than $100 million, and with either if in between). Second, a member may not charge a customer for forwarding proxy material. Members charge the issuer for providing this service.



✓T A K E N O T EFINRA Rule 2251 and SEC rules require member firms to process and promptly

forward all proxy and related information, such as annual reports, regarding a security to the beneficial owner if the member carries the account in which the security is held for the beneficial owner and the security is registered in a name other than the name of the beneficial owner.

3. 1. 4 HOLDING CUSTOMER MAIL (FINRA RULE 3150)

A member firm may hold mail for a customer who will not be receiving mail at his or her usual address, provided that:

■ the member receives written instructions from the customer that include the time period during which the member is requested to hold the customer’s mail.

■ If the requested time period included in the instructions is longer than three consecutive months, the customer’s instructions must include an acceptable reason for the request (e.g., safety or security concerns).

The member under FINRA Rule 3150 is obligated to: ■ inform customers in writing of any alternate methods, such as email or access through

the member’s website, that customers may use to receive or monitor account activity and information; and

■ obtain confirmation of the receipt of such information from customers; and ■ the member verifies at reasonable intervals that the customer’s instructions still apply. ■ During the time that a member is holding mail for a customer, the member must be able to

communicate with the customer in a timely manner to provide important account infor-mation, such as privacy notices.

■ A member holding a customer’s mail must take actions reasonably designed to ensure that the customer’s mail is not tampered with, held without the customer’s consent, or used by an AP of the member in any manner that would violate rules and the securities laws.

✓T A K E N O T EConvenience is not an acceptable reason for holding mail longer than three

months.

3. 1. 5 THIRD-PARTY TRADING

In most accounts, there are two parties: (1) the customer (the account owner), and (2) the member firm executing orders entered by the customer. In a third-party account, someone other than, or in addition to, the customer is authorized to enter orders. A fiduciary account is an example of a third-party account (discussed later in this Unit). The fiduciary is the third party (in addition to the account owner and the member firm) authorized under state law to trade the account. Discretionary accounts are another example of third-party trading.

In a discretionary account, the account owner gives the member trading authorization. To do so, the customer signs a power of attorney. This authorization may be revoked by the cus-tomer in writing, at any time, and ends on the death or mental incompetence of the customer.



Third-party trading can be limited or full. Limited authorization allows the third party to enter orders only. Full authorization allows order entry and permits the authorized party to withdraw funds from the account. Any disbursements must be in the account name, not in the name of the authorized third party.

A trade is discretionary if the member chooses any of the following order-related items: • Action (buy or sell)• Asset (the security to be bought or sold)• Amount (number of shares or dollar amount)

If the member chooses the price or timing of an order, it is not discretionary; rather, it is termed a not held order.

*E X A M P L E If a customer said, “Buy me 1,000 shares of CSCO when the price is right,” dis-cretionary authority would not be required to handle this order, because the customer would be choosing the action, the security, and the amount.

However, if the customer said, “Buy me as much CSCO as you think I should have,” discretionary authority would have to be in place to handle this order, because the member would be choosing the number of shares.

An order to “buy $50,000 worth of a solid high-tech stock,” would require dis-cretion, because the member would be choosing the security.

✓T A K E N O T ERetail orders granting time or price discretion are limited to the day the order is

given, unless the firm has written authorization from the customer to the contrary. Institutional not-held-orders are not affected if given on a GTC basis.

Discretionary authority must be approved by a principal before its exercise. In addition, a principal must approve all discretionary order tickets promptly after execution and must fre-quently review all discretionary accounts to detect potential abuses, such as unsuitable trades or churning (discussed later in this Unit).

3. 1. 6 CUSTOMER TRADE CONFIRMATIONS (FINRA RULE 2232)

FINRA Rule 2232 requires its members to give or send a confirmation to customers at or before the completion of any transaction and to be in compliance with SEC Rule 10b-10.

At minimum, a confirmation must contain the following information: ■ Whether the member acted as agent or principal ■ The identity of the shares or units as well as the price and number of shares (if the trade

price on the confirmation is incorrect, the actual price prevails) ■ Whether the member acted as dual agent (dual agency occurs when a firm crosses stock

between two customers, charging each side a commission) ■ The commission in an agency trade



■ The markup or markdown in a principal trade of a listed security (SEC rules refer to markups and markdowns as the difference between the reported trade price and the price to the customer. If the trade ever moves through a proprietary account, it is considered a principal trade)

■ Payment for order flow: member firms may agree to preference (direct) all of their orders in a certain stock or stocks to a particular market maker; in return, that market maker will rebate, on a cents-per-share basis, a portion of its profit; these agreements must be in writ-ing and be disclosed

■ If the member is a market maker in the security ■ If a control relationship exists between the issuer and the member ■ Date and time of the transaction execution or a statement that it will be furnished upon

request ■ A debt security traded on the basis of a dollar price, the dollar price at which the transac-

tion was effected, and the yield to maturity calculated from that dollar price ■ A debt security effected on the basis of yield, the confirmation must show the yield at

which the transaction was effected, including the percentage amount and its either cur-rent yield, yield to maturity, or yield to call. If effected at yield to call, the type of call, the call date, and call price; and

— the dollar price calculated from the yield at which the transaction was effected; and

— if effected on a basis other than yield to maturity, and the yield to maturity is lower than the represented yield, the yield to maturity in addition to the represented yield.

Summary Chart of Yield and Call Disclosures

Disclosures

Dollar Price Basis Dollar Price

YTM based on dollar price

Yield Price Basis Yield

YTM, YTC or Current Yield

Dollar price based on yield

Callable Security Call legend

Surprisingly, the SEC rule does not mention a couple of important points that are however picked up by FINRA. With respect to an NMS stock, FINRA requires that the settlement date and, where applicable, the fact that a security is a callable equity security. Lastly, that the customer may contact the member firm for additional information about the security must be found on the customer confirmation.

✓T A K E N O T ESEC Rule 10b-10 requires that confirmations for DVP trades be delivered to cus-

tomers no later that T+1.



✓T A K E N O T EThere is no requirement to disclose yield on a trade confirmation for CMOs. If the

broker-dealer chooses to do so, additional information would be required. However, the nominal face amount and interest rate, the maturity date, and the settlement date along with the weighted average coupon (WAC) should be included on CMO confirms.

3. 1. 7 ELECTRONIC DELIVERY OF INFORMATION

FINRA allows members to electronically send documents, such as confirmations and account statements, to customers as long as certain conditions are met. To do so, the firm must have procedures in place to show that the information sent has been delivered as intended and that the confidentiality and security of personal information are protected. Furthermore, customers must provide written consent to electronic delivery.

In addition, a customer who consents to receive information and documents electronically must be provided with the information in paper form, upon request.

✓T A K E N O T EWhile many firms also include information on whether the trade was solicited or

unsolicited, the SEC does not require such disclosure. Copies of customer confirma-tions must be retained for three years.

3. 1. 8 CUSTOMER ACCOUNT TRANSFER CONTRACTS

When a customer whose securities account is carried by a member (the carrying member) wants to transfer the account to another member (the receiving member), the customer must sign an account transfer form. Upon receipt from a customer of a broker-to-broker transfer instruction form (TIF), the receiving member must immediately submit the instruction to the carrying member in ACATS (Automated Customer Account Transfer Service). Customers may choose to move assets to another firm for a wide variety of reasons: better or wider variety of services, lower costs, or simply a brother-in-law is now a broker at the receiving firm. It may also be that the customer has learned the broker is under investigation by regulators or has apparently committed rule violations in connection with the account. Whatever the reason, we must respect the transfer instructions.

The carrying member must, within one business day following the receipt of the TIF from the customer, validate the transfer instruction to the receiving member.

Within three business days following the validation of the transfer instruction, the carry-ing member must complete the transfer of the customer’s security account assets to the receiv-ing member. In short, that’s one day validate, three days ship. If the asset is non-transferable, the firm has five business days to send the proceeds from liquidation.

When the transfer take place, the receiving member and the carrying member must imme-diately establish fail-to-receive and fail-to-deliver contracts at then-current market values upon their respective books of account against the long/short positions, including options, that have not been delivered/received, and the receiving/carrying member must debit/credit the related money amount.



For purposes of this rule, customer authorization could be the customer’s actual signature or an electronic signature.

✓T A K E N O T ENot all assets are eligible to be transferred through ACATS. Even those assets

that are deemed eligible by the system may not be by the receiving brokerage firm, because it likely has its own requirements as to which assets it will accept. It may not, for example, accept certain proprietary mutual funds or bond ladder accounts.

The carrying member, within one business day following receipt, must validate and return the transfer instruction to the receiving member with an attachment showing all securities positions.

The carrying firm may take exception to the transfer instruction if: ■ the account is flat and reflects no transferable assets; ■ the account number is invalid; ■ the Social Security number on the instruction does not match the number on the carrying

firm’s records; ■ the account title does not match the title on the carrying firm’s record; or ■ the customer signature on the instruction is improper.

✓T A K E N O T EA carrying member may not take exception to a transfer instruction and thereby

deny validation because of a dispute over securities positions or the money balance in the account.

Both firms must promptly (within five business days) resolve any exceptions taken.Upon validation, the carrying member must freeze the account and refuse any new orders.

In addition, all open orders, such as stops or limits, must be canceled. The only exception to the acceptance of new orders is option positions, which expire within seven business days.

Within three business days following validation, the carrying firm must complete the transfer of the account. If any positions are not transferred to the receiving firm due to a fail to receive at the carrying firm, fail to receive and fail to deliver contracts must be established by the members. Fail contracts, dealer to dealer, are discussed later.

Certain assets are nontransferable. These include proprietary products, such as unit trusts managed by the carrying firm. In these situations, the customer can retain these assets at the carrying firm or liquidate and have the resulting cash balance transferred. The securities underlying when-issued contracts are subject to delayed delivery. Rather than transfer the contract, the carrying firm retains the contract until the underlying securities are issued. At this point, the securities are transferred. Also note that partial transfers are acceptable. For example, a customer could elect to transfer only his equity securities, leaving the remainder at the carrying firm.

It is a violation to interfere with a customer’s request to transfer an account in connection with the change in employment of the customer’s registered representative where the account is not subject to any lien.

A bulk transfer (sometimes called a “block” transfer) of customer accounts is permitted in certain circumstances. Assume, for example, that Firm A, the newly appointed sponsor of a mutual fund or variable insurance product, desires 200 variable annuity customers where



the contracts are held by the insurance company issuer or broker-dealer sponsor to transfer over. This can be done in bulk if the customers have provided their consent via an affirmative consent letter. Under FINRA rules, however, the use of a negative consent letter is permitted only if there is a compelling reason. A compelling reason might be a registered representa-tive assigned to the customer’s variable insurance product is no longer available to service the account, and the BD of record no longer intends to provide the services performed by the representative.

Firms must include the following information in the client negative response letter: ■ A short description of the reason for the transfer ■ Notice to the clients that they have the right to object to the transfer ■ How the client can transfer to another firm ■ Provide a sufficient time period for the customer to respond to the letter (at least 30 days

from the receipt of the letter unless exigent circumstances exist that warrant a shorter time period)

■ Disclose any cost that will be imposed on the customer as a result of the transfer, including costs to the customer if the customer initiates a transfer of the account after the account is moved pursuant to the negative response letter

■ Include a statement regarding the firm’s compliance with Securities and Exchange Com-mission (SEC) Regulation S-P (Privacy of Consumer Financial Information) in connec-tion with the transfer

✓T A K E N O T EBlock Transfers may be used only when the registered representative’s prior

broker-dealer agrees to participate in this program. If the prior broker-dealer is unwill-ing to participate in this block transfer program, it will be necessary for the registered representative to transfer the accounts using an Individual Change of Dealer Authori-zation Form.



Sample Transfer Instruction Form

3. 1. 9 DEATH OF A CUSTOMER

With regard to individual accounts, once a member becomes aware of the death of the account owner, the member must cancel all open orders, mark the account Deceased, and freeze the assets in the account until receiving instructions and documentation from the exec-utor of the decedent’s estate. If the account has a third-party power of attorney, the authoriza-tion is revoked.

✓T A K E N O T EDiscretionary authority ends at the death of the account owner.



The documents necessary to release the assets of a decedent are: ■ certified copy of the death certificate; ■ inheritance tax waivers; and ■ letters testamentary.

If one party in a JTWROS account dies, the account cannot be transferred into the name of the new owner (the other party) until the member receives a certified copy of the death certificate.

If one party in a TIC account dies, the decedent’s interest in the account goes to his estate. The executor for the decedent must present the proper documents before the assets belonging to the decedent can be released. In some states, the death of a tenant in a TIC account requires that the executor present an affidavit of domicile to the member, which shows the decedent’s estate will be handled under the laws of that state.

✓T A K E N O T EIn TIC accounts, the death of a tenant requires that the member firm freeze

the account and acceptance of orders until the required documents are presented. Compare this with a JTWROS account, in which the death of one tenant does not preclude the remaining tenant from entering orders.

With regard to partnership accounts, if one partner dies, the member needs written author-ity from the remaining partners before executing any further orders. This written authorization generally takes the form of an amended partnership agreement.


—— 1. If a member learns that one party in a JTWROS account has died, the member may immediately transfer the assets to the surviving owner.

—— 2. If a member learns that one party in a JTWROS account has died, it must immediately freeze the account and acceptance of orders until it receives the proper documentation.

—— 3. Members must send statements to customers at least quarterly; or, if there is activity in the account in any given month, a statement must be sent that month.

—— 4. Customers must be notified of any free credit balance in their account at least quarterly.

—— 5. A rescission offer must be in writing and include an agreement to buy back the securities at the higher of cost or market value, and to pay interest to the customer based on cost from date of purchase to date of repurchase.



3. 1. 10 COMPONENTS OF SUITABILITY OBLIGATIONS (FINRA RULE 2111)

Under FINRA Rule 2111, there are three main obligations: ■ Reasonable-basis suitability ■ Customer-specific suitability ■ Quantitative suitability

The reasonable-basis obligation requires a member firm or AP to have a reasonable basis to believe, having applied reasonable diligence, that a recommendation is suitable for at least some investors. What constitutes reasonable diligence varies depending on the complexity and risks associated with the security or investment strategy. It also depends on the member’s or AP’s familiarity with the security or investment strategy. Reasonable diligence must lead to recognizing the potential risks and rewards associated with the recommended security or strat-egy by the AP and member. Inability to distinguish and explain the risks when recommending a security or strategy violates the suitability rule.

The customer-specific obligation requires a member or AP to have a reasonable basis to believe that the recommendation is suitable for a particular customer based on that customer’s investment profile. For example, an elderly person who previously may have had a remarkable degree of sophistication but now shows signs of diminished capacity, would require the greatest supervisory care if a representative should offer for consideration a fixed-income product, such as a reverse convertible note or bond. As a principal, you would demand an explanation as to why this security is right for this particular customer.

Quantitative suitability requires a member or AP who has control over a customer account to have a reasonable basis for believing that a series of recommended transactions, even if suit-able when viewed in isolation, are not excessive and unsuitable for the customer when taken together. No single test defines excessive activity; however, factors such as the turnover rate, the cost-equity ratio, and the use of in-and-out trading in a customer’s account may provide a basis for a finding that a member or AP has violated the quantitative suitability obligation.

3. 1. 11 SUITABILITY INFORMATION

The registered representative must attempt to collect suitability information, which is the information necessary to be able to make suitable recommendations for a customer. Inquiry should be made as to the customer’s income, net worth (excluding value of a primary resi-dence), tax status, number of dependents, investment objectives, risk tolerance, time horizon, and other holdings. Should the customer fail to provide this information, the account still may be opened but no recommendations can be made.

The only signature required on the form is that of the principal accepting (approving) the account.

!T E S T T O P I C A L E R TThere is no requirement for the customer’s signature. However, do not let indus-

try practice get in the way of answering a signature question correctly. Most members include a W-9 and a predispute arbitration agreement as part of the new account opening package, both of which require a customer’s signature. These documents are separate from the new account form itself. Non-US citizens must sign form W-8.



3. 1. 12 UNIQUE SUITABILITY ISSUES

All recommendations to customers must be suitable based on investment objectives, risk tolerance, and related information. There are situations, however, that require separate disclo-sure, a written suitability determination, or both.

If a member firm or its associates recommends a security through a social media site, such as Facebook or MySpace, it triggers FINRA Rule 2111 regarding suitability.

Whether a particular post on a website is a recommendation for a security will depend on the facts and circumstances. The Series 24 examination tests candidates’ ability to make judg-ment calls on limited facts and circumstances.

Here are a few examples. A web-based communication that would fall outside the definition of a recommendation would be if a member firm created a website available to customers that have an electronic library containing research reports, which may include buy-sell recommenda-tions as well as news, quotes, and charts that customers may request. The facts indicate this is not a recommendation, and suitability rules are not triggered.

An example of communication that falls within the definition of a recommendation under the rule would be a member that sends a targeted email or pop-up screen to a customer or tar-geted group of customers encouraging them to buy a security.

Another example of a recommendation would include a member that sends its customers an email stating that they should invest in stocks from a particular industry sector and urges custom-ers to buy stocks from a list.

As you can see, it can be a challenge to identify when a recommendation is made triggering suitability concerns. Compliance officers must consider many factors when developing proce-dures and best practices for the member firm’s WSPs in supervising the use of social media sites that recommend specific investment products.

As a best practice, compliance officers might consider prohibiting all interactive electronic communications that recommend a specific investment product and any link to a recommenda-tion unless a thoroughly trained and qualified registered principal has granted prior approval of the content. In addition, some member firms maintain libraries of previously approved commu-nications to which their representatives have regular access. Compliance officers might consider prohibiting communications that recommend specific investments unless the communication matches a preapproved template and the recommendation has been approved by a registered principal.



✓T A K E N O T EIn making suitable recommendations, customers must be armed with all material

facts. For example, a broker-dealer must disclose whether it owned, at the close of the previous month, 1% or more of any class of the subject issuer’s equity securities. Firms must also explain their rating systems and disclose whether analyst compensation is tied to the firm’s investment banking revenues, the analyst or household members have any financial interest in the subject company, the firm has received fees for investment bank-ing services or has managed or co-managed a public offering for the subject issuer within the past 12 months, and the firm either expects to receive or intends to seek any invest-ment banking fees from the subject issuer in the three months following publication.

3. 1. 13 REGULATION S-P

Regulation S-P, mandated by the Gramm-Leach-Bliley Act, requires that firms take iden-tity theft seriously and have adequate safeguards in the form of privacy policies to protect nonpublic personal information from unauthorized access or use. Member firms must provide an initial privacy notice to new customers when an account is opened and must provide an annual privacy notice to all customers. Regulation S-P permits firms to disclose nonpublic per-sonal information to unaffiliated third parties unless the customer has elected to opt out of the disclosure. Examples of nonpublic personal information include a customer’s Social Security number, account balances, transaction history, the fact that the individual was at one time a customer, and any information collected through a consumer reporting agency or an internet cookie.

✓T A K E N O T EAn Internet cookie is created with the view to allow the member firm to collect

information about the customer and is an example that illustrates one of the many ways that any financial institution may obtain information about a consumer in con-nection with providing a financial product or service to that specific consumer. If the information is not specific, it is known as “blind data” or aggregate information that contains no personal identifiers. It is not deemed to be personally identifiable informa-tion and, therefore, not subject to Regulation S-P requirements.

Regulation S-P distinguishes between a consumer and a customer. A consumer is an indi-vidual who obtains a financial product or service from a firm and has no further contact with the firm. A customer is an individual who has an ongoing relationship with a firm. Consumers are given an initial privacy notice only, while customers must be given both an initial and annual privacy notice.

Regulation S-P also requires members to adopt policies and procedures that provide ade-quate safeguards of confidential customer information and records. Not a month goes by with-out a headline of a major break in security at a large company. Technological advancements, such as Wireless Fidelity (Wi-Fi), present many confidentiality issues for firms. Among the many security concerns is that data are broadcast out into the airwaves, making intercep-tion easier. Wireless connections present an attractive mechanism for hackers to tap into the user’s workstation to gain access to the corporate network. Before permitting brokers to access customer information remotely, members must implement and update appropriate measures to secure customer information. These measures may need to go far beyond a firewall and off-the-shelf defensive software to stay ahead of criminals who want to access your systems.



✓T A K E N O T EReasonable opt-out methods available to members include providing a reply form

with the opt-out notice, an electronic means to opt out if the customer has agreed to the electronic delivery of information, and a toll-free number that customers may call. The SEC has stated that members are not providing a reasonable means to opt out if the only method to do so is by writing a letter to the member.

3. 1. 14 REGULATION S-AM LIMITATIONS ON AFFILIATE MARKETING

Regulation S-AM is the sister to Regulation S-P and states that a broker-dealer is prohib-ited from using eligibility information received, such as information regarding the consumer’s transactions from an affiliate company, to make a marketing solicitation to a prospective cus-tomer unless:

■ the potential marketing use of that information has been clearly, conspicuously, and con-cisely disclosed to the consumer;

■ the consumer has been provided a reasonable opportunity and a simple method to opt out of receiving the marketing solicitations; and

■ the consumer has not opted out.

This regulation also applies to investment companies, investment advisers, and transfer agents registered with the Commission.

3. 1. 15 FAIR AND ACCURATE CREDIT TRANSACTIONS ACT OF 2003 (FACT ACT)

The Fair and Accurate Credit Transactions Act of 2003 (FACT Act) requires that each financial institution or creditor develop and implement a written program to detect, prevent, and mitigate identity theft in connection with the opening of certain accounts or the mainte-nance of certain existing accounts (referred to as the Red Flags Rule). In addition, it requires that card issuers assess the validity of change-of-address notifications and that each user of consumer reports develop reasonable policies and procedures to respond to the receipt of a consumer reporting agency’s notice of a consumer address discrepancy.

3. 1. 16 CUSTOMER ACCOUNT STATEMENTS

Members are required to send statements to customers at least quarterly. If there is activity in the account in any given month, a statement must be sent that month. Activity is defined as purchases, sales, interest or dividends received, or any funds flowing in or out of the account.

The SEC has a related rule regarding notification of free credit balances (cash balances) in customer accounts. Free credit balances are a rarity, as most firms provide automatic sweep into a money market fund or bank sweep program of any cash balances in customer accounts awaiting reinvestment. However, the SEC requires that customers be notified of any free credit balance in their accounts at least quarterly or whenever a statement is sent. This notification



must state that free credit balances are not segregated by the member firm, that they may be used by the member in the conduct of its business, and that they are available to the customer on demand.

In addition, each general securities member must include in the account statement an advisory that the customer should promptly report any inaccuracy or discrepancy in that per-son’s account to his brokerage firm. In cases where the customer’s account is serviced by both an introducing and a clearing firm, each general securities member must include in the advi-sory a reference that such reports should be made to both firms.

✓T A K E N O T EIf the sweep account provided by a member firm is a money market fund for

the investment or reinvestment of free-credit balances, the fund must be a no-load, open-end management investment company registered under the Investment Com-pany Act of 1940. If customers are provided with a bank sweep program, the method for determining interest rate the customer may expect must be disclosed along with any other protections and benefits such as FDIC coverage.

Nevertheless, the SEC (under Rule 15c3-2) requires that customers be notified of any free credit balance in their accounts at least quarterly or whenever a statement is sent. This notification must state that:

■ these balances are not segregated by the member firm; ■ they may be used by the member in the conduct of its business; and ■ they are available to the customer on demand.

Customer account statements must include a statement advising customers to promptly report any discrepancy or inaccuracy to her brokerage firm and clearing firm.

!T E S T T O P I C A L E R TFree credit balance notification is required monthly in active accounts and quar-

terly in inactive accounts. If a question regarding the frequency of written statements to customers does not make the distinction between active and inactive, the answer is quarterly.

In January of each year, members must send statements to customers showing a summary of all interest and dividends credited to the account as well as the gross proceeds of all sales made the prior year. The statement is sent to the account owner and to the IRS on Form 1099.

Joint Accounts. With respect to joint accounts, the statement is sent to the person whose Social Security number is on the account. While the member collects information on all parties in a joint account, each account has a primary Social Security number.



3. 1. 17 OFFER OF RESCISSION

If, on reviewing an order ticket, a principal discovers that a registered representative solic-ited a clearly unsuitable trade for a customer, one option available to the member is to offer to rescind the trade. Under state law, an offer of rescission must be in writing and include an agreement to:

■ buy back the securities for the original consideration paid; and ■ pay interest to the customer based on cost from date of purchase to date of repurchase.

Offers of rescission must be accepted or rejected by the customer within 30 days of receipt.

✓T A K E N O T EThe Uniform Securities Act (USA) has jurisdiction over securities transactions at

the state level. State securities laws are referred to as blue-sky laws.

3. 1. 18 FORWARDING OF PROXY MATERIALS

Member firms must cooperate with issuers by ensuring that customers whose stock is held in street name are alerted to all financial matters concerning issuers (e.g., quarterly reports, proxy statements). To do so, members act as forwarding agents for all proxies and other corpo-rate materials received from an issuer for street name stock.

Member firms that are owners of record must vote street name stock in accordance with the wishes of the beneficial owners. If a customer signs and returns a proxy statement and fails to indicate how the shares are to be voted, the member must vote the shares as recommended by management.

If a customer does not return the proxy by the 10th day before the annual shareholders meeting, the member may vote the shares as it sees fit as long as the matters to be voted on are of minor importance. If the matters to be voted on are of major importance (e.g., merger, issuance of additional securities), the member may never vote the shares as it sees fit. In this case, if the proxy is not returned, the shares are not voted.

Member firms are reimbursed by issuers for all costs relating to the forwarding of proxy materials. Such costs include postage and related clerical expenses.

3. 1. 19 FAIR PRICES AND COMMISSIONS (FINRA RULE 2121)

Rule 2121, also known as the 5% policy, was adopted to ensure that the investing public receives fair treatment and is charged reasonable rates for brokerage services. It is considered a guideline only and not a firm rule.

This policy applies to non-exempt securities in both the OTC and the exchange markets. It does not apply to exempt securities, such as municipal bonds. It also does not apply to pro-spectus offerings. If a member is required to give a customer a prospectus in any transaction, that transaction is outside the scope of the 5% policy (e.g., new issues, mutual funds, variable annuities, and direct participation programs).

When a dealer sells a security to a customer, the price paid by the customer included the dealer’s mark-up. When the dealer buys a stock or bond from a customer, the dealer marks down the security, which reduces the money that the customer receives. The amount of the mark-up and mark-down is calculated from the prevailing market price of the security. It is



incumbent upon the dealer to charge an amount that is fair and reasonable. The price must be reasonably related to the current market price of the security. Charging excessive mark-ups and not disclosing this to the customer is deemed fraudulent and is a violation of Securities Exchange Act of 1934.

There is an exemption from this rule. Namely, if the customer is a Qualified Institutional Buyer (QIB) who can independently evaluate risks, and the security is non-investment grade, the broker-dealer may make transactions that are exempt from FINRA Rule 2121.

!T E S T T O P I C A L E R TThe 5% policy applies to both agency and principal transactions. It applies to

markups, markdowns, and commissions but not to securities sold by prospectus.

In assessing the fairness of a member’s commission and markup practices, FINRA consid-ers the following factors.

■ Type of security. In general, there is more market risk associated with making markets and trading in common stocks than in bonds (assuming the bonds are nonconvertible). The more risk a member must assume, the greater the justification for higher markups.

■ Availability. An inactively traded stock would command a higher markup than an actively traded stock.

■ Price. The percentage markup should decrease as the selling price of a stock increases. ■ Dollar amount. The greater the dollar amount, the lower the percentage markup. ■ Pattern of markups. Although FINRA is concerned primarily with detecting cases where

a member has established a pattern of excessive markups, a single incident would still be considered an unfair markup.

■ Disclosure. In unique situations involving unusual securities or special transactions where there is little or no precedent for determining the fairness of a commission or markup, FINRA will look favorably on a member that discloses its fee in advance of the transac-tion. However, this does not relieve the member of the obligation to keep such fees rea-sonable and fair.

Markups and markdowns are computed from the prevailing market price at time of sale. This price is a function of the market environment in which the security trades.

FINRA has identified three types of market environments in which market makers operate: ■ Active, competitive markets ■ Inactive, competitive markets ■ Dominated and controlled markets

In an active, competitive market, the prevailing market price is the inside market at time of sale.



*E X A M P L E There are four market makers in XYZZ as follows:

XYZZ

Bid Ask

Market Maker 1 31.10 31.30




If Market Maker 2 were to sell 100 shares of XYZZ to a customer at 31.80 net, the amount of the markup would be $.50, computed from the inside offer of 31.30. The percentage markup would be 1.6% (.50 ÷ 31.30).

If Market Maker 3 bought 100 shares of XYZZ from a customer at 30.70 net, the amount of the markdown would be $.55, computed from the inside bid of 31.25. The percentage markdown would be 1.7% (.55 ÷ 31.25).

In an inactive, competitive market, a market maker must use its contemporaneous (recent) purchases from other dealers as the prevailing market price for markdowns and its contempo-raneous sales to other dealers as the prevailing market price for markups. Because there is relatively little trading activity, the inside market is not a reliable guide. In dominated and controlled markets, market makers must use actual cost, not quotations, as the prevailing mar-ket price for markups and markdowns.

Some other points to remember regarding pricing are as follows. ■ In the absence of other bona fide evidence, a member’s own contemporaneous cost (price

at which the firm last bought as principal) is the best indication of the prevailing market price.

■ When a nonmarket maker sells to a customer in a riskless principal trade, markup is com-puted from the member’s cost.

Summary Chart of Prevailing Market Price

Market Markups Markdowns

Active competitive Lowest asked price Highest bid price

Inactive competitive Contemporaneous sales to other dealers

Contemporaneous purchases from other dealers

Dominated/controlled Cost Cost

Proceeds Transaction. The 5% policy also is applicable to a proceeds transaction. A proceeds transaction is one in which a customer enters an order to sell and instructs the registered representative to use the proceeds to make a purchase (i.e., sell this and use the proceeds to buy that). FINRA views a proceeds transaction as a single trade for markup/commission purposes.

To compute percentage markup in a proceeds transaction, a member must: ■ determine the compensation earned on the sell side; ■ determine the compensation earned on the buy side; and ■ add the two and apply the total to the inside market on the buy side (the second trade).



*E X A M P L E There are four market makers in ALTT as shown:

ALTT

Bid Ask

Market Maker 1 14.65 15




Market Maker 3 sells 100 shares of ABCD on behalf of a customer, for which it charges a commission of $87.50. The proceeds are used to buy 100 shares of ALTT, which Market Maker 3 sells at 15.35 net. The computation is as follows:

Dollar

Sell side $ 87.50

Buy side $ 35.00

Total $122.50

The markup on the buy side is $.35, which is computed from the inside offer of 15. Applying the total to the inside market on the buy side results in a percentage markup of 8.17%. The computation is $122.50 ÷ $1,500.00.

3. 1. 19. 1 Markups on Debt Securities

Since mark-ups and mark-downs are calculated from the prevailing market price of the security, including fixed-income securities, it is critical to get current transaction information. In the next unit, we will cover TRACE, which serves to provide publically available pricing information of debt securities.

It is not unusual, however, for a dealer in debt securities to purchase the bonds from a third party in order to sell it to a customer. This is the dealer’s contemporaneous cost, which serves as the base point to calculate the mark-up. The contemporaneous cost is deemed to be a highly reliable indication of the prevailing market price. Keep in mind that this rule is not absolute; it is more of a guideline. A dealer may make a trade with the view to sell it with a mark-up, but in the time the dealer is in possession of the bond, news of a credit rating change could substantially alter the prevailing market price.

Since a firm’s markup or markdown on a corporate debt security with a customer is cal-culated from the prevailing market price of that security and absent other information to the contrary, the prevailing market price is the firm’s contemporaneous cost or the firm’s contem-poraneous proceeds.

A firm may seek to overcome the presumption that its contemporaneous cost (proceeds) is indicative of the prevailing market price if any one of the following events have occurred.

■ Interest rates changed after the contemporaneous transaction to a degree that the pricing of the bond has changed.

■ The credit quality of the bond changed significantly after the contemporaneous transac-tion.

■ News was issued that had an effect on the pricing of the bond.



If none of these factors results in providing a prevailing market price, a firm may then consider the pricing information from similar securities.

A similar debt security is one that has a comparable maturity, call features, credit rating, yield, and public float.

✓T A K E N O T EThese markup/markdown rules do not apply to municipal securities.

3. 1. 20 FAIR DEALING

While sales efforts must be judged by the uniqueness of each member-customer relation-ship, certain actions on the part of registered representatives are not considered fair dealing and may result in disciplinary action by FINRA. A principal, in reviewing trade blotters and customer account activity, should question any of the following.

■ Blanket recommendations of low-priced securities. It is highly unlikely that speculative securities will be suitable for all persons solicited. A supervisor who notices on the blotter that a representative has sold the same stock to a wide variety of different investors would be expected to inquire as to why this is happening and document the inquiry. It may be nothing. On the other hand, it may just be a blanket recommendation that would require corrective action. Failing to notice this fair dealing infraction could lead to disciplinary action taken against not only the representative but the manager for failing to supervise.

■ Excessive trading activity. Called churning, excessive trading is difficult to quantify. It must be judged based on the objectives, risk tolerance, and history of the account. Mak-ing a profit does not mitigate the offense; the fact that an account generates a profit as the result of excessive trading is not a valid defense in an arbitration hearing.

■ Trading in mutual fund shares. By definition, mutual funds are longer-term investment vehicles, and short-term trading raises questions of churning and suitability.

■ Recommending purchases beyond the customer’s ability to pay. Frequent sellouts or trade cancellations can indicate potential problems.

Other prohibited activities include the following: ■ Setting up fictitious accounts to execute trades otherwise prohibited ■ Entering orders that are unauthorized by customers or sending confirmations to cause cus-

tomers to accept trades to which they have not agreed ■ Trading on a discretionary basis without written authorization ■ Unauthorized use of customer funds or securities ■ Circulating rumors; spreading false or misleading information that would improperly influ-

ence a security’s market price ■ Piggybacking (e.g., a broker effecting for an account a transaction that is essentially the

same as effected by a customer on the belief that the customer acted on inside informa-tion)



*C A S E S T U D Y FINRA alleged that from August 2009 through November 2010, Aker Surrey, LLC failed to establish and maintain a supervisory system and enforce written supervisory procedures reasonably designed to identify and prevent unsuitable excessive trading and churning in customer accounts. Specifically, FINRA found that the member firm relied entirely on a single exception report with inadequate parameters to identify active accounts with patterns of unsuitable and excessive trading. FINRA alleged that Aker Surrey had access to its clearing firm’s additional exception reports but that it failed to use those reports. Consequently, FINRA concluded that Aker Surrey failed to identify at least 49 accounts where 40 of the instances came from a single office. The firm provided no guidance on thresholds regarding transaction- or commission-based restrictions that should be placed on accounts with significant turnover ratios.

3. 1. 21 BREAKPOINT “SALES” ■ Breakpoints are quantity discounts: the greater the dollar amount of a purchase, the lower

the sales charge. ■ Breakpoint sales, on the other hand, is jargon in the securities industry that means sales just

below the breakpoint in an effort by representatives to share in the higher sales charges applicable on sales below the breakpoint. This is inconsistent with just and equitable principles of trade.

*E X A M P L E The member must advise the customer that, for a few dollars more, the customer could qualify for a lower sales charge.

■ FINRA does not define near a breakpoint. Therefore, members must make certain that cus-tomers are advised of a fund’s breakpoint schedule. The rule is in place because members, and indirectly, registered representatives, could earn more concession dollars on a smaller customer investment (with a higher sales charge) than on a larger customer investment (with a smaller sales charge).

Group purchases of shares, such as those made by investment clubs or by multiple clients (omnibus account) of an investment adviser, do not qualify for breakpoints. Each client will pay a sales charge based on that client’s purchase amount.

3. 1. 22 NET TRANSACTIONS WITH CUSTOMERS (FINRA RULE 2124)

Member firms are required to disclose and obtain consent from a customer prior to execut-ing a transaction with the customer on a net basis.

A net transaction is a principal transaction in which a market maker, after having received an order to buy an equity security, purchases the equity security at one price (from another broker-dealer or another customer) and then sells to the customer at a different price.

For noninstitutional customers, a member must obtain the customer’s written consent on an order-by-order basis, and such consent must evidence the customer’s understanding of the terms and conditions of the transaction.



For institutional customers (as defined earlier in this Unit), a member may obtain consent on an order-by-order basis, using one of three methods.

Written consent on an order-by-order basis prior to executing a transaction for or with the customer on a net basis. The consent must evidence the customer’s understanding of the terms and conditions of the order.

A negative consent letter that clearly discloses the terms and conditions for handling the customer order(s) and provides a meaningful opportunity to object to the execution of transactions on a net basis. If the customer does not object, then the member may reasonably conclude that it has consented to the member trading on a “net” basis with the institutional customer. The member may then rely on the letter for all or a portion of the customer’s orders (as instructed by the customer).

Oral disclosure and consent also is available on an order-by-order basis. Oral disclosure and consent must, as previously stated, clearly explain the terms and conditions for handling the customer order and provide the institutional customer with a meaningful opportunity to object to the execution of the transaction on a net basis. The member also must log each order-by-order disclosure.

3. 2 ANTI-MONEY LAUNDERING REGULATION (FINRA RULE 3310)

Money laundering is a serious crime that involves an effort to conceal the source of ille-gally obtained funds from activities such as trafficking in narcotics and fraud, and attempt-ing to make those funds appear legitimate. Brokerage accounts have been used to this end and continue to be viewed by racketeers, terrorists, and other criminals to launder money. Principals must be diligent in identifying and reporting any attempts by criminals to use bro-kerage accounts for illicit activities. Therefore, among other things, the Bank Secrecy Act (BSA) and FINRA Rule 3310 require all member firms to identify money laundering risks by developing, implementing, and monitoring an effective anti-money laundering (AML) program designed to achieve, not only compliance with the BSA and related regulations, but thwarting the aims of criminals and terrorists.

The firm’s AML program must be approved in writing by a member of senior management as well as any subsequent change to the program. If the approving senior manager leaves the member firm, the AML program should be re-approved by the new manager. Specifically, the rules would require member firms to:

■ establish and implement policies and procedures that can be reasonably expected to detect and cause the reporting of transactions that raise suspicion and by identifying red flags that signal money laundering;

■ establish and implement policies, procedures, and internal controls reasonably designed to achieve compliance with the Bank Secrecy;

■ designate to FINRA an individual or individuals responsible for implementing and moni-toring the day-to-day operations and internal controls of the program and escalating suspi-cious activity to appropriate compliance officials;

■ provide ongoing training for appropriate personnel; and ■ provide for annual independent testing for compliance by someone qualified to perform

the test. If a member firm engages solely in proprietary trading or conducts business only with other broker-dealers, an independent test is required only every two years on a calen-dar-year basis. There is no standard language or template for the AML independent test.



As we read in an earlier unit, firms are required to designate and identify to FINRA, through the FINRA Contact System (FCS), the compliance officer charged with oversight of the firm’s anti-money laundering program. The firm must provide name, title, mailing address, email address, telephone number, and facsimile number of this contact. If there is a change in the designation, the firm must provide notification to FINRA within 30 days and then verify the name(s) within 17 business days after the end of each calendar year.

✓T A K E N O T EFINRA Rule 3310 requires that a member of the firm’s senior management ap-

prove the firm’s anti-money laundering program and that the program be reviewed at least annually by an independent examiner who is knowledgeable in the Bank Secrecy Act and its associated regulations. Independent means that testing may not be con-ducted by either a person who performs the functions being tested or the designated anti-money laundering compliance person. Furthermore, it may not be conducted by someone who reports to either of those people.

There is an exception to the requirement that firms conduct an independent test of its AML compliance program annually. The exception applies to firms that do not execute trans-actions for customers or otherwise carry customer accounts and do not act as an introducing broker. These firms may test once every two years. Examples of firms that may test every two years are firms engaged solely in merger and acquisition work, firms engaged solely in selling DPPs, and firms engaged solely in private placements.

3. 2. 1 CURRENCY RECEIPT

Brokerage firms do not often accept cash; nevertheless, the Bank Secrecy Act requires broker-dealers to report, on Form 112, any currency received in the amount of more than $10,000 on a single day. Though paying for purchased securities with currency is not prohib-ited, many firms do not permit this. Failure to report can result in fines of up to $500,000, 10 years in prison, or both. Records relating to Form 112 must be retained for five years.

Form 112 must be filed within 15 days of receipt of the currency. This rule is part of the regulatory effort to address money laundering. The two federal agencies empowered to handle this abuse are the Federal Reserve and the Department of the Treasury. CTR Form 112 must be submitted electronically, hosted on a secure website. Keep in mind that legitimate funds also may be used to fund criminal activities, such as terrorism. Currency receipts are but one tool to help identify “reverse” laundering, which is funding crime with legitimate funds. AML laws and rules are written with the view to impede money laundering as well as the financing of terrorism.

✓T A K E N O T EAlthough broker-dealers do not often accept cash deposits, illegal activity, such

as insider trading or stock manipulation, may generate illicit funds. If unchecked and those funds are moved out of the brokerage account, the money has been laundered.



Sample CTR Page—Form 112



3. 2. 2 SUSPICIOUS ACTIVITY REPORTS

The USA PATRIOT Act requires firms to report to Financial Crimes Enforcement Network (FinCEN) when there is an event, transaction, or series of events or transactions that appear to be questionable. The act requires firms, through their supervisory user, to file a suspicious activity report (SAR) to FinCEN any transaction that alone or in the aggregate involves at least $5,000 in funds or other assets if the firm suspects that it falls within one of the following four classes:

■ The transaction involves funds derived from illegal activity ■ The transaction is designed to evade the requirements of the Bank Secrecy Act ■ The transaction appears to serve no business or lawful purpose ■ The transaction involves the use of the firm to facilitate criminal activity

*E X A M P L E A pattern of cash deposits over time, none of which individually would require a CTR filing, could trigger a suspicious activity report (SAR) filing.

✓T A K E N O T EStructuring refers to handling currency transactions in a way designed to avoid

reporting requirements.

Firms must file a SAR within 30 days of becoming aware of the suspicious transaction(s). Copies of each SAR filing and the related documentation must be retained for five years from the date of the filing.

The act also requires that the filing of a SAR remain confidential. The person involved in the transaction that is the subject of the report must not be notified. If subpoenaed, the firm must refuse to provide the information and must notify FinCEN of the request unless the dis-closure is required by FinCEN, the SEC, an SRO, or other law enforcement authority.

In addition, the USA PATRIOT Act requires firms to make and retain records relating to wire transfers of $3,000 or more. Information to be collected includes the name and address of sender and recipient, the amount of the transfer, the name of the recipient’s financial institu-tion, and the account number of the recipient.

Similar to the CTR, Form 111 must be submitted electronically through the BSA E-Filing System.



Sample SAR—The party must not be notified

3. 2. 3 STAGES OF MONEY LAUNDERING

Placement, layering, and integration are terms used to describe the three stages through which dirty money is laundered. In the placement stage, currency enters the financial sys-tem. When illicit monies are deposited at a financial institution, placement has occurred. To conceal their activities, money launderers must either violate the reporting requirements of the Bank Secrecy Act and the USA PATRIOT Act, or circumvent the traditional financial system entirely (e.g., the purchase of money orders from money service bureaus).



Layering describes an activity intended to obscure the trail left by the dirty money. During the layering stage, a launderer may conduct a series of transactions to build layers between the funds and their illicit source. For example, a series of wire transfers would constitute layering.

During the final stage of the laundering process, illicit funds are integrated with monies from legitimate sources as they enter the mainstream economy.

3. 2. 4 RED FLAGS

There are particular signs of suspicious activity that may suggest money laundering. If a red flag is detected, additional diligence is required. Examples of red flags include the following.

■ A customer engages in transactions that lack business sense or apparent investment strat-egy or are inconsistent with the customer’s goals.

■ A customer attempts to make frequent or large deposits of currency, insists on dealing only in cash equivalents, or asks for an exemption from the firm’s policies relating to the deposit of cash or cash equivalents.

■ For no apparent reason, a customer has multiple accounts under a single name or multiple names, with a large number of interaccount or third-party transfers.

■ A customer has a large number of wire transfers to unrelated third parties inconsistent with the customer’s business.

■ A customer exhibits a lack of concern regarding risks, commissions, or other transaction costs.

3. 2. 5 SECTION 314(A) REQUEST

About twice a month, FinCEN will email broker-dealers, banks, and other financial insti-tutions notifying a User Supervisor of FinCEN’s Secure Information Sharing System at the broker-dealer that there is a list of available people and businesses subject to a high level of scrutiny by a law enforcement case agent. Those authorized by the firm are then to immedi-ately compare FinCEN’s lists with the firm’s list of customers to see if there is a match. If there is a match to a named subject, you must respond to the 314(a) request within 14 calendar days.

3. 3 DEALING WITH NONMEMBERS & CONTINUING COMMISSIONS

3. 3. 1 DEALINGS WITH NONMEMBERS

Member firms can only grant concessions, discounts, and other allowances to fellow mem-bers. Nonmember firms, including suspended members, always buy at the public price, never at a discount. In general, nonmember firms are treated the same as the general public. However, there is an exception: foreign nonmember firms, which, for whatever reason, are ineligible for membership, may be granted concessions, discounts, or other allowances provided they agree to abide by FINRA’s Rules.



Similarly, members may not pay a commission to a nonmember for executing an over-the-counter trade in a nonexempt security. Commissions, however, may be paid to nonmembers for executing trades in exempt securities or to nonmembers executing trades on an exchange floor.

Also, member firms, when organizing a group to underwrite nonexempt securities, can only invite other members into the syndicate or selling group. However, when it comes to exempt securities, such as municipal bonds, nonmembers such as banks can be part of the underwriting group.

A suspended member cannot be part of a group underwriting nonexempt securities.

✓T A K E N O T ESuspended members cannot be a part of an underwriting syndicate for nonex-

empt securities, even if the member’s suspension period would end before the effec-tive date of the offering.

3. 3. 2 CONTINUING COMMISSIONS

A registered person who leaves a member firm (e.g., upon retirement) may continue to receive commissions on business placed while employed. There must, however, be a contract to this effect before the representative leaves the firm. Heirs of a deceased representative may receive continuing commissions if this is part of the written agreement.

There is no requirement for members to pay continuing commissions. Continuing com-missions may never be paid on business referred or introduced by an employee after that per-son ceases to be registered with the member.

3. 4 COMMUNICATIONS WITH THE PUBLIC (FINRA RULE 2210)

Communications with the public takes many forms, such as brochures, emails, weblogs, speaking engagements, and written reports. Supervision of communications is no different than any other aspect of operating a broker-dealer building a culture of compliance. Each member must establish, maintain, and enforce WSPs to supervise communications, and since each firm differs and may have procedures that are more restrictive than FINRA’s require-ments, supervisors must make certain all APs know and follow the firm’s guidelines.

In keeping with FINRA Rule 2210, there are three principal categories of communications: ■ Retail communications ■ Correspondence ■ Institutional communications

“Retail communication” means any written (including electronic) communication that is distributed or made available to more than 25 retail investors within any 30 calendar-day period. A retail investor is any person other than an institutional investor, regardless of whether the person has an account with the member.

“Correspondence” means any written (including electronic) communication that is dis-tributed or made available to 25 or fewer retail investors within any 30 calendar-day period.



“Institutional communication” means any written (including electronic) communication that is distributed or made available only to institutional investors, but does not include a member’s internal communications (e.g., internal memos).

Examples of institutional investors include the following: ■ Another member firm or registered representative ■ Bank ■ Savings and loan (S&L) ■ Insurance company ■ Registered investment company (mutual fund) ■ Employee benefit plan with at least 100 participants ■ Governmental entity or subdivision ■ Person acting solely on behalf of an institutional investor ■ Any entity with $50 million or more of total assets

FINRA mandates that no member may treat a communication as having been distributed to an institutional investor if the member firm has reason to believe that the communication or any part of it will be forwarded or made available to any retail investor.

✓T A K E N O T EIf an entity does not fall under any of the designated categories for an institu-

tional investor, they must be considered and treated as a retail investor. That is true whether or not the person has an account with the member firm.

3. 4. 1 WRITTEN PROCEDURES, EDUCATION, AND TRAINING

Prior principal review is not required for correspondence. Member firms that do not review correspondence in advance must have written procedures in place providing for the educa-tion and training of their representatives as to FINRA rules on public communications and document this training in writing. Firms must have procedures in place for a postdistribution review of at least some of each representative’s correspondence to ensure adherence to FINRA rules. Principals must be prepared to evidence to FINRA and SEC examiners during their routine review of a member firm that there are procedures in place and those procedures are being followed. A firm’s inability to provide such evidence could lead to sanctions for failing to supervise.

With regard to incoming correspondence, firms can elect to do a predistribution review or a postdistribution review. If a firm elects the latter, it must take steps to ensure that proper pro-cedures are followed if any incoming mail contains either a customer complaint or customer funds or securities.

When developing firm procedures, it would be wise to keep in mind that all communica-tion must be based on principles of fair dealing and good faith. That means an omission of any material fact within the context of a presentation that could be judged misleading. An omis-sion could be deemed to occur even if the information is in the presentation but placed (“hid-den”) in a footnote, which could hinder investors’ understanding depending on the nature of the audience. Members and their APs must know their audience and provide communication that is appropriate. A large, public audience of elderly investors would be handled quite differ-ently from a closed audience of known registered investment advisers.



Communications with the public may not predict performance or imply that an excellent past performance will likely be repeated. In other words, no exaggerated claims or forecasts. That said, the rules do not preclude the use of legitimate, known, and accepted mathematical principals and analysis tools.

A few additional content standards for retail communications and correspondence include prominently using the name of the firm and clearly indicating that the services and products discussed are offered through the member firm.

If a reference is used, such as tax-free, the communication must point to which income taxes apply (state, local, federal) unless free from all taxes. It is a violation to say tax-free with regard to an investment if it is in fact only tax deferred.

When communication involves the performance of mutual funds and/or ETFs, the maxi-mum expense ratio must be included.

Overall, any recommendations made to investors must be reasonable and must disclose conflicts of interest. If the firm is a market maker in the recommended security or managed a public offering of the recommended issuer in the last 12 months, that must be disclosed. If the representative making the recommendation has an interest in the issuer, that too must be disclosed.

!T E S T T O P I C A L E R TPrior principal approval is not required for incoming or outgoing customer corre-

spondence. If a firm does not review correspondence before distribution, it must have procedures in place to perform a postdistribution review. A file of all correspondence must be retained for three years.

3. 4. 2 INSTITUTIONAL COMMUNICATIONS

Individual participants of employee benefit plans and qualified plans are not considered institutional investors. If a member has reason to believe that a communication or excerpt of the communication intended for institutional investors will be forwarded to or made avail-able to a person who is not an institutional investor, the communication must be treated as retail communications until the member reasonably concludes that the improper practice has ceased. This distinction is important, because any account that isn’t an institutional account is a retail account and requires more rigorous review.

Each member firm is expected to establish written procedures that are appropriate to its business, size, structure, and customers for the review of institutional communications used by the member and its APs by a principal.

The firm’s procedures must be reasonably designed to ensure that institutional communi-cations comply with applicable standards. When firm procedures do not require review of all institutional communications prior to first use or distribution, they must include provision for the education and training of APs as to the firm’s procedures governing institutional commu-nications, documentation of such education and training, and surveillance and follow-up to ensure that such procedures are implemented and adhered to.

Evidence that these supervisory procedures have been implemented and carried out must be maintained and made available on request by FINRA examiners.



3. 4. 3 RETAIL COMMUNICATIONS

As previously stated, retail communication is defined as “any written (including elec-tronic) communication that is distributed or made available to more than 25 retail investors within any 30-calendar-day period.” Communication that would ordinarily be thought of as advertising falls under this definition.

What is a retail investor? It’s any person—other than an institutional investor—regardless of whether the person has an account with the firm.

An appropriately qualified registered principal of the member must approve each retail communication before the earlier of its use or filing with FINRA’s Advertising Regulation Department.

The requirement to have a principal approve retail communication does not apply if, at the time that a member intends to distribute it,

■ another member has filed it with FINRA’s Advertising Regulation Department and has received a letter from the department stating that it appears to be consistent with appli-cable standards; and

■ the member using it in reliance on the letter has not materially altered it and will use it in a manner that is consistent with the conditions of FINRA’s Advertising Department’s letter.

In addition, the requirement of prior principal approval generally will not apply with regard to any retail communication that is posted on an online interactive electronic forum, and any retail communication that does not make any financial or investment recommenda-tion or otherwise promote a product or service of the member.

FINRA also may grant an exception from the approval rule for good cause.

!T E S T T O P I C A L E R TNote that the term “retail investor” refers to any customer, existing or prospec-

tive, that does not fit into the definition of institutional client. With the exception of individuals who have total assets of at least $50 million, all individual investors are considered retail customers.

Retail communications and correspondence must prominently disclose the name of the member and the name of the firm as disclosed on Form BD. The firm also may include a fictional name by which it is commonly known. To comply with all recordkeeping require-ments, communications should be retained for at least three years in a format and media that complies with regulations, and for the first two years be in a readily accessible location. The file must include the name of the principal who approved the communication and the date approval was given.

3. 4. 4 FILING REQUIREMENTS

Certain retail communication relating to investment companies (that includes mutual funds, variable contracts, UITs), direct participation programs (such as limited partnerships), and collateralized mortgage obligations (CMOs) must be filed with FINRA within 10 days of first use (postfiling).

Collateralized mortgage obligations are multi-class debt instruments backed by a pool of mortgages, such as Ginnie Maes. FINRA Rule 2216 states that before a member can sell a



CMO to a retail customer (anyone other than an institutional investor), the firm must offer the customer educational material that includes information and a discussion on the:

■ characteristics and risks of CMOs, including prepayment rates and average lives; interest rates, including their effect on value and prepayment rates; tax considerations; transaction costs; and liquidity;

■ structure of CMOs, including the different tranches that are offered and the risks pertain-ing to each;

■ relationship between mortgage loans and mortgage securities; ■ questions an investor should ask before investing; and ■ glossary of terms.

Any retail communication concerning CMOs: ■ may not compare CMOs to any other investment vehicle, including bank CDs; ■ must disclose, if applicable, that a government agency backing applies only to the face

value of the CMO and not to any premium paid; and ■ must disclose that a CMO’s yield and average life will fluctuate depending on the prepay-

ment rate and changes in interest rates.

With regard to retail communication relating to options and security futures, the mem-ber must file copies with FINRA at least 10 days before first use (prefiling). Firms have two methods of filing with FINRA’s Advertising Regulation Department: (1) electronically using a web-based filing system, or (2) in hard copy. The web-based system for filing materials is called Advertising Regulation Electronic Files (AREF).

Options advertising is limited to: ■ a general description of the security being offered and its issuer, the Options Clearing

Corporation; ■ a description of the nature and functions of the options markets; and ■ the name and address of the person at the member firm placing the advertisement from

whom a current OCC Disclosure Booklet may be obtained.

Recommendations, past performance, and projected performance are not permitted in options advertising.

For a period of one year beginning on the date reflected in the Central Registration Depository (CRD®) system as the date that FINRA membership became effective, the member must file with the department at least 10 business days prior to first use any retail com-munication that is published or used in any electronic or other public media. Once that year has elapsed, prefiling is not required except for options, security futures, and certain invest-ment company material.

All retail communication for investment companies that include a ranking or comparison that is generally not published, or is the creation of the investment company or the member, must be filed at least 10 business days before first use. If the ranking or comparison is generally published or is the creation of an independent entity (e.g., Lipper, Morningstar®), the basic filing rules for investment companies apply (within 10 days of first use [postfiling]).

All retail communication for investment companies that contain bond fund volatility rat-ing must be prefiled.

Any form of public communication provided to a member by an investment company is not subject to filing by the member. In this case, it is the investment company’s responsibility to see that a proper filing has been made.



If FINRA believes that a member’s retail communication has departed from acceptable standards, it can mandate prefiling of any communications with the public.

✓T A K E N O T EAll filings with FINRA’s Advertising Regulation Department must include the ac-

tual or anticipated date of first use, the name and title of the principal who approved the retail communication, and the date the approval was given.

3. 4. 4. 1 Exceptions to Filing Requirements

The following types of communications are excluded from filing requirements: ■ Those relating solely to changes in a member’s name, personnel, location, ownership, busi-

ness structure, officers or partners, phone, fax, or teletype numbers, or to mergers involving and/or acquisitions by another member

■ Those identifying only a member’s Nasdaq symbol or the Nasdaq symbol and security in which the member makes a market

■ Those identifying only the member and/or offering a security at a stated price ■ Those for internal distribution only and not distributed to the public ■ Those prepared by mutual fund underwriters and used without material change ■ Retail communications that do not make any financial or investment recommendation or

otherwise promote a product or service of the member including so-called “blind” recruit-ment ads

Also excluded from the filing requirements are prospectuses, preliminary prospectuses, tombstones, offering circulars, and similar documents used in connection with an offering of securities filed with the SEC.



Sample Cover Sheet for Advertising Submission to FINRA

FINRA REF. # ______________________________FILING COVER SHEET ReplicaAdvertising RegulationFINRA9509 Key West Avenue Review Type: � EXPEDITED OR � REGULARRockville, Maryland 20850Phone: (240) 386-4500Fax: (240) 386-4568Please contact department if faxing more than 10 pages DATE: 28 Feb 2013

MEMBER NAME: Bryn Mawr Research CRD #: 13012A

MAILING ADDRESS: 220 Route 30 Wayne, PA 19073

CONTACT PERSON: Adam Andrews PHONE: 610-501-2000 FAX: 610-501-2001* Indicates required fields; omission may delay the material’s review.

Communication Information*Descriptive Title of Communication: (Only ONE communication per filing cover sheet) # of Pages

Preceded or accompanied by a prospectus: � YES � NO

Firm External Reference #: (Optional)

Please provide a cover letter that describes the proposed use of the communication.

*Delivery Methods: (Select ONE Delivery Method)

� Acct Statement related communications (ACCTMSSG) � Articles & 3rd party reprints (AR TICLE) � B/D use & other institutional material (BDUSE) � Brochures, pamphlets and catalogs (BROCHURE) � Audio/Video tapes, CDs & DVDs (DISC/TPE) � Email, IM, SMS or text messages (ELECMSSG) � Fund specific information sheets(s) (FUNDFACT) � Flyers, wrappers, hand delivered items (HANDOUT) � Mailed sales material (MAILING) � Periodic & other performance reports (PERFREPT) � Telemarketing & other phone scripts (PHONE)

� Information released to the press (PRESSREL) � Print ads, posters & signs (PRINTAD) � Radio ads & radio broadcasts (RADIO) � Research reports – equity & debt (RESEARCH) � Seminar related communications (SEMINAR) � Software output, IA Tools, illustrations (SOFTWARE) � Business related stationery (STATIONE) � TV ads & TV broadcasts (TV) � Public Web sites & significant updates (WEBPUBLC) � Password protected Web sites & updates (WEBPASS)

*Rule Definitions: (Select ONE Rule Definition)

� Retail

� Correspondence � Institutional Sales Material

� Public Appearance � Independently Prepared Reprint

*Products: (Select ALL Products applicable to the communication)

� 529 Education Funding Plans � Closed-end Mutual Fund � Discount Brokerage � Fixed Insurance � Hedge Funds � Note Offerings � Private Placements � Stocks

� Corporate Bonds � Collateralized Mortgage obligation � Direct Participation Program � General Business � Municipal Securities � Options � Real Estate Investment Trusts � Unit Investment Trust

� Certificates of Deposit � Day Trading � Exchange Traded Fund � Government Securities � Open-End Mutual Fund � Other � Security Futures � Variable Annuity � Variable Life Insurance

*Information regarding the registered principal who approved the communcation:

*Name: *Title: *CRD ID

*Date of Approval (MM/DD/YY)

*Date of First Use (MM/DD/YY)

Waiting for Review Prior to Use:� YES � NO

Interactive Web Site (Update)

Charles Morgan CCO 91519

04/01/1302/21/13

10

(Actual or Anticipated)



3. 4. 5 PUBLIC APPEARANCE

Public appearance is participation in a seminar, webinar, forum, radio or television inter-view, or other public appearance or public speaking activity.

Each member shall establish written procedures that are appropriate to its business, size, structure, and customers to supervise its associated persons’ public appearances. Such pro-cedures must provide for the education and training of associated persons who make public appearances as to the firm’s procedures, documentation of such education and training, and surveillance and follow-up to ensure that such procedures are implemented and adhered to. Evidence that these supervisory procedures have been implemented and carried out must be maintained and made available to FINRA upon request.

Any scripts, slides, handouts, or other written (including electronic) materials used in connection with public appearances are considered communications for purposes of this rule, and members must comply with all applicable provisions of this rule based on those communi-cations’ audience, content, and use.

If an associated person recommends a security in a public appearance, the associated per-son must have a reasonable basis for the recommendation. The associated person also must disclose any conflicts of interest that may exist, such as having a financial interest in any secu-rity being recommended.

3. 4. 6 INDEPENDENTLY PREPARED REPORTS

An independently prepared reprint is any article reprint prepared by an independent publisher and not materially altered by the member firm (other than to correct factual errors). An independent publisher is one who is not an affiliate of the member firm or is not an underwriter of any security mentioned in the reprint. Independently prepared reprints require preuse approval by a principal to ensure accuracy of the reprint but are not subject to any filing requirements with FINRA.

✓T A K E N O T EAn article may be used as an independent reprint if the publisher is not affiliated

with the issuer or the member firm in any way. The member firm may alter the con-tents of an independently prepared reprint only to correct factual errors or to make the article consistent with regulatory standards.

3. 4. 7 INSTANT MESSAGING (IM)

Instant messaging is an electronic form of communication with the public that can fit into either of two categories, depending on how it is used. If falling within the numerical limits previously described, it can be considered correspondence. If not, it will be retail communica-tion. The difference is that correspondence does not require prior principal approval, while retail communication does. FINRA requires that if firms permit IM, they must use a platform that enables members to monitor, archive, and retrieve message traffic. Copies of message traf-fic must be kept for three years.



!T E S T T O P I C A L E R TThe use of FINRA on a business card or letterhead must be in a smaller type size

than that used in the member’s name.

3. 4. 8 SPECIFIC STANDARDS

In addition to general standards that require good taste and truthfulness, FINRA has spe-cific standards applicable to communications with the public. It is unprofessional to claim opinions, projections, and forecasts as guarantees of performance.

Testimonials must not be misleading or suggest that past performance (or the personal experience of the person providing the testimonial) is an indication of future performance. If the member firm paid a fee to the person for the testimonial or endorsement that had a value in excess of $100, it must be disclosed that it is a paid testimonial. If the testimonial implies that the person is making the statement based on special experience or knowledge, the adver-tisement must state the person’s qualifications.

Any statement in a public communication to the effect that any service will be furnished free of charge cannot be made unless such service will be provided without condition or obligation.

Public communication may not make any reference to membership in FINRA or any other SRO that would imply endorsement or approval.

Advertisements in connection with the recruitment of sales personnel must not contain exaggerated or unwarranted claims about opportunities in the securities business and should not refer to specific earnings figures or ranges that are not reasonable.

✓T A K E N O T EBlind recruitment advertisements (those that direct the reader to forward a

resume to an undisclosed employer) are the only form of communication with the public that do not require the member’s name.

Communications should not discuss periodic plans, such as dollar cost averaging, without disclosing that these plans do not ensure a profit and do not protect against loss in a declin-ing market. Further, the communication should point out that investors should consider their ability to continue purchases through adverse financial conditions.


—— 1. All outgoing customer correspondence must be approved by a principal before distribution.

—— 2. Retail communication must be approved by a principal before use.

—— 3. A general securities principal must review all public communications.

—— 4. Copies of retail communication must be retained for three years from last use.



Before or after? Identify whether the following retail communication must be filed 10 days before or 10 days after first use.

—— 5. Retail communication related to investment companies and direct partici-pation programs

—— 6. Retail communication related to options

—— 7. Any retail communication filed by firms that are in their first year of FINRA membership

—— 8. Retail communication relating to investment company products that include a ranking or comparison that is generally not published or is the creation of the investment company or the member firm

—— 9. A breakpoint sale allows a customer to obtain a reduced charge on a quantity purchase of mutual fund shares.

3. 4. 9 SOCIAL NETWORKING

FINRA’s Social Networking Task Force was organized to discuss how member firms and registered representatives could make use of social media websites for business while ensur-ing customer protection from false or misleading claims, as well as ensuring that compliance departments of member firms are able to effectively supervise associated persons’ involvement in these sites.

Firms are required to retain records of communications related to the member’s business that are made through social media sites. Firms that intend to communicate directly or permit representatives to communicate through social media sites must make certain they are able to capture that communication and retain records of those communications. (See Rules 17a-3 and 17a-4 and FINRA Rule 4510 for more information.)

Firms must determine which system or program is best for them in providing the retention and retrieval functions necessary to comply with the books and records rules.

3. 4. 9. 1 Suitability Issues and Communications

If a member firm or one of its associates recommends a security through a social media site, such as Facebook, LinkedIn, or MySpace, it triggers FINRA Rule 2111 regarding suitability.

Whether a particular post on a website is a recommendation for a security will depend on the facts and circumstances. The Series 24 examination asks questions about specific dates, percentages, haircuts, and so on; but there is more to it than that. As a principal level exam, it tests a candidate’s ability to parse questions carefully and to make difficult judgment calls based on limited facts and circumstances.

As an example, a web-based communication that would fall outside the definition of a rec-ommendation would be if a member firm created a website available to customers that have an electronic library containing research reports, which may include buy/sell recommendations as well as news, quotes, and charts that customers may request. The facts indicate this is not a recommendation, and suitability rules are not triggered.

An example of communication that falls within the definition of recommendation under the rule would be when a member sends a targeted email or pop-up screen to a customer or targeted group of customers encouraging them to buy a security.



Another example of a recommendation would include a member that sends its customers an email stating they should be invested in stocks from a particular industry sector and urges customers to buy stocks from a list with “buy” recommendations.

As you can see, it can be a challenge to identify when a “recommendation” is made, thereby triggering suitability concerns. Compliance officers must consider many factors when developing procedures and best practices for the member firm’s written supervisory procedures (WSPs) in supervising the use of social interactive electronic communications on a social media site that recommend specific investment products.

As a best practice, compliance officers might consider prohibiting all interactive electronic communications that recommend a specific investment product and any link to a recommen-dation unless a thoroughly trained and qualified registered principal has granted prior approval of the content. In addition, some member firms maintain libraries of previously approved com-munications to which their representatives have regular access. Compliance officers might consider prohibiting communications that recommend specific investments unless the com-munication matches a pre-approved template and the recommendation has been approved by a registered principal.

In recent years, yields on T-bills, for example, have been at historic lows. This has prompted some investors, including senior citizens, to take risk that they either cannot identify or are inadequately disclosed in hopes of achieving greater returns. This is known as yield chasing. In this environment, retail investors are susceptible to recommendations to chase yields with-out applying the risk-reward model. Supervisors must enforce robust-heightened supervisory systems to ensure no one at the firm would offer securities or services that:

■ reps have not been adequately trained or cannot explain; ■ customers don’t understand; ■ pose risk beyond what is reasonable for that particular individual investor in hopes of get-

ting greater returns (yield chasing); ■ lack liquidity required by a customer; ■ have cash flow outside the investor’s time horizons; ■ lack transparency to make an informed decision; and ■ imply a special expertise where none exists.

*C A S E S T U D Y Mr. Gavrilo Princip, representing Boonville Securities, attempted to convince senior citizens he was a bona fide senior financial advisor with his designation of “Chartered Senior Advisor.” His sales material stated, “Gavrilo is one of only 4,000 Chartered Senior Advisors (ChSA) in the U.S. and is therefore well-trained and qualified to render advice on senior finances.” This claim was unsubstantiated. One of several complainants (a woman in her 80s) indicated that the ChSA designation influenced her decision to purchase his offered annuity products. In the complaint, she claimed that when she began to express dissatisfaction with a particular product, “Mr. Princip pointed to his credentials in senior financial services or something to that affect” and told her that, “The product is a great investment for people over 65.” Mr. Princip earned more than $650,000 selling annuities during the year he used the unsupported ChSA designation.



The use of a specious title with the view to burnish a resume is inconsistent with just and equitable principals of trade. Mr. Princip was sanctioned. He was fined $50,000 and barred from associating in any capacity with any FINRA-regulated firm for making misrepresentations, omitting material facts, and using misleading state-ments to customers. Boonville Securities was ordered to pay restitution and fined $100,000 for failing to properly supervise Mr. Gavrilo’s activities in view of significant red flags and for failing to properly maintain advertising records. This decision has been appealed.

As mentioned in Unit 2, suitability is more than just making appropriate recommenda-tions based on a customer’s profile. A representative has an additional obligation to reasonably explain the characteristics and risks associated with the securities being recommended.

Failure to obtain sufficient knowledge of the characteristics and risks of securities and rec-ommend them anyway is deemed making an unsuitable trade and subjects the representative and the supervising principal to sanctions.

A registered representative recently admitted in an on the record (OTR) interview with FINRA examiners that he had not read the offering memorandum of a privately placed series of notes that had a history of missing coupon payments. He also admitted he had not par-ticipated in due diligence meetings where the full risks of the offering were disclosed and discussed. Nevertheless, not knowing much about the notes, he placed them in a customer’s account. He told examiners that had he known about the risks, he would never have placed them with customers who had declared their risk tolerance to be medium. He was fined and suspended.

Alternative funds are a potential source of suitability problems. As the name implies, alternative mutual funds employ non-traditional trading strategies and investments. These alternative (alt) funds tend to be complex, and even though they are registered under the Investment Company Act of 1940, unlike hedge funds, investors can expect greater risk expo-sure. Principals must be confident that the representatives selling or attempting to sell alt funds be thoroughly knowledgeable about the characteristics of the fund but that they are careful as to how and whom they approach.

✓T A K E N O T EA registered representative must know his customer and make appropriate rec-

ommendations based on the customer’s profile. In addition, he must be knowledge-able about the securities being offered. It is not possible for a representative to make a reasonable and suitable recommendation if he knows nothing about the character-istics of the securities he is offering. The greater the complexity of the security, the greater the need for enhanced understanding by those offering it, and delineation and clarification of the risks associated with it when selling or attempting to sell to customers.

✓T A K E N O T EAlternative funds (also known as “alt” mutual funds) are SEC-registered funds

that may hold more non-traditional investments and employ more complex strate-gies than traditional mutual funds. Alt funds might invest in global real estate, spot commodities and futures, leveraged loans, start-ups and unlisted securities. All of these expose investors beyond traditional stocks, bonds, and cash. In addition to the customary market risks associated with traditional mutual funds, alternative funds



may carry additional risks from strategies as well, such as targeting specific returns or benchmarks. Supervisors are expected to exert the appropriate effort to regulate the sale of such complex investments and have a reasonable supervisory system in place to determine whether the purchases of alternative investments would cause a customer’s account to be unsuitably concentrated in those investments. Lastly, supervisors must adequately train the staff to analyze suitability standards as part of alternative investment suitability review. Alt funds and hedge funds are not the same. Alt funds are regulated, which limits their operations in ways that do not apply to unregistered hedge funds.

3. 4. 9. 2 Interactive Electronic Forums

FINRA’s definition of public appearance is an unscripted participation in an interactive electronic forum, such as an online seminar. FINRA does not require prior principal approval for extemporaneous remarks made by representatives who make public appearances. However, these interactive electronic forums are subject to other supervisory requirements and to the content requirements of FINRA’s communications rule, such as recordkeeping and making a reasonable effort to state facts accurately and outside any possible quiet period (See quiet period in Unit 5).

The Merriam-Webster’s Online Dictionary defines blog as “a website that contains an online personal journal with reflections, comments, and often hyperlinks provided by the writer.”

Some parts of an interactive electronic forum, such as seen on a profile page of a blog, are static; that is, content is accessible to all visitors and remains up until removed or revised. FINRA considers static blogs as an advertisement. If a firm or its associated persons (APs) sponsor a static blog, they must obtain prior principal approval. Merely updating the blog, even frequently, does not change that.

Blogs that engage in real-time interactive communication with third parties are deemed to be interactive electronic forums by FINRA. In that case, no prior principal approval is required, but it must be supervised.

Social networking sites, such as Facebook, Twitter, and LinkedIn, include static content and interactive content. Generally speaking, static content is accessible to all, such as a repre-sentative’s profile, background, or wall information, as opposed to a status update on Facebook, which is interactive content. A principal of the firm must approve all static content on a social networking site established either by the firm or a registered representative before it is posted. Twitter is deemed a social networking, micro-blog service enabling users to send and receive text-based posts of up to 140 characters. If posts are made by a member firm or a representative on its behalf with the public’s participation, the micro-blog would be generally considered retail communications and subject to principal approval, recordkeeping, and filing requirements.

Representatives who are permitted to tweet about investments to their followers should do so only with prior approval. Tweeting overly positive messages without disclosing material information about any recommendation could lead to sanctions.

Social networking makes it somewhat easy to solicit and gain a recommendation or testi-monial. The greatest of care should be taken with regard to testimonials. Any retail commu-nication that includes a testimonial must explain that the testimonial may not represent the experience of others and is not a guarantee of futures performance. If more than $100 was paid for the testimonial, that too must be disclosed.



Lastly, do not confuse clearly distinguishable paid advertising with paying for or in any way rewarding someone for the purpose of influencing the price of a security. For example, it would be a violation of FINRA Rule 5230 to furnish theater tickets to a news reporter for writing something favorable about a company in order to boost its stock price or to slip a radio show host a few hundred dollars to disparage a company with the view to push the stock price down.

✓T A K E N O T E Static content on a social media site must receive approval from a principal prior to use.

3. 4. 9. 3 Supervision of Interactive Electronic Communications

Supervision by the firm or its APs who use blogs or social networking sites must be done in a manner reasonably designed to ensure that they do not violate the content requirements of FINRA’s communications rules.

Firms may adopt risk-based principles to supervise incoming, outgoing, and internal elec-tronic communications. For example, firms may adopt sampling and lexicon-based searches. Words and phrases, such as attorney, make check payable to cash, and you cannot lose may capture some communication that would need additional supervisory scrutiny and possible discipline.

Firms must be stricter in their review of employees’ incoming, outgoing, and internal elec-tronic communications between non-research and research departments concerning the con-tent of a research report. NASD Rule 2711 requires a firm’s legal and compliance department be copied on all such communication.

A member firm must ensure that those associated persons who participate in social media sites for business purposes are supervised and monitored and that the firm is prepared to dis-cipline anyone found in violation of company policies and FINRA rules. Furthermore, only those that are thoroughly trained in use of this type of media and do not present unneces-sary risks to customers and potential customers may participate. Associated persons who have presented compliance risks in the past with regards to sales practices, in particular, should be prohibited from establishing social media sites for business purposes.

FINRA does not treat posts by customers or other third parties as the firm’s communica-tion with the public subject to FINRA Rule 2111 unless the firm has involved itself in the preparation of the content or explicitly or implicitly endorsed or approved the content.

✓T A K E N O T E If copied and posted, interactive content can be rendered static on a Web page or blog.

3. 5 TELEMARKETING (FINRA RULE 3230)

If a registered representative wishes to engage in cold calling prospects, the representative must adhere to the following provisions of the FINRA Rule 3230:

■ Cold calls can only be made between the hours of 8:00 am and 9:00 pm at the called-person’s location (prospect’s local time)

■ The caller must disclose his name and the name of the member firm, the telephone num-ber or address at which the caller may be contacted, and that the purpose of the call is to solicit the purchase of securities or related services



■ If the called person wishes to not be re-contacted, that person’s name and phone number must be placed on a Do-Not-Call list and maintained for an indefinite period

■ Callers must transmit caller identification information (caller ID blocking is prohibited) ■ Callers must not use deceptive or abusive telemarketing acts or practices

The act deals with solicitations made using telephone lines, which includes electronic mail and fax transmissions. It does not deal with solicitations made using the U.S. mail.

In addition to a firm-specific Do-Not-Call list, there is a National Do-Not-Call list main-tained by the FTC indefinitely. Members may not make telephone solicitations to persons on this list with three exceptions.

■ The member has an established business relationship with the recipient of the call. ■ The member has obtained the person’s prior written consent. ■ The person making the call has a personal relationship with the recipient of the call.

An established business relationship exists if: ■ the person to be contacted has made a financial transaction or has a security position, a

money balance, or account activity with the member within the 18 months immediately preceding the date of the call;

■ the member is(was) the broker-dealer of record for the person within the 18 months imme-diately preceding the date of the call; or

■ the person has contacted the member to inquire about a product or service within the three months immediately preceding the date of the call.

✓T A K E N O T EIf a member inadvertently calls someone on the National Do-Not-Call list, there

is a safe harbor provision in the law. As long as an inadvertent call is made no more than 31 days from the date a firm obtained the latest version of the list, there is no violation.

*E X A M P L E A member obtains a version of the list on May 31. On June 4, a person contacts the administrator of the registry and places his name on the list. If a member contacts this person on June 20, there is no violation, because the list used by the member is no more than 31 days old.



U N I T T E S T

1. During an examination of BDA, FINRA examin-ers noted during the exit interview that the firm failed to adequately address communications and correspondence in the firm’s written supervisory procedures. Which of the following statements would be least likely to be mentioned by FINRA examiners?A. Communications and correspondence may

include a fictional name by which the member is commonly recognized.

B. A broker-dealer must disclose any relationship between the member and any person who is named in the communication.

C. A broker-dealer must disclose the specific products or services being offered by the member if it includes other company names in the communication.

D. A broker-dealer may not publish a “blind” recruitment advertisement.

2. Retail communications relating to which of the following must be filed with FINRA by an estab-lished member firm? I. Investment companies II. Direct participation programs III. Government securitiesA. I onlyB. I and IIC. II and IIID. I, II, and III

3. Which of the following is classified as retail com-munication?A. Newspaper advertisementB. Internal memoC. Thank you note to a clientD. Radio interview

4. A testimonial used by a member firm in connec-tion with retail communications must stateA. the qualifications of the person giving the

testimonial if a specialized or experienced opinion is implied

B. that past performance is not indicative of future performance and that other investors may not obtain comparable results

C. the fact that compensation was paid to the person giving the testimonial if more than $100 in value was paid

D. all of these

5. Under FINRA rules, a member may pay continu-ing commissions to a retired representative I. only if a written agreement is in effect II. based on business generated while employed III. based on business introduced after retirementA. I and IIB. I and IIIC. II and IIID. I, II, and III

6. A member firm must prefile retail communications if I. the member has not yet celebrated its first

anniversary of the date its FINRA membership became effective

II. the communication relates to options III. the communication relates to CMOs IV. under an order from FINRA to prefileA. I and IVB. II and IIIC. I, II, and IVD. I, II, III, and IV



7. Which of the following statements regarding anti-money laundering detection within a registered broker-dealer is TRUE?A. Broker-dealers with institutional customers

ONLY are exempt from developing and implementing AML policies and procedures.

B. If the approving senior manager leaves the member firm, the AML policies and procedures of the firm should be reapproved by the newly appointed manager.

C. Placement, layering, and integration are stages of moving currency from the Bureau of Engraving and Printing to Federal Reserve Banks.

D. The Bank Secrecy Act requires that simple “red flags” with no proof or evidence of a crime be kept confidential and that no one outside the firm may be alerted.

8. Under FINRA rules, a member may charge a cus-tomer for all of the following services EXCEPTA. safekeeping of securitiesB. collection of interest and dividendsC. forwarding proxy materialD. appraisal of securities

9. In dealing with nonmember and suspended mem-ber firms, which of the following statements is TRUE? A. Signing an underwriting agreement with a

suspended member firm is acceptable ONLY if the underwriting will take place following the suspension.

B. A member may join a nonmember bank in the underwriting of municipal bonds and split concessions with the bank as though it were a member.

C. A German nonmember broker-dealer, which operates under a regulatory scheme acceptable to the home country, opens a branch in New York City with the view to conduct business within the United States may share in commissions with a member firm.

D. In dealing with nonmembers, sharing commissions and other allowances is not permissible under any circumstances.

10. A member firm may pay commissions to a non-member for executing I. a nonexempt securities transaction in the

over-the-counter market II. an exempt securities transaction in the over-

the-counter market III. a nonexempt securities transaction on an

exchange floorA. I and IIB. I and IIIC. II onlyD. II and III

11. Those member firms that promote day-trading strategies must implement procedures to approve day-trading accounts. Day-trading risk disclosure statements must be provided to A. each separate customerB. the SECC. the Federal Reserve BoardD. the Board of Directors of buy-side institutional

customers

12. Correspondence distributed to institutional inves-tors may be sent to each of the following EXCEPTA. an employee benefit plan with 100 or more

participantsB. a person acting solely on behalf of an

institutional investorC. any entity with $50 million or more in total

assetsD. a bank that has a history of distributing

passages of its institutional correspondence to its retail customers

13. Each of the following communications is exempt from any filing requirement to FINRA’s Advertis-ing Regulation Department EXCEPTA. a change in the member’s name or business

structureB. internal memos and changes to the MPID

onlyC. information prepared by a mutual fund

underwriter and used without changeD. generally accessible websites



14. Member firms that promote day-trading strategies mustA. implement procedures to approve day-trading

accountsB. apply for a MPID with FINRAC. promptly provide the Options Disclosure

Document to inquiring customersD. promptly provide the member firm’s most

recent balance sheet and income statement to inquiring customers

15. Which of the following materials is(are) subject to FINRA’s filing requirements? I. Retail communications describing the

performance ranking of an open-end management investment company

II. Prospectus for a face-amount certificate company

III. Prospectus for a closed-end management investment company

IV. Internal memo describing the benefits of an investment in a certain unit investment trust

A. I onlyB. I and IVC. II and IIID. III and IV

16. All research reports must disclose I. any control relationship with the issuer II. the price at the time the original

recommendation was made III. the fact that the member firm has a 1% or

more position in the security IV. the name of the member firm providing the

recommendationA. I and IIIB. II and IVC. III and IVD. I, II, III, and IV

17. To which of the following persons may a broker-dealer pay commissions under a continuing com-mission contract? I. Retired employee, for past business II. Widow of a former employee, for past business III. Retired employee who refers an old neighbor

to the broker-dealer IV. Retired employee who, in the course of his

travels, acquires new business for the broker-dealer

A. I and IIB. II and IIIC. II and IVD. III and IV

18. Which of the following statements regarding recruiting advertising by FINRA member firms are TRUE? I. It is not subject to FINRA filing. II. It may not contain exaggerated claims about

opportunities in the securities business. III. It is not permitted. IV. So-called “blind” ads do not have to mention

the member’s name.A. I and IIB. II and IIIC. II and IVD. III and IV

19. Which of the following must be included in a testimonial made on behalf of a member firm and distributed to potential clients? I. Qualifications of the person giving the

testimonial if a specialized or an expert opinion is implied

II. Length of time the testimonial covers III. Fact that the returns and investment

performance cited in the testimonial may not be easily duplicated

IV. Whether compensation in excess of $100 was paid to the person giving the testimonial

A. I, III, and IVB. I and IVC. II and IIID. III and IV



20. Written recommendations prepared by a registered representative need the prior approval ofA. the appropriate SROB. a principal of the firmC. the SECD. the FCC

21. An associated person of a member firm has made a public appearance to explain market strategies that are widely available to senior citizens. Super-vision of this activity would need to include each of the following EXCEPTA. the member firm is required to establish

written procedures to supervise an associated person’s public appearances

B. training must be provided to associated persons who make public appearances

C. surveillance is necessary to be certain policies and procedures pertaining to senior investors are being adhered to

D. written evidence such as a diploma or transcript must be obtained evidencing that the associated person has been granted a nationally recognized designation to advise senior investors

22. A FINRA member firm has identified that a walk-in customer looking to open a cash account appears on the Office of Foreign Asset Control’s (OFAC) list. Who must oversee your firm’s deal-ings with this individual? A. The firm’s AML officerB. The registered representative and the

immediate supervisor C. The OSJ principalD. The firm’s financial and operations principal

23. A new customer has just opened a margin account at your firm. She has given her lawyer limited power of attorney over the account to pursue a trading strategy suitable for senior investors while she makes an extended pleasure trip to Europe. Which of the following statements regarding this customer’s communications are TRUE? A. The firm may hold mail for the customer while

she is traveling internationally for specific periods.

B. Monthly statements must be sent to those people with power of attorney over the account.

C. The firm must send confirmations to those persons who have been granted power of attorney over an account.

D. The firm must hold mail for the customer without restriction for as long as she requires the service.

24. Mr. Andrews walks into one of your firm’s small branches wishing to open up a cash account. He has been referred to your firm by one of its biggest clients. He provides sufficient information to open the account but has no identification with him. The firm procedures may A. permit the account to be opened, accept

a deposit, and follow all the firm’s written procedures for this situation

B. not open the account until proper identification is received

C. open the account and accept a deposit but must, by rule, refrain from investing until proper identification is received

D. open the account but refrain from accepting a deposit until proper identification is received

25. A branch office is in the process of opening a new account with a customer, a handicraft im-porter, who indicates that he does a lot of busi-ness abroad. He further indicates that he will be sending and receiving approximately 10 money wires per month. The new account form comes to you for approval. As a compliance officer, you will likely A. approve the account with instructions to

carefully scrutinize each transaction B. approve the account C. decline the account D. advise your legal department to file a

suspicious activity report



26. Under FINRA rules, each of the following must be present at each OSJ EXCEPTA. principalB. folder of customer complaintsC. copy of the firm’s written supervisory

proceduresD. all exception reports

27. SEC Rule 10b-10 requires that confirmations be given or sent to customersA. on trade dateB. on or prior to T+1C. on or prior to T+2D. at or prior to completion of the transaction

28. A principal must review and/or endorse all of the following EXCEPTA. confirmationsB. order ticketsC. new account formsD. retail communications




1. D. All retail communications and correspondence must conspicuously disclose the name of the member firm, or the name under which the member’s broker-dealer conducts its business as disclosed on Form BD, and may include a fictional name under which the member is commonly recognized. The communication also must disclose any relationship, if any, between the member and any non-member or individual who also is named in the piece. Lastly, if it includes other names, the communication must show which products or services the member is offering. Blind recruitment advertisements are acceptable.

2. B. An established member must file retail communications relating to investment companies and direct participation programs with FINRA within 10 days of first use (postfiling). Filing of retail communications relating to U.S. government securities is not required.

3. A. Retail communication is defined as “any written (including electronic) communication that is distributed or made available to more than 25 retail investors within any 30 calendar-day period.” The newspaper advertisement qualifies.

4. D. If a member uses a testimonial in its retail communications, the following rules apply: if more than $100 in value is paid for the testimonial, you must state the fact that it is a paid testimonial; the communication must not suggest that past performance (or the personal experience of the person making the testimonial) is an indication of future performance; and if the testimonial implies that the person is making the statement based on special knowledge or experience, the communication must state the person’s qualifications.

5. A. Continuing commissions can only be paid to a retired representative if there is a written agreement in place between the member and the retired representative, and payout is based only on business generated while employed.

6. C. For a period of 1 year beginning on the date reflected in the Central Registration Depository (CRD®) system as the date that FINRA membership became effective, the member must file with the department at least 10 business days prior to first use any retail communication. Retail communications relating to options must be prefiled. If a member is under an order from FINRA to prefile, it must do so.

7. B. All registered broker-dealers, without exception, are required to develop and implement policies and procedures to detect and thwart money-laundering activity.

8. C. Members may not charge customers for forwarding proxy statements (members are reimbursed by issuers for providing this service). Also, once a charge is made for research, the exclusion from the definition of an IA no longer exists.

9. B. Certain exempt securities, such as municipal debt securities, may be underwritten by nonmember firms, such as banks. Although the bank municipal underwriting division would be registered with the MSRB, it is not be required in this case to be registered with FINRA. Nevertheless, FINRA member firms in this case would be permitted to share commissions with the bank if a proper, written underwriting agreement is in place.



10. D. FINRA regulates OTC transactions in nonexempt securities. Therefore, all transactions in these securities must be between members. The only time a member can pay a nonmember a commission is for executing a trade outside of FINRA’s jurisdiction (e.g., exempt securities and listed securities traded on an exchange floor).

11. A. Those member firms promoting day-trading strategies are obligated to caution their noninstitutional customers as to the risks involved. The firm must provide to each separate customer a risk disclosure statement as well as posting it on the member’s website.

12. D. No member may treat a communication as having been distributed to an institutional investor if the member firm has reason to believe that the communication, or any part of it, will be made available to retail investors.

13. D. For a period of 1 year that the FINRA membership became effective, the member must file with the Department at least 10 business days prior to first use any retail communication that is published or used in any electronic or other public media, including generally accessible websites, newspapers, magazines or other periodicals, radio, television spots, telephone or audio recording, signs, billboards, movies, or telephone directories (other than routine listings).

14. A. Those member firms that promote day-trading strategies must implement procedures to approve day-trading accounts.

15. A. Prospectuses and internal memos need not be filed with FINRA.

16. D. The source of the recommendation, the security’s price, any member firm interest in the security of 1% or more, and the fact that the member firm is a market maker in the security must all be disclosed in the research report. In addition, if a control relationship exists between the member and the company being recommended, this fact also must be disclosed.

17. A. A member firm may continue to pay commissions to either a retired employee or to a former employee’s widow, provided that a prior written contract exists. Commissions may be paid only on business generated while employed.

18. C. Blind ads are perfectly legal and need not mention the member’s name. Recruiting advertising may not contain exaggerated claims about brokerage business opportunities.

19. A. When a member firm uses a testimonial, the testimonial must be accompanied by a statement that this person’s experience does not necessarily represent those of other customers; disclosure of any compensation paid, if material; and the testimonial giver’s qualifications, if an expert opinion is implied.

20. B. Written recommendations are subject to principal review and approval.

21. D. There is no requirement that an AP have a designation to advise senior investors. However, establishing procedures to supervise, train, and to surveil is mandated in FINRA rules pertaining to public appearances.

22. A. Financial institutions, including broker-dealer firms, must designate an officer of the firm as having responsibility for monitoring OFAC regulations, reporting and overseeing the blocking of transactions, or declining of business with certain customers.



23. A. The customer is ultimately responsible for her own account. Confirmations of trades will be sent to a third party only upon written request, with the customer receiving duplicates. A member may hold mail for a customer who will not be receiving mail at her usual address as long as the member firm receives written instructions from the customer that include the period during which the member is requested to hold the customer’s mail. If the requested time period is longer than 3 consecutive months (including any aggregation of time), it must include an acceptable reason for the request (safety or security concerns). Convenience is not an acceptable reason for holding customer mail longer than 3 months.

24. A. SEC rules require that member firms verify a customer’s identity within a reasonable time period before or after account opening. Therefore, the account may be opened and investments made. The firm must have in place procedures to cover such exigencies.

25. A. There is no indication requiring a SAR. Subject to the firm’s written supervisory procedures, a principal will likely approve the account with instructions to carefully review each transaction. Wire orders are not unusual but if the customer were to ask for a third-party wire order, although legal, could constitute a red flag requiring a large step up in supervision if it is even permitted by the firm.

26. D. OSJs must be managed by a resident principal. The OSJs responsibilities include enforcing the firm’s written supervisory procedures, reviewing customer accounts periodically, maintaining copies of customer records including customer complaints, and inspecting the branch offices periodically. A copy of the FINRA manual, as well as a copy of the firm’s written supervisory procedures, must be kept at each location where business is conducted. If exception reports are requested from a clearing firm for a specific OSJ, they are maintained there and made available for inspection by FINRA examiners. There is no requirement to keep all the exception reports a member firm may order.

27. D. Customer confirmations must be given or sent at or prior to completion of the transaction.

28. A. A principal is not required to review confirmations. However, order tickets, which are the first record of the trade, must be reviewed by a principal.




Quick Quiz 3.A

1. F. When one party in a JTWROS account dies, the account cannot be transferred to the other party until a certified copy of the death certificate, inheritance tax waivers, and letters testamentary are presented to the member firm.

2. F. The death of one tenant in a JTWROS (or CPWROS) account does not preclude the remaining tenant from entering orders. However, in a TIC account, the death of one tenant requires the firm to freeze the account until required documents are presented.

3. T. Activity is defined as purchases, sales, interest or dividends received, or any funds flowing in or out of the account.

4. T. The notification must state that these balances are not segregated by the member firm, that the member in the conduct of its business may use them, and that they are available to customers on demand.

5. T. The customer has 30 days to accept or reject the offer.

Quick Quiz 3.B

1. F. Customer correspondence can be reviewed after distribution.

2. T. All retail communications must be first approved by a principal prior to its use.

3. F. Options communications must be approved by a registered options principal (ROP). A general securities principal must review all other public communications.

4. T.

5. 10 days after.

6. 10 days before.

7. 10 days before, and prefiling must continue during that first year.

8. 10 days before. If the ranking or comparison is generally published or is the creation of an independent entity, the basic filing rules for investment companies apply (10 days after).

9. F. The term, “breakpoint sale” refers to the prohibited practice of allowing a client to purchase shares of a mutual fund in an amount just below a breakpoint without describing the savings that could be obtained by investing just a little bit more or signing a letter of intent.

Series_24_03.indd 219 6/16/2015 3:16:06 PM

221

u n i t

Supervision of Trading and Market Making

Securities in the United States trade on different markets, each with a different set of rules. This Unit addresses the rules applicable to each market. Emphasis is placed on NASDAQ rules, although it also

discusses OTC Equity Securities and NYSE trading. The Uniform Practice Code (UPC) of FINRA (the 11000 series of rules) regulates dealer-to-dealer transactions in the over-the-counter market. These rules cover securities settlement and delivery. If needed, see Appendix A and B for a refresher discussion on equities trading.

The supervision of trading and market making activities on the Series 24 examination accounts for 32 questions.

4


O B J E C T I V E S

222

When you have completed this Unit, you should be able to:

■ distinguish between an exchange-traded NMS securities and OTC Equity Securities;

■ outline basic NYSE operations;

■ explain the trading rules for the Nasdaq stock market;

■ explain the limit order rules;

■ define the requirements for OTC Bulletin Board market making;

■ list the exceptions to filing Form 211;

■ identify the Penny Stock rules;

■ explain the functions of the Nasdaq Market Center;

■ list the basic ACT functions and rules;

■ outline the basics of ACES;

■ describe the TRACE rules;

■ explain the trading halt rules;

■ explain Regulation SHO;

■ define the scope of the UPC;

■ distinguish between the various settlement dates;

■ explain the regulation behind, and list the requirements of, a good delivery list;

■ list the ex-dates for various types of settlements;

■ explain close-out requirements;

■ calculate accrued interest;

■ explain the regulation of ADRs/GDRs; and

■ discuss the rules relating to clearly erroneous trades.


223Unit 4 Supervision of Trading and Market Making

4. 1 SECURITIES TRADING MARKETS

4. 1. 1 MARKET CENTERS

When a member firm’s customer calls a broker to place an order to buy or sell, the firm forwards the order to a market center to be executed. The following are market centers that are available for trade execution.

An exchange is a market center where traders can buy or sell securities. For a stock that’s listed on an exchange (e.g., NYSE or Nasdaq), the firm may direct the order to that exchange or to a competing exchange. Alternatively, the order may be forwarded to a member firm reg-istered as a market maker in that stock.

A market maker is a member firm that publishes quotes in a stock and stands ready to buy or sell a given number of shares on a continuous basis. Market makers are generally required to publish firm quotes and may not back away from them. In addition, market makers are expected to maintain quotes that are priced somewhere near the national best bid and offer. In other words, they are precluded from entering “stub quotes” that are priced so far away from the market that it’s clear that they were never intended to be executed.

Some market makers, in an attempt to increase order flow, will pay other member firms for routing customer orders to them. This is known simply as payment for order flow and is an acceptable practice.

For a stock that trades in an over-the-counter (OTC) market, such as the OTC Bulletin Board, the firm would send the order to an OTCBB market maker.

Market makers are not permitted to accept any kind of payment from an issuer to act as a market maker in its stock. This, however, does not preclude a market maker from receiving payment for its investment banking services, including being reimbursed for expenses associ-ated with registering the stock with the SEC or the states.

An order may be directed to a separate division of the member firm to be filled from inven-tory from the firm’s propriety account rather than sending it to a market or market makers. This internalization permits the brokerage firm to make money on the spread in similar fash-ion to a market maker.

Orders also may be routed to an electronic communications network (ECN). An ECN is an electronic trading system that automatically matches buy and sell orders at specified prices. ECNs are SEC-sanctioned alternative trading systems (ATS) that are open 24 hours a day and match buy and sell orders as agents, not as principals. Extended hours orders are handled by ECNs.

Throughout the history of trading securities in the United States, the NYSE set the stan-dards. Normal trading times from 9:30 am until 4:00 pm ET Monday through Friday was the norm. However, in the latter part of the twentieth century, the demand for after-hours trad-ing grew. Now, after the closing bell, ECNs make it easy for both institutional and individual investors to access the after-hours market. However, care must be taken, because after-hours volume is low, often leading to higher volatility, wider spreads, and larger price fluctuations than investors would expect to see during the day session. Supervisors should be mindful that customers trading after-hours face these additional trading risks. Institutional customers may be fully able to manage these risks, but extra care should be taken to supervise retail customer accounts.

There are a variety of market makers. For example, A “Qualified OTC Market Maker” must maintain a minimum net capital, of the lesser of $250,000 or $25,000 plus $5,000 for each security in excess of five in which it makes a market. An OTC Margin Security is any securities listed on the Nasdaq Stock Market.


224 Unit 4 Supervision of Trading and Market Making

The term “Qualified Third Market Maker” is a dealer in any stock registered on a national securities exchange and maintains minimum net capital of the lesser of $500,000, or $100,000 plus $20,000 for each security in excess of five stocks in which it makes a market.

The term “Qualified Block Positioner” is a dealer who must maintain a minimum net capital of $1,000,000.

✓T A K E N O T EAs of August 1, 2006, the Nasdaq stock market began to operate as an indepen-

dent national securities exchange. As a result, the distinction between “listed” and “unlisted” securities has become blurred. Furthermore, with its acquisition of NYSE Arca Equities, the NYSE competes directly with Nasdaq in that Arca operates as a fully electronic stock exchange. A NYSE member firm that also is a member of the NYSE Arca must have supervisory procedures that incorporated rules of both exchanges.

4. 1. 2 AGENCY VERSUS PRINCIPAL

All customer trades executed on an exchange floor are done on an agency basis—the firm executing the trade on behalf of the customer acts as a broker, charging the customer a com-mission. Acting as a broker means finding a buyer for a seller and vice versa.

In the over-the-counter market, however, a member firm may act as either a broker (agency) or a dealer (principal). When acting as a dealer, the member is on the other side of a trade with a customer—when a customer buys, it is the member who is selling to that customer from its inventory; and when a customer sells, it is the member who is buying from that customer for its inventory. To act as a dealer, the member must maintain an inventory of that particular security.

In addition, when acting as a dealer, a member will mark up when a customer buys and mark down when a customer sells. When a price to a customer includes a markup or mark-down, it is termed a net price. A firm may never charge a commission in addition to a markup or markdown. This is called a hidden profit and is a rules violation.



4. 2 NEW YORK STOCK EXCHANGE

4. 2. 1 NYSE LISTING REQUIREMENTS

The New York Stock Exchange is one of 11 registered exchanges operated by the Intercontinental Exchange. The NYSE Group is comprised of the NYSE, NYSE MKT, NYSE Arca, NYSE Amex Options, NYSE Arca Options, and NYSE Bonds. The NYSE maintains a physical floor-based business model to offer equities through IPOs and trading in a liquid sec-ondary market. Not all companies are eligible or choose to list their securities for trading on the NYSE; but if they do, they must satisfy the exchange’s exacting standards. The Series 24 exam only requires a general knowledge of the minimum criteria. Other than the minimum $4 share price at the time of listing, numerical values are not tested.

A company applying for listed trading on the NYSE must be registered with the SEC; in other words, it needs to be a publicly owned company. It must offer a minimum number of shares and have a minimum number of round-lot shareholders. However, aside from objective values, the company must enjoy a good degree of national interest as a mature, front-rank com-pany in its industry. The exchange has broad discretion in its listing process that go beyond minimum numerical, objective standards. Apart from the few standards thus mentioned, the Exchange offers several alternative admixtures of capitalization, earnings, cash flow, et cetera, but none involve a minimum earnings per share.



These listing requirements are very similar to those established for Nasdaq Global Select and Capital Market securities.

!T E S T T O P I C A L E R TThough the numerical values are not tested, note that there is no minimum earn-

ings per share (EPS) requirement to qualify for NYSE listing.

4. 2. 1. 1 Delisting

The NYSE reserves the right to delist issuers for a number of reasons, including failure to meet minimum maintenance criteria (e.g., number of shareholders owning 100 shares or more, number of publicly held shares). Bankruptcy, abnormally low share price or share volume, and corporate actions not deemed to be in the public interest could result in delisting.

If an issuer wants to voluntarily delist from the NYSE, all that is required is for the board of directors to approve. The issuer must furnish the NYSE with a certified board resolution evidencing board approval.

✓T A K E N O T EA voluntary delisting also requires that the issuer file Form 25 with the NYSE and

simultaneously with the SEC. The Form certifies that the issuer has complied with the rules of the Exchange, as well as those of the Commission regarding a voluntary delist-ing.

4. 2. 2 TRADING FLOOR PARTICIPANTS

The NYSE trading model includes several important market participants. They are the designated market maker (DMM), special liquidity providers (SLPs), and floor brokers, as well as firms that trade NASDAQ UTP (unlisted trading privileges).

The chief underlying principal of all securities law is to protect customers. With that in mind, know that trading floor participants are restricted from impacting any trade for their own accounts or the accounts of an associated person, or an account over which it has discre-tion that would impair the protection of investors and the maintenance of a fair and orderly market. At a minimum, trading floor participants must yield priority, parity, and precedence (see the following) in trade execution to those who are not members or associated persons. In other words, customers come first. However, floor participants may act, for example, as market makers or effect bona fide hedge transactions.

✓T A K E N O T EA bona fide hedge could involve a customer long a stock and long a put option.



4. 2. 2. 1 Designated Market Makers (DMMs)

The DMM on the NYSE Floor brings order and liquidity to an exchange floor. Each listed stock is assigned by the NYSE or NYSE MKT to a particular DMM who is responsible for maintaining a liquid and continuous two-sided auction market. In a word, DMMs are the only people who are held accountable for maintaining a fair and orderly market.

The DMM trades, in part, with proprietary algorithms and commits to providing pools of liquidity for the market in an assigned stock providing price improvement and match-ing incoming orders based on a Capital Commitment Schedule. The DMM unit receives only public information about orders—no first looks—so they may compete against all other market participants. DMMs have the obligation to maintain an orderly market in the stocks they’ve been assigned, quote at the National Best Bid and Offer (NBBO) a specified percent-age of the time, and facilitate price discovery at the open, close, and in periods of significant imbalances.

*E X A M P L E A DMM resembles a traffic cop at a busy, high-speed intersection, keeping the traffic moving without incident.

4. 2. 2. 1. 1 Supplemental Liquidity Providers

A class of off-floor, electronic market maker that is permitted to compete with the DMM is known as a supplemental liquidity provider (SLP). SLPs are required to maintain in round lots a bid or an offer at the National Best Bid (NBB) or the National Best Offer (NBO) at least 10% of trading day for any security they are assigned. Note the requirement is for a bid or an offer (one-sided market) unlike the requirement for the DMM. In return for this service, they are rewarded with a rebate (liquidity fees) from the NYSE when their quote results in a transaction. Adding liquidity to the market is rewarded with rebates, because it generates more quoting activity, which leads to tighter spreads.

4. 2. 2. 1. 2 Retail Liquidity Program

The NYSE and NYSE MKT Retail Liquidity Program promotes price improvement for individual investors on retail order flow and competes with dark pools by providing transpar-ency and cost savings for individual investors through price improvement on retail order flow for NYSE and NYSE MKT-listed and NASDAQ UTP-traded equity securities.

The following are two new classes of market participants on the NYSE and NYSE MKT. ■ Retail liquidity providers (RLPs), which are required to provide potential price improve-

ment for retail orders in the form of nondisplayed interest that is better than the best protected bid or the best protected offer (PBBO). Similar to other dedicated liquidity provider programs, RLPs would receive certain economic benefits in exchange for meeting performance obligations.

■ Retail member organizations (RMOs), which would be eligible to submit certain retail order flow (retail orders) to the exchange. Retail orders are generally defined as unmodi-fied agency orders that originate from a natural person.

Member organizations other than RLPs also would be permitted to submit retail price improvement. In short, the RLP program permits exchanges to advantage the “little guy.”



4. 2. 2. 1. 3 Non-displayed Liquidity/Dark Pools

A dark pool sounds ominous, but it is simply trading volume that is offered away from, for example, a trading platform such as a stock exchange. For example the NYSE Arca offers both displayed and non-displayed liquidity. A dark pool may refer to an alternative trading system (ATS) not available to the public but rather large institutions. Both buy-side and sell-side traders look to trade particularly large orders anonymously and with low impact to market prices. Dark pools are dark, because buyers and sellers expect confidentiality of their trading information. There are many dark pools operated both by exchange companies, such as BATS, as well as broker-dealers, such as UBS ATS and Barclays LX.

!T E S T T O P I C A L E R T■■ The DMM has an obligation to quote at the NBBO a specified percentage of

the time.

■■ Not held orders cannot be accepted by the DMM.

■■ The DMM firm is responsible for setting the opening quote in stocks it represents.

■■ The DMM must meet strict depth and continuity standards.

4. 2. 2. 1. 4 Trading Posts

On the NYSE floor, there are a number of trading posts surrounded by video display ter-minals and related telecommunications equipment. DMMs are positioned at these posts, and each has been assigned the exchange responsibility for certain issues of listed companies. DMMs combine both a physical auction market and an automated auction that makes use of algorithms to post quotes from the DMM as well as other market participants. Their quotes are on parity with quotes from other market participants.

Gathered around the post is a trading crowd, which can be as small as one floor broker or many more on those days following unexpected news. In addition to order flow from floor broker hand-held devices, orders are entered into the market through the Universal Trading Platform.

4. 2. 2. 2 Floor Brokers

Floor brokers are generally employees of the member firms that have a trading license. Their primary function is to handle the order flow received from buy-side customers from the upstairs trading rooms of their employers and other member firms.

4. 2. 2. 3 Quotes

The current, two-sided quote is the best bid (highest price someone is willing to pay to buy) and the best offer (lowest price that someone is willing to accept to sell). Market orders are generally filled at the current quote. The current quote also will include size indicating how many shares are there to buy at the best bid and to sell at the best offer. DMMs have an obligation to quote at the NBBO a specified percentage of the time.



*E X A M P L E A quote in General Electric Company (GE) might be:

26.12 26.15 70 × 30

There are 7,000 shares to buy at 26.12 and 3,000 shares to sell at 26.15. Cus-tomer market orders to buy generally will be filled at 26.15, while customer market orders to sell generally will be filled at 26.12.

4. 2. 3 ORDER TYPES

4. 2. 3. 1 Market Orders

A market order is an order to buy or sell at the prevailing market price. A not held mar-ket order cannot be accepted by the DMM. These orders can, however, be accepted by floor brokers and two-dollar brokers.

A not held market order is a market order in which the floor trader has the discretion to execute the order when the trader feels it is best. The trader has some discretion with regard to the price and/or timing of the order.

Market orders can be at the open or the close. These orders are filled at the opening price and closing price, respectively.

Unless there is an order imbalance of 50,000 shares or more, market on close orders can-not be entered after 3:45 pm on the NYSE. For example, assume that at 3:45 pm the market for XYZ is 31.05–31.07, with 10,000 shares at the bid and 70,000 shares at the offer. There is an order imbalance of 60,000 shares on the sell side. Therefore, in this case, a market on close (MOC) order to buy XYZ can be entered after 3:45 pm (3:50 pm for Nasdaq).

4. 2. 3. 2 Limit Orders

A limit order is an order to buy or sell at a specific price or better.

4. 2. 3. 3 Stop Orders

A stop order is a resting order to buy or sell that is activated when the stock trades at or through the stop price. Once triggered automatically, the order becomes a market order. The DMM unit may then offer price improvement on the resulting market order.

A stop order, also known as a stop loss order, is designed to protect a profit or prevent a loss if the stock begins to move in the wrong direction.

No guarantee exists that the executed price will be the stop price, unlike the price on a limit order. Buy stop orders are entered above the current market, whereas sell stop orders are entered below the current market.

A trade at the stop price triggers the order, which then becomes a market order. A stop order takes two trades to execute, which are:

■ trigger—the trigger transaction at or through the stop price activates the trade; and then ■ execution—the stop order becomes a market order and is executed at the next price,

completing the trade.



DMMs or their trading assistants are prohibited from uncovering information about unelected stop orders when arranging the open or for any purpose.

4. 2. 3. 3. 1 Buy Stop Order

A buy stop order protects a profit or limits a loss in a short stock position. The buy stop is entered at a price above the current market and is triggered when the market price touches or goes through the buy stop price.

*E X A M P L E A customer has shorted 1,000 shares of XYZ stock at $55, and the stock is now at $48. The customer would like to wait for more gain but is concerned the stock will reverse itself and begin to rise, eroding some of the unrealized profit. To address this, the customer could place the following order: buy 1,000 XYZ 49 stop. If the stock does start to move up, once it trades at or through the stop price of 49, the order becomes a market order to buy 1,000 XYZ.

Technical traders who track support and resistance levels for stocks also use buy stop orders. For instance, MNO stock trades between 38 and 42. It never seems to go above 42 or below 38. Technicians believe that if the stock breaks through resistance, it will continue to move upward at a rapid pace. Therefore, they will not buy at 40, because there is little upside potential. However, they may place a buy stop order above the resistance level knowing that if the stock breaks resistance and begins to move up, they will buy the stock before it develops upward momentum.

An investor might place a stop order to buy 100 MNO at 42.25 stop when the market is at 40 if he believes 42 represents a technical resistance point, above which the stock price will continue to rise.

MNO Buy Stop Order

42

38

Resistance

Support

Buy stop entered withtrigger price of 42.25

Buy stop triggered andbecomes market order

4. 2. 3. 3. 2 Sell Stop Order

A sell stop order protects a profit or limits a loss in a long stock position and is entered at a price below the current market.



*E X A M P L E A customer is long 1,000 shares of XYZ at $32, and the stock is now at $41. The customer would like to wait for more gain but is concerned the stock will reverse itself and begin to fall, eroding some of the unrealized profit. To address this, the customer could place the following order: sell 1,000 XYZ 40 stop. If the stock does start to move down, once it trades at or through the stop price of 40, the order becomes a market order to sell 1,000 XYZ.

Technical traders also use sell stop. Technicians believe that if a stock breaks through sup-port, it will fall. Therefore, they will not short the stock at 40, because there is little downside potential. Historically, the stock has not traded below 38. However, they may place a sell stop order just below the support level knowing that if the stock breaks through support and begins to move down, they will short the stock before it develops downward momentum.

An investor who is long stock might place a stop order to sell 100 MNO at 37.75 stop when the market is at 40 if the investor believes 38 represents a technical support point below which the stock will continue to fall.

MNO Sell Stop Order

42

38

Resistance

SupportSell stop entered withtrigger price of 37.75

Sell stop triggered andbecomes market order

If a large number of stop orders are triggered at the same price, a flurry of trading activity takes place as they become market orders. This activity will accelerate the advance or decline of the stock price.

A stop limit order is a stop order that, once triggered, becomes a limit order instead of a market order.

*E X A M P L E A customer long 1,000 shares of MNO calls and places the following order: “I want to sell my MNO stock if it falls to $30, but I don’t want less than $29.95 for these shares.” The order is entered as, sell 1,000 MNO 30 stop 29.95. If the MNO shares trade at or below 30, the order becomes a limit order to sell at $29.95 or bet-ter. The risk with this type of order is that the market could leap between the stop and limit price resulting in the customer missing an execution. Assume once the order is entered, the stock trades thusly: 30.01, 29.97, 29.94, 29.92, and so on. The trade at 29.97 triggers the order at which point the order becomes a limit to sell at 29.95 or better (higher). In this scenario, the customer is unable to sell. The risk with a limit order is that the investor may miss the limit.



✓T A K E N O T EBuy limit and sell stop orders are reduced on the ex-date. Those orders placed

above the market—sell limits and buy stops—are not adjusted on the ex-date.

For stock dividends and stock splits, all orders are adjusted. If there is a reverse split, all orders are canceled.

In addition, market orders can specify at the open or at the close. These orders are filled at the opening or closing price, respectively.

Under NYSE rules, market on close (MOC) orders cannot be entered after 3:45 pm. However, if there is an order imbalance of 50,000 shares or more at 3:45, MOC orders can be entered after 3:45 but only on the opposite side of the market from the imbalance.

*E X A M P L E If, at 3:45, the market for GE is 35.20–35.22 5,000 by 60,000, there would be an order imbalance of 55,000 shares on the offer (sell) side. Therefore, market orders to buy at the close could be entered after 3:45 with floor official approval.

Further discussion on time in force (TIF) orders is provided later in the unit.

✓T A K E N O T EFor reverse stock splits, all open orders, both above and below the market, are

canceled.


—— 1. Minimum criteria for listing on the NYSE include number of shareholders, earning per share, earnings, and number of publicly held shares.

—— 2. Only a DMM may accept not held orders.

—— 3. A DMM may not trade for its own account.


4. 3 TRADING HALTS, LIMITATIONS, AND ERRORS

4. 3. 1 TRADING HALTS AND LIMITATIONS

Since its creation, NYSE Rule 80B was written and amended with the view to restrain extraordinary market-wide volatility. It has gone through many changes and continues to be the subject of apparently continuous change. This text shows the pilot as it is in effect on trad-



ing markets at publication. Consult with your instructor and/or Exam-tips to stay up-to-date with this ever-changing rule.

Current Rule 80B

Level of Market Declines S&P 500 from the Previous Trading Day Halt Times

Level 1 7% drop from close 15 mins

Level 2 13% drop from close 15 mins

Level 3 20% drop from close rest of the day

Although FINRA does not have the authority to halt trading on an exchange, it may initiate trading halts or close its Alternative Display Facility (ADF) or any Trade Reporting Facility (TRF) to quotation and/or trade reporting activity. This occurs if it determines there is a basis for it, such as to permit dissemination of material news or extraordinary market activity. FINRA members have an obligation to notify FINRA whenever they have knowledge of any matter pertaining to an NMS stock that has not been disclosed to the pubic or they identify some regulatory problem relating to the security.

✓T A K E N O T EDuring marketwide trading halts with a duration that will close the market for the

remainder of the trading day, the following rules apply.

■■ Orders that are pending at the time of the halt and new orders received after the halt begins should be treated as good until canceled and held by the firm for execution at the reopening of the next trading session.

■■ At-the-close orders pending at the time trading is halted should be canceled. At-the-close orders received after trading is halted should be declined.

■■ The SEC is authorized by law to summarily suspend trading in any security (other than an exempted security) for up to 10 business days. The Commission also may summarily suspend trading on any national stock exchange for up to 90 calendar days but only if the President does not disapprove of its decision.

Members cannot trade until the trading halt is lifted. Nasdaq member firms may not effect trades directly in Nasdaq or exchange-listed securities on either domestic or foreign markets for their own accounts and may not solicit customer orders.

4. 3. 2 LIMIT UP-LIMIT DOWN (LULD)

The limit up-limit down mechanism is a pilot program established in a joint effort by the exchanges and FINRA that is intended to prevent trades in individual securities from occur-ring outside a specified price band. This price band is set at a percentage level above and below the average price of the stock over the immediately preceding five-minute trading period. Price limit band percentages will vary during the phase-in period. It is unlikely that FINRA’s qualifications department would ask questions about specific numbers that are subject to rapid change. However, know that price bands will not include the first 15 minutes or last 30 min-utes of trading, which means that the LULD is effective from 9:45 am–3:30 pm, ET.



The price bands double during the opening and closing periods of the trading day. If the stock’s price does not naturally move back within the price bands within 15 seconds, there will be a five-minute trading pause. During a LULD halt, BDs may accept orders and publish quotes.

As a pilot, the limit up-limit down mechanism is being implemented in two phases. The first phase applies the limit up-limit down mechanism to all stocks in the S&P 500 and Russell 1000 indexes. This is in force at publication. The second phase of the implementation will apply the limit up-limit down mechanism to all remaining NMS securities.

The SEC states that this new plan requires that all trading centers, such as NASDAQ, NYSE, BATS, et cetera, establish, maintain, and enforce written policies reasonably designed to prevent the display of offers below the lower price band and bids above the upper price band ultimately for all NMS stocks.

Note that the purpose of this is to reduce the negative impact of sudden, unanticipated price movements in NMS stock with the intent to protect investors and promote fair and orderly markets.

✓T A K E N O T EMore than most, these rules are subject to change, and Series 24 candidates

should check with their instructors or Nasdaq’s website for the latest information of single stock circuit breakers and the limit up-limit down plan.

4. 3. 3 SEC RULE 201

SEC Rule 201 is referred to as a circuit breaker or alternative uptick rule. It requires trad-ing centers to restrict short selling if a covered security (not OTCBB or OTC Pink) declines by 10% or more from the prior close. The restriction applies to the display and execution of short sales and is applicable during the remainder of the trading day through the next busi-ness day. The goal is to enable long sellers to sell their shares before any short sellers once the circuit breaker is triggered.

The alternative uptick rule permits short selling after the trigger if the price of the security is above the current national best bid.

Chief features of the alternative uptick rule SEC Rule 201 include the following. ■ Short Sale-Related Circuit Breaker. The circuit breaker is triggered for a security any day

in which the price declines by 10% or more from the prior day’s close. ■ Duration of Price Test Restriction. Once the circuit breaker has been triggered, the rule

applies to short sale orders in that security for the remainder of the day, as well as the fol-lowing day.

■ Securities Covered by Price Test Restriction. The rule generally applies to all equity secu-rities that are listed on a national securities exchange, whether traded on an exchange or in the over-the-counter market.

■ Implementation. The rule requires trading centers like Nasdaq to establish, maintain, and enforce written policies and procedures designed to prevent the execution or display of a prohibited short sale.



Exception reports may be made available for trades reported to the FINRA/Nasdaq TRF from the Short Sale Monitor in securities on the Short Sale Circuit Breaker list for the follow-ing circumstances:

■ Sold short, not marked exempt ■ Sold short, marked exempt ■ Sold short on an uptick ■ Marked exempt, but not on the circuit breaker list

Any firm that has access to a Nasdaq Workstation or Weblink ACT 3.0 may connect to the Short Sale Monitor.

4. 3. 4 ERRONEOUS REPORTS

The price at which an order was executed is binding on the customer—even if the member provides an inaccurate report to the customer.

4. 3. 5 ORDER AUDIT TRAIL SYSTEM (OATS)

FINRA agreed to design and implement an Order Audit Trail System (OATS) sufficient to allow FINRA to reconstruct markets, conduct surveillance, and enforce its rules. This audit trail must provide an accurate, time-sequenced (hour, minute, and second) record of orders and transactions, beginning with the receipt of an order and further documenting the life of the order through execution or cancellation.

*E X A M P L E A customer enters a market order to buy 1,000 shares of ABC. The order, which was executed at 38.35, is erroneously reported to the customer as having been done at 38.20. The 38.35 price is binding on the customer.

Similarly, an order that was executed, but in error reported as a nothing done, is binding on the customer. On the other hand, if a customer order was not executed but was in error reported to have been executed, the “trade” is not binding on the customer.

!T E S T T O P I C A L E R TPlan for four or five questions about exchange transactions. The bulk of the trad-

ing questions will ask about the OTC marketplace.



4. 4 NASDAQ

4. 4. 1 INTRODUCTION TO THE NASDAQ STOCK MARKET

The Nasdaq is a screen-based, SEC-registered stock exchange. The Nasdaq can be divided into two main components: (1) the Global Market, and (2) the Capital Market. Within the Global Market, there is a special tier called Global Select, whose listing standards are designed to compete with those of the NYSE.

Securities eligible for Nasdaq listing are equity and equity equivalent securities, such as common stock, preferred stock, warrants, rights, limited partnerships, American depositary receipts (ADRs), and convertible bonds.

As is the case with the other trading venues, liquidity is prized. NASDAQ offers its mem-bers optional routing functionality that permits them to access liquidity by using a variety of routing algorithms (also known as strategies) that determine the destination of an order. One such algorithm is the NASDAQ DOT strategy. This is a method of designating an order to go the NYSE or NYSE MKT for participation in the opening and closing. Order routing processes are available to participants from the opening of the System at 4:00 a.m. ET until the closing of the System at 8:00 p.m. ET.

✓T A K E N O T EA small number of limited partnership interests are negotiable and trade on OTC

and exchanges. These partnerships are known as master limited partnerships (MLPs).

Investors may trade shares of beneficial interest in REITS on stock exchanges or OTC as well.

4. 4. 2 NASDAQ LISTING REQUIREMENTS

To qualify for Nasdaq listing for the Global Select Market, the Global Market, and the Capital Market, issuers must meet certain minimum criteria that relate to total assets, net worth, number of publicly held shares, bid prices, pretax income, and so forth.

Some of Nasdaq’s minimum listing requirements for a company’s equity securities to trade on the Global Select Market include a bid price of $4 per share for initial inclusion and $1 per share for continued listing. There must be at least three market makers for initial inclusion and two market makers for continued listing.

Companies already listed or quoted on another marketplace (e.g., listed on a regional exchange) may qualify for a Capital Market listing under the market capitalization listing standard only. To do so, the issue must meet the minimum market value and bid price require-ments for 90 consecutive trading days before applying for listing.

There also are nonquantitative criteria that issuers must meet to qualify for Nasdaq listing. These include:

■ minimum of two independent directors; ■ establishment of an audit committee; ■ providing shareholders with quarterly and annual reports; ■ having an annual shareholders meeting; ■ soliciting proxies for all shareholder meetings; and ■ executing a listing agreement with FINRA.



4. 4. 2. 1 Issue Termination

FINRA may terminate or suspend an issue’s inclusion in Nasdaq if: ■ the issuer files for bankruptcy; ■ the issuers’ independent accountants issue a disclaimer opinion on the company’s financial

statements (a disclaimer opinion is one in which the accountants, for whatever reason, cannot render an opinion); or

■ FINRA deems termination to be in the public interest.

A security that has been terminated must, prior to reinclusion, comply with the require-ments of initial inclusion. If suspended, however, a security, prior to reinclusion, must meet the requirements for continued inclusion (maintenance standards).

4. 4. 3 REGISTRATION AS A NASDAQ MARKET MAKER

To register as a Nasdaq market maker, a firm must be a member of Nasdaq and file an appli-cation with the FINRA District Office denoting compliance with the net capital and other financial and operational rules. The District Office will interview the principal officers of the firm to determine if the firm is qualified to be a Nasdaq market maker.

FINRA then sends an approval form to Nasdaq’s Subscribers Services department, and they in turn will notify the firm and activate all the firm’s services. FINRA will amend the firm’s membership agreement to include the new line of business.

Once registered as a market maker in any issue, additional registrations are easier. If a mar-ket maker wants to be registered in a newly authorized issue, its registration request (made via a Nasdaq terminal) is effective immediately if the request is made within five business days of the issue’s inclusion in Nasdaq. If the request is made more than five business days after inclu-sion, the registration is effective the same day. The newly registered market maker must then begin quoting the security within five business days. Once registered as a market maker in a Nasdaq issue, a member must maintain firm, two-sided, continuous quotations in that issue. Quotes must be current and accessible during the normal market hours of 9:30 am–4:00 pm ET Monday through Friday. A voluntary pre-market trading session begins at 4:00 a.m. and con-tinues until 9:30 a.m. Post-market trading begins at 4:00 p.m. and continues until 8:00 p.m.

Because participation in pre- and post-market trading sessions by market makers and ECNs is strictly voluntary, there is generally less liquidity, inferior prices, and higher volatility. It would be appropriate for supervisors to insist that their APs caution investors who anticipate trading during these times about the risks and that they should strongly urge their customers to use limit orders.

Nasdaq also requires market makers to continuously maintain a two-sided quotation within a designated percentage of the National Best Bid and Offer (NBBO). This eliminates trade executions against market maker placeholder quotations traditionally priced far away from the inside market, known as “stub quotes.” This rule covers all NMS stocks.

In short, no stub quotes are allowed. Market regulators hope that, by prohibiting stub quotes, the risk of trades being executed at irrational prices will be reduced. This has the added benefit of fewer trade breaks if the market becomes volatile.

4. 4. 3. 1 Primary Market Maker

For a Global Market stock, a market maker may be deemed to be a primary market maker in that stock if the firm meets certain criteria (not tested).



The advantage of being a primary market maker in a Global Market stock is that it allows the market maker an exemption from the locate requirement of Regulation SHO (discussed later) in certain transactions. If a market maker is a primary market maker in a particular stock, a P indicator is displayed next to its identification symbol.

4. 4. 3. 2 Withdrawal as a Nasdaq Market Maker

In certain situations, a market maker may apply to FINRA for an excused withdrawal if, for a short period, the market maker wishes to withdraw its quotes from Nasdaq. Before with-drawing its quote, the market maker must receive permission to do so from FINRA.

Certain stocks are fungible in that their trading characteristics are predictable. In these cases, any experienced market maker can trade them. Other securities have unique trading characteristics, and firms are reluctant to have someone other than the person experienced in that security take over if the experienced trader is unavailable.

Unavailability can result from sudden illness, religious holidays, jury duty, or vacation. In these instances, the member may apply for an excused withdrawal until the experienced trader returns. Both application and response are made electronically via a Nasdaq terminal.

Other reasons for seeking an excused withdrawal include equipment malfunction, invol-untary failure to maintain a clearing agreement, legal considerations, and the requirements of Regulation M (discussed in the supervision of investment banking unit). If an excused with-drawal results from failure to maintain a clearing agreement, the firm may re-enter Nasdaq as soon as a new clearing agreement is established.

If granted, excused withdrawals generally cover no more than five business days. If granted based on legal considerations, the time frame can be up to 60 calendar days.

*E X A M P L E If a market maker comes into possession of inside information on the subject security, FINRA will immediately excuse the firm from continuing to make a market.

Seeking an excused withdrawal due to a sudden influx of orders, sudden price changes, or a pending news announcement is not permitted. If found to be in violation of FINRA rules, FINRA can suspend or terminate a market maker.

*E X A M P L E If a market maker fails to enter quotes within five business days after registra-tion is effective, the firm will be involuntarily terminated as a market maker in that security.

In contrast, a market maker may want to voluntarily terminate its registration in a particu-lar security. To do so, the market maker withdraws its quotes from Nasdaq. This alerts FINRA that the member wants to terminate registration in that security. Should the member wish to reregister as a market maker in that security, it must wait at least 20 business days (from termination date).



!T E S T T O P I C A L E R T■■ A market maker’s initial registration is effective only when it is notified by

FINRA.

■■ When a market maker becomes registered in an issue, it must enter quotes within five business days.

■■ Excused withdrawals are generally allowed for five business days.

■■ Voluntary terminations require a 20-business-day waiting period before reregistration.

4. 4. 3. 3 Payments for Market Making

Member firms are prohibited from accepting any type of compensation from an issuer to make a market in the issuer’s securities. Compensation includes cash, loans, stock in the issuer, and so forth. This prohibition extends to affiliates of the issuer, as well as to promoters engaged by the issuer. This prohibition does not include payment for services rendered or reimburse-ment of expenses.

*E X A M P L E If a market maker pays the Nasdaq listing fees for an issuer and is reimbursed, there is no violation.


—— 1. For initial listing as a Capital Market stock, an issue must have a minimum bid price of $4 per share.

—— 2. The only reasons FINRA may terminate an issue’s inclusion in Nasdaq are if the issuer files for bankruptcy or the issuer’s independent accountants issue a disclaimer opinion on the company’s financial statements.

—— 3. A market maker may seek an excused withdrawal because of equipment malfunction, a pending news announcement, involuntary failure to maintain a clear-ing agreement, the requirements of Regulation M, sudden price changes, or influx of orders.

—— 4. To voluntarily terminate its registration in a particular security, a market maker withdraws its quotes from Nasdaq.

—— 5. Market makers are prohibited from accepting any type of compensation from an issuer to make a market in the issuer’s securities, but may accept payment for services rendered and reimbursement of expenses.



4. 4. 4 LEVELS OF NASDAQ SERVICE

Once registered with FINRA, market makers display their quotes and interact with other market makers, other members, and the investing public through Nasdaq, a computer and tele-communication network. The workhorse of Nasdaq is Workstation, a terminal that facilitates quotations, trade executions, and transaction reporting.

A key to understanding quotations over Nasdaq is the inside market, which is the highest bid and the lowest asked price. Customers wanting to buy stock at the market are looking for the lowest asked price, while customers wanting to sell stock at the market are looking for the highest bid.

There are three levels of Nasdaq service available to subscribers. Level 1 service is for registered representatives and individual investors. With Level 1, subscribers can view bid and ask quotes on a security (the bid and ask quote shown on Level 1 is the inside market), last sale information, and share volume statistics.

✓T A K E N O T EThe inside market is sometimes referred to as the NBBO, which stands for na-

tional best bid and offer or top of the book.

Level 2 service is for OTC traders and financial institutions (e.g., pension funds, invest-ment companies). It displays the bid and ask quote, with size, for each market maker in a particular security. It also shows last sale and share volume information.

*E X A M P L E An abbreviated example of Level 2 service is as follows.

ABCD Last 31.10

Market Maker Bid Ask Size

MLCO 31 31.12 10–20

MHMY 31.10 31.20 16–25

SALD 31.05 31.15 3–10

WEED 31 31.12 2–15

MLCO is willing to buy up to 1,000 shares at 31 and sell up to 2,000 shares at 31.12. MHMY is willing to buy up to 1,600 shares at 31.10 and sell up to 2,500 shares at 31.20, et cetera.

The quotes displayed could be principal quotes (the market maker willing to buy and sell for its own account). The quotes could represent customer limit orders to buy and sell at these prices, or the quotes could represent a combination of the two. Over Level 1, the quote for ABCD would be as follows:

Bid Ask Size Last

31.10 31.12 16–35 31.10

Level 3 service is for market makers. It provides the services of Level 2 plus the capability to enter the system to update quotes and/or displayed size.



✓T A K E N O T EA principal quote at the inside market could represent a pegged order, which

is a limit order that is automatically adjusted to follow the inside price. The price of a pegged buy order always equals the highest bid, while the price of a pegged sell order always equals the lowest offer. By entering a pegged order, market participants provide liquidity at the NBBO.

✓T A K E N O T EMarket participants who post bids or offers are adding liquidity to the mar-

ketplace by being willing to buy, or sell, shares at the posted price. If a transaction occurs, the counter party to the liquidity-adding firm is taking liquidity out of the mar-ketplace by reducing the number of shares available to trade.

*E X A M P L E ABC Securities posts a bid of 85.00 for 100 shares of MNO. XYZ Securities then sells 100 shares to ABC for 85.00. In this case, ABC added liquidity to the market-place by being willing to buy 100 shares. XYZ is taking liquidity from the marketplace, because there are 100 shares fewer in the marketplace available.

A protected bid or protected offer means a quotation in an NMS stock that is displayed by an automated trading center, and is an automated quotation that is the best bid or best offer of a national securities exchange.

4. 4. 5 TYPES OF OTC TRANSACTIONS

In the over-the-counter market, a member can act as either a broker or a dealer—but not both—in the same transaction.

*E X A M P L E There are four market makers in ABCD. Their quotes are as follows.

ABCD

Bid Ask

Market Maker 1 10 10.50




Inside Market 10.25–10.50

Situation 1. If a retail customer of Market Maker 1 wants to buy 100 shares of ABCD at the market, the firm, being a market maker in the stock, acts as a dealer (principal). The firm might sell to its customer at 11 net (with a markup).



Situation 2. If a retail customer of a member (not a market maker in ABCD) wants to buy 100 shares of ABCD at the market, the firm, to fill the order, buys from Market Maker 1 at 10.50 and sells the stock to its customer at 10.50 plus a $50 com-mission. In this case, the member acted as an agent, matching buyer (their customer) with a seller (Market Maker 1) and charging a commission.

Situation 3. The member in Situation 2 could have handled the trade in another manner. It could have bought 100 shares from Market Maker 1 at 10.50, put the stock into its riskless principal account, and immediately moved it out of this account to the customer’s account at 11 net. This type of transaction is termed a riskless principal transaction (or a riskless and simultaneous transaction). It is riskless to the member.

The only reason that the firm bought the stock was to fill a customer order, not for its own investment purposes. It simultaneously buys the stock and sells it to its customer with a markup. While this may appear to be a principal (dealer) trade, for regulatory purposes, it is considered an agency transaction.

✓T A K E N O T EA riskless and simultaneous transaction occurs when a firm buys from a market

maker to fill a customer order and charges a markup. This transaction is subject to the 5% policy, and disclosure of the markup is required on the customer confirmation if the security is traded on Nasdaq.

For example, if a customer places an order to buy 1,000 shares of XYZ from a firm, and the firm does not make a market in XYZ, it may purchase the stock from a market maker currently at the inside market. It then sells the stock to the customer with a markup. As a riskless and simultaneous transaction, the markup must be dis-closed.

4. 4. 6 VWAP

When a buy-side customer places a particularly large order with the trading desk of a member firm, the order will likely require many trades through the time allotted to fill. Large orders have the potential to disrupt pricing and, if not effected well, could impact the market negatively. How well that trading service is performed is often measured by using the Volume Weighted Average Price, better known as the VWAP, as a measurement.

The VWAP of a stock trade differs from the average price as higher volume trades have a greater impact on the VWAP. For example, assume there are two trades in WXYZ stock: 100 shares at 20, and 300 shares at 21. The average price is $20.50, but the VWAP is $20.75, calcu-lated as follows: 100 shares at 20 represents $2,000 in value, while 300 shares at 21 represents $6,300 in value. The total value traded is $8,300. Dividing the total value traded ($8,300) by the number of shares traded (400) results in a VWAP of $20.75. You will be expected to calculate VWAP on the Series 24.

FINRA rules require that members, once in receipt of a VWAP order, refrain from engag-ing in any activity that compromises the customer’s interest in favor of the member’s propri-etary trading interest. Members must also place information barriers to prevent the internal disclosure of any VWAP order received. If a registered representative were to learn of a large, potentially market-moving, VWAP order, the representative cannot solicit orders in that stock. Only unsolicited orders are acceptable. Member firms who accept VWAP or similar large orders are required to disclose in writing that the member may engage in hedging or



other positioning activity that could affect the market for a security that is involved in the transaction.

Members must establish supervisory procedures reasonably designed to ensure the integrity of its trading activity (best execution obligations, Rule 2320) and to evaluate the execution quality of VWAP and other large orders.

4. 5 NASDAQ TRADING RULES

4. 5. 1 CHARACTER OF QUOTATIONS

As previously stated, once registered as a market maker in a NASDAQ stock, the member is obligated to maintain a firm two-sided quote. Further, it must be willing to buy or sell at least 100 shares at its stated quote. If a market maker displays a quote size greater than 100 shares, it must, on receipt of an order from another member, be willing to buy or sell at least up to the size displayed.

In addition, a market maker’s quote must be reasonably related to the prevailing market (the inside market). If a market maker’s quotes are not reasonably close to the prevailing market, FINRA will require the firm to re-enter its quotes. If it fails to do so, the firm will be terminated as a market maker in the security.

NASDAQ features a price/time priority model to ensure all trades are fair and transparent for all market participants. All displayed limit orders are treated equally and are executed in the order in which they were received at the same price.

4. 5. 1. 1 Offers at Stated Prices-Firmness of Quotations (FINRA Rule 5220)

All quotes entered by Nasdaq market makers must be firm for the size displayed. If a market maker fails to honor a stated quote, the market maker is backing away, which disrupts normal trading operations and is a rules violation. It is not only a violation of Rule 5220 but also 2010 in that backing away is deemed inconsistent with high standards of commercial honor and principals of trade.

There are, however, two situations in which a market maker does not have to honor a stated quote.

■ If, prior to the time an order is received, the market maker enters a revised quote into Nasdaq, the quote on the screen (the previous quote) does not have to be honored.

■ If, at the time an order is received, the market maker is in the process of executing a trade, and on completion of the trade immediately enters a revised quote into Nasdaq, the mar-ket maker does not have to honor the previous quote.

The firmness of the quotations rule applies to covered securities, which are securities for which quantitative and last-sale information is available through an automated reporting system.

FINRA prohibits the use of computer-generated quote updates if these systems are used to keep a market maker’s quote away from the inside market (auto quote policy). Automated updating is permitted when the update is to ensure that the market maker maintains the same bid and ask quote in another trading system.



✓T A K E N O T EAccording to the firm quote rule, market makers are obligated to execute orders

at a price at least as favorable as their published quote, for an amount up to their published size. The obligation to honor an order begins when the order is presented, whether it is received through the phone or via an electronic communications net-work.

4. 5. 1. 2 Prohibition from Locking or Crossing (FINRA Rule 6240)

During the hours of 8:00 am to 6:30 pm ET, market makers are prohibited from display-ing a bid for an NMS stock that either locks or crosses the market. A locked market is one in which the inside bid (highest bid) and the inside offer (lowest asked price) are the same. A crossed market is one in which the inside bid is higher than the inside offer.

*E X A M P L E The displayed market for ALTT (an NMS stock) is as follows.

ALTT

Bid Ask





Inside Market 29.75–30

Situation 1. If Market Maker 2 wants to update its quote to 30–30.13, the new inside market will be 30-30, which is a locked market.

Situation 2. If Market Maker 2 wants to update its quote to 30.05–30.13, the new inside market will be 30.05–30, which is a crossed market.

In Situation 1, if Market Maker 2 is anxious to buy stock at 30, it might want to buy stock from Market Makers 1 and 4, both of which are offering stock at that price. The same argument can be made in Situation 2. Why bid for stock at 30.05 when stock can be bought from Market Makers 1 and 4 at 30?

4. 5. 1. 3 Regulation SHO

SEC Regulation SHO promulgates uniform rules for short sales and is a common topic seen on the Series 24 exam.

4. 5. 1. 3. 1 Order Marking

The Commission requires that sell orders in all equity securities be marked as long, short, or short-exempt. Sales can be marked long only if the security to be delivered is in a good control location, physically in the customer’s account, or the broker-dealer reasonably expects the owner of the security will deliver it by the settlement date. If the customer borrows stock to effect delivery, the order ticket must be marked short. Sales marked short-exempt are not subject to the provisions of Regulation SHO.



4. 5. 1. 3. 2 Locate and Delivery Requirements (Rule 203)

Before effecting a short sale in any equity security, firms must locate securities available for borrowing. Regulation SHO prohibits a broker-dealer from accepting a short sale order in any equity security from another person, or effecting a short sale for its own account, unless the firm:

■ has borrowed the security or entered into an arrangement to borrow the security, or ■ has reasonable grounds to believe that the security can be borrowed for delivery on settle-

ment. The firm must make and document the locate before effecting the short sale, regard-less of when seller’s short position may be closed out (e.g. purchasing the securities back the same day).

!T E S T T O P I C A L E R TIn accordance with Regulation SHO, customers are long if they own:

■■ the subject securities;

■■ convertible securities and have issued conversion instructions;

■■ options and have issued exercise instructions; or

■■ rights or warrants and have issued exercise instructions.

Note that a person long a securities futures contract is not considered to own the underlying security until the contract stops trading and the futures contract settles by physical delivery.

Customers who are long and short the same security are considered long to the extent of the net long position only. This is important to note during the 20 business days a tender offer is underway.

4. 5. 1. 3. 3 Exceptions to the Locate Requirement

There are several exceptions to the locate requirement. First, market makers are exempt in connection with bona fide market-making activities. Next, the locate requirement does not apply to a short sale order received from another broker-dealer. For example, if an introducing firm places a short sale order through its clearing firm, it is the responsibility of the introducing firm, not the clearing firm, to determine that the security being shorted can be borrowed to effect delivery.

!T E S T T O P I C A L E R TShort sales by primary market makers in connection with bona fide market mak-

ing activity are short-exempt.

Another exception occurs in the following scenario: if a convertible security, option, or warrant has been tendered for conversion/exercise but the security is not reasonably expected to be received by settlement date, the locate requirement does not apply. Under SEC rule 203, delivery must be made within 35 calendar days of trade date. If not, the firm that handled the sale must take immediate steps to close out the fail to deliver by purchasing or borrowing the securities.



!T E S T T O P I C A L E R TWhen a seller does not deliver the sold securities by the transaction’s settlement

date, the broker-dealer has established a “fail to deliver.”

This 35-calendar-day rule also applies to stock sold under Rule 144. Once the holding period requirements have been met, a customer may sell the stock long, even though it will likely take longer than the standard settlement cycle for the stock to come back from the transfer agent free of any restrictions.

4. 5. 1. 3. 4 Available Securities List (Easy-to-Borrow List)

Securities lending companies, provide securities to facilitate short sales. These firms pub-lish and circulate lists to broker-dealers to identify securities easily available for borrowing. Such a list may be used to provide assurance that the securities may be borrowed to effect delivery. The short sale rule requires that to be useful, these available securities lists must be updated every 24 hours.

✓T A K E N O T ELists of securities available for borrowing (easy-to-borrow) allow broker-dealers

to make affirmative determination on a blanket rather than on an individual basis. With regards to the reasonable grounds test, FINRA finds this practice acceptable but only if the list is updated daily.

4. 5. 1. 3. 5 Hard-to-Borrow List

In making an affirmative determination for short sales, firms create a “hard-to-borrow” list, which identifies securities that are in limited supply and difficult or impossible to borrow. It cannot be presumed that if a security is not on this list, it can be borrowed for short sale purposes. Like an easy-to-borrow list, a hard-to-borrow list must be updated daily. Practically speaking, just because a security is not on the hard-to-borrow list does not by itself satisfy the reasonable grounds test of Rule 203. A hard-to-borrow list can only be used for Global Market securities and exchange-listed securities. For Capital Market stocks, a member must use an easy-to-borrow list.

4. 5. 1. 3. 6 Threshold Securities and Short Sale Delivery Requirements

A threshold security is any equity security of an issuer where, for five consecutive settle-ment days, there are fails to deliver at a registered clearing agency of 10,000 shares or more, and the level of fails is equal to at least one-half of one percent of the issue’s total shares out-standing. The appropriate SRO updates its threshold security list daily. A security ceases to be a threshold security if it does not meet or exceed the specified levels for five consecutive settlement days.

According to FINRA Rule 4320, if a market maker or any participant of a clearing agency registered with the SEC (e.g., the NSCC) has a fail to deliver position in a threshold security open for 10 business days after settlement (13 consecutive settlement days), the firm must immediately close the position by purchasing the securities, or it may not engage in any short selling activities without first having borrowing or entering into a bona fide agreement to bor-row the security.



Put another way, until a security appears on a threshold list for 13 consecutive settlement days and a firm has an open fail position in that security for those days, Regulation SHO does not require a closeout.

In addition, if a market maker has a fail to deliver in a threshold security for 13 consecu-tive settlement days, it may not effect another short sale in that security until it either closes out the fail by purchasing the securities or pre-borrows the stock. In this case, it can enter a short sale only to the extent of its borrowing. If the security is not borrowable and the firm is unable to purchase the securities, it may have to seek an excused withdrawal from FINRA, because being prohibited from short selling effectively precludes the firm from acting as a market maker.

The closeout and preborrow requirement does not apply to a net syndicate short position in a threshold security as long as the syndicate takes steps to close out the short by the 30th calendar day following the effective date of the offering.

Lastly, if a firm accepts a sell order and the ticket is marked long, the firm must make deliv-ery when due and cannot use borrowed securities to do so. This prevents naked short selling, which is selling long without a position in the security. The intent is to buy back later the same day. In this case, the ticket should have been marked short, and the locate requirement should have been met to satisfy SEC Rule 203.

!T E S T T O P I C A L E R TIn the case where a market maker is subject to the preborrowing restriction of

not closing out a fail to deliver in a threshold security, it may have to seek an excused withdrawal from FINRA, because being prohibited from short selling effectively pre-cludes the firm from acting as a market maker.

The closeout and pre-borrow requirement does not apply to a net syndicate short position in a threshold security as long as the syndicate takes steps to close out the short by the 30th calendar day following the effective date of the offering.

4. 5. 1. 4 SEC Rule 204

To further address “naked” short selling, or short selling without a borrow, the SEC enacted Rule 204 of Regulation SHO in 2009. Rule 204 requires participants in NSCC’s Continuous Net Settlement System (CNS) to close out any fail to deliver position that exists on the trade’s settlement date for any equity security. This is true for both long and short sales. If the fail to deliver resulted from a long sale or in connection with bona fide market-making activities, the position must be closed out by the beginning of regular trading hours on the third business day after settlement (S+3). If, however, the fail to deliver resulted from a short sale, the position must be closed out by the beginning of regular trading hours on the first business day after settlement (S+1). A close out would be accomplished through either purchasing or borrowing securities of like kind and quantity.

*E X A M P L E If a customer sold stock long, settling regular way, and does not deliver the securities, then the fail to deliver must be closed out on T+6, because regular way settlement for equities is T+3. If, however the trade was executed with cash settle-ment (T+0), then the close out would occur on T+3.



4. 5. 1. 4. 1 Pre-Borrow Penalty

If a participant fails to close out an open fail by the deadline, Rule 204 imposes restrictions on a broker-dealer to effect future short sales in that security. A broker-dealer working outside Rule 204 is required to first borrow (or set up an agreement to borrow) the stock before accept-ing any short sales orders either for customers or for their own proprietary trading account. The pre-borrow penalty remains in effect until the open “fail” is closed out by actually buying the stock.

4. 5. 1. 4. 2 Pre-Fail Credit

A broker-dealer may avoid a close-out requirement or pre-borrow penalty by buying enough shares to offset the fail.

4. 5. 1. 4. 3 Key Points of Rule 204

The following are key points to remember regarding Rule 204. ■ Rule 204 applies to all equity securities. ■ The purchase or borrow of securities will not qualify as a closeout if the participant knows

the securities will not actually be delivered by settlement. ■ Rule 204 requires that BDs track all fails to deliver from both long and short sales, and

then borrow or buy-in a sufficient amount of stock to close out the fails at the beginning of regular trading on S+1 (in the case of short sales) and S+3 (in the case of long sales).

■ If the BD does not close out the position within that time period, it may be temporarily barred from effecting short sales in that stock for any customer unless it pre-borrows that stock.

■ Closeout requirements do not apply to Rule 144 stock.

✓T A K E N O T EIf an introducing firm places a short sale order through its clearing firm, it is the

responsibility of the introducing firm, not the clearing firm, to determine that the security being shorted can be borrowed.

*E X A M P L E Short sales by primary market makers in connection with bona fide market mak-ing activity are short-exempt.

!T E S T T O P I C A L E R TIn accordance with Regulation SHO, customers are long if they own:

■■ the subject securities;

■■ convertible securities and have issued conversion instructions;

■■ options and have issued exercise instructions; or

■■ rights or warrants and have issued exercise instructions.



Note that a person long a securities futures contract is not considered to own the underlying security until the contract stops trading and the future will be settled by physical delivery.

Customers who are long and short the same security are considered long to the extent of the net long position only.

4. 5. 1. 4. 4 Exceptions to the Locate Requirement

There are several exceptions to the locate requirement. First, market makers are exempt in connection with bona fide market-making activities. Next, the locate requirement does not apply to a short sale order received from another broker-dealer. For example, if an introducing firm places a short sale order through its clearing firm, it is the responsibility of the introducing firm, not the clearing firm, to determine that the security being shorted can be borrowed to effect delivery.

Another exception occurs in the following scenario: if a convertible security, option, or war-rant has been tendered for conversion/exercise, but the security is not reasonably expected to be received by settlement date, the locate requirement does not apply. Under SEC rules, delivery must be made within 35 calendar days of trade date. If not, the firm that handled the sale must take immediate steps to close out the fail by purchasing or borrowing the securities.

This 35-calendar-day rule also applies to stock sold under Rule 144. Once the holding period requirements have been met, a customer may sell the stock long, even though it will likely take longer than the standard settlement cycle for the stock to come back from the transfer agent free of any restrictions.

✓T A K E N O T ELists of securities available for borrowing (easy-to-borrow) allow broker-dealers

to make affirmative determination on a blanket rather than on an individual basis. FINRA finds this practice acceptable if the list is updated daily.

✓T A K E N O T EIf a customer sells long and fails to deliver the securities by the settlement date,

the position must be bought within 10 business days of the settlement date.

✓T A K E N O T ERegulation SHO is effective until 4:15 pm ET, because trade reporting can be

delayed causing reports after the 4:00 pm close.

4. 5. 1. 5 Closeout of Short Sales

Long sales not resulting in delivery must be closed out (i.e., bought in) after 10 business days from settlement. Short sales not resulting in delivery are covered by Regulation SHO. If a particular issue of stock has a significant number of shares that have been shorted and not delivered, it is termed a threshold security. If a market maker has a fail to deliver in a threshold security open for 13 consecutive settlement days, Regulation SHO requires that the position be closed out by purchasing the securities. If the security is not on the threshold list, closeout is not required.



4. 5. 1. 6 Short Interest Reporting (FINRA Rule 4560)

Short positions in both customer and proprietary accounts must be reported to FINRA twice a month as of the 15th and the last business day of the month. Reports are made on those positions that have settled as of the reporting dates. Further, reports must be received by FINRA no later than 6:00 pm on the second business day after each reporting date.

Introducing firms, as well as executing brokers in a prime brokerage relationship, are exempt from reporting. Rather, it is the firm carrying the position that reports.

4. 5. 1. 7 Opening Cross

The opening cross rules are designed to create a single opening price, similar to the open on an exchange floor. These rules, among other things, replace the trade or move rules, which dealt with locking/crossing quotes entered prior to market open.

On-the-open orders can be market orders or limit orders. They can be entered as early as 7:00 am and must be entered before 9:28 am.

4. 5. 1. 8 Closing Cross

The closing cross rules are designed to create a single closing price much like the exchanges. On-the-close orders can be market orders or limit orders. They can be accepted immediately after the market opens until 3:50 pm.

4. 5. 2 CUSTOMER LIMIT ORDER PROTECTION RULE (THE MANNING RULE)

The FINRA customer limit order protection rule (Manning Rule) applies to exchange-listed and OTCBB securities. The intent of this rule is that market makers have a responsibil-ity to provide best execution for their customers’ limit orders, if they choose to accept them, whether through their market making capacity or sent to or received from another member.

*E X A M P L E There is no requirement for a market maker to accept a limit order, but if it does, the firm cannot continue to trade the security for its own account at prices that would satisfy the customer’s limit.

If a member firm executes a trade for its own account at or through a customer’s limit order price, the firm must execute the customer’s limit order within one minute. The firm need not execute a larger order for a customer than it executes for its own account.

✓T A K E N O T EA market maker is holding a customer limit order to buy 1,000 shares at 20. If the

market maker buys 400 shares for the firm’s account at 20, the firm also must execute 400 shares of the customer’s limit order at 20.

Customer limit orders must be executed promptly after eligibility.



All customer limit orders that a firm receives, either from its own customers or from another broker-dealer (member-to-member orders), are subject to this interpretation.

Member-to-member limit orders are considered customer orders, not proprietary orders. Firm orders entered with a market maker for the firm’s proprietary account are not protected under this rule.

Limit orders are protected between 9:30 am and 6:30 pm. That is, during those hours, members must handle their customer limit orders with care so members do not trade ahead of those limit orders. This is true for those customer limit orders received from their own custom-ers or from another member, in that they are prohibited from trading at prices equal or superior to the customer’s limit order without executing the limit order. They are not protected 24 hours a day.

A recent amendment to the Manning Rule provides further benefit to customers. Before the amendment, a member holding a customer limit to buy at 31.01 who, as principal, bought at 31.00, could fill the order at either 31.00 or 31.01. Now, the member must pass along any price improvement it received in the execution of its order to the customer order. In this case, the member must fill the customer order at 31.00.

In a similar vein, FINRA Rule 5320 prohibits firms from trading ahead of customer mar-ket (or marketable limit) orders. The rule prohibits a firm that accepts and holds a customer market order from trading for its own account at prices that would satisfy the customer market order unless the firm immediately executes the customer order. This applies to exchange-listed as well as Nasdaq securities.

*E X A M P L E The inside market for ABCD is 10.00–10.05, and Firm A accepts and holds a cus-tomer market order to buy 1,000 shares. If Firm A buys 1,000 shares of ABCD from Firm B (or from any other source) at the bid, it is required to fill the customer’s order at that price. Similarly, if Firm A bought shares for its own account below the inside bid, it would be required to fill the customer order at that price.

✓T A K E N O T EMember firms are not required to accept customer limit orders. If such orders are

accepted, reasonable fees may be charged for their acceptance and execution with adequate disclosure.

4. 5. 3 MANNING ORDER EXEMPTIONS

With the proper disclosures, a firm may trade ahead of the following customer limit orders: ■ Orders from institutional accounts, such as

— a bank, savings and loan association, insurance company, or registered investment company,

— an investment adviser registered either with the SEC, a state securities commission, or

— any other entity (whether a natural person, corporation, partnership, trust, or other-wise) with total assets of at least $50 million



■ Orders for a noninstitutional account of 10,000 shares or more and value of $100,000 or more

■ Not held or working orders (the dealer is given discretion as to the price and time of the execution)

These exemptions are permitted provided the terms and conditions have been communi-cated fully to a customer before or at the time an order is accepted and the customer approves. Trading along agreements must be on an order-by-order basis. There can be no blanket agree-ments. An Intermarket Sweep Order (ISO) is exempted from limit order from the Order Protection Rule. Customers, typically professional buy-side traders, require their orders to be executed in one market even if there is a better quote elsewhere. This may be done as part of an algorithmic trading scheme.

4. 5. 4 ORDER PRIORITY METHOD

Provided the methodology is applied consistently, a firm may choose any reasonable way to execute the multiple limit orders it holds. Additionally, firms are not required to allocate execution between limit orders at the same price.

A firm may not knowingly favor its own customer limit orders over limit orders it accepts from other firms on behalf of their customers.

*E X A M P L E A firm has two limit orders to buy 300 shares of ABCD at 20. If the market maker then buys 200 shares at 20, one of the two limit orders must be executed for 200 shares. There is no need to give execution to the other.

4. 5. 5 PRICE PROTECTION OF CUSTOMER LIMIT ORDERS

When a firm accepts a limit order from one of its retail customers that includes a com-mission, commission equivalent, markup, or markdown in the limit order price, the firm must protect the limit order at its stated limit order price, or net price.

*E X A M P L E If a customer enters a limit order to buy and requests that total costs not exceed $11 per share, and if the customer is informed of a markup of .25, the customer order would be deemed a limit order at $10.75. The price at which the limit order is protected must be clearly explained to the customer.

Market maker trades are not affected by ticket, clearing, or other charges. If a market maker, as principal, buys 500 shares at 15, incurring costs equal to .02 cents per share, it must protect customer limit orders at 15, not 15.02.

!T E S T T O P I C A L E R TA customer limit order to buy 500 shares of ABCD at 20 (gross) including a .25

markup must be protected at 19.75.



*E X A M P L E A market maker quotes 30–30.25 10 x 10. If the firm receives a customer order to buy 400 shares at 30.10, it must, within 30 seconds, update its Nasdaq quote to 30.10–30.25 4 x 10.

If the market maker were to receive an order to buy 400 shares at 30, it would have to update its quote size to 14 x 10.

There are several exceptions to the limit order display rule. If a limit order is of de minimis size (10% or less of the market maker’s displayed size), no display is required as long as the market maker is at the inside market.

*E X A M P L E If a market maker at the inside is quoting 36.36–36.50 20 x 10 and receives an order to buy 100 shares at 36.36 (less than 10% of the displayed size of 2,000 shares), it is not required to update its displayed size. However, the order still must be protected.

Other exceptions to the display rule include: ■ customers who request that their limit orders not be displayed; ■ odd-lot limit orders; ■ all-or-none limit orders; ■ block size orders (10,000 shares or more); and ■ orders that are delivered to an eligible ECN.

An ECN is a trading system operated by members, not FINRA. ECNs can be eligible or ineligible. An ineligible ECN is one in which quotes (orders) placed with it are not necessar-ily available to all market participants.

*E X A M P L E If a market maker, in receipt of a customer limit order priced better than its cur-rent quote, enters the order into an ineligible ECN, the investing public, including other market makers, would not know about it unless they subscribed to that ECN’s service.

An eligible ECN is one in which quotes placed with it are communicated to Nasdaq for public dissemination. The SEC, to eliminate this inequity, requires the following.

■ If a market maker enters a quote (priced better than its current quote) into an ineligible ECN, it must update its Nasdaq quote.

■ If a market maker enters a quote (priced better than its current quote) into an eligible ECN, it is not required to update its Nasdaq quote.



4. 5. 6 INFORMATION BARRIERS

Similar to what was discussed in Unit 2 about information barriers being placed between analysts in the capital markets department and other departments, those member firms that have proprietary trading desks in addition to market-making trading desks must also create information barriers. The purpose of this barrier is to prevent information regarding customer limit orders from reaching the proprietary desk. With such a safeguard in place, the proprietary desk could unknowingly trade at prices at or better than customer limit orders without violat-ing FINRA rules.

✓T A K E N O T EIf information barriers are in place, a non-market-making desk within a firm could

trade ahead of a customer limit order without a violation, because the desk would have no knowledge of the customer limit orders accepted by the trading department.

4. 5. 7 PRICE IMPROVEMENT

Customer limit orders need not be executed if a market maker provides price improvement.

*E X A M P L E A market maker is quoting ABCD stock at 8–8.25, and a customer enters a limit order to buy 200 shares of ABCD at 8.05. Another customer enters a market order to sell 500 shares at 8.10. The market maker can fill the customer sell order at 8.10 without executing the limit order, because price improvement of .05 was provided.

The rules for price improvement are as follows: for limit orders that are priced at $1 or more and are at or inside the best inside market, the minimum price improvement required is $.01. For limit orders priced at less than $1 and that are at or inside the best inside market, the minimum price improvement required is the lesser of $.01 or one-half the current inside spread.

4. 5. 8 SEC LIMIT ORDER DISPLAY RULE (SEC RULE 604)

The SEC limit order display rule appertaining to all NMS stocks requires that a market maker immediately publish and display in its quotation the price and full size of each customer limit order it holds that:

■ is priced better than its current quote; or ■ adds to the size associated to the quote.

The display rule requires market makers to update their quotes immediately to reflect customer limit orders. Immediately is defined as within 30 seconds of receiving an order under normal market conditions. The 30 seconds begin when the individual trader responsible for quoting the order receives it, not when a registered representative receives the order from the customer. This 30-second rule does not apply to market openings or shortly thereafter, when trading begins after a trading halt, or when an initial public offering begins trading.



*E X A M P L E A market maker’s quote for ABCD stock is 10.50–10.75, 10 × 10. If the mar-ket maker receives a limit order to buy 200 shares at 10.60, the market maker must update its quote to 10.60–10.75, 2 × 10 within 30 seconds. However, if the market maker receives a limit order to buy 200 shares at 10.50, the market maker must up-date its quote to 10.50–10.75, 12 × 10 within 30 seconds.

An exception to the limit order display rule exists if the customer’s limit order is less than or equal to 10% of the market maker’s displayed quote size (de minimis size). In this situation, updating the quote to reflect the size of the limit order is not required. This exception applies only if the market maker is at the inside market at the time of order receipt.

*E X A M P L E A market maker’s quote for ABCD stock is 10.50–10.75, 20 × 10. If the market maker receives a limit order to buy 100 shares at 10.50, the displayed size does not have to be updated, because the order is less than or equal to 10% of the market maker’s displayed quote size. However, the order still must be protected.

4. 5. 8. 1 Exceptions to the Display Rule

The limit order display rule does not apply to: ■ customer limit orders executed upon receipt; ■ limit orders when customers request that they not be displayed; ■ special orders, including odd lot orders, and all-or-none limit orders; ■ block-sized orders (at least 10,000 shares); and ■ limit orders delivered immediately to an ECN that complies with the ECN display alterna-

tive.

4. 5. 8. 2 ECN Display Alternative

Before the implementation of the limit order handling rules, market makers could use ECNs to create hidden markets. This allowed market makers to quote a better price on an ECN than they were quoting through Nasdaq. The ECN amendment requires that a market maker quoting a better price in an ECN update its Nasdaq quote to reflect the improved price.

A market maker can satisfy this requirement by using a linked or an eligible ECN, which allows automatic communication to the Nasdaq system and gives other market makers or dealers access to the orders. Even those members who do not subscribe to the ECN must have access. Ineligible ECNs do not automatically communicate to Nasdaq.

✓T A K E N O T EIf a market maker receives an order priced better than its current quote and im-

mediately delivers it to an eligible ECN, it is not required to update its Nasdaq quote. If the order is delivered to an ineligible ECN, it must update its Nasdaq quote.



Sending an order to an ECN does not relieve a member of its obligation to protect cus-tomer orders under the Manning Limit Order Protection Rule. A member firm cannot trade ahead of customer limit orders sent to ECNs.

In an Order Handling Release, the SEC stated that if a market maker holding an undis-played limit order receives a market order from the opposite side of the market, the firm must execute the market order at the undisplayed limit price.

*E X A M P L E A market maker is quoting a stock at 17.32–17.35, 10 × 10. The firm is holding an undisplayed (at the customer’s direction) order to buy 300 shares at 17.33. If the firm receives a market order to sell stock, the SEC Release requires that it be executed at 17.33.

QQ U I C K Q U I Z 4 . C 1. A market maker in ABCD is quoting 20–20.25, 13 × 10, which is the inside market. The market maker accepts a customer order to buy 100 shares at 20. According to SEC rules, the market maker must

A. update its quote to 20–20.25, 14 × 10B. update its quote to 20–20.25, 13 × 11C. protect the orderD. refuse the order

2. A market maker is holding an undisplayed customer limit order to buy 500 shares at 10.25 while quoting 10–10.40, 10 × 10. The customer’s limit order includes an agreed-on markup of .15. If the market maker then receives a market order to sell 200 shares and executes against the undisplayed limit, the market maker must fill the customer order at

A. 10.25B. 10.40C. 10.10D. 10.00

3. A market maker holds a customer limit order to buy 300 shares of ABCD at 10 AON. The market maker purchases 100 shares of ABCD as principal at 10. Limit order rules require that the market maker

A. execute 100 shares of the customer limit order and protect the remaining 200 shares

B. execute 100 shares of the customer limit order and cancel the remainderC. not execute the customer limit orderD. execute the full customer order

4. A market maker is quoting 10.10–10.30, 8 × 10 at the inside market. The bid at 10.10 represents a customer limit order. To avoid triggering a Manning obliga-tion, the market maker must purchase as principal at least

A. .05 above the bidB. .01 above the bidC. .05 above the askedD. .01 above the asked



5. The inside market for ABCD stock is 20–20.30, 12 × 20. A market maker in the stock is currently quoting 19.95–20.30, 10 × 10 and receives a customer order to buy 500 shares at 20.20. The market maker’s quote

A. is not required to be updated, because it is not at the inside priceB. must be updated to 20.20–20.30, 5 × 10C. must be updated to 20.20–20.30, 10 × 10D. must be updated to 20.20–20.30, 12 × 10

4. 5. 8. 3 Trading Along

Trading along allows a market maker (or DMM) to buy or sell an agreed-upon amount at a price that would satisfy an institution’s order to buy or sell.

*E X A M P L E An institution places an order to buy 100,000 shares of a stock at 26.45. If 60,000 shares become available at that price and the market maker has an agreement in place to trade along on a 50-50 basis, the market maker would take 30,000 shares and the institution the remaining 30,000 shares.

Without an agreement with the institution, the market maker, under the limit order protection rule, would be obligated to execute the entire order for the institu-tion’s account.

Under FINRA rules, trading along agreements must be on an order-by-order basis. There can be no blanket agreements.

4. 5. 9 FRONT RUNNING (FINRA RULE 5270)

If a member or any associated person has nonpublic knowledge of an impending block order to buy or sell, that member or person cannot place an order in front of the block order.

This prohibition applies not only to proprietary accounts but also to employee and employee-related accounts and accounts over which the member has been given discretionary authority. The front running prohibition extends not only to the security that is the subject of the block order, but also to options on that security. For purposes of this rule, a block order is an order for 10,000 shares or more.

*E X A M P L E There have been cases in which a firm, to circumvent the rule, executed the block order in pieces, each for less than 10,000 shares. Their defense was that they were not buying in front of a block order to buy as there was, technically, no block order. Needless to say, they succumbed in a Code of Procedure hearing.

4. 5. 10 TRADING AHEAD OF RESEARCH REPORTS

Members are prevented from adjusting their inventory, either in a market-making account or a proprietary trading account, ahead of the release of a research report.



*E X A M P L E A member is about to issue a rating upgrade for XYZZ. Knowing that the release will trigger an inflow of big orders, the member increases its position in anticipation of filling orders from inventory. According to FINRA, this action would not be in the best interest of the investing public.

FINRA recommends, but does not require that members maintain an information barrier to prevent a market making or proprietary trading desk from obtaining advance knowledge of impending research reports.

!T E S T T O P I C A L E R TTrading ahead is distinct from front running. Trading ahead always concerns

research reports; front running involves placing an order for a firm or employee before a customer order.

4. 5. 11 MANIPULATIVE QUOTATIONS

Member firms are prohibited from publishing, by any means, any report of a securities transaction unless the member knows or has reason to believe that the transaction was bona fide (actually occurred). Similarly, members are prohibited from publishing, by any means, any quotation for a security unless they believe the quotation is bona fide.

Members also are prohibited from entering orders that are designed to mark the close. Marking the close means entering orders or falsely reporting trades to affect the closing price of a security.

Similarly, members are prohibited from telling customers that a security is being offered to them at the market unless the member has reason to believe that a market exists for the security other than the market created by that member.

✓T A K E N O T EA manipulative act is distinct from a prohibited act in that manipulation is

designed to induce investors to take an action that they would otherwise not take. For example, painting the tape is the practice of buying and selling a specific stock, creating the illusion of high trading volume and significant investor interest. This can attract unsuspecting investors into buying the stock. Painting the tape is sometimes referred to as wash sales—that is, buying and selling the same stock at the same price to create the illusion of activity.

Furthermore, FINRA Rule 6140 specifically prohibits members from executing or partici-pating in an account for which there are executed purchases of any NMS stock at successively higher prices, or sales at successively lower prices, for the purpose of creating an artificial appearance of activity in the stock for the purpose of improperly influencing the market price of the security for the purpose of establishing a price that does not reflect the true state of the market in a security.



Examples of that kind of prohibited behavior include: ■ executing any transaction in a security that involves no change in beneficial ownership; or ■ entering an order to buy a security with the knowledge that an order of substantially the

same size and price for the sale of the security has been or will be entered by or for the same or different parties, or vice versa (entering an order for the sale knowing that an order of substantially the same size and price for the purchase of the security has been or will be entered).

Member firms may not execute purchases or sales of any NMS security for any account in which it has an interest that is excessive in view of the member’s financial resources or in view of the market for the security.

Members may not participate or have any interest in the profits of a manipulative opera-tion or knowingly manage or finance a manipulative operation, including any pool, syndicate, or joint account organized or used intentionally for the purpose of unfairly influencing the market price of NMS securities or making loans to a pool in a margin account.

No member or associated person may hold any interest in any joint account for buying or selling an NMS security, unless the joint account is reported promptly to FINRA. The report must contain the following information:

■ Name of the account, with names of all participants and their respective interests in profits and losses

■ A statement regarding the purpose of the account ■ Name of the member carrying and clearing the account ■ A copy of any written agreement or instrument relating to the account

No member may offer that a transaction or series of transactions to buy or sell an NMS security will influence the closing transaction in that security. They are also not permitted to bluff by placing big orders for stocks, bonds, or futures in order to get others to think the price will rise (or fall) and then cancel the order and do the opposite; this is a practice known as spoofing.

4. 5. 12 NASDAQ TRADING HALTS

Nasdaq provides real-time surveillance of issuer activity by reviewing press releases and monitoring price and volume activity. Nasdaq issuers must give FINRA prior notice of any material news before its release. FINRA recommends that issuers provide information at least 10 minutes before public disclosure.

Nasdaq MarketWatch has the authority to implement temporary trading halts to allow for even dissemination of material news.

When a temporary trading halt has been implemented, MarketWatch notifies the news wires and all markets where the Nasdaq stock or derivatives are listed. No FINRA members may trade during the trading halt, whether interdealer or customer, solicited or unsolicited. Any trading during a halt violates FINRA Rule 5260, which prohibits members from effecting transactions or publishing quotes during a time when a trading halt is in effect.



4. 5. 12. 1 Other Trading Suspensions

Nasdaq also suspends trading in conjunction with all SEC suspensions, regulatory suspen-sions, and cease trade orders (CTOs) from other regulators. Trading halts vary in length, but trading normally resumes 30 minutes after the media’s complete dissemination of the news. These codes apply to two market categories: (1) NASDAQ-Listed Securities, which carry the code of “N,” and (2) exchange-listed securities with the market category code “C.”

4. 5. 13 TRADING HALT CODES

Once trading stops, MarketWatch updates the trading halt status on the Nasdaq News frame. The following codes reflect the status of trading halts, suspensions, and CTOs in Nasdaq and non-NASDAQ securities.

T1 Halt—News pending: Trading is halted pending the release of material news.T2 Halt—News released: The news has begun the dissemination process through a

Regulation FD compliant method(s).T3 Halt—Resumption times: The news has been fully disseminated through a

Regulation FD-compliant disclosure method. Nasdaq determined that system misuse or mal-function that caused extraordinary market activity no longer has a material effect on the market for the security, or that system misuse or malfunction is not the cause of the extraordi-nary market activity, or Nasdaq determined the conditions that led to a halt in an ETF are no longer present. Two times will be displayed: (1) the time when market participants can enter quotations, followed by (2) the time the security will be released for trading. All trade halt and resumption times will be posted in HH:MM:SS format.

✓T A K E N O T EThere is a five-minute window that allows market makers to adjust their quotes

before the reopening of trading.

T5 Single stock trading pause in effect: Trading has been paused by Nasdaq due to a 10% or more price move in the security in a five-minute period.

T6 Halt—Extraordinary market activity: Trading is halted when: ■ extraordinary market activity in the security is occurring; ■ Nasdaq determines that such extraordinary market activity is likely to have a material

effect on the market for that security; and ■ Nasdaq believes that such extraordinary market activity is caused by the misuse or mal-

function of an electronic quotation, communication, reporting, or execution system oper-ated by, or linked to, Nasdaq, or

■ after consultation with either a national securities exchange trading the security on an UTP basis or a non-Nasdaq FINRA facility trading the security, that such extraordinary market activity is caused by the misuse or malfunction of an electronic quotation, commu-nication, reporting, or execution system operated by, or linked to, such national securities exchange or non-Nasdaq FINRA facility.

T7 Single stock trading pause/quotation only period: Quotations have resumed for affected security, but trading remains paused.



T8 Halt—Exchange-traded fund (ETF): Trading is halted in an ETF due to the con-sideration of, among other factors, the extent to which trading has ceased in the underlying security or securities, whether trading has been halted or suspended in the primary market(s) for any combination of underlying securities accounting for 20% or more of the applicable cur-rent index group value, or the presence of other unusual conditions or circumstances deemed to be detrimental to the maintenance of a fair and orderly market.

T12 Halt—Additional information requested by Nasdaq: Trading is halted pending receipt of additional information requested by Nasdaq.

H4 Halt—Non-compliance: Trading is halted due to the company’s non-compliance with Nasdaq listing requirements.

H9 Halt—Not current: Trading is halted, because the company is not current in its required filings.

H10 Halt—SEC trading suspension: The Securities and Exchange Commission has sus-pended trading in this stock.

H11 Halt—Regulatory concern: Trading is halted in conjunction with another exchange or market for regulatory reasons.

M Individual security volatility trading pause: Trading has been paused in an exchange-listed issue (market category code = C)

D Security deletion from Nasdaq/CQS

4. 5. 13. 1 News and Resumption Times

When Nasdaq has determined that adequate media coverage of material information has occurred for T1 and T2 trading halts, the halt status is updated with a T3 indicator. Two times are displayed with a five-minute interval between them. The first time specifies when market makers can reenter quotations. The second time indicates when the stock will resume trading.

4. 5. 13. 2 Nonregulatory Trading Halt

When a significant order imbalance occurs with regard to a particular stock, trading on the floor is halted to alert market participants to the situation and to allow the DMM to dissemi-nate information concerning the price range where trading will resume. A nonregulatory halt on an exchange floor does not preclude other markets (the third market or the ECN market) from trading the stock.

4. 5. 14 BEST EXECUTION AND INTERPOSITIONING (FINRA RULE 5310)

In customer transactions, a firm must determine, whether acting as agent for the account of its customer or where transactions are executed as principal, the best market for a security and buy or sell so that the resulting price to the customer is as favorable as possible under pre-vailing market conditions.

In reviewing customer transactions, FINRA will consider the following to determine whether members are executing in the best available market:

■ Character of the market for the security (e.g., price, volatility, and liquidity) ■ Size and type of transaction ■ Number of markets checked ■ Accessibility of quotations



Best execution means more than best price; execution quality (which includes speed of execution, fill rates, price improvement, and so forth) also is important. Member firms are required to have procedures in place to monitor their trade executions and to take action where appropriate.

✓T A K E N O T EThe best execution rules apply not only to your customers but also to customers

of other member firms that are routing their customer orders to your firm for order handling and execution.

When acting in an agency capacity for a customer, a member firm cannot place a third party between itself and the best available market (members cannot route an order through another firm). They must go directly to the best available market (to a firm at the inside market).

Generally, interpositioning results in a less-favorable price to the customer, as the third party will trade at the inside market and then add additional costs for itself.

!T E S T T O P I C A L E R TThe only time interpositioning can be justified is if it results in a better execution

for the customer. Better means a lower price than the inside offer or a higher price than the inside bid.

Members cannot justify interpositioning by charging a lower-than-normal commission, nor can they use inadequate staffing to justify this practice.

4. 5. 15 REGULATION NMS

Regulation NMS (National Market System) was designed to bring trading and report-ing uniformity to the various securities markets in the United States. The two rules dealing with order routing and order execution reporting, Rule 606 and 605, are described in order of importance.

✓T A K E N O T ENMS stocks are defined as those trading on national and regional exchanges, as

well as Nasdaq equities. Regulation NMS does not apply to securities trading on the OTCBB or the Pink Quote.

4. 5. 15. 1 Regulation NMS Rule 606

With regard to best execution, the SEC requires firms to publicly disclose their order rout-ing methods. Firms are required to make public quarterly reports that identify:

■ the market centers to which they route a significant percentage of their orders; and ■ the nature of their relationships with these centers, including any payment for order flow

arrangements or profit-sharing agreements.



The quarterly reports must be divided into four types of securities: (1) NYSE-listed, (2) other exchange listed, (3) Nasdaq equities, and (4) exchange-listed options.

NMS Rule 606 only impacts nondirected orders, which are orders for which the firm determines where the order is routed for execution. Directed orders, for which the customer specifies the market or market center to which the order should be sent for execution, are not covered by the rule.

This SEC rule also mandates that firms disclose to customers, upon written request, where their nondirected orders over the prior six months were routed for execution. Furthermore, firms must notify their customers, in writing, at least annually of the availability of this information.

4. 5. 15. 1. 1 Rule 606 Exemptions

If a member firm routed 500 or fewer customer orders subject to Rule 606 in any month during the most recent calendar quarter, they are exempt from reporting for that quarter. For example, if Maximum Trade & Co. directed 1,400 orders in the quarter and no month exceeded 500 directed orders, that member firm would be exempt from reporting that quarter.

Furthermore, if orders sent to market centers amount to less than 5% of nondirected order flow, no report is required.

4. 5. 15. 2 Regulation NMS Rule 605

In addition to disclosure of order routing information, the SEC requires market centers to make publicly available monthly reports on covered orders that include statistical measures of execution quality. Reports are compiled by each stock exchange and Nasdaq. The securities covered by this rule are exchange-listed equities and Nasdaq equities.

The information required in these monthly reports includes data on: ■ the effective spreads; ■ how market orders of various sizes are executed relative to the public quotes; ■ rate of price improvement and price disimprovement; ■ fill rates; and ■ speed of execution.

Only market and limit order executions, including marketable limit orders and IOC (immediate or cancel) limit orders are included in these reports. Orders that require special handling (such as FOK [fill or kill], not held, and average price orders) are excluded.

4. 5. 15. 3 SEC Rule 607

A broker-dealer acting as agent and receiving a payment for order flow of an NMS stock is required to disclose in writing a detailed description of the nature of the compensation received and the firm’s policies for determining where it routes customer orders. This must be disclosed at the opening of the account and annually thereafter.



4. 5. 15. 4 Regulation NMS Rule 611—The Order Protection Rule

Regulation NMS, as we now know, was written with the view to bring trading and report-ing uniformity to the various securities markets in the United States. Among the various rules mandated by the SEC are Regulation NMS Rules 611 and 612. Rule 611, the order protection rule, handles trade-throughs. A trade-through occurs when a firm executes a customer order at a price when a better price is available. For example, if stock is being offered on the NYSE floor at the top of the book price of $28.18, and a firm buys the stock on another market center at $28.20, the firm traded through the best price available and disadvantaged its customer by two cents per share. Although there are exceptions, Rule 611 prohibits trade-throughs.

✓T A K E N O T EAnother unacceptable practice is prearranged trading. This is an offer to sell

matched with an offer to buy back (or vice versa) at the same price or some pre-arranged price. These risk-free trades hold out the promise of certain tax advantages otherwise not attainable in a fair and open market. Prearranged trading is prohibited.

4. 5. 15. 4. 1 Rule 611(b)

Rule 611(b) provides the following noteworthy exceptions to the trade-through provision of the Order Protection Rule of Regulation NMS.

■ Stopped orders. From time to time, a block trader will use stopped order in an effort to guarantee a maximum (or minimum) price on a trade for an institutional customer. The portfolio manager, for instance, would know with certainty that he won’t pay more than a certain amount when buying or selling a particular stock.

■ Self Help. This exception permits a trading center (ATS or an exchange) to fill at a worse price due to delays caused by malfunctioning equipment.

■ Flickering quote due to rapidly changing price quotations. The SEC granted trading cen-ters a one-second quote window to evaluate the quotes of competing trading centers. If quotes are flickering, then the first trading center is permitted to execute at the least aggressive best bid or offer displayed by the flickering market center. For example, if the best bid on a market center is flickering between $20.50 and $20.51, then the first trading center can execute at $20.50 without violating rule 611.

■ Volume weighted average price (VWAP) orders. The rule also permits VWAP orders and market open, close, or reopening orders following a halt, or in other words, those orders that are not priced with any reference to a quoted price of a stock at the time of execution. More about VWAP is covered earlier in this Unit.

Lastly, but arguably the most common exception to rule 611, is the Intermarket Sweep Order (ISO).

Intermarket Sweep Order (Incoming). This exception makes it possible for a trading center to immediately execute any incoming order identified as an intermarket sweep order (ISO), even if a better-priced protected quote exists at another market center as traders at-tempt to fill customers’ block orders.

Intermarket Sweep Order (Outgoing). This permits a broker-dealer to execute an ISO at a price inferior to a protected quote. These are likely used when printing blocks for customers away from the inside. The SEC permits a broker to use the ISO as long as it simul-taneously attempts to remove better-priced protected quotes.



✓T A K E N O T EIf the ADF or any TRF is unable to transmit real-time trade reporting information

to the appropriate SIP, members would not be prohibited from trading through other markets where trading is not halted.

4. 5. 15. 5 Regulation NMS Rule 612—Sub-Penny Rule

For NMS stocks trading at $1 or above, the minimum pricing increment is $.01. Sub-penny pricing is permitted for NMS stocks trading at less than $1. In this case, the minimum increment is $.0001. Note that OTCBB and OTC Pink stocks trading at any price can be quoted in sub-pennies. Also keep in mind that if a market maker or ECN receives an order quoted in sub-pennies, the order must be to a penny. For example, a market maker may accept order of $1.05 but not order of $1.051. Buy-limit orders are rounded down to the nearest penny, whereas sell-limit orders are rounded up to the nearest penny.

!T E S T T O P I C A L E R TThe SEC has the authority to suspend trading in any security, for whatever

reason, for 10 business days. Further, the Commission can suspend trading on any national securities exchange for 90 calendar days.

4. 5. 16 TRADES FOR MANAGED ACCOUNTSA managed account is one in which the member, for an annual fee (wrap fee), provides

a variety of services to that account. Investment advisory accounts and wrap accounts are examples of managed accounts. Under the Investment Advisers Act of 1940, member firms generally execute transactions with these accounts in stocks in which they are a market maker on an agency basis. However, they may act as principal but must make disclosure and obtain consent prior to completion of the trade.

✓T A K E N O T EWrap fees include commissions, investment management, performance evalua-

tion, and custody services. When the member engages in this activity, registration as an IA is required.

4. 5. 17 ANTICOMPETITIVE PRACTICES

The SEC, after a lengthy investigation of the Nasdaq Stock Market, issued a report on cer-tain anticompetitive practices of certain market makers. The report, called the 21(a) Report, concluded there was serious collusion between market makers regarding:

■ the setting of bid-ask spreads; ■ the sharing of information regarding customer limit orders; ■ the sharing of information regarding the release of research reports; and ■ the sharing of information on trading strategies and inventory positions.



In addition, market makers who did not participate were subject to harassment and other forms of intimidation. The 21(a) Report mandated many changes in the rules and the manner in which they are enforced.

Any attempt to influence another member regarding quotations or spreads, or any conduct that retaliates against or discourages the competitive activities of other members, is a gross violation and can lead to suspension or expulsion.

Another result of the 21(a) Report was the creation of Series 55, which is required for Nasdaq market makers, proprietary OTC traders, and for persons who directly supervise these activities.

✓T A K E N O T E “Ghosting” is an example of an illegal practice by multiple market makers col-

luding to influence the price of a stock. Market makers are to compete with each other for the markets to work. Ghosting is subject to the severest of penalties.

4. 5. 18 TIME SYNCHRONIZATION

Members must synchronize business clocks daily. All computer system clocks must be syn-chronized to within one second of the National Institute of Standards (NIST) atomic clock and must remain accurate within a one-second tolerance of the NIST clock. (Check with your instructor. There is a proposal to reduce the tolerance for computer clocks to 50 milliseconds.) Mechanical stamping devices will remain at one second.

4. 5. 18. 5. 1 Order Information

An OATS report must record the following information for NMS stocks: ■ Date and time of order receipt ■ Name of contra party (firm or customer) ■ Order identifier ■ Terms of the order ■ Where the order was routed for execution ■ Whether the order was modified ■ Execution price

OATS reports for each trade in an NMS security must be submitted to FINRA daily. FINRA then uses the OATS data to match against the execution reports submitted to TRF/ACT, which is discussed in a following unit. Enabling the matching of OATS reports to trade reports requires that each order have a unique identifier.

4. 5. 19 FINRA RULE 5290

Trade shredding is a term used to describe the practice of splitting customer orders into multiple smaller orders (e.g., a 1,000-share order split into ten 100-share orders) to maximize payment for order flow from the market maker to which the orders are directed. In other words, the payment for order flow would be greater on ten 100-share orders than it would be for a single 1,000-share order. Trade shredding is a prohibited practice.



QQ U I C K Q U I Z 4 . D Match the market environments with the prevailing market price for each.

A. Dominated/controlled marketB. Active competitiveC. Inactive competitive

—— 1. Lowest asked price/highest bid price

—— 2. Contemporaneous sales to other dealers/contemporaneous purchases from other dealers

—— 3. Cost/cost

True or False?

—— 4. FINRA views a proceeds transaction as a single trade for markup/commis-sion purposes.

—— 5. FINRA may issue a trading halt on Nasdaq and non-Nasdaq securities.

—— 6. Under the Investment Advisers Act of 1940, member firms must execute all transactions with managed accounts in stocks in which they are a market maker on a principal basis.

4. 6 NON-NASDAQ OTC

4. 6. 1 OVER THE COUNTER BULLETIN BOARD (OTCBB)

The Over the Counter Bulletin Board (OTCBB) is an electronic interdealer quotation service for more than 3,300 issues that do not meet the listing requirements of stock mar-kets, such as NASDAQ and, therefore, fall outside the National Market System. As such, the OTCBB (which has no listing standards) acts as a non-NMS quotation service for OTC equity securities. Although the OTCBB has no listing requirements, there is an eligibility require-ment to be registered and current as a reporting company with the SEC in order to be quoted by a market maker. There only needs to be one market maker. Key features to the OTCBB include the following:

■ Domestic securities not listed elsewhere ■ Transmits real-time quote, price, and volume information ■ Foreign equity securities and ADRs that are registered with the SEC ■ Several hundred market makers ■ Equity securities in the process of being delisted from an exchange or Nasdaq for noncom-

pliance with maintenance listing standards; ■ Displays indications of interest and prior-day trading activity in direct participation

programs; ■ OTCBB may use the Nasdaq worksation to update quotes, report trades, and register in

active stocks; and ■ OTCBB may accept bids/offers in fractions as small as 1/256 or in decimals up to six places.



✓T A K E N O T EBecause the OTCBB is a quotation service for stocks that are not listed or traded

on Nasdaq or any other exchange, no stock can be traded on the OTCBB and Nasdaq at the same time. Whenever referencing the OTCBB, never use the word “listed.”

4. 6. 2 REGISTRATION AS OTC MARKET MAKER

To register as a market maker in Bulletin Board securities, a member must file Form 211 with FINRA. The form, which is signed by a principal, attests to the firm’s compliance with SEC Rule 15c2-11, which requires that a market maker obtain, maintain, and review financial information on the issuer.

Members must be knowledgeable about the issuer’s financial condition and operating his-tory. File form 211 at least three business days in advance of entering quotations.

In addition to attesting to having performed financial due diligence, the Form 211 filing must include information on the member’s initial quotation if the quote is to be firm. The member must provide a rationale for determining the priced entry.

If the initial quotation is to be nonfirm, this information is not required. However, if the member later wishes to enter a priced bid and/or offer, it must file a supplemental report with FINRA describing the basis on which the priced entry was determined.

The supplemental report must be received by FINRA at least three business days before the priced entry appears.

4. 6. 2. 1 Piggybacking

A Form 211 filing is not required if the member is able to piggyback on the quotes of another market maker. If an existing market maker in the security meets the continuous quote rule, a new market maker can enter the Bulletin Board with quotations without having to file Form 211.

The continuous quote rule is applicable if: ■ an existing market maker has published quotes on the security on at least 12 business days

during the preceding 30 calendar days; and ■ there have been no more than four consecutive business days during this 30-day period

without a quotation.

In this case, a new market maker can piggyback on the existing market maker’s quotes. If the security has met the continuous quote rule, the word active appears on the screen next to the symbol. If the word eligible appears, it means that an existing market maker has not yet met the continuous quote rule, and a Form 211 filing would be required for a new market maker.



Sample FINRA Form 211

!T E S T T O P I C A L E R TIf a firm piggybacks on an existing market maker and that market maker subse-

quently withdraws, the firm does not have to file Form 211. It can remain as a market maker.

A firm can enter the Bulletin Board without filing if the quote it enters represents unsolic-ited customer interest. Once that interest has been filled, the firm must withdraw or file Form 211 to continue.

4. 6. 2. 2 OTC Bulletin Board Quotations

Quotation entries may consist of: ■ a priced bid and/or offer (a one-sided quote is acceptable); ■ unpriced indications of interest; ■ bids wanted and/or offers wanted; or ■ a bid or offer reflecting unsolicited customer interest.

Any quote is acceptable as long as it is properly identified.



Every quotation entry must include the phone number of the market maker’s trading desk. If a firm has more than one trading location, a geographic indicator must be appended to the market maker’s identifier to let subscribers know where the security is traded.

Market makers can enter and update quotes on a real-time basis. Subscribers to the OTCBB can access an inside market for a security as long as there are at least two market makers dis-playing firm two-sided quotes. Priced quotations must be firm for a minimum number of shares as shown. These quotation sizes apply to any IDQS that permits updates on a real-time basis.

OTCBB Minimum Quotation Sizes

Price (Bid or Offer) Minimum Quote Size

0.0001–0.0999 10,000 shares

0.10–0.1999 5,000 shares

0.20–0.5099 2,500 shares

0.51–0.9999 1,000 shares

1.00–174.99 100 shares

175.00+ 1 share

*E X A M P L E If a Bulletin Board market maker is quoting 11.10–11.60, it must be willing to buy or sell at least 100 shares at these prices.

*E X A M P L E Any increment beyond an upper limit triggers the minimum quote size for the next tier. A bid (or offer) of $0.51 must be firm for a size of 1,000 shares.

An exception to the firmness of quote rule is made for direct participation programs (DPPs). Due to IRS regulations, a priced bid or offer for a DPP is never firm.

4. 6. 2. 3 Regulatory Filing

SEC rules require that all issuers whose securities are quoted on the Bulletin Board be current in their regulatory filings. If an issuer is delinquent, the modifier E appears next to its symbol. Once delinquent, the issuer has 30 days (if SEC reporting) or 60 days (if report-ing to banking or insurance regulators) to become current. Otherwise, the issuers’ securities are removed from the Bulletin Board until the appropriate filings have been made. When removed, they will trade in the OTC Pink marketplace, which have no regulatory reporting requirements.

Although issuers of OTCBB-quoted securities have an SEC filing requirement, issuers have no such requirement to file with the Nasdaq Stock Market or FINRA. Market makers, on the other hand, are required to provide the periodic financial reports filed by OTCBB issuers with the SEC or other regulatory authorities in order to maintain eligibility for being quoted on the OTCBB.



4. 6. 2. 4 OTC Pink Marketplace

As there is no requirement for companies quoted in the OTC Pink marketplace to be cur-rent in their regulatory filings, this quotation medium is at the low end of transparency and disclosure.

The OTC Pink marketplace offers a real-time quote system on the Web by the OTC Markets Group, Inc. It is registered with the SEC as an ATS. If a member firm wishes to make a market in an OTC Pink security, it must follow the rules applicable to Bulletin Board market makers (it too must file Form 211), unless an exception is available (e.g., piggybacking).

Although the OTC Markets Group operates an ATS, it does not operate as an ECN or a dark pool. It is a network, and therefore does not charge fees on a per-share or transaction basis.

QQ U I C K Q U I Z 4 . E 1. All of the following statements about OTCBB securities are true EXCEPT

A. issues in the process of delisting from the NYSE are eligible for inclusionB. foreign securities and ADRs must be registered with the SEC before inclusionC. minimum listing standards for OTCBB inclusion are similar to those of

Nasdaq Capital Market securitiesD. during normal business hours, priced quotes for DPPs are not firm

2. The piggybacking exemption is available to market makers in

I. Capital Market securities II. Bulletin Board securities III. Pink Quote securities IV. Global Market securitiesA. I and IVB. II onlyC. II and IIID. III only

3. A non-market making firm wishes to begin market-making activity in 5 Nasdaq stocks. The firm must do all of the following EXCEPT

A. meet minimum net capital requirementsB. await initial notification from FINRA for approval to act as a market makerC. report to Nasdaq any payments received from issuers to engage in market-

making activityD. file an application for each security in which it intends to act as market maker

4. 6. 2. 5 Penny Stock Transactions

A penny stock is a non-NMS, OTC equity security trading at less than $5 per share. A penny stock is a low-priced OTCBB or OTC Pink Market stock. The SEC rules on designated securities are the 15(g) rules.

As an aside, you now know a penny stock is defined in part for purposes of this rule as hav-ing a bid price of less than $5 per share. This definition comes from SEC Rule 3a-51-1. As a



word of caution, do not confuse this with the “Cheap Stock” rule promulgated by the NYSE (Rule 431(c)(2)), which deals with margin requirements for stocks valued under $5 per share.

■ Rule 15(g)2 requires that customers, before their initial transaction in a penny stock, be given a copy of the Risk Disclosure Document. The member must receive written acknowl-edgment from the customer that the document has been received. Not surprisingly, the document describes penny stocks in less than flattering terms.

■ Rule 15(g)3 requires members to provide penny stock purchasers with a current bid and asked quote on the stock to prevent the practice of quoting prices that are away from the current market to customers.

■ Rules 15(g)4 and 15(g)5 require members to provide penny stock purchasers with infor-mation on the compensation to be earned by both the member and the registered repre-sentative as the result of the transaction. This is to prevent excessive markups.

■ Rule 15(g)6 requires members to provide penny stock purchasers with monthly state-ments showing the estimated market value of each penny stock purchased.

■ Rule 15(g)9 addresses sales practices to curb abusive selling. This rule requires members that are soliciting new customers to make a suitability determination. The member must inquire as to the prospective customer’s income, net worth, objectives, and risk tolerance and then prepare a suitability statement showing why the proposed penny stock trade is suitable for the customer. This statement must then be sent to the customer for a signature. Once returned, the member may effect the trade (send a confirmation).

However, a member may solicit an established customer without having to prepare a suit-ability statement. An established customer is one who has:

■ effected a non-penny stock transaction or made a deposit of funds or securities in an account at least one year before the proposed penny trade; or

■ made three unsolicited purchases of penny stocks, on three separate days, involving three separate issues. Once a customer buys three different penny stocks, he is no longer covered by the suitability statement requirement.

In addition to the established customer exception, other exemptions from 15(g)9 include: ■ unsolicited trades; ■ transactions with institutional accredited investors; ■ private placements meeting the requirements of SEC Rule 505 or 506; and ■ transactions executed by a member whose revenue from penny stock trades is 5% or less

of total revenue.

With one exception, the exemptions previously noted also apply to the penny stock dis-closure rules (15(g)2–15(g)6). The exception is for established customers who, while exempt from 15(g)9, are subject to 15(g)2–15(g)6.

4. 6. 2. 6 Reverse Convertible Bonds

Reverse convertible bonds are debt instruments with embedded put options that allow bond issuers the right to convert the bond’s principal into shares of equity at a predetermined set date. The issuer would exercise the option if the shares underlying the option fell below a set price. If this occurred, the bondholders would receive the shares rather than their principal when the bond matured.



Yields on these bonds are higher than similar bonds without the reverse convertible fea-ture due to the additional risk assumed by the bondholder. Keep in mind that due to this addi-tional risk, reverse convertible bonds should trigger suitability concerns, which were covered in an earlier unit.

A comparison between these bonds and convertible bonds gives a clear picture of the logic behind their name.

Whereas a convertible bond gives the shareholder the right to convert the bond to equity and receive shares of the issuer’s stock, the reverse convertible turns this around by giving the issuer the right to convert the bond to equity and pay those shares to the bondholder instead of cash when the bond matures.

!T E S T T O P I C A L E R TSeveral testable points about the penny stock rules include the following.

■■ Broker-dealers whose transactions in penny stocks account for 5% or less of total revenues are exempt from the penny stock rules.

■■ Established customers are exempt from the cold call rules (suitability statement) but not from the disclosure rules.

■■ The rules apply to Pink Sheet or Bulletin Board stocks under $5 per share only.

4. 7 THE THIRD MARKET

The Securities Acts Amendments of 1975 created the environment that led to the devel-opment of the third market. These amendments were designed to remove barriers to competi-tion among the exchanges and the over-the-counter market and foster the development of a national securities market and settlement system.

One of the results of the act was that the NYSE rule requiring members to execute orders in listed stocks on the exchange floor was to be phased out over time. Thus, the NYSE became subject to competition from ECNs and over-the-counter member firms making a market in exchange-listed stocks. This is known as the Third Market; that is, listed stocks that trade OTC.

4. 7. 1 CONSOLIDATED QUOTATION SYSTEM (CQS)

Once the third market developed, a system was needed to provide quotes from both third market makers and DMMs in listed stocks. The Consolidated Quotation System (CQS) pro-vides bid and ask quotes, with size, for NYSE and other exchange-listed equity securities.

!T E S T T O P I C A L E R T Securities quoted are common stock, preferred stock, ADRs, warrants, and rights. Debt securities, straight or convertible, are not quoted.

CQS currently operates from 9:00 am to 6:30 pm ET. For the most part, however, the action is during normal market hours.



4. 7. 2 CONSOLIDATED TAPE SYSTEM (CTS)

The Consolidated Tape System (CTS) reports real-time trade information on listed equity securities. The Tape is called consolidated because trades in all listed equity securities that take place in any market are reported. This reporting service is provided by the Consolidate Tape Association (CTA).

✓T A K E N O T EThe Tape will show last sale information on listed equity securities traded on any

U.S. exchange. Network A (Tape A) reports trades in NYSE-listed equity securities, while network B (Tape B) reports trades in listed equity securities on NYSE Arca, NYSE MKT, and other regional exchanges. Network C (Tape C) refers to the Nasdaq’s UTP Plan, which disseminates real-time trade and quote data for certain Nasdaq-listed securities. The three tapes are registered SIPs (securities information processors).


—— 1. The penny stock rules apply to any OTC equity security with a price of less than $5 per share.

—— 2. Established customers are exempt from the suitability requirements of the penny stock rules.

—— 3. Before filling an order for a Pink Sheet security, a member is required to contact a minimum of 5 dealers to determine the prevailing market.

—— 4. Convertible debt securities are quoted in the CQS system.

—— 5. CQS operates from 9:00 am to 6:30 pm ET.

—— 6. After a voluntary withdrawal of quotes, a Nasdaq or ADF market maker must wait 10 business days to reregister.

4. 8 TRADING SYSTEMS, PROCESSES

Nasdaq Book is an order display and execution system for Nasdaq-listed securities. It allows firms to list multiple quotes and orders for the same security and creates a single limit order trading book. It was developed to address concerns regarding market fragmentation (dif-ficulty in finding the best price) and decimalization (difficulty in accessing the depth of trading interest in a stock). Overall, the system has created greater market transparency.

Nasdaq Book displays the total amount of trading interest at the best prices (inside mar-ket), as well as four price levels away, for a total of five price levels on the bid and offer sides of the market. Each price level shows the aggregate trading interest at that level, including attributable and nonattributable quotes/orders. If an order is attributable, the price and size of the order is displayed next to the market participant’s unique identifier (MPID). In contrast,



if a market participant designates an order as nonattributable, it is not displayed next to its MPID. Rather, all nonattributable interest at a particular price level is aggregated and dis-played under a special anonymous MPID, NSDQ.

The NSDQ MPID allows the firm placing the order to remain anonymous until execution, at which time the member’s name is revealed to the contra party. If a member submits a nonat-tributable quote/order and requests full anonymity, any execution is processed anonymously. While the transaction report indicates the details of the trade, it does not reveal the identity of the contra party.

✓T A K E N O T ENSDQ MPID allows the firm to be displayed in the marketplace without revealing

the firm’s MPID.

✓T A K E N O T EUnder the Manning Rule II, if a market maker receives an order priced better

than its quote, that order must be displayed. Under Nasdaq Book rules, the market maker could place the order in NSDQ without having to update its attributable quote.

Nasdaq Book offers the following viewing screens. ■ QuoteView. This screen shows the best bid and offer of each quoting market participant,

as well as the inside market for each Global Market and Capital Market stock. ■ DepthView. This screen shows the aggregate size of all quotes at the top five price levels.

In other words, it shows how many shares, in total, there are to buy or for sale at these price levels.

■ PowerView. This screen combines the information in QuoteView and DepthView. ■ TotalView. This screen includes PowerView and provides the details behind DepthView.

It includes the names of the market participants and the price and size of their attributable quotes and orders.

Only one NSDQ MPID is shown on QuoteView, the best priced non-attributable bid and offer quotes. All NSDQ amounts within the best five price levels are reflected in DepthView. In the same vein, market participants may have multiple quotes in the system, but only their best price will be displayed in QuoteView. Their other trading interest is shown in DepthView.

4. 8. 1 LEVELS OF NASDAQ SERVICE

There are three levels of service in the Nasdaq Market Center (NMC). ■ Level I shows the last sale, as well as the inside market and volume information, and is

intended for use by registered representatives and the investing public. ■ Level II shows all bid-and-ask quotes in a security with size for each quoting participant

and is intended for use by traders and order entry firms. ■ Level III allows market makers to update their quotes and/or size and includes all of the

features of Levels I and II.



4. 8. 2 TIME STAMP

Nasdaq, an ATS, ECN or regional stock exchange will time stamp each order or quote upon receipt. The time stamp determines the ranking for execution purposes as orders at the same price level are executed on a first in, first out basis. Each quote increment receives a separate stamp to ensure that market participants will not lose time priority for updating their displayed trading interest to show greater size.

Remember that computer clocks must be synchronized to within one second (subject to change) from the NIST atomic clock. Pre-stamping an order is a violation. For example, if a trader feels certain that an order from a customer is coming down and wants to capture a price now in anticipation of the order, he may be tempted to pre-stamp. It is a form of prearranged trading and is also a violation of recordkeeping rules.

*E X A M P L E When a market maker increases size at the same price level, the original quantity will keep the original time stamp, and the additional quantity will have a new time stamp. If a market maker decreases size at the same price level, the remaining amount retains the original priority. Once a market maker’s displayed size is decremented to zero, it no longer retains time priority, even though it may have reserve size (which is not displayed) or a feature that automatically refreshes its displayed size.

4. 8. 3 DECREMENTATION

Decrementation is quote size reduction resulting from executions. Upon execution, an order is reduced by an amount equal to the size of that execution. If the displayed size is reduced to less than one round lot and the market participant has reserve size, the displayed size will be replenished from the reserve.

✓T A K E N O T EMarket participants are required to display a minimum of 100 shares in order to

use reserve size. Also note that if a firm uses reserve size, the amount in reserve must be at least 100 shares.

If a participant’s attributable interest is reduced to less than one round lot and the firm has no reserve size, Nasdaq will zero out the exhausted side of the market for 30 seconds. During this period, the firm must update its quote. If, after 30 seconds, the firm does not update its quote, Nasdaq will refresh its quote $.25 for 100 shares, to one cent away from the worst-displayed price in QuoteView.

A Market Maker Peg Order is a one-sided, attributable limit order in which the price is automatically adjusted, helping NASDAQ market makers comply with the Exchange’s rules regarding market maker quotation requirements and obligations in their registered securities.



4. 8. 4 NONDIRECTED, PREFERENCED, AND DIRECTED ORDERS

To access quotes, market participants can enter, in addition to market and limit orders, one of the following types of orders: nondirected, preferenced, or directed. An order may be of a size up to 999,999 shares and must indicate whether it is a buy, sell, sell short, or sell short exempt. Orders can be in round lots, mixed lots, or odd lots.

4. 8. 4. 1 Nondirected Orders

Nondirected orders are liability orders, which means they create an obligation for the recipient to either buy or sell. These orders must be market or marketable limit orders. A nondirected order will be matched with the highest-ranked quotes on the opposite side of the market, as shown in the following table.

The Nasdaq Book will automatically match any nondirected buy and sell quotes/orders entered by order entry firms and market makers against the quotes/orders of those same firms on the other side of the market if such a quote/order is at the inside price.

✓T A K E N O T ENasdaq market makers are required to accept automatic executions. ECNs have

a choice—they can either accept automatic executions or accept delivery of an order, which they can respond to if they wish. If they accept delivery, they must respond within five seconds of receipt.

*E X A M P L E There are four market makers in ABCD, ranked in time priority 1 through 4.

BidDisplayed Size

Reserve Size

MM #1 20 1,000 5,000

MM #2 20 1,000 3,000

MM #3 20 1,000 5,000

MM #4 19.90 1,000 10,000

A 9,000-share, nondirected market order to sell is entered into the system, which accesses displayed size at the best price and then reserve size in time priority. The sys-tem executes 1,000 against MM #1, 1,000 against MM #2, and 1,000 against MM #3. The system then executes 5,000 against the reserve of MM #1 and 1,000 against the reserve of MM #2. After the execution, the result is as follows.

BidDisplayed Size

Reserve Size

MM #1

MM #2 20 1,000 1,000

MM #3 20 1,000 4,000

MM #4 19.90 1,000 10,000

MM #1 has 30 seconds to update its quote.



4. 8. 4. 2 Preferenced Orders

These are orders that are sent to a specific market participant that is at the inside market. They interact with the selected firm’s display size as well as its reserve size. If the market par-ticipant that receives the order is not at the inside market, the order is sent back to the enter-ing party. If a partial fill is received (after exhausting the selected firm’s displayed and reserve size), the unexecuted portion is returned to the entering party.

4. 8. 4. 3 Directed Orders

These orders are used to access a specific quote in the system. In most cases, these orders are nonliability orders and, as such, must be for 100 shares greater than the display size with an all-or-none (AON) designation, or delivered with a minimum acceptable quantity (MAQ) of at least 100 shares greater than the display size. In this way, there is no obligation for the recipient to execute. The recipient may, at its discretion, accept the order, partially fill the order, counter the order, or decline the order.

Directed orders also can be liability orders. Directed liability orders must be within the market participant’s display size and price. Market participants that elect to receive directed liability orders must have the modifier d next to their MPID. Other market participants can elect not to receive directed liability orders. These orders must be responded to within five seconds by the receiving firm.

✓T A K E N O T EDual liability exists for firms that elect to accept directed liability orders. These

firms can have their quotes executed against through the nondirected order process when at the inside market and, at the same time, be liable for directed liability orders at the same quote.

4. 8. 5 EXECUTION ALGORITHMS

NMC gives participants three options as to how their orders will interact with quotes in the system: (1) price/time, (2) price/size/time, and (3) price/time with access fee consider-ation. With price/time, the best price is accessed first, with the first and subsequent executions based on time priority. With price/size/time, the best price is accessed first, with the first and subsequent executions based on size. This means the largest sized quotes are executed first. With price/time with access fee consideration, the order is executed as with price/time, but any market participant that charges a fee is accessed last. Some ECNs charge a fee for execu-tions against their quotes.

✓T A K E N O T EIf no execution algorithm is specified at time of order entry, the system will assign

it as price/time.



4. 8. 6 TIME IN FORCE ORDERS (TIF)/DESIGNATIONS ■ Day orders. If, after entry into the system, the order is not executed, the order, or unex-

ecuted portion, is returned to the entering firm at 4:00 pm. ■ Total day orders. If, after entry into the system, the order is not executed, the order, or

unexecuted portion, is returned to the entering party at 8:00 pm. This order is designated as an X order, meaning it is good through extended hours trading. It is available for display beginning at 7:00 am.

■ Good-till-canceled orders (GTC). If, after entry into the system as GTC “market day,” the order is not executed, the order, or unexecuted portion, remains available for display and/or execution until market close at 4:00 pm. The order will remain in the system until canceled by the entering party, or until one year from entry, whichever comes first.

■ Total good-till-canceled orders (GTX). These are similar to GTC orders, except that the order is available for display/execution up until 8:00 pm.

■ Immediate-or-cancel orders (IOC). If, after entry into the system, a marketable limit, or unexecuted portion, becomes nonmarketable, the order, or unexecuted portion, is can-celed and returned to the entering party. These orders can be entered during normal mar-ket hours only.

■ Total immediate-or-cancel orders (IOX). These are similar to IOC orders, except that they are available for execution anytime between 7:00 am and 8:00 pm.

■ Pegged orders. A pegged order is a limit order, the price of which is automatically adjusted to follow the inside market. The price of a pegged buy order would always equal the high-est bid, whereas the price of a pegged sell order would always equal the lowest offer. A reverse-pegged order would peg to the opposite side of the market. It would peg at a price that deviates from the opposite side of the market by .01. Thus, a reverse-pegged buy order would be priced at .01 less than the inside offer, and a reverse-pegged sell order would be priced at .01 more than the inside bid.

By entering a regular pegged order, market participants inject liquidity at the best inside price set by other firms. By entering a reverse-pegged order, market participants are providing liquidity at a price as close as possible to the opposite side of the market. As a result, in cases where the inside spread is greater than .01, the entry of a reverse-pegged order would establish a new inside market.

Users may select a cap price beyond which a pegged order will not be executed. Once a price cap is reached, the pegged/reverse-pegged order is converted to a regular limit order at the cap price.

A regular pegged order may not be used to establish the inside bid or offer. Therefore, if all nonpegged displayable interest at the inside is exhausted, the new inside would be the next best price level where nonpegged interest exists, and the price of pegged orders would be adjusted accordingly. If there are no participants on the same side of the market, pegged orders are canceled.

■ Discretionary orders. An order that, when entered into the system, has both a displayed bid or offer price, as well as a nondisplayed discretionary price or range at or in which the participant is also willing to buy or sell, if necessary. The display price must be fixed. A discretionary order may not result in a quote that locks or crosses the NBBO and may not be executed at a price that trades through the quote of any ITS exchange unless it also is designated as a sweep order.



■ Sweep orders. An order that may be delivered to, or executed by, market participants at multiple price levels. A trader will split an order into numerous parts comprising the best prices and amounts available at different levels. It is used by traders who care more about filling an order quickly (buy or sell) than about price. These orders are sometimes called sweep-to-fill orders.

To prevent large price movements due to sweep orders, a Nasdaq rule limits the number of price levels against which a single sweep order may execute. The rule limits a single order’s sweep to 10% + .01 away from the current inside market.

*E X A M P L E The current inside bid for ABCD is $10.00. Firm A enters an unpriced sweep order to sell 10,000 shares. There are currently 4,000 shares available to buy between $8.99 and $10.00, with another 3,000 shares available at $8.98. On the basis of the for-mula above, the threshold price will be $8.99 ($10.00 – 10% – .01). Therefore, 4,000 shares of the order will execute, and the new inside bid will be $8.98. The remaining 6,000 shares of the order will be returned to the entering party, because there is no additional liquidity at or above the threshold bid price.

■ Intermarket sweep order. Limit orders that the customer requires be executed in a specific market even if there is a better price found on another market center. This is an exception to the order protection rule. As previously stated, institutional buy-side investors often use algorithmic trading schemes that may require an ISO. These orders are not subject to auto-routing and must be marked with the trade indicator of “F.” The firm sending the ISO fulfills its regulation NMS order-protection obligations by simultaneously sending orders to those market centers with better prices.

■ Summary orders. A limit order that will be returned to the entering party if, upon receipt, it is marketable. In other words, it is a limit that locks or crosses the market. If the order was not marked Summary, it would be executed in time priority.

■ Summary quotes. Market participants can elect to give Nasdaq summary quotes, which allows these firms to maintain trading interest at multiple price levels. The quotes have to be designated as Summary at the time of entry.

■ Auto-ex orders. This type of order executes only against quotes maintained by market participants that provide automatic execution and that do not charge an access fee.

4. 8. 7 LOCKED/CROSSED MARKET DURING NORMAL MARKET HOURS

With Nasdaq Market Center (NMC), locked or crossed markets are eliminated during normal market hours. If a firm attempts to lock the market, the order is routed to the market participant next in line for execution at the locking quote. If a firm attempts to cross the mar-ket, NMC will not display the order. Instead, the order is treated as a marketable limit and entered into the system as a nondirected order for execution in time priority.



4. 8. 8 PRICE DEVIATION

Nasdaq has implemented a price validation deviation process for limit orders entered into NMC. The process will calculate when a limit order price is away from the inside market by a predetermined amount. In this case, Nasdaq provides the warning message Rej. Over Allowable Deviation. Override & Resend. If the entering party elects to override, the order is processed. The following table summarizes the allowable deviations.

*E X A M P L EPrice

Allowable Deviation

$1–$5 0.375

$5–$15 0.50

$15–$25 0.625

$25–$100 0.75

The inside market for ABCD is $12.00–$12.10. The acceptable limit range would be between $11.50 and $12.60. A firm entering a buy limit below $11.50 and a sell limit above $12.60 will receive a reject message, which it can choose to override.

4. 8. 9 ANTI-INTERNALIZATION QUALIFIER (AIQ)

Many market makers enjoy the benefits of internal order flow from their retail customer base, executing retail orders against their own quotes. However, a firm can enter an order with an anti-internalization qualifier (AIQ) modifier, which means the system only executes against the quotes of other market participants, not against the quotes of the entering party. Firms may use the AIQ modifier on an order-by-order basis.

4. 8. 10 ADF (ALTERNATIVE DISPLAY FACILITY)

As noted earlier, linked ECNs display their Nasdaq quotes in the NMC. Unlinked, or ineligible, ECNs do not. As a result, FINRA was forced by the SEC to create and operate its Alternative Display Facility (ADF) to display quotes for these unlinked ECNs. Quotes are displayed for all Nasdaq equities and for exchange-traded funds, such as QQQs and SPDRs, on a voluntary basis from 8:00 am—6:30 pm ET. Normal business hours, however, are the cus-tomary 9:30 am to 4:00 pm ET. The ADF operates with rules very similar to those of Nasdaq, such as the prohibition (with limited exceptions) of locking and crossing quotations. Another similarity exists in that an ADF market maker that voluntarily (unexcused) withdraws its quotations from the ADF and not re-enter within five minutes may not reregister as a market maker in that security for 20 business days.

To keep it simple, the ADF is the FINRA-operated facility allowing its members to quote or effect trades in NMS stocks other than on an exchange. The ADF collects and disseminates quotations and trade reports, and compares trades.

A member firm that wishes to use the ADF must register as a Registered Reporting ADF Market Maker or a Registered Reporting ADF ECN. These often are referred to as an ADF Trading Center, or simply Trading Center.



Every trading center must provide other Trading Centers direct electronic access. Broker-dealers that are not ADF Trading Centers must be granted indirect electronic access for execu-tion against the ADF Trading Center’s best bid or offer.

✓T A K E N O T ENo ADF Trading Center may impose unfair and discriminatory terms or conditions

with the view to prevent, or in any way prohibit, any person from obtaining indirect access to a quotation indirectly. A FINRA member that provides indirect access must treat the order routed through it as though it were the firm’s own order.

✓T A K E N O T EADF Trading Centers must only submit automated quotations. Manual quotations

are not permitted for submission to the ADF.

4. 8. 11 OPENING CROSS

The opening cross rules are designed to create a single opening price similar to the open on an exchange floor. Among other things, these rules replaced the trade or move rules, which dealt with locking/crossing quotes entered before market open.

The orders acceptable for the opening cross are as follows. ■ Market on open orders (MOO) can be filled only at the opening price. ■ Limit on open orders (LOO) specify a limit price and can be filled only during the opening

cross at that price or better. ■ Imbalance only orders (IO) are priced orders designed to offset any imbalance during the

opening cross. They can be executed only against MOO and LOO and early regular hours orders. These are liquidity-improving orders and will execute only to the extent that there is offsetting liquidity.

MOO, LOO, and IO orders can be entered, canceled, and adjusted between 7:00 am and 9:28 am. After 9:28 am, new MOO and LOO orders cannot be entered, nor can existing MOO and LOO orders be canceled or modified. After 9:28 am, existing IO orders cannot be canceled or modified. However, new IO orders can be entered between 9:28 am and 9:30 am.

✓T A K E N O T EAs previously indicated, regular orders entered before 9:28 am are eligible to par-

ticipate in the opening cross. After 9:28 am, orders that are entered will not partici-pate in the cross, with the exception of new IO orders.

4. 8. 12 THE CROSS PROCESS

Nasdaq Market Center (NMC) Execution System quotes go live at 9:25 am and are shown in time priority. To prevent locked or crossed markets, all such quotes are held in a separate queue. Before the opening cross, these in queue orders are executed against the best bid or best offer.



Starting at 9:28 am until market open, Nasdaq displays an order imbalance (IO) indica-tor, which is updated every five seconds. The indicator displays the current match price; the number of shares priced at the match price on the basis of accumulated MOO, LOO, IO, and early regular orders entered; and the size of the imbalance. This is done to attract more buyers if there are too many sellers and vice versa.

On the basis of the accumulated orders on the buy-and-sell sides of the market, an open-ing price is set to maximize the number of orders filled. This is termed the clearing price. These orders are cleared in one sweep at 9:30 am—the opening cross and creates the Nasdaq Official Opening Price (NOOP). At this point, regular trading begins. Orders executed prior to the opening cross must be reported with a “.T” modifier designating that the execution did not occur during normal market hours.

4. 8. 13 CLOSING CROSS (NASDAQ)

The closing cross rules are designed to create a single closing price. On the close orders (OC) can be market (MOC) or limit (LOC). They can be accepted from 7:00 am until 3:50 pm. After that time, Nasdaq stops accepting entry, cancellation, or modification of OC orders.

To offset an imbalance between the bid and offer sides of the market, Nasdaq accepts imbalance only orders (IO) until market close. IO orders must be priced. After 3:50 pm, exist-ing IO orders cannot be canceled or modified, although new IO orders can be entered.

Beginning at 3:50 pm, Nasdaq publishes an order imbalance indicator that is updated every five seconds until market close. The indicator provides information on:

■ the current reference price, which is the price at which paired shares are maximized and the imbalance is minimized;

■ the number of paired shares at the reference price; and ■ the number of shares that would remain unexecuted at the current reference price and the

side of the imbalance (buy or sell).

✓T A K E N O T EIO orders are not at risk for execution before the market close and are not repre-

sented in a market maker’s quote.

✓T A K E N O T ENasdaq’s TotalView is a data feed service that displays the full order book depth

for Nasdaq market participants. The service also disseminates the NOII as well as each quote and order in Nasdaq-, NYSE-, NYSE MKT- and regional-listed securities on Nasdaq.

4. 8. 14 ACES (ADVANCED COMPUTERIZED EXECUTION SYSTEM)

ACES is a Nasdaq order routing system that allows quick and convenient routing of orders between order-entry firms and to their preferenced market makers’ internal trading systems for execution. Orders are sent through ACES from an order entry firm’s Nasdaq terminal. After the market maker executes an order, a confirmation is sent back to the order entry firm



through ACES. The market maker that receives the order pays for the use of ACES. The sys-tem handles both Global Market and Capital Market stocks. With the use of ACES, there is no maximum order size.

Among the services provided by ACES are: ■ acceptance of both market and limit orders; ■ execution at the inside price; ■ online review of order status; ■ end-of-day activity reports; ■ limit order maintenance; and ■ automatic reporting on a system using ACT technology.

QQ U I C K Q U I Z 4 . G 1. Which of the following systems is an order-routing system that can be custom-ized to allow order-entry firms to direct orders to the internal trading system of specific market makers?

A. EMMAB. SIPC. CAESD. ACES

2. If no execution option is specified at time of order entry, the Book will assume

A. price/timeB. price/size/timeC. price/time with access fee considerationD. time/price

3. GTC orders are available for display/execution until

A. 4:00 pm each dayB. 5:15 pm each dayC. 5:30 pm each dayD. 6:30 pm each day

4. Reverse-pegged buy orders are priced at

A. .01 higher than the inside offerB. .01 lower than the inside offerC. .01 higher than the inside bidD. .01 lower than the inside bid

5. If the current inside bid for WXYZ is $24.00, the threshold price for an unpriced sweep order to sell would be

A. $23.99B. $24.01C. $21.59D. $26.41

6. Once a price cap is reached, a pegged or reverse-pegged order becomes a

A. pre-stamp orderB. limit orderC. discretionary orderD. sweep order



7. Orders for exchange-listed securities that are delivered to market participants without delivering the order to an exchange are known as

A. fill-or-return ordersB. discretionary ordersC. summary ordersD. cap orders

8. Day orders designated as X orders expire, if unexecuted, at

A. 4:00 pm that dayB. 5:15 pm that dayC. 8:00 pm that dayD. at or before market open on the following business day

9. If a market maker’s attributable interest is reduced to less than 100 shares, and the firm has no reserve size, Nasdaq will zero out the exhausted side of the mar-ket for

A. 5 secondsB. 10 secondsC. 15 secondsD. 30 seconds

10. OTC transactions must be reported within 10 seconds of execution.

A. TrueB. False

4. 9 WEBLINK ACT

Weblink ACT facilitates trade reporting and clearing using a web-based system that compares trade information reported to the FINRA/Nasdaq TRF by locking-in trades to the National Securities Clearing Corporation (NSCC). All trades thus reported are deemed locked in and are considered firm obligations and must be honored on the scheduled settlement date.

Clearing firms can use Nasdaq Weblink ACT to manage their risk by placing limitations on correspondent buying and selling as well as blockbuster limits.

Level 3

Sample ACT Trade Entry

Role: Market Maker

Order Entry

Short Sale:

As-Of

Reversal

Trade Thru Exempt

Trade Date:

Trade Modifiers:

Side:

TOOL Info:Capacity:

Give up:

Branch Seq#:

Clearing #:

Level 2

Share Quantity:

Contra Info:Capacity:

Give up:

Branch Seq#:

Clearing #:

Security:

Clearing & Reporting

Neither

AGU

QSR

Clear

Report

Price:

Contract

Price Override

Fee

Clearing Price

$

Contra:

Special Instruction

Special

Step Out

NDQ Step Out

NDQ Sales Fee

Level 4

Trade Time:

Settlement (Level 1)

Standard 3-Day

Same Day - Cash

Next Day

Other

Memo:

nqmozvzzt100 84.00Sell

Principal

07312011

F-Intmkt Swp

Send Unlock

✓

✓

✓

None

0.00

None

Series_24_04.indd 285 6/17/2015 8:41:14 AM


As noted earlier, Nasdaq became a registered stock exchange in late 2006. One of the requirements to be considered an exchange was to separate its trade execution services from its trade reporting facility. To do this, FINRA Trade created the trade reporting facility (FINRA/Nasdaq TRF) to report NMS stocks executed otherwise than on an exchange. Technically, the Nasdaq/TRF reports trades for Nasdaq stocks and exchange-listed stocks traded in the third market, whereas the OTC Reporting Facility (ORF) reports OTC Pink stocks.

4. 9. 1 SECURITIES REPORTED

Trade reports all OTC interdealer domestic and foreign equity transactions. Convertible bonds listed on Nasdaq, non-Nasdaq securities, and “out of system” transactions, also are reported through a FINRA facility such as a TRF or the ORF.

4. 9. 2 REPORTING PARTICIPANTS

Reporting participants defined by FINRA include the following.

4. 9. 2. 1 Market Makers

Included are Nasdaq market makers that are self-clearing firms (i.e., members of a regis-tered clearing agency) or have a clearing arrangement with a clearing broker.

4. 9. 2. 2 Order Entry Firms

These member firms execute orders on behalf of other member firms in stocks in which they are not market makers; many order entry firms are self-clearing.

4. 9. 2. 3 Clearing Brokers

Clearing brokers are member firms that have been identified as principals for clearing and settling a trade, whether for their own accounts or for a correspondent firm.

4. 9. 2. 4 Correspondent Executing Brokers

These are member firms that execute their own trades but clear them through a clearing member firm, as previously identified; these firms use give up clearing arrangements, because the clearing broker is given up to the market maker that executes the trade. The clearing broker takes custody of securities purchased by a correspondent executing broker. A clearing mem-ber firm is obligated to accept and clear each trade that the system identifies as having been effected by the firm itself or by any correspondent executing broker.



4. 9. 3 TRANSACTION REPORTING BY TRF PARTICIPANTS (FINRA RULE 6380A)

Market makers and order entry firms are the two types of participants that input trade reports into the Trade Reporting Facility (TRF). Reports must be made as soon as possible but no later than 10 seconds of trade execution. Transactions not reported within 10 seconds after execution must be designated as late.

Whether firms subscribe to Weblink ACT or some other system to facilitate trade report-ing to FINRA/Nasdaq TRF, OTC trades must comply with the 10-second reporting rule.

As a cautionary note, do not delay a trade report until the last second. A pattern of late reporting may trigger a violation of FINRA Rule 2010 (i.e., behavior inconsistent with high standards of commercial honor and just and equitable principles of trade).

4. 9. 4 REPORTING RESPONSIBILITIES

In general, only one side, the executing party, reports the trade. The specific reporting responsibilities are summarized as follows.

Transaction Between Who Reports

Two executing brokers (manually negotiated) Sell side only

Market maker and nonmarket maker (order entry firm) Market maker only

Two nonmarket makers (two order entry firms) Sell side only

Executing broker and customer Executing broker

!T E S T T O P I C A L E R TIn interdealer trades, the only time the buy side reports is when the buyer is a

marker maker and the selling dealer is not.

4. 9. 5 CLEARING FIRM OBLIGATIONS TO A FINRA REPORTING FACILITY

Self-clearing market makers must accept and clear each trade identified as belonging to that market maker. Nonclearing market makers must notify the TRF of the clearing arrange-ment and guarantee acceptance of their trades by the clearing broker. Promptly notify the TRF of any change.

If market makers inadvertently fail to maintain a clearing agreement at any time, they are removed from a FINRA facility and cannot act as a market maker until an alternate clearing arrangement is in place.

!T E S T T O P I C A L E R TFor market makers, voluntary failure to maintain a clearing agreement is treated

like a voluntary termination. They must wait 20 business days before attempting to reregister. If failure to maintain a clearing agreement is involuntary, the firm may reen-ter once a new clearing agreement is in place.



Clearing brokers must accept their own trades and those on behalf of their correspondents. Clearing brokers may terminate clearing arrangements with correspondents at any time by supplying notice. After notice is acknowledged by a FINRA trade reporting facility, the clear-ing broker’s responsibilities to the correspondent are ended as soon as the facility takes steps to remove the clearing broker from the system for that correspondent firm.

QQ U I C K Q U I Z 4 . H True or False?

—— 1. Trades in OTC Equity Securities (“gray market”) are not reportable.

—— 2. In a transaction between two nonmarket makers, the buyer reports.

—— 3. The FINRA trade reporting facilities transmit last sale information.

—— 4. Clearing brokers and correspondent executing brokers are the two types of participants that input trade reports.

—— 5. Trade reports must be made within 10 seconds of trade execution.

—— 6. If a market maker involuntarily fails to maintain a clearing agreement, the market maker is subject to an excused withdrawal and can begin quoting after arranging an alternate clearing arrangement.

4. 9. 6 TRADE INPUT SYMBOLS

Each trade report must contain pertinent trade information, including the: ■ symbol; ■ number of shares; ■ unit price excluding remuneration (the protected price, which excludes such things as

commissions and markups); ■ execution time; ■ symbol indicating the reporting party representing the market maker side or the order

entry side; ■ symbol indicating whether the transaction is a buy, sell, sell short, sell short-exempt, or

cross (a cross-transaction occurs when a broker-dealer acts as agent or principal for both the buyer and seller);

■ symbol indicating whether the trade is executed as principal or agent; and ■ symbol that identifies the clearing relationship for both sides of the trade, including any

give up trade (give up reporting occurs when a broker-dealer that accepts orders, known as a participant, passes them to another broker-dealer for submission to the TRF).

4. 9. 7 PRICES REPORTED TO THE TRF

The price to be reported through the TRF excludes commissions, markups, and mark-downs. The following examples identify proper price reporting.



Principal Trades. In a principal trade, a market maker either buys from a customer less a markdown or sells to a customer with a markup. In other words, the market maker is either buying for inventory or selling from inventory.

*E X A M P L E A market maker buys 500 WXYZ from a customer at 28.50 net, which includes a markdown of 20 cents per share. The trade is reported as 500 at 28.70.

Riskless Principal Trades. In riskless principal transactions, a nonmarket maker, to fill a customer order, buys from a market maker and simultaneously sells the stock to the customer with a markup.

*E X A M P L E To fill a customer market order to buy 300 ABCD, an order entry firm buys from a market maker at 17.40 and simultaneously sells the stock to the customer at 17.60 net, which includes a markup of 20 cents per share. The trade is reported as 300 shares at 17.40.

Agency Cross-Transactions. In agency cross-transactions, a member is acting as agent for both buyer and seller, charging each side a commission. This also is known as a dual agency transaction.

*E X A M P L E A firm buys 400 shares of WXYZ for a customer at 21.50 and simultaneously sells 400 shares of WXYZ to a customer at 21.50 charging each side a commission of $100. The trade is reported as 400 shares at 21.50.

Principal Cross-Transactions. In principal cross-transactions, a market maker buys and sells as principal, charging the buyer a markup and the seller a markdown.

*E X A M P L E A market maker buys 200 shares from a customer at 37.50 net, which includes a markdown of 20 cents per share, and simultaneously sells 200 shares to a customer at 37.90 net, which includes a markup of 20 cents per share. The trade is reported as 200 shares at 37.70.



QQ U I C K Q U I Z 4 . I Match the following prices with the appropriate descriptions.

A. 21.75B. 22.35C. 22.50D. 22.10

—— 1. Price at which a principal trade of 100 shares at 22.10, which includes a markdown of .40, is reported

—— 2. Price at which a principal trade of 100 shares at 22.10, which includes a markup of .35, is reported

—— 3. Price at which a riskless principal trade with a purchase of 100 shares at 22.10 and sale of 100 shares at 22.10 plus a markup of .30 is reported

—— 4. Price at which a sale of 22.35 less commission of .35 is reported

4. 9. 8 TRADE REPORTING RULES

FINRA provides a number of methods to report transactions in OTC equity securities. For transactions taking place while FINRA facilities are open, a member must report trades within 10 of execution. Reports also must be made for trades made outside normal market hours. Normal market hours are from 9:30 am to 4:00 pm ET. FINRA requires that trades taking place in NMS stocks outside those hours be reported to an authorized reporting facility, such as the ADF (Alternative Display Facility, operated by FINRA) which is open from 8:00 am to 6:30 pm, or TRFs or the ORF, which are open from 8:00 am to 8:00 pm.

Reports made of after-hours trades do so with a modifier of “.T.” If a trade was executed between midnight and 8:00 am, the trade must be reported on trade date no later than 8:15 am. If a trade was executed between the close of a FINRA facility and midnight, the trade must be reported on an “as/of” basis the following business day (T+1) by 8:15 am. If either category of trades is reported after 8:15 am, the trade must be reported with a late, outside-normal-market-hours trade report modifier of “.U.”

The FINRA/Nasdaq TRF and ORF permit firms to submit outside normal market hours trade reports to the two facilities throughout the day. The other two TRFs—the ADF and FINRA/NYSE TRF—also permit these reports to be submitted during normal market hours.



Summary of Trade Reporting Rules

Trade Execution Time

Reporting Requirement Report Time Trade Modifier

Midnight– 7:59:59 am

8:15 am 8:00 am–8:15 am on trade date

.T

After 8:15 am .U

8:00 am– 9:29:59 am

Within 10 seconds of execution*

Within 10 seconds of execution

.T

Trade reported late .U

9:30 am– 4:00 pm



N/A

Trade reported late .Z

4:00:01 pm– 8:00 pm(4:00:01 pm– 6:30 pm for ADF)



.T

Trade reported late .U

8:01:01 pm 11:59:59 pm (6:30:01 pm– 11:59:59 pm for ADF)

By 8:15 am on T+1, “as/of”

8:00 am–8:15 am on T+1

.T

After 8:15 am on T+1

.U

!T E S T T O P I C A L E R TSome testable points about reporting modifiers are as follows.

■■ .T is used when trades are effected outside of market hours but reported on the same day.

■■ As-of is used when trades are effected outside of market hours but reported the next day.

■■ A no-was trade is a correction report. No represents the canceled portion; Was represents the correction. No-was reports must be made by 8:00 pm on the day of the trade.

After-hours trading permits market participants to react to late breaking news. However, one of problems with after-hours trading is that volume is low, and that often means high volatility. Stocks may make large movements in reaction to after-the-bell news. Spreads are wider as well due to much lighter volume. Protection, like trailing stops, that is available during normal hours is not available in the after market. These factors contribute to making after-hours trading a challenge.

4. 9. 9 LATE REPORTS (“AS/OF” AND T+N)

If a trade is not reported on time, it must be reported as soon as possible and must be desig-nated as late. Trades that are not reported on trade date for whatever reason must be reported on an “as/of” basis on a subsequent date (T+N) and be designated as late. Furthermore, trades, such as those executed outside normal market hours, are to be reported on an as/of basis,



typically the next business day (T+1). However, if that doesn’t happen and the trade is not reported on T+1, it must be reported on a subsequent date (T+N) and be designated as late.

4. 9. 10 TRADE REPORTING

The following report modifiers describe special trading circumstances.

4. 9. 11 COMMON MODIFIERS

.C (cash trade) is used for a cash (same day) settlement.

.N (next day) is used for a next-day settlement.

.O (price override) is used when a transaction to be entered is within 10 seconds and the market has moved away from the reported trade price.

.Z (late trade report) designates a transaction reported more than 10 seconds after execution.

.SNN (extended settlement trade) For this modifier, add .S and the number of settle-ment days between four and 60 to indicate the appropriate number of business days in which the trade will settle (e.g., .S08 for eight days).

.P (late execution prior reference price) designates a transaction that was reported on time but relates to a trade that arose at an earlier time during the day. The time on the trade report should be the time the obligation to trade arose, and the price should be the price at the time the order should have been executed. Some systems may still use .PRP.

.W (stop stock transaction) is used to modify two different trade reports. First, a stop stock trade, which is a transaction resulting from an order in which a member and another party agree that the order will be executed at the stop stock price or better. The trade report will include the time at which the parties agreed to the stop stock price, not the actual time the trade was executed. The modifier is not appended to the report of a stop stock trade if the trade is executed and reported within 10 seconds of the time the member and the other party agree to the stop stock price. A DMM may not stop stock against the book or for his own account.

.W (weighted average price/special pricing formula) The .W modifier also is used as a modifier by firms for trade pricing based on average weighting or another special pricing formula for Nasdaq. Combinations of modifiers are expected. A member can report that a transaction is both a weighted average price (.W) and outside market hours (.T) transaction.

✓T A K E N O T EA stop stock transaction is not the same as a stop order.

A stop stock transaction is an order in which a member and another party agree that the order will be executed at a stop stock price or better, and then executed at the stop stock price or better.



As we saw earlier in Unit 4, a stop stock transaction may be flagged with the trade modifier as trade-through exempt, if it qualifies as such under SEC Rule 611 of Regulation NMS.

By comparison, a stop order is a market or limit order that does not become ef-fective until a certain market price is reached and is executed. Stop order transactions are not reported with a special trade report modifier.

Market Centers are identified with the following symbols.

Market Center Symbols

Q Nasdaq Stock Market trade

D FINRA ADF

N New York Stock Exchange trade

A NYSE MKT (Formerly American Stock Exchange)

B NASDAQ OMX BX

C National Stock Exchange trade

I International Securities Exchange trade

M Chicago Stock Exchange (CHX) trade

W Chicago Board Options Exchange trade

X NASDAQ OMX PHLX

O Other than Over the Counter Market trade for any security

U Unspecified Multiple Market trades

Z Unspecified Multiple Non-FINRA Market trades

0 ADF/ORF

1 NASDAQ TRF

2 NSX TRF

3 NYSE TRF

F Foreign Market

H BATS Exchange, Inc.



✓T A K E N O T ESummary of Trade Reporting Modifiers

.C Cash trade option

.F Intermarket sweep order

.J Subpenny designator

.M Nasdaq official closing price

.N Next day

.P Prior reference price

.Q Nasdaq official opening price

.T Outside market hours

.U Pre-open and aftermarket trades reported late sold out of sequence

.W Weighted average price/stopped stock

.X Cross trade

.Z Late trade

A step-out allows an executing broker to step out (or allocate) all or a portion of a trade to other brokers. In other words, a step-out indicator functions as a position transfer rather than a trade. For every step-out, one firm is stepping out of (or transferring) the position, and the other firm is stepping into (or receiving) the position. Member firms may effect a “step-out” by submitting a clearing-only report to a FINRA facility, such as ORF.

QQ U I C K Q U I Z 4 . J Match the following trade reporting modifiers with the appropriate description.

A. .TB. .SNNC. As-ofD. .CE. .Z

—— 1. A cash settlement

—— 2. A late trade report

—— 3. An extended settlement

—— 4. A trade is effected outside of market hours but reported on the same day

—— 5. A trade is effected outside of market hours but reported on the next day

4. 9. 12 LOCKING IN TRADES—THE 20 MINUTE RULE

The ADF, FINRA/Nasdaq, TRF, and the ORF provide trade acceptance and comparison functionality. This means that the reporting party submits the trade information, and the con-tra party then accepts or declines the trade information submitted.



✓T A K E N O T EThe FINRA/NYSE TRF does not provide trade acceptance and comparison func-

tionality and, therefore, trades must be locked in before they can be submitted.

A BD has 20 minutes from the time of execution to accept or reject the trade information submitted by the reporting BD.

4. 9. 13 REPORTING CANCELED TRADES

The cancellation of any trade previously submitted must be made by the party responsible for submitting the original trade report. For trades executed through a Nasdaq system that reports to Nasdaq TRF, the party that would have been responsible for reporting the trade, had the system not been in place, must make the cancellation report. The time frame for reporting canceled trades is as follows.

■ For trades executed during normal hours and canceled at or before 4:00, the cancellation report must be made within 10 seconds of the time the trade is canceled.

■ For trades executed during normal hours and canceled after 4:00 but before 8:00 pm, the member responsible must use its best efforts to report the cancellation not later than 8:00. If the member is unable to do so, it must report the cancellation by 8:00 pm on the follow-ing business day.

■ For trades executed during normal hours and canceled after 8:00 pm, the cancellation report must be made by 8:00 pm on the following business day.

■ For trades executed outside of normal hours and canceled before 8:00 pm on the date of execution, the cancellation report must be made that day by 8:00 pm.

■ For trades executed outside of normal hours and canceled after 8:00 pm on the date of execution, the cancellation report must be made by 8:00 pm on the following business day.

4. 9. 14 NASDAQ RISK MANAGEMENT

Sample Summary Risk Scan

Buying Buy Limit Buy % Selling Sell Limit Sell % Blockbuster Sizeable Limit

Cap Mark

$68,800.00 $1.000.000.00 6.88% $50.249.12 $1.000.000.00 5.02% $100,000.00 $75,000.00 Off

$98.647.00 $2.500.000.00 $490.530.00 $2.500.000.00 19.62% $100,000.00 $75,000.00 Off

There is a great deal of risk in trading that goes well beyond market risk. In today’s markets where those with direct market access can effect high frequency, algorithmic trades, the need for an automated control system to head off fat finger or miscalculated algo errors, pre-trade risk management is a valuable tool.



4. 9. 14. 1 Single Trade Limit

A single trade limit is a pre-established dollar amount established by Nasdaq for a single trade, above which the Nasdaq Risk Management system enables a clearing firm to review the trade before it is obligated to clear the trade. Rules allow a review period of 15 minutes before the clearing broker must accept or decline the trade. If the clearing firm does not affirma-tively accept or decline the trade, the Nasdaq Risk Management Service will instruct appro-priate TRF that the trades should be either automatically declined or automatically subjected to normal processing in which the clearing broker will act as principal to clear the trades. Transactions exceeding this limit are sometimes called blockbuster trades. The 15-minute period allows the member time to assess risk of the trade.

4. 9. 14. 2 Gross Dollar Thresholds

Clearing brokers may establish a maximum gross dollar limit for their correspondents, which is a daily dollar amount of purchases and sales for each correspondent. If exceeded, the clearing broker is alerted. These limits may be raised and lowered during the trading day or from one day to the next. An early warning alarm, called the pre-alert, informs the clearing broker-dealer when the correspondent has reached 70% of the gross dollar threshold.

4. 9. 14. 3 SuperCap Limit

Super Caps means the daily dollar amounts for purchases and sales that a clearing firm establishes in the Nasdaq Risk Management system for each correspondent executing broker. That amount may be raised or lowered on an inter-day or intra-day basis.

If a correspondent’s gross dollar threshold (Super Cap) is exceeded, the clearing broker and TRF will be notified. Nasdaq Risk Management will automatically instruct TRF that any trade in excess of an applicable “sizeable limit” that was set by the correspondent firm is subject to review by the clearing firm until the correspondent’s trading activity no longer exceeds a gross dollar threshold. The clearing firm has 15 minutes from execution to review any single trade negotiated by its correspondent that equals or exceeds the limit in order to decide to act as principal for the trade or to decline to act as principal. If the clearing broker does not affir-matively accept or decline the sizeable trade at the end of 15 minutes, the system will instruct TRF to act in accordance with pre-established instructions; that is, accept or decline the trade.

4. 9. 14. 3. 1 Reporting Transactions Summary

The following is required when reporting transactions information: ■ Stock symbol (FINRA will not issue a symbol for an equity security unless it has a CUSIP

number.) ■ Number of shares ■ Trade price ■ Time of execution (only after 10 seconds) ■ Action: Buy, sell, short sell, cross ■ Trade capacity: Principal, agent, riskless principal, step-out, give-up



4. 9. 15 EXEMPT TRANSACTIONS

Certain Nasdaq transactions are exempt from last sale information reporting require-ments, including:

■ trades resulting from increase of options, warrants, and convertible securities; ■ registered primary offerings; ■ private placements; ■ transactions reported automatically by another reporting system; ■ odd-lot transactions; and ■ transactions at the agreed price that do not reflect the current market (typically for gift-

ing).

!T E S T T O P I C A L E R TAlthough odd-lot transactions are exempt from last sale information purposes,

they are not exempt from reporting for settlement and clearing purposes.

4. 9. 16 OTHER REPORTING RULES

For agency crosses, where a member is acting in a dual agency capacity, the transaction is reported only once.

*E X A M P L E A firm sells for a customer as agent 100 shares at 60 less a $50 commission and simultaneously buys for a customer as agent 100 shares at 60 plus a $50 commission. The report is 100 shares at 60.

For principal crosses, where a market maker buys and sells as principal, the transaction is reported only once.

4. 9. 17 OTC EQUITY REPORTING (FINRA RULE 6400)

Rule 6400 deals with the quoting and trading requirements of OTC equity securities.

ORF. The OTC Reporting Facility (ORF) is a service provided by FINRA that accom-modates reporting trades in OTC Equity Securities executed other than on an exchange and for trades in restricted equity securities effected under Rule 144A.

With respect to those OTC Equity Securities and Restricted Equity Securities that are not eligible for clearance and settlement through the NSCC, the ORF comparison function is not available. However, this does support the entry and dissemination of last sale data on those securities.



4. 9. 17. 1 TRACE—Rule 6700

TRACE is FINRA’s trade reporting system for OTC primary and secondary market trans-actions in TRACE-eligible fixed income securities, such as corporate, agency, government-sponsored enterprises (GSE), and asset-backed securities, including those effected pursuant to Rule 144A. This mandatory reporting by market participants is facilitated through the Trade Reporting and Compliance Engine (TRACE). The current TRACE reporting time is 15 minutes for transactions in eligible securities from 8:00 am to 6:29.59 pm ET on each busi-ness day. FINRA then immediately disseminates trade information to the investing public to promote market transparency. Transactions executed on a business day less than 15 minutes before 6:30:00 p.m. ET must be reported no later than 15 minutes after the TRACE system opens the next business day (T + 1), and if reported on T + 1, designated “as/of” and include the date of execution.

Member firms are identified by an MPID. MPID is an abbreviation for Market Participant Identification and must use that identifier for trade reporting and for an audit trail. Obtain an MPID from FINRA. A firm may have more than one MPID if, for example, there are multiple clearing firm arrangements.

Dollar denominated corporate debt securities issued by a U.S. or foreign private issuer, including church bonds, agency debt securities, and mortgage and asset-backed securities, fall within the definition of a TRACE-eligible security. FINRA makes available a file each day at 7:00 am ET of all TRACE-eligible securities, and it’s updated throughout the day until 8:00 pm. Specifically excluded from TRACE reporting are:

■ U.S. Treasury securities (T-bonds, T-notes etc.); ■ debt of foreign sovereign government; ■ money-market instruments (debt at issuance with a maturity of one calendar year or less); ■ debt securities that are not DTC eligible or are in physical form.

!T E S T T O P I C A L E R TMunicipal securities are not TRACE-eligible securities. Municipal securities trans-

actions are reported by MSRB’s EMMA system.

TRACE is not an execution system; it is a trade reporting system only. It does not accept quotations, nor does it provide settlement and clearance functions. Facts about TRACE reporting to consider include the following.

■ Both sides to an interdealer trade must report (dual side reporting). ■ Trades must be reported within 15 minutes of execution. Otherwise, the transaction report

will be late. ■ Primary market trades that execute at a fixed offering price are reportable with T+1. Those

primary market trades other than asset-backed securities that execute at market prices are reportable within the normal 15-minute window required of secondary market trades.

TRACE displays: ■ settlement date; ■ commission (total dollar amount); ■ capacity (either agent or principal); ■ execution date and time; ■ quantity;



■ price; ■ yield; ■ whether there was any special settlement or condition that may have affected the price; ■ whether the trade was reported late; and ■ whether the price reflects that a commission was charged;

For example, if the executing broker were long bonds, it would report that it sold as princi-pal net to the introducing broker. If the introducing broker charged its customer a commission, the introducing broker must report the commission in the separate “commission” field through the TRAQS Web browser interface.

In another example, if the firm received an unsolicited order from a customer to purchase TRACE-Eligible Securities at the market and the firm had no position requiring it to go to the street to buy bonds in pieces through its omnibus account, when the order is filled and an agency commission is charged, this is how it’s reported:

Report an agency buy from each firm that sold the firm TRACE-Eligible-Securities. The firm then reports an agency sell with “C” (for the end customer), and the amount of the com-mission charged in the commission box.

Once FINRA receives trade information on TRACE-eligible debt securities, as previously stated, it immediately disseminates this information to the public.

Although all broker-dealers have an obligation to report transactions in OTC Corporate Bonds and Agency Debt to TRACE, the actual technical platform is known as FINRA Trade Reporting and Quotation Service (TRAQS). TRAQS is a central communication source and is the primary collector, disseminator, and support service that is used by members for the posting of quotes and reporting of trades to FINRA for not only TRACE-eligible securities but transactions in OTC Equity Securities (non-NMS stocks), DPPs, and Restricted Equity Securities to the ORF TRAQS website. ORF stands for OTC Reporting Facility.

If a member fails to abide by the rules of the TRACE service or fails to promptly pay for the service, FINRA may, upon notice, terminate service to the member.

4. 9. 17. 1. 1 Give-up

A correspondent broker-dealer, which plans to trade and report through its clearing firm, must sign a TRACE Participant Agreement.

As previously mentioned, if an introducing member firm takes an order, it has an obliga-tion to report the executed transaction to TRACE. It also must report its activity with the end customer and with the clearing firm.

The clearing broker-dealer and the introducing firm must submit two signed TRACE Participation Agreements. Under a “give-up” agreement, the introducing firm, which does not have access to TRACE, may directly fulfill the requirement to report both the buy trade and sell trade by authorizing (giving up) the clearing firm to submit both TRACE reports on its behalf.

✓T A K E N O T ETRACE is open from 8:00 am until 6:30 pm ET. If a trade is effected within

15 minutes of closing, the trade does not have to be reported that day. However, it must be reported within 15 minutes of system opening on the following business day.

Market Session Normal Hours

Regular Market Session 8 a.m. to 5:15 p.m.

Post-Market Trading Session 5:15 p.m. to 6:30 p.m.



4. 10 NASDAQ INTERNATIONAL SERVICE

The Nasdaq International Service allows market makers to publish quotes and execute trades outside the United States in:

■ Global Market securities; ■ any non-Canadian foreign security or ADR that is part of Nasdaq but not a Global Market

security; and ■ any equity security listed on a national securities exchange.

✓T A K E N O T ENasdaq Capital Market securities are not part of Nasdaq International except for

foreign securities and ADRs.

Market makers can register as European Only market makers, which means they can quote the stock from 3:30 am to 9:00 am ET (the European session). Market makers can also register as International Service market makers, which means their market is good not only for the European session, but for the domestic session as well.

Firms must be registered with FINRA as European Only or International Service market makers. At the time of registration, firms must select, on a security-by-security basis, one of the following periods to define their market making commitment:

3:30 am to 9:00 am5:30 am to 9:00 am7:30 am to 9:00 am

To participate in Nasdaq International, firms must be members or approved affiliates. An approved affiliate is a broker-dealer that is:

■ not a FINRA member; ■ authorized to conduct business in the UK in accordance with the Financial Services Act

of 1986; and ■ controlled by, controls, or is under common control with a member.

✓T A K E N O T EApproved affiliates are limited to European-only registration.

Clearance and settlement of European session trades must be effected through a regis-tered clearing agency that uses a continuous net settlement system (CNS). Last sale reports in the European session must be made to FINRA within three minutes of execution. Like their domestic counterparts, European session market makers make daily and monthly volume reports to FINRA. For trades executed outside of normal European hours, market makers must make weekly reports.

Other International Service rules are similar to those of Nasdaq. ■ Excused withdrawals are permitted. ■ Voluntary termination is accomplished by quote withdrawal. If a market maker withdraws

its quotes from the European session, it may continue to act as a market maker in the domestic session if it is registered as an International Service market maker.

■ Quotes must be firm for the size displayed.



4. 11 OPENING PRICE OF NASDAQ IPOS

The syndicate manager must notify Nasdaq by 6:45 pm on the night before the issue is released for trading as to what the public offering price (POP) will be. The POP will be the first bid during the 15-minute quotation period. Market makers must quote the issue for 15 minutes before any trades can be executed. Any trades executed during this period represent a violation of FINRA rules.

4. 12 NASDAQ MARKETWATCH

To maintain a fair and orderly marketplace for investors and listed companies, Nasdaq MarketWatch, working closely with FINRA, uses automated, real-time surveillance systems to scan for irregular trading activity on the Nasdaq stock market. When trading activity is sus-pected of being in violation of exchange rules and policies, MarketWatch refers the activity to FINRA’s Department of Market Regulation for further review and possible disciplinary action. MarketWatch also may contact a listed company for its view on why unusual market activity is occurring, reviews news notifications that may affect listed companies, and exerts its best effort to judge the materiality of an announcement.

MarketWatch also oversees the disclosure of important information by Nasdaq-listed com-panies as well as monitoring their compliance with exchange rules. Nasdaq requires that its listed companies make timely disclosure to the public through any Regulation FD-compliant method of information that would likely affect the value of its securities or influence the deci-sions of market participants.

Nasdaq-listed companies must notify MarketWatch at least 10 minutes prior to the release of important news to the general public during Nasdaq/MarketWatch market hours (4:00 am to 8:00 pm ET). Notification by listed companies must be provided to MarketWatch through the Electronic Disclosure submission system. MarketWatch generally implements trading halts from 7:00 a.m. – 8:00 p.m. ET.

4. 12. 1 TEMPORARY TRADING HALTS

Between the hours of 4:00 am and 7:00 am ET, temporary trading halts also may be admin-istered at the request of a NASDAQ-listed company in anticipation of the release of material news, or if trading in the stock is halted in a foreign market. When appropriate, MarketWatch may implement temporary halts prior to the public dissemination of material news. A tempo-rary trading halt is a good thing. It allows material news to be widely disseminated so existing and potential shareholders know that all trading is based on publicly held facts. Although the length of the halt can vary, trading normally restarts about 30 minutes after the press release or some Regulation FD-compliant method. Much depends on communication with the listed company.



✓T A K E N O T ENasdaq-listed companies have an obligation to notify MarketWatch at least 10

minutes prior to the release of material news when the public release of the informa-tion is made between 7:00 am and 8:00 pm ET. If the public release of the material information is made outside those times, they are required to alert MarketWatch prior to 6:50 am ET. The consideration of temporary trading halts occurs during regular market hours as well as during pre-market and after-hours trading sessions.

4. 12. 1. 1. 1 List of Nasdaq MarketWatch Duties

The following is a summary of Nasdaq MarketWatch duties: ■ Identify clearly erroneous trades ■ Review news disclosures ■ Review unusual market activity ■ Review market participant trading activity ■ Administrate trading halts ■ Adjudicate trade breaks ■ Excused withdrawals and Reg M activity ■ Administrate market participant quoting obligations ■ Refers potential violations to FINRA ■ Provides real-time surveillance for activity on the Nasdaq Stock Market ■ Looks to provide an orderly market and level playing field for investors

QQ U I C K Q U I Z 4 . K Match the following items with the appropriate description.

A. .TB. As/ofC. TRACED. OTC Pink MarketplaceE. .ZF. OTCBB

—— 1. Type of security not subject to regulatory reporting requirements

—— 2. Example of a security that is reported to the Nasdaq/TRF

—— 3. The system that provides reports for corporate bond transactions

—— 4. Modifier included when a trade performed outside of market hours is reported on the next business day

—— 5. Modifier included when a trade performed outside of market hours is reported on the same day

—— 6. Modifier included when a trade is not reported on time



4. 13 UNIFORM PRACTICE

The Uniform Practice Code (UPC) of FINRA was created to set rules for dealer-to-dealer transactions in the over-the-counter market. The Code only applies to transactions in nonexempt securities.

4. 13. 1 EXCLUSIONS

The Code does not apply to transactions: ■ executed on an exchange floor; ■ in exempt securities; ■ in redeemable investment company securities, such as mutual funds (publicly traded funds

are subject to the Code); and ■ settled outside the united states.

The authority to issue interpretations and rulings and to administer the Code rests with the Uniform Practice Committee of FINRA.

4. 13. 2 SETTLEMENT DATES

Regular way settlement for most securities is the third business day following trade date. It is the date on which a buyer is expected to pay for securities purchased and a seller to make delivery on securities sold.

Cash settlement transactions require delivery of securities from sellers and payment from buyers on the same day the trade is executed (same-day settlement). UPC rules require that cash settlement transactions be finalized on or before 2:30 pm ET.

Seller’s option is a type of settlement that can occur if the seller, for good reason, will be unable to deliver the securities to the buyer by the regular way settlement date. If granted by the buying dealer, the seller can make delivery on or before the date the option expires.

Under UPC rules, the earliest the seller can make delivery is the fourth business day fol-lowing the trade date. (If the seller were able to deliver any earlier, the option would not be required.) Before making delivery to the purchaser, the seller must give the buyer a written notice of intention to deliver. This notice must be given at least one business day prior to making delivery.

Summary of Settlement Rules

Equity 3 business days

Corporate and municipal bonds 3 business days

Equity options Next business day

Index options Next business day

T-bills, T-notes, and T-bonds Next business day

US government agency 3 business days

Seller’s option No sooner than T+4

Cash settlement Same day

Regulation T T+5



✓T A K E N O T EAs a general rule, all physical deliveries must be made by the seller at the office of

the purchaser on the prescribed settlement date. Any expenses incurred in connection with the delivery are borne by the seller.

✓T A K E N O T EBy way of comparison, NYSE rules vary somewhat in that delivery on a seller’s

option contract can be made as early as two business days from trade date and as late as 60 business days from trade date.

4. 13. 2. 1 Syndicate Settlement

The final settlement of syndicate accounts must be effected by the manager within 90 days following the syndicate settlement date, which is the date on which the securities are deliv-ered by the issuer to or for the account of the syndicate members.

4. 13. 2. 2 Clearance and Money Settlement

As noted in an earlier Unit, interdealer trades are reported and submitted to National Securities Clearing Corp. (NSCC) for clearance and settlement. NSCC works on a continu-ous net settlement (CNS) basis (interdealer buys and sells, per security, are netted each day for delivery and money settlement purposes).

Delivery for many securities is accomplished through bookkeeping entries at a securities depository, such as the Depository Trust Company (DTC). DTC provides securities certificate safekeeping for member firms, and changes in ownership are made by computerized entries rather than physical delivery.

Depository Trust & Clearing Corp. (DTCC) was formed with the acquisition of NSCC by DTC. To clear transactions, firms must be members of NSCC or clearing corporations associ-ated with an exchange, such as Midwest Clearing Corp. DTC itself is involved in custody and safekeeping, not in clearance. DTC also processes dividend and interest payments on securi-ties it holds in safekeeping.

4. 13. 3 EX-CLEARING TRADES

As the majority of interdealer trades are confirmed and settled electronically, the need for paper confirmations has diminished. Nonetheless, there are trades, such as when-issued con-tracts, that are settled outside the scope of automated confirmation and transaction reporting systems and NSCC. The rules for these ex-clearing trades are as follows.

■ Interdealer paper confirmations must be sent no later than T+1. ■ When one party to a trade (the confirming member) sends a confirmation but does not

receive one in return, the confirming member must send a don’t know (DK) notice to the nonconfirming member after four business days from trade date.

■ After receipt of the DK notice, the nonconfirming member has four business days to either confirm or DK the trade.

■ If no response is received from the nonconfirming member, the confirming member can consider the nonresponse as a DK and can drop the trade or pursue remedies under the Code of Arbitration.



4. 13. 4 WHEN-ISSUED CONTRACTS

A when-issued (WI) contract is a written agreement between members to buy or sell a security prior to its issuance. These trades are settled ex-clearing, so paper confirmations are required. Each WI contract must contain:

■ a description of the security and the plan, if any, under which the security is to be issued; ■ the designation of FINRA as the authority to rule on the contract; and ■ procedures for marking the contract to the market.

The buying member treats a WI contract as a margin purchase by putting up 50%. If the price of the contract declines in the when-issued trading market, the seller (the unsecured party) may demand additional collateral. This is called marking to the market and repre-sents the difference between the contract price and the market price. Under Uniform Practice Rules, mark to the market requests must be met promptly.

On the other hand, if the price in the when-issued trading market rises, the buyer can demand a refund of the up-front money equal to the difference between the contract price and the market price. Failure to comply with a demand for additional collateral or a demand for a refund entitles the buyer (in the event of a refund demand) or the seller (in the event of a demand for additional collateral) to close the contract without notice (by making an offsetting purchase or sale).

Funds received by the selling member (50%), as well as any additional funds received as the result of mark to the market requests, must be segregated by that member on its books and records.

Settlement of when-issued contracts is determined by the Uniform Practice Committee after a sufficient percentage of the issue is outstanding.

✓T A K E N O T EIn the event the Committee does not declare a delivery date, delivery may be

made by the seller (e.g., syndicate) on the business day following written notice of intent to deliver.

4. 13. 5 STOCK BORROWED

When a member, for whatever reason, borrows stock from another member or securities lending firm, the following rules apply.

■ The borrowing member must put up, in cash, an amount equal to the market value of the borrowed stock.

■ The borrowed stock is marked to the market daily, which may require the borrower to put up more cash or receive a partial refund.

■ The lender is entitled to any dividends on the loaned stock. ■ The stock is returnable upon demand of the lender.

On the flip side, securities lending may not be appropriate for all investors. For example, proxy voting rights on loaned securities are forfeited, and loaned shares are not protected by SIPC. However, subject to its limits, the cash collateral received for the loaned securities is protected by SIPC.



4. 13. 6 CLEARLY ERRONEOUS TRADES

Nasdaq has the authority to declare any interdealer trade null and void or adjust the terms of any interdealer trade if the terms of the trade are clearly in error (e.g., obvious error in price, number of shares). Nasdaq can take these actions on its own or in response to a complaint from a member.

If a member wants to have a trade nullified or adjusted, it must notify Nasdaq Market Operations within 30 minutes of the execution and provide all the details surrounding the trade. After review, Nasdaq will make a decision to:

■ void the trade; ■ adjust the terms of the trade; or ■ take no action.

Either side to the trade can appeal Nasdaq’s decision. Any appeal must be made to the Market Operation Review Committee (MORC) within one-half hour of receiving Nasdaq’s decision. All decisions made by the Committee are final and binding.

In the case of an outlier transaction, Nasdaq officials may consider requests after 30 min-utes but no longer than 60 minutes after the transaction in question.

An outlier transaction is when the execution price of the security is greater than three times the current numerical guidelines.

✓T A K E N O T EInitial notification is made to Nasdaq Market Operations. Appeals of their deci-

sion must be made to the Market Operations Review Committee.

✓T A K E N O T EObvious errors can be avoided by fat-finger checks that allow a comparison of

price instructions on incoming orders against the current displayed size and price in the market. If the order is outside a preset threshold with the displayed price and size, the order will be rejected before it can be executed.

Firms can set order limits at several levels to ensure that fat-fingered orders never execute.

The so-called flash crash of May 6, 2010, is thought to have been caused by a fat-finger error. Some traders may set a fat-finger check for any trade size that they know to be larger than what they customarily place.

4. 14 GOOD DELIVERY RULES

Before a security that has been sold can be delivered to the buyer, it must be in good deliv-erable form. Good delivery describes the physical condition, signatures, attachments, and denominations of the certificates involved in a securities transaction. Although good delivery is mostly a matter of street-side settlements between buying and selling dealers, it also applies to deliveries from customers on sell orders.



In any dealer-to-dealer transaction, the delivered securities must be accompanied by a properly executed uniform delivery ticket. The transfer agent is the final arbiter of whether a security meets good delivery.

4. 14. 1 UNIT DELIVERY RULE

For round-lot sales of common stock, delivery must be made in denominations that add up to 100 shares or are divisible by 100 shares.

*E X A M P L E For a 300-share sale, the seller could deliver:

■■ one 300-share certificate;

■■ three 100-share certificates;

■■ six 50-share certificates;

■■ two 100-share certificates, one 60-share certificate, and one 40-share certificate; or

■■ three 60-share certificates and three 40-share certificates.

Each of these deliveries meets the requirements of the rule. However, delivering four 75-share certificates would not be good delivery. Can you take the certificates and make stacks of 100 shares? If the answer is yes, it is good delivery.

4. 14. 1. 1 Partial Deliveries

A partial delivery is acceptable under Uniform Practice Rules if the amount remaining to be delivered does not include an odd lot.

*E X A M P L E Delivering 200 shares to satisfy a 300-share sale would be good delivery (the amount remaining is a round lot). However, delivering 250 shares in the same sce-nario would not be good delivery, because the remainder would be an odd lot.

4. 14. 2 BOND DELIVERIES

Each delivery of bearer bonds must be in denominations of $1,000 or $5,000. Any other denomination is a counterfeit. For registered bonds, delivery must be in denominations of $1,000 or multiples thereof ($5,000, $10,000, $25,000, et cetera) but in no event in a denomi-nation larger than $100,000.

If a bond issue has become the subject of a partial call, delivering certificates subject to the call is not good delivery (unless identified at time of trade as being called bonds). Rather, it is presumed that the buyer wants to buy bonds not subject to the call. However, if the issue is subject to an in-whole call, delivery of any certificate is good delivery. The only bonds the seller can deliver are ones subject to the call.



4. 14. 3 COMPUTATION OF ACCRUED INTEREST

The majority of bonds trade and interest, which means that the buyer pays the seller the market price of the bond plus any interest accrued since the previous interest payment date. Because the buyer will receive the full amount of the next interest payment (including inter-est that accrued while the seller still owned the bond), the seller must be reimbursed for that portion of the interest.

Most bonds pay interest every six months on either the 1st or the 15th of specified months. The payment dates are known as coupon dates.

*E X A M P L EIf the interest dates are: The bonds are known as:

January 1 and July 1 J&J bonds

February 15 and August 15 F&A 15 bonds

March 1 and September 1 M&S bonds

April 1 and October 1 A&O bonds

May 15 and November 15 M&N 15 bonds

June 15 and December 15 J&D 15 bonds

Accrued interest affects bond transactions when settlement occurs between coupon dates.

*E X A M P L E If a J&J bond trades in March, the buyer will collect six months of interest in July from the issuer even though the buyer owned the bond for only three months of that period.

The buyer and seller settle this by adding the accrued interest to the cost of the buy trans-action (as well as to the sales proceeds). Therefore, the buyer pays the accrued interest to the seller and receives the full interest payment on the next coupon date. The net amount is what has been earned by the buyer for that six-month period.

Unless the settlement date of a bond transaction coincides with the bond’s interest pay-ment date, the cost of the bond to the buyer will include accrued interest. By the same token, the proceeds to the seller will include accrued interest.

Accrued interest is calculated from (including) the prior interest payment date—the last coupon date—up to (but not including) the settlement date. The buyer owns the bond on the settlement date, which means that the interest for that day belongs to the buyer.

In computing accrued interest for corporate bonds, each month is assumed to have 30 interest days.



*E X A M P L E A corporate bond paying interest on January 1 and July 1 is purchased on Thursday, March 17, trade date. To compute the number of days of accrued interest payable to the seller, start with the settlement date. Because corporate bonds settle regular way, settlement date is Tuesday, March 22.

Days of Accrued Interest

Jan Feb Mar Total

30 30 21 81 days

There are 21 interest days in March (interest accrues up to but not including settlement date) and 30 days of interest for January and February. Interest begins ac-cruing on January 1, which is the prior interest payment date.

*E X A M P L E A corporate bond paying interest on February 15 and August 15 is purchased on Tuesday, May 7, trade date. To compute accrued interest, start with the settlement date, Friday, May 10. The computation is as follows:

Days of Accrued Interest

Feb Mar Apr May Total

16 30 30 9 85 days

The key is to recognize that interest begins to accrue on February 15. As there are 30 interest days in each month, there are 16 days of accrued interest in February (15th through the 30th, inclusive, is 16 days). If a corporate bond pays on the 15th, the first month will have 16 days of accrued interest.

4. 14. 4 ASSIGNMENTS

All stock and bond certificates must be assigned (endorsed by signature) by the owner, whose name is known to the registrar and printed on the face of the certificate. Upon the sale or transfer of the security, the owner must affix his signature on the place indicated on the back of the certificate. Alternatively, an endorsement may be made by signing a detached (separate) assignment, also known as a stock power or power of substitution.

Any separate assignment must contain all of the same information as the assignment on the back of the certificate, including an irrevocable appointment of attorney (with power of substitution) and a full description of the security (e.g., name of issuer, issue, certificate num-ber, amount). One stock or bond power can be used with any number of certificates for one security, but a separate power is required for each different security.

To avoid rejection by the transfer agent, all signatures must be guaranteed by a party acceptable to the transfer agent, such as a member clearing firm or a bank that participates in the NYSE medallion program. The NYSE developed the Medallion Signature Guarantee Program, which provides for the use of medallions by participants in place of signatures in effecting assignments.



Replica of a Medallion Stamp

In addition to an annual fee, the administrative expenses are borne by the program’s par-ticipants. The program covers all signatures placed on securities, stock and bond powers, CDs, deeds, and so forth, and provides for indemnification insurance for participants in the case of fraud. The program does not guarantee the certificate but rather the signature only.

For nonparticipants, signature requirements are as follows. ■ For stock registered to an individual, the signature must exactly match the name registered

on the face of the certificate. ■ For stock registered in joint names, the exact signature of all owners is required. ■ For stock registered in corporate name, interchangeable endorsements are acceptable

(Acme Inc., Acme & Co., Acme and Co., Acme Company, and so forth). ■ For stock registered in the name of a deceased person, the only acceptable endorsement is

that of the executor of the decedent’s estate. ■ For stock registered in the name of a minor child, the only acceptable endorsement is that

of the custodian. ■ For stock registered in the name of a trust, the only acceptable endorsement is that of the

trustee.

4. 14. 5 AMERICAN DEPOSITARY RECEIPTS (ADRs)

ADRs are investment vehicles allowing US investors to buy and sell foreign securities without having to exchange dollars for foreign currency. ADRs, which are liquid, US-registered securities, are issued by US commercial banks and registered with the SEC by filing Form F-6. If the depositary receipt is traded outside the United States, it is called a Global Depositary Receipt (GDR).

*E X A M P L E The Shanghai branch of a US bank buys shares of Good Luck Wireless, Inc., puts them in safekeeping, and then issues receipts for these shares to US investors. The receipts are issued in a fixed ratio (e.g., two Good Luck shares underlie each receipt). The receipts (ADRs) trade freely in the US market. Dividends are paid to the ADR holder in US dollars, not renminbi.



ADR holders: ■ do not have preemptive rights (the bank has these rights); however, the bank is required

to sell the rights and distribute the proceeds pro rata to ADR holders; ■ do receive dividends (dividends are declared in the foreign currency and payable to hold-

ers in US dollars; the currency exchange is performed by the bank); and ■ have the right to demand delivery of the underlying shares (there are several banks that

can handle the conversion of the depositary receipt into the underlying shares).

For purposes of delivery, ADRs are governed by the rules of the Uniform Practice Code. Lastly, investors in ADRs are subject to a variety of risks including foreign currency risk, mar-ket risk, and political risk.

4. 14. 6 FOREIGN INTERNAL SECURITIES

A foreign internal security is a foreign security, not an ADR. Purchasing a foreign inter-nal security involves the exchange of US dollars for foreign currency. While the rules of the Uniform Practice Code apply to ADRs, the rules of the country where the security princi-pally trades govern the clearance, settlement, and delivery of foreign internal securities. Lastly, investors in ADRs are subject to a variety of risks, including foreign currency risk, market risk, and political risk.

4. 14. 6. 1 Foreign Ordinary Share Trading

Foreign ordinaries are shares issued by a foreign corporation that trade on a foreign exchange, such as the Tokyo Stock Exchange. These shares may be traded in the United States in the over-the-counter markets through a U.S. market maker.

International trading access is not required, and orders are executed in US dollars. Those foreign stocks that are not DTC eligible will likely be subject to additional fees.

4. 14. 6. 2 International Stock Trading

For investors seeking to invest internationally, most common stock and ETFs listed on markets, such as the London Stock Exchange in the UK or Spain’s Bolsa de Madrid, may be entered at any time but will be executed during the local market hours. Other restrictions on trading internationally include, no short selling, cash trades (no margin), and market and limit orders only (no all-or-none or fill-or-kill orders). Trading in international stocks also is limited to buying and selling the stock on the same market. A stock purchased from the London Stock Exchange cannot then be sold on the Deutsche Börse (German Exchange). DTCC’s Depository Trust Company (DTC) provides custody for millions of securities issues, mostly stocks and bonds, from the United States and over a hundred other countries.

4. 14. 7 REJECTION AND RECLAMATION

A buyer will reject delivery from a seller if the securities delivered are not in good form (e.g., certificates are mutilated, there is no signature guarantee). A buyer also will reject deliv-ery if delivery is made prior to settlement date.



Reclamation, on the other hand, is available if a member inadvertently accepts a delivery on settlement date and later discovers that the securities were not in good deliverable form. Reclamation represents the right to return a security that had previously been accepted.

A uniform reclamation form must accompany all reclamations. Any security returned to the selling member without this form may be sold out by that member. Reclamation must be made within the following periods.

■ If the certificates delivered have minor irregularities, the time frame for reclamation is 15 days from delivery date.

■ If the certificates delivered are refused by the transfer agent (for whatever reason) or if the certificates are stolen or counterfeit, the time frame is 30 months from delivery date.

■ If the certificates are subject to partial call, there is no time limit for reclamation.

There are two types of bond deliveries that are never subject to reclamation: (1) bond certificates subject to an in-whole call, and (2) bonds where the issuer goes into default after trade date.



Sample Uniform Reclamation Form

4. 14. 8 DIVIDENDS AND DISTRIBUTIONS

When a corporation wants to make a quarterly distribution to shareholders, the corpora-tion declares a record date, which is the date all shareholders of record as of the close of busi-ness will receive the dividend. At that time, the corporation also announces a payable date, which is the date on which the dividend will be sent to qualifying shareholders.



In addition to these dates (declaration date, record date, and payable date), there is a fourth date—the ex-dividend date—which is set and published by the market where the secu-rity principally trades (e.g., the ex-dividend date is set by the NYSE if the stock is listed, and by FINRA if the stock trades over the counter).

4. 14. 9 EX-DATES

The ex-date is the date on which the stock begins to trade without (ex) the dividend (if stock is bought on the ex-date, the buyer will not receive the dividend). To receive the divi-dend, the stock must be bought before the ex-date.

Under Uniform Practice Rules, the ex-dates for cash and stock dividends as well as for related distributions (e.g., stock splits) are as follows:

■ For regular way trades—two business days prior to record date ■ For cash settlement trades—one business day after record date

For cash dividends in which the value of the dividend is 25% or more of the market value of the stock, or where the number of shares in a stock dividend or stock split represents a 25% or more increase, the ex-date is one business day after payable date.

Buying on the ex-date in a regular way trade will not entitle the buying member to the upcoming dividend as the trade will settle after record date. However, it might be tempting to buy on the record date in a cash settlement transaction (same-day settlement) to capture the dividend. In this case, the buying member will receive the dividend from the issuer, as the buyer is the owner of record on the record date. However, then the selling member will simply add the dividend to the price paid for the stock. So, there is no advantage in trying to capture the dividend in this manner.

The basic rule—to receive the dividend, the buyer must purchase the stock before the ex-date—remains intact as the ex-date for this type of transaction is the business day after record date.

✓T A K E N O T EDERP will help you remember the order in which the dates involving dividend

distributions occur.

The order of dates is Declaration, Ex, Record, Payable.

!T E S T T O P I C A L E R TDeclaration, record, and payment are determined by the board of directors, and

FINRA, or the exchange, determines ex-date.

*E X A M P L E If RST declares a cash dividend of $.75 to stockholders of record on Wednesday, June 21, the ex-date is Monday, June 19.



*E X A M P L E Consider the following scenarios involving the ex-date. The following calendar points to a record date of Wednesday, June 21. May an investor who purchases the stock on Friday, June 16, expect to receive the dividend?

June

Record Date

Sun

4

11

18

25

Mon

5

12

19

26

Tue

6

13

20

27

Wed

7

14

21

28

Thu

1

8

15

22

29

Fri

2

9

16

23

30

Sat

3

10

17

24

The answer is yes. A trade taking place on June 16 is expected to settle regular way (T+3) on the 21st, the record date. The ex-date in this case would be the 19th, which is two business days prior to the record date. Occasionally, an investor and the contra party agree to cash settlement, which is the same day. In that case, the effec-tive ex-date would be the business day following the record date, which would be the 22nd. This cash settlement ex-dividend, or any ex-distribution, is not published and handled for adjustments in the back office.

4. 14. 10 DUE BILLS

Due bills are sent dealer to dealer when the wrong party receives the dividend from the issuer. This occurs for trades executed prior to the ex-date (thereby entitling the buyer to the dividend) that, for whatever reason, do not settle until after the record date. When this hap-pens, the buying member sends a due bill to the selling member for the amount of the dividend received by the selling member in error.

The first day a stock trades without a due bill is the ex-date; a purchase on the ex-date does not entitle the buyer to the dividend. The buyer would not be due the dividend because of late settlement.



Sample Due Bill Form

4. 14. 11 OPEN ORDER ADJUSTMENTS

The opening quotes for a Nasdaq stock are adjusted downward on the morning of the regular way ex-date to reflect the value of the upcoming cash dividend. Market makers also must adjust downward any buy limit orders on their books. Buy limit orders are entered below the prevailing market and could be inadvertently triggered by the ex-date reduction. Unless a customer indicates do not reduce (DNR) on a buy limit order, the market maker automatically adjusts the limit price downward by the same amount the stock is reduced. Similarly, sell stop orders also are reduced.

Sell limit orders, which are entered above the prevailing market, are not adjusted for cash dividends. All orders on the books of market makers are adjusted for stock dividends and stock splits.

✓T A K E N O T EIf a cash dividend includes a fraction, it is rounded up for ex-date reduction pur-

poses. For example, if a cash dividend is $.065, the subject stock, on the morning of the ex-date, is reduced by $.07.

4. 14. 12 CLOSE-OUT REQUIREMENTS—BUY-IN

In trades between members, failure to deliver securities sold does not result in cancellation of the trade. If securities are not delivered to the buying member on settlement, the buyer may close out the position no earlier than the third business day following settlement date. Prior to



buying in the position, the member must provide written notice of the proposed buy-in to the seller by 12:00 noon, two business days prior to executing the buy-in. This means that written notice may be delivered to the seller as early as the day after settlement.

✓T A K E N O T EThe seller is permitted to make a partial delivery prior to the proposed buy-in

date as long as the amount remaining to be delivered is not an odd lot or does not contain an odd lot. If the buy-in results in a loss (the stock price at buy-in was higher than the contract price), the loss is borne by the contra broker (i.e., the member that failed to deliver on settlement date).

Upon receiving the written notice of a proposed buy-in, the selling member can claim no fault, which means the selling member cannot deliver, because another member (a third party) is not delivering to the selling member. In this case, the seller will retransmit the writ-ten notice to the third party. This retransmittal extends the proposed buy-in date by seven calendar days.



Sample Notice of Buy-In

4. 14. 13 CLOSE-OUT REQUIREMENTS—SELL OUT

A sellout occurs if a member sells securities to another member (the buyer) and the buy-ing member fails to pay when the securities are delivered on settlement date. Sellouts can be executed any time after settlement. No prior written notice is required. As before, any loss resulting from the sellout (the sale price at sellout was lower than the contract price) will be borne by the contra broker (i.e., the member that failed to pay on settlement date).



4. 14. 14 ORDER ENTRY

Before the execution of an order to buy or sell, a registered representative must fill out an order ticket. At minimum, the ticket must contain:

■ account number or name; ■ terms and conditions of the order; ■ whether the trade is solicited, unsolicited, or discretionary; ■ if a sale, whether long or short; ■ if a short sale, notation as to the locate requirement; ■ the time the order was received, the time of entry, and the price at which it was executed; ■ to the extent feasible, the time of execution or cancellation; ■ the identity of the representative responsible for the account (RR#) and any other person

who entered or accepted the order on behalf of the customer; and ■ if the order is a not held order.

If a customer has a long and a short position in the same security, the customer is long or short, for ticket-marking purposes, based on the net position.

*E X A M P L E If a customer is long 600 shares of ABC in a cash account and short 200 shares of ABC in a margin account, the customer has a net long position of 400 shares. If the customer sells the 600 shares in the cash account, the order ticket be marked 400 long–200 short.

All order tickets must be reviewed, individually or as part of a trade blotter, by a principal promptly after execution. Copies must be retained for three years. Order tickets are created and maintained electronically through the firm’s order management system.

!T E S T T O P I C A L E R TThe account name or number must be on the order ticket before order execution.

No change to the account designation can be made without the prior approval of a principal. If the name/number is changed, the facts surrounding the change must be documented in writing and retained for three years.



4. 14. 15 COMPLETION OF A TRANSACTION

A trade is considered complete on the settlement date, which, for regular way transac-tions, is three business days following trade date. FINRA, however, defines completion of a purchase transaction as when:

■ the customer pays in full or in part (margin) on settlement date; ■ the member firm makes the appropriate accounting entries on settlement date (this hap-

pens if the customer has sufficient cash or SMA in the account to pay for the trade—in this case, the firm debits the customer’s money market fund and/or SMA on the settlement date); or

■ the securities are delivered into the account if the customer pays before settlement date.All of these definitions of completion of a purchase are mutually exclusive.

✓T A K E N O T EIf the customer pays before settlement date, the trade is not considered complete

until the securities are delivered into the account, which should occur on settlement.

Similarly, completion of a sale is defined as when: ■ the customer delivers the securities on settlement date to satisfy the sale; ■ the member firm makes the appropriate account entries on settlement date (this happens

if the member is holding the customer’s securities; on settlement date, the member debits the customer’s securities position and credits the account with the sales proceeds); or

■ the sales proceeds are credited to the account if the customer delivers the securities before settlement date.

4. 14. 16 COMPLETION OF A CUSTOMER SELL ORDER

When a customer, who is in possession of the securities, places a sell order and fails to deliver the securities by settlement date, the member firm, under SEC rules, must close out the position (buy in the securities) after 10 business days from settlement date. In unusual circum-stances, the member could apply to its DEA for an extension of time.

✓T A K E N O T EIf, for whatever reason, the member firm is unable to close out the position

within 60 days of settlement date, the firm will be prohibited from selling that security as principal and buying that security, as an agent, for a customer.



QQ U I C K Q U I Z 4 . L True or False?

—— 1. The ex-date for most stock splits is the business day after the record date.

—— 2. A securities buy-in can take place no sooner than the business day after the settlement date.

—— 3. Notification of a dividend distribution must be made to the Exchange or FINRA at least 10 days before the record date.

—— 4. Stock borrowed, dealer to dealer, requires the borrower to put up 50%.

—— 5. Clearly erroneous trades must be reported to FINRA within 30 minutes of the execution.

—— 6. Bearer bonds must be delivered in denominations of $1,000 or $5,000.

—— 7. Accrued interest payable to the seller includes the prior interest payment date but does not include the settlement date.

—— 8. The time frame for reclamation of stolen or counterfeit certificates is unlimited.

—— 9. Sellouts can be executed any time after settlement without prior written notice.




1. In an active, competitive market, the prevailing market price for determining a markdown isA. the highest bidB. the lowest bidC. the highest offerD. the lowest offer

2. Under rules, a nondirected order must beA. a market orderB. a marketable limit orderC. a market order or a marketable limit orderD. a limit order

3. A Nasdaq market maker uses an in-house system that tracks changes in the inside market and gen-erates quote updates to keep the market maker’s quotes away from the best market. This action isA. permitted only for Global Market stocksB. permitted only for Capital Market stocksC. permitted only for Nasdaq-listed convertible

bondsD. prohibited

4. An excused withdrawal may be granted by Nasdaq for which of the following reasons? I. Equipment malfunction II. The market maker is in possession of inside

information on the issuer III. The market maker involuntarily fails to

maintain a clearing agreement IV. A pending news announcement concerning

the issuerA. I, II and III B. II and III C. III and IV D. I, II, III, and IV

5. With consent of the account holder, a market maker in WXYZ may act in a principal capacity when selling WXYZ stock to which of the follow-ing accounts?A. Employee accountsB. Wrap accountsC. Trust accountsD. Retirement accounts

6. In a proceeds transaction, markup is computed based onA. the compensation earned on the sell sideB. the compensation earned on the buy sideC. a combination of Choice A and B applied

against the prevailing market price on the sell side

D. a combination of Choice A and B applied against the prevailing market price on the buy side

7. The modifier .Z appended to an ACT report indi-cates that the trade reportA. is being made lateB. is an aggregated reportC. includes a mixed lotD. is an as/of trade

8. Under ACT rules, trades must be reported withinA. 10 seconds of executionB. 60 seconds of executionC. 90 seconds of executionD. 2 seconds of of execution

9. To voluntarily terminate registration as a Nasdaq market maker, a member firmA. withdraws its quotes from NasdaqB. makes an electronic request of NasdaqC. files the appropriate forms with NasdaqD. moves its quotes away from the prevailing

market

10. Interpositioning can be justified when A. a member charges a lower-than-normal

commissionB. a member’s trading room is inadequately

staffedC. a member receives order flow in returnD. a member receives a superior execution



11. Unless an exemption is available, member firms must provide purchasers of penny stocks with I. a risk disclosure document II. current bid and ask quotes III. compensation to be earned by both the

member and the registered representative IV. monthly statementsA. I onlyB. I and II C. II and III D. I, II, III, and IV

12. The rules prohibiting front running apply to I. proprietary accounts II. employee accounts III. employee-related accounts IV. accounts over which the member has

discretionary authorityA. I onlyB. I and IV C. II and III D. I, II, III, and IV

13. A firm one-sided quote is permitted forA. Global Market stocksB. Capital Market stocksC. Bulletin Board stocksD. none of these

14. A market maker in a Global Market stock is quot-ing 23.15–23.30, 10 × 10. A customer enters an order to buy 400 shares at 23.15. Under SEC rules, the market makerA. must sell 400 shares at 23.15B. must update its quote size to 10 × 14C. must update its quote size to 14 × 10D. is not required to take any action

15. A locked market is one in which the inside bid isA. lower than the inside offerB. the same as the inside offerC. the same or higher than the inside offerD. higher than the inside offer

16. The NSDQ identifier on Nasdaq reflectsA. attributable orders/quotesB. nonattributable orders/quotesC. preferenced orders/quotesD. directed orders/quotes

17. Which of the following are defined as penny stocks? I. Capital Market stock trading at $5 per share II. Bulletin Board stock trading at $5 per share III. Listed stock trading at $5 per share IV. Pink Sheet stock trading at $5 per share A. I and II B. I and IV C. II and IV D. I, II, III, and IV

18. Failure to honor a firm quote is calledA. backing awayB. interpositioningC. front runningD. trading ahead

19. A T1 modifier displayed on a Nasdaq terminal indicatesA. that news is pendingB. that news has been releasedC. the time market makers can begin quoting the

stockD. the time market makers can begin trading the

stock

20. If a registered reporting ADF market maker volun-tarily terminates its registration by withdrawing its quotes from ADF, it may NOT reregister in that security forA. 1 business dayB. 5 business daysC. 10 business daysD. 20 business days

21. A Series 55 license is required forA. Nasdaq market makersB. proprietary OTC tradersC. persons who supervise Nasdaq market makers

and proprietary OTC tradersD. all of these

22. Under rules, the maximum order size isA. 999 sharesB. 9,999 sharesC. 99,999 sharesD. 999,999 shares



23. Under trade reporting rules, an as/of trade is oneA. executed during normal market hours and

reported on the following business dayB. executed outside of normal market hours and

reported on the day of executionC. executed during normal market hours

and reported the following week on Form TD. executed outside of normal market hours and

reported on the following business day

24. Nasdaq Level 1 data serviceA. displays the inside market and last sale

informationB. displays the bid and ask quotes, with size, for

each market maker in a particular unlisted security

C. displays the bid and ask quotes, with size, for each market maker in a particular listed security

D. enables market makers to update their quotes

25. Which of the following statements is FALSE? A. The FINRA/Nasdaq TRF and ORF permit

firms to submit outside normal market hours trade reports throughout the day.

B. If a trade was executed between midnight and 8:00 am, the trade must be reported on trade date by 8:15 am.

C. If a trade was executed between the close of a FINRA facility and midnight, the trade must be reported on an “as/of” basis the following business day (T+1) by 8:15 am.

D. The ADF, ORF, and the TRFs are open from 8:00 am until 6:30 pm.

26. Which of the following orders is a member permit-ted to execute during a trading halt?A. Unsolicited orders from any sourceB. Unsolicited orders from institutions onlyC. Unsolicited orders from offshore

accounts onlyD. None of these

27. A crossed market is one in which the inside bid is A. lower than the inside offerB. the same as the inside offerC. the same or higher than the inside

offerD. higher than the inside offer

28. If no execution option is specified at time of order entry, Nasdaq will assumeA. Price/TimeB. Price/Size/TimeC. Price/Time with access fee

considerationD. Time/Price

29. Under SEC rules, limit orders that improve a mar-ket maker’s price or size must be displayed within how many seconds of receipt? A. 15B. 30C. 45D. 60

30. Under SEC rules, which of the following limit orders do NOT have to be displayed?A. All-or-none ordersB. Block size ordersC. Orders delivered to an eligible ECND. All of these

31. FINRA has the authority to issue a trading halt with regard to I. Global Market stocks II. Capital Market stocks III. third-market stocks IV. Bulletin Board stocksA. I onlyB. I and II C. I, II, and III D. I, II, III, and IV

32. An average weighted price trade that occurred outside market hours is modified byA. .T and .WB. .T onlyC. .W onlyD. .LATE

33. A T.2 modifier displayed over Nasdaq indicates thatA. a news announcement is pendingB. a news announcement has been madeC. market makers can begin quoting the stockD. market makers can begin trading the stock



34. A Bulletin Board market maker is quoting a stock at 5.25–5.50. Under FINRA rules, the market maker must be willing to buy or sell, at its stated quotes, a minimum ofA. 100 sharesB. 200 sharesC. 500 sharesD. 1,000 shares

35. Under rules, preferenced orders are sent toA. a specific market maker at the inside marketB. a specific market maker away from the inside

marketC. any market maker at the inside marketD. any market maker away from the inside

market

36. OATS rules apply to I. Global Market securities II. Capital Market securities III. NYSE-listed securitiesA. I onlyB. I and II C. III onlyD. I, II, and III

37. The open outcry of bids and offers characterizes most closelyA. NYSE tradingB. Nasdaq tradingC. third-market tradingD. non-Nasdaq trading

38. Order execution reports by market centers must be preparedA. dailyB. monthlyC. quarterlyD. annually

39. To review its trades to ensure best execution, an introducing firm can request which of the follow-ing from its clearing firm?A. FOCUS reportB. Trade blotterC. OATS reportD. Compliance Report Card

40. To qualify for a Global Select Market listing on Nasdaq, an issuer must have a bid price of at leastA. $2 per shareB. $3 per shareC. $4 per shareD. $5 per share




1. A. In an active, competitive market, the prevailing market price for determining markup or markdown is the inside market at time of sale. For markups, it is the lowest offer. For markdowns, it is the highest bid.

2. C. Nondirected orders must be market or marketable limit orders (i.e., they must be immediately executable).

3. D. Autoquote systems that are designed to track changes in the inside market and automatically adjust a market maker’s quotes (to keep market makers away from the best market) are prohibited.

4. A. An excused withdrawal may be requested by a market maker and granted by FINRA because of illness, vacation, and religious holidays; equipment malfunction; involuntary failure to maintain a clearing agreement; or the market maker comes into possession of inside information on the subject security. Seeking an excused withdrawal due to a sudden influx of orders, sudden price changes, or a pending news announcement is not permitted.

5. B. Under the Investment Advisers Act of 1940, market makers, when selling to managed accounts, may act in a principal capacity with consent of the advisory client. A wrap account is a managed account.

6. D. A proceeds transaction is viewed as one transaction for markup/markdown purposes. To compute, a member must add the compensation earned on the sell side to the compensation earned on the buy side and apply the total to the inside market on the buy side.

7. A. The modifier .Z indicates that the trade report is being made late (after 10 seconds).

8. A. All trades must be reported to the TRF within 10 seconds of execution.

9. A. To voluntarily terminate a Nasdaq registration, a market maker withdraws its quotes.

10. D. Interpositioning (placing a third party between a member and the best available market) is prohibited unless it results in a better execution for the customer.

11. D. Transactions exempt from the disclosure rules include unsolicited trades, trades with accredited institutional investors, and trades executed by a member whose revenue from penny stock trades is 5% or less of total revenue. If an exemption is not available, purchasers of penny stocks must receive the risk disclosure document; current bid and ask quotes; information on the compensation to be received by both the representative and the member in connection with the transaction; and monthly statements.

12. D. Front running refers to stepping ahead of a block order to buy or sell. The prohibition on front running applies to proprietary accounts, employee and employee-related accounts, and accounts over which the member has discretionary authority. The prohibition also applies to options on the subject security.

13. C. Any quote displayed over the OTCBB is acceptable as long as it is properly identified. For Nasdaq stocks, market makers must maintain firm, two-sided quotes.



14. C. If a market maker receives a customer order that improves its price or size, the order must be displayed within 30 seconds of receipt unless an exemption is available. In this case, the market maker now has 1,400 shares to buy at 23.15. Therefore, the quote size must be updated to 14 × 10.

15. B. A locked market is one in which the inside bid and inside offer are the same (e.g., 16.25–16.25).

16. B. The NSDQ identifier is used to collect all nonattributable interest at a particular price level. These are anonymous orders sent by market participants.

17. C. A penny stock is a non-NMS (Bulletin Board or OTC Pink) stock trading under $5 per share. If a stock is listed on an exchange or is on Nasdaq, it is not a penny stock regardless of price.

18. A. Failure to honor a stated quote is a rules violation called backing away.

19. A. A T1 modifier displayed during a trading halt indicates that news is pending.

20. D. If a registered reporting ADF market maker voluntarily terminates registration in a particular security by withdrawing its quotes, the market maker may not attempt to reregister in that security for 20 business days.

21. D. A Series 55 license is required for both Nasdaq market makers and proprietary traders. In addition, any person who supervises these activities also must be Series 55 licensed.

22. D. Maximum order size is 999,999 shares. Note that larger orders may be split to get under the size limits of the system.

23. D. An as/of trade is one executed outside of normal market hours and reported the following business day. For example, interdealer trades executed between 8:00 pm and midnight are reported on the following business day.

24. A. Level I service provides subscribers with bid and ask quotes (the inside market), last sale information, and volume information.

25. D. The ADF is open from 8:00 am until 6:30 pm. The TRFs and the ORF are open from 8:00 am until 8:00 pm.

26. D. If a security is subject to a trading halt, a member may not execute any trades in that security.

27. D. A crossed market is one in which the inside bid is higher than the inside offer (e.g., 16.30–16.25).

28. A. Price/Time is the default option used by Nasdaq.

29. B. A customer order that improves a market maker’s price or size must be displayed immediately, which, according to the SEC, means within 30 seconds of receipt. There is no limit order display rule on the OTCBB.

30. D. Under SEC rules, the following limit orders do not have to be displayed: odd-lot orders, block size orders, all-or-none orders; orders where the customer requests that the market maker not display the order, and orders that are immediately delivered to an eligible ECN.

31. D. FINRA is empowered to issue a trading halt for Nasdaq securities and listed securities trading in the third market. In addition, FINRA can halt trading in non-Nasdaq issues.

32. A. A member can report that a transaction is both a weighted average price (.W) and outside market hours (.T) transaction.



33. B. A T2 modifier indicates that news has been released.

34. A. When displaying priced (firm) quotes, Bulletin Board market makers are currently subject to the following minimum quote sizes: a priced bid or offer of $1.00 to $174.99 has a minimum quote size of 100 shares.

35. A. Preferenced orders are sent to a specific market maker. That firm must be at the inside market. Otherwise, the order will be returned to the sending firm.

36. D. The OATS rules apply to NMS securities listed on the Nasdaq stock market.

37. A. Open outcry is a means of price discovery on an exchange floor. Brokers communicate their trading interest, as buyers or sellers, with the high bid and the low offer prevailing.

38. B. Under SEC Rule 605, market centers, such as the NYSE, are required to prepare monthly reports that include statistical measures of execution quality.

39. D. While an introducing firm is required to do its own independent review of best execution, it may request from its clearing firm a copy of its Compliance Report Card. This report, prepared for executing firms by FINRA, details the number of trades in which the introducing firm participated that were executed outside of the inside market.

40. C. There are multiple standards under which an issuer can qualify for a Global Select Market listing. A constant for each is the requirement to have a bid price of at least $4 per share.




Quick Quiz 4.A

1. F. There is no minimum earnings per share requirement.

2. F. Not held orders may not be accepted by the DMM. Floor brokers and two-dollar brokers may accept these orders.

3. F. The DMM may trade it its own account.

Quick Quiz 4.B

1. T.

2. F. FINRA may terminate an issue’s inclusion in Nasdaq for the reasons given, but may also terminate the listing if it deems termination to be in the public interest.

3. F. A pending news announcement, sudden price changes, and an influx of orders are not acceptable reasons for an excused withdrawal. Equipment malfunction, involuntary failure to maintain a clearing agreement, and the requirements of Regulation M are among the acceptable reasons for seeking a withdrawal.

4. T.

5. T. For example, if a market maker pays the Nasdaq listing fees for an issuer and is reimbursed, there is no violation.

Quick Quiz 4.C

1. C. Because this order of 100 shares is less than or equal to 10% of the market maker’s displayed size, the market maker is not required to update its quote size. It must, however, protect the order.

2. C. The limit order must be protected at 10.10 (10.25–.15 point markup).

3. C. The market maker is not required to execute this customer limit order under the Manning Rule because it is an all-or-none order. If the order had not been marked AON, the market maker would have to execute 100 shares at 10 or better.

4. B. Market makers, when acting as principal, can avoid triggering a Manning obligation by purchasing at a price that is higher than the limit. To qualify for this exception, the price improvement must be at least .01.

5. B. The market maker must update its quote.

Quick Quiz 4.D

1. B.

2. C.

3. A.

4. T.

5. T. FINRA has the authority to initiate a trading halt with regard to the Nasdaq Stock Market and non-Nasdaq securities.

6. F. Under the Investment Advisers Act of 1940, market makers, when selling to managed accounts, may act in an agency capacity.

Quick Quiz 4.E

1. C. There are no minimum listing standards for OTCBB inclusion. Among eligible OTCBB securities are equity securities in the process of being delisted from the NYSE, NYSE MKT, or Nasdaq, and foreign equities and ADRs that are registered with the SEC under Section 12 of the Exchange Act. Although priced quotes are firm during normal business hours, priced quotes on DPPs are not.

2. C. The piggybacking exemption is available to prospective market makers in OTCBB and non-Nasdaq OTC securities.



3. C. Non-market making firms must apply and receive approval from FINRA to become market makers. Market makers must meet minimum net capital requirements and be in good standing with FINRA. They must also register separately in each security in which they intend to make a market. Market makers are prohibited from receiving payments from issuers for making a market.

Quick Quiz 4.F

1. T.

2. T.

3 F. There is no requirement to check with 5 dealers. The price must be fair and reasonable.

4. F. CQS securities include exchange-listed equities. Common stock, preferred stock, ADRs, warrants, and rights are included; debt securities, straight or convertible, are not quoted.

5. T.

6. F.

Quick Quiz 4.G

1. D. ACES (Advanced Computerized Execution System) is a customizable order routing system that allows order-entry firms to route orders into the internal trading systems of market making firms with whom they have arrangements. The market makers that receive the orders pay the fees for the use of ACES.

2. A. Price/time is the default option used by NMC.

3. A. A basic GTC market day order is available for display/execution until market close at 4:00 pm. Those that enter GTC system day orders may expect them to be available and protected to 8 pm.

4. B. A reverse-pegged order pegs to the opposite side of the market. It pegs at a price that deviates from the opposite side of the market by .01. Thus, a reverse-pegged buy order would be priced at a penny less than the inside offer.

5. C. To prevent large price movements due to sweep orders, Nasdaq limits the number of price levels a sweep order may execute against to 10% plus a penny away from the inside market. As sales are made against the bid, 10% plus a penny translates into $2.41 below the bid.

6. B. Once a price cap is reached, pegged orders become limit orders at the cap price.

7. A. This is the definition of a fill-or-return order.

8. C. X orders designate that the order is good through extended hours trading.

9. D. Once exhausted, firms have 30 seconds to update their quotes.

10. A. OTC transactions in NMS stocks (which are reported through the ADF or a TRF) and OTC equity securities (e.g., non-NMS stocks quoted on the OTCBB, which are reported through the ORF) must be reported within 10 seconds of the trade. Trades effected in restricted equity securities and under 144A are subject to end of day reporting.

Quick Quiz 4.H

1. F. OTC equity securities are reported through the OTC Reporting Facility (ORF).

2. F. In a transaction between two nonmarket makers, the seller reports the TRF.

3. T. The system transmits last sale information.

4. F. Market makers and order entry firms are the two types of participants that input trade reports into the TRF.

5. T. Trade reports must be input within 10 seconds of trade execution.

Series_24_04.indd 330 6/17/2015 8:58:10 AM


6. T. If a market maker involuntarily fails to maintain a clearing agreement, the market maker is subject to an excused withdrawal and can begin quoting after arranging an alternate clearing arrangement.

Quick Quiz 4.I

1. C.

2. A.

3. D.

4. B.

Quick Quiz 4.J

1. D.

2. E.

3. B.

4. A.

5. C.

Quick Quiz 4.K

1. D.

2. F.

3. C.

4. B.

5. A.

6. E.

Quick Quiz 4.L

1. F. The ex-date for stock splits and stock dividends is the business day after the payable date where the number of shares represents a 25% or more increase.

2. F. A securities buy-in can take place no sooner than 3 business days after the settlement date.

3. T.

4. F. The borrowing member must put up, in cash, an amount equal to the market value of the borrowed stock.

5. T.

6. T.

7. T.

8. F. Reclamation of stolen or counterfeit certificates must be made within 30 months from the delivery date.

9. T.

Series_24_04.indd 331 6/17/2015 8:58:10 AM



1. SEC Rule 10b-17 requires issuers of listed securi-ties to advise the exchange of an upcoming record date at least how many days in advance? A. 10B. 15C. 20D. 30

2. A confirmation for a when-issued contract in-cludes all of the following EXCEPTA. a description of the securityB. designation of FINRA as the authority to rule

on the contractC. settlement dateD. procedures for marking the contract to the

market

3. All of the following deliveries are subject to reclamation EXCEPTA. a bearer bond delivered with missing couponsB. a mutilated certificateC. a bond that defaults after trade dateD. a bond certificate rejected by the transfer

agent

4. In an interdealer trade of 600 shares, all of the fol-lowing would be good delivery EXCEPTA. two 300-share certificatesB. five 120-share certificatesC. twelve 50-share certificatesD. six 60-share certificates and six 40-share

certificates

5. For interdealer trades that are settled ex-clearing, paper confirmations must be sentA. on trade dateB. no later than T+1C. no later than T+2D. on or prior to settlement date

6. The ex-date for stock dividends and/or splits that are valued at 25% or more of the subject security is 1 business day A. prior to record dateB. after record dateC. prior to payable dateD. after payable date

7. The ex-date for cash settlement transactions is 1 business dayA. prior to record dateB. after record dateC. prior to payable dateD. after payable date

8. Which of the following statements regarding the physical delivery of securities are TRUE? I. Delivery is made at the office of the seller. II. Delivery is made at the office of the buyer. III. Delivery expenses are borne by the seller. IV. Delivery expenses are borne by the buyer.A. I and IIIB. I and IVC. II and IIID. II and IV

9. If a buying member fails to pay for securities purchased when they are delivered on settlement date, the selling member can sell out the positionA. any time after settlement dateB. after giving 1 day’s written noticeC. after giving 2 days’ written noticeD. after giving 3 days’ written notice

10. A corporate bond paying interest on March 1 and September 1 is purchased on Friday, May 19, in a regular way trade. The number of days of accrued interest payable to the seller isA. 78B. 79C. 83D. 84



11. Accrued interest is I. added to the buyer’s confirmation II. subtracted from the buyer’s confirmation III. added to the seller’s confirmation IV. subtracted from the seller’s confirmationA. I and IIIB. I and IVC. II and IIID. II and IV

12. The first day a stock trades without a due bill at-tached is theA. declaration dateB. ex-dateC. record dateD. payable date

13. When one member borrows stock from another member, which of the following statements are TRUE? I. The borrowing member must meet the initial

Regulation T requirement. II. The borrowed stock is marked to the market

daily. III. The lending member is entitled to any

dividends on the loaned stock. IV. The stock is returnable upon demand of the

lending member.A. I, II and IV B. I and III C. II, III, and IV D. I, II, III, and IV

14. If securities delivered in an interdealer trade are refused by the transfer agent, the time frame for reclamation isA. 15 days from delivery dateB. 45 days from delivery dateC. 90 days from delivery dateD. 30 months from delivery date

15. Under Uniform Practice Rules, a partial delivery of common stock in an interdealer trade isA. acceptable without restrictionB. acceptable with the approval of the Market

Operations Review CommitteeC. acceptable as long as the amount remaining to

be delivered does not include an odd lotD. unacceptable




1. A. Issuers must notify the exchange (if listed) or FINRA (if unlisted) at least 10 days in advance of the record date as to when that date will be. This allows the exchange or FINRA sufficient time to set and publish the ex-date.

2. C. At the time a when-issued contract is written, settlement date is not known. It is eventually determined by the Uniform Practice Committee once a sufficient percentage of the issue is outstanding.

3. C. In this instance, the buying member assumes any loss on the defaulted bond. Reclamation was not designed to shield members from market risk. Bonds delivered with missing coupons, mutilated certificates, and bonds rejected by the transfer agent can all be reclaimed.

4. B. For round-lot sales, delivery must be in denominations that add up to 100 shares or are divisible by 100 shares.

5. B. For interdealer trades that are settled outside the scope of an automated confirmation and transaction system, paper confirmations must be sent no later than T+1.

6. D. The ex-date for most stock splits and stock dividends is 1 business day after payable date.

7. B. For cash settlement trades (same day settlement), the ex-date is 1 business day after record date.

8. C. All physical deliveries are made by the seller at the office of the purchaser. Any expenses incurred in connection with the delivery are borne by the seller.

9. A. A sellout will occur if a member sells securities to another member (the buyer) and the buying member fails to pay when the securities are delivered on settlement date. Sellouts can be executed anytime after settlement date. Unlike buy-ins, no prior written notice is required.

10. C. Interest begins to accrue on the prior interest payment date and accrues up to, but not including, settlement date. Regular way settlement for a trade executed on Friday, May 19, is Wednesday, May 24. The computation is: 30 days (March) + 30 days (April) + 23 days (May) = 83 days. For corporate bonds, every month is assumed to have 30 interest days.

11. A. Accrued interest is payable by the buyer to the seller, so it is added to the buyer’s purchase price. The seller receives the accrued interest, so it is added to the seller’s proceeds.

12. B. The first day a stock trades without a due bill is the ex-date, because a purchase on the ex-date does not entitle the buyer to the dividend.

13. C. Regulation T does not apply to borrowing stock. Rather, the borrowing member must put up, in cash, an amount equal to the value of the borrowed stock. The position is marked to the market daily, which may require the borrower to put up more cash if the value declines. In addition, the lender is entitled to any dividends on the loaned stock and can demand return of the stock at any time.

14. D. If securities accepted by a member in an interdealer trade are subsequently rejected by the transfer agent (for whatever reason), the time frame for reclamation is 30 months from delivery date.

15. C. A partial delivery is acceptable only if the amount remaining to be delivered does not include an odd lot.


335

u n i t

Supervision of Investment Banking and Research

This Unit focuses on the Securities Acts of 1933 and 1934 and their application to both the new issue and the trading markets.

The supervision of investment banking and research accounts for 32 questions of the Series 24 examination.

5


O B J E C T I V E S

336

When you have completed this Unit, you should understand the following:

■ Public and private offering regulations

■ Requirements to conduct and document due diligence of issuers

■ M&A, tender offers, corporate financial advisory, and valuation services

■ Fundamental terms of loan documents

■ Terms of bankruptcy and the potential claims and priorities of investors

■ Corporate annual and quarterly reports

■ Communication regulations related to new issues

■ Public notices excluded from the definition of prospectus

■ What constitutes research

■ Research report approval and dissemination processes

■ Disclosure requirements for analysts who make public appearances


337Unit 5 Supervision of Investment Banking and Research

5. 1 LEGISLATIVE OVERVIEW

5. 1. 1 SECURITIES ACT OF 1933The primary purpose of the Securities Act of 1933 is to require full and fair disclosure in

connection with the sale of securities to the public. Senate hearings in the 1920s and after the crash of 1929 uncovered widespread fraud in the issuance of securities. New issues were sold with little or no disclosure and could be purchased on margin with as little as 5% down.

The act requires that a new issue, unless exempt, must be registered with the SEC before public sale. All investors must receive a detailed prospectus prior to purchase. Also, if the U.S. mail or other means of interstate commerce are used to sell a new issue, the requirements of the act apply.

This act is sometimes referred to as the Prospectus Act, the Truth in Securities Act, the Paper Act, or the Full and Fair Disclosure Act. No matter what its nickname, it all points to one chief theme: to provide the public with sufficient, cogent information about publicly traded securities.

✓T A K E N O T EInterstate commerce represents transactions between states. If the security in-

volved in interstate commerce is a U.S.-issued security, the definition is expanded. For instance, the wire transfer of U.S.-issued securities between San Juan, Puerto Rico, and Washington, D.C., comes under the SEC as this is considered interstate com-merce, even though neither point in the transaction is a U.S. state.

A basic rule: if the transaction is not intrastate, it is interstate.

✓T A K E N O T EAlthough a prospectus must be delivered to customers with the offer or sale of

mutual funds, unit trusts, follow-on dilutive offerings of common stock by public reporting companies, ETFs need only make final and summary prospectuses available (e.g., on a website, for viewing or downloading). There is no requirement to send one to those who trade the exchange-traded fund, such as SPY on NYSE Arca. Publicly traded closed-end funds also do not require the delivery of a prospectus.

5. 1. 2 DEFINITION OF A SECURITY

A security can be defined as any investment in a common enterprise for profit, with man-agement performed by a third party. An element of risk must be present.

Excluded from the definition of a security under the act are: ■ CDs insured by the FDIC (no risk); ■ fixed annuities (no risk); ■ currencies (no third-party management); and ■ futures contracts (no third-party management).


338 Unit 5 Supervision of Investment Banking and Research

5. 1. 3 SECURITIES EXCHANGE ACT OF 1934

The Securities Exchange Act of 1934 was passed primarily to curb abuse in the secondary (trading) markets. Among a great many other things, the act and its amendments accom-plished the following:

■ Creation of the SEC, which was created and empowered to enforce federal securities laws; the SEC subsequently delegated some of its authority to various SROs

■ Requires the registration of broker-dealers and investment advisers ■ Requires the registration of securities exchanges and all national securities associations ■ Requires the registration of broker-dealer representatives with the appropriate SRO ■ Requires the registration of securities information processors (SIPs) ■ Requires the registration of municipal broker-dealers and municipal advisors ■ Empowered the Federal Reserve to control the extension of credit on securities transac-

tions ■ Requires publicly traded issuers to file financial and operational reports with the SEC ■ Creation of rules dealing with insider trading ■ Creation of rules dealing with secondary market trading activity of market makers and

underwriters

!T E S T T O P I C A L E R TActivities involving new issues or the primary market (registration, prospectus

requirements, and underwriting) are regulated by the Securities Act of 1933.

Activities involving trading of securities or the secondary market are regulated by the Securities and Exchange Act of 1934.

5. 2 TYPES OF UNDERWRITINGS

The new issue market consists of companies going public—privately owned businesses raising capital by selling common stock to the public for the first time. New issue securities also are known as initial public offering (IPO) securities. The additional issue market is made up of new securities issues from companies that are already publicly owned. These companies are now increasing their equity capitalization by issuing more stock.



In addition to being classified by whether they represent initial or additional issues of new securities, offerings can be classified by the final distribution of their proceeds.

✓T A K E N O T EAdditional issue offerings are sometimes referred to as follow-on or add-on

offerings.

5. 2. 1 PRIMARY OFFERINGS

A primary offering is one in which the proceeds of the underwriting go to the issuer. A corporation increases its capitalization by selling stock (either a new issue or previously autho-rized but unissued stock). It may do this at any time and in any amount, provided the total stock outstanding never exceeds the amount authorized in the corporation’s bylaws. Although there are exceptions, the 1933 Securities Act requires that securities being offered to the pub-lic be done so by prospectus.

5. 2. 2 SECONDARY OFFERINGS

A secondary offering (aka secondary distribution) is one in which one or more major stockholders in the corporation are selling all or a major portion of their holdings. The under-writing proceeds are paid to the stockholders rather than to the corporation. Typically, second-ary offerings occur in situations in which the founder of a business, and perhaps some of the original financial backers, determine that there is more to be gained by going public than by staying private.

Offerings and Markets

New Issue (IPO) Market Additional Issue Market

Primary Offering Company is going public; underwriting proceeds go to the company

Company is already public; underwriting proceeds go to the company

Secondary Offering Company is going public; underwriting proceeds go to the selling stockholders

Company is already public; underwriting proceeds go to the selling stockholders

5. 2. 3 SPLIT OFFERINGS

A split offering is a combination of a primary and a secondary offering. Some of the stock offered will be issued by the corporation, and the rest represents shares held by present stockholders.

5. 2. 4 SHELF REGISTRATION (RULE 415)

Rule 415 of Regulation C of the Securities Act of 1933 permits issuers to quickly raise money in the capital markets when needed or when market conditions are just right. For example, if a company files a shelf registration statement with the Commission, there is no



intention to immediately sell the securities. However, when the right time arrives, either interest rates are at a likely low point, or funds are needed to complete the final phase of a large factory, the company can takedown the securities from the shelf without the delay of an SEC review.

Shelf registration (shelf offering) is available for both primary as well as secondary offer-ings or even a combination. So, when the time is right, the shelf takedowns are then offered with a base prospectus, sometimes known as a core prospectus, along with a prospectus supple-ment, which defines the terms of current offering and other information omitted from the prospectus. That must be filed with the Commission no later than the second business day following the date of the determination of the offering price, or the date it is first used after effectiveness in connection with a public offering or sale, whichever is earlier. There is some, but not much of a delay.

For those issuers who are eligible to use the SEC Form S-3 (discussed later in this Unit), registration statements must contain (by reference) all the issuer’s reports filed with the SEC, such as the 10-K, 8-K, et cetera, after the shelf offering’s effective date. Since market partici-pants are deemed up-to-date with the business operations, there is, in this case, no need to file a supplement (aka post-effective amendment). Once the shelf has its effective date there will be no delay whatsoever for the SEC to review the terms of the offering.

The expression takedown has multiple meanings. In one sense it is the amount received by members of an underwriting syndicate. When used in connection with a Rule 415 shelf offering, it means taking down securities off the shelf.

*E X A M P L E An issuer wants to sell $300 million of five-year AA/Aa2-rated notes, but only when market interest rates allow the sale to be made on a 6.40 basis. The current market is somewhat oversold and rates for five-year investment grade notes are about 6.55. If the issuer waits for rates to fall 15 basis points and then files a regis-tration statement with the SEC, rates may move back up before the registration is effective.

To address this type of situation, an issuer files a shelf registration statement with the SEC, which, once effective, is good for two years. Therefore, as soon as rates fall, the issuer has an effective registration statement in place and can sell the five-year notes with little delay. This permits issuers to match financing needs with market conditions. For certain well-known, sea-soned issuers (WKSI—pronounced wik´-see), discussed later in this Unit, the two-year period is extended to three years.

5. 2. 5 AT-THE-MARKET OFFERINGS

An at-the-market offering is an additional issue offering with no fixed offering price. The shares are to be sold at the market when the offering is effective. The additional shares could be sold at different prices once effective.

5. 2. 6 NEGOTIATED VERSUS COMPETITIVE

Underwritings can be classified as either negotiated or competitive. A negotiated under-writing is one in which the issuer selects an underwriter and negotiates the terms of the offer-ing. A competitive offering is one in which the issuer announces its intention to solicit bids



from underwriters and selects a firm based on net interest cost. The winning bid is the one that provides the issuer with the lowest net interest cost.

✓T A K E N O T EMost corporate underwritings are done on a negotiated basis, while U.S. govern-

ment issues and many municipal issues are underwritten on a competitive basis.

5. 2. 7 ALTERNATIVE PUBLIC OFFERING (APO)

An APO is sometimes referred to as a reverse takeover where shareholders of a private company choose to gain control of a company whose stock is publicly traded and merge it with their private company.

A public company that is registered with the SEC and merged with the private com-pany permits the private company to avoid the expensive and onerous review by regulators. However, comprehensive disclosure is filed on Form 8-K (current report) immediately upon completion of a reverse merger transaction.

Going public through this reverse takeover process permits a privately held company to become a public cheaper and very likely with less stock dilution than through an IPO.

5. 3 TYPES OF UNDERWRITING COMMITMENTS

5. 3. 1 FIRM COMMITMENT

The firm commitment is the most widely used type of underwriting contract. Under its terms, the underwriter contracts with the issuing corporation, selling stockholders, or both to buy the securities described in the contract, within a defined price and quantity range, on or about a given date—all of which is explained in a letter of intent signed by both the under-writer and the issuer during the early stages of negotiation.

Although this letter of intent is conditional, for all practical purposes, the underwriter is committing to buying securities from the issuer and paying the underwriting proceeds to the company. The underwriter does this without full assurance that the securities can be resold to the public at a profit. If part of an issue that is being distributed under a firm commitment contract goes unsold, any losses incurred are borne by the syndicate members.

✓T A K E N O T EIn firm commitment offerings, underwriters often will use a commitment commit-

tee to determine if the firm, based on the results of their due diligence, should commit its resources to a particular offering.



5. 3. 2 BEST EFFORTS

A best efforts arrangement calls for the underwriter to buy securities from the issuer as agent, not as principal. The underwriters are not committed and therefore are not at risk. The underwriters will use their best efforts to sell all of the issue but will not give any assurances that they will sell any of the securities.

*E X A M P L E If a corporation’s plan is to issue 100,000 shares of common stock at $20 per share, but—after exerting best efforts—the underwriter is able to distribute only 80,000 shares, the extent of the underwriter’s commitment is limited to 80,000 shares and not the full 100,000 shares.

5. 3. 2. 1 All-or-None Offerings

In an all-or-none offering, if the underwriters are unable to sell all of the securities being offered within a prescribed time frame, the offering is canceled.

5. 3. 2. 2 Mini-Max Offerings

Like an all-or-none offering, a mini-max underwriting is a form of best-efforts offering with a floor and a ceiling on the number of shares the issuer is willing to sell.

*E X A M P L E An issuer wants to sell 200,000 shares (ceiling) to the public but is willing to accept a sale of 120,000 shares (floor). If the underwriters are able to sell the floor amount within a prescribed time frame, the offering is effective. If not, the offering is canceled.

5. 3. 2. 2. 1 Escrow for Contingent Offerings

Under SEC Rule 15c2-4, all customer checks representing purchases at the offering price must be placed in an escrow account at a qualified financial institution (QFI) if the offering is contingent on the successful sale of a minimum number of shares. This rule applies to all-or-none and mini-max offerings.

✓T A K E N O T EMonies deposited or transmitted into an independent bank escrow account may

include saving accounts and bank money market accounts. The SEC’s Division of Market Regulation also will accept investments in short-term CDs issued by a bank or short-term securities issued or guaranteed by the United States. The bank escrow agent must take care to not place funds in instruments whose maturity date would exceed any contingency date. A savings and loan does not meet the definition of a bank for this rule.



5. 3. 3 STANDBY UNDERWRITINGS

Standby underwritings come into play when a publicly held corporation proposes to issue additional common stock. The corporation may be obligated to protect the proportional own-ership interest of the current stockholders (subject to the securities laws of the issuer’s state of incorporation). If this is the case, the company must first offer any additional issue of the same class of stock to the existing stock owners before offering the securities to the general public. This is done through a subscription rights offering.

Typically, any number of a company’s current stockholders will not exercise their preemp-tive rights (right of first refusal). Therefore, the issuing company will not sell all the additional shares. To ensure that all of the additional issues will be sold, a standby underwriter is engaged. This firm unconditionally agrees (firm commitment) to buy all shares not subscribed to by shareholders.

5. 4 ORGANIZING THE UNDERWRITING

5. 4. 1 UNDERWRITER ENGAGEMENT

To sell securities, an issuer will engage an investment banker who will review the proposed underwriting and recommend a specific structure. After the basic terms of the underwriting are negotiated and agreed to by both parties, the banker issues a letter of intent to the issuer, defining the basic underwriting terms.

The letter of intent also addresses the risks the underwriter is willing to assume and the risks that will be assumed by the issuer. One risk the underwriter never assumes is the risk that an event will occur that will affect the investment merit of the securities (after the signing of a letter of intent but before registration is effective).

*E X A M P L E After signing the letter of intent, the FDA announces, “The issuer’s products cause cancer in laboratory rats.” In this instance, the underwriter can withdraw from its commitment by invoking the market-out clause contained in the letter.

✓T A K E N O T EUnder SEC Rule 3a4-1, an issuer may, with the permission of the managing

underwriter, use its employees to help sell the issue if the employees are not subject to a statutory disqualification, compensated based on sales, and associated with any broker-dealer. As a practical matter, Rule 3a4-1 will only come into play in small offerings.



5. 4. 2 SYNDICATE FORMATION

The investment bank that negotiates with the issuer is the managing underwriter. To reduce risk, the manager forms a syndicate, inviting other member firms into the underwriting group. Once formed, the syndicate members sign an agreement, called the agreement among underwriters, which details the responsibilities and obligations of each syndicate member.

The syndicate manager in a firm commitment underwriting often is referred to as the statutory (or lead) underwriter. You also may see this person referred to as the book runner or bookrunning manager.

5. 4. 3 SELLING GROUP FORMATION

To broaden distribution channels, the manager selects other member firms to assist in the sale of the securities. These members comprise the selling group. Unlike syndicate members, selling group firms assume no risk for the underwriting. They act solely as agents in the distri-bution of the new issue.

The manager negotiates contract terms with each selling group member, which will be memorialized in the selected dealer agreement. The agreements set forth the estimated public offering price (or a range) and under what circumstances a selling concession will be allowed. By signing the agreement, each member of the selling group becomes obligated to sell the new issue at the public offering price.

✓T A K E N O T EUnder SEC rules, a selling group is formed after the filing of a registration

statement.

5. 4. 4 AGREEMENT AMONG UNDERWRITERS (AAU)

The topics addressed in this agreement, which is signed by all syndicate members, include the following.

5. 4. 4. 1 Participation of Each Syndicate Member

The level of participation of each syndicate member is the percentage of the offering each syndicate member is obligated to buy from the issuer.

5. 4. 4. 2 Manager’s Fee

The manager’s fee is the amount, expressed in cents per share, that the syndicate manager earns for each share sold. It is the compensation the manager receives for overseeing all regula-tory filings connected with the new issue and for making all decisions on behalf of the other syndicate members.

Liability for Unsold Securities. If the syndicate is unable to sell all the securities pur-chased from the issuer, the unsold securities remain in the syndicate account. The liability for these unsold shares rests with the syndicate members on either a divided (Western ac-count) or undivided (Eastern account) basis.



Shares Trading at a Premium. The agreement among underwriters must state that, consistent with Regulation M, the book-running lead manager and the other syndicate members must require that any shares trading at a premium to the public offering price that are returned by the buyer after secondary trading has begun to:

■ be used to offset the existing syndicate short position; or ■ if no syndicate short position exists, the member must either

— offer returned shares at the public offering price to unfilled customers’ orders pursuant to a random allocation methodology, or

— sell returned shares on the secondary market and donate profits from the sale to an unaffiliated charitable organization with the condition that the donation be treated as an anonymous donation.

5. 4. 4. 3 Provision, If Any, for Overallotment

If the syndicate manager, based on anticipated demand, wants to sell more shares than ini-tially registered with the SEC, the manager can invoke the green shoe clause on short selling. A green shoe clause, negotiated and agreed to by the issuer, allows the syndicate to sell up to 15% more shares than initially registered within 30 days of the IPO trading. The additional shares are made available to the syndicate by the issuer.

To be effective, a green shoe clause must be disclosed in both the registration statement filed with the SEC and the prospectus.

A more dangerous way to overallot would be to short sell. In this case, the syndicate is selling more shares than it buys from the issuer, and delivery to purchasers at the offering price is accomplished by buying back shares in the secondary market. If demand is strong, short covering will be done at a loss. How that loss is shared by the syndicate members is described in the agreement among underwriters.

5. 4. 4. 4 Concession

The concession is the amount, expressed in cents per share, that represents the gross profit made by members of the selling group for each share sold by those members.

5. 4. 4. 5 Reallowance

With the permission of the manager, a syndicate or selling group member may sell the new issue to a member that is not part of the underwriting group. This firm must agree to sell the new issue at the public offering price.

The compensation earned by this firm is termed a reallowance, which is generally one-half of the concession.

!T E S T T O P I C A L E R TAll underwriters and distribution participants in offerings of nonexempt securities

must be member firms.



5. 4. 5 UNDERWRITING COMPENSATION

There always is a spread between the price at which underwriters buy stock from issuers and the price at which they offer the shares to the public. The price to the issuer is referred to as the underwriting proceeds, and the price to the buying investors as the public offering price (POP).

The underwriting spread consists of three major components: ■ Manager’s fee for negotiating the deal and managing the entire underwriting and public

distribution process ■ Underwriting fee for assuming the risk of buying securities from the issuer without assur-

ance that any or all of the securities can be resold ■ Selling concession for finding and placing the securities with investors

In general, underwriters tend to conform with industry standards and normal practices with regard to the makeup of the spread and the percentage accounted for by each of the three components.

The syndicate manager’s fee is the smallest percentage, and the selling concession is the largest. Expenses come out of the underwriting fee.

*E X A M P L E Assume a 1 million share initial public offering of common stock. Shares will be sold to the public for $10.00, and the underwriting spread is $.65 per share. The fol-lowing illustration depicts the distribution of the spread and proceeds of the under-writing. The $.65 spread is allocated as follows.

■■ Syndicate manager’s fee: compensation for the manager’s role in the underwriting—in this case, $.12 per share, or $120,000 for 1 million shares. The manager’s fee is typically the smallest portion of the spread.

■■ Underwriting fee: this portion of the spread compensates syndicate members for the risk they assume in the underwriting. The underwriting fee—in this case, $.13 per share—is allocated to syndicate members on the basis of their participation.

■■ Selling concession: the largest portion of the spread is the selling concession, the amount received by any member that sells the shares. In this case, the concession is $.40 per share.



Who Gets What in an Underwriting

$650,000 of the proceeds goesto the underwriters. This feeis known as the gross spread.

$400,000 selling concession paid to syndicate members and selling group members on the basis of the number of shares sold by each firm.

$120,000 management fee paidto the managing underwriter.

$130,000 underwriting fee paid to all syndicate members on the basis of their pro rata underwriting participation.

A.

B.

C.

A

B

C

New Issue Incorporated

Common Stocks1 Million Shares

Price $10

$9,350,000 of the proceedsgoes to the issuer.

$10 million gross from the sale of the issue to the public.

(1 million shares $10 = $10 million)

The amount of the spread varies by issue and can be influenced by any of the following. ■ Type of commitment: A firm commitment earns a larger spread than a best efforts agree-

ment because of the risks the underwriter assumes. ■ Security’s marketability: A bond rated AAA has a smaller spread than a speculative stock. ■ Issuer’s business: A stable utility stock usually has a smaller spread than a more volatile

stock. ■ Offering size: In a very large offering, the underwriter can spread costs over a larger number

of shares; thus, the per-share cost may be lower, resulting in a smaller spread.



*E X A M P L E Sample Underwriting Worksheet

Underwriting Discount (AKA gross spread) 7%

Underwriter Role Share

Allotment

Management Fee

20% of Spread

Underwriting Fee

20% of Spread

Selling Concession

60% of Spread

Reynard Simpson Lead Manager 2,000,000 $478,950 $372,000 900,000

Adam Jones & Co. Co-Manager 1,000,000 $239,475 $186,000 450,000

Fischer, Ireland Brothers Co-Manager 1,000,000 $239,475 $186,000 450,000

Crédit la Maison de France Underwriting Syndicate 500,000 $93,000 225,000

Smithers, Dunn Underwriting Syndicate 500,000 $93,000 225,000

Carroll, Rudolph & Co. Underwriting Syndicate 50,000 $9,300 22,500

SunBank of Ontario, LTD Underwriting Syndicate 50,000 $9,300 22,500

Morgan, Wexhall & James Underwriting Syndicate 50,000 $9,300 22,500

TOTAL 5,150,000 $957,900 $957,900 2,317,500

Shares sold 5,500,000 Total

Public Offering Price $15.5 per share $85,250,000

Underwriting Discount 6% 0.93 per share $5,115,000

Proceed paid to issuer $14.57 per share $80,135,000

QQ U I C K Q U I Z 5 . A Match the following items with the best definition or description.

A. Cooling-off periodB. Securities Act of 1933C. Red herringD. Split (combined) offeringE. Indication of interest

—— 1. Has aspects of both a primary and secondary offering

—— 2. An investor’s expression of a conditional wish to purchase a new security after that investor has read a preliminary prospectus

—— 3. Interval between the filing date of a registration statement and the date on which the security becomes effective

—— 4. Abbreviated prospectus distributed while an issuer’s registration state-ment is reviewed by the SEC

—— 5. Federal securities legislation mandating full and fair disclosure about new issues

5. 4. 6 LIABILITY FOR UNSOLD SECURITIES

If the syndicate is unable to sell to the public all the securities purchased from the issuer, the liability relating to these unsold securities accrues to each syndicate member in accordance with the terms outlined in the agreement among underwriters.



*E X A M P L E There is a $200 million common stock offering; as of the close of business on the effective date, only $160 million was sold, leaving $40 million in the syndicate account.

Syndicate Member Participation % Sold Unsold Western Eastern

1 $ 80 m 40% $ 60 m $20 m $20 m $16 m

2 $ 60 m 30% $ 60 m — — $12 m

3 $ 40 m 20% $ 20 m $20 m $20 m $ 8 m

4 $ 20 m 10% $ 20 m — — $ 4 m

Totals $200 m 100% $160 m $40 m $40 m $40 m

!T E S T T O P I C A L E R TIf the syndicate is divided (Western account), syndicate members are liable only

to the extent of their participation. In the example, syndicate members 1 and 3 are liable for $20 million each, which represents their unsold allotment. Members 2 and 4 are not liable, as each sold its agreed-upon participation.

If the syndicate is undivided (Eastern account), all syndicate members share in the liability based on their percentage participation. Syndicate member 1 is liable for 40% of the unsold securities, syndicate member 2 for 30%, and so forth.

QQ U I C K Q U I Z 5 . B Match the following terms with their appropriate descriptions.

A. Selling groupB. SyndicateC. Divided accountD. Undivided accountE. ReallowanceF. Manager’s feeG. StatutoryH. Market outI. All-or-noneJ. Firm commitmentK. NegotiatedL. CompetitiveM. Concession

—— 1. Syndicate members are liable only to the extent of their participation

—— 2. All syndicate members share in liability proportionate to their participation

—— 3. Type of underwriter that manages a firm commitment underwriting

—— 4. The smallest portion of the underwriting spread

—— 5. Paid to FINRA member firms that are not members of the underwriting group



—— 6. The largest portion of the underwriting spread

—— 7. Clause that allows an underwriter to back away from its firm commitment obligation

—— 8. A type of offering that requires an escrow account for customer checks

—— 9. The most widely used type of underwriting contract

—— 10. Underwriting used mostly for municipal and government issues

—— 11. Underwriting used mostly for corporate issues

—— 12. Must sign the agreement among underwriters

—— 13. Act as agent in the distribution of a new issue

5. 5 THE REGISTRATION PROCESS

5. 5. 1 FILING THE REGISTRATION STATEMENT

To register a new issue of securities with the SEC, a first-time issuer may file a registration statement using SEC Form S-1 (or Form F-6 for ADRs, Form S-11 for REITs or Form 20-F for foreign private issuer). Included in the statement are the following:

■ A detailed description of the business and its history ■ Audited financial statements and related financial information on capitalization ■ Information on the anticipated use of the proceeds ■ Biographical data on the officers and directors of the issuer ■ Information on risk factors including competition, legal proceedings pending against the

issuer, the regulatory environment, and so forth ■ Information on the issuer’s dividend policy ■ The proposed price (or range) of the issue and the anticipated underwriting spread ■ Prospectus

✓T A K E N O T EAlthough the SEC Form S-1 is commonly used by established companies to regis-

ter their securities, there are many other forms that can be used by issuers, including SB-1, which is used by small business issuers to register offerings of $10 million or less, provided the issuer has not registered more than $10 million in securities over the preceding 12 months. If any registration form is amended before the end of the wait-ing period, the amendment is effective immediately. Another notable form is the S-3, used by well-known seasoned issuers (WKSI) who have, for example, issued $1 billion in nonconvertible securities in the past three years. Also note that Form S-4 is used to report mergers and acquisitions to the SEC. The Form F-6 is used to register deposi-tary shares, such as American depositary receipts (ADRs). The Form S-11 is used for registration of securities issued by real estate investment trusts (REITS).



✓T A K E N O T EMost corporate issuers are C corporations, which means income is taxed at both

the corporate level and the shareholder level. Shareholders are taxed on dividends received that are paid out of income already taxed. S corporations, on the other hand, are taxed like partnerships: income from the corporation flows through to the share-holders who are responsible for any taxes due. Unlike a C corporation, an S corpora-tion can have only one class of stock and is limited to 100 shareholders.

A limited liability corporation (LLC) is taxed like a partnership, but unlike a part-nership, the owners are not personally liable for the company’s debts.

5. 5. 1. 1 Waiting Period

Once the registration statement is filed, the issuer enters into a waiting period. At this time, the SEC makes a comprehensive review of the statement for full and fair disclosure. The waiting period is intended to provide time during which the investing public and other mem-ber firms will have the opportunity to become informed about the new issue without having to make an immediate decision.

✓T A K E N O T EThe syndicate may be formed before or after the filing of a registration state-

ment. The selling group, however, can only be formed after the filing.

5. 5. 1. 2 Preliminary Prospectus

After filing, offers, but not sales, can be made to the investing public by means of a pre-liminary prospectus. A preliminary prospectus, also called a red herring, can be used to take nonbinding indications of interest. A red herring can be quickly prepared, because it is part of the registration statement, five copies of which must be filed with the SEC if it varies from the form of prospectus included in the registration statement. SEC rules permit the omission of information regarding the anticipated offering price and the underwriting spread in a red her-ring. This document, however, must contain the caption: Information contained herein is subject to completion or amendment.

Waiting periodEffective date—offeringperiod may begin

Issuer files registrationstatement with the SEC

Prior to the filing of the registration statement,no sales can be solicitedand no prospectus cancirculate.

No one can solicit salesduring the waiting period,but indications of interestcan be solicited with ared herring.

Sales can now be solicited, but the firm must use a final prospectus.

The Three Phases of an Underwriting



✓T A K E N O T EIn taking indications of interest, it may be tempting for a registered representative

to highlight parts of a red herring to focus the customer on what the representative believes to be the key issues. Marking or highlighting a prospectus is a violation of federal securities law and can lead to termination of employment and other severe penalties.

If a member receives a check from a customer during the waiting period that is earmarked for the purchase of shares of the new issue, the member must return the check. Placing the check in the customer’s account could be viewed as a sale, not an offer, which is prohibited until the offering is effective.

Due Diligence. During the waiting period, underwriters must conduct a formal due dili-gence meeting for the benefit of investors who want information about the issue, the issuer’s financial background, and the intended use of the proceeds. For issues that are expected to attract national interest, meetings might be scheduled at different locations around the country. Representatives of the issuer and the managing underwriter attend these meetings and answer questions from brokers, securities analysts, and the public.

Insufficient Disclosure. If the SEC believes that there is not sufficient disclosure in the registration statement, the issuer receives a deficiency letter from the Commission requir-ing additional disclosures. Until disclosure is adequate, registration is not effective. If no information requests are received from the SEC or, if received, are satisfactorily resolved, the registration is effective at the conclusion of the waiting period.

Material Omissions or Misleading Information. If it appears to the SEC that the reg-istration statement contains material omissions or misleading information, the SEC issues a stop order suspending the registration process, because the statement needs a rewrite. When an amended statement is filed, the waiting period begins again.

✓T A K E N O T EIf the SEC believes there is insufficient disclosure in any registration statement

(e.g., S-1 or F-6), the issuer receives a deficiency letter from the Commission calling for additional disclosure.

5. 5. 1. 3 Final Prospectus

Just before the effective date, a determination as to final pricing is made and a final pro-spectus is prepared. At that time, a formal underwriting agreement is signed by the issuer and the syndicate manager. Once the issue is declared effective by the SEC, sales can be confirmed.

Once an issue is effective (cleared by the SEC), the issuer appears to have met all the fil-ing and disclosure requirements. The SEC never expresses an opinion on the securities being offered. In fact, SEC Rule 425 requires that the following disclaimer be printed on the front cover of every prospectus:

Neither the SEC nor any state securities commission has determined whether this prospectus is truthful or complete. Nor have they made, nor will they make, any deter-mination as to whether anyone should buy these securities. Any representation to the contrary is a criminal offense.



Ten copies of a prospectus that discloses information previously omitted from the prospec-tus filed as part of the registration statement must be filed with the SEC.

✓T A K E N O T EAll buyers of the new issue must receive a copy of the final prospectus at or

before confirmation of sale. This can be satisfied by the access equals delivery rule dis-cussed later in this Unit. If sent in print form, the final prospectus must be sent under separate cover.

5. 5. 1. 4 Forward-Looking Statements

Any statements that are not based on historical fact are forward-looking statements. A forward-looking statement predicts, projects, or uses future events as expectations or possibili-ties. Although such statements are based on management’s estimates and expectations and available competitive, financial, and economic data, they are inherently uncertain. A variety of factors could cause the results to differ significantly from what is contained in any forward-looking statements. Put another way, these statements are subject to numerous assumptions, risks, and uncertainties that change over time.

When shareholders ask company management about what they sense will be the likely business environment in the future, there is an implicit understanding that certain statements are speculative; nevertheless, the SEC demands that public companies include a disclaimer on discussions with investors in order to emphasize this point. When properly emphasized, stock-holders generally may not take legal action against company management for forward-looking statements, which prove to be erroneous. The Private Securities Litigation Reform Act of 1995 provides certain safe harbor provisions against fraud claims dealing with forward-looking statements.

While it is clear that no one can predict the future, management often is in the best posi-tion to identify emerging trends and to speak about the company’s response.

Section 21E of the Securities Exchange Act of 1934 demands certain standards in com-munication. Issuers must identify these statements by the use of certain prescribed words, such as estimate, anticipate, predict, expect, and potential.

Regulation S-K establishes guidelines to be used when preparing projections and exhibits. The basis of the projections must be reasonable and the time frame used must be appropriate. In addition, S-K requires that the underwriting agreement, an issuer’s certificate of incorpora-tion and by-laws, et cetera, be included in the registration statement.

The SEC permits, but does not require, an outside review of the projections made. If an issuer uses an outside reviewer, it must disclose:

■ the qualifications of the reviewer; ■ the extent of the review; ■ the relationship between the reviewer and the issuer; and ■ all material factors regarding the review process and how the outside review was obtained

or sought.

Regulation S-X is critical, because it looks to the qualifications of accountants who are acceptable to the Commission. For example, is the accountancy firm registered and in good standing in the state in which they operate and are they independent from the client company?



Lastly, Regulation S-X governs the form and content of financial statements directing the efforts of accountants on proper terminology and accuracy in the implementation of generally accepted accounting principals (GAAP) adopted by the SEC.

✓T A K E N O T EThe applicability of a safe harbor for forward-looking statements does not extend

to blank check companies, rollup transactions, or to issues of penny stocks.

5. 5. 1. 5 Civil Liability

All persons who sign the registration statement (officers and directors of the issuer, accoun-tants and attorneys representing the issuer, et cetera) are potentially liable for damages if there is an omission or misstatement of material facts. Suits alleging fraud in connection with any offering of securities must be brought within two years after the discovery of the facts consti-tuting the violation but no later than five years after such violation.

Civil penalties apply when the omission or misstatement is unintentional. If the fraud is willful, then criminal penalties, which consist of a $10,000 fine, five years in prison, or both, apply. Civil penalties are generally limited to the loss sustained by the investor.

!T E S T T O P I C A L E R TAll securities issues—exempt or nonexempt, registered or unregistered—are sub-

ject to the antifraud provisions of federal securities law.

5. 5. 2 UNIFORM SECURITIES ACT (USA)

In addition to registering new issues with the SEC prior to public sale, an issuer must also register the security in each state in which it is to be sold, unless an exemption is available. These registration requirements and exemptions are provided by the Uniform Securities Act (USA), which is state law, and the National Securities Markets Improvements Act of 1996 (NSMIA), which is a federal law, rather than the Securities Act of 1933.

The USA provides two methods for securities issuers to register their securities in a state, plus a special method for certain federal covered securities. They are:

■ notice filing; ■ coordination; and ■ qualification.

5. 5. 2. 1 Notice Filing

The previously mentioned National Securities Markets Improvement Act of 1996 (NSMIA) designated certain securities as federal covered and, therefore, removed them from the jurisdiction of the state regulatory authorities. Federal covered securities include those listing on most of the U.S. stock exchanges as well as registered investment companies (e.g., mutual funds). Although the states are preempted from requiring registration for federal cov-ered securities, status as a federal covered security is not a pre emption of the anti-fraud laws.



The Uniform Securities Act gives the administrator the authority to require notice filings with respect to federal covered securities, which are often investment companies registered with the SEC under the Investment Company Act of 1940. So, what is this notice filing? Primarily, it is an opportunity for the states to collect revenue in the form of filing fees because, unlike with the other methods of registration, the administrator has limited powers to review any documentation filed with his department.

5. 5. 2. 2 Coordination

The most common form of registration for those securities that are not federal covered (typically securities traded on the OTC Bulletin Board or the OTC Pink marketplace, for-merly known as the Pink Sheets) is coordination. A security may be registered by coordination if a registration statement has been filed under the Securities Act of 1933 in connection with the same offering.

Registration by coordination becomes effective at the same time the federal registration becomes effective.

5. 5. 2. 3 Qualification

This method is the most difficult in terms of filing requirements. It can be used by a first-time issuer that wants to register in only one state (a Rule 147 offering). It also can be used by an existing issuer that wants to increase the number of states in which its securities can be sold. The registration is effective as determined by the state Administrator, generally 30 days after filing.

Certain securities are exempt from being formally registered with a state. These include: ■ U.S. government and municipal issues; ■ securities issued or guaranteed by a foreign government with which the United States has

diplomatic relations; and ■ federal covered securities under the NSMIA (although the “informal” notice filing may

be required); if the common stock of an issuer is federal covered, all of the issuer’s other securities also are exempt.

State securities laws, also known as blue-sky laws, affect solicitations directed out of a particular state and solicitations directed into a particular state. Thus, these laws apply to offers that come into a state from any other location and offers that go out of a state to any other location.

While there are exceptions, member firms and their registered representatives must be reg-istered as broker-dealers and agents, respectively, in each state in which they conduct business.

!T E S T T O P I C A L E R TAll state registrations are good for one year from the effective date and must be

renewed annually. Renewal means paying the appropriate fee.



5. 5. 3 DELIVERY OF PROSPECTUS

In certain offerings, a final prospectus must be delivered by all members to buyers in the secondary market for a specified period following the effective date. This is termed the pro-spectus delivery requirement period and is discussed in the following section. This can be satisfied by the access equals delivery rule discussed later in this Unit.

5. 5. 3. 1 Prospectus Delivery Requirements for IPOs

Following a company’s filing of a registration statement with the SEC through its EDGAR system begins the waiting period. Issuers and their underwriters must take care not to try to favorably condition the market by gun-jumping, which could greatly delay the effective date. The Commission could respond to gun-jumping by calling for a cooling-off period to allow the effect of advertisements and speeches, et cetera, to fade. (Gun-jumping is discussed later in this Unit.) It is a common practice for a company to file a preliminary prospectus with the SEC simultaneously with the registration statement. Although the preliminary prospectus may be found on the SEC’s website, it is not circulated to prospective investors. However, a broker-dealer participating in a distribution must deliver a copy of the preliminary prospectus to any person who is expected to receive a confirmation of sale at least 48 hours prior to the sending of a confirmation.

During the post-effective period, which begins when the Commission declares the regis-tration statement effective, if the securities are listed on an exchange, such as the NYSE or NASDAQ, a prospectus is delivered for 25 days following the effective date or 90 days if the security is to be quoted in the OTC Pink marketplace or over the OTCBB (non-Nasdaq). If the registration statement relates to an offering of securities of a “blank check company,” the period for prospectus delivery requirement does not terminate until 90 days after the date funds are released from the escrow.

A free writing prospectus (FWP) is permitted following the effective date but only is accompanied or preceded by the prospectus.

5. 5. 3. 2 Prospectus Delivery Requirements for Additional Issue Offerings

If the security is listed, a prospectus must be delivered only in connection with purchases at the public offering price, and once the distribution is complete, there is no obligation to deliver a prospectus in secondary market transactions. If the security is an OTC Equity Security, the prospectus delivery requirement period is 40 days.

5. 5. 3. 3 Contents of Prospectus Used After Nine Months

For those prospectuses used more than 9 months after the effective date, such as in con-nection with mutual funds, any information previously required to be contained in the pro-spectus may be omitted if later information covering the same subjects, including the latest available certified financial statement, as of a date not more than 16 months prior to the use of the prospectus, is contained.

✓T A K E N O T EIf a prospectus delivery requirement period exists in the secondary market, a

prospectus must be delivered by all dealers—including those that did not participate in the distribution.



If there is a prospectus delivery requirement period and the information in the prospectus becomes misleading due to a material development (e.g., a patent approval, or the loss of a major customer), the issuer has the obligation to update the information. This can be done by stickering the outside cover page with the updated information. Stickering a prospectus can be done as soon as the new information is filed with the SEC—it is effective immediately with the SEC.

5. 5. 4 PUBLIC COMMUNICATIONS

As a general statement, once a registration statement is filed, the Securities Act of 1933 prohibits the advertisement of the new issue. Rule 134 and 135 set guidelines for communica-tions, which are permitted during the waiting period. These are tombstone advertisements and are limited in scope.

5. 5. 4. 1 Tombstone Advertisements

Tombstone advertisements under Rule 134 are prepared by the syndicate manager and are generally placed in financial media on or before the effective date of the offering. A tombstone advertisement is limited to information on the:

■ name of the issuer; ■ type of security being offered; ■ number of shares to be sold; ■ public offering price (or a range); and ■ names of the syndicate members.

Rule 135 addresses tombstone advertisements placed by the issuer, not the syndicate man-ager. Under this rule, when an issuer files a registration statement with the SEC, it may place a tombstone advertisement. The advertisement includes all the information in a Rule 134 advertisement with one exception: an issuer’s advertisement cannot include the names of the syndicate members.

All tombstone advertisements must contain the following advisory:

This announcement is neither an offer to sell nor a solicitation of an offer for any of these securities. This offer is made only by prospectus.



Sample Tombstone

June 30, 2015



5. 5. 4. 2 Research Report Distributions

Rule 137 allows broker-dealers that are not participating in the underwriting to publish research on the new issue if:

■ the recommendation is published in the normal course of its business; ■ the firm received no compensation, directly or indirectly, from any participant in the

underwriting, including the issuer, selling shareholders (if any), syndicate members, and selling group members; and

■ the issuer is not, nor has been in the past three years

— a blank check company, or

— an issuer of an offering of penny stock.

Rule 138 allows broker-dealers that are participating in the distribution to publish research on securities of the issuer that are nonequivalent to the security being underwritten.

*E X A M P L E If ABCD were issuing new shares of its common stock, the underwriting partici-pants could publish research on nonconvertible debt or nonconvertible preferred stock of ABCD. Distribution participants would, however, be prohibited from publishing research on convertible debt or convertible preferred securities of ABCD, as these are considered equivalent.

For additional issue offerings, these research prohibitions created a conflict between the information needs of the market and the SEC’s sensitivity to any action that would condition the market to be more receptive to a new issue. The Securities Act of 1933 is clear: sales can only be made through a prospectus.

To mediate the conflict, the SEC adopted Rule 139, which only applies to additional issue offerings that meet the definition of an actively traded security (discussed later in this Unit).

Rule 139 allows research to be published by distribution participants on the security being underwritten if the following conditions are met.

■ The recommendation is contained in a publication that is distributed with reasonable regularity in the normal course of business and includes recommendations on other com-panies in the issuer’s industry or contains a comprehensive list of all securities being rec-ommended by the firm.

■ The recommendation is given no greater space or prominence in the publication than that given to other recommendations.

■ The current recommendation is no more favorable than in the past.

✓T A K E N O T EIf an additional issue offering meets the requirements of Rule 139, the quiet

period of 10 days under the NASD Rule 2711 will not apply. A research report on the subject issuer can be published during the underwriting period and immediately thereafter. (NASD Rule 2711 will likely change in the consolidated rulebook to FINRA Rule 2241 in 2015. It is not necessary to memorize most rule numbers, but they are included for quick reference).



5. 5. 5 SEC OFFERING REFORMS

The SEC has adopted flexible rules relating to the offering process. The following defini-tions and rules, which are not available to penny stock issuers, are summarized as follows.

5. 5. 5. 1 Issuer Classes

The rules divide issuers into four primary classes, each entitled to varying degrees of flex-ibility in offering securities to the public.

■ Well-known seasoned issuers (WKSIs). To qualify as a WKSI, an issuer must have at least $700 million in common equity held by nonaffiliates. Alternatively, an issuer can qualify if, during the preceding three years, it issued at least $1 billion in nonconvertible debt securities.

■ Seasoned issuers. To qualify, an issuer must have at least $75 million in public float value. ■ Unseasoned issuers are public companies required to file reports with the SEC but that

are not seasoned issuers. ■ Nonreporting issuers are companies not required to file reports with the SEC (e.g., pri-

vately held companies).

5. 5. 5. 2 Shelf Registration

For WKSIs, a shelf registration statement is effective immediately.

5. 5. 5. 3 Liberalizing Communications

SEC offering rules permit communications by all classes of issuers more than 30 days before a registration statement filing if they do not reference the upcoming offering.

The rules permit a type of written communication called a free writing prospectus. During the period following the filing of a registration statement, all classes of issuers may make writ-ten offers in the form of a free writing prospectus. This type of communication, which must be in writing, is an offer to sell or a solicitation of an offer to buy securities that are the subject of a registration statement. All FWPs must be filed with the SEC on the day of first use. A WKSI can use an FWP whether or not the registration statement is filed.

5. 5. 5. 4 Access Equals Delivery

Offering rules acknowledge the widespread use of the internet and the use of electronic communications by adopting an access equals delivery model for meeting prospectus delivery obligations. A prospectus will be deemed to precede or accompany a security for sale if the final prospectus has been filed with the SEC. To view the final prospectus, log on to the SEC’s website.

To preserve an investor’s ability to trace securities to a registered offering, the underwrit-ers, not later than two business days after the offering closes, must provide investors with a notice that they bought securities in a registered offering.

The access equals delivery rule also applies to the aftermarket prospectus delivery obligations.



Preliminary prospectuses must be printed. Mutual funds must provide investors with a paper prospectus.

✓T A K E N O T EThe SEC has defined a class of ineligible issuers that are largely excluded from

taking advantage of these offering reforms. Ineligible issuers include those that:

■■ are not current in their financial reporting under the Securities Exchange Act of 1934;

■■ are, or were during the past three years, blank-check (SPAC) or shell companies or penny stock issuers;

■■ are limited partnerships offering and selling their securities other than in a firm commitment underwriting;

■■ have filed for bankruptcy during the past three years; or

■■ have been the subject of a stop order under the Securities Act of 1933.

5. 6 GUN JUMPING

Jumping the gun relates to soliciting orders or conditioning the market for an upcoming offering before the effective date of the offering. Before the aforementioned securities offering reforms, the only acceptable communication before the effective date for an IPO was a red herring. For follow-on offerings, an issuer could take advantage of SEC rules 137-139.

As the result of the reforms, there are now two additional safe harbors to protect issuers from a gun jumping violation. For follow-on offerings, SEC Rule 168 allows a reporting issuer to publish regularly released factual business and forward looking information at any time. For IPOs, SEC Rule 169 allows a non-reporting issuer to publish regularly released factual business information that is meant for general use; that is, outside of the scope of a potential investor.

Factual business information includes information about the business or financial affairs of an issuer, information regarding an issuer’s products, and any information included in reports filed with the SEC.

Forward looking information included earnings forecasts, future business plans, and state-ments about future business performance.

!T E S T T O P I C A L E R TRoad shows, pitch books, and conferences have been used for years to acquaint

the financial community with information on a prospective public offering once the preliminary prospectus is printed. An electronic road show is one transmitted by elec-tronic means, such as over the internet. If transmitted live, a road show is considered a form of oral communication. Recorded road shows are considered to be a written communication.

Except in the case of road shows for an IPO of equity securities, road show pre-sentations that are recorded do not have to be filed with the SEC. An IPO issuer could avoid the filing requirement by making at least one version of a bona fide electronic road show readily available electronically to any potential investor.



5. 7 RESTRICTIONS ON SALES OF INITIAL EQUITY PUBLIC OFFERINGS AND NEW ISSUE ALLOCATIONS

5. 7. 1 FINRA RULES 5130 AND 5131

These rules are designed to protect the integrity of the public offering process by ensuring that:

■ members make a bona fide public offering of securities at the public offering price; ■ members do not withhold securities in a public offering for their own benefit or use such

securities to reward (or threaten) persons who are in a position to direct future business to the member; and

■ industry insiders, such as members and their associated persons, do not take advantage of their insider status to gain access to new issues for their own benefit at the expense of public customers.

Rule 5130 only applies to a new issue, which is defined as any initial public offering of equity securities. The rule does not apply to additional issue offerings, debt securities, restricted or exempt securities, convertible securities, preferred stock, investment company securities, or ADRs that have a preexisting market outside the U.S. Also excluded are REITs and DPPs. Essentially, the rule applies to IPOs of common stock.

5. 7. 2 RESTRICTED PERSONS

Rule 5130 prohibits member firms from selling a new issue to any account in which restricted persons are beneficial owners. Restricted persons are defined as:

■ member firms; ■ employees of members; ■ finders and fiduciaries acting on behalf of the managing underwriter, including attorneys,

accountants, and financial consultants; ■ portfolio managers, including any person who has the authority to buy or sell securities for

a bank, savings and loan association, insurance company, investment adviser or collective investment account, investment corporation, venture capital funds, or any other vehicle engaged primarily in the purchase or sale of securities; and

■ any person owning 10% or more of a member firm.

Any immediate family member of any previously mentioned person also is restricted. Immediate family includes parents, in-laws, spouses, siblings, children, or any other individual to whom the person provides material support.

*E X A M P L E Aunts, uncles, and grandparents are not considered immediate family. If, however, one of these individuals lives in the same household as a restricted person, that individual is a restricted person.



There is an exemption granted to employees of a limited business broker-dealer, which is defined as a firm engaged solely in the purchase and sale of investment company/variable contract securities, direct participation program securities, or both.

✓T A K E N O T EThis exemption only applies to employees of a limited business firm, not the firm

itself.

5. 7. 3 DE MINIMIS RULE

If the beneficial interests of restricted persons do not exceed 10% of an account, the account may purchase a new equity issue. Restricted persons will be able to have an interest in an account that purchases new equity issues if no more than 10% of the account’s beneficial owners are restricted persons.

5. 7. 4 SPINNING

Spinning is the practice of allocating highly sought-after IPO shares (also known as hot stock) to individuals who are in a position to direct securities business to the firm. This is why portfolio managers are categorized as restricted persons. These individuals are in a position to direct business to a firm and may be willing to do so based on the size of their allocation.

Rule 5131 prohibits spinning. An executive officer or director has a beneficial interest in the company and is subject to the following prohibitions:

■ If the company is currently an investment banking services client of the member or the member has received compensation from the company for investment banking services in the past 12 months

■ If the person responsible for making the allocation decision knows, or has reason to know, that the member intends to provide, or expects to be retained by the company for invest-ment banking services within the next three months

■ On the express or implied condition that such executive officer or director, on behalf of the company, will retain the member for the performance of future investment banking services

This rule does not apply to allocations directed in writing by the issuer or selling share-holders, provided that the member firm has no involvement, directly or indirectly, in the allocation process.

✓T A K E N O T EA directed shares program is established by the company for employees to pur-

chase shares at the IPO price. Underwriters must plan for and request their underwrit-ers sufficient shares to be sold in this fashion.



5. 7. 5 QUID PRO QUO ALLOCATIONS

Furthermore, Rule 5131 prohibits members from threatening to withhold shares they allo-cate of a new issue as an inducement to compensate them excessively in relation to the ser-vices provided by the member.

5. 7. 6 FLIPPING

Flipping refers to the sale of new issue shares, such as a hot stock, purchased within 30 days following the offering date. Rule 5131 prohibits members or APs from directly or indirectly attempting to recoup a commission or credit paid or awarded to an AP for selling shares of a hot stock that are then flipped by a customer, unless the book runner has assessed a penalty bid on the entire syndicate. The rule also requires that members record and maintain information regarding any penalties or disincentives assessed or its associated persons in connection with a penalty bid in addition to their existing requirements to maintain records with respect to penalty bids.

5. 7. 7 CARVE-OUT PROCEDURES

Under the de minimis provision in the rule, a restricted person (such as a hedge fund man-ager) may indirectly participate in new equity issues through a collective investment account if their beneficial interest does not exceed 10% of the fund’s equity. To address this, FINRA allows hedge funds, where restricted persons own more than 10% of the shares, to buy new equity issues of the fund to segregate the interests of restricted and nonrestricted persons, and to direct the profit from a new issue investment so that restricted persons receive a benefit not to exceed 10% of their actual percent ownership of the fund.

*E X A M P L E If 30% of a hedge fund’s partners are restricted persons and that fund buys 10,000 shares of a new equity issue, no more than 1,000 shares may be attributed in the aggregate to those restricted partners’ accounts. In contrast, if 7% of a hedge fund’s partners are restricted persons, no more than 700 shares may be attributed in the aggregate to those restricted partners’ accounts. Hedge fund managers are required to represent to the member firms through which they purchase new issues, that the account is in compliance with the rule. They must determine the eligibility status of their shareholders on an annual basis, as representations can be more than 12 months old.

5. 7. 8 REPRESENTATIONS

Under Rule 5130, prior to selling a new equity issue to an account, a member must obtain a representation from the account owner (or a person authorized to represent the account holder) that the account is eligible to purchase a new equity issue at the POP. If an interest is held by a bank, investment adviser, or other conduit, prior to selling the new issue, a member must obtain a representation from the conduit that all purchasers are in compliance with the



rule (i.e., they are not restricted). All representations must be obtained within the 12-month period prior to the sale of the new issue.

All records relating to whether an account is eligible to purchase new equity issues must be retained for at least three years following the new issue sale.

✓T A K E N O T EThe initial verification must be in the form of a positive affirmation letter (i.e.,

the customer must respond in writing that he is not a restricted person). The annual verification may be in the form of a negative consent letter (i.e., unless otherwise informed, we will assume you continue to be eligible to purchase new common stock issues).

5. 7. 9 RESTRICTIONS ON THE PURCHASE AND SALE OF INITIAL EQUITY PUBLIC OFFERINGS

The book-running managing underwriter of a new issue must file the following two lists with FINRA with respect to an initial offering of equity securities:

■ The initial list of syndicate members, their underwriting commitment, and retention amounts on or before the offering date (the retention amount in this context means the percentage of offered securities allotted to syndicate members after setting aside a portion of the issue for sales to institutions and selling group members); and

■ The final list of distribution participants and their underwriting commitment and reten-tion amounts no later than three business days after the offering date.

5. 7. 10 STANDBY PURCHASERS

If, based on indications of interest (IOI) taken during the cooling-off waiting period, it appears that the issue is not selling well, the syndicate manager may allow sales to standby purchasers, individuals, or firms that would otherwise be restricted under FINRA Rule 5130 from buying at the public offering price.

Securities purchased pursuant to a standby arrangement are not subject to FINRA Rule 5130 provided:

■ the standby arrangement is disclosed in the final prospectus; ■ the standby arrangement is in writing; and ■ the managing underwriter represents, in writing, that it was unable to find any other pur-

chasers for the securities.

✓T A K E N O T ESecurities purchased in a standby arrangement are restricted for resale for a pe-

riod of three months. Syndicate members are likely buyers in a standby arrangement.



5. 7. 11 ISSUER-DIRECTED SALES

The prohibitions of FINRA Rule 5130 on the purchase of new equity issues do not apply to securities that are specifically directed by the issuer to certain restricted persons. However, issuer-directed sales may not be made to members, to an account in which any employee of a member firm has a beneficial interest, or to an account in which finders or fiduciaries have an interest. Naturally, there is an exception: if this person or a member of his immediate family is an employee of the issuer, then IPO sales can be made to this account.

Also, if an issuer is engaged in a nonunderwritten offering, the issuer may direct sales to a member firm. This makes sense, because there are no members involved in the underwriting.

5. 7. 12 TIE-IN ARRANGEMENTS

A tie-in arrangement is one in which a member firm, in return for letting a customer buy shares of a new issue at the POP, requires the customer to buy a certain number of shares in the secondary market. This type of arrangement is fraud under the Securities Exchange Act of 1934 and is strictly prohibited.

Another type of tie-in arrangement occurs when banks, which are members, attempt to tie commercial loans made to broker-dealers and others to investment banking services provided by the banks. It is a violation of federal banking law and FINRA rules for a bank to extend credit on the condition that the borrower engages in some other business with the bank.

*E X A M P L E Examples of violations include providing bridge loans in which the loan is to be repaid out of the proceeds of a bond offering managed by the bank and providing federally insured bridge loans to support a merger or acquisition managed by the bank.

5. 7. 13 “REDUCED PRICING” PROHIBITION

Syndicate and selling group members are prohibited from offering anyone (other than the members) a discount from the public offering price. This requirement applies until the offer-ing is terminated or, after having made a bona fide attempt to sell the fixed price securities at the public offering price, the syndicate/group is unable to continue selling of the securities at the POP.

✓T A K E N O T ENo member firm participating in a selling syndicate or group in connection with

a fixed-price offering may offer to a non-member of the selling syndicate or group any securities in the offering at a price below the stated public offering price (reduced price). Furthermore, when selling securities for a customer in order to generate funds to buy a new issue, members can pay no more than fair market price for the securities in exchange for securities in the offering.



5. 7. 14 PUBLIC OFFERINGS OF SECURITIES WITH CONFLICTS OF INTEREST (FINRA RULE 5121)

If a member offers its shares to the public, customer checks subscribing to the new issue must be placed in an escrow account. On completion of the offering, the member must imme-diately do a net capital computation and provide a copy to FINRA.

If its computed capital is less than 120% of minimum, or its AI-to-NC ratio exceeds 10:1, the offering must be canceled and the monies returned to the new issue purchasers. The mem-ber can use the net proceeds of the offering in performing the computation. As a side note, no member may sell its own stock into a discretionary account when a conflict exists. With a self underwriting, there is a built-in conflict of interest. It’s not illegal to have a conflict of inter-est; however, the broker-dealer must have received specific written approval of the transaction from the account holder and must retain documentation of the approval in its records.

QQ U I C K Q U I Z 5 . C True or False?

—— 1. A member may accept a customer check during the cooling-off period if it is postdated and held in an escrow account.

—— 2. Buyers of new issues must receive a final prospectus before the confirma-tion of sale.

—— 3. Under the USA, coordination is available only to established companies that have previously registered with the state.

—— 4. The prospectus delivery requirement for IPOs that are to be quoted in the OTC Pink marketplace is 90 days.

—— 5. The prospectus delivery requirement for IPOs that are to be listed is 40 days.

—— 6. A firm can continue publishing research reports during the cooling-off period if the securities being recommended are not equivalent to the security being underwritten.

—— 7. The employees of a member engaged solely in the sale of mutual fund shares are not allowed to buy new equity issues at the POP.

—— 8. A selling group member received an allotment of securities from the book running manager at the agreed discounted price. The group member may deliver these securities to the account of its customers at the same concession price.

5. 8 REGULATION M

Regulation M looks to prevent manipulation primarily with additional issue offerings by impeding certain activities of syndicate members, market makers, issuers, affiliates of issu-ers (e.g., officers), and others who have an interest in the outcome of an offering of covered securities.



Market makers who also are syndicate members in an additional issue offering may be able to affect the offering price of the security prior to the effective date. To address this situation, the SEC created a three-tiered definition of a security based on trading volume and public float value. These definitions, as well as restrictions placed on market makers and syndicate members, are described in Rule 101.

✓T A K E N O T EThe following is an example of a covered security for purposes of Regulation M.

A distribution of notes that are convertible into common stock, the convertible notes are the “subject security,” the common stock is the “reference security,” and both the convertible notes and the common stock are “covered securities.”

5. 8. 1 REGULATION M RULE 101

If a security meets the definition of an actively traded security (tier 1), there are no restric-tions placed on market makers or syndicate members prior to the effective date. An actively traded security is one with an average daily trading volume (ADTV) value of at least $1 mil-lion and a public float value of $150 million or more.

Securities with an ADTV of at least $100,000 and a public float value of $25 million or more (tier 2) are subject to a restricted period of one day—the business day before the effec-tive date.

Securities that do not meet the criteria previously outlined are tier 3 securities and are subject to a restricted period of five days—the five business days before the effective date.

As noted, there is no restricted period for actively traded securities. The SEC believes it would be difficult for market makers and syndicate members to manipulate the market prior to the effective date, given the trading characteristics of these securities.


If there is a restricted period, the issuer and its affiliates (including officers and selling shareholders, if any) cannot bid for or purchase the security during this period.


If a market maker who also is a syndicate member elects to function as a passive market maker during the restricted period, the following rules apply.

■ Notification must be made to Nasdaq one business day in advance of the restricted period. ■ Quotes over Nasdaq must be identified as those of a passive market maker (PSMM is the

Nasdaq modifier). ■ Passive bids can be no higher than the highest independent bid, which is a bid made by a

market maker not involved in the underwriting.



!T E S T T O P I C A L E R TIf there is a restricted period, the following rules apply.

■■ Market makers who also are syndicate members can either seek an excused withdrawal for the restricted period or elect to function as a passive market maker (Rule 103).

■■ Syndicate members who are not market makers are prohibited from purchasing, making a bid for, or inducing the purchase of the security during the restricted period. They could, however, execute unsolicited orders.

✓T A K E N O T EThere is one circumstance in which a passive bid can be higher than the highest

independent bid. If a passive market maker receives a customer limit order to buy at a price higher than the higher independent bid, that limit order must be displayed.

Passive market makers also are subject to daily net purchase limitations (number of shares bought less number of shares sold). The limit is 30% of that market maker’s average daily trad-ing volume in the stock. Once a passive market maker reaches or exceeds the net purchase limit, the firm must seek an excused withdrawal for the remainder of the trading day.

*E X A M P L E A market maker (who also is a syndicate member) has an average daily trading volume of 20,000 shares in the subject security. Its daily net purchase limit would be 6,000 shares. During the restricted period, its net purchases total 5,800 shares. At that point, it could accept a customer sell order for 200 shares, which would put it at the limit (6,000 shares), requiring an excused withdrawal. Or, at that point, it could accept a customer sell order for 600 shares, which would put it over the limit (6,400), again requiring an excused withdrawal.

Information on average daily trading volume on the stock to be underwritten, as well as the average daily trading volume of each market maker in the stock, is supplied to the syn-dicate manager by FINRA. Passive market making can only be done in fixed price offerings underwritten on a firm commitment basis and is only permitted if an independent market exists for the stock.

An independent market exists if there is at least one market maker in the stock not involved in the underwriting.



!T E S T T O P I C A L E R TTestable points regarding Rule 103 of Regulation M include the following.

■■ Application for passive market making activity must be made one business day before the restricted period.

■■ Passive market making activity can occur only if an independent market exists.

■■ Passive market making activity can occur only in firm commitment underwritings.

■■ Passive market makers are subject to the limit order display rule.

■■ Actively traded securities (ADTV value of $1 million and a public float of $150 million or more) are not subject to passive market making.


While many new issues trade at a premium to the offering price in the secondary market, there are some that trade below the offering price, creating serious problems for the syndicate.

*E X A M P L E If a new offering is offered at $20 per share and, once effective, is bid at $19.25 in the secondary market, customers who agreed to buy at the offering price may walk away, convinced the underwriters overpriced the deal.

Stabilization is permitted to ensure an orderly distribution. One member of the syndicate, generally the manager, is permitted to place a stabilizing bid over Nasdaq. With a stabilizing bid in place, it is unlikely that the price of the new issue will fall below the stabilizing bid, at least for the short term.

The basic rules on stabilization are as follows. ■ Stabilization is only permitted for fixed-price offerings underwritten on a firm commit-

ment basis; thus, at-the-market offerings can never be stabilized. ■ To place a stabilizing bid, an independent market must exist. ■ Notice of stabilization must appear in the prospectus. ■ Only one stabilizing bid is permitted. In addition, a stabilizing bid always is placed as a

one-sided market and must be identified as such over Nasdaq. ■ Stabilizing bids are placed at or below the public offering price but never above. A stabiliz-

ing bid can never be higher than the highest independent bid in the primary listing market for the security.

■ Stabilizing bids can be lowered or raised but never above either the public offering price or the highest independent bid.

In additional issue offerings, members are permitted to place a pre-effective stabilizing bid. The manager must notify Nasdaq of its intention and indicate whether the pre-effective bid will be converted to a conventional bid once the offering is effective.



Before placing a one-sided stabilizing bid, the manager must notify Nasdaq of its intention to place the bid and provide the following to Nasdaq:

■ Whether the bid will be a penalty bid (PBID) or a penalty-free bid (SYND) ■ A copy of the cover page of the prospectus ■ Whether the syndicate will engage in any short covering

A penalty bid is one in which the manager can reclaim the underwriting fee and/or the concession received by a member of the underwriting group if too many customers of that member quickly sell the stock at the stabilizing bid.

If the stabilizing bid doesn’t deter negative market reaction to a new issue, the manager can release members of the syndicate and selling group from their commitment to sell at the public offering price. The manager does this by lowering the offering price. This action, of course, would eliminate any profit to be made on the underwriting.

5. 8. 4. 1 Time Limits

Although penalty bids are generally lifted within 30 days, and the green shoe overallot-ment option is also generally exercised during the first 30 days, Rule 104 places no time limit on how long price support activities may last. However, Uniform Practice Rules of FINRA require that final settlement of corporate syndicate accounts be made within 90 days following the date the issuer delivers the securities to the syndicate. Because stabilization is prohibited once the syndicate disbands, there is a de facto limit of 90 days.

5. 8. 4. 2 Records

Records relating to stabilization activities must be retained by the syndicate manager for three years. If a syndicate member other than the manager places the stabilizing bid, that syn-dicate member must provide stabilization information to the manager within three business days of commencement of stabilization, and daily thereafter.


SEC Rule 105 limits short selling prior to the effective date of an additional issue offering. Before this rule took effect, it was possible for investors, prior to the effective date, to short the stock, driving down the price. This would in turn force the manager to lower the public offer-ing price. The short sellers would then buy at the offering price, covering the short position and making some money for themselves.

Rule 105 prohibits purchases at the offering price to cover short positions established within five business days of the effective date.

✓T A K E N O T EWith regards to a shelf offering, a member firm must examine individually each

takedown off a shelf (sometimes referred to as a “tranche”) to determine whether it is a “distribution” under Regulation M



QQ U I C K Q U I Z 5 . D Match each of the following rules with the appropriate description.

A. Rule 101B. Rule 102C. Rule 103D. Rule 104E. Rule 105

—— 1. Prohibits certain issuer activities during the underwriting period

—— 2. Allows passive market-making activity during the restricted period

—— 3. Regulates stabilizing bids

—— 4. Prohibits manipulative short sales in advance of a public offering

—— 5. Limits activity of underwriters who also are market makers

5. 9 EXEMPT SECURITIES AND TRANSACTIONS

5. 9. 1 EXEMPT SECURITIES

Certain new issues of securities are exempt from the registration requirements of the Securities Act of 1933. An exempt security is any security exempt by law from having to register with the SEC prior to public sale.

*E X A M P L E Exempt securities include U.S. government and agency securities, municipal secu-rities, commercial paper, banker’s acceptances, and foreign government bonds.

5. 9. 2 EXEMPT TRANSACTIONS

If a new issue of nonexempt securities is sold in an exempt transaction, no prospectus is required and the registration requirements of the act are greatly reduced or eliminated. Exempt transactions include the following:

■ Regulation A+ offerings (small- and medium-sized enterprises) ■ Rule 147 offerings (intrastate offerings) ■ Regulation D offerings (private placements) ■ Rule 145 transactions (corporate reclassifications) ■ Regulation S transactions (offshore transactions)



5. 9. 2. 1 SEC Regulation A+

With the passage of the JOBS Act, a new capital formation scheme for small- and medium-sized firms was called for to ease the red tape associated with IPOs. Although Regulation A was an alternative to a full IPO, it was never fully used—chiefly because it was limited to only $5 million and the offering needed to be registered in each and every state the securities were being sold—a very expensive and time consuming process. State administrators also judge the merits of an offering, in some cases prohibiting the sale of securities it deems too risky, such as what happened to Apple Computers in Massachusetts in 1980. All of this added up to making Regulation A unworkable.

On March 25, 2015, the SEC approved Regulation A+. It became effective on June 19, 2015. This new regulation provides for two offering tiers.

■ Tier 1—securities offerings up to $20 million in a 12-month period, including no more than $6 million sold on behalf of selling shareholders. Subject to a coordinated review by states and the SEC.

■ Tier 2—securities offerings up to $50 million in a 12-month period, including no more than $15 million of securities sold on behalf of selling shareholders. The $50 million limit is subject to a periodic review by the Commission.

Tier 2 permits a kind of mini-IPO allowing small, emerging companies to forego venture capital and raise substantial capital that is subject only to SEC scrutiny, preempting the bur-den of state regulation. New and innovative companies can look to nonaccredited investors such as their customers, employees, or even the general public for substantive financing with only a fraction of the regulatory burdens formerly seen. That said, Regulation A+ Tier 2 offer-ings are still subject to rigorous disclosure requirements to the SEC, similar to an S-1 review, including audited financial statements and annual, semiannual, and current reports. Tier 2s are not available to what the SEC calls certain “bad actors.”

These Regulation A+ offering statements and disclosures must be filed on EDGAR in the same fashion as we previous read about S-1 registrations for IPOs. Tier 2 issuers are required to concurrently file a short-form Form 8-A to register a class of securities under Exchange Act. This is very desirable because it allows a Tier 2 issuer, if it chooses to do so, to list on a national securities exchange.

Highlights of Regulation A+ Exemption include the following. ■ General public solicitation is permitted on television, social media, etc. ■ In a 12-month period, issuers may raise up to $20 million for Tier 1 and $50, million for

Tier 2. ■ Tier 2 offerings are open to the public, not limited to “accredited investors.” Tier 2 inves-

tors must be “qualified” investors. There are two ways to qualify.

— Be an accredited investor as defined in Rule 501 of Regulation D.

— Limit the investment to a maximum of the greater of 10% of their net worth or 10% of their net income per offering. Tier 1 has no investment limits.

■ Investors may self-certify their income or net worth. No burdensome documentation is required to prove income or net worth.

■ Must file a disclosure document and audited financials with the SEC and await approval from the SEC. The Offering Circular will receive the same level of scrutiny as a Form S-1 in an IPO.



■ Tier 2 issuers are required to provide two years (or such shorter time as the issuer has been in existence) of audited financial statements. Tier 1 offerings require reviewed financials, not audited.

■ Tier 2 issuers are required to make an annual disclosure filing, a semiannual report, and current reports (similar to Form 10-K, Form 10-Q, and Form 8-K), which can be termi-nated after the first year if the shareholder count drops below 300. There is no ongoing disclosure requirement for Tier 1.

■ Tier 2 preempts state law. Tier 1 offerings remain subject to state regulation. ■ There are no shareholder limits. ■ Securities issued in a Reg A+ offering are unrestricted and freely transferable. However,

issuers may choose to impose transfer restrictions on certain shareholders. ■ Investment companies (i.e., private equity funds, venture funds, hedge funds) may not use

Reg A+ to raise capital.

5. 9. 2. 2 Rule 147 Offerings

To qualify for an intrastate offering exemption, a corporate issuer must be incorporated in that state. In the case of a partnership, the principal place of business must be within that state. To determine residency, the issuer, in addition to being incorporated or having its prin-cipal office in the state, must meet the following 80% tests.

■ At least 80% of the issuer’s assets must be located in that state. ■ At least 80% of the issuer’s revenue must be generated in that state. ■ At least 80% of the proceeds of the offering must be deployed in that state (an issuer can-

not use a 147 exemption to expand out of state).

To qualify, the issuer files Form 147 with the SEC at least 10 business days prior to the effective date of the offering. Member firms underwriting the issue must ensure that all persons to whom offers or sales are made are residents of that state.

✓T A K E N O T EA single offer or sale to a nonresident destroys the exemption.

Other limitations include the following. ■ All shares being offered must be primary shares. Sales by affiliates are not permitted. ■ Once the offering is complete, secondary market trading is limited to residents of that

state; this resale restriction to nonresidents lasts for nine months from completion of the offering.

5. 9. 2. 3 Regulation D Offerings

Under the Securities Act of 1933, non-exempt securities offered to investors must either be registered with the SEC or conform to an exemption provided by rules in Regulation D of the act.



A private placement involves the sale of unregistered securities by either a publicly traded (SEC-reporting) company or, more obviously, a privately held company. A company seeking to raise capital through a private placement under Rule 506(b) can be sold without regard to dollar size to an unlimited number of accredited investors and up to 35 nonaccredited inves-tors. The Dodd-Frank Wall Street Reform and Consumer Protection Act prohibits felons and other bad actors from relying on a Rule 506 safe harbor.

An accredited investor is defined as a(n): ■ institution, such as an investment company, corporation, bank, or pension fund; ■ individual with annual income of $200,000 or more in each of the two most recent years

with a reasonable expectation of similar earnings in the current year; ■ spouse with annual income of $300,000 or more in each of the two most recent years with

a reasonable expectation of similar earnings in the current year; ■ individual or joint account with a net worth of $1 million or more exclusive of the equity

in the primary residence; or ■ officer or director of the issuer, the company whose shares are being sold privately.

A nonaccredited investor is one who does not meet these definitions. The SEC has stated that while nonaccredited, these investors must be sophisticated and allowed the right to use a purchaser representative to help evaluate the merits and risks of the proposed investment. A purchaser representative could be a tax adviser, accountant, or the like. Because of the conflict of interest, most firms prohibit registered representatives from acting as purchaser representa-tives, though there is no rule prohibiting this.

In counting the number of nonaccredited investors, the following rules apply. ■ A corporation, partnership, or other entity is counted as one purchaser. If, however, the

entity was organized for the purpose of acquiring the securities, each owner will be counted separately.

■ Any relative or a spouse of a purchaser who has the same principal address as the purchaser is excluded from the count (if husband and wife each purchase units of a private place-ment, they count as one purchaser).

■ Any trust, estate, or corporation in which a purchaser or relative/spouse has more than a 50% interest is excluded from the count (if a purchaser and a trust that he controls each purchase units, they will be counted as one purchaser).

Regulation D states that purchaser representatives cannot be affiliated in any way with the issuer. An exception is granted if the purchaser representative, though affiliated with the issuer, is a relative of the investor by blood, marriage, or adoption.

All prospective investors must receive a copy of the offering circular (known as the private placement memorandum) within a reasonable period prior to confirmation of sale. All inves-tors must sign an investment letter attesting to their understanding of the risks being assumed. The amount of disclosure required in the offering circular depends on the dollar amount of the private placement. The greater the amount, the greater the disclosure:

■ Rule 505. Private placement where an issuer can only offer and sell up to $5 million of its securities in any 12-month period

■ May sell to an unlimited number of “accredited investors” and up to 35 other persons who do not need to satisfy the sophistication or wealth standards associated with other exemp-tions

■ Must inform purchasers that they receive “restricted” securities, meaning that the securi-ties cannot be sold for six months or longer without registering them



■ Cannot use general solicitation or advertising to sell the securities ■ Rule 506. Private placement where there is no limit on the amount sold

Since the adoption of Regulation D, the SEC took the view that general solicitation and advertising be prohibited in order to take advantage of the safe harbor provided under Rule 506—the member firm soliciting investors would have to have a preexisting relationship with all persons solicited. No cold calling to generate interest was allowed. This put smaller issuers and member firms (with fewer qualified investors) at a disadvantage to larger member firms in competing for Regulation D work.

This view still holds; however, new Rule 506(c) permits general solicitation in Regulation D private placements if certain flexible conditions are satisfied, such as:

■ all purchasers are accredited investors, or the issuer reasonably believes they are at the time of the sale; and

■ the issuer is under an affirmative obligation to take reasonable steps to verify that purchas-ers are accredited investors.

New Rule 506(c) also permits private investment funds (pooled investments) to solicit generally, as well, so long as they point their sales efforts at “qualified purchasers” as defined under the Investment Company Act of 1940.

✓T A K E N O T EA qualified investor under the Investment Company Act of 1940 is a natural

person who owns at least $5 million in investments or any entity acting for its own account, or that of other qualified investors who own and invest on a discretionary basis at least $25 million in investments.

This new rule does not supersede the older rule. If the conditions of Rule 506(c) cannot be satisfied, or the issuer chooses not to use general solicitation or advertising, the standard safe harbor rules apply.

A Rule 504 offering, which is distinct from most of the Regulation D rules, involves the offering of securities in which the dollar amount does not exceed $1 million. It is distinct from Rule 505 and 506 in that:

■ there are no limitations on the number of purchasers, accredited or nonaccredited; ■ there is no requirement that purchasers meet suitability or sophistication standards; ■ there are no restrictions on solicitation or advertising; ■ it can be used by an issuer to make a public offering of its securities; and ■ there are no restrictions as to resale.

Rule 504 offerings are not available for blank check companies (entities without a defined business or business plan).

Rule 508 permits equity offerings through online crowdfunding portals. Small businesses may seek up to $1 million per year from small investors through a crowdfunding portal that must be registered with the SEC and FINRA. Advertising is permitted. Crowdfunding rules are evolving.



5. 9. 2. 3. 1 Private Placements of Securities Issued by Member Firms

Rule 5122 requires that a member firm offering its own securities in a private placement, known as a member private offering (MPO), file a copy with FINRA’s Corporate Financing Department of any private placement memorandum used at or prior to providing PPM or a term sheet to any prospective investor. Amendments to the PPM or term sheet must be submitted to the department within 10 calendar days of being provided to an investor or pro-spective investor. If there are no offering documents, the firm must indicate that. Firms are required to file electronically through the FINRA Firm Gateway.

Unit 1 provided information about Firm Gateway and becoming a member. Understand that the Gateway supplies FINRA with many different types of information. Other than pri-vate offering memoranda and Form NMA that you already know about, requests for exam waivers, changes to the membership agreement, annual audit reports, clearing arrangements, and much more are submitted through the Gateway. The Gateway also provides filing remind-ers of upcoming rule changes.

5. 9. 2. 3. 2 Private Placements Filing Requirements

FINRA Rule 5123 requires each member firm that sells a security in a non-public offer-ing to submit to FINRA a copy of any private placement memorandum, term sheet, or other offering document, including any material revisions, used in connection with the sale within 15 calendar days of the date of first sale. Alternatively, if there are no offering documents, the member firm must notify FINRA that no such offering documents were used. The required documents or notification must be made electronically in searchable PDF using a newly devel-oped private placement filing system through the FINRA Firm Gateway. When a member firm makes a notice filing, there will be no response from FINRA (i.e., no comment letter or clearance letter). An example of a notice filing with which you might be more familiar is Form 144 to the SEC.

!T E S T T O P I C A L E R TSecurities purchased from an issuer under Section 4(6) are exempt from registra-

tion under the Securities Act of 1933. This exemption is available for offerings that do not exceed $5 million, are made only to accredited investors, do not involve any advertising or solicitation, and for which a Form D has been filed. This exemption is different from Regulation D where a limited number of non-accredited investors may participate.

✓T A K E N O T ERegulation D exemptions are available only to the issuer of the securities to be

sold. The exemptions are not available to selling shareholders.

✓T A K E N O T ERelying upon the JOBS Act, the SEC has removed the prohibition on general

solicitation or advertising in private placements under Rule 506(c), provided that the issuer take “reasonable steps” to verify that all participants in private placements are “accredited investors” as defined in Rule 501 of Regulation D of the Securities Act of 1933.



5. 9. 2. 4 Online Offerings of Private Placements

The SEC permits investors to view private placement memoranda on the internet if the following conditions are met.

■ A member must prequalify investors by having them complete an online questionnaire to determine whether they are accredited or sophisticated.

■ Once qualified, investors can view offering documents on a password-protected page. This page is available to investors only after a member has determined that they are accredited or sophisticated.

■ Investors can purchase securities only in transactions posted after they have been quali-fied.

The SEC takes the view that the qualification of accredited and sophisticated investors by completing a questionnaire and posting a notice of private offerings on a password-protected page would not involve any form of general solicitation or advertising.

!T E S T T O P I C A L E R TOne popular use of Regulation D is through a PIPE (Private Investment in Public

Equity) transaction. In a PIPE, investors purchase securities directly from a publicly traded issuer in a private placement. The securities purchased are restricted and can-not be immediately resold. After the closing of the transaction, the issuer immediately prepares and files a registration statement with the SEC for the securities issued in the PIPE. Once the registration is effective, public resale of the PIPE securities may begin.

5. 9. 2. 5 SEC Rule 145

This rule exempts certain types of corporate reorganizations from having to register shares under the Securities Act of 1933. The basic exemptions include:

■ a stock split; ■ a stock dividend; and ■ a change in par value of existing shares.

If an issuer were required to register the additional shares resulting from a stock split or stock dividend, these events would not occur.

Certain reorganizations do require registration. These include: ■ a merger in which the surviving company issues additional shares to acquire the shares of

the target company; ■ a consolidation in which the shares of existing holders of each company involved in a

merger are exchanged for shares in a new entity; and ■ an acquisition in which the acquiring company issues additional shares for the assets of

the target company.

5. 9. 2. 6 Regulation S

Offers and sales made outside the United States by both U.S. and foreign issuers are excluded from the registration provisions of the Securities Act of 1933. Because securities dis-



tributed offshore by issuers need not be registered with the SEC, they are therefore restricted for the purposes of Rule 144. To avoid registration under Regulation S:

■ the offer and sale must be made in an offshore transaction; and ■ there can be no directed selling efforts in the United States in connection with the offer-

ing.

To be an offshore transaction, offers and sales cannot be made to any person or entity in the United States. However, U.S. citizens residing outside the United States could purchase these securities. All sales made under Regulation S must be reported to the SEC on Form 8-K.

✓T A K E N O T ERegulation S addresses the sale of unregistered securities by U.S.-based issuers

to non-U.S. residents. A holding period (aka distribution compliance period) on Regu-lation S securities is necessary to prevent flow back into the U.S. There is a holding period of six months if the issuer is a reporting company (10K, 8K, and so forth), and one year for nonreporting companies. Debt securities have a holding period of 40 days. The bonds or notes are then considered “seasoned.”

However, sales may be made immediately to any SEC-designated offshore securi-ties market.

✓T A K E N O T ERegulation S applies to United States issuers. Foreign issuers are not subject to

this regulation if certain requirements are met: to be a foreign issuer, no more than 50% of its voting securities and no more than 20% of its debt securities can be owned by persons with a U.S. address. If a foreign issuer does not meet these require-ments, it will be subject to the provisions of Regulation S (no sales to entities in the United States).

5. 9. 2. 7 Foreign Corrupt Practices Act

The Foreign Corrupt Practices Act of 1977 (FCPA) prohibits bribery of foreign officials. Member firms acting as agents for issuers of publicly traded securities must make and keep books and records that accurately reflect the company’s transactions. The purpose is intended to prohibit “slush funds,” which may be used to make illegal payments or mislabel payments and expenses. Members involved in this line of business are expected to have a system of inter-nal controls to evaluate risk with regards to the FCPA.



5. 10 SEC RULE 144

5. 10. 1 RULE 144—SELLING RESTRICTED AND CONTROL SECURITIES

Rule 144 regulates the sale of both control and restricted securities. Control securities are those owned by people who are affiliated with the issuer, such as directors, officers, a spouse of an officer, or persons who own more than 10% of a company’s outstanding securities. Such per-sons are subject to volume limitations on the sale of these securities for if they are affiliated with the company.

Unless it is unregistered, such as privately placed stock, control stock is not subject to the holding period requirements imposed on restricted stock but is subject to volume limits throughout the time the owner holds the control position.

✓T A K E N O T EIf an unaffiliated individual owns 7% of the voting stock of XYZ, that person is

not a control person. However, if that person’s spouse owns 5% of the voting stock, then both would be considered control persons. In other words, if there is a greater than 10% interest held by immediate family members, then all those family members owning voting stock are control persons.

Restricted securities are those acquired through a Regulation D private placement or any means other than a registered public offering. Restricted securities may not be sold until they have been held fully paid for a minimum of six months. According to Rule 144, after holding restricted stock fully paid for six months, an affiliate may begin selling shares but is subject to the volume restriction rules in the following list. Furthermore, restricted stock is not subject to the 10-second reporting requirement (see reporting requirements in Unit 4). In any 90-day period, an investor may sell the greater of:

■ 1% of the total outstanding shares of the same class at the time of sale; or ■ the average weekly trading volume in the stock over the past four weeks on all exchanges

or as reported through Nasdaq.

After the six-month holding period, affiliated persons remain subject to the volume restrictions for as long as they are affiliates. For unaffiliated investors, the stock may be sold completely unrestricted after the six-month holding period has been satisfied.

Selling shares under Rule 144 effectively registers the shares. In other words, buyers of stock being sold subject to Rule 144 are not subject to any restrictions if they choose to resell.

!T E S T T O P I C A L E R TWhen you encounter a Rule 144 question, look for the following two things.

■■ What kind of stock is being sold? (restricted or control)

■■ Who is selling it? (an insider or noninsider)

Only restricted stock has a holding period. Unless unregistered, control stock can be sold immediately, but volume limits always apply.



Summary of the Provisions of Rule 144

Restricted Stock (unregistered)

held by a non-affiliate (non-insider)

Restricted Stock(unregistered)

held by an affiliate(insider)

Control Stock(registered)

held by an affiliate(insider)

• six-month hold• sell freely thereafter

• six-month hold• volume limits thereafter

• no hold• volume limits always apply

RULE 144

5. 10. 1. 1 Volume Limits

Rule 144 limits the total sales of stock over any 90-day period to the greater of: ■ 1% of the total outstanding shares of the same class at time of sale; or ■ the average weekly trading volume in the stock over the past four weeks on all exchanges.

!T E S T T O P I C A L E R TOnly restricted stock has a holding period. Control stock, unless it is restricted

due to it being acquired in a private placement, can be sold immediately; but volume limits always apply.

Which of the following is subject to the holding period provisions of Rule 144?A. A corporate insider who has held restricted stock for 2 years.B. A nonaffiliate who has held registered stock for 3 years.C. A nonaffiliate who has held control stock for 6 months.D. A nonaffiliate who has held restricted stock for 3 months.

Answer: D. Only restricted stock obtained as part of a private placement is subject to the 6-month holding period for both affiliates and nonaffiliate; registered shares are not and control stock is not. The nonaffiliate in choice D, who has held the shares for only 3 months, will still be subject to the holding period until the 6-month requirement is met.

When required, Form 144 must be filed no later than concurrently with the sale of the stock, and the filing is good for 90 days. If the intended sale during any 90-day period for an affiliate is small, the filing requirement is waived. This is known as the de minimis filing threshold for affiliates. Sales in amounts not exceeding 5,000 shares or $50,000 in sale proceeds are permitted without filing Form 144.

As previously mentioned, a nonaffiliated seller may sell privately placed securities to the public in unlimited amounts and without filing Form 144. However, following the six-month holding period and continuing for an additional six months, the seller must comply with the requirement that there be available adequate, current, public information about the issuer.



This can be accomplished by verifying that the company is a reporting company that regularly files 10K and 10Q reports with the SEC.

Insiders defined under Rule 144 are not allowed to enter short sales in the securities of companies in which they are insiders. They also are restricted from participating in specula-tive options transactions. If an insider profits from the sale of securities held for less than six months, these short-swing profits are required to be disgorged (returned) to the company. Report any trading of insider-owned securities to the SEC within two business days of the transaction.

5. 10. 1. 2 Broker-Dealer Restrictions

The SEC restricts broker-dealers from actively soliciting buyers for control shares or for arranging private negotiations between buyers and sellers of control stock. Additionally, all sales under Rule 144 are to be executed as agency transactions, meaning that the firm matches a buyer and seller.

Buyers of 144 stock must come to firms on an unsolicited basis. Initiating contact with cus-tomers or other broker-dealers for the purpose of selling the stock is prohibited, but callbacks are allowed under the following circumstances.

■ Customer callbacks may be made to customers who expressed interest in the stock within the past 10 business days.

■ Broker-dealer callbacks may be made to those firms that expressed interest within the past 60 calendar days.

Broker-dealers may not register as market makers in anticipation of Rule 144 transactions. If a firm is currently registered as a market maker in the stock, the firm can purchase for its inventory. This is an exception from the rule that firms may act in an agent capacity only in Rule 144 transactions.

A firm may purchase as dealer under one additional exception. Block positioners are firms defined under SEC Rule 3b-8 as firms that purchase long or sell short blocks of stock worth $200,000 or more. These firms may be treated as market makers for Rule 144 transactions.

!T E S T T O P I C A L E R TReview the following points regarding Rule 144.

■■ Restricted stock has a six-month holding period unless the holder is the estate of a deceased person.

■■ Restricted stock held by an estate is exempt from both the holding period requirements and the volume limitations of Rule 144.

■■ There is no holding period on registered control stock, but volume limits always apply.

■■ Rule 144 transactions should be agency-only unless the firm is a registered market maker or block positioner in the stock.

■■ Callbacks are allowed to customers who indicated interest within the past 10 business days and to firms that indicated interest within the past 60 calendar days.



✓T A K E N O T EInsiders cannot short. They are prohibited from taking short-swing profits and

cannot engage in short naked options positions or short sales.

Insiders are permitted, however, to write calls against a long stock position. On the other hand, a corporation cannot write calls against its own stock; for example, stock held in its treasury. If exercised, the company must deliver shares, thereby in-creasing the number of shares outstanding. This would require shareholder approval.

5. 10. 2 RULE 144A

An issuer of debt or equity securities that wishes to rely upon an exemption from the sig-nificant burdens of registration with the SEC under the Securities Act of 1933 often selects Regulation D, or Regulation S for those issuers raising capital outside the United States. In either case, it’s important that those investors who purchase securities under those regulations do not fall into the definition of an underwriter and be deemed to be making a distribution. Rule 144A provides a safe harbor for those investors known as qualified institution buyers (QIBs). Rule 144A allows nonregistered foreign and domestic securities to be traded among QIBs in the United States without holding period requirements.

5. 10. 3 144A TRADES BY QIBS REPORT THROUGH ORF

Rule 144A provides an exemption for secondary market trading of unregistered securities among QIBs. A QIB is an institution (pension fund, investment company, insurance company, and so forth) with a securities portfolio valued at $100 million or more. Member firms are con-sidered QIBs if they have a securities portfolio valued at a less restrictive $10 million or more. QIBs cannot be individuals, no matter how wealthy they may be.

QIBs can trade unregistered securities with each other without concern for a holding period and volume restrictions. Rule 144A provides a limited exemption for secondary market trading of unregistered securities among QIBs only.

Ordinarily, trades in NMS and OTC equity securities must be reported within 10 seconds; but last sale reports in restricted equity securities are made to FINRA’s OTC Reporting Facility (ORF) by participants on the same business day. Failure to report in a timely manner will have to report on an as/of basis to denote execution on a prior day with the appropriate modifier. For more information, see Trade Report Rules in Unit 4. Participants to the ORF must obtain from the system a unique Market Participant Symbol (MPID) and use that identifier for all trade reporting. Eligible 144A debt securities are reported through TRACE.

Rule 144A provides a liquid secondary market for securities issued in exempt offerings under Regulation D and Regulation S for those investors that meet the definition of a qualified institutional buyer (QIB).

✓T A K E N O T EThe ORF is provided by FINRA to report those trades in OTC equity securities

(i.e., those not reported through an exchange and also for last sales reports in 144A stock).



QQ U I C K Q U I Z 5 . E Match the following amounts to the appropriate description. Some choices may be used more than once.

A. 5,000B. 147C. $50 millionD. 35E. 20F. 10G. 9H. $1 millionI. $100 millionJ. 60

—— 1. Number of nonaccredited investors that can buy a private placement under Rule 506(b) of Regulation D

—— 2. Form 144 does not need filing if a shareholder sells fewer than this amount of shares

—— 3. Number of months a state resident must hold securities before sale to a nonstate resident under an intrastate offering

—— 4. A company may sell up to this amount under a Regulation A+ offering

—— 5. Intrastate offering also is known by this rule number

—— 6. Number of seconds to report a trade in an NMS security.

—— 7. Under Rule 144, customers may be called back if they expressed interest within this number of business days

—— 8. Minimum amount of net worth for an accredited individual investor under Regulation D

—— 9. Minimum amount of assets for QIBs under Rule 144A

—— 10. Ownership of more than this percentage of a firm’s outstanding stock qualifies an otherwise unaffiliated investor as a control person



5. 11 TENDER OFFERS AND CORPORATE BUY-BACKS

5. 11. 1 TENDER OFFERS BY ISSUERS (SELF TENDER)

When an entity publicly announces its intention to acquire, in a tender offer, shares of a target company, the following rules apply.

■ Once the tender is announced by filing for Schedule TO-I, the entity making the offer can no longer buy the target company’s share in the open market (Rule 10b-13). The only shares it can purchase are those tendered by shareholders.

■ The entity making the offer is similarly prohibited from buying convertible securities or call options (equivalent securities) of the target company in the open market. It could, however, make open market purchases of other nonconvertible securities of the issuer.

■ The tender offer, unless withdrawn, under Regulation 14E, must remain open for at least 20 business days from the date the offer is first announced.

■ If the terms of the offer are changed, the revised offer must remain open for at least 20 business days from the commencement and 10 business days from the date the terms are changed.

The target company, within 10 business days of the announcement, must provide its share-holders with a statement:

■ accepting or rejecting the offer; ■ expressing no opinion on the offer; or ■ that it is unable to take a position on the offer.

The statement must outline the reasons for the position taken.

5. 11. 2 SHORT TENDER RULE

Shareholders of the target company are permitted to tender shares only to the extent of their net long position.

*E X A M P L E A customer is long 400 shares of ABCD in a cash account and short 100 shares of the stock in a margin account. If ABCD becomes the target of a tender offer, the cus-tomer would be permitted to tender 300 shares, the net long position. If the customer were permitted to tender the 400 shares in the cash account and the tender offer was successful in acquiring all the outstanding shares, the customer would be short 100 shares with no way to cover.

A customer is considered long a stock if the customer: ■ owns the stock; ■ owns a convertible security and has issued conversion instructions; or ■ owns a call option and has issued exercise instructions.



✓T A K E N O T EIf a tender offer is for less than 100% of the outstanding shares or is contingent

on a minimum number of shares being tendered, holders of convertible securities (not options) can tender without first converting. They will only be required to convert if their tender is accepted.

If an investor has written calls against a long stock position and the tender offer price exceeds the exercise price of the calls, then the investor can only tender those shares that remain uncovered.

!T E S T T O P I C A L E R TAn investor is long 300 shares of ABCD in a cash account and short 300 shares of

ABCD in a margin account. A tender offer for ABCD is announced. How many shares may be tendered by the investor?

Only the investor’s net long position may be tendered. The investor’s long posi-tion of 300 shares is fully offset by the short position of 300 shares. No shares can be tendered in this situation.

5. 11. 3 ISSUER BUYING ITS OWN SECURITIES

If an issuer wants to buy back its own stock in the open market, SEC Rule 10b-18 applies. ■ Transactions on any given day can only be effected through one market maker or desig-

nated market makers (DMM). ■ Transactions on any given day cannot exceed 25% of the average daily trading volume

measured over the prior four calendar weeks. Block purchases count against the daily pur-chase limit. There is an exception to this, however. It’s called the “one block per week exception.” As the name implies, issuers are permitted to make one block purchase of its common stock per week outside of the prescribed volume restrictions.

■ Transactions cannot affect the opening or closing of security. A safe harbor is available if the issuer is not involved in the first transaction of the day or any transaction in the last half hour of trading (3:30–4:00 pm ET).

■ Transactions can be executed at prices no higher than the highest independent bid or the last reported sale price, whichever is higher.

✓T A K E N O T EIf an issuer’s security is an actively traded security as defined in Regulation M, the

safe harbor will not apply for the 10-minute period prior to market close. For other issuers, the safe harbor will not be available for purchases effected within 30 minutes of closing.

In other words, an issuer with an ADTV less than $1 million per day, or a public float value below $150 million, is not permitted to make a trade in its stock within the last 30 minutes of the normal trading day. Companies with higher average trading volume or public float value may trade up until the last 10 minutes.



To address concerns that the rule adversely affects issuers with low to moderate trading volume, the SEC allows issuers to make one block purchase of its stock each week without regard to the 25% volume limit if it makes no other 10b-18 purchases that day.

5. 12 PUBLIC DISTRIBUTION OF SECURITIES WITH CONFLICTS OF INTEREST

5. 12. 1 FINRA RULE 5121

When a member firm, for example, wishes to go public, it must abide by FINRA Rule 5121. In the initial public offering, the member, to avoid a clear conflict of interest, must engage an independent qualified underwriter to help it:

■ perform due diligence; and ■ prepare the registration statement and the prospectus.

The securities must have a bona fide public market or be investment grade. FINRA Rule 5121 does not apply to the issuing member and its employees. These are

considered issuer-directed sales.

5. 12. 1. 1 Independent Qualified Underwriter

An independent qualified underwriter must have been a book-running manager of at least three public offerings of equity securities of which each must have been for not less than 50% of the anticipated gross proceeds of the proposed offering for at least the three-year period immediately preceding the filing of the registration statement.

No person associated with the firm in a supervisory capacity with respect to public offer-ings may have been convicted, within the previous five years, of having violated the antifraud provisions of federal securities law.

Suitability. In recommending the purchase of its employer’s stock to customers, regis-tered representatives of the member going public must ensure that all buyers are suitable. Records of each suitability determination must be maintained by the member for three years.

Discretionary Accounts. With regard to discretionary accounts, registered representa-tives of the member going public cannot purchase shares for these accounts without first receiving the customer’s written permission.

Affiliated Relationships. The requirement to use an independent qualified underwriter applies not only to initial public offerings of the member’s shares but also to initial public offerings where there is an affiliated relationship between issuer and member. An affiliation exists if there is a 10% or more ownership interest between the two.



5. 12. 1. 2 Escrow of Proceeds

All proceeds from a public offering by a member firm of its own securities must be placed in escrow. The member firm must then perform a net capital computation demonstrating the net capital of the firm is no less than 120% of the minimum or that the AI:NC ratio is no greater than 10:1. In performing the calculation, the proceeds from the offering may be taken in consideration in calculating net capital.

*E X A M P L E A member is 100% owned by a privately held corporation. If the corporation wanted to go public, the member could not act as syndicate manager. The member must engage an independent qualified underwriter.

✓T A K E N O T EAll customer checks received to purchase the new issue must be placed in an

escrow account pending a net capital computation.

5. 13 CORPORATE FINANCING RULES/NOTIFICATION REQUIREMENTS (FINRA RULE 5110 AND 5190)

5. 13. 1 OFFERINGS SUBJECT TO RULE 5110

The Corporate Financing Department (CFD), established by the Board of Governors of FINRA, was created to review the fairness of compensation to be received by underwriters. The offerings subject to review are equity and convertible debt issues.

Nonconvertible debt and nonconvertible preferred stock are exempt if they are rated as investment grade. Also exempt from having to file are offerings under Regulation D (Rule 505 and 506), U.S. government and agency securities, municipal securities, open-end management companies, and unit trusts.

Closed-end funds (publicly traded funds) are subject to filing, as are Regulation A offer-ings, Rule 147 offerings, direct participation programs, right offerings, and securities sold under FINRA Rule 5121.

✓T A K E N O T EExemptions available to 5110 from filing do not apply to the notice requirements

of 5190.

✓T A K E N O T EThe CFD is controlled by the Board of Governors, which means the board can

exempt any offering from having to file if it deems an exemption to be in the public interest.



5. 13. 1. 1 Information Filed

To determine fairness, the syndicate manager files the following information with the CFD:

■ The underwriting spread ■ Reimbursement of expenses from issuer to underwriter ■ The amount of any stock, warrants, or options received as part of the compensation pack-

age ■ The right of first refusal to participate in future underwritings ■ Nonaccountable expense allowances ■ All other items of value including information on overallotment

The CFD also will review any items of compensation received by the underwriters during the 180-day period immediately preceding the filing of the registration statement. The idea is to determine if any of these items have been received in connection with the offering. If received during the 180-day period preceding the filing, the CFD will presume the compensa-tion was received in connection with the offering.

File the information previously noted with FINRA within one business day of filing a reg-istration statement with the SEC.

5. 13. 1. 2 Unfair or Unreasonable Compensation

The CFD considers the following to be unfair or unreasonable compensation: ■ Any options or warrants received by the underwriters that are exercisable below the public

offering price ■ Any options or warrants received by the underwriters that have a life of more than five

years ■ Any freely transferable stock received by the underwriters; stock received as part of the

compensation package must be restricted for resale for 180 days from effective date; if the amount of securities received does not exceed 1% of the securities being offered, the lock-up period will not apply

■ Any nonaccountable expense allowance in excess of 3% of the underwriting spread ■ Any right of first refusal for future public or private offerings that has a duration of more

than three years from the effective date ■ Any overallotment option (green shoe clause) that allows the underwriters to purchase,

from the issuer, more than 15% of the stock being offered for public resale ■ The CFD will do a pro forma exercise of any options or warrants received; if, upon exer-

cise, the number of shares combined with any shares received up front exceeds 10% of the shares being offered to the public, this is considered unreasonable compensation

■ A tail fee continuing beyond two years

A tail fee, sometimes called a termination fee, permits an underwriter to receive fees if the underwriter’s services are terminated by an issuer, and then the issuer hires another under-writer to complete the job. Any tail fee arrangement granted to the underwriter more than two years from the date the member’s services are terminated would be considered unreasonable compensation.



5. 13. 1. 2. 1 Reimbursement of Expenses

In reviewing reimbursement of expenses from issuer to underwriter, the CFD looks for reimbursements that are normally borne by the underwriters.

*E X A M P L E If the underwriters are reimbursed by the issuer for paying blue-sky fees, there is no problem, because these fees are normally paid by the issuer. If, however, the underwriters are reimbursed for solicitation costs, this reimbursement would be considered part of the overall compensation package, because this expense is nor-mally borne by the underwriters and would be considered an unreasonable syndicate expense from the underwriting fee.

If informed by the CFD that the compensation is unreasonable, the syndicate manager must immediately notify the other syndicate members and take steps to adjust the compensa-tion items. Otherwise, the offering cannot occur.

Rule 5190 is a requirement for those members participating in offerings, such as IPOs, PIPEs, follow-on, secondary, blocks, “bought” offerings, shelf (both initial and subsequent takedowns) et cetera, to examine each one individually to determine whether it is a “distribu-tion” under Regulation M.

The notice requirements of Rule 5190 apply to any offering of a covered exchange-listed security or an OTC Equity Security, (Unit 4 describes an OTC Equity Security as a non-NMS security) that meets the definition of a “distribution” and does not qualify as excepted activity, such as Rule 144A transactions, or as an excepted security, such as investment grade non-con-vertible debt or preferred stock. The notice requirements of Rule 5190 apply to both securities subject to a restricted period and to those securities that are “actively traded.”

For a distribution that is subject to a restricted period, firms must provide notification to FINRA (via the Regulation M Restricted Period Notification) of the firm’s determination of the applicable restricted period, and the basis for that determination, along with the date of commencement of the restricted period, no later than the business day prior to the first com-plete trading session of the applicable restricted period, unless later notification is necessary under specific circumstances.

✓T A K E N O T EA “bought deal” is a firm commitment by the underwriter who purchases the se-

curities without any pre-marketing effort. This is usually done for a WKSI. The owner/underwriter then re-sells the securities on a best-efforts basis.



5. 14 SECURITIES EXCHANGE ACT OF 1934 REPORTING REQUIREMENTS

5. 14. 1 FILINGS BY ISSUERS

Once an issuer is publicly traded, it is obligated to file certain reports with the SEC. These include an annual report on Form 10-K [Form 20-F for foreign private issuers (FPIs)] and quar-terly reports on Form 10-Q. Other required reporting events include the following.

Form 8-K (the Current Report). Use this form to report newsworthy events to the SEC, such as change in management, change in the company’s name, mergers or acquisitions, and major new product introductions. Only domestic issuers use this form. FPIs are exempt from filing Forms 8-K but may instead be required to furnish Forms 6-K, which largely serve the same purpose of making material information available to the public. Form 6-K also may be used to register ADRs. ADRs, which are U.S.-registered securities, also are exempt, because the underlying company is non-U.S.

5. 14. 2 FILINGS BY NONISSUERS

Corporate insiders, such as officers and directors, are required to file information on changes in their holdings with the SEC. Form 3 is used for the initial report, while Form 4 is used for subsequent reports. When an investor, investor group, or other entity acquires a 5% or more interest in an issuer of securities, that person must file Schedule 13-D with the SEC. The form must include information on the person’s intentions with regard to seeking control of the issuer. The form also is filed with the issuer and with the market where the security principally trades.

✓T A K E N O T EReport any changes in insider holdings to the SEC within two business days of

the change.

Schedule 13-D filing requirements do not apply to insiders. If an officer acquires a 5% or more interest, this information is provided to the SEC on Form 4.

Investment companies and related entities use Schedule 13-G if they acquire a 5% or more interest in an issuer. Under the Investment Company Act of 1940, investment compa-nies are prohibited from controlling, or seeking to control, any issuer. Therefore, a 13-G, not 13-D, is the required filing, and it must be made within 45 days after each calendar year-end during which the position is held.

Form 13F is filed by institutional investment managers who have discretion over $100 mil-lion or more in Section 13(f) securities. Form 13F is required to be filed within 45 days of the end of a calendar quarter. Among other things, the 13F requires disclosure of the name and class, the CUSIP number, and the number of shares as of the end of the calendar quarter. It also requires disclosure of the total market value of those equity securities under management that trade on an exchange, such as Nasdaq and the NYSE, as well as certain options, warrants, and closed-end investment company shares. Mutual funds are not on the list of reportable securities.



!T E S T T O P I C A L E R TThe following table highlights the timing requirements for various SEC filings.

Form/Schedule When Filed

8K Within 4 business days of an event of consequence

10K Within 90 days of year-end

10Q Within 45 days of the end of the quarter

13D Within 10 days of acquiring a 5% or more beneficial ownership of an issuer

13G Within 45 days of the end of the calender year after acquiring a 5% or more beneficial ownership of an issuer

Form 4 Within 2 business days of any change

Form 3 Within 10 calendar days

Form 13F Within 45 days of the end of the calendar quarter

✓T A K E N O T EOnly those institutional investment managers who have discretion over $100

million or more in Section 13(f) securities need to file the Form 13F with the Com-mission. Section 13(f) securities generally include equity securities that trade on an exchange (including Nasdaq), certain equity options and warrants, shares of closed-end investment companies, and certain convertible debt securities. The shares of open-end investment companies (i.e., mutual funds) are not Section 13(f) securities.



Sample Form 3

You may not send a completed printout of this form to the SEC to satisfy a filing obligation. You can only satisfy an SEC filing obligation by submitting the information required by this form to the SEC in electronic format online at https://www.onlineforms.edgarfiling.sec.gov.

OMB APPROVAL OMB Number: 3235-0104Expires: December 31, 2014 Estimated average burden hours per response. . . . . . 0.5

UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549FORM 3 Form 3

INITIAL STATEMENT OF BENEFICIAL OWNERSHIP OF SECURITIES (Print or Type Responses)

1. Name and Address of Reporting Person* 2. Date of Event Requiring Statement (Month/Day/Year)

3. Issuer Name and Ticker or Trading Symbol

(Last) (First) (Middle) 4. Relationship of Reporting Person(s) to Issuer (Check all applicable)

Director 10% OwnerOfficer (give Other (specify

title below) below)

5. If Amendment, Date Original Filed (Month/Day/Year)

6. Individual or Joint/GroupFiling (Check Applicable Line)

__Form filed by One Reporting Person __Form filed by More than One ReportingPerson

(Street)

(City) (State) (Zip)Table I — Non-Derivative Securities Beneficially Owned

1. Title of Security (Instr. 4)

2. Amount of Securities Beneficially Owned (Instr. 4)

3. Ownership Form: Direct (D) or Indirect (I) (Instr. 5)

4. Nature of Indirect Beneficial Ownership (Instr. 5)

Reminder: Report on a separate line for each class of securities beneficially owned directly or indirectly. * If the form is filed by more than one reporting person, see Instruction 5(b)(v).

Potential persons who are to respond to the collection of information contained in this form are notrequired to respond unless the form displays a currently valid OMB control number. (Over)

SEC 1473 (11-11)


—— 1. A tender offer must remain open for at least 30 days from the date the terms were announced.

—— 2. A customer is considered long stock under the short tender rule if he owns a call, right, or warrant.

—— 3. When a member firm wishes to go public, it must engage the services of a qualified independent underwriter to price its IPO.

—— 4. Representatives must get written permission from discretionary account customers prior to purchasing shares of the employer’s stock for these accounts.

—— 5. The Corporate Financing Department considers options or warrants that are exercisable below the POP as unreasonable compensation only if they have a life of more than 5 years.



—— 6. Reimbursement of solicitation costs is considered part of the underwriters compensation package by the Corporate Financing Department.

—— 7. A foreign issuer of stock traded on the NYSE must file an 8K with the SEC within 15 days of a reportable event.

—— 8. A nonaffiliated investor that acquires a 5% ownership interest in an issuer of securities must file a Form 4 with the SEC.

5. 15 FAIR DISCLOSURE (REGULATION FD)

Regulation Fair Disclosure (Regulation FD) was adopted by the SEC to curb the selective disclosure of material nonpublic information by issuers to analysts and institutional investors. Regulation FD requires that when an issuer discloses material information, it does so publicly to provide a level playing field.

Regulation FD also addressed the intentional and unintentional disclosure of material, nonpublic information. Whenever an issuer (or any person acting on its behalf) discloses material, nonpublic information to any person outside the issuer, the issuer must simultane-ously make public disclosure of that same information if the disclosure is intentional. In the case of unintentional disclosure, the issuer must promptly (before the start of the next trading day) make public disclosure.

Regulation FD permits issuers to make public disclosure by filing or furnishing a Form 8-K with the Commission or by disseminating information “through another method (or combina-tion of methods) of disclosure that is reasonably designed to provide broad, non-exclusionary distribution of the information to the public.” Public conference calls, press releases, and web-casts are allowable, Regulation FD-compliant, methods of public disclosure.

5. 16 REGULATION FD COMPLIANT METHODS OF DISCLOSURE

Regulation FD compliant methods of disclosure include any of the following, or combina-tion of the following:

■ A broadly disseminated press release ■ Filing a Form 8-K, 10-Q, or 10-K with the SEC ■ Widely available, non-exclusionary conference calls ■ Press conferences or webcasts with adequate notice that are freely accessible ■ Company websites

Companies must provide disclosures so that clear information is readily available to readers.



✓T A K E N O T EFor information to be considered public, ensure that the website is widely known

and a recognized channel of distribution. Give investors a reasonable waiting period to react to the information.

5. 17 SARBANES-OXLEY ACT

The Sarbanes-Oxley Act of 2002, sometimes referred to as SOX, was enacted in response to a number of major corporate and accounting scandals, including Enron and WorldCom. This legislation established enhanced standards for all U.S. public company boards, manage-ment, and public accounting firms. Among other things, SOX created the Public Company Accounting Oversight Board (PCAOB) to oversee, regulate, inspect, and discipline account-ing firms in their roles as auditors of public companies. SOX also covers issues such as audi-tor independence, corporate governance, internal control assessment, and enhanced financial disclosure.

Section 302 of SOX addresses internal control certifications. The principal executive offi-cer and the principal financial officer must certify that they have reviewed all periodic finan-cial reports, such as the 10-K and the 10-Q, that they do not contain any material untrue statements or omissions of material facts, and that they have evaluated their internal controls within the previous 90 days and have reported on their findings.

Section 401 of SOX addresses disclosure in periodic reports, focusing on the require-ment that financial statements include all material off-balance sheet liabilities, obligations, or transactions.

Section 402 of SOX requires enhanced conflict of interest provisions. The major result of this section is the prohibition of personal loans to executives. Loans for home improve-ments and securities purchases on margin are examples of several limited exceptions to the prohibition.

Section 403 of SOX requires that, within 10 days of becoming an officer, director, or greater than 10% shareholder of a publicly traded issuer, such person must file with the SEC a statement as to his/her ownership of the common stock of the issuer.

Section 404 of SOX requires issuers to publish information in their annual reports con-cerning the scope and adequacy of their internal accounting controls. Independent account-ing firms, in the same report, must attest to, and report on, their assessment of the effectiveness of the issuer’s internal controls.

5. 18 FAIRNESS OPINIONS (FINRA RULE 5150)

FINRA Rule 5150 requires specific disclosures related to conflicts of interest, which could arise when a member firm provides a fairness opinion in connection with mergers, acquisi-tions, or the purchase of assets. Fairness opinions express a conclusion as to whether the con-



sideration offered in a transaction is within the range of what would be considered fair. In a fairness opinion, a member firm is required to disclose:

■ if the firm has acted as a financial advisor to any party to the transaction and, if applicable, that it will receive compensation that is contingent upon the successful completion of the transaction;

■ any material relationships that existed during the past two years with any party involved in the transaction and whether any compensation was or will be received as a result of the relationship;

■ if any information that formed a basis for the opinion was supplied to the firm by the party requesting the opinion and whether this information was independently verified;

■ if the fairness opinion was approved or issued by a fairness committee; and ■ whether the fairness opinion expresses a view about the fairness of the amount or nature

of the compensation to any of the company’s officers or directors relative to the compensa-tion to the public shareholders of the company.

A member firm that issues fairness opinions must have procedures in place regarding the circumstances in which it will use a fairness committee to approve or issue a fairness opinion. Procedures must include the process for selecting personnel to be on the committee, the nec-essary qualifications for such persons, and the process to promote a balanced review by the committee. In other words, the committee should include persons who did not serve on the deal team.

5. 19 HART SCOTT RODINO (HSR)

This Act (HSR) is an amendment to the antitrust laws and requires both parties to an intended acquisition or merger to file information on the proposed transaction with the FTC and the Department of Justice. Upon filing, a 30-day waiting period (15 days for all-cash trans-actions) ensues during which time the FTC and the Department of Justice makes a determina-tion as to whether the proposed transaction violates antitrust laws.

It is unlawful to close the transaction during the waiting period. Although the waiting period can be as long as 30 days, the FTC may request additional time to review the informa-tion presented. On the other hand, the filing parties may request that the waiting period be terminated early if there are no obvious impediments to the deal.

✓T A K E N O T EThe filing requirement is triggered only if the value of the transaction exceeds

certain dollar thresholds, which are adjusted upward over time. As of 2014, a filing is required if the value of the transaction exceeds a $75.9 million threshold.

Related to HSR is Regulation M-A, which has been designed to provide guide-lines to companies involved in tender offers as well as mergers and acquisitions. Among other things, it requires that a summary term sheet be provided to investors as part of the disclosure process. The summary term sheet must be on the first or sec-ond page of the disclosure document and must contain the material facts about the proposed transaction in bullet format.



✓T A K E N O T ERegulation M-A is part of Regulation S-K, which defines rules for all financial

reports filed with the SEC.

5. 20 RESEARCH REPORTS

The SEC defines a research report as a client communication, distributed to at least 15 persons, that analyzes individual securities and provides information on which to base an investment decision. All research reports, at minimum, must make the following disclosures:

■ Market price at date of report ■ If the member is a market maker in the security being recommended ■ If a control relationship exists between the member and the issuer of the security being

recommended (e.g., an officer of the member sits on the issuer’s board of directors) ■ If the member or its officers have a financial interest in any of the recommended issuer’s

securities and the nature of the interest (a member that discloses that it owns 1% or more of any class of common equity securities of the recommended issuer is deemed to be in compliance with the requirement to disclose its financial interest)

■ If the member was a manager or co-manager of any offering of the issuer within the last 12 months (selling group participation is not disclosed)

■ The member also must provide, or offer to furnish on request, additional information sup-porting the recommendation

In addition, member firms may show the price history of the recommended security. If shown, the member must show price performance for at least 12 months prior. Further, the member may show past recommendations in its research reports. If it does, however, it can only show recommendations it has made of comparable companies, and it must show all com-parable recommendations made within the last 12 months.

Spot Checks. As a final check on a member’s compliance with FINRA rules on com-munications with the public, FINRA, at any time, can spot-check a member’s records.

5. 20. 1 INVESTMENT ANALYSIS TOOLS (FINRA RULE 2214)

FINRA’s communications and disclosures rules generally prohibit members from making predictions regarding investments. However, with the availability of technological tools that use a formula to calculate the probability of different outcomes given a particular investment or strategy, FINRA now permits the use of investment analysis tools under certain circumstances.

To offer such tools, a member must provide the following to customers: ■ A description of the criteria and methodology used ■ A statement that results may vary with each use and over time ■ A description, if applicable, of the universe of investments used in the analysis ■ A statement that the outcomes projected by the tool are hypothetical in nature and are

not guarantees of future results



Furthermore, members that offer or intend to offer an investment analysis tool must pro-vide FINRA with access to the tool within 10 days of first use (postfiling). If the tool is offered exclusively to institutional investors, the filing requirement does not apply.

5. 20. 2 RESEARCH ANALYST CONFLICTS OF INTERESTNASD Rule 2711 (Proposed FINRA Rule 2241) is intended to improve the objectivity

of research reports and provide investors with more useful and reliable information when mak-ing investment decisions. Members must take steps to ensure that all research reports reflect an analyst’s honest view and that any recommendation is not influenced by conflicts of interest, such as investment banking business with the issuer.

If a member issues a report or a research analyst renders an opinion that is inconsistent with the analyst’s actual views regarding a subject company, FINRA considers such action to constitute a fraudulent act and conduct inconsistent with just and equitable principles of trade.

Members, which are subject to this rule, must adopt WSPs that ensure compliance. A senior officer of a member must electronically attest annually to FINRA by April 1 of each year that it has adopted and implemented those procedures and that the compensation of each research analyst was reviewed and approved and the basis for the compensation was documented.

5. 20. 3 CONTACT BETWEEN RESEARCH ANALYSTS AND INVESTMENT BANKING PERSONNEL

To prevent conflicts of interest between the delivery of research and activities of the firm’s investment banking department, the rules require the following:

■ Prohibit investment banking personnel from supervising or controlling research analysts and from influencing analysts’ compensation

■ Bar investment banking personnel from discussing research reports with analysts prior to issuance; investment bankers cannot approve research reports

■ Preclude firms from tying analyst compensation to specific investment banking transac-tions

■ Preclude analysts from becoming involved in any effort to solicit investment banking busi-ness from existing or prospective clients

■ Prohibit analysts from participating in a road show relating to an investment banking transaction

✓T A K E N O T EInvestment banking personnel may review a research report before issuance only

to verify the factual accuracy of information in the report and to identify any potential conflicts of interest. However, any communication in this regard between investment bankers and analysts must be made through a legal or compliance official of the member firm.



5. 20. 4 LIMITATIONS ON CONTACTS BETWEEN RESEARCH ANALYSTS AND ISSUERS

The new rules prohibit the use of research reports and ratings to influence issuer decisions regarding securities offerings. Specifically, the new rules prohibit analysts from:

■ sharing draft reports with issuers for any reason other than fact checking (a firm’s legal or compliance department must approve any changes suggested by the issuer);

■ sharing with the issuer information on the price target, proposed rating, or the research summary; and

■ offering or threatening to withhold favorable ratings as inducement for future investment banking business.

5. 20. 5 QUIET PERIODSA member firm, acting as manager or co-manager of a securities offering, may not publish

research nor may an analyst make a public appearance regarding the subject company for 40 days following an initial public offering (IPO), or for 10 days following an additional issue offering.

There are two exceptions to the quiet periods rule. ■ If there is a significant news event affecting the subject company, firms may issue a research

report and analysts may make a public appearance during the applicable quiet period pro-vided they are authorized to do so by a legal or compliance department official.

■ If the subject company is an actively traded security as defined in Regulation M, SEC Rule 139 allows research to be issued and public appearances to be made during the 10-day quiet period applicable to additional issue offerings (discussed further in the investment banking Unit).

The Jumpstart Our Business Startups Act (or JOBS Act) is intended to facilitate capital formation for emerging growth companies (EGC). (An EGC has a total annual gross revenues of less than $1 billion.)

Essentially, the Act prohibits the SEC and FINRA from adopting a rule in connection with an IPO of an EGC that restricts, based on functional role, which AP of a broker-dealer may arrange for communications between an analyst and a potential investor. In addition, the Commission may not prohibit a securities analyst from participating in communicating with the management of an EGC that is also attended by any other AP of a broker-dealer whose functional role is other than as securities analyst.

Furthermore, the SEC may not prohibit a broker-dealer from publishing or distributing any research report or making a public appearance within any prescribed time period following the IPO date of the emerging growth company.

5. 20. 6 REQUIRED DISCLOSURES IN RESEARCH REPORTS AND PUBLIC APPEARANCES

To ensure that the investing public receives objective information, the rules require: ■ firms to clearly explain their rating systems, use rating terms according to their plain mean-

ing, note the percentage of all ratings that they have assigned to each category (e.g., buy/sell/hold), and document the percentage of investment banking clients in each category;

■ analysts to disclose if their compensation is tied to the firm’s investment banking revenues;



■ disclosure in analyst’s research reports and public appearances if they or any member of their households have a financial interest in the subject security, and if their employer firms owned 1% or more of any class of a subject company’s equity securities at the close of the previous month;

■ research reports to disclose if, within the last 12 months, the firm has received fees for investment banking services from or managed or co-managed a public offering for a com-pany that is the subject of a research report (they also must disclose if the firm expects to receive or intends to seek in the three months following publication of a research report, any investment banking fees from any company that is the subject of a report); and

■ disclosure if the subject company is or was during the 12 months before issuance of the report, a client of the member.

5. 20. 7 RESTRICTIONS ON PERSONAL TRADING BY ANALYSTS AND RELATED PERSONS

The new rules impose restrictions on trading activity by analysts that prepare research and their household members. The new rules prohibit analysts and members of their households from:

■ investing in a company’s securities either (1) prior to the company’s initial public offering if the company is in the business sector covered by the analyst, or (2) for 30 days before and 5 days after the analyst issues a research report on the company or changes a rating or a price target on the company; and

■ ntrading against the analyst’s most recent recommendation.

5. 20. 8 BOOSTER SHOTS

In public offerings, officers of the issuing company often buy shares at the public offering price. These shares are subject to a lock-up period (e.g., 12 months) during which the officers, directors, and issuer-directed shareholders are prohibited from selling the shares acquired in the offering. They are free to sell their shares once the lock-up period ends, following an announcement by the book-running manager to the issuer and the general public through a major news service at least two business days prior to the release of the stock that the lock-up period is over.

To create a more favorable selling environment for the insiders, the underwriters would sometimes issue research reports (booster shots) at the end of the lock-up period. The officers would reciprocate by directing investment banking business to the firm(s) issuing booster shot research reports. To curb this activity, firms that acted as manager or co-manager of a securities offering may not publish a research report or make a public appearance for 15 days before and 15 days after the expiration of the lock-up period. Due to the JOBS Act, FINRA is expected to withdraw the booster shot restrictions for companies that have less than $1 billion in revenue ahead of their IPOs. Check with your instructor for the latest information about this evolving law and accompanying rules.



5. 20. 9 TERMINATION OF COVERAGE

If a member firm intends to terminate its research coverage of a subject company, notice of coverage termination must be made. The member must publish a final research report on the company that must be comparable in scope and detail to prior reports and must include a final recommendation or rating. If it is not practical to produce a comparable report with a final recommendation or rating (e.g., the analyst covering the company has left the firm), the final research report must disclose the member’s rationale for its decision to terminate coverage.

5. 20. 10 SUPERVISORY PROCEDURES

Each member firm must adopt written supervisory procedures to ensure that the firm and its employees are in compliance with FINRA Rule 3130. Further, each member must attest annually that it has adopted and implemented these procedures. The annual attestation must be made by a senior officer of the member and must specifically address the compensation of research analysts, which is summarized as follows.

■ Compensation cannot be tied to a specific investment banking transaction. ■ A committee that reports to a member’s board of directors must review and approve at

least annually the compensation of research analysts (investment banking personnel are prohibited from serving on the committee).

■ The committee must document in writing the basis on which each analyst’s compensation was established. Factors the committee must consider include the quality of the research produced, the correlation between an analyst’s recommendations and stock price perfor-mance, and the overall ratings received from clients, independent rating services, and the member’s sales force.

5. 20. 11 THIRD-PARTY RESEARCH

If a member distributes research produced by a nonmember affiliate, such as a foreign broker-dealer or an independent third party, it must accompany the research with third-party research disclosures, if applicable. These disclosures are the same as those required if the report had been prepared by the member. For example, is the distributing member a market maker in the stock? Has the distributing member received investment banking compensation from the subject company within the past 12 months?

✓T A K E N O T EThe disclosure requirements do not apply to research reports prepared by an in-

dependent third party that the member makes available to its customers upon request or through a member-maintained website. Also note that it is acceptable for an issuer to pay an independent third party to prepare a research report if the disclosure of payment is made.



5. 20. 12 ANALYST CERTIFICATION (SEC REGULATION AC)

Regulation AC requires member firms to include in research reports a statement by the analyst certifying that the views expressed accurately reflect the analyst’s personal views and a statement indicating whether the analyst’s compensation was or will be related to views in the research report.

Further, firms must prepare and maintain records relating to public appearances by research analysts. Within 30 days after each calendar quarter, firms must make a record that includes a statement by the analyst that the views expressed in all public appearances during the quarter reflected the analyst’s personal view at that time. The record also must include a statement by the analyst that no part of his compensation was or will be related to the views expressed.

If the firm does not obtain these statements, it must notify its examining authority. In addition, for 120 days thereafter, the firm must disclose in any research report it distributes authored by that analyst that the analyst did not provide the required certification.

✓T A K E N O T ERegulation AC applies to research of any type (equity, fixed income, et cetera).

5. 20. 13 INVESTMENT BANKING QUARTERLY REPORTS

A member firm that has, as a line of business, investment banking services must file with FINRA written reports signed by a senior officer within 10 business days of the end of each cal-endar quarter describing each internal investigation initiated in the previous calendar quarter. The report must include the date each internal investigation began, the status of each open internal investigation, the resolution of any internal investigation reached during the previous calendar quarter and, with respect to each internal investigation, the identity of the security, trades, accounts, associated persons of the member, or associated person of the member’s fam-ily members holding an account under review. The firm must also include a copy of the mem-ber’s policies and procedures.

If a violation of the 1934 Securities Exchange Act is uncovered during the review, the firm must, within five business days of completion of an internal investigation, file a written report detailing the completion of the investigation, including the results of the investigation, any internal disciplinary action taken, and any referral of the matter to any regulatory authority.



U N I T T E S T

1. For an additional issue offering in which the sub-ject security is quoted on the OTCBB, an inter-dealer quotation system, the prospectus delivery requirement period isA. 25 daysB. 40 daysC. 60 daysD. 90 days

2. The Securities Exchange Act of 1934 applies to all of the following EXCEPTA. regulation of new issuesB. registration of broker-dealersC. use of credit on the purchase of securitiesD. secondary market trading

3. Which of the following securities are exempt from registration under the Securities Act of 1933? I. U.S. government securities II. Municipal bonds III. AAA rated corporate bonds IV. AAA rated preferred stockA. I and IIB. I, II, and IIIC. II and IVD. I, II, III, and IV

4. Under FINRA rules on underwritings, an affiliated relationship exists between a member firm and an issuer if the ownership interest between the two equalsA. 5% or moreB. 10% or moreC. 15% or moreD. 20% or more

5. Records of each suitability determination made in connection with the sale of a member’s securities must be retained forA. 3 yearsB. 5 yearsC. 6 yearsD. the life of the account

6. The Securities Act of 1933 applies to all of the following EXCEPTA. registration of new issuesB. regulation of insider tradingC. full and fair disclosureD. prospectus preparation

7. Standby purchasers are not subject to FINRA Rule 5130 provided I. the standby arrangement is disclosed in the

final prospectus II. the standby arrangement is in writing III. the syndicate manager represents, in writing,

that it was unable to find any other purchasers for the securities

IV. the securities are locked up for 3 monthsA. I, III, and IV B. II and III C. II and IV D. I, II, III, and IV

8. Securities Act Rule 144 addresses the sale ofA. letter stockB. control stockC. both A and BD. neither A nor B

9. If there is a restricted period under Regulation M, a syndicate member that is not a market maker is prohibited from all of the following EXCEPTA. purchasing the subject securityB. executing an unsolicited order for the subject

securityC. inducing the purchase of the subject securityD. making a bid for the subject security

10. The winning bid in a competitive offering is the one that provides the issuer withA. the lowest couponB. the smallest spreadC. the highest offering priceD. the lowest net interest cost



11. All of the following events would be reported on Form 8-K by a Nasdaq issuer EXCEPTA. the issuance of unregistered shares under

Regulation SB. a change in executive officersC. a major acquisitionD. a change of 5% or more in the number of

shares outstanding

12. An overallotment provision in an underwriting agreement must be disclosed in A. the prospectusB. the registration statementC. both A and BD. neither A nor B

13. Under SEC Rule 10b-13, a company that is the target of a tender offer must provide its sharehold-ers with a statement indicating acceptance or rejection of the offer within how many business days of the announcement?A. 5B. 10C. 15D. 20

14. Prior to placing a stabilizing bid, SEC Rule 104 requires that the syndicate managerA. notify Nasdaq as to whether the bid will be a

penalty bid or a penalty-free bidB. provide Nasdaq with a copy of the cover page

of the prospectusC. advise Nasdaq as to whether the syndicate will

engage in any short coveringD. all of these

15. Under the SEC Rule 415, a shelf registration, once effective, allows an unseasoned issuer to sell secu-rities for up to how long from the effective date?A. 6 monthsB. 12 monthsC. 18 monthsD. 2 years

16. An offering in which an underwriter uncondition-ally agrees to purchase all shares not subscribed to by shareholders in a rights distribution is termedA. a standby underwritingB. a shelf underwritingC. an all-or-none underwritingD. a secondary offering

17. All of the following items of compensation would be considered unreasonable by the Corporate Financing Department EXCEPTA. an overallotment option of 15%B. any freely transferable stockC. any options exercisable below the public

offering priceD. any right of first refusal for future offerings

with a life of more than 3 years

18. Which of the following are defined as securities? I. Fixed annuities II. Variable annuities III. Investment companies IV. CDs insured by the FDICA. I and IIIB. I and IVC. II and IIID. II and IV

19. A Schedule 13-D filing is made when I. an unaffiliated entity acquires a 5% or more

interest in an issuer II. an insider acquires a 5% or more interest in

the employing issuer’s securities III. an investment company acquires a 5% or more

interest in an issuerA. I onlyB. I and II C. II and III D. I, II, and III



20. Under SEC Rule 10b-18, a safe harbor is provided to an issuer buying back its own stock in the open market if the issuer I. is not involved in the first transaction of the

day II. is not involved in any purchase during the last

half-hour of trading III. does not effect any block purchases IV. does not effect any trades with institutionsA. I and II B. I, III, and IV C. II and III D. I, II, III, and IV

21. Under SEC Rule 103, once a passive market maker reaches or exceeds its daily net purchase limit, the market maker mustA. seek an excused withdrawal for the remainder

of that trading dayB. notify Nasdaq and execute subsequent trades

as an agentC. move its quotes away from the inside marketD. adjust its quote size to 1 × 1

22. The Trust Indenture Act of 1939 applies to I. corporate bonds II. corporate stock III. sold interstate IV. sold intrastateA. I and IIIB. I and IVC. II and IIID. II and IV

23. Under SEC Rule 10b-13, all of the following would be prohibited from tendering shares EXCEPT A. an investor long call optionsB. an investor short against the boxC. an investor short stockD. an investor long stock

24. An underwriting that provides a floor and a ceiling on the number of shares an issuer is willing to sell is termedA. best effortsB. mini-maxC. standbyD. firm commitment

25. Under SEC Rule 104, stabilization is permitted in I. fixed price offerings II. at-the-market offerings III. firm commitment offerings IV. best effort offeringsA. I, II, and III B. I and III C. II, III, and IV D. II and IV

26. All of the following offerings must be filed with FINRA’s Corporate Financing Department EXCEPTA. direct participation programsB. rights offeringsC. offerings in which a member firm is going

publicD. unit trusts

27. Under Regulation D, all of the following are ac-credited investors EXCEPT A. an officer or director of the issuerB. an institutionC. an individual with a net worth of $500,000D. an individual with annual income of $200,000

for the past two years.

28. A single offer or sale to a nonresident would void the exemption provided byA. Rule 144B. Rule 147C. Regulation A+D. Regulation D



29. A U.S. company wishes to raise additional capital through the issuance of a $750 million ongoing non-convertible debenture offering relying on a safe harbor from registration and without a quali-fied indenture. The sales of these securities will be conducted privately with the assistance of an agent who will place the securities with qualified institutional buyers only. Which of the following statements is TRUE?A. The agent is required to submit the

underwriting agreement and AAU to FINRA’s Corporate Financing Department for analysis of compensation.

B. The agent is required to submit through the FINRA Firm Gateway any and all sales documents, such as the PPM, within 15 days of the first sale.

C. The issuer is required to submit to the SEC a Form D within 15 days of the first sale of the securities.

D. The QIBS who buy these securities are prohibited from reselling them to any other person during the Rule 144 holding period.

30. An underwriter will act as an agent in all of the following offerings EXCEPTA. standbyB. best effortsC. mini-maxD. all-or-none




1. B. The prospectus delivery requirement periods in the aftermarket are as follows: for IPOs, 90 days if the security is non-Nasdaq and 25 days if the security is to be listed or quoted over Nasdaq. For additional issues, there is no requirement to deliver a prospectus in the secondary market if the security is listed or on Nasdaq. Once the distribution is complete, there is no further obligation to deliver a prospectus. If the security is non-Nasdaq, the prospectus delivery requirement period is 40 days.

2. A. The Securities Act of 1933 addresses new issues. The Securities Exchange Act of 1934 created the SEC, required the registration of broker-dealers, exchanges, and SIPs, empowered the Federal Reserve to control the extension of credit on securities transactions, and created rules dealing with secondary market trading. The Securities Act of 1933 addresses the primary (new issue) market, while the Securities Exchange Act of 1934 addresses the trading market.

3. A. Exempt securities include U.S. governments, U.S. government agency securities, and municipal securities. Corporate securities are nonexempt and must be registered with the SEC prior to public sale.

4. B. If there is a 10% or more ownership interest between a member firm and an issuer, an affiliated relationship is said to exist between the two. This means that in an IPO, the member would have to engage an independent qualified underwriter if it were underwriting shares of the affiliated issuer.

5. A. In recommending the purchase of its employer’s stock to customers, registered representatives of the member going public must make certain that all buyers are suitable. Written records of each suitability determination must be retained for 3 years.

6. B. The regulation of insider trading is covered under the Securities Exchange Act of 1934. The Securities Act of 1933 addresses new issues and related disclosures.

7. D. If the issue is not moving well, the syndicate manager may allow standby purchasers, individuals, or firms who would otherwise be restricted under FINRA Rule 5130, to buy at the offering price. Securities purchased in a standby arrangement are not subject to FINRA Rule 5130 provided the arrangement is disclosed in the final prospectus, the arrangement is in writing, and the syndicate manager represents in writing that it was unable to find any other purchasers for the new issue. Securities purchased pursuant to a standby arrangement are subject to a 3-month lockup.

8. C. Rule 144 addresses the sale of unregistered (letter) stock as well as the sale of control stock.

9. B. Under Regulation M, a syndicate member in an additional issue offering is prohibited from purchasing, making a bid for, or inducing the purchase of the subject security during the restricted period. Executing unsolicited orders is permitted.

10. D. In competitive underwritings, the winning bid is the one that provides the issuer with the lowest net interest cost.

11. D. Form 8-K is used to report newsworthy events to the SEC; the issuance of unregistered shares under Regulation S, a change in executive officers, and a major acquisition are all newsworthy events that would be reported on Form 8-K. A change of 5% or more in the number of shares outstanding would be reported to the SEC on Form 10-C.



12. C. Any overallotment provision (green shoe clause) must be disclosed in both the registration statement and in the prospectus. The green shoe must be executed within 30 days.

13. B. Once a tender offer is announced, the target company, within 10 business days of the announcement, must provide its shareholders with a statement indicating acceptance or rejection of the offer and the reasons for the position taken.

14. D. Prior to placing a one-sided stabilizing bid, the manager notifies Nasdaq of its intention to place the bid and provides Nasdaq with the following information: whether the bid will be a penalty bid or a penalty-free bid, a copy of the cover page of the prospectus, and whether the syndicate will engage in any short covering (buying back in the secondary market to cover short sales made at the public offering price).

15. D. Once effective with the SEC, a shelf registration is good for 2 years. This allows unseasoned issuers who are looking for a window of opportunity to have an effective registration in place if and when the window opens.

16. A. A standby offering is one in which the underwriter stands by and waits the outcome of a rights distribution. If all the rights are not exercised, the underwriter, on a firm commitment basis, will purchase those shares not subscribed to by shareholders.

17. A. The CFD considers the following to be unreasonable compensation: options or warrants exercisable below the POP; options or warrants with a life of more than 5 years; any freely transferable stock (any stock received by the underwriters must be restricted for resale for 6 months); any right of first refusal for future underwritings that has a duration of more than 3 years from the effective date; and any overallotment option (green shoe) that allows the underwriters to purchase more than 15% of the shares being registered from the issuer.

18. C. A security is any investment for profit with management performed by a third party. In addition, an element of risk must be present. Fixed annuities are not considered securities, because return is guaranteed by the insurance company issuer. Similarly, CDs are insured, thereby eliminating risk and guaranteeing a return.

19. A. Schedule 13-D is made when an unaffiliated entity acquires a 5% or more interest in an issuer. Investment companies would file Schedule 13-G. Insiders would file Form 4.

20. A. If the issuer does not affect the opening or closing of the security, the issuer is in compliance with SEC Rule 10b-18. Block purchases are permitted, as are trades with institutions. Note that for actively traded issues, its safe harbor extends to 10 minutes prior to close.

21. A. Once a passive market maker reaches or exceeds its net daily purchase limit (30% of its ADTV), the firm must seek an excused withdrawal for the remainder of the trading day.

22. A. The Trust Indenture Act of 1939 applies to corporate bond issues, sold interstate, where the dollar amount to be sold is $5 million or more. The act requires issuers, prior to issuance, to appoint a trustee whose job is to protect the bondholders.

23. D. To tender stock, a customer must be long the stock. Being long call options does not satisfy this requirement unless the customer has issued exercise instructions. If a customer is short against the box, the customer’s net position is zero.

24. B. A mini-max offering is a form of best efforts with a floor (minimum) and a ceiling (maximum) on the number of shares the issuer is willing to sell.

25. B. Stabilization is only permitted for fixed price offerings underwritten on a firm commitment basis. At-the-market offerings are those other than fixed-price offerings.



26. D. Nonconvertible debt and nonconvertible preferred stock offerings are exempt if they are rated as investment grade. Also exempt are Regulation D offerings, U.S. government and agency securities, municipal securities, mutual funds, and unit trusts.

27. C. Accredited investors include institutions, individuals with a net worth of $1 million or more excluding the value of the primary residence, individuals with annual income of $200,000 or more, and officers and directors of the issuer.

28. B. Rule 147 offerings (intrastate offerings) can only be made to residents of the state where the issuer resides.

29. C. The issuer may offer unregistered securities privately under Regulation D. Because the amount is $750 million, the firm’s reliance on an exemption from registration provided under Section 4(2) of the Securities Act of 1933 would be found under Regulation D Section 506, which permits a theoretically unlimited amount of capital to be raised. The Form D notice must be filed by the issuer with the Commission within 15 calendar days from the first sale. The QIB purchasers are exempt from any holding period due to their reliance on Rule 144A if the QIB restricts re-sales to other QIBs. Because these securities are offered privately and only to QIBs, they are exempt from FINRA Rule 5123 and the requirement to submit underwriting documents under FINRA Rule 5110 to the Corporate Financing Department.

30. A. A standby underwriting is done on a firm commitment (principal) basis. Best efforts, mini-max, and all-or-none underwritings are done on an agency basis.




Quick Quiz 5.A

1. D.

2. E.

3. A.

4. C.

5. B.

Quick Quiz 5.B

1. C.

2. D.

3. G.

4. F.

5. E.

6. M.

7. H.

8. I.

9. J.

10. L.

11. K.

12. B.

13. A.

Quick Quiz 5.C

1. F. Checks received from customers during the waiting period must be returned.

2. F. Buyers of new issues must receive a final prospectus at or prior to the confirmation of sale.

3. F. Coordination is available to first-time issuers. Information is filed with the state and SEC concurrently. The security becomes effective in the state when released by the SEC.

4. T.

5. F. The prospectus delivery requirement for IPOs that are to be listed or quoted in Nasdaq is 25 days.

6. T.

7. F. An exception applies to employees of members engaged solely in the sale of investment company securities and DPPs.

8. F.

Quick Quiz 5.D

1. B.

2. C.

3. D.

4. E.

5. A.

Quick Quiz 5.E

1. D.

2. A.

3. G.

4. C.

5. B.

6. F.

7. F.

8. H.

9. I.

10. F.



Quick Quiz 5.F

1. F. A tender offer must remain open for at least 20 business days from the date the terms were announced.

2. F. For the purposes of the short tender rule, customers are considered long stock only if they have issued exercise instructions for calls, rights, or warrants.

3. T.

4. T.

5. F. Options or warrants exercisable at a price below the POP are unreasonable compensation regardless of their duration. Options or warrants also are considered unreasonable compensation if their life is more than 5 years.

6. T.

7. F. Form 8-K must be filed by domestic issuers only.

8. F. Nonaffiliated investors must file a Schedule 13D within 10 days when they acquire a 5% or more beneficial ownership interest in an issuer of securities. Form 4 is filed by insiders of the issuer to report an ownership change and must be filed within 2 business days of any change.


413

TRADING CYCLEMany who sit for the Series 24 exam have worked in the securities business for years, even

decades. That said, it is more the rule than the exception that most aspiring General Securities Principals have little to no hands-on trading experience. It might be useful to delineate the basics of trading in order to put the topic into perspective before tackling the Trading and Market Making Unit of the LEM. We will also touch on a few of the key regulatory concerns pertaining to trading. This is a back-to-basics review, so we’re limiting this discussion to only long sales of equity securities.

Retail equity trading is largely automated; much of it happens in real time. Here, in slow motion, are the basic steps involved.

First: Customer places an order with a broker-dealer. Second: It is then checked and validated.Third: It is routed and executed.Fourth: It is reported.Fifth: It is then processed and settled.

Let’s take a look now at these steps in more detail starting with placing an order.

1. THE ORDER

A customer order may be placed through a live phone conversation, in person, by email (if acceptable to the BD), or through an online system provided by the firm. Voicemail orders are rarely, if ever, accepted. An individual customer order is called a retail order. Orders from an institution are called wholesale, or institutional, orders.

For example, Mrs. Lee is looking to add an addition to her home. She concludes that the best way to fund this project is to sell some of her stock. She calls her broker and places the sell order.

Equity orders are priced at either the BID or the ASK. The bid price is what an industry buyer such as a broker-dealer is willing to pay for a stock that’s being sold by the customer. The ask/offer is the price a BD is willing to sell the security at (i.e., the sale price).

From the customer’s point of view, the stock is sold for the bid price and bought at the ask/offer. If the market were 40.30–40.33, Mrs. Lee could expect to receive $40.30 per share less a commission or a markdown.

Here’s where it begins to get a bit dicey. Exchange-listed securities trade on an inter-market basis. That means, stocks often trade not only on the exchange where it is listed but also on other exchanges that have unlisted trading privileges (UTP) or in the OTC market. As a result, there are many different prices put up from those different exchanges and markets. There isn’t just one bid or ask price. This would be massively complicated if it were not for the services of a SIP—Securities Information Processor. The SIP (there are only three of them) gather and consolidate all the information pouring in from the participants (such as Nasdaq or NYSE MKT) and come up with the best bid and offer (i.e., the NBBO, National Best Bid and Offer). That information is then disseminated.

Appendix A


414 Appendix A

Here’s the takeaway: The three SIPs in the United States that collect, consolidate, and disseminate all price and trade data from our 11 stock exchanges come up with the NBBO. Mrs. Lee then has confidence the markets are working for her. She knows that, subject to her place in line, she’s going to receive the best price for her stock.

In late 2014, Nasdaq OMX Group won the bid to operate one of the three SIPs known as Tape C. (Its official nomenclature is the UTP Plan). It’s a tough job operating a SIP. Securities Information Processors have to be on top of their game in a big way, providing quotes in micro-seconds and having a reliable backup.

The NYSE in late 2014 experienced a glitch with its two SIPs that forced a shift of opera-tions out to a backup in Chicago. Those two SIPs, known on the street as Tape A and Tape B, serve all exchange-listed securities (excluding those listed on the Nasdaq Stock Exchange); the Consolidated Tape Association provides both tapes, sometimes known as the CTA/CQ Plan. Moving to Chicago was part of the CTA’s business continuity plan.

Sometimes Nasdaq has issues, too. Not long ago, trading in Nasdaq halted due to a fail-ure of the UTP SIP. Quote dissemination broke down. Thanks to unlisted trading privileges (UTP), Nasdaq stocks trade on the NYSE MKT but only if the SIP is doing its job. A glitch in the SIP may corrupt the entire NMS quote stream.

A SIP’s contract can provide for some good revenue, but the big money comes from the sale of information to market-data providers like Bloomberg. That revenue is then divided up from the three SIPs among the exchanges. FINRA also gets a chunk. In short, the SIP is responsible to consolidate and distribute data (such as the NBBO) in real time to various media vendors. The SIP is essentially the glue that holds the $24 trillion U.S. equity markets together and satisfies a big part of the purpose SEC Regulation NMS (National Market System).

TRADING ON A PRINCIPAL OR AGENCY BASISAgencyThose broker dealers that trade on an agency basis charge commissions. There is no own-

ership risk. Mrs. Lee would likely be charged a commission.

PrincipalBDs that trade on a principal basis do so to and from their own inventory. They assume

ownership and, therefore, have inventory risk. BDs trading in this fashion are compensated in one of two ways or both.

— Buying and selling at the NBBO at the same time. This is known as “spread trading,” namely profiting from the difference between buying at the best bid and selling at the best offer. Market makers (MMs) attempt to do this by trading “the book.”

— BDs can mark a trade up or down. While most trades take place at the NBBO price, illiquid equities can be marked up or down. Some international customers may request a markup or markdown rather than a commission due to tax considerations unique to that country.

It is important to note that once an order is received from a customer, the firm generally cannot trade that security for its own account at a better price than what would satisfy a cus-tomer’s order unless that order is also immediately executed at the size and at the same price as the firm trade or better. Trading ahead of customer orders would likely be deemed a violation of the Manning Rule.

Orders placed by reps must capture the relevant order information like the symbol, trans-action type, order type, and any other qualifier. The SEC’s books and records rule requires this information be collected and can be placed manually on a paper order ticket or electronically


415Appendix A

through an online order entry system. In either case, it must be time stamped. These records must be maintained for three years; the first two years must be maintained in a readily acces-sible place.

2. CHECKED AND VALIDATED

When the order is entered, the details of it should be checked to ensure accuracy. If a stock symbol is entered incorrectly, it would likely result in a broken trade, which could cost the firm and representative not only money but loss of reputation as well. It must be checked to ensure accuracy. Account numbers and other personal account information should be checked to ensure it, too, is accurate.

A check also needs to be made to make sure the customer is authorized to enter a certain type of order. For example, clients looking to buy a stock on margin must have an account that is authorized to do so. Following a thorough check, the order is routed for execution.

3. ROUTING AND EXECUTION

Although routing can be handled nowadays with dynamic routers provided by third par-ties, ordinarily high-touch trading starts with the firm’s trading desk or department. Exactly where the order is ultimately executed depends on a variety of things, such as which market provides the most historical liquidity and improved prices or which stock market has the fast-est trade execution platform.

That last one is very important for those high-frequency traders (HFTs) who rely on very low latency for certain algorithmic trading schemes. The expression low latency is just a fancy way of saying quick trading. It’s not unusual nowadays to have a DMA (direct market access) customer enter and have executed 5,000 or 6,000 orders or more in one second. Trades are being executed and reported in microseconds. HFT customers are the most likely customers to be provided by their broker-dealer with DMA, which bypasses the firm’s trading desk. This kind of DMA trading is called low or “no-touch.” No-touch doesn’t mean no obligation; the broker-dealers still have an obligation to monitor their DMA customer’s behavior. No broker-dealer can throw its hands up and say to the regulators, “We didn’t know what they were doing.”

The desk may send an order to some exchange or to an OTC market maker. Another method is by using an ATS (alternative trading system). An ATS is a trading system (there are dozens) that is essentially an electronic system for matching buyers and sellers.

ATSs play an important role in accessing additional liquidity and speed beyond what is found in traditional stock markets. In some cases, such as trading large blocks, an ATS can protect the price. Trading away from an exchange could possibly avoid a sharp fall in the price caused by flooding the market with a lot of shares. An example of one type of ATS is a dark pool, where institutional investors may trade in large blocks without showing their hand to others, thereby avoiding market impact. Dark pools account for about 17% of the trading vol-ume in the U.S. stock market.

Apart from using an exchange, OTC market makers, or an ATS, the firm may execute internally on a principal basis or cross it with another customer order.

Many introducing firms rely on their clearing firm to help execute orders. Under FINRA’s Best Execution Rule 5310, BDs must use reasonable due diligence to obtain the most favorable prices possible in a given market for their customers.

One step to assure compliance with this rule is to assess and compare from time to time the order execution quality received with what could have been received if the order had been routed differently. The trading desk has to have a reasonable and justifiable belief that sending an order to some ATS or MM results in a generally better price than had they sent it to some other venue.


416 Appendix A

If an introducing broker relies upon its clearing firm to route orders, it is the clearing firm that must do an order execution quality assessment. However, the IB is required to confirm with its clearing firm that it is, in fact, performing the assessment in order to fulfill its own best execution responsibility.

4. REPORTING

Once the trade is made, it must be reported so price and volume information about the order can be disseminated to the investing public through the appropriate SIP.

When trades are effected on an exchange such as Nasdaq or NYSE, it’s the job of the exchange to handle the reporting through SIPs provided by the Consolidate Tape System (CTS) for the NYSE, its smaller offshoots and regional exchanges, or by Nasdaq’s UTP Trade Data Feed (UTDF).

However, if the trade is effected over-the-counter, the BD executing the trade must do the reporting. For example, if a trade were to take place in a non-NMS stock away from an exchange or effect a trade in 144A restricted securities, the report would be made through the OTC Reporting Facility (ORF). Information to be provided in the report includes

■ stock symbol, ■ number of shares, ■ time (in milliseconds), ■ price, ■ long or short sale, ■ step-in indicator (the ORF can match corresponding step-out and step-in submissions; see

your LEM for more on step-outs), and ■ linking a reversal to the original trade.

Whereas trading in NMS stocks on exchanges requires a high degree of linkage and interdependency, non-NMS takes place across a number of connected BDs that are not interdependent.

In case you forgot from your Series 7 studies, a non-NMS stock would most often be a small- or micro-cap stock, which is also called an OTC Equity Security. The expression “OTC Equity Security” is more than a mere description; it actually has a proper legal definition. They are securities NOT listed on a national securities exchange, such as NYSE and Nasdaq, or securities listed on regional exchanges, but they do not qualify for dissemination of transac-tion reports to the CTS/UTDF. An example of where one might find OTC Equity Securities being traded includes the OTCBB and OTC Pink Market. Those trades, as you now know, are reported to FINRA’s ORF system.

Other FINRA reporting facilities include the Alternative Display Facility (ADF) for OTC transactions in NMS stocks effected off-exchange and the Trade Reporting Facilities (TRFs), to which firms report OTC transactions in NMS stocks taking place off-exchange but are listed on an exchange. FINRA has established TRFs in conjunction with the pertinent exchange, namely, FINRA/NASDAQ TRF and FINRA/NYSE TRF.

The ADF serves both as a trade reporting and quotation display and collection facility for purposes of transactions in NMS stocks effected away from an exchange.


417Appendix A

FINRA Facility Type of Trades

ADF OTC transactions in NMS stocks

FINRA/NASDAQ TRF OTC transactions in NMS stocks

FINRA/NYSE TRF OTC transactions in NMS stocks

ORF

Transactions in OTC Equity Securities (i.e., non-NMS stocks such as OTCBB securities, Pink Sheets securities, ADRs, Canadian issues, foreign securities, and non-exchange-listed DPP securities) and Restricted Equity Securities

The ORF is the facility through which members report OTC transactions in OTC Equity Securities and Restricted Equity Securities.

FINRA OATS Reporting RequirementLastly, a report must be made to the Order Audit Trail System (OATS). Firms are required

to establish an electronic method for reporting to OATS. How that connection is made is beyond the scope of the Series 24. That’s an information technology specialty.

OATS reports should include: ■ order type, ■ special handling codes, ■ order receipt time, ■ execution time, ■ critical order events, ■ receipt/transfer within the firm, and ■ route outside the firm.

This all helps FINRA create a comprehensive audit trail for OTC Equity Securities as well as exchange-listed securities. Proprietary orders in OTC Equity Securities made by bona fide market makers in the stock are not subject to the reporting requirements of OATS.

When two BDs, for example, open a “conversation” using the OTC Link (an ATS oper-ated by the OTC Markets, Inc., the modern day descendent of the Pink Sheets), FINRA considers that a negotiation over the phone for purposes of OATS reporting, and negotiations are not reportable events. Only when the terms of a trade are agreed to is the new order and execution reportable, with the time the parties agreed to those terms as the order receipt time and the execution time.


418 Appendix A

*E X A M P L E The specific reporting requirements for OTC Link messages that result in an ex-ecution are as follows:

A firm is required to report all executions that are a result of the firm receiving an OTC Link message, regardless of whether the OTC Link message is sent by a mar-ket maker or a non-market maker broker-dealer. As previously noted, both the new order and execution are reportable once the terms of a trade are agreed to, with the time the parties agreed to those terms as the order receipt time and the execution time. The OATS execution report must be linked to the related trade report submitted to the ORF.

Introducing broker-dealers may have an understanding with the clearing firm that they are handling the reporting responsibilities. If so, it should be clear understanding in writing. Then verify that their trades are being reported.

5. PROCESSING AND SETTLEMENTDTCC Report (A non-media report)

Trade information is not only sent to the applicable reporting facility but it must also be sent to the DTCC for processing and settlement. DTCC debits the account of one broker-dealer and credits another. Members are not required to submit non-tape reports like these to FINRA within 10 seconds of trade execution. There is more information about the 10-second reporting rule in Unit 4.

Once the trade is executed and reported, a confirmation to the customer must be sent within one business day after the trade date. This is done by clearing firms on behalf of their correspondent IBs. Following that, the trade cycle is complete.


419

Appendix B


420 Appendix B


421

Numerical10-second update requirement As of November 4,

2013, it is required that trades in eligible securities be reported to FINRA within 10 seconds following execu-tion. See TRF.

9:30X 9:30X is the time at which the primary market dis-seminates the first print after the 9:30 am ET market open.

12(b)-1 Fee Fee assessed shareholders by an open-ended management company for promotional expenses. The fee must be registered as such with the SEC and be disclosed to investors.

AACATS See automated customer account transfer service.accredited investor As defined in Rule 501 of Regulation

D, any institution or individual meeting minimum net worth requirements for the purchase of securities quali-fying under the Regulation D registration exemption.

An accredited investor is generally one who: ■ has a net worth of $1 million or more, excluding

equity in the principal residence; ■ has had an annual income of $200,000 or more

in each of the two most recent years (or $300,000 jointly with a spouse) and who has a reasonable expectation of reaching the same income level in the current year;

■ is an officer or director of the issuer; or ■ is an institutional investor.

accretion of bond discount An accounting process whereby the initial cost of a bond purchased at a discount is increased annually to reflect the basis of the bond as it approaches maturity.

accrual accounting A method of reporting income when earned and expenses when incurred, as opposed to re-porting income when received and expenses when paid.

accrued interest The interest that has accumulated since the last interest payment up to, but not including, the settlement date and is added to a bond transaction’s contract price. There are two methods for calculating accrued interest: (1) the 30-day-month (360-day-year) method for corporate and municipal bonds, and (2) the actual-calendar days (365-day-year) method for govern-ment bonds. Income bonds, bonds in default, and zero-coupon bonds trade without accrued interest (flat).

accumulation account An account established to hold securities pending their deposit into a municipal securi-ties unit investment trust.

accumulation stage The period during which contribu-tions are made to an annuity account.

accumulation unit An accounting measure used to determine an annuitant’s proportionate interest in the insurer’s separate account during an annuity’s accumula-tion (deposit) stage.

ACES See Advanced Computerized Execution Service.ACT Automated Confirmation Transaction Service. Com-

pares trade information provided by market participants and submits locked-in trades for clearance and settle-ment. Also disseminates last sale information to the public. The FINRA/Nasdaq TRF operates on the ACT technology platform. Upload functionality for the ACT platform is available through the Nasdaq Workstation/Weblink ACT.

Act of 1933 See Securities Act of 1933.Act of 1934 See Securities Exchange Act of 1934.active, competitive market A market where no market

maker dominates trading activity and where interdealer trades occur at competitive prices.

add-on financing An issue of stock by a public company subsequent to its IPO. See follow-on offering.

ADF See alternative display facility.administrator An official or agency that administers the

securities laws of a state.ADR (American Depositary Receipt) A security

created by a U.S. bank that evidences ownership to a specified number of shares of a foreign security held in a depositary in the country of the issuing company. ADRs are nearly identical to U.S. securities and facilitate lower transaction costs as well as dividend distribution. Similar to GDR (Global Depositary Receipt), which is traded outside the United States.

Advanced Computerized Execution Service (ACES) A subscription service offered by Nasdaq that allows or-der entry firms to route orders to their preferred market makers’ internal trading systems.

ADTV The average daily trading volume of a security as calculated over the preceding four calendar weeks.

advertisement Any promotional material designed for use by newspapers, magazines, billboards, radio, television, telephone recording, or other public medium where the firm has no control over the type of individuals being exposed to the material.

Advertising Regulation Electronic Files (AREF) The web-based system for filing advertising materials with FINRA is called Advertising Regulation Electronic Files (AREF).

Glossary


422 Glossary

affiliate (1) A person who directly or indirectly owns, con-trols, or holds with power to vote 10% or more of the outstanding voting securities of a company. (2) With respect to a direct participation program, any person who controls, is controlled by, or is under common con-trol with the program’s sponsor and includes any person who beneficially owns 50% or more of the equity inter-est in the sponsor. (3) Under the Investment Company Act of 1940, a person who has any type of control over an investment company’s operations, which includes anyone with 5% or more of the outstanding voting se-curities of the investment company or any corporation of which the investment company holds 5% or more of outstanding securities. See also control person; insider.

agency bond U.S.-dollar-denominated debt secu-rity issued by an agency or issued or guaranteed by a government-sponsored enterprise (GSE). Executions of agency debt is reportable to TRACE via the TRAQs website.

agency basis See agency transaction.agency transaction A transaction in which a broker-

dealer acts for the accounts of others by buying or sell-ing securities on behalf of customers. Syn. agency basis.

agent (1) An individual or firm that effects securities transactions for the accounts of others. (2) A person licensed by a state as a life insurance agent. (3) A securities salesperson who represents a broker-dealer or issuer when selling or trying to sell securities to the investing public.

algorithmic trading Algorithmic trading makes use of computer programs for entering pre-programmed trading instructions on electronic trading platforms. The algorithm, usually proprietary, has a set of auto-matic responses to many complex market conditions. Depending on the circumstances, the algorithm may generate low or ultra low latency orders. Syn. also trad-ing, black-box trading.

alternative display facility (ADF) A display-only facility that is operated by FINRA. The ADF provides FINRA members with a facility for the display of quotes (best bid and offer), trade reports, and the comparison of trades. CQS-listed securities, as well as Nasdaq-listed securities, are eligible for posting quotations through the ADF. ADF does not provide automated order routing functionality, execution facilities, or linkages between ADF trading centers.

alternative trading system (ATS) SEC-approved non-exchange trading system designed to match buyers and sellers. For example, WELX and CITICROSS. An ATS does not govern or discipline subscriber behavior. An ECN is a subset to an ATS.

American Stock Exchange A registered stock exchange that was purchased by NYSE Euronext in 2008. It was renamed NYSE Amex Equities and renamed again in May 2012 as NYSE MKT. The letters MKT are pro-nounced as individual letters. This exchange should not be confused with the NYSE Amex Options Exchange.

annuity A contract between an insurance company and an individual; it generally guarantees lifetime income to the individual on whose life the contract is based in return for either a lump sum or a periodic payment to the insurance company. The contract holder’s objective is usually retirement income.

Anti-Internalization Qualifier (AIQ) A modifier that allows market makers to execute only against the quotes of other market makers, not against their own quotes.

appreciation The increase in value of an asset.arbitrage The simultaneous purchase and sale of the same

or related securities to take advantage of a market inef-ficiency.

arbitrageur One who engages in arbitrage.arbitration The arrangement whereby an SRO, or a desig-

nated arbitration association, hears and settles disagree-ments between members. Unresolved disputes with customers also are submitted to binding arbitration.

artificial transactions Attempts to stage a hot market for a stock; such transactions are strictly prohibited. Some-times referred to as wash trading or painting the tape.

ask An indication by a trader or a dealer of a willingness to sell a security or a commodity; the price at which an investor can buy from a broker-dealer. Syn. offer.

assignment A document accompanying or part of a stock certificate that is signed by the person named on the certificate for the purpose of transferring the certificate’s title to another person’s name.

assistant representative–order processing See Series 11.

associated person of a member Any employee, manager, director, officer or partner of a member broker-dealer or other entity (issuer, bank, et cetera), or any person controlling, controlled by, or in common control with that member.

ATS See alternative trading system.auction market A market in which buyers enter competi-

tive bids and sellers enter competitive offers simultane-ously. The NYSE is an auction market. Syn. double auction market.

Automated Confirmation Transaction Service (ACT) Compares trade information provided by market participants and submits locked-in trades for clearance and settlement. Also disseminates last sale information to the public. The FINRA/Nasdaq TRF operates on the ACT technology platform. Upload functionality for the ACT platform is available through the Nasdaq Workstation/Weblink ACT.


423Glossary

Automated Customer Account Transfer Service (ACATS) An automated system that standardizes procedures for transferring assets in a customer account from one brokerage firm to another.

Automated Quotation System (Nasdaq) The Nasdaq Stock Market is a U.S. registered stock exchange pro-viding an automatic execution venue. Trade reporting for Nasdaq trades goes through the FINRA/Nasdaq Trade Reporting Facility (TRF).

Bback away The failure of an over-the-counter market

maker to honor a firm bid and asked price; this violates Conduct Rules. Syn. backing away.

balloon maturity A repayment schedule for an issue of bonds wherein a large number of the bonds come due at a prescribed time (normally at the final maturity date); a type of serial maturity.

basis point A measure of a bond’s yield, equal to 1/100 of 1% of a yield. A bond whose yield increases from 5.0% to 5.5% is said to increase by 50 basis points.

basis quote The price of a security quoted in terms of the yield that the purchaser can expect to receive.

best efforts underwriting A new issue securities un-derwriting in which the underwriter acts as an agent for the issuer and puts forth best efforts to sell as many shares as possible. The underwriter has no liability for unsold shares, unlike a firm commitment underwriting. See underwriting.

best execution The responsibility of the broker-dealer to seek the most favorable terms for the execution of client transactions.

bid An indication by an investor, a trader, or a dealer of a willingness to buy a security or commodity; the price at which an investor can sell to a broker-dealer.

blank-check company A company with no business plan. Investors have no knowledge as to how cash assets in the firm are to be spent. A highly speculative company that has the view to merge with or acquire another company. See SPAC.

blockbuster A trade that exceeds the single trade limit of a correspondent firm in the ACT system. Currently, this limit is $1,000,000. The clearing firm has 15 min-utes to accept or decline the trade. If no indication is made, the clearing firm is obligated to accept the trade.

block positioners Firms defined under the SEC Rule 3b-8 as firms that purchase long or sell short blocks of stock worth $200,000 or more.

blue-chip stock The equity issues of financially stable, well-established companies that have demonstrated their ability to pay dividends in both good and bad times.

blue-sky To register a securities offering in a particular state.

blue-sky laws Nickname for state regulations governing the securities industry coined in the early 1900s by a Kansas Supreme Court justice who wanted regulation to protect against “speculative schemes that have no more basis than so many feet of blue sky.”

bona fide quote A bid or an offer from a broker-dealer to buy or sell securities; it indicates a willingness to execute a trade under the terms and conditions accom-panying the quote.

bond A legal obligation of an issuing company or govern-ment to repay the principal of a loan to bond investors at a specified future date. Bonds are usually issued with a par or face value of $1,000, representing the amount of money borrowed. The issuer promises to pay a percentage of the par value as interest on the borrowed funds.

bookrunning manager The investment bank respon-sible for the order book including the allocation of securities. The bookrunning manager’s name appears above all other members of the syndicate on a tomb-stone advertisement. Syn. book runner.

branch office Any location identified by any means to the public as a place where a registered broker-dealer conducts business.

breaking the buck (or break the buck) Jargon used to describe the net asset value (NAV) of a money market fund falling below $1. Breaking the buck may happen if a fund leverages assets. Without outside emergency help, the investors would lose money. Those investors needing added security may choose investment grade money market funds (e.g., Moody’s Aaa-mf, Aa-mf), which have demonstrated a strong ability to meet the dual objectives of a money market fund of providing liquidity and preserving capital.

breakpoint The schedule of sales charge discounts offered by a mutual fund for lump-sum or cumulative invest-ments.

breakpoint sale The sale of mutual fund shares in an amount just below the level at which the purchaser would qualify for reduced sales charges; this violates FINRA Conduct Rules.

broker (1) An individual or firm that charges a fee or commission for executing buy and sell orders submit-ted by another individual or firm. (2) The role of a firm when it acts as an agent for a customer and charges the customer a commission for its services.

broker-dealer Person or firm in the business of buying and selling securities. A firm may act as both broker (agent) or dealer (principal) but not in the same transaction. Broker-dealers normally must register with the SEC, the appropriate SROs, and any state in which they do business.

bulge bracket (1) Members of an underwriting syndicate who appear on a tombstone advertisement. (2) The largest full-service broker-dealers in the world.


424 Glossary

bulletin board See OTC Bulletin Board.bunching orders Combining individual trade executions

at the same price for reporting purposes into a single trade report. Nasdaq no longer supports the bunched (.B) trade reports.

buy-in The procedure that the buying firm of a security follows when the selling firm fails to complete the con-tract by delivering the security. The buying firm closes the contract by buying the security in the open market and charging the account of the selling firm for transac-tion fees and any loss caused by changes in the markets.

buying power The amount of securities a margin client can buy using the special memorandum account bal-ance and without depositing additional equity. Buying power is 2 × SMA. For pattern day traders, buying power is 4 × maintenance margin excess.

buy-side Those natural or institutional persons who trade for proprietary accounts, such as mutual funds, insur-ance companies, hedge funds, pension funds, et cetera. Syn. sell-side (e.g., market makers). Some large compa-nies may both buy and sell side operations.

Ccallable bond A type of bond issued with a provision al-

lowing the issuer to redeem the bond prior to maturity at a predetermined price.

capping Placing selling pressure on a stock in an attempt to keep its price low or to move its price lower; this is manipulative.

cash account An account in which the customer is required by the SEC’s Regulation T to pay in full for securities purchased not later than two days after the standard payment period. Syn. special cash account.

cashiering department Department within a brokerage firm that delivers and receives securities and money to and from other firms and clients of the firm.

cash settlement Requires delivery of securities from the seller and payment from the buyer on the same day the trade is executed.

cash transaction A settlement contract that calls for delivery and payment on the same day the trade is executed; payment is due by 2:30 pm ET (or within 30 minutes of the trade if made after 2:00 pm ET).

C corporation A traditional and most common type of incorporated company. A “C corp” is permitted to have an unlimited number of shareholders. Used by compa-nies that require many investing shareholders and ex-pect to offer shares publicly. Shareholders are shielded from personal liability.

Chicago Board Options Exchange (CBOE) The self-regulatory organization with jurisdiction over all writing and trading of standardized options and related contracts listed on that exchange. The first national securities exchange listing and trading options.

churning Excessive trading in a customer’s account by a registered representative who ignores the customer’s interests and seeks only to increase commissions.

circuit breaker halt Occurs when all trading in Nas-daq and exchange-listed securities by member firms is halted, because extraordinary market movements cause a marketwide drop in stock prices. For example, Rules 80B and 80C of the NYSE call for trading halts based on a decline in the S&P 500 and Russell 1000 Indexes.

class A share (1) A class of mutual fund share issued with a front-end sales load. A mutual fund offers different classes of shares to allow investors to choose the type of sales charge they will pay. (2) Shares of a company that have differing characteristics from other classes of stock (e.g., Class A shares in a company offering multiple share classes may offer super voting privileges of 10 times the number of votes Class B shares may offer).

class B share A class of mutual fund share issued with a back-end load. A mutual fund offers different classes of shares to allow investors to choose the type of sales charge they will pay.

class C share A class of mutual fund share issued with a level load. A mutual fund offers different classes of shares to allow investors to choose the type of sales charge they will pay.

clearing agency An intermediary (third party) between the buy and sell sides in a securities transaction that receives and delivers payments and securities. Any or-ganization that fills this function, including a securities depository, such as the Stock Clearing Corp of Phila-delphia (SCCP) or the National Securities Clearing Corporation (NSCC).

clearing broker-dealer A broker-dealer that clears its own trades as well as those of introducing (corre-spondent) brokers. A clearing broker-dealer can hold customers’ securities and cash. Syn. carrying broker.

clearly erroneous trades Transactions in which an ob-vious error has occurred in the security’s price, number of shares, identification, or other relevant terms. Under FINRA Rule 11890, such trades may be submitted to FINRA for review. FINRA may subsequently declare the transaction null and void, adjust the terms, or decline to act on the complaint. If a party to the trade wishes to appeal the staff determination, it may seek review by the Market Operations Review Committee (MORC).

close (1) The price of the last transaction for a particular security on a particular day. (2) The midprice of a clos-ing trading range.


425Glossary

closed-end management company An investment company that issues a fixed number of shares in an actively managed portfolio of securities. The shares may be of several classes, and they are traded in the second-ary marketplace, either on an exchange or over the counter. The market price of the shares is determined by supply and demand and not by NAV. Syn. publicly traded fund.

closing range The relatively narrow range of prices at which transactions take place in the final minutes of the trading day.

CNS See Continuous Net Settlement.Code of Arbitration FINRA’s formal method of

handling securities-related disputes or clearing contro-versies between members, public customers, clearing corporations, or associated persons.

Code of Procedure (COP) FINRA’s formal procedure for handling trade practice complaints involving viola-tions of the Member Conduct Rules.

collateral Certain assets set aside and pledged to a lender for the duration of a loan. If the borrower fails to meet obligations to pay principal or interest, the lender has claim to the assets.

collateralized mortgage obligation (CMO) A mort-gage-backed corporate security. Unlike pass-through obligations issued by FNMA and GNMA, its yield is not guaranteed and it does not have the backing of any agency of the federal government. These issues attempt to return interest and principal at a predetermined rate. See also tranche.

collect on delivery (COD) See delivery vs. payment.colocation Colocation exists when a high-frequency trad-

er sets up a trading platform (computer servers) on an exchange or in very close proximity to a market center to save a small amount of time on order execution. This small savings in time, measured in sub-milliseconds, gives the trader an advantage over those traders whose servers are in distant locations. See low latency.

combined account A customer account that has long and short margin positions in different securities. Syn. mixed account.

commingling The combining by a brokerage firm of one customer’s securities with another customer’s securities and pledging them as joint collateral for a bank loan; unless authorized by the customers, this violates SEC Rule 15c2-1.

commission A service charge assessed by an agent in return for arranging the purchase or sale of a security. A commission must be fair and reasonable, consider-ing all the relevant factors of the transaction. Syn. sales charge.

commission recapture A form of institutional discount brokerage. Investment managers direct a portion of bro-kerage business to a member firm, which then rebates a portion of the commission back to the fund to pay for services, such as SIP services, accounting, and research. The rebate is paid directly to the firm as apposed to another CSA known as soft dollars. Both commission-sharing agreements are regulated under Section 28(e) of the SEA.

Commodities Futures Trading Commission (CFTC) A federal government agency that regulates commodity futures and option markets.

common stock A security that represents ownership in a corporation. Holders of common stock exercise some control by electing a board of directors and voting on changes in capital structure, such as a stock split.

competitive inactive markets Occurs when there are two or three nondominant market makers in a security with low trading activity. Contemporaneous sales to, and purchases from, other dealers are used to establish a prevailing price for markups and markdowns.

completion of the transaction The point at which a customer pays any part of the purchase price to the broker-dealer for a security he has purchased or deliv-ers a security that he has sold. If the customer makes payment to the broker-dealer before the payment is due, the completion of the transaction occurs when the broker-dealer delivers the security into the customer’s account, which is the settlement date.

compliance department The department within a bro-kerage firm that oversees the trading and market-mak-ing activities of the firm. It ensures that the employees and officers of the firm are abiding by the rules and regulations of the SEC, exchanges, and SROs.

confirmation A printed document that states the trade, settlement date, and money due from or owed to a cus-tomer; it is sent or given to the customer on or before the settlement date.

Consolidated Quotation System (CQS) A quota-tion system only providing last-sale reporting service for exchange-listed equity securities. Newly registered CQS market makers must begin entering quotes within five days.

Consolidated Tape A service of the Consolidated Tape Association (CTA), an SEC registered SIP, that deliv-ers real-time market data to subscribers as they occur on the various exchanges. The Tape distributes reports to subscribers over two different networks that the subscribers can tap into through either the high-speed electronic or the low-speed ticker lines. Network A reports transactions in NYSE-listed securities. Network B reports NYSE MKT and NYSE Arca securities trans-actions and reports of transactions in regional exchange issues.


426 Glossary

contemporaneous trader A person who enters a trade at or near the same time and in the same security as a person who has acted on inside information. The con-temporaneous trader may bring suit against the inside trader.

continuing education Firm element is required for all registered persons who have direct contact with the public; it is conducted annually. Regulatory element is required for all registered persons within 120 days of second registration anniversary and every three years thereafter.

Continuous Net Settlement (CNS) An automated book-entry (no certificates) accounting system. The system provides clearance for equities, corporate and municipal bonds, UITs, and more.

control (controlling, controlled by, under common control with) The power to direct or affect the direc-tion of the management and policies of a company, whether through the ownership of voting securities, by contract, or otherwise. Control is presumed to exist if a person, directly or indirectly, owns, controls, holds with the power to vote, or holds proxies representing more than 10% of a company’s voting securities.

control of securities A term used to indicate the respon-sibilities of a broker-dealer with regard to securities in its possession. Under the SEC’s customer protection rule, broker-dealers must maintain control over custom-er funds and securities. Securities are considered under the control of, or in the possession of, a broker-dealer if they are in the broker-dealer’s physical possession or are in an alternative location acceptable to the SEC.

control person (1) A director, officer, or other affiliate of an issuer. (2) A stockholder who owns more than 10% of any class of a corporation’s voting securities.

control security Any security owned by a director, of-ficer, or other affiliate of the issuer or by a stockholder who owns at least 10% of any class of a corporation’s outstanding securities. Who owns a security, not the se-curity itself, determines whether it is a control security.

convertible bond A debt security, usually in the form of a debenture, that can be exchanged for equity securities of the issuing corporation at specified prices or rates.

COP See Code of Procedure.coordination See registration by coordination.corporate account An account held in the name of a

corporation. The corporate agreement, signed when the account is opened, specifies which officers are autho-rized to trade in the account. In addition, a corporation must provide a copy of its charter and bylaws authoriz-ing a margin account.

corporate securities limited representative See Series 62.

correspondence Any written (including electronic) communication that is distributed or made available to 25 or fewer retail investors within any 30-calendar-day period.

CQS See Consolidated Quotation System.credit agreement A component of a customer’s margin

account agreement, outlining the conditions of the credit arrangement between broker and customer.

crowdfunding Generally, the financing of microcompa-nies through pooling of money from large numbers of unsophisticated, nonaffluent investors often through the internet.

crossed market Occurs when one market maker bids for stock at a higher price than another market maker asks for the stock.

current market value (CMV) The worth of the secu-rities in an account. The market value of listed and Nasdaq securities is based on the closing prices on the previous business day. Syn. long market value.

current report See Form 8K.CUSIP Council on Uniform Securities Identification Pro-

cedures. A CUSIP number is a unique nine character alphanumeric code appearing on the face of a security certificate that is assigned to that security by Standard & Poor’s Corporation. The CUSIP number is used to expedite clearance and settlement.

custodial account An account in which a custodian enters trades on behalf of the beneficial owner, often a minor.

custodian An institution or person responsible for making all investment, management, and distribution deci-sions in an account maintained in the best interests of another. Mutual funds have custodians responsible for safeguarding certificates and performing clerical duties.

customer Any person who opens a trading account with a broker-dealer. A customer may be classified in terms of account ownership, trading authorization, payment method, or types of securities traded.

customer agreement (margin agreement) A docu-ment that a customer must sign when opening a margin account with a broker-dealer; it allows the firm to liquidate all or a portion of the account if the customer fails to meet a margin call.

customer ledger The accounting record that lists sepa-rately all customer cash and margin accounts carried by a firm.

customer limit order protection See Manning Rule.customer protection rule See Rule 15c3-3.customer statement A document showing a customer’s

trading activity, positions, and account balance. The SEC requires that customer statements be sent at least quarterly.


427Glossary

Ddark pool Refers to a place such as Goldman Sachs’s

Sigma X, an ATS where a supply of shares exists that is not displayed for all to see. Dark pools are akin to members-only trading platforms for those desiring to execute larger trades without their interest being made known through an open book. A dark pool provides anonymity to investors and sensitivity of share prices to movement when any sizeable demand appears.

dated date The date on which interest on a new bond issue begins to accrue, usually the issue date, although the bonds may be delivered at a later date.

DEA See Designated Examining Authority.dealer (1) An individual or firm that is engaged in the

business of buying and selling securities for its own ac-count. (2) The role of a firm when it acts as a principal and charges the customer a markup or markdown. Syn. principal.

debit balance The amount of money a customer owes a brokerage firm.

debt security A security representing a loan by an inves-tor to an issuer, such as a corporation, municipality, the federal government, or a federal agency. In return for the loan, the issuer promises to repay the debt on a specified date and to pay interest.

declaration date The date on which a corporation an-nounces the amount, payment date, and record date of an upcoming dividend.

decrementation The process by which a market maker’s published quote size is automatically reduced due to executions.

defined benefit plan A qualified retirement plan that specifies the total amount of money that the employee will receive at retirement.

defined contribution plan A qualified retirement plan that specifies the amount of money that the employer will contribute annually to the plan.

delivery The change in ownership or control of a security in exchange for cash. Delivery takes place on the settle-ment date.

delivery versus payment (DVP) A transaction settle-ment procedure in which securities are delivered to the buying institution’s bank in exchange for payment of the amount due. Syn. collect on delivery (COD).

derivative An investment vehicle, the value of which is based on the value of another security. Futures, forwards, swaps, and options are among the most com-mon types of derivatives. Derivatives are generally used by institutional investors to increase overall portfolio return or to hedge portfolio risk.

Designated Examining Authority (DEA) A broker-dealer registered with the SEC has assigned a desig-nated examining authority, such as FINRA, CBOE, or another self-regulatory organization (SRO) to examine the firm’s books, records, sales practices, and so forth. A securities firm may have more than one DEA.

designated market maker (DMM) A member of the NYSE or NYSE MKT that is held accountable for maintaining a fair and orderly market. They must, among other things, quote at the NBBO a certain percentage of the time and facilitate price discovery through the trading day, at the open and close and dur-ing periods of significant order imbalance.

direct market access (DMA) Buy-side customers, such as a hedge fund, that are granted direct electronic ac-cess to trading markets (no interaction with broker; no touch). It is used to control costs and permit very fast order execution (low latency often paired with algorith-mic trading).

direct participation program (DPP) A business organized so as to pass all income, gains, losses, and tax benefits to its owners (partners), the investors; the business is usually structured as a limited partnership. Examples include oil and gas programs, real estate programs, agricultural programs, motion pictures, and cattle programs. Syn. program.

discount The amount for which a security may be pur-chased less than the principal amount or par value.

discretion Authority given to someone other than the beneficial owner of an account to make investment decisions for the account concerning the security, the number of shares or units, and whether to buy or sell. The authority to decide timing or price only does not constitute discretion.

discretionary account An account in which the cus-tomer has given the registered representative authority to enter transactions at the representative’s discretion.

display rule SEC rule that requires that a market maker immediately publish and display in its quotation the price and full size of certain customer limit orders that improve its size or price.

diversification A risk management technique that mixes a wide variety of investments within a portfolio, thus minimizing the impact of any one security on overall portfolio performance.

dividend A distribution of the earnings of a corpora-tion. Dividends may be in the form of cash, stock, or property. All dividends must be declared by the board of directors. Syn. stock dividend.

DJIA See Dow Jones Industrial Average.DK See don’t know.DMA See direct market access.DMM See designated market maker.dominated or controlled markets A market that is

strongly influenced by one or two market makers.


428 Glossary

don’t know (DK) A response to a confirmation received from a broker-dealer indicating a lack of information about, or record of, a securities transaction.

Dow Jones averages The most widely quoted and oldest measures of change in stock prices. There are four aver-ages, each based on the prices of a limited number of stocks in a particular category.

Dow Jones Industrial Average (DJIA) The most widely used market indicator, composed of 30 large, actively traded issues of major American companies.

Dow Jones Transportation Average (DJTA) A market indicator composed of 20 transportation stocks.

Dow Jones Utilities Average (DJUA) A market indica-tor composed of 15 utilities stocks.

down tick See minus tick.due bill A printed statement showing the obligation of a

seller to deliver cash dividends to a purchaser. due diligence The careful investigation by the underwrit-

ers that is necessary to ensure that all material informa-tion pertinent to an issue has been disclosed to prospec-tive investors.

due diligence meeting A meeting at which an issu-ing corporation’s officials and representatives of the underwriting group present information on and answer questions about a pending issue of securities. The meet-ing is held for the benefit of brokers, securities analysts, and institutional investors.

duplicate confirmation A copy of a customer’s con-firmation that a brokerage firm sends to an agent or an attorney if the customer requests it in writing. In addition, if the customer is an employee of another broker-dealer, SRO regulations may require a duplicate confirmation to be sent to the employing broker-dealer.

duration of tender offers The period for which tender offers are held open following the first publication of the offer. SEC rules require that this period be at least 20 business days.

DVP See delivery versus payment.

EECN See Electronic Communications Network.effective date The date the registration of an issue of

securities becomes effective, allowing the underwrit-ers to sell the newly issued securities to the public and confirm sales to investors.

Electronic Communications Network (ECN) Any electronic trading system that widely disseminates to third parties orders entered by market makers, institu-tional investors, and so forth. ECNs are agency broker-dealers.

eligible contract participant Someone who has a demonstrable ability to make or take delivery of an underlying commodity to a futures contract, or a com-modity pool with assets exceeding $5 million. An ECP is exempt from FINRA Rule 5123.

emergency market conditions When extraordinary market movements cause a marketwide drop in stock prices and all trading in Nasdaq and exchange-listed securities by Nasdaq member firms is halted.

Employee Retirement Income Security Act of 1974 (ERISA) The law that governs the operation of most corporate pension and benefit plans. The law eased pension eligibility rules, set up the Pension Benefit Guaranty Corporation, and established guidelines for the management of pension funds. Corporate retire-ment plans established under ERISA qualify for favor-able tax treatment for employers and participants. Syn. Pension Reform Act.

equity In a margin account, equity equals what is owned minus what is owed. Alternatively, ownership in a company.

escrow agreement The certificate provided by an ap-proved bank that guarantees that the indicated securi-ties are on deposit at that bank.

Exchange Act See Securities Exchange Act of 1934.exclusive processor Any securities information proces-

sor (SIP) or SRO that engages on an exclusive basis on behalf of any national securities exchange, or any exchange that engages on an exclusive basis on its own behalf, in collecting, processing, or preparing for distribution or publication any information with respect to transactions effected by an exchange or quotations published by any electronic system operated by a SIP.

execution system An automated system for order entry that facilitates trading in the OTC market.

excess equity The value of securities in a margin account that is in excess of the federal requirement. Syn. margin excess; Regulation T excess.

excess margin securities The securities in a margin ac-count that are in excess of 140% of the account’s debit balance.

exchange Any organization, association, or group of persons that maintains or provides a marketplace in which securities can be bought and sold. An exchange does not have to be a physical place, and several strictly electronic exchanges do business around the world.

Exchange Act See Securities Exchange Act of 1934.ex-date The first date on which a security is traded with-

out entitling the buyer to receive distributions previ-ously declared.

executor A person given fiduciary authorization to man-age the affairs of a decedent’s estate.

exempt security A security exempt from the registration requirements (although not from the antifraud require-ments) of the Securities Act of 1933. Examples include U.S. government securities and municipal securities.

exempt transaction (federal) Transactions that do not trigger a federal registration. Examples include: Regula-tion A+ offerings; Regulation S offerings; Regulation D offerings; and Rule 147 offerings.


429Glossary

Ffail to deliver Following a transaction, the seller, whether

a long sale or a short sale, is unable to deliver the securities. The fail-to-deliver is an allowable asset on the carrying broker-dealer’s books subject to a haircut if aged more than four business days.

fast market An exchange or stock market experiencing extreme volatility and high share volume. This condi-tion may be the result of positive or negative news. Not to be confused with high frequency trading (HFT).

Federal Deposit Insurance Corporation (FDIC) A federal government agency that insures deposits in banks and thrifts for $250,000 per depositor.

Federal Reserve The central bank of the United States that regulates the monetary system. Strives for price stability and economic growth.

fictitious quotation A bid or an offer published before being identified by source and verified as legitimate. A fictitious quote may create the appearance of trading activity where none exists; this violates the Conduct Rules.

fidelity bond Insurance coverage required by self-regula-tory organizations for all employees, officers, and part-ners of firms to protect members from employee theft. Generally, 120% times capital requirement.

fiduciary A person legally appointed and authorized to hold assets in trust for another person and manage those assets for the benefit of that person.

final prospectus The legal document that states the price of a new issue security, the delivery date, the underwrit-ing spread, and other material information. It must be given to every investor who purchases a new issue of registered securities. Syn. prospectus.

Financial Industry Regulatory Authority (FIN-RA) The largest regulator for securities firms doing business in the United States. It oversees approximately 635,000 registered representatives. Overseen by the SEC, its primary role is to maintain the fairness of U.S. capital markets. FINRA was preceded by NASD, which merged with most of NYSE Regulation in 2007 to form a new regulatory authority.

FINRA Rule 5130 Deals with IPOs of common stock. Defines restricted persons as member firms, employees of member firms and their immediate families, finders and fiduciaries, portfolio managers, and 10% or more owners of member firms.

firm quote The actual price at which a trading unit of a security (such as 100 shares of stock or five bonds) may be bought or sold. All quotes are firm quotes unless otherwise indicated.

5% markup policy FINRA Rule 2121, a general guide-line for the percentage markup, markdown, and com-missions on OTC securities transactions. The policy is intended to ensure fair and reasonable treatment of the investing public.

five-minute window The period between the time when market makers may re-enter quotations and the time when the security will be released for trading as indi-cated by Nasdaq MarketWatch through a T3 code.

fixed annuity An insurance contract in which the insur-ance company makes fixed dollar payments to the annuitant for the term of the contract, usually until the annuitant dies. The insurance company guarantees both earnings and principal.

fixing Trading in a new security for the purpose of stabiliz-ing its price above the established public offering price; this practice is prohibited. Syn. pegging.

follow-on offering An offering of securities following a company’s initial public offering (IPO). May be primary or secondary. See add-on financing.

foreign associate A non-U.S. citizen employed by a FINRA member firm. Foreign associates are subject to registration but are exempt from having to pass a quali-fying licensing exam.

Form 3 A legal document used by officers, directors, and principal stockholders of a corporation to file an initial statement of beneficial ownership of equity securities. The form is filed with the SEC.

Form 4 A legal document used to update Form 3 when there are changes in the beneficial ownership of a cor-poration. Filed within two business days of any change.

Form 8K A legal document used to report events of consequence that occur in a corporation; such events include changes in control of the corporation or in its name, address, financial standing, board of directors, or auditors. Syn. current report.

Form 10C A legal document used by an issuer of securities quoted on Nasdaq to report a change of more than 5% in the amount of securities it has outstanding.

Form 10K An annual audited report. A Form 10K is due within 90 days of year-end.

Form 10Q A quarterly report containing a corporation’s unaudited financial data. A Form 10Q is due 45 days after the end of each of the first three fiscal quarters.

Form 13F SEC required form for investment managers, who in the course of its business, exercises discretion over $100 million.

Form BD The Uniform Application for Broker-Dealer Registration. Broker-dealers must file this form to regis-ter with the SEC, SROs, and states through the Central Registration Depository (CRD) system, operated by FINRA. BDs are required to promptly update Form BD whenever the form becomes inaccurate or incomplete.

Form F-6 SEC required form to both register American Depositary Receipts and to provide current information to the public similar to Form 8-K.

Form 20-F SEC form to both comply with SEC require-ment to file annual reports within four months of the end of the company’s fiscal year and as a registration statement of foreign private issuers.


430 Glossary

Form 112 (CTR) A currency transaction report for those transactions in currency of more than $10,000.

Form NMA FINRA’s electronic New Membership Ap-plication.

401(k) plan A tax-deferred defined contribution retire-ment plan offered by an employer.

403(b) plan A tax-deferred annuity retirement plan available to employees of public schools and certain nonprofit organizations.

Form SB-1 An SEC form used by small business issuers to register offerings of less than $10 million.

fourth market The market where securities are traded directly from one institutional investor to another with-out the services and commissions of a brokerage firm.

fraud The deliberate concealment, misrepresentation, or omission of material information or the truth, so as to deceive or manipulate another party for unlawful or unfair gain.

free credit balance The unencumbered cash funds in customer accounts. Broker-dealers are required to notify customers of their free credit balances at least quarterly and to carry the credit as a liability on the broker-dealer’s books.

freeriding Buying and immediately selling securities with-out making payment. This practice violates the SEC’s Regulation T.

front running A prohibited practice of entering an order for the benefit of a firm or securities professional before entering customer orders.

frozen account An account requiring cash in advance before a buy order is executed.

FTSE 100 Index of 100 companies listed on the London Stock Exchange. It is used as a prosperity gauge of busi-ness in the United Kingdom.

full power of attorney A written authorization for someone other than the beneficial owner of an account to make deposits and withdrawals and execute trades in the account.

fully disclosed broker See introducing broker.futures Contracts that are exchange-traded obligations for

a specific commodity or financial instrument. Inves-tors with a long position (buyers) are obligated to take delivery of the commodity on a future date. Investors with a short position (sellers) are obligated to deliver the commodity on the specified future date. If the seller does not own the commodity, potential loss is unlim-ited because of the promise to deliver. The seller may have to pay a much higher price to acquire the com-modity for delivery. Futures may be highly leveraged.

Ggeneral securities principal See Series 24.general securities representative See Series 7.ghosting Illegal practice of two or more market makers

colluding to influence the price of a security.give-up A process whereby an executing broker-dealer

credits a trade to another broker-dealer.good delivery A term describing a security that is nego-

tiable, in compliance with the contract of the sale, and ready to be transferred from seller to purchaser.

green shoe option A provision of an issue’s registra-tion statement that allows an underwriter to buy extra shares from the issuer (thus increasing the size of the offering) if public demand proves exceptionally strong. The term derives from the Green Shoe Manufacturing Company, which first used the technique. The maxi-mum number for new shares that can be purchased is 15% of the total amount of shares covered by the issuer’s registration statement. The green shoe option must be executed within 30 days.

guardian A fiduciary who manages the assets of a minor or incompetent for the benefit of that person.

Hhaircut The reduction in the value of securities in a

broker-dealer’s trading/investment account used in calculating net capital. It is a conservative asset valua-tion practice required by the SEC to provide a cushion against investment losses.

hedge fund A fund that can use one or more alternative investment strategies, including hedging against market downturns, investing in asset classes, such as curren-cies or distressed securities, and using return-enhanced tools, such as leverage, derivatives, and arbitrage. These funds tend to have very high minimum investment requirements.

high-touch order An order, usually customized and handled by a trader as opposed to low-touch orders, which are automated. Often used in connection with the expressions “working the order” and “gut instinct.”

highest current independent bid A bid from a market maker that is not participating in the distribution.

high frequency trading (HFT) High-frequency trad-ing is executing algorithmic, ultra-low latency com-puterized trading strategies. HFT may respond to tiny changes in market inefficiencies. Algorithmic trading programs are often proprietary. See algorithmic trading.


431Glossary

high-yield security A noninvestment grade security un-der the TRACE rules. A corporate security that is rated as speculative grade by a nationally recognized statis-tical rating agency (e.g., Ba1 or lower by Moody’s Inves-tors Services, or BB+ or below by Standard & Poor’s Corporation). For purposes of TRACE dissemination, unrated (NR/NA) debt securities are also classified as noninvestment grade securities.

HR-10 plan See Keogh plan.hypothecation Pledging to a broker-dealer securities

bought on margin as collateral for the margin loan.

IIDQS Interdealer quotation system. See OTCBB.immediate family A parent, mother-in-law or father-in-

law, husband or wife, child, sibling, or other relative supported financially by a person associated with the securities industry.

independently prepared reprints A form of public communication that requires principal approval prior to use. Does not have to be filed with FINRA.

indication of interest An investor’s expression of con-ditional interest in buying an upcoming securities issue after the investor has reviewed a preliminary prospec-tus. An indication of interest is not a commitment to buy.

individual retirement account (IRA) A retirement investing tool for employed individuals that allows an annual contribution of 100% of earned income up to a maximum of $5,500 in 2013 and indexed to infla-tion beyond that year. Some or all of the contribution may be deductible from current taxes, depending on the individual’s adjusted gross income and coverage by employer-sponsored qualified retirement plans.

inducements Techniques that are used to persuade customers to buy or sell securities, such as claims of no commission or commission rebate. Any action of this sort is prohibited by the Securities Exchange Act of 1934.

information barrier A descriptive name for the division within a brokerage firm that prevents inside informa-tion from passing from corporate advisers to traders.

initial margin requirement The amount of equity a customer must deposit when making a new purchase in a margin account. The SEC’s Regulation T requirement for equity securities is currently 50% of the purchase price.

initial public offering (IPO) The first sale of securities by a C corporation to the public.

in-part call Redemption of a certain portion of a bond issue.

inside information Material information that has not been disseminated to, or is not readily available to, the general public.

inside market The best (highest) bid price at which an OTC stock can be sold, and the best (lowest) ask price at which the same stock can be bought in the inter-dealer market.

insider Any person who has or has access to material, nonpublic information about a corporation.

Insider Trading Act See Insider Trading and Securities Fraud Enforcement Act of 1988.

Insider Trading and Securities Fraud Enforcement Act of 1988 Legislation that defines what constitutes the illicit use of nonpublic information in making secu-rities trades and the liabilities and penalties that apply.

institutional account This is any account opened by a bank, S&L, insurance company, or registered invest-ment company, an investment adviser registered either with the SEC or with a state, or any corporation, trust, or natural person, et cetera, with total assets of at least $50 million.

institutional sales material A form of public commu-nication that does not require prior principal approval. Does not have to be filed with FINRA.

intermarket sweep order (ISO) A limit order submit-ted for automatic execution in a specific market center even when the other market center (exchange) is post-ing a better price. This appears to be a trade-through, but when sending an ISO, the sender fulfills Regulation NMS order-protection obligations by simultaneously sending orders to market centers with better prices. These orders are not auto-routed and are marked with an “F” trade indicator.

interpositioning Placing a third party in the middle of a trade between a broker-dealer and the best available market. The practice violates FINRA Rules unless it results in a lower cost to the customer or higher sales proceeds.

interstate offering An issue of securities registered with the SEC and sold to residents of states other than that in which the issuer does business.

intrastate offering An issue of securities exempt from SEC registration, available to companies that do business in one state, and sell their securities only to residents of that same state.

introducing broker (IB) A broker-dealer that does not hold customers’ money or securities; instead, it intro-duces customer accounts to a clearing broker-dealer, which holds all cash and securities for those accounts. Syn. fully disclosed broker.

investment adviser (1) Any person who makes in-vestment recommendations in return for a flat fee or percentage of assets managed. (2) For investment companies, the individual or an affiliated IA organized as a corporation who has the day-to-day responsibility of investing the cash and securities held in the fund’s portfolio in accordance with the objectives stated in the fund’s prospectus.


432 Glossary

investment banker An institution in the business of rais-ing capital for corporations and municipalities.

Investment Grade Debt securities in the following credit categories are “Investment Grade”: AAA/Aaa, AA/Aa, A/A, and BBB/Baa.

in-whole call The redemption of a bond issue in its entirety at the option of the issuer, as opposed to its redemption based on a lottery held by an independent trustee.

IPO See initial public offering.IRA See individual retirement account.IRA rollover The reinvestment of assets that an individual

receives as a distribution from a qualified tax-deferred retirement plan into an individual retirement account within 60 days of receiving the distribution. The indi-vidual may reinvest either the entire sum or a portion of the sum, although any portion not reinvested is taxed as ordinary income.

IRA transfer The direct reinvestment of retirement assets from one qualified tax-deferred retirement plan to an individual retirement account. The account owner nev-er takes possession of the assets, but directs that they be transferred directly from the existing plan custodian to the new plan custodian.

Jjoint account An account in which two or more indi-

viduals possess some form of control over the account and may transact business in the account. The account must be designated as either joint tenants in common or joint tenants with rights of survivorship.

joint tenants with rights of survivorship (JTWROS) A form of joint ownership of an account whereby a de-ceased tenant’s fractional interest in the account passes to the surviving tenants. It is used almost exclusively with spouses.

Kknowledgeable employee An executive officer, direc-

tor, trustee, general partner, advisory board member, and the like.

Lladdered strategy When bonds are all purchased at the

same time but mature at different times, like the steps of a ladder. As the shorter maturities come due, they are reinvested and become the long-term bonds.

laddering The promotion of inflated pre-IPO prices for the sake of obtaining a greater allotment of the offering. For instance, an underwriter pushes up the offering price of an IPO through promotion in order to please the issuer and receive a larger allotment in return. This is a prohibited practice.

late trade A transaction reported more than 10 seconds after execution (30 seconds prior to November 4, 2013). A trade reported late during normal market hours is appended with a .Z modifier.

legend stock Private placement stock; stock certificates are issued with a stamped notification that requires the fulfillment of a holding period before transfer. Syn. let-tered stock, restricted security.

lettered stock Private placement stock. See legend stock; restricted security.

locked market The situation created when there is no spread between the bid and the ask on the same security—that is, one market maker bids for a stock at the same price that another market maker quotes its ask price. Violates FINRA conduct rules.

legal list The selection of securities determined by a state agency (usually a state banking or insurance com-mission) to be appropriate investments for fiduciary accounts.

Level 1 The basic level of Nasdaq service; through a desk-top quotation machine, it provides registered represen-tatives and public subscribers with up-to-the-minute inside bid and ask quotations on hundreds of over-the-counter stocks.

Level 2 A level of Nasdaq data service; providing real time bid and ask quotations by market marker of each Nasdaq-, NYSE-, NYSE MKT-, and regional exchange-listed security.

Level 3 The highest level of Nasdaq service; through a desktop quotation machine, it provides real time inside bid and ask quotations, supplies the bids and asks of each market maker for a security, and allows each mar-ket maker to enter new and updated quotations.

limited liability company (LLC) A hybrid between a partnership and a corporation in that it combines the pass-through treatment of a partnership with the lim-ited liability accorded to corporate shareholders.

limited partnership A business formed by filing a charter with a state and consists of a general partner and one or more limited partners. The charter delineates the rights and powers of the general and limited partners, per-centages of ownership, distributions of profits and com-pensation. The general partner manages the business. The limited partners are liable only for the amount of their investment and have very limited management decision-making authority. A limited partnership is a form of direct participation program that combines the limited liability of a corporation with the benefits of partnership taxation.

limited power of attorney A written authorization for someone other than the beneficial owner of an account to make certain investment decisions regarding transac-tions in the account.


433Glossary

limited principal A person who has passed an exami-nation attesting to the knowledge and qualifications necessary to supervise the business of a broker-dealer in a limited area of expertise. A limited principal is not qualified in the general fields of expertise reserved for a general securities principal; these include supervision of underwriting and market making and approval of advertising.

limited representative A person who has passed an ex-amination attesting to the knowledge and qualifications necessary to sell certain specified investment products.

loan consent agreement Optional contract between a brokerage firm and a margin customer that permits the firm to lend the margined securities to other brokers; the contract is part of the margin agreement.

locate requirement SEC rule requiring firms to locate securities for borrowing prior to the short sale of any equity security. See Regulation SHO.

locked market The situation created when there is no spread between the bid and the ask on the same security; that is, one market maker bids for a stock at the same price that another market maker quotes its ask price.

low latency Low latency refers to very short time periods (faster than human perception) for investors to connect to exchanges and ECNs to effect transactions. The lower the latency, the greater the trading advantage for high frequency traders. Syn. ultra-low latency.

Mmake a market To stand ready to buy or sell a particu-

lar security as a dealer for its own account. A market maker accepts the risk of holding the position in the security.

managed underwriting An arrangement between the issuer of a security and an investment banker in which the banker agrees to form an underwriting syndicate to bring the security to the public. The syndicate manager then directs the entire underwriting process.

Manning Rule Rule that bans member trading ahead of customer orders. Syn. customer limit order protection.

margin The amount of equity contributed by a customer as a percentage of the current market value of the securi-ties held in a margin account.

margin account A customer account in which a broker-age firm lends the customer part of the purchase price of securities.

margin call The Federal Reserve Board’s demand that a customer deposit a specified amount of money or securi-ties when a purchase is made in a margin account; the amount is expressed as a percentage of the market value of the securities at the time of purchase. The deposit must be made within one payment period. Syn. Fed call; federal call; federal margin; Reg T call; T call.

margin maintenance call A demand that a margin cus-tomer deposit money or securities when the customer’s equity falls below the margin maintenance require-ment.

margin maintenance requirement The minimum eq-uity that must be held in a margin account, determined by the broker-dealer and by the SRO. The amount of equity required varies with the type of security bought on margin, and the broker-dealer’s house requirement is usually higher than that set by the SRO.

markdown The difference between the highest current bid price among dealers and the lower price that a dealer pays to a customer.

market letter A publication that comments on securities, investing, the economy, or other related topics and is distributed to an organization’s clients or to the public.

market maker A dealer willing to accept the risk of hold-ing a particular security in its own account to facilitate trading in that security.

Market Participant Identity (MPID) An MPID is obtained from FINRA and serves as a unique identifier for member firms to report trades and to satisfy audit requirements.

mark to the market To adjust the value of the securi-ties in an account to the current market value of those securities; used to calculate the market value and equity in a margin account.

markup The difference between the lowest current offer-ing price among dealers and the higher price a dealer charges a customer.

markup policy See 5% markup policy.matched order Simultaneously entering identical or

nearly identical buy and sell orders for a security to create the appearance of active trading in that security. This violates the anti-fraud provisions of the Securities Exchange Act of 1934.

material information Any fact that could affect an investor’s decision to trade a security.

minimum margin requirement See margin mainte-nance requirement.

minus tick A security transaction’s execution price that is below the previous execution price, by a minimum amount.

modifier See trade modifiers.municipal finance professional (MFP) An associated

person of a FINRA member firm engaged in municipal securities underwriting, trading, sales, financial advi-sory, research, investment advice, or any other activi-ties that involve communication with public investors. APs whose activities are limited solely to sales with natural persons and clerical or ministerial functions are not MFPs.

municipal securities principal See Series 53.


434 Glossary

Municipal Securities Rulemaking Board (MSRB) A self-regulatory organization that regulates the issu-ance and trading of municipal securities. The Board functions under the supervision of the Securities and Exchange Commission; it has no enforcement powers.

Nnaked short selling Selling a stock short without first

borrowing the stock or confirming that the stock can be borrowed. Sellers who cannot deliver the shares sold by settlement will cause a fail-to-deliver transaction. Naked short selling is a violation.

Nasdaq Composite Index The Nasdaq Composite Index measures all (over 5,000) Nasdaq domestic and non-U.S. based common stocks listed on the Nasdaq Stock Market.

Nasdaq Execution Services Nasdaq’s broker-dealer.Nasdaq Global Market Companies The Nasdaq

Global Market consists of companies that meet, and continue to meet, stringent financial and liquidity requirements and agree to meet specific corporate gov-ernance standards.

Nasdaq Global Select Market Companies The Nas-daq Global Select Market demands the highest initial listing standards. Issuers of Global Select securities are well known by regulatory authorities and investors around the world as companies that provide market participants with a high degree of transparency, liquid-ity, and strict corporate governance. Considered the top tier of Nasdaq-listed securities.

NASD Rule 2711 Deals with research analyst conflict of interest rules.

National Association of Securities Dealers, Inc.(NASD) The self-regulatory organization for the over-the-counter markets. NASD was organized under the provisions of the 1938 Maloney Act. NASD was dissolved with the formation of FINRA in 2007. See FINRA.

National Market System (NMS) A national system devised for trading equity securities in the United States. SEC Regulation NMS promulgates rules for order protection, access to market data, minimum price increments, and market data. Those securities ineligible for the NMS are known as non-NMS securities. Non-NMS securities may trade on the OTCBB where there are no listing requirements.

National Securities Clearing Corporation (NSCC) An organization that acts as a medium through which member brokerage firms and exchanges reconcile accounts with each other. Provides clearance and settlement functions as well as ACATS. See quali-fied service representative.

net asset value (NAV) The value of a mutual fund share calculated once a day, based on the closing market price for each security in the fund’s portfolio. It is computed by deducting the fund’s liabilities from the total assets of the portfolio and dividing this amount by the num-ber of shares outstanding.

net capital The amount of cash and SEC-approved assets readily convertible into cash that a broker-dealer owns in excess of its liabilities. The SEC sets net capital requirements to ensure that broker-dealers have enough capital to deal responsibly with the investing public.

Net Order Imbalance Indicator (NOII) Nasdaq dis-seminates imbalance information every five seconds:

■ Opening Cross: 9:28 to 9:30 am ET; ■ Closing Cross: 3:50 to 4:00 pm ET; and ■ IPO and Halt Crosses: beginning with the quote-

only period of the IPO of halt resumption.net transaction A principal transaction in which a

market maker, after having received an order to buy (or sell) a stock, buys (or sells) the stock at one price and then sells to (or buys from) the customer at a different price.

new account form The form that must be filled out for each new account opened with a brokerage firm. The form specifies, at a minimum, the account owner, trading authorization, payment method, and types of securities appropriate for the customer.

new issue market The securities market for shares in pri-vately owned businesses that are raising capital by sell-ing common stock to the public for the first time. Syn. primary market. See also initial public offering (IPO).

New York Stock Exchange (NYSE) A marketplace in the United States that maintains a physical, floor-based trading model. It is one of several equities and derivative exchanges operated by the Intercontinental Exchange (ICE).

New York Stock Exchange Composite Index An in-dex of the common stocks, ADRs, REITs, and tracking stock listed on the NYSE.

nominal owner The person in whose name securities are registered if that person is other than the beneficial owner. This is the role of a brokerage firm when cus-tomer securities are registered in street name.

nominal quote A quotation on an inactively traded secu-rity that does not represent an actual offer to buy or sell but is given for informational purposes only.

nonaccredited investor An investor not meeting the income or net worth requirements of Regulation D. Nonaccredited investors are counted for purposes of the 35-investor limitation for Regulation D private place-ments.

nonallowable asset An asset that a broker-dealer may not include when computing its net capital.


435Glossary

nonissuer transaction A securities trade that does not directly or indirectly benefit the issuer. Under the Uniform Securities Act, the proceeds of a nonissuer transaction go to the selling stockholder. Most nonis-suer transactions are secondary transactions.

non-Nasdaq registration In accordance with SEC 15c2-11, firms that wish to make market in OTC Pink or OTC Bulletin Board securities must file Form 211 with FINRA.

nonqualified retirement plan A corporate retirement plan that does not meet the standards set by the Em-ployee Retirement Income Security Act of 1974. Con-tributions to a nonqualified plan are not tax deductible.

nonregistered fingerprint individuals Those natural persons who have access to a broker-dealer’s books and records, such as an outside bookkeeper, who are other-wise not registered but are fingerprinted.

normal trading hours The hours during which Nasdaq market makers must be open for business (9:30 am ET–4:00 pm ET, Monday–Friday). System hours for NASDAQ is 4:00 a.m. to 8 p.m.

“notice” filing Filing required offering documents elec-tronically in searchable PDFs through a FINRA or SEC Gateway. When a member firm makes a notice filing, there will be no response from the regulator (i.e., no comment letter or clearance letter). Form 144 to the SEC is an example of a notice filing.

notice filing (blue sky law) The procedure used by federal covered securities, primarily investment compa-nies, to notify the state securities administrator that the securities will be offered for sale in the state and allow the state to collect fees. The administrator’s only juris-diction is with regard to violation of anti-fraud statutes.

NRF See nonregistered fingerprint individuals. numbered account An account titled with something

other than the customer’s name; the title might be a number, symbol, or special title. The customer must sign a form designating ownership of the account.

Ooffering circular Similar to a prospectus used by corpora-

tions issuing less than $50 million of stock. The SEC’s Regulation A+ allows these offerings an exemption from the full registration requirements of the Securities Act of 1933.

office of supervisory jurisdiction (OSJ) The broker-dealer office responsible for supervising the activities of registered representatives and associated persons housed in that office and in other offices within the same region.

Office of the Comptroller of the Currency (OCC) A federal government agency of the U.S. Treasury. It regu-lates national banks.

Office of Thrift Supervision (OTS) An independent federal government agency of the U.S. Treasury that regulates thrifts.

official statement (OS) A document prepared by the issuer of municipal securities in connection with a primary offering disclosing material information about the issuer’s securities. It is the issuer’s responsibility to publish. It is not considered an advertisement.

omnibus account A master account in the name of a carrying broker-dealer that holds customer securities.

order memorandum The ticket completed by a regis-tered representative that contains customer instructions regarding the placement of an order. The memorandum contains such information as the customer’s name and account number, a description of the security, the type of transaction (buy, sell, sell short, et cetera) and any special instructions (such as time or price limits).

ORF (OTC Reporting Facility) Trades in all over-the-counter domestic equity securities, including foreign se-curities and ADRs, must be reported within 10 seconds through the OTC Reporting Facility (ORF) (30 sec-onds prior to November 4, 2013). FINRA disseminates the information on a real-time basis.

OTC Bulletin Board (OTCBB) The OTCBB is a regu-lated interdealer quotation system owned by FINRA. It displays real-time quotes, last-sale prices, and volume information for OTC equity securities not listed or traded on an exchange. OTCBB securities include national, regional, and foreign equity issues, warrants, units, ADRs, and DPPs.

OTC Equity Security A non-NMS stock.OTC market The security market in which broker-

dealers negotiate directly with one another rather than through an auction on an exchange floor. The trading takes place over computer and telephone networks that link brokers and dealers around the world.

overallotment Occurs when the public interest is espe-cially strong and the underwriter sells more than the number of shares available.

overbought The appetite for an asset overly pushes the price of it to levels not supported by the fundamentals (e.g., investors in high-yield municipal notes were concerned about the overbought market that earlier in the week pushed yields even lower).

over the counter (OTC) Term used to describe a security that is traded through the telephone- and computer-connected OTC market rather than through an exchange. See OTC market.

Ppainting the tape The practice by a broker-dealer of

creating a false appearance of active trading to induce customers to either buy or sell.


436 Glossary

partnership account An account that empowers the individual members of a partnership to act on behalf of the partnership as a whole.

passive market making In accordance with Rule 103 of Regulation M, market-making firms that also are under-writers may enter quotes and execute trades as a market maker if their bids do not exceed the highest indepen-dent bid. Net daily purchase limit is 30% of ADTV.

pattern day trader Someone who executes four or more day trades in a five-business-day period. Minimum equity for such accounts is $25,000.

payable date Day on which a declared dividend is paid to all stockholders owning shares on the record date.

penalty bid Used to minimize sellbacks of public offering stock to the underwriters at the stabilizing bid. The bid may be entered by the book-running managing under-writer to reclaim a selling concession from a syndicate member in connection with an offering when the securities originally sold by the syndicate member are purchased in syndicate covering transactions.

penny stock A non-NMS, OTC equity security trading at less than $5 per share. A penny stock is a low-priced OTCBB or OTC Pink Market stock. The SEC rules on designated securities are the 15(g) rules. See OTC equity security.

pension plan A contract between an individual and an employer, labor union, government entity, or other institution, that provides for the distribution of pension benefits at retirement.

person As defined in securities law, an individual, corpora-tion, partnership, association, fund, joint stock com-pany, unincorporated organization, trust, government or political subdivision of a government.

piggyback exception An exception from the market maker filing requirements under Rule 15c2-11 exists if the security has been quoted on at least 12 business days over the past 30 calendar days and there have been no more than four consecutive business days without a quotation during this period.

Pink Sheets OTC Markets (Pink) operates an e-quo-tation system that displays bids and asks from market makers for thousands of OTC stocks. The name Pink Sheets comes from the color of paper on which they were printed.

possession of securities See control of securities.power of substitution See stock power.PPM Private Placement Memorandum. This is used in

connection with certain offerings exempt from the Se-curities Act of 1933, sometimes known as the Prospec-tus Act. A PPM is less onerous for companies to write than a prospectus and often is used by issuers to attract investors who wish to participate in a private equity or debt offering. For instance, a PPM would likely include the biographies of senior management, a detailed busi-ness plan, et cetera.

preemptive right The legal right of stockholders to maintain their proportionate ownership by purchasing newly issued shares before the new stock is offered to the public.

preliminary prospectus An abbreviated prospectus that is distributed while an issuer’s registration statement is being reviewed by the SEC. It contains the essential facts about the forthcoming offering (except the under-writing spread, final public offering price, and date on which the shares will be delivered). Syn. red herring.

prime broker Provides custody and financing of securities while other firms (called executing brokers) handle all trades placed by the customer.

primary distribution See primary offering.primary market makers Firms registered as market mak-

ers in Global Market stocks who satisfy at least two of the following.

■ Quotes are maintained at the inside market at least 35% of the time.

■ The dealer maintains a spread of no greater than 102% of the average dealer spread.

■ No more than 50% of the quotes are updated without being accompanied by an execution.

■ A volume of 1½ times the proportionate volume in the stock is executed.

primary offering An offering in which the proceeds of the underwriting go to the issuing corporation.

principal transaction A transaction in which a broker-dealer either buys securities from customers and takes them into its own inventory or sells securities to cus-tomers from its inventory. Dealers cannot act as both principal and agent in the same transaction.

private placement memorandum (PPM) A PPM is used in connection with certain offerings exempt from the Securities Act of 1933, sometimes known as the Prospectus Act. A PPM is far less onerous for com-panies to write than a prospectus and is often used by issuers to attract investors who wish to participate in a private equity or debt offering. A PPM would likely in-clude for biographies of senior management, a detailed business plan, et cetera.

profit-sharing plan An employee benefit plan estab-lished and maintained by an employer whereby the employees receive a share of the profits of the business. The money may be paid directly to the employee, deferred until retirement, or a combination of both approaches.

prospectus See final prospectus.proxy A limited power of attorney from a stockholder au-

thorizing another person to vote on stockholder issues according to the stockholder’s instructions. To vote on corporate matters, a stockholder must either attend the annual meeting or must vote by proxy.


437Glossary

prudent man rule A legal maxim that restricts trades in a fiduciary account to only those investments that a reasonable and prudent person might make.

public appearance A form of public communication that requires principal approval. Does not have to be filed with FINRA.

public offering price (POP) The price of new shares disclosed in the issuing corporation’s final prospectus.

Qqualification See registration by qualification.qualified purchaser This is a term found under the

Investment Company Act of 1940. It means in part any natural person who owns $5 million or more in securities.

qualified retirement plan A corporate retirement plan that meets the standards set by the Employee Retire-ment Income Security Act of 1974. Contributions to a qualified plan are tax deductible.

Qualified Special Representative (QSR) An NSCC full-service member (NSCC member) who has been granted status as a QSR for the purposes of locking-in trades for other NSCC members and/or their corre-spondents.

qualified third-market maker An OTC dealer that makes a market in an exchange-listed stock and that meets minimum net capital requirements.

quarterly securities count The counting of securities under its possession or control that a broker-dealer must conduct each calendar quarter. The procedure includes verifying securities in transit, comparing the count with its records, and recording all unresolved differences.

quotation The price being offered or bid by a market maker or broker-dealer for a particular security.

Rreclamation Reclamation occurs when a buyer, after ac-

cepting securities as good delivery, later discovers that the certificates were not in good deliverable form. The securities can be sent back to the selling dealer with a Uniform Reclamation Form attached.

record date The date established by a corporation’s board of directors that determines which of its stockholders are entitled to receive dividends.

red herring See preliminary prospectus.reference security A security into which a subject

security may be converted, exercised, or exchanged that may influence significantly the subject security’s value in accordance with Regulation M.

registered Term that describes a security that prints the name of the owner on the certificate. The owner’s name is stored in records kept by the issuer or a transfer agent.

registered options principal (ROP) The officer or partner of a brokerage firm who approves, in writing, accounts in which options transactions are permitted.

registered principal An associated person of a member firm who manages or supervises the firm’s investment banking or securities business. This includes persons who train associated persons. Unless the member firm is a sole proprietorship, it must employ at least two registered principals.

registration by coordination A process that allows a security to be sold in a state. It is available to an issuer who files for registration of the security under the Secu-rities Act of 1933 and files duplicates of the registration documents with the state administrator. State registra-tion becomes effective at the same time the federal registration statement becomes effective.

registration by qualification A process that allows a security to be sold in a state. It is available to an issuer who files for registration of the security with the state administrator, meets minimum net worth, disclosure and other requirements, and files appropriate registra-tion fees. The state registration becomes effective when the administrator so orders.

registration statement The legal document that dis-closes all pertinent information concerning an offering of a security and its issuer. It is submitted to the SEC in accordance with the requirements of the Securities Act of 1933 and forms the basis of the final prospectus that is distributed to investors.

regular way A settlement contract that calls for delivery and payment within a standard payment period from the date of the trade.

Regulation A+ The provision of the Securities Act of 1933 that exempts from registration offerings of securi-ties issued during a 12-month period.

Regulation D The provision of the Securities Act of 1933 that exempts from registration securities offerings.

Regulation M SEC regulation that addresses market maker activities during syndication.


438 Glossary

Regulation NMS An SEC regulation that fosters com-petition between markets/exchanges and competition among individual orders through four initiatives. (1) The ‘‘Order Protection Rule’’ requires trading centers to enforce written policies designed to prevent trade-throughs. (2) The ‘‘Access Rule’’ requires fair access to quotations, establishes a limit on access fees to harmo-nize the pricing of quotations across different trading centers, and requires every exchange to enforce written rules that prohibit their members from engaging in a pattern or practice of displaying quotations that lock or cross automated quotations. (3) The ‘‘Sub-Penny Rule’’ prohibits market participant from accepting, ranking, or displaying orders, quotations, or indications of interest in a pricing increment smaller than a penny, except for orders, quotations, or indications of interest that are priced at less than $1.00 per share. (4) ‘‘Market Data Rules’’ amendments that update the requirements for consolidating, distributing, and displaying market information.

Regulation S-AM An SEC regulation that allows a con-sumer, in certain limited situations, to block affiliates of brokers/dealers, investment companies, investment advisers, and transfer agents registered with the Com-mission from soliciting the consumer based on eligibil-ity information.

Regulation SHO Mandates a locate requirement with regard to short sales. Before entering a short sale order, members are required to locate the security to be as-sured that delivery can be made on the settlement date. The locate requirement applies to short sales in all equity securities.

Regulation SP An SEC regulation covering privacy rules promulgated under the Gramm-Leach-Bliley Act. A broker-dealer must provide customers with a notice of its privacy policies and practices and must not disclose nonpublic personal information about a consumer to nonaffiliated third parties unless it provides certain information to the consumer and the consumer has not opted out of the disclosure. Rigorous standards to protect privacy also are required under the regulation.

Regulation T The Federal Reserve Board regulation that governs customer cash accounts and the amount of credit that brokerage firms may extend to customers for the purchase of securities. Reg T currently sets the loan value of marginable securities at 50% and the payment deadline at two days beyond regular way settlement.

Regulation U The Federal Reserve Board regulation that governs loans by banks to broker-dealers for the purchase of securities. Also deals with loans from banks to customers.

rehypothecation The pledging of a client’s securities as collateral for a bank loan. Brokerage firms may rehy-pothecate up to 140% of a customer’s debit balance.

rejection Right of the buyer of a security to refuse to ac-cept delivery to complete a trade because the security does not meet the requirements of good delivery.

restricted account A margin account in which the eq-uity is less than the Regulation T initial requirement.

restricted security An unregistered, nonexempt security acquired either directly or indirectly from the issuer, or an affiliate of the issuer, in a transaction that does not involve a public offering.

retail communication Any written (including electron-ic) communication that is distributed or made available to more than 25 retail investors within any 30-calen-dar-day period. A retail investor is any person other than an institutional investor, regardless of whether the person has an account with the member.

retention requirement The provision of Regulation T that applies to the withdrawal of securities from a re-stricted account. The customer must deposit an amount equal to the unpaid portion of the securities being with-drawn in order to reduce the debit balance. The reten-tion requirement is the reciprocal of the initial margin requirement. Related item(s): restricted account.

reverse churning The practice of putting clients into fee-based accounts who trade infrequently.

rights offering An issue of additional shares of stock accompanied by the opportunity for each current stockholder to maintain a proportionate ownership by purchasing additional shares before the stock is offered to the non-shareholders.

riskless and simultaneous transaction The buying or selling by a broker-dealer of a security for its own account so as to fill an order previously received from a customer. Although the firm is technically acting as a principal in the trade, the transaction is relatively risk-less, because the purchase and sale are consummated almost simultaneously.

roll-up A roll-up is an attempt to convert direct participa-tion interests into marketable securities of a successor corporation. Roll-ups seek to turn an illiquid DPP, such as a limited partnership, into a more liquid security.

Rule 10b-21 SEC rule that is targeted at short sellers who purposely mislead a broker-dealer about their ability or intention to deliver securities by the settlement date causing a fail to deliver. In addition, it targets short sellers who deceive broker-dealers about their source of borrowable securities to satisfy the locate requirement of Regulation SHO, as well as long sellers who falsify to their broker-dealers that they actually own the shares being sold.

Rule 101 Restricts the activities of distribution partici-pants during new offerings of securities under Regula-tion M.

Rule 102 Identifies restrictions on issuers and selling security holders and is intended to prevent market ma-nipulation by these persons before a distribution under Regulation M.


439Glossary

Rule 103 Allows market makers (who also are syndicate members) to engage in passive market making during a restricted period.

Rule 104 Regulates the prices at which stabilizing bids may be made under Regulation M.

Rule 105 Prohibits manipulative short sales in anticipa-tion of an offering under Regulation M.

Rule 144 SEC rule requiring that persons who hold con-trol or restricted securities may sell them only in limited quantities, and that all sales of restricted stock by control persons must be reported to the SEC by filing a Form 144, “Notice of Proposed Sale of Securities.”

Rule 144a Allows nonregistered foreign and domestic securities to be sold to certain qualified institutional investors in the U.S., without holding period require-ments.

Rule 145 SEC rule that excepts stock splits and stock dividends from the registration requirements of the Securities Act of 1933.

Rule 147 SEC rule that provides exemption from the registration statement and prospectus requirements of the Securities Act of 1933 for securities offered and sold exclusively intrastate.

Rule 15c2-1 SEC rule that prohibits broker-dealers from using customer securities as collateral for a loan in excess of loans made to customers.

Rule 15c2-11 SEC rule requiring prospective market makers in non-Nasdaq stocks to file Form 211 with FINRA at least three business days prior to quotation entry. In signing Form 211, the firm agrees to maintain a file on the issuer that contains financial and opera-tions information.

Rule 15c3-1 The SEC Net Capital rule governing the net capital requirements of broker-dealers.

Rule 15c3-2 SEC rule requiring broker-dealers to inform customers of their free credit balances at least quarterly.

Rule 15c3-3 The SEC Customer Protection rule that requires (1) that carrying firms have the daily require-ment to reduce to possession or control all fully paid-for securities and all excess margin securities, and (2) that carrying firms must, each week, compute monies owed to the BD by customers (debits) and monies owed by the BD to customers (credits). If credits exceed debits, the excess must be on deposit in a special reserve ac-count within one hour after banks open on the second business day following computation.

Rule 17a-3 SEC rule governing the maintaining of re-cords by a broker-dealer and the posting of such records.

Rule 17a-4 SEC rule governing the retention time and storage by a broker-dealer of records and reports.

Rule 17a-5 SEC rule governing the filing by a broker-dealer of FOCUS reports.

Rule 17a-11 SEC rule governing violations of the net capital rule and setting out early warning rules.

Rule 17f-2 SEC rule requiring the fingerprinting of all associated persons and others who handle cash or secu-rities, and the keeping of such fingerprint records.

Rule 204 Regulation SHO requirement for participants in NSCC’s Continuous Net Settlement System (CNS) to close out any fails that exists on the settlement date (T+3) for an equity security.

Rule 405 (1) Defunct NYSE rule requiring the exercise of due diligence to learn the essential facts about every customer. Syn. know your customer rule. See FINRA Rule 2111 and 2090. (2) SEC Rule 405 provides defini-tions of ineligible issuers, unseasoned reporting issuers, WKSIs.

Rule 415 SEC rule governing shelf offerings. The rule allows an issuer to sell limited portions of a new issue over a two-year period.

Rule 504 SEC rule providing that an offering of less than $1 million during any 12-month period may be exempt from full registration. The rule does not restrict the number of accredited or nonaccredited purchasers.

Rule 505 SEC rule providing that an offering of $1 mil-lion to $5 million may be exempt from full registration. The rule restricts the number of nonaccredited purchas-ers to 35 but does not restrict the number of accredited purchasers.

Rule 506 SEC rule providing that an offering of more than $5 million may be exempt from full registration. The rule restricts the number of nonaccredited purchas-ers to 35 but does not restrict the number of accredited purchasers.

Rule 611—Order Protection Rule The rule states that a trading center, such as Nasdaq or the NYSE, enforce written policies and procedures that are reasonably designed to prevent trade-throughs on that trading center of protected quotations in NMS stocks. See trade-through, Regulation NMS.

Rule 1014 A NASD rule, which sets 12 standards for admission as a member of FINRA. The rule seeks to ascertain, among other things, whether an applicant is qualified by exam, free of any criminal or civil actions, and that past infractions, if any, have been disclosed. FINRA also will determine if the applicant has made proper contractual agreements with a clearing firm(s), banks, and service bureaus; has sufficient capital; and in all ways is ready to perform its lines of business and duties of a broker-dealer.

Rule 6434 This FINRA rule prohibits market participants from displaying, ranking, and accepting quotations, or-ders, or indications of interest in OTC Equity Securities priced in an increment smaller than $0.01 if the order is priced at $1.00 per share or greater. If the quotation, order, or indications of interest is priced less than $1.00 per share, the minimum pricing increment is $0.0001.


440 Glossary

SSAR A suspicious activity report that must be filed for cash

transactions where a customer appears to be avoid-ing BSA reporting requirements by not filing CTR or whose action suggests money laundering or other nefarious activity.

sale See sell.Schedule 13D The form that must be filed by an indi-

vidual (or individuals acting in concert) after acquiring beneficial ownership of 5% or more of any nonexempt equity security. It must be sent within 10 business days to the issuing company, the exchange where the stock is trading, and the SEC.

Schedule 13G An abbreviated Schedule 13D used prin-cipally by an investment company, bank, or insurance company if it acquires a 5% position in the normal course of business and not for the purpose of changing or influencing control of the company. The schedule must be filed 45 days after the first calendar year-end when the firm becomes subject to the requirement.

seasoned issuers An issuer with at least $75 million in public float value.

secondary market An aftermarket. Investors buy from and sell to each other apart from the issuer. Exchanges, such as Nasdaq, NYSE, and NYSE MKT, facilitate the secondary market. Prices are set by supply and demand.

SEC Rule 203 A broker-dealer effecting a short sale in any equity security must “locate” the security being bor-rowed and document the location prior to the trade en-try. The rule effectively prohibits a broker-dealer from accepting a short sale order unless the broker-dealer has borrowed the security so that it can be delivered on the settlement date. The rule provides for some limited exceptions, such as shorts effected in connection with bona-fide market making.

Section 28(e) A code section of the Securities Exchange Act of 1934 that regulates commission sharing arrange-ments, such as soft-dollar programs.

Securities Act of 1933 Federal legislation requiring the full and fair disclosure of all material information about the issuance of new securities. Syn. Act of 1933; Full Disclosure Act; New Issues Act; Prospectus Act; Trust in Securities Act; Truth in Securities Act; Securities Act.

Securities and Exchange Commission (SEC) Com-mission created by Congress to regulate the securi-ties markets and protect investors. It is composed of five commissioners appointed by the president of the United States and approved by the Senate. The SEC enforces, among other acts, the Securities Act of 1933, the Securities Exchange Act of 1934, the Trust Inden-ture Act of 1939, the Investment Company Act of 1940, and the Investment Advisers Act of 1940.

Securities Exchange Act of 1934 Federal legislation that established the Securities and Exchange Commis-sion. The act aims to protect investors by regulating the exchanges, the over-the-counter market, extension of credit by the Federal Reserve Board, broker-dealers, insider transactions, trading activities, client accounts, and net capital. Syn. Act of 1934; Exchange Act; SEA.

Securities Information Center (SIC) The organization designated by the SEC to act as a central data bank for reports of lost and stolen securities.

Securities Information Processor (SIP) A market data vendor engaged in the business of collecting, process-ing, or distributing transactions in, or quotations for, any nonexempt security (e.g., Tape A and B provided by the Consolidated Tape Association, and Tape C pro-vided by Nasdaq OMX Group. SIPs must be registered with the SEC.

Securities Investor Protection Corporation (SIPC) A nonprofit membership corporation created by an act of Congress to protect clients of brokerage firms that are forced into bankruptcy. Membership is composed of all brokers and dealers registered under the Securities Ex-change Act of 1934, all members of national securities exchanges, and most FINRA members. SIPC provides customers of these firms up to $500,000 coverage for cash and securities held by the firms (coverage of cash is limited to $250,000).

segregation Holding customer-owned securities separate from securities owned by other customers and securities owned by the brokerage firm.

selected dealer agreement A written agreement between an underwriting syndicate and selling group members. The agreement spells out compensation, offering price(s), and obligations to follow FINRA underwriting rules.

self-regulatory organization (SRO) An organization accountable to the SEC for the enforcement of federal securities laws and the supervision of securities practices within an assigned field of jurisdiction.

seller’s option A settlement contract that calls for deliv-ery and payment according to a number of days agreed to by the buyer. The earliest delivery can be made is settlement date + 1.

selling away An associated person engaging in private securities transactions without the knowledge and consent of the employing broker-dealer. This violates FINRA rules.

selling dividends Inducing customers to buy mutual fund shares by implying that an upcoming distribution will benefit them; this practice is prohibited.

sell-side Member firms that take an order from a buy-side firm and then “work” the order. These traders are quali-fied by passing the Series 55 exam. See sell-side.


441Glossary

sellout Procedure that the seller of a security follows when the buyer fails to complete the contract by accepting delivery of the security. The seller closes the contract by selling the security in the open market and charging the account of the buyer for transaction fees and any loss caused by changes in the market.

separate account The account that holds funds paid by variable annuity contract holders. The funds are kept separate from the insurer’s general account and are invested in a portfolio of securities that matches the contract holders’ objectives.

Series 3 The national commodity futures exam. Pass-ing this exam serves to meet the requirements of the National Futures Association to issue the license that is needed to do futures business with the public.

Series 4 The registered options principal license, which qualifies the holder to supervise the sale and trading of options. A Series 7 qualification is a prerequisite for this license. Every FINRA member firm engaged in trad-ing options must employ at least one registered options principal.

Series 6 The investment company/variable contract prod-ucts limited representative license, which entitles the holder to sell mutual funds and variable annuities and is used by many firms that sell primarily insurance-related products. The Series 6 can serve as the prerequisite for the Series 26 license.

Series 7 The general securities registered representative license, which entitles the holder to sell all types of securities products with the exception of commodities futures (requires a Series 3 license).

Series 9/10 The NYSE branch office manager (BOM) or general securities sales supervisor limited principal license, which entitles the holder to supervise the sale of all types of securities products except most futures, which are comprised of Series 9 (options) and Series 10 (general securities). Cannot supervise investment bank-ing or market making. Cannot approve advertising.

Series 11 The assistant representative–order processing license (sales assistant), which entitles the holder to accept unsolicited orders, enter order tickets, update client information, fill out client new account forms, and provide to customers quotes and other pro forma information relating to securities. The license does not permit the holder to determine suitability, recommend transactions, or provide advice to customers. An as-sistant representative–order processing may be compen-sated on a salary or hourly wage basis only.

Series 14 The NYSE Compliance Official examination for those individuals designated as having day-to-day compliance responsibilities for NYSE-member firms and each other person who supervises 10 or more people engaged in compliance activities.

Series 23 The General Securities Principal—Sales Su-pervisor Module, which offers an alternative to persons associated with FINRA members who are registered as Series 9/10 to complete the Series 24. The Series 23 examination covers material from the Series 24 not otherwise covered under the Series 9/10.

Series 24 The general securities principal license entitles the holder to supervise the business of a broker-dealer. A Series 7 or a Series 62 is a prerequisite. The Series 24 can serve as the prerequisite for the Series 51 license.

Series 26 The investment company/variable contract products limited principal license, which entitles the holder to supervise the sale of investment company and variable annuity products. A Series 6 or a Series 7 qualification is a prerequisite. The Series 26 can serve as the prerequisite for the Series 51 license.

Series 27 The financial and operations limited principal license, which entitles the holder to supervise the financial administration of a brokerage firm.

Series 51 The municipal fund securities principal license, which entitles the holder to supervise the activities of registered representatives effecting municipal fund se-curities transactions [e.g., 529 college savings plans and Local Government Investment Pools (LGIPs)].

Series 53 The municipal securities principal license, which entitles the holder to supervise the municipal securities business of a brokerage firm. A Series 7 or a Series 52 qualification is a prerequisite.

Series 62 The corporate securities limited representative license, which entitles the holder to sell all types of corporate securities but not, for example, municipal securities, options, or DPPs.

settlement The completion of a trade through the delivery of a security and the payment of cash or other consideration.

settlement date The business day on which delivery of a security and payment of money is to be made through the facilities of a registered clearing agency in connec-tion with the sale of a security. Settlement provisions are standardized by the Uniform Practice Code.

shelf registration An SEC provision allowing well-known, seasoned issuers (WKSIs) to register a new issue security without selling the entire issue at once. The issuer can sell limited portions of the issue over a two-year, and for WKSI companies three-year, period without reregistering the security. See Rule 415.

short The term used to describe the selling of a security not owned by the seller. For example, an investor who borrows shares of stock from a broker-dealer and sells them on the open market is said to have a short posi-tion in the stock.

short against the box The term used to describe the selling of a security, contract, or commodity that the seller owns but prefers not to deliver; frequently this is done to defer taxation.


442 Glossary

short interest The total number of shares in the stock that are reflected on the books and records of a report-ing firm as short as of the current reporting period’s settlement date.

short sale The sale of a security that the seller does not own, or any sale consummated by the delivery of a security borrowed by or for the account of the seller.

short securities difference A shortfall between the number of shares identified in a broker-dealer’s ac-counting records and the number of shares in a physical count of its securities.

SIC See Securities Information Center.simplified arbitration An expedient method of set-

tling disputes involving claims not exceeding $50,000, whereby a panel of arbitrators reviews the evidence and renders a decision. All awards are made within 30 business days.

SIP See Securities Information Processor.SLP See supplemental liquidity provider.SPAC A special purpose acquisition corporation is a type of

blank-check company. Owners of SPAC shares expect the SPAC to be acquired by, or merged with, another company within a certain time period.

special memorandum account (SMA) A notation on a customer’s general or margin account indicating that funds are credited to the account on a memo basis; the account is used much like a line of credit with a bank.

special reserve bank account A separate account maintained by a broker-dealer for the exclusive benefit of customers.

spoofing Bidding or offering with the intent to cancel the bid or offer before execution.

spread In a quotation, the difference between the bid and the ask prices of a security. In a new issue, the differ-ence between the POP and proceeds to the issuer.

stabilizing Bidding at or below the public offering price of a new issue security. Underwriting managers may enter stabilizing bids during the offering period to prevent the price from dropping sharply. See also fixing.

standby underwriter An investment banker that agrees to buy any part of an issue that has not been purchased by current stockholders through a rights offering. The firm exercises the remaining rights, maintains a trading market in the rights, and offers the stock acquired to the public.

statutory disqualification Prohibiting a person from associating with a self-regulatory organization because the person has been expelled, barred, or suspended from association with a member of a self-regulatory organi-zation; has had his registration suspended, denied, or revoked by the SEC; has been the cause of someone else’s suspension, barment, or revocation; has been con-victed of certain crimes; or has falsified an application or report that he is required to file with or on behalf of a membership organization.

sticky offering An offering of new shares of stock that are difficult to sell. This may be a result of bad news about the company whose stock is being sold or the overall economy.

stock power A standard form that duplicates the back of a stock certificate and is used for transferring the stock to the new owner’s name. A separate stock power is used if the registered owner of a security does not have the certificate available for signature endorsement. Syn. irrevocable stock power; power of substitution.

stock record A broker-dealer’s accounting system that shows separately for each security all long and short positions, as well as the location of each security, the holdings of all customers, and all securities due from or owed to other broker-dealers. Syn. securities record.

stock record break A discrepancy between the num-ber of shares reported in a broker-dealer’s accounting records and the number of shares in a physical count of its securities. The discrepancy can be due to a counting error or to missing securities.

stop stock price The specific price at which a member firm agrees to a stop stock transaction. The price is based on prices at which the stock is trading at the time the order is received. The specified price may vary from current market prices due to the order size and the number of shares available at those prices.

stub quote Order placed far from a stock’s market price. Used by market makers when they want to be sure no trades occur. Syn. placeholder quote.

subject quote A tentative quote the market maker must reconfirm.

subordinated loan A loan to a broker-dealer in which the lender agrees to subordinate its claim to the claims of the firm’s other creditors.

suitability A determination made by a registered repre-sentative as to whether a particular security matches a customer’s objectives and financial capability. The representative must have enough information about each customer to make this judgment.

Super Display Book (SDBK) The electronic order entry and processing system used by the New York Stock Exchange. SDBK replaced SuperDOT.

supplemental liquidity provider (SLP) An off-floor (upstairs), electronic member of the NYSE or NYSE MKT who is compensated for adding liquidity to the market on specifically assigned stocks.

switching Redeeming shares in a mutual fund in order to purchase shares in a different fund. Although not a vio-lation per se, it is a supervisory concern due to possible additional sales charges and tax liabilities.

SYND Nasdaq quote montage symbol for a non-penalty stabilizing bid.


443Glossary

syndicate A group of investment bankers formed to handle the distribution and sale of a security on behalf of the issuer. Each syndicate member is responsible for the sale and distribution of a portion of the issue. Syn. underwriting syndicate.

systematic risk Undiversifiable risk generally associated with a downturn in the market. Common stock that is fundamentally sound may lose market value due to a downturn in overall market conditions.

systemic risk The risk associated with the failure of entire financial markets. A single financial institution collapse leading to another and another cascading throughout a region or the world is an example of systemic risk, not to be confused with systematic risk.

Ttender offer An offer to buy securities for cash or for cash

plus securities.tentative net capital A broker-dealer’s total available

capital minus all nonallowable assets. It is capital before haircuts are taken.

term sheet A non-binding document spelling out the general, important ideas of an agreement. A term sheet is short of details but explains for what the money is being raised, the nature of the project, what percentage of the company is being offered, and so forth.

testimonial An endorsement of an investment or service by a celebrity or public opinion influencer. The use of testimonials in public communications is regulated by FINRA.

third market Exchange-listed securities traded over-the-counter.

tick A minimum upward or downward movement in the price of a security.

TIF See transfer instruction form.TIN (Taxpayer Identification number) A unique nine-

digit number assigned by the IRS to a business or an individual. An EIN (Employer Identification Num-ber) identifies a business, while SSNs (Social Security numbers) or ITINs (Individual Taxpayer Identification numbers) identify an individual.

tombstone A printed advertisement that is limited to basic information about the offering, such as the name of the issuer, type of security, names of the underwriters, and where a prospectus is available.

TotalView A data feed operated by the Nasdaq Stock Ex-change. It provides information about every quote and order at every price level in Nasdaq-, NYSE-, NYSE MKT-, and regional-listed securities on Nasdaq and supplies the Net Order Imbalance Indicator (NOII).

TRACE Trade Reporting and Compliance Engine. FINRA Rule 6700 requires members to report OTC secondary market transactions in eligible fixed-income securities to FINRA. TRACE is the vehicle that facilitates the mandatory trade reporting of eligible corporate bonds and the public dissemination of market data that is subject to certain restrictions.

trade-by-trade match Occurs when both parties to the trade submit transaction data, and the ACT system performs an online match.

trade comparison The memorandum sent by both broker-dealers engaged on either side of a trade; it con-firms the details of the transaction.

trade confirmation A printed document that contains details of a transaction, including the settlement date and amount of money due from, or owed to, a customer. It must be sent to the customer on or before the settle-ment date.

trade date The date on which a securities transaction is executed.

Trade Reporting Facility (TRF) FINRA/Nasdaq’s Trade Reporting Facility (TRF) provides FINRA members with a service for the reporting and reconciliation of transactions effected away from an exchange floor. Nasdaq operates the TRF, but it is subject to FINRA rules. Trades by FINRA members on Nasdaq, NYSE, and other exchange-listed securities executed off an ex-change floor may be reported to FINRA/Nasdaq’s TRF.

trade shredding A prohibited practice that involves splitting a large single order into smaller orders to maxi-mize payment for order flow.

trade-through The execution of trades at prices inferior to protected quotations displayed by other trading centers.

trading ahead Engaging in trading activity in anticipa-tion of the issuance of research reports is a prohibited practice.

trading along Buying or selling at the same time and at the same price as an institutional customer. Need order by order agreement with the institution (no blanket approvals).

trading halt codes Indicate the status of trading halts, suspensions, and cease trade orders (CTOs) in Nasdaq and Consolidated Quotation System (CQS) securities.

tranche One of the classes of securities that forms an issue of collateralized mortgage obligations. Each tranche is characterized by its interest rate, average maturity, risk level, and sensitivity to mortgage prepayments. Neither the rate of return nor the maturity date of a CMO tranche is guaranteed. See also collateralized mortgage obligation.


444 Glossary

transfer agent A person or corporation responsible for recording the names and holdings of registered security owners, seeing that certificates are signed by the appro-priate corporate officers, affixing the corporate seal, and delivering securities to the new owners.

transfer instruction form Customers desiring to transfer assets from a brokerage firm to another firm must submit a transfer instruction form to the new firm. This form also is known as a TIF.

trustee (1) A person legally appointed to act on the ben-eficiary’s behalf. (2) A bank designated by an issuer of municipal debt as the custodian of funds and represen-tative of bondholders appointed to ensure compliance with the bond contract.

Trust Indenture Act of 1939 The legislation requir-ing that all publicly offered, nonexempt debt securities be registered under the Securities Act of 1933 and be issued under a trust indenture that protects the bond-holders. An exemption from the Act is available for bond issues of $5 million or less issued in a three-year period.

two-dollar broker An exchange member that executes orders for other member firms when their floor brokers are especially busy. Two-dollar brokers charge a com-mission for their services; the amount of the commis-sion is negotiated.

UUGMA See Uniform Gifts to Minors Act.UIT See unit investment trust.underlying securities The securities that are bought or

sold when an option, right, or warrant is exercised.underwriter An investment banker who works with an

issuer to help bring a security to the market and sell it to the public.

underwriting The procedure by which investment bank-ers channel investment capital from investors to corpo-rations and municipalities that are issuing securities.

underwriting compensation The amount paid to a broker-dealer firm for its involvement in offering and selling securities.

underwriting discount See underwriting spread.underwriting manager The brokerage firm responsible

for organizing a syndicate, preparing the issue, negoti-ating with the issuer and underwriters, and allocating stock to the selling group. Syn. manager of the syndi-cate; managing underwriter; syndicate manager, book running manager. Related item(s): agreement among underwriters; syndicate.

underwriting spread The difference in price between the public offering price and the price an underwriter pays to the issuing corporation. The difference rep-resents the profit available to the syndicate or selling group. Syn. underwriting discount; underwriting split.

underwriting syndicate See syndicate.unethical trading practices The use of any manipula-

tive, fraudulent, or deceptive activity in selling securi-ties. See front running, capping, painting the tape.

Uniform Gifts to Minors Act (UGMA) Legislation that permits a gift of money or securities to be given to a minor and held in a custodial account that is managed by an adult for the minor’s benefit.

Uniform Practice Code (UPC) The FINRA policy that establishes guidelines for a brokerage firm’s dealings with other brokerage firms.

Uniform Securities Act (USA) Model legislation for se-curities industry regulation at the state level. Each state may adopt the legislation in its entirety or it may adapt it (within limits) to suit its needs. Related item(s): blue-sky laws; Series 63.

Uniform Transfers to Minors Act (UTMA) Legislation adopted in some states that permits a gift of money or securities to be given to a minor and held in a custodial account that an adult manages for the minor’s benefit until the minor reaches a certain age (not necessarily the age of majority). Related item(s): Uniform Gifts to Minors Act.

unit investment trust (UIT) An investment company that sells a fixed number of redeemable shares in a pro-fessionally selected portfolio of securities. It is organized under a trust indenture, not a corporate charter.

unlisted securities Securities that are not listed on any registered exchange.

Unlisted Trading Privilege (UTP) The right granted to exchange member firms to trade in stocks not listed on that exchange. The exchange granting the privilege must itself first receive clearance to do so by applying to the SEC.

unseasoned issuers Public companies required to file reports with the SEC but that are not seasoned issuers.

UTP See Unlisted Trading Privilege.

Vvariable annuity An insurance contract in which the

insurance company guarantees a minimum total pay-ment to the annuitant at the end of the accumulation stage. The performance of a separate account, generally invested in equity securities, determines the amount of this total payment.

vesting (1) An ERISA guideline stipulating that employ-ees must be entitled to their entire retirement benefits within a certain period of time even if no longer em-ployed. (2) The amount of time that an employee must work before retirement or before benefit plan contribu-tions made by the employer become the employee’s property without penalty. The IRS and the Employee Retirement Income Security Act of 1974 set minimum requirements for vesting in a qualified plan.


445Glossary

volatility The magnitude and frequency of changes in the price of a security or commodity within a given period.

Volume-Weighted Average Price (VWAP) The VWAP is the price at which the majority of trading in a stock took place in a given period. It is determined by multiplying the price by the shares traded for each transaction and dividing the total transaction value by the total number of shares traded for the period. Buy-side customers often judge the quality of a trade by its VWAP for the trading period.

Wwash sale Selling a security at a loss for tax purposes and,

within 30 days before or after that sale, purchasing the sale or a substantially identical security. The IRS disallows the claimed loss. This only applies to losses; one may sell a security, realize a gain, and immediately repurchase establishing a new cost basis and holding period.

wash trade A wash trade occurs when a customer enters a purchase order and a sale order for the same security at the same time. It creates a false appearance of activity in a security and is a prohibited practice.

Wells Notice A Wells Notice or Wells Letter indicates that the regulator intends to bring an enforcement action against an individual or a business. If the notice is against a publicly traded company, it usually has the effect of depressing the current market price.

when-issued (WI) A securities issue that has been autho-rized and is sold to investors before the certificates are ready for delivery. Typically, such securities include new issue municipal bonds, stock splits, and Treasury securi-ties. Syn. when-, as-, and if-issued security.

Whistleblower Office The Whistleblower Office of the SEC’s Division of Enforcement is responsible for handling whistleblower tips and complaints and set-ting awards for people who provide leads to successful enforcement actions.

wire transfer A method to electronically transfer funds from one person or institution to another.

Wilshire 5000 The broadest measure of the U.S. stock market. Contains virtually every stock listed on the NYSE, NYSE MKT, and Nasdaq.

WKSI A well-known, seasoned issuer is a company that is current in its 10K, 10Q, and 8K filings and has a greater than $700 million market capitalization or issued $1 billion in nonconvertible securities over the past three years.

working capital A measure of a corporation’s liquidity—that is, its ability to transfer assets into cash to meet current short-term obligations. It is calculated by sub-tracting total current liabilities from total current assets.

workout quote A qualified quotation whereby a broker-dealer estimates the price on a trade that will require special handling owing to its size or to market condi-tions. See also bona fide quote; firm quote; nominal quote.

wrap account A managed account in which the cus-tomer pays one annual package price for all products and services for the account. Considered to be advisory accounts.

wrap fee program Any advisory program under which a specified fee or fees not based directly upon transactions in a client’s account is charged for investment advisory services (which may include portfolio management or advice concerning the selection of other investment advisers) and the execution of client transactions. The exclusion from the definition of investment adviser available under both state and federal law to broker-dealers is not in effect for those offering wrap fee programs.

writing a scale Process by which a syndicate establishes the yield for each maturity in a new serial bond issue in order to arrive at its competitive bid. See scale.

Yyield The effective rate of return earned on a security

expressed as a percentage. For reporting purposes, TRACE calculates and disseminates the lower of yield to call or yield to maturity. TRACE generally shows the call that produces the worst yield.

yield to call (YTC) The rate of return on a bond that ac-counts for the difference between the bond’s acquisition cost and its proceeds, including interest income, calcu-lated to the earliest date that the bond may be called by the issuing corporation. See bond yield.

yield to maturity (YTM) The rate of return on a bond that accounts for the difference between the bond’s acquisition cost and its maturity proceeds, including interest income. See bond yield.

Zzero-coupon bond A corporate or municipal debt secu-

rity traded at a deep discount from face value. The bond pays no interest; rather, it may be redeemed at maturity for its full face value. It may be issued at a discount, or it may be stripped of its coupons and repackaged.

zero-minus tick A security transaction’s execution price that is equal to the price of the last sale but lower than the last different price.

zero-plus tick A security transaction’s execution price that is equal to the price of the last sale but higher than the last different price.


447

Symbols

5% policy 18412b-1 fees 127, 13015c3-3 13820 minute rule 29421(a) Report 26635-calendar-day rule 24975-5-10 test 123314(a) request 1951035 exchange 136.C (cash trade) 292.N (next day) 292(OC), On the close orders 283.O (price override) 292.P (late execution prior reference price)

292.SNN (extended settlement trade) 292.T 290“.T” modifier 283.W (stop stock transaction) 292.W (weighted average price/special pricing

formula) 292.Z (late trade report) 292

A

ACATS (Automated Customer Account Transfer Service) 174

acceptance, waiver, and consent (AWC) 60

access equals delivery 356, 360accredited investor 375accrued interest 308ACES 283actively traded security 368active military service 25additional issue market 338ADF (Alternative Display Facility) 290administrator 355Advertising Regulation Electronic Files

(AREF) 200affiliated person 125affiliated relationships 387affirmative determination 246after-hours market 223aged 99agency basis 224agency crosses 297agency cross-transactions 289agent bank 71aggregate indebtedness (AI) 100AI-to-NC ratio 102, 109, 115all-or-none offering 342

Alternative Display Facility (ADF) 233, 281

alternative funds 207alternative public offering (APO) 341alternative standard 100alternative trading systems (ATS) 223alt mutual funds 207American Depositary Receipts (ADRs)

236, 310AML independent test 190annual certification of compliance 66annuitants 135annuity 135anti-internalization qualifier (AIQ) 281anti-reciprocal rule 130appealing a decision 61approved affiliate 300arbitration panel 64arbitrator 63

chair-qualified public 64nonpublic 64public 64

“as/of” basis 291asset-based charge 127associated person 3, 20ATS 271at-the-market offering 340automatic sweep 182average daily trading volume (ADTV)

368

B

back-end load 127backing away 243Bank Secrecy Act (BSA) 190bank’s premises 48barring a member or associated person 61best efforts 342best execution 262blank check 376blank check company 356blanket agreements 252, 257blanket recommendations 188blind recruitment ads 201blockbuster trades 296block order 257block positioners 382blog 208blotters 112Blue Sheets 91blue-sky laws 184, 355bona fide hedge 226bond deliveries 307

book runner 344bookrunning manager 344books and records 109booster shots 400borrowing from or lending to customers 55“bought” offerings 390breakpoints 131, 132breakpoint sales 133, 189broker 224BrokerCheck® 3, 61BSA E-Filing System 193bulk transfer 175business continuity plan (BCP) 45, 66buy-in 317buy-side 228buy stop order 230

C

caller ID blocking 210Capital Commitment Schedule 227Capital Market 236Capital Market Securities 226carrying firm 94carve-out 364C corporations 351cease and desist order 61cease trade orders (CTOs) 260censure 61Central Registration Depository (CRD)

3, 20CEO certification 47chairperson roster 64charges for services 170cheap stock 272Cheap Stock rule 81chief compliance officer (CCO) 66Chief Executive Officer (CEO) 66churning 172, 188civil penalties 354claimant 63class action claims 63Class A shares 131Class B shares 131Class C shares 131clearing agreements 120clearly erroneous trades 306closed-end fund 122closing cross 250CMOs 174COD 71Code of Arbitration 62Code of Procedure 59, 61cold calls 209

Index


448 Index

collateralized mortgage obligations (CMOs) 199

common modifiers 292competitive offering 340complaint file 56computation of accrued interest 308concession 345conflict of interest 203, 367Consolidated Quotation System (CQS)

273Consolidated Tape System 274contemporaneous cost 187contemporaneous traders 92continuing commissions 196continuing education (CE) 25continuous net settlement (CNS) basis

304continuous net settlement system (CNS)

300contracts of employment 54control relationship 67, 173control securities 380convertible bonds 236core prospectus 340Corporate Financing Department (CFD)

388correspondence 196credit agreement 73crossed 280crossed market 244cross guarantee 83cross-transaction 288crowdfunding 376CTR Form 112 191culture of compliance 47, 161CUSIP number 296custody of customer funds or securities 41customer account records 112customer complaints 48, 56customer identification program (CIP)

169customer ledgers 112Customer Limit Order Protection Rule

(Manning Rule) 250Customer Protection Rule 114, 138customer-specific obligation 179

D

dark pools 227, 228, 271date and time 173day orders 279day trader 83day-trading accounts 163dealer 224death certificate 178death of the account owner 177debt/equity ratio 104, 109deferred variable annuities 138deficiency letter 352definition of investment adviser 140

delivery versus payment 70Department of Enforcement 58Department of Member Regulation

(DMR) 5Department of Registration and Disclo-

sure 8Depository Trust Company (DTC) 114,

304designated examining authority (DEA)

4, 103designated market maker (DMM) 227,

228designation record 43directed orders 263, 278direct market access (DMA) 120direct participation programs (DPPs) 67,

270disciplinary history of member firms and

their registered persons 62disciplined firm 44disclaimer opinion 237Disclosure Reporting Pages (DRPs) 20,

21discretionary account 171, 387discretionary authority (limited power of

attorney) 56, 172discretionary orders 279distressed debt 68diversified 123Division of Market Regulation (DMR)

93doing business as 4Do-Not-Call list 210do not reduce (DNR) 316DTC eligible 298dual agency transaction 289dual side reporting 298due bills 315due diligence 352DVP account 71

E

early warning reports 109Eastern account 344easy-to-borrow list 246ECN 253EDGAR system 356eFOCUS System 105electronic communications network

(ECN) 223electronic delivery of information 174eligible ECN 253emerging growth companies (EGC) 399engineers 140equity-linked note (ELN) 69equity REITs 134erroneous reports 235escrow account 342escrow of proceeds 388ETF net capital haircuts 85

exaggerated claims 198exception reports 113, 120exceptions to the locate requirement 249exchange 223exchange-traded funds (ETFs) 84exchange-traded notes (ETNs) 85excused withdrawal 238ex-date 232, 314ex-date reduction 316ex-dividend date 314executing brokers 71execution on a DVP/RVP basis 71execution quality 262executive representative 10, 16exempt security 372expulsion 61extended trading hours 167

F

fail to deliver 99, 246Fair and Accurate Credit Transactions

Act of 2003 (FACT Act) 182fair and orderly market 227fair dealing 188Fed call 72Federal Deposit Insurance Corporation

(FDIC) 49Federal Reserve Board 72fee-based accounts 71fees and assessments 11fidelity bonding insurance 117Financial Crimes Enforcement Network

(FinCEN) 193fine 61fingerprinting 21FINOP 15FINRA 3FINRA Contact System (FCS) 191FINRA Firm Gateway 4, 377FINRA Manual 41FINRA/Nasdaq TRF 235, 290FINRA/NYSE TRF 290FINRA Rule 213 163FINRA Rule 2010 161FINRA Rule 2060 58FINRA Rule 2090 161FINRA Rule 2111 179, 180, 205FINRA Rule 2121 185FINRA Rule 2124 189FINRA Rule 2150 57FINRA Rule 2210 196FINRA Rule 2216 199FINRA Rule 2232 172FINRA Rule 2241 359FINRA Rule 2265 167FINRA Rule 2270 163FINRA Rule 2330 138FINRA Rule 3110 44FINRA Rule 3120 48FINRA Rule 3130 66


449Index

FINRA Rule 3150 171FINRA Rule 3220 53, 54FINRA Rule 3230 209FINRA Rule 3240 55FINRA Rule 3270 52FINRA Rule 3310 190, 191FINRA Rule 4360 117FINRA Rule 4370 66FINRA Rule 4512 161FINRA Rule 4513 56FINRA Rule 4530 10FINRA Rule 4560 250FINRA Rule 5130 362FINRA Rule 5131 362FINRA Rule 5150 395FINRA Rule 5260 259FINRA Rule 6400 297FINRA Rule 8210 10FINRA’s Corporate Financing Depart-

ment 377firewall 181firm commitment 341firm element 26firm quotations 243firm two-sided quote 243fixed annuity 135flipping 364floor brokers 226, 228flow-through 134FOCUS II 105FOCUS Part III facing page 108FOCUS reports 105FOGS Report 105follow-on offerings 361Foreign Corrupt Practices Act of 1977

(FCPA) 379foreign internal security 311foreign nonmember firms 195Form 4 391Form 6-K 391Form 8-K 121, 341, 379, 394Form 8-K (the Current Report) 391Form 8-T 12Form 10-K 391Form 13F 391Form 20-F 350Form 25 226Form 111 193Form 112 113, 191Form 144 377Form 211 268, 271Form 1099 183Form ADV 140formation or structuring of public offer-

ings 41Form BD 4, 5, 199Form BDW 6, 10Form BR 6, 7Form CMA 4, 9Form Custody 105former employer 23

Form F-6 310, 350Form MC-400 8, 9Form N-1A 121Form NMA 4Form S-11 350Form SSOI 105Form U-4 12, 18Form U-5 12, 22, 60Form W-8 179forward-looking statement 353four-year records 113free credit balances 182free writing prospectus 356, 360front-end load 127front running 257full authorization 172fully disclosed firm 94

G

gatekeepers 47general ledger 112geographically dispersed (working re-

motely) 41ghosting 266“give-up” agreement 299give up clearing arrangement 120, 286Global Depositary Receipt (GDR) 310Global Market 236, 237Global Select 236Global Select Market 236good control locations 114good delivery 306good-till-canceled orders (GTC) 279Gramm-Leach-Bliley Act 181green shoe clause 345, 389gross dollar limit 296gross dollar threshold (Super Cap) 296guarantees against loss 57gun-jumping 356

H

H4 Halt—non-compliance 261H9 Halt—not current 261H10 Halt—SEC trading suspension 261H11 Halt—regulatory concern 261haircuts 98hard-to-borrow list 246Hart Scott Rodino (HSR) 396hearing panel 60hidden profit 224high standards rule 48high-touch 415holding mail 171hold in street name 69hypothecation agreement 73

I

imbalance 232imbalance only orders (IO) 282immediate family member 362immediate-or-cancel orders (IOC) 279inappropriate exchanges 138independently prepared reprint 203independent market 369independent qualified underwriter 387Individual Change of Dealer Authoriza-

tion Form 176ineligible ECN 253In-Firm delivery 26information barriers 254information obtained as fiduciary 58inside information 89inside market 240insiders 382Insider Trading Act 92Insider Trading and Securities Fraud

Enforcement Act of 1988 89instant messaging 203institutional accounts 161institutional communications 196institutional customers 51integration 194interactive electronic forum 208interdealer trades 287interested person 125Intermarket Surveillance Group (ISG)

91Intermarket Sweep Order (ISO) 252, 280internal investigations of securities trans-

actions for insider trading 48internalization 223internal office inspections 47Internal Revenue Code Sections 403(b)

136international stock trading 311interpositioning 262introducing firms 94, 95inverse ETFs 85investment adviser 4, 139Investment Advisers Act of 1940 139,

265investment analysis tools (FINRA Rule

2214) 397investment banker 343investment clubs 189Investment Company Act of 1940 121issuer buying its own securities 386

J

JBO 67joint accounts 183joint back office (JBO) arrangement 100JTWROS account 178jumping the gun 361just and equitable principals of trade 207


450 Index

K

k(1) exemption 116k(2)(i) exemption 116k(2)(ii) exemption 116Know Your Customer rule 161

L

late reports 291layering 194letter of intent 133letters testamentary 178Level 1 240Level 2 240Level 3 240Level I 275Level II 275Level III 275levels of Nasdaq service 240leveraged ETFs 84lifetime records 111limited authorization 172limited business broker-dealer 363limited liability corporation (LLC) 351limited partnership 67limited trading market 98limit on open orders (LOO) 282limit order 229limit order display rule 254limit up-limit down (LULD) 233, 234linked or an eligible ECN 255Lipper 200loan consent agreement 73locate requirement 245location held out 45locked 280locked market 244lock-up period 400long-term capital gains 131Lucite tombstones 53

M

maintenance margin excess 83managed account 265management companies 122management investment company 121manager’s fee 344managing underwriter 344Manning Limit Order Protection Rule

256Manning Rule 251margin 72margin account disclosure 165margin agreement 73markdown 289mark-downs 187market centers 223market maker 95, 223market on close (MOC) 232market on open orders (MOO) 282

Market Operation Review Committee (MORC) 306

market order 229marking the close 258marking to the market 305markup 289mark-ups 187material inadequacies 109Medallion Signature Guarantee 309mediation 66mediator 66member private offering (MPO) 377Memo of Understanding (MOU) 66micro-blog 208mid-case referral rule 64military ID 169mini-max 342minimum net capital requirement 94, 95minor rule violation (MRV) 60misappropriation theory 92modifier E 270monetary awards 65monetary sanctions 61money laundering 169, 190monthly computation 115Morningstar® 200mortgage REITs 134MPID 274, 383MSRB 3mutual fund 122mutual fund share class table 131

N

naked short selling 80Nasdaq 223Nasdaq Book 274Nasdaq Global Select 226Nasdaq International Service 300Nasdaq Market Center (NMC) 275Nasdaq market maker 237Nasdaq Market Operations 306Nasdaq MarketWatch 259, 301Nasdaq Official Opening Price (NOOP)

283Nasdaq’s Subscribers Services department

237Nasdaq TRF 295Nasdaq UTP (unlisted trading privileges)

226Nasdaq Workstation 235NASD Rule 1014 5, 9NASD Rule 1017 9NASD Rule 1030 26NASD Rule 1080 12NASD Rule 1160 16, 67NASD Rule 2340 71NASD Rule 2711 209, 398NASD Rule 3040 51, 52NASD Rule 3050 56

National Adjudicatory Council (NAC) 9, 58

National Best Bid and Offer (NBBO) 227, 237

National Futures Association (NFA) 17National Institute of Standards (NIST)

266National Securities Clearing Corp. 120National Securities Markets Improve-

ments Act of 1996 (NSMIA) 354negative consent letter 190negative response letter 176negotiated underwriting 340net asset value 127net basis 189net capital 98net price 224network A 274network B 274network C 274networking arrangement 48new issue market 338NIST atomic clock 276NMS Rule 606 263NMS Rule 611 264NMS securities 234NMS stocks 237no fault 317nonaccredited investor 375nonconventional investments (NCIs) 68nondirected orders 263, 277nondiversified 123noninstitutional customer 49noninterested 125nonmember firms 195non-NMS 49nonqualified 135nonregulatory halt 261nonreporting issuers 360normal market hours 273normal trading times 223not held market order 229not held order 172notice filings 355NSCC 297NSMIA 140NYSE 223NYSE MKT 227NYSE Regulation, Inc. 3NYSE Rule 80B 232

O

OATS report 266OCC Disclosure Booklet 200odd lot 307offer to rescind 184Office of Foreign Assets Control (OFAC)

169office of supervisory jurisdiction (OSJ)

39, 41, 47


451Index

Office of the Whistleblower 65omnibus account 70, 189on the close orders (OC) 283on the record (OTR) 207open-end company 122open “fail” 248opening cross 250opening cross rules 282Options Clearing Corporation 200opt-out methods 182Order Audit Trail System (OATS) 235order entry firms 286order marking 244order ticket 319ORF 290, 383OTCBB 234OTCBB market maker 223OTCBB minimum quotation sizes 270OTC Bulletin Board 223OTC Equity Security 49, 356OTC Pink 234OTC Pink marketplace 270, 271OTC Reporting Facility (ORF) 297“out of system” transactions 286outside business activity 52overallotment option 389Over the Counter Bulletin Board

(OTCBB) 267

P

PAB accounts 116painting the tape 258panel composition 64parity 226parking 25partial delivery 307passive market maker 368, 369pattern day trader 83payable date 313payments for market making 239pegged orders 279penalty bid (PBID) 371penalty-free bid (SYND) 371penny stock 271person-in-charge 16piggybacking 271P indicator 238PIPE (Private Investment in Public

Equity) 378placement 194POD 71pooled investment vehicle 121portfolio margining 84power of substitution 309pre-borrow penalty 248precedence 226preemptive rights 311, 343preferenced orders 278prehearing conference 60preliminary prospectus 351

premembership interview (PMI) 5price improvement 254price/time priority model 243primary market maker 237primary offering 339primary residence of an associated person

45prime broker 71prime brokerage account 71principal cross-transactions 289principal executive officer 395principal trade 289principal underwriter 126priority 226private placement 375private placement memorandum 377Private Securities Litigation Reform Act

of 1995 353private securities transaction 51proceeds transaction 186proctor 26prompt payment 129Prospectus Act 337prospectus delivery requirement 356prospectus updating 125proxy statements 184public appearance 203, 208Public Disclosure Program 62publicly traded funds 388public offering price (POP) 128

Q

Qualified Block Positioner 224qualified financial institution (QFI) 342Qualified Institutional Buyer (QIB) 185,

383Qualified OTC Market Maker 223qualified securities 114Qualified Third Market Maker 224quantitative suitability 179quid pro quo allocations 364quiet periods 399

R

real estate investment trust (REIT) 133reallowance 345reasonable-basis obligation 179reclamation 312recommending purchases beyond the

customer’s ability to pay 188record date 313redeemable security 126redemptions 129red flag 195Red Flags Rule 182red herring 351reduced pricing prohibition 366registration and delivery instructions 69registration by coordination 355regular way 71

regular way settlement 303Regulation AC 402Regulation A offerings (small offerings)

372Regulation D offerings 374Regulation D offerings (private place-

ments) 372Regulation Fair Disclosure (Regulation

FD) 394Regulation M 238, 367Regulation M-A 396, 397Regulation M Rule 101 368Regulation M Rule 102 368Regulation M Rule 103 368Regulation M Rule 104 370Regulation M Rule 105 371Regulation NMS (National Market

System) 262Regulation S 378, 383Regulation S-AM 182Regulation SHO 238, 245Regulation S-K 353, 397Regulation S-P 176, 181, 182Regulation S transactions (offshore trans-

actions) 372Regulation S-X 353Regulation T 72regulatory element 25, 26reimbursement of expenses 390religious holidays 238repurchase agreements 57reserve requirement 114respondent 59, 63restricted persons 362restricted securities 380restrictions on supervisory personnel 47retail account 49retail communications 196retail investor 199Retail Liquidity Program 227reverse churning 71reverse convertible bonds 272reverse laundering 191reverse stock splits 232review of securities transactions for

insider trading 48right to demand delivery 311risk-based review 47risk-based reviews of correspondence and

communication 47risk-based reviews of transactions 47riskless and simultaneous transaction 242riskless principal transactions 289roll-up 68round-lot 307routing algorithms 236Rule 10b-13 385Rule 10b-21 80Rule 15c3-2 183Rule 15(g)2 272Rule 15(g)3 272


452 Index

Rule 15(g)4 272Rule 15(g)5 272Rule 15(g)6 272Rule 15(g)9 272Rule 22c-1 127Rule 134 357Rule 144 246, 380Rule 144A 297, 383Rule 144 stock 248Rule 145 transactions (corporate reclas-

sifications) 372Rule 147 offering 355Rule 147 offerings (intrastate offerings)

372, 374Rule 204 247Rule 415 339Rule 2111 161Rule 2330 136Rule 3110 45Russell 1000 indexes 234

S

S+1 247S+3 247, 248sales charge 127sales load 126same-day settlement 303sample breakpoint schedule 132sample CTR page 192Sample Form 3 393sample margin disclosure statement 166sample risk disclosure statement 164sample tombstone 358sample trading risk disclosure statement

168sanctions 60, 61Sarbanes-Oxley Act of 2002 395SAR filings 113Schedule 13-D 391Schedule 13-G 391Schedule I 105Schedule TO-I 385S corporation 351seasoned issuers 340, 360SEC Form S-1 350SEC Form S-3 340secondary offering 339SEC Regulation SHO 244SEC Rule 3a4-1 343SEC Rule 3a-51-1 271SEC Rule 10b-10 172, 173SEC Rule 10b-17 90SEC Rule 10b-18 90, 386SEC Rule 12b-1 128SEC Rule 15c2-4 342SEC Rule 15c2-11 268SEC Rule 15c3-3 114, 116SEC Rule 17a-3 111SEC Rule 17a-4 111, 116, 170SEC Rule 17a-11 109

SEC Rule 17f-1 110SEC Rule 17f-2 21SEC Rule 19h-1 8SEC Rule 35d-1 127SEC Rule 137 359SEC Rule 138 359SEC Rule 139 359SEC Rule 145 378SEC Rule 169 361SEC Rule 201 234SEC Rule 203 245SEC Rule 425 352SEC Rule 607 263SEC Rules 17a-3 116Section 19 130Section 21E 353Section 23 128Section 28(e) 133sector funds 124secured demand note agreement 101Securities Act of 1933 337Securities Acts Amendments of 1975

273Securities and Exchange Commission

(SEC) 3Securities Exchange Act of 1934 (SEA)

39, 338Securities Information Center (SIC) 110Securities Investor Protection Corpora-

tion (SIPC) 86, 87, 88security 337self-conferred degrees 40seller’s option 303selling away 51selling dividends 131selling group 344sellout 318sell stop order 230semiannual statement 108senior citizens 206separate account 126Series 4 15Series 6 13Series 7 13Series 9/10 16Series 11 13Series 14 16Series 16 16Series 22 13Series 24 15Series 26 15Series 27 15Series 51 16Series 53 16Series 55 14, 266Series 62 14Series 79 15Series 86/87 14Series 99 14settlement date 320sharing in customer accounts 57

shelf offering 121shelf registration (shelf offering) 340, 360short interest reporting 250Short Sale Monitor 235Short Sale-Related Circuit Breaker 234short swing profit 89Short Tender Rule 385signature required 179simplified arbitration 64single trade limit 296SIPs (securities information processors)

274six-month holding period 380six-year records 112slush funds 379SMA 83social media 180, 205Social Security number 175soft dollars 133S&P 500 234special liquidity providers (SLPs) 226Special Reserve Bank Account for the

Exclusive Benefit of Customers 114

spinning 363split offering 339spoofing 259stabilization 370stabilizing bid 370standby underwritings 343statements to customers 182state registration 164statute of limitations 65statutory disqualification (SD) 8statutory (or lead) underwriter 344step-out 294stickered 121stickering 357stock record 112stop loss order 229stop order 229strategy-based margin account 85structuring 193stub quotes 223, 237subordinated loans 101subpenny pricing 265suitability 387suitability information 179summary chart of yield and call disclo-

sures 173summary of settlement rules 303summary of the provisions of Rule 144

381summary of trade reporting rules 291summary orders 280summary quotes 280Super Caps 296supervising OSJ 56supervision of multiple OSJs by a single

principal 47supplemental FOCUS information 105


453Index

Supplemental Inventory Schedule (SIS) 105

supplemental liquidity provider (SLP) 227

suspended members 196suspension 61suspicious activity report (SAR) 193sweep account 183sweep orders 280syndicate manager 301syndicate settlement date 304

T

T+0 247T+1 173T1 Halt—news pending 260T2 Halt—news released 260T+3 247T3 Halt—Resumption times 260T5 Single stock trading pause in effect

260T+6 247T6 Halt—extraordinary market activity

260T7 Single stock trading pause/quotation

only period 260T8 Halt—exchange-traded fund (ETF)

261T12 Halt—additional information

requested by Nasdaq 261tail fee 389Tape A 274Tape B 274Tape C 274tax waivers 178telemarketing 210temporary subordinated loans 102temporary trading halts 301tender offer 385tentative net capital 98, 99termination of independent accountant

108terrorism 169testimonial 204, 208Third Market 273third-party account 171third-party research disclosures 401

three-year records 112threshold security 246, 249TIC account 178tie-in arrangement 366tier 1 368tier 2 368tier 3 368time in force (TIF) 232time stamp 276tippee 89tipper 89tombstone advertisements 357total day orders 279total good-till-canceled orders (GTX)

279total immediate-or-cancel orders (IOX)

279TRACE 298, 383TRACE-eligible securities 298trade acceptance and comparison 295trade blotter 319Trade Reporting and Compliance Engine

(TRACE) 69trade reporting facility (TRF) 233trade shredding 266trading ahead 251trading ahead of research reports 257trading along 257trading halt 259trading in mutual fund shares 188tranche 371transfer and hold in safekeeping 69transfer and ship 69transfer instruction form (TIF) 174TRAQS 299treble damages 92TRF 287, 288, 296trial balance 108trust indenture 121Trust Indenture Act of 1939 121two-sided quotation 237two-sided quote 228

U

undue concentration haircut 99unfair or unreasonable compensation 389Uniform Practice Code 311

Uniform Practice Committee 303Uniform Practice Rules 305Uniform Securities Act (USA) 184, 354unit investment trust 121unit trusts 122unseasoned issuers 360USA PATRIOT Act 169UTP Plan 274, 413

V

variable annuity 13, 95, 135variable annuity exchange 137verification of signatures 170voluntarily terminate 238voluntary delisting 226voluntary termination 287

W

waiting period 351wash sales 258web-based communication 205Web CRD 22Weblink ACT 3.0 235website 165well-known 340well-known seasoned issuers (WKSIs)

360Wells Notice 8Western account 344when-issued (WI) contract 305withdrawals of equity 119wrap fees 265written reports for firms engaging in

investment banking services 48written supervisory procedures 39, 42, 90

Y

yield chasing 206


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